UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended: March 31, 2009

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition from  _____  to  _____ 

Cortland Bancorp

(Exact name of registrant as specified in its charter)

Ohio		34-1451118
(State or other jurisdiction of Incorporation or organization)		(I.R.S. Employer Identification No.)
194 West Main Street, Cortland, Ohio		44410
(Address of principal executive offices)		(Zip code)

(330) 637-8040

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer and large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o		Accelerated filer þ		Non-accelerated filer o		Small reporting company þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

TITLE OF CLASS		SHARES OUTSTANDING
Common Stock, No Par Value		at May 6, 2009 4,525,556 Shares

 

 

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Cortland Bancorp and Subsidiaries:
Consolidated Balance Sheets — March 31, 2009 (unaudited) and December 31, 2008			2
Unaudited Consolidated Statements of Income — Three Months Ended March 31, 2009 and 2008			3
Unaudited Consolidated Statement of Changes in Shareholders’ Equity — Three months ended March 31, 2009 and 2008			4
Unaudited Consolidated Statements of Cash Flows — Three months ended March 31, 2009 and 2008			5
Unaudited Notes to Consolidated Financial Statements March 31, 2009			6 - 19
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Consolidated Average Balance Sheets, Yields And Rates — Year to Date March 31, 2009, December 31, 2008 and March 31, 2008			20
Selected Financial Data			21
Financial Review			22 - 37
Item 3. Quantitative and Qualitative Disclosures About Market Risk			38 - 39
Item 4. Controls and Procedures			40
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			41
Item 1A. Risk Factors			41
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			41
Item 3. Defaults Upon Senior Securities			41
Item 4. Submission of Matters to a Vote of Security Holders			41
Item 5. Other Information			41
Item 6. Exhibits			43
Signatures			50
Exhibit 31.1
Exhibit 31.2
Exhibit 32

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands, except share data)

		(Unaudited)
		MARCH 31,				DECEMBER 31,
		2009				2008
ASSETS
Cash and due from banks		$	6,358			$	8,394
Interest bearing deposits			46,291				18,449
Total cash and cash equivalents			52,649				26,843
Investment securities available for sale (Note 3)			110,097				121,348
Investment securities held to maturity (estimated fair value of $63,688 at March 31, 2009 and $71,210 at December 31, 2008) (Note 3)			62,778				70,406
Total loans (Note 4)			236,411				246,017
Less allowance for loan losses (Note 4)			(2,585	)			(2,470	)
Net loans			233,826				243,547
Premises and equipment			7,505				7,571
Bank owned life insurance			12,862				12,748
Other assets			13,683				10,902
Total assets		$	493,400			$	493,365
LIABILITIES
Noninterest-bearing deposits		$	56,717			$	58,635
Interest-bearing deposits			325,354				321,318
Total deposits			382,071				379,953
Federal Home Loan Bank advances			62,500				62,500
Other short term borrowings			6,112				5,648
Subordinated debt			5,155				5,155
Other liabilities			4,227				4,081
Total liabilities			460,065				457,337
SHAREHOLDERS’ EQUITY
Common stock — $5.00 stated value — authorized 20,000,000 shares; issued 4,728,267 in 2009 and 2008			23,641				23,641
Additional paid-in capital			20,850				21,078
Retained earnings			5,083				6,480
Accumulated other comprehensive loss			(12,646	)			(11,078	)
Treasury stock at cost, 202,630 at March 31, 2009 and 230,800 at December 31, 2008			(3,593	)			(4,093	)
Total shareholders’ equity			33,335				36,028
Total liabilities and shareholders’ equity		$	493,400			$	493,365

See accompanying notes to the unaudited consolidated financial statements
of Cortland Bancorp and Subsidiaries

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands, except per share data)

		THREE MONTHS ENDED
		MARCH 31,
		2009				2008
INTEREST INCOME
Interest and fees on loans		$	3,851			$	3,905
Interest and dividends on investment securities:
Taxable interest income			1,029				1,546
Nontaxable interest income			349				389
Dividends			40				44
Interest on mortgage-backed securities			1,192				1,103
Other interest income			20				79
Total interest income			6,481				7,066
INTEREST EXPENSE
Deposits			1,835				2,477
Borrowed funds			703				833
Subordinated debt			43				79
Total interest expense			2,581				3,389
Net interest income			3,900				3,677
Provision for loan losses			151				75
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES			3,749				3,602
OTHER INCOME
Fees for other customer services			537				554
Investment securities gains — net			87				73
IMPAIRMENT LOSSES ON INVESTMENT SECURITIES:
Impairment losses on investment securities			(10,312	)
Non credit-related losses on securities not expected to be sold recognized in other comprehensive income before tax			6,584
Net impairment losses on investment securities			(3,728	)			—
Gain on sale of loans — net			71				10
Other real estate (losses) gains — net			(14	)			51
Earnings on bank owned life insurance			135				134
Other non-interest income			84				49
Total other income			(2,828	)			871
OTHER EXPENSES
Salaries and employee benefits			1,838				1,787
Net occupancy and equipment expense			492				480
State and local taxes			105				139
FDIC expense			80				11
Bank exam and audit expense			108				115
Office supplies			99				94
Other operating expenses			558				531
Total other expenses			3,280				3,157
INCOME (LOSS) BEFORE FEDERAL INCOME TAXES			(2,359	)			1,316
Federal income tax expense (benefit)			(962	)			282
NET INCOME (LOSS)		$	(1,397	)		$	1,034
BASIC EARNINGS PER COMMON SHARE (NOTE 6)		$	(0.31	)		$	0.23
DILUTED EARNINGS PER COMMON SHARE (NOTE 6)		$	(0.31	)		$	0.23
CASH DIVIDENDS DECLARED PER SHARE		$				$	0.21

