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, 2010

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

Commission file number: 0-13814

Cortland Bancorp

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

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 o		Non-accelerated filer o		Small reporting company þ
		(Do not check if a smaller reporting company)

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 14, 2010 4,525,545 Shares

 

 

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Cortland Bancorp and Subsidiaries:
Consolidated Balance Sheets — March 31, 2010 (unaudited) and December 31, 2009			2
Consolidated Statements of Income — (unaudited) Three Months ended March 31, 2010 and 2009			3
Consolidated Statements of Changes in Shareholders’ Equity — (unaudited) Three months ended March 31, 2010 and 2009			4
Consolidated Statements of Cash Flows — (unaudited) Three months ended March 31, 2010 and 2009			5
Notes to Consolidated Financial Statements (unaudited) March 31, 2010			6 - 23
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, 2010, December 31, 2009 and March 31, 2009			24
Selected Financial Data			25
Financial Review			26 - 40
Item 3. Quantitative and Qualitative Disclosures About Market Risk			41 - 42
Item 4. Controls and Procedures			43
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			44
Item 1A. Risk Factors			44
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			44
Item 3. Defaults Upon Senior Securities			44
Item 4. (Removed and Reserved)			44
Item 5. Other Information			44
Item 6. Exhibits			45
Signatures			51
Exhibit 10.20.1
Exhibit 10.21.1
Exhibit 10.22.1
Exhibit 10.27.1
Exhibit 10.28.1
Exhibit 10.29.1
Exhibit 10.32.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share data)

		(Unaudited)
		MARCH 31,				DECEMBER 31,
		2010				2009
ASSETS
Cash and due from banks		$	6,901			$	8,212
Interest bearing deposits			22,427				36,611
Total cash and cash equivalents			29,328				44,823
Investment securities available for sale (Note 3)			157,537				141,273
Investment securities held to maturity (estimated fair value of $30,491 at March 31, 2010 and $31,490 at December 31, 2009 ) (Note 3)			29,635				30,651
Total loans (Note 4)			237,137				248,248
Less allowance for loan losses (Note 4)			(2,447	)			(2,437	)
Net loans			234,690				245,811
Premises and equipment			6,986				7,127
Bank owned life insurance			13,322				13,211
Other assets			14,418				14,403
Total assets		$	485,916			$	497,299
LIABILITIES
Noninterest-bearing deposits		$	57,302			$	60,173
Interest-bearing deposits			317,985				327,322
Total deposits			375,287				387,495
Federal Home Loan Bank advances			51,500				56,500
Other short term borrowings			7,119				6,866
Subordinated debt			5,155				5,155
Other liabilities			8,123				4,375
Total liabilities			447,184				460,391
SHAREHOLDERS’ EQUITY
Common stock — $5.00 stated value — authorized 20,000,000 shares; issued 4,728,267 in 2010 and 2009; outstanding shares 4,525,545 in 2010 and 4,525,551 in 2009			23,641				23,641
Additional paid-in capital			20,850				20,850
Retained earnings			1,036				142
Accumulated other comprehensive loss			(3,201	)			(4,131	)
Treasury stock at cost, 202,722 at March 31, 2010 and 202,716 at December 31, 2009			(3,594	)			(3,594	)
Total shareholders’ equity			38,732				36,908
Total liabilities and shareholders’ equity		$	485,916			$	497,299

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

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(Amounts in thousands, except per share data)

		THREE
		MONTHS ENDED
		MARCH 31,
		2010				2009
INTEREST INCOME
Interest and fees on loans		$	3,679			$	3,851
Interest and dividends on investment securities:
Taxable interest income			1,486				2,160
Nontaxable interest income			321				349
Dividends			40				40
Other interest income			23				20
Total interest income			5,549				6,420
INTEREST EXPENSE
Deposits			1,116				1,835
Borrowed funds			622				703
Subordinated debt			22				43
Total interest expense			1,760				2,581
Net interest income			3,789				3,839
PROVISION FOR LOAN LOSSES			175				151
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES			3,614				3,688
OTHER INCOME
Fees for other customer services			545				537
Investment securities gains — net							87
Impairment losses on investment securities:
Impairment losses on investment securities			(275	)			(10,251	)
Non credit-related (gains) losses on securities not expected to be sold (recognized in other comprehensive income before tax)			(269	)			6,584
Net impairment losses on investment securities			(544	)			(3,667	)
Gain on sale of loans — net			4				71
Other real estate losses — net			(4	)			(14	)
Earnings on bank owned life insurance			136				135
Other non-interest income			27				84
Total other income			164				(2,767	)
OTHER EXPENSES
Salaries and employee benefits			1,261				1,838
Net occupancy and equipment			472				492
State and local taxes			108				105
FDIC premiums			225				80
Bank exam and audit fees			109				108
Office supplies			86				99
Other operating expenses			478				558
Total other expenses			2,739				3,280
INCOME (LOSS) BEFORE FEDERAL INCOME TAXES			1,039				(2,359	)
Federal income tax expense (benefit)			145				(962	)
NET INCOME (LOSS)		$	894			$	(1,397	)
BASIC EARNINGS (LOSS) PER COMMON SHARE (NOTE 6)		$	0.20			$	(0.31	)
DILUTED EARNINGS (LOSS) PER COMMON SHARE (NOTE 6)		$	0.20			$	(0.31	)
CASH DIVIDENDS DECLARED PER SHARE		$	—			$	—

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

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)

(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, 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															2,777								2,777
Other comprehensive loss related to securities for which other than temporary impairment has been recognized in earnings, net of tax															(4,345	)							(4,345	)
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
THREE MONTHS ENDED MARCH 31, 2010
BALANCE AT JANUARY 1, 2010		$	23,641			$	20,850			$	142			$	(4,131	)		$	(3,594	)		$	36,908
Comprehensive income:
Net income											894												894
Other comprehensive income, net of tax :
Unrealized gains on available- for-sale securities, net of reclassification adjustment															753								753
Other comprehensive gain related to securities for which other than temporary impairment has been recognized in earnings, net of reclassification adjustment, net of tax benefit															177								177
Total comprehensive income																							1,824
BALANCE AT MARCH 31, 2010		$	23,641			$	20,850			$	1,036			$	(3,201	)		$	(3,594	)		$	38,732

COMPONENTS OF OTHER COMPREHENSIVE
LOSS (INCOME)

		THREE MONTHS ENDED
		MARCH 31,
		2010				2009
Net unrealized holding gains (losses) on available-for-sale securities arising during the period, net of tax		$	571			$	(3,931	)
Reclassification adjustment for net gains realized in net income, net of tax			—				(57	)
Reclassification adjustment for other than temporary impairment losses on debt securities, net of tax			359				2,420
Net unrealized gains (losses) on available- for-sale securities, net of tax		$	930			$	(1,568	)

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

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(Amounts in thousands)

		FOR THE
		THREE MONTHS ENDED
		MARCH 31,
		2010				2009
NET CASH FLOWS FROM OPERATING ACTIVITIES		$	472			$	737
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities available for sale			(17,787	)			(76	)
Proceeds from call, maturity and principal payments on securities			7,521				12,989
Net decrease in loans			11,249				9,402
Proceeds from disposition of other real estate			11
Purchases of premises and equipment			(6	)			(100	)
Net cash flows from investing activities			988				22,215
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in deposit accounts			(12,208	)			2,118
Pay down of Federal Home Loan Bank advances			(5,000	)
Net increase in short term borrowings			253				464
Treasury shares reissued							272
Net cash flows from financing activities			(16,955	)			2,854
NET CHANGE IN CASH AND CASH EQUIVALENTS			(15,495	)			25,806
CASH AND CASH EQUIVALENTS
Beginning of period			44,823				26,843
End of period		$	29,328			$	52,649
SUPPLEMENTAL DISCLOSURES
Interest paid		$	1,825			$	2,626
Income taxes paid		$	400			$	210

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, 2010 are not necessarily indicative of the results that may be expected for the year ending December 31, 2010. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2009, included in our Form 10-K for the year ended December 31, 2009, filed with the United States Securities and Exchange Commission. The accompanying consolidated balance sheet at December 31, 2009, 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.

The Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) topic 105 Generally Accepted Accounting Principles became effective on July 1, 2009. At that date, the ASC became FASB’s officially recognized source of authoritative U.S. generally accepted accounting principles (GAAP) applicable to all public and non-public non-governmental entities, superseding existing FASB, American Institute of Certified Public Accountants (AICPA), Emerging Issues Task Force (EITF) and related literature. Rules and interpretive releases of the SEC under the authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. All other accounting literature is considered non-authoritative. The switch to the ASC affects the way companies refer to U.S. GAAP in financial statements and accounting policies. Citing particular content in the ASC involves specifying the unique numeric path to the content through the Topic, Subtopic, Section and Paragraph structure.

2.) Reclassifications:

Certain items contained in the 2009 financial statements have been reclassified to conform to the presentation for 2010. Such reclassifications had no effect on the net results of operations.

3.) Investment Securities:

Investments in debt and equity securities are classified as held to maturity, trading or available for sale. Securities classified as held to maturity are those that management has the positive intent and ability to hold to maturity. 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 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 available for sale are carried at fair value with unrealized gains and losses recorded as a separate component of shareholders’ equity, net of tax effects. Realized gains or losses on dispositions are based on net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Interest on securities is accrued and credited to operations based on the principal balance outstanding, adjusted for amortization of premiums and accretion of discounts.