See accompanying notes to the unaudited consolidated financial statements
of Cortland Bancorp and Subsidiaries

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands)

														ACCUMULATED								TOTAL
						ADDITIONAL								OTHER								SHARE-
		COMMON				PAID-IN				RETAINED				COMPREHENSIVE				TREASURY				HOLDERS’
		STOCK				CAPITAL				EARNINGS				LOSS				STOCK				EQUITY
THREE MONTHS ENDED MARCH 31, 2008
BALANCE AT JANUARY 1, 2008		$	23,200			$	20,976			$	9,386			$	(94	)		$	(4,644	)		$	48,824
Cumulative effect of adjustment from adoption of of Emerging Issues Task Force issue 06-04											(539	)											(539	)
Balance after cummulative effect of adjustment			23,200				20,976				8,847				(94	)			(4,644	)			48,285
Comprehensive loss:
Net income											1,034												1,034
Other comprehensive loss, net of tax:
Unrealized losses on available- for-sale securities, net of reclassification adjustment															(1,591	)							(1,591	)
Total comprehensive loss																							(557	)
Common stock transactions:
Treasury shares reissued							(64	)											300				236
Treasury shares purchased																			(148	)			(148	)
Cash dividends declared											(967	)											(967	)
BALANCE AT MARCH 31, 2008		$	23,200			$	20,912			$	8,914			$	(1,685	)		$	(4,492	)		$	46,849
THREE MONTHS ENDED MARCH 31, 2009
BALANCE AT JANUARY 1, 2009		$	23,641			$	21,078			$	6,480			$	(11,078	)		$	(4,093	)		$	36,028
Comprehensive loss:
Net loss											(1,397	)											(1,397	)
Other comprehensive loss, net of tax:
Unrealized losses on available for-sale securities, net of reclassification adjustment															(2,435	)							(2,435	)
Other comprenhensive income (loss), related to securities for which other than temporary impairment has been recognized in earnings, net of tax															867								867
Total comprehensive loss																							(2,965	)
Common stock transactions:
Treasury shares reissued							(228	)											500				272
BALANCE AT MARCH 31, 2009		$	23,641			$	20,850			$	5,083			$	(12,646	)		$	(3,593	)		$	33,335

		MARCH 31,
		2009				2008
DISCLOSURE OF RECLASSIFICATION FOR AVAILABLE FOR SALE SECURITY GAINS AND LOSSES:
Net unrealized holding losses on available-for-sale securities arising during the period, net of tax		$	(3,971	)		$	(1,543	)
Less: Reclassification adjustment for net gains realized in net income, net of tax			(2,403	)			48
Net unrealized losses on available- for-sale securities, net of tax		$	(1,568	)		$	(1,591	)

See accompanying notes to the unaudited consolidated financial statements
of Cortland Bancorp and Subsidiaries

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands)

		FOR THE
		THREE MONTHS ENDED
		MARCH 31,
		2009				2008
NET CASH FLOWS FROM OPERATING ACTIVITIES		$	798			$	777
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities available for sale			(137	)			(6,912	)
Purchases of securities held to maturity							(20,857	)
Proceeds from call, maturity and principal payments on securities			12,989				38,569
Net decrease ( increase) in loans made to customers			9,402				(3,282	)
Proceeds from disposition of other real estate							190
Purchases of premises and equipment			(100	)			(484	)
Net cash flows from investing activities			22,154				7,224
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in deposit accounts			2,118				(5,485	)
Proceeds from Federal Home Loan Bank advances							4,000
Pay down of Federal Home Loan Bank borrowings
Net increase (decrease) in short term borrowings			464				(1,453	)
Dividends paid							(967	)
Purchases of treasury stock							(148	)
Treasury shares reissued			272				236
Net cash flows from financing activities			2,854				(3,817	)
NET CHANGE IN CASH AND CASH EQUIVALENTS			25,806				4,184
CASH AND CASH EQUIVALENTS
Beginning of period			26,843				9,441
End of period		$	52,649			$	13,625
SUPPLEMENTAL DISCLOSURES
Interest paid		$	2,626			$	3,426
Income taxes paid		$				$

See accompanying notes to the unaudited consolidated financial statements
of Cortland Bancorp and Subsidiaries

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

1.) Basis of Presentation:

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S.GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2009 are not necessarily indicative of the results that may be expected for the year ending December 31, 2009. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2008, included in our Form 10-K for the year ended December 31, 2008, filed with the United States Securities and Exchange Commission. The accompanying consolidated balance sheet at December 31, 2008, has been derived from the audited consolidated balance sheet but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

2.) Reclassifications:

Certain items contained in the 2008 financial statements have been reclassified to conform to the presentation for 2009. Such reclassifications had no effect on the net results of operations.

3.) Investment Securities:

Securities classified as held to maturity are those that management has the positive intent and ability to hold to maturity. Securities held to maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts, with such amortization or accretion included in interest income.

Securities classified as available for sale are those that could be sold for liquidity, investment management, or similar reasons even though management has no present intentions to do so. Securities available for sale are carried at fair value using the specific identification method. Changes in the unrealized gains and losses on available for sale securities are recorded net of tax effect as a component of comprehensive income.

Trading securities are principally held with the intention of selling in the near term. Trading securities are carried at fair value with changes in fair value reported in the Consolidated Statements of Income (unaudited).

Securities are evaluated periodically to determine whether a decline in their value is other-than-temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other-than-temporary. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospect for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

Realized gains or losses on dispositions are based on net proceeds and the adjusted carrying amount of securities sold, or called using the specific identification method. The table below sets forth the proceeds and gains or losses realized on securities sold or called for the period ended:

		Three Months
		March 31,
		2009				2008
Proceeds on securities sold		None				None
Gross realized gains		None				None
Gross realized losses		None				None
Proceeds on securities called		$	7,804			$	25,411
Gross realized gains			87				73
Gross realized losses		None				None

Securities available for sale, carried at fair value, totaled $110,097 at March 31, 2009 and $121,348 at December 31, 2008 representing 63.69% and 63.28%, respectively, of all investment securities. These levels provide an adequate level of liquidity in management’s opinion.

Investment securities with a carrying value of approximately $107,059 at March 31, 2009 and $104,162 at December 31, 2008 were pledged to secure deposits and for other purposes.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The amortized cost and estimated fair value of debt securities at March 31, 2009, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.

		AMORTIZED				ESTIMATED
		COST				FAIR VALUE
Investment securities available for sale
Due in one year or less		$	1,000			$	1,003
Due after one year through five years			4,141				4,261
Due after five years through ten years			2,387				2,506
Due after ten years			42,188				19,994
			49,716				27,764
Mortgage-backed securities			75,792				78,584
Total		$	125,508			$	106,348

		AMORTIZED				ESTIMATED
		COST				FAIR VALUE
Investment securities held to maturity
Due in one year or less		$	18,358			$	18,444
Due after one year through five years			2,838				2,928
Due after five years through ten years			8,828				8,974
Due after ten years			18,880				19,601
			48,904				49,947
Mortgage-backed securities			13,874				13,741
Total		$	62,778			$	63,688

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The amortized cost and estimated fair value of investment securities available for sale and investment securities held to maturity as of March 31, 2009, are as follows:

						GROSS				GROSS				ESTIMATED
		AMORTIZED				UNREALIZED				UNREALIZED				FAIR
		COST				GAINS				LOSSES				VALUE
Investment securities available for sale
U.S. Government agencies and corporations		$	10,336			$	563			$				$	10,899
Obligations of states and political subdivisions			7,283				313				45				7,551
Mortgage-backed and related securities			75,792				2,853				61				78,584
Trust preferred pools/collateralized debt obligations			30,995								22,783				8,212
Corporate securities			1,102												1,102
Total debt securities			125,508				3,729				22,889				106,348
Other securities			3,749												3,749
Total available for sale		$	129,257			$	3,729			$	22,889			$	110,097

						GROSS				GROSS				ESTIMATED
		AMORTIZED				UNREALIZED				UNREALIZED				FAIR
		COST				GAINS				LOSSES				VALUE
Investment securities held to maturity
U.S. Treasury Securities		$	133			$	18			$				$	151
U.S. Government agencies and corporations			27,413				358								27,771
Obligations of states and political subdivisions			21,358				713				46				22,025
Mortgage-backed and related securities			13,874				346				479				13,741
Total held to maturity		$	62,778			$	1,435			$	525			$	63,688

The following provides a summary of the amortized cost and estimated fair value of investment securities available for sale and investment securities held to maturity as of December 31, 2008:

						GROSS				GROSS				ESTIMATED
		AMORTIZED				UNREALIZED				UNREALIZED				FAIR
		COST				GAINS				LOSSES				VALUE
Investment securities available for sale
U.S. Government agencies and corporations		$	11,314			$	561			$				$	11,875
Obligations of states and political subdivisions			7,293				289				84				7,498
Mortgage-backed and related securities			80,073				2,067				162				81,978
Trust preferred pools/collateralized debt obligations			34,600				6				19,460				15,146
Corporate securities			1,102												1,102
Total debt securities			134,382				2,923				19,706				117,599
Other securities			3,749												3,749
Total available for sale		$	138,131			$	2,923			$	19,706			$	121,348

						GROSS				GROSS				ESTIMATED
		AMORTIZED				UNREALIZED				UNREALIZED				FAIR
		COST				GAINS				LOSSES				VALUE
Investment securities held to maturity
U.S. Treasury Securities		$	134			$	18			$				$	152
U.S. Government agencies and corporations			32,894				407				50				33,251
Obligations of states and political subdivisions			22,626				726				49				23,303
Mortgage-backed and related securities			14,752				265				513				14,504
Total held to maturity		$	70,406			$	1,416			$	612			$	71,210

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The following is a summary of the fair value of securities with unrealized losses and an aging of those unrealized losses at March 31, 2009:

		Less than 12 months								12 months or longer								Total
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
Obligations of states and political subdivisions		$	2,109			$	64			$	841			$	27			$	2,950			$	91
Mortgage-backed and related securities			431				13				3,987				527				4,418				540
Trust preferred pools/collateralized debt obligations			898				350				7,314				22,433				8,212				22,783
Total		$	3,438			$	427			$	12,142			$	22,987			$	15,580			$	23,414

The above table represents 79 investment securities where the current value is less than the related amortized cost.

The following is a summary of the fair value of securities with unrealized losses and an aging of those unrealized losses at December 31, 2008:

		Less than 12 months								12 months or longer								Total
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
U.S. Government agencies and corporations.		$	3,947			$	50			$				$				$	3,947			$	50
Obligations of states and political subdivisions			2,906				105				370				28				3,276				133
Mortgage-backed and related securities			7,046				526				12,098				149				19,144				675
Trust preferred pools/collateralized debt obligations			2,737				1,944				12,199				17,516				14,936				19,460
Total		$	16,636			$	2,625			$	24,667			$	17,693			$	41,303			$	20,318

The above table represents 135 investment securities where the current value is less than the related amortized cost.

The Company reviews investment debt securities on an ongoing basis for the presence of other than temporary impairment (OTTI) with formal reviews performed quarterly. OTTI losses on individual investment securities were recognized during the first quarter 2009 according to FSP FAS 115-2 and FAS 124-2 issued by the FASB on April 9, 2009. This new guidance requires that credit-related OTTI be recognized in earnings while noncredit-related OTTI on securities not expected to be sold is recognized in other comprehensive income (loss) (OCI). The credit-related OTTI recognized in earnings during the first quarter 2009 related to securities newly deemed other than temporarily impaired. The credit-related OTTI recognized during the first quarter 2009 was $3.7 million and was solely related to available-for-sale securities newly having a book value of $11.5 million. Noncredit-related OTTI on these securities, which are not expected to be sold, was $6.6 million and was recognized in OCI during the first quarter 2009.

The unrealized losses on the Company’s investment in U.S. Government agencies and corporations, obligations, of states and political subdivisions, and mortgage-backed and related securities were caused by changes in market rates and related spreads, as well as reflecting current distressed conditions in the credit markets and the market’s on-going reassessment of appropriate liquidity and risk premiums. It is expected that the securities would not be settled at a price less than the amortized cost of the Company’s investment because the decline in market value is attributable to changes in interest rates and relative spreads and not credit quality, and because the Company does not intend to sell those investments and it is not more likely than not that the Company will be required to sell the investments before recovery of its amortized cost basis less any current-period credit loss. The Company does not consider those investments to be other-than-temporarily impaired at March 31, 2009.

The unrealized loss on investments in corporate securities relates to Collateralized Debt Obligations, (CDO’S), representing pools of trust preferred debt primarily issued by bank holding companies and insurance companies. The net unrealized loss on these securities at March 31, 2009 was $22,783 as compared to a $19,454 loss at December 31, 2008. At March 31, 2009, the Company recognized $3,728 of other-than-temporary losses attributable to six CDO’s with a cost basis of $11,539. The impairment charges were recognized after determining the likely future cash flows of these securities had been adversely impacted from the previous quarter.

During September 2008, the U.S. government placed mortgage finance companies Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC), under conservatorship, giving management control to their regulator, the Federal Housing Finance Agency, or FHFA, and providing both companies with access to credit from the U.S. Treasury. Debt obligations now provide an explicit guarantee of the full faith and credit of the United States government to existing and future debt holders of Fannie Mae and Freddie Mac limited to the period under which they are under conservatorship.

In response to the takeover, the Federal Deposit Insurance Corporation tentatively approved a rule, proposed by all four federal bank regulators, that eases capital requirements for federally insured depository institutions that hold FNMA and FHLMC corporate debt, subordinated debt, mortgage guarantees and derivatives.

Adversely affected by these actions were the value of the common stock and preferred stock of both FNMA and FHLMC. Neither the Company nor its bank subsidiary owned any common or preferred shares of either FNMA or FHLMC.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

4.) Concentration of Credit Risk and Off Balance Sheet Risk:

The Company currently does not enter into derivative financial instruments including futures, forwards, interest rate risk swaps, option contracts, or other financial instruments with similar characteristics. The Company also does not participate in any partnerships that might give rise to off-balance sheet liabilities.

The Company, through its subsidiary bank, is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and financial guarantees. Such instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

In the event of nonperformance by the other party, the Company’s exposure to credit loss on these financial instruments is represented by the contract or notional amount of the instrument. The Company uses the same credit policies in making commitments and conditional obligations as it does for instruments recorded on the balance sheet. The amount and nature of collateral obtained, if any, is based on management’s credit evaluation.

		CONTRACT OR
		NOTIONAL AMOUNT
		March 31,				December 31,
		2009				2008
Financial instruments whose contract amount represents credit risk:
Commitments to extend credit:
Fixed rate		$	1,809			$	1,301
Variable			33,176				35,699
Standby letters of credit			873				850

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Generally these financial arrangements have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit are conditional commitments issued by the Company’s subsidiary bank to guarantee the performance of a customer to a third party. Since many of these commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment and income producing commercial properties.

The Company’s subsidiary bank also offers limited overdraft protection as a non-contractual courtesy which is available to demand deposit accounts in good standing for business, personal or household use. The Company reserves the right to discontinue this service without prior notice. The available amount of overdraft protection on depositors’ accounts not included in the table above at March 31, 2009 totaled $11,625 and $11,536 at December 31, 2008. The total average daily balance of overdrafts used in 2009 was $130 and $161 in 2008, or approximately 1.1% of the total aggregate overdraft protection available to depositors at March 31, 2009 and 1.4% at December 31, 2008.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The Company, through its subsidiary bank, grants residential, consumer and commercial loans, and also offers a variety of saving plans to customers located primarily in Northeast Ohio and Western Pennsylvania. The following represents the composition of the loan portfolio:

		March 31,				December 31,
		2009				2008
1-4 family residential mortgages			28.0	%			28.1	%
Commercial mortgages			55.4	%			52.3	%
Consumer loans			3.4	%			3.3	%
Commercial loans			7.8	%			11.3	%
Home equity loans			5.4	%			5.0	%

There are $418 in mortgage loans held for sale included in 1-4 family residential mortgages as of March 31, 2009, and $236 at December 31, 2008. These loans are carried, in the aggregate, at the lower of cost or estimated market value based on secondary market prices.

The following table sets forth the aggregate balance of underperforming loans for each of the following categories at March 31, 2009 and December 31, 2008:

		March 31,				December 31,
		2009				2008
Loans accounted for on a non-accrual basis		$	693			$	858
Loans contractually past due 90 days or more as to interest or principal payments (not included in non-accrual loans above)		NONE				NONE
Loans considered troubled debt restructurings (not included in non-accrual loans or loans contractually past due above)			412				432

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The following shows the amounts of contractual interest income and interest income actually reflected in income on loans accounted for on a non-accrual basis and loans considered troubled debt restructuring for the three months ended March 31, 2009 and 2008.

		March 31,				March 31,
		2009				2008
Gross interest income that would have been recorded if the loans had been current in accordance with their original terms (contractual interest income)		$	23			$	52
Interest income actually included in income on the loans			9				5

A loan is placed on a non-accrual basis whenever sufficient information is received to question the collectibility of the loan or any time legal proceedings are initiated involving a loan. When a loan is placed on non-accrual status, any interest that has been accrued and not collected on the loan is charged against earnings. Cash payments received while a loan is classified as non-accrual are recorded as a reduction to principal or reported as interest income according to management’s judgment as to collectibility of principal.

A loan is returned to accrual status when either all of the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, collectible, or when it otherwise becomes well secured and in the process of collection. When a loan is charged-off, any interest accrued but not collected on the loan is charged against earnings.

Loans are considered impaired when, based on current information and events, it is probable the Company will be unable to collect all amounts due in accordance with the original contractual terms of the loan agreement, including scheduled principal and interest payments. If a loan is impaired, a specific valuation allowance is allocated, if necessary. Impaired loans are generally included in non-accrual loans. Management does not individually evaluate certain smaller balance loans for impairment as such loans are evaluated on an aggregate basis. These loans include 1 — 4 family, consumer and home equity loans. Impaired loans were evaluated using the fair value of collateral as the measurement method. Impaired loans, or portions thereof, are charged off when deemed uncollectible.

Impaired loans were as follows:

		March 31,				December 31,
		2009				2008
Balance of impaired loans with no allocated allowance		$	937			$	483
Balance of impaired loans with an allocated allowance			636				441
Total recorded investment in impaired loans		$	1,573			$	924
Amount of the allowance allocated to impaired loans		$	341			$	262
Average balance of impaired loans		$	1,064			$	1,489

The impaired loans included in the table above were primarily comprised of collateral dependent commercial loans. Interest income recognized on these loans subsequent to their classification as impaired was $7 for the three months ended March 31, 2009 and $37 for the twelve months ended December 31, 2008.

Loans in the amount of $25,532 as of March 31, 2009, and $27,499 as of December 31, 2008 were not included in any of the above categories and were not currently considered impaired, but which can be considered to be potential problem loans.

Any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed above either do not (i) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (ii) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The following is an analysis of the allowance for loan losses for the periods ended March 31, 2009 and March 31, 2008:

		THREE MONTHS
		2009				2008
Balance at beginning of period		$	2,470			$	1,621
Loan charge-offs:
1 — 4 family residential mortgages			7				140
Commercial mortgages			—				31
Consumer loans and other loans			57				56
Commercial loans			2				1
Home equity loans			—				17
			66				245
Recoveries on previous loan losses
1 — 4 family residential mortgages			—				—
Commercial mortgages			1				1
Consumer loans and other loans			29				34
Commercial loans			—				—
Home equity loans			—				—
			30				35
Net charge-offs			(36	)			(210	)
Provision charged to operations			151				75
Balance at end of period		$	2,585			$	1,486
Ratio of annualized net charge-offs to average loans outstanding			0.06	%			0.38	%

For each of the periods presented above, the provision for loan losses charged to operations is based on management’s judgment after taking into consideration all known factors connected with the collectibility of the existing portfolio. Management evaluates the portfolio in light of economic conditions, changes in the nature and volume of the portfolio, industry standards and other relevant factors. Specific factors considered by management in determining the amounts charged to operations include previous loan loss experience; the status of past due interest and principal payments; the quality of financial information supplied by customers; the cash flow coverage and trends evidenced by financial information supplied by customers; the nature and estimated value of any collateral supporting specific loan credits; risk classifications determined by the Company’s loan review systems or as the result of the regulatory examination process; and general economic conditions in the lending area of the Company’s bank subsidiary. Key risk factors and assumptions are systematically updated to reflect actual experience and changing circumstances.

The Company maintains an allowance for losses on unfunded commercial lending commitments to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses. This allowance is reported as a liability on the balance sheet within accrued expenses and other liabilities, while the corresponding provision for these losses is recorded as a component of other expense.

Certain asset-specific loans are evaluated individually for impairment, based on management’s best estimate of discounted cash repayments and the anticipated proceeds from liquidating collateral. The actual timing and amount of repayments and the ultimate realizable value of the collateral may differ from management’s estimates.

The expected loss for certain other commercial credits utilizes internal risk ratings. These loss estimates are sensitive to changes in the customer’s risk profile, the realizable value of collateral, other risk factors and the related loss experience of other credits of similar risk. Consumer credits generally employ statistical loss factors, adjusted for other risk indicators, applied to pools of similar loans stratified by asset type. These loss estimates are sensitive to changes in delinquency status and shifts in the aggregate risk profile.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

5.) Legal Proceedings:

The Bank is involved in legal actions arising in the ordinary course of business. In the opinion of management, the outcomes from these matters, either individually or in the aggregate, are not expected to have any material effect on the Company.

6.) Earnings Per Share and Capital Transactions:

The following table sets forth the computation of basic earnings per common share and diluted earnings per common share. Basic earnings per share is computed by dividing net income by the weighted average number of shares outstanding during the applicable period.

		Three Months Ended
		March 31,
		2009				2008
Net Income (loss)		$	(1,397	)		$	1,034
Weighted average common shares outstanding*			4,525,326				4,489,630
Basic earnings per share*		$	(0.31	)		$	0.23
Diluted earnings per share*		$	(0.31	)		$	0.23
Dividends declared per share*		$	0.00			$	0.21

7.) Stock Repurchase Program

On February 27, 2007, the Company’s Board of Directors approved a Stock Repurchase Program which permitted the Company to repurchase up to 100,000 shares of its outstanding common shares in the over-the-counter market or in privately negotiated transactions in accordance with applicable regulations of the Securities and Exchange Commission. Based on the value of the Company’s stock on February 27, 2007, the commitment to repurchase the stock over the program was approximately $1,715.

On August 14, 2007, the Company’s Board of Directors authorized the repurchase of up to an additional 100,000 shares of its outstanding common shares in over-the-counter market or in privately negotiated transactions. Based on the value of the Company’s stock on August 14, 2007, the commitment to repurchase these additional shares over the program was approximately $1,635.

On November 27, 2007, the Company’s Board of Directors increased to 300,000 shares the size of its current stock buyback program by authorizing the repurchase of up to an additional 100,000 shares of its outstanding common shares in the over-the-counter market or in privately negotiated transactions. Based on the value of the Company’s stock on November 27, 2007, the commitment to repurchase these additional shares over the program was approximately $1,375.

The repurchase program terminated on February 28, 2009. Repurchased shares are designated as treasury shares, available for general corporate purposes, including possible use in connection with the Company’s dividend reinvestment program, employee benefit plans, acquisitions or other distributions. Under the program the Company repurchased 205,986 shares in 2007, 51,817 shares in 2008 and none in 2009. The Company reissued 28,170 shares to existing shareholders through its dividend reinvestment program during 2009, net of repurchased fractional shares.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

8.) Subordinated Debt

In July 2007 a trust formed by the Company issued $5,000 of floating rate trust preferred securities as part of a pooled offering of such securities due December 2037. The Bancorp owns all $155 of the common securities related to this trust. The Company issued subordinated debentures to the trust at an interest rate that floats quarterly at the 3-month Libor rate plus 1.45% in exchange for the proceeds of the trust preferred offering. The debentures constitute the assets of this trust. The Company may redeem the subordinated debentures, in whole or in part, at a premium declining ratably to par in September 2012.

In accordance with FASB Interpretation No.46, as revised in December 2003, the trust is not consolidated with the Company’s financial statements. Accordingly, the Company does not report the securities issued by the trust as liabilities, but instead reports as liabilities the subordinated debentures issued by the Company and held by the trust. The subordinated debentures qualify as Tier 1 capital for regulatory purposes in determining and evaluating the Company’s capital adequacy.

9.) Fair Value Measurements (SFAS No. 157)

Effective January 1, 2008, the Company adopted the provisions of FAS No. 157, Fair Value Measurements, for financial assets and financial liabilities. FAS No. 157 provides enhanced guidance for using fair value to measure assets and liabilities. The standard applies whenever other standards require or permit assets or liabilities to be measured at fair value. The standard does not expand the use of fair value in any new circumstances. The FASB issued Staff Position No. 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13, which removed leasing transactions accounted for under FAS No. 13 and related guidance from the scope of FAS No. 157. On April 9, 2009, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. 157-4 (“FSP 157-4”), “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly”, which the Company elected to early adopt this FSP and the results have been applied on the financial statements and disclosures herein, without a material impact on the consolidated financial statements. FSP 157-4 provides guidance for determining fair value if there has been a significant decrease in the volume and level of activity for an asset or liability in relation to normal market activity. In that circumstance, transactions or quoted prices may not be determinative of fair value. Significant adjustments may be necessary to quoted prices or alternative valuation techniques may be required in order to determine the fair value of the asset or liability under current market conditions. The adoption of FSP 157-4 resulted in the use of valuation techniques other than quoted prices for the valuation of the Company’s collateralized debt obligations.

FAS No. 157 establishes a hierarchal disclosure framework associated with the level of pricing observability utilized in measuring assets and liabilities at fair value. The three broad levels defined by FAS No. 157 hierarchy are as follows:

Level 1: Quoted prices are available in active markets for identical assets or liabilities as of the reported date.

Level 2: Pricing inputs are other than quoted prices in active markets, which are either directly or indirectly observable as of the reported date. The nature of these assets and liabilities include items for which quoted prices are available but which trade less frequently, and items that are fair valued using other financial instruments, the parameters of which can be directly observed.

Level 3: Assets and liabilities that have little to no pricing observability as of the reported date. These items do not have two-way markets and are measured using management’s best estimate of fair value, where inputs into the determination of fair value require significant management judgment or estimation.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The following tables presents the assets reported on the consolidated statements of financial condition at their fair value as of March 31, 2009 and December 31, 2008 by level within the fair value hierarchy. As required by SFAS No. 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Fair Value Measurements at 3/31/09 Using

Quoted Prices in

Active Markets for

Significant Other

Significant

Identical Assets

Observable Inputs

Unobservable Inputs

Description

03/31/09

(Level 1)

(Level 2)

(Level 3)

Available for Sale Securities

$

106,348

None

$

97,034

$

9,314

Fair Value Measurements at 12/31/08 Using

Quoted Prices in

Active Markets for

Significant Other

Significant

Identical Assets

Observable Inputs

Unobservable Inputs

Description

12/31/08

(Level 1)

(Level 2)

(Level 3)

Available for Sale Securities

$

117,599

None

$

101,351

$

16,248

The following table presents the changes in the Level 3 fair-value category for the three months ended March 31, 2009. The Company classifies financial instruments in Level 3 of the fair-value hierarchy when there is reliance on at least one significant unobservable input to the valuation model. In addition to these unobservable inputs, the valuation models for Level 3 financial instruments typically also rely on a number of inputs that are readily observable either directly or indirectly.

																										Net unrealized
																										losses
						Net realized/																				Included in net
						Unrealized gains/																				income for the
						(losses) included in								Transfers				Purchases								period relating
										Other				in and/or				issuances								to assets held at
		January 1,				Noninterest				Comprehensive				out of				and				March 31,				March 31,
		2009				Income				Income				Level 3				settlements				2009				2009
Assets
Securities Available for sale		$	16,248			$	(3,728	)		$	(3,206	)		$				$				$	9,314			$	(3,728	)

On September 30, 2008, the Company changed its valuation technique for pooled trust preferred holdings available-for-sale. Previously, the Company relied on prices compiled by third party vendors using observable market data (Level 2) to determine the values of these securities. However, SFAS 157 assumes that fair values of financial assets are determined in an orderly transaction and not a forced liquidation or distressed sale at the measurement date. Based on financial market conditions at September 30, 2008, the Company concluded that the fair values obtained from third party vendors reflected forced liquidation or distressed sales for these trust preferred securities. Therefore, the Company estimated fair value based on a discounted cash flow methodology using appropriately adjusted discount rates reflecting nonperformance and liquidity risks. The change in the valuation technique for these trust preferred securities resulted in a transfer of these securities into Level 3 financial assets.

The Company conducts other-than-temporary impairment analysis on a quarterly basis. The initial indication of other-than-temporary impairment for both debt and equity securities is a decline in the market value below the amount recorded for an investment. A decline in value that is considered to be other-than-temporary is recorded as a loss within non-interest income in the consolidated statement of income. In determining whether an impairment is other than temporary, the Company considers a number of factors, including, but not limited to, the length of time and extent to which the market value has been less than cost, recent events specific to the issuer, including investment downgrades by rating agencies and economic conditions of its industry, and the Company’s intent and ability to retain the security for a period of time sufficient to allow for a recovery in market value or maturity. Among the factors that are considered in determining the Company’s intent and ability is a review of its capital adequacy, interest rate risk position and liquidity.

The Company also considers the issuer’s financial condition, capital strength and near-term prospects. In addition, for debt securities the Company considers the cause of the price decline (general level of interest rates and industry- and issuer-specific factors), current ability to make future payments in a timely manner and the issuer’s ability to service debt. The assessment of a security’s ability to recover any decline in market value, the ability of the issuer to meet contractual obligations and the Company’s intent and ability to retain the security require considerable judgment.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

Certain of the corporate debt securities are accounted for under EITF 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests that Continue to Be Held by a Transferor in Securitized Financial Assets.” For investments within the scope of EITF 99-20 at acquisition, the Company evaluates current available information in estimating the future cash flows of these securities and determines whether there have been favorable or adverse changes in estimated cash flows from the cash flows previously projected. The Company considers the structure and term of the pool and the financial condition of the underlying issuers. Specifically, the evaluation incorporates factors such as interest rates and appropriate risk premiums, the timing and amount of interest and principal payments and the allocation of payments to the various note classes. Current estimates of cash flows are based on the most recent trustee reports, announcements of deferrals or defaults, expected future default rates and other relevant market information.

The Company owns 32 collateralized debt obligation securities (CDO) totaling $35,110 (par value) that are backed by trust preferred securities issued by banks, thrifts, insurance companies and real estate investment trusts. These securities were all rated investment grade at inception. During the second half of 2008 and the first quarter of 2009, factors outside the Company’s control impacted the fair value of these securities and will likely continue to do so for the foreseeable future. These factors include but are not limited to: guidance on fair value accounting, issuer credit deterioration, issuer deferral and default rates, potential failure or government seizure of underlying financial institutions or insurance companies, ratings agency actions, regulatory actions. As a result of changes in these and various other factors during the first quarter 2009, Moody’s Investors Service, Fitch Ratings and Standards and Poors downgraded multiple CDO securities, including securities held by the Company. Thirty-one of the CDO securities held by the Company are now considered to be below investment grade, with one security still rated investment grade. The deteriorating economic, credit and financial conditions experienced in 2008 and 2009 have resulted in illiquid and inactive financial markets and severely depressed prices for these securities. The Company analyzed the cash flow characteristics of these securities within the scope of EITF 99-20. The Company determined that for 26 of these securities, it does not intend to sell the securities and it is not more likely than not that the Company will be required to sell the securities before recovery of its amortized cost basis. It was determined that there was no adverse change in the cash flows for these 26 securities. The Company does not consider the investment in these assets to be other-than-temporarily impaired at March 31, 2009. However, there is a risk that subsequent evaluations could result in recognition of other-than-temporary impairment charges in the future. Upon completion of the March 31, 2009 analysis, our model indicated other-than-temporary impairment on the remaining six securities, all of which experienced additional defaults or deferrals during the period. These six securities had other-than-temporary impairment losses of $10.3 million, of which $3.7 million was recorded as expense and $6.6 million was recorded in other comprehensive income. These six securities remained classified as available for sale at March 31, 2009, and together, the 32 securities subjected to EITF 99-20 accounted for $22.8 million of the unrealized loss in the trust preferred pools/collateralized debt obligations category at March 31, 2009.

The following table details the six debt securities with other-than-temporary impairment, their credit ratings at March 31, 2009 and the related losses recognized in earnings:

																		Alesco Preferred
		PreTSL II								PreTSL								Funding VIII				Tropic CDO V
		Mezzanine				PreTSL				XVI D				PreTSL				Class E Notes 1				Class B-1L
		Moody’s				VIII B-3				Fitch				XVI D				Moody’s				Moody’s
		Rated Ca				Rated Ca				Rated C				Rated C				Rated Ca				Rated Ca				Total
Amount of Other-Than Temporary Impairment Related to credit loss at January 1, 2009		$	—			$	—			$	—			$	—			$	—			$	—			$	—
Addition			53				88				37				72				293				3,185				3,728
Amount of Other-Than- Temporary Impairment Related to credit loss at March 31, 2009		$	53			$	88			$	37			$	72			$	293			$	3,185			$	3,728