Unrealized losses on investments have not been recognized into income. Management has considered whether the present value of cash flow expected to be collected are less than the security’s amortized cost basis (the difference defined as the credit loss), the magnitude and duration of the decline, the reasons underlying the decline and the Company’s intent to sell the security or whether it is more likely than not that the Company would be required to sell the security before its anticipated recovery in market value, to determine whether the loss in value is other-than-temporary.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The following is a summary of investment securities:

						Gross				Gross				Estimated
		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value
March 31, 2010
Investment securities available for sale
U.S. Government agencies and corporations		$	35,240			$	463			$	120			$	35,583
Obligations of states and political subdivisions			13,310				211				66				13,455
Mortgage-backed and related securities			89,278				2,963				51				92,190
Trust preferred pools/collateralized debt obligations			20,523								8,250				12,273
Corporate securities			287												287
Total debt securities			158,638				3,637				8,487				153,788
Regulatory stock			3,749												3,749
Total available for sale		$	162,387			$	3,637			$	8,487			$	157,537
Investment securities held to maturity
U.S. Treasury securities		$	128			$	12			$				$	140
U.S. Government agencies and corporations			5,991				150								6,141
Obligations of states and political subdivisions			15,837				592				11				16,418
Mortgage-backed and related securities			7,679				345				232				7,792
Total held to maturity		$	29,635			$	1,099			$	243			$	30,491

						Gross				Gross				Estimated
		Amortized				Unrealized				Unrealized				Fair
		Cost				Gains				Losses				Value
December 31, 2009
Investment securities available for sale
U.S. Government agencies and corporations		$	20,465			$	315			$	227			$	20,553
Obligations of states and political subdivisions			12,351				230				83				12,498
Mortgage-backed and related securities			89,613				2,729				280				92,062
Trust preferred pools/collateralized debt obligations			21,068								8,944				12,124
Corporate securities			287												287
Total debt securities			143,784				3,274				9,534				137,524
Regulatory stock			3,749												3,749
Total available for sale		$	147,533			$	3,274			$	9,534			$	141,273
Investment securities held to maturity
U.S. Treasury securities		$	130			$	11			$				$	141
U.S. Government agencies and corporations			5,990				134								6,124
Obligations of states and political subdivisions			16,097				631				15				16,713
Mortgage-backed and related securities			8,434				326				248				8,512
Total held to maturity		$	30,651			$	1,102			$	263			$	31,490

At March 31, 2010 and December 31, 2009 regulatory stock consisted of $3,523 in Federal Home Loan Bank (FHLB) stock and $226 in Federal Reserve Bank (FED) stock. Each investment is carried at cost, and the Company is required to hold such investments as a condition of membership in order to transact business with the FHLB and the FED.

The FHLB of Cincinnati’s financial condition remained strong despite the economic recession and the FHLB of Cincinnati continued to fulfill its role as an important provider of reliable and attractively priced wholesale funding, with a competitive dividend paid to the Bank in each of the four quarters of 2009 and the first quarter of 2010.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The amortized cost and fair value of debt securities at March 31, 2010, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.

		March 31, 2010
		Amortized				Estimated
		Cost				Fair Value
Investment securities available for sale
Due in one year or less		$	3,230			$	3,242
Due after one year through five years			527				547
Due after five years through ten years			29,962				30,109
Due after ten years			35,641				27,700
Subtotal			69,360				61,598
Mortgage-backed securities			89,278				92,190
Total		$	158,638			$	153,788
Investment securities held to maturity
Due in one year or less		$	2,857			$	2,911
Due after one year through five years			697				754
Due after five years through ten years			7,007				7,162
Due after ten years			11,395				11,872
Subtotal			21,956				22,699
Mortgage-backed securities			7,679				7,792
Total		$	29,635			$	30,491

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 loses realized on securities sold or called for the period ended:

		THREE MONTHS
		March 31,
		2010				2009
Proceeds on securities sold		None				None
Gross realized gains		None				None
Gross realized losses		None				None
Proceeds on securities called		None				$	7,804
Gross realized gains		None					87
Gross realized losses		None				None

Securities available for sale, carried at fair value, totaled $157,537 at March 31, 2010 and $141,273 at December 31, 2009 representing 84.17% and 82.17%, 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 $92,544 at March 31, 2010 and $87,678 at December 31, 2009 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 following is a summary of the fair value of securities with unrealized losses and an aging of those unrealized losses at March 31, 2010:

		Less than 12 Months								12 Months or More								Total
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
U.S. Government agencies and corporations		$	13,013			$	120			$				$				$	13,013			$	120
Obligations of states and political subdivisions			5,371				65				1,161				12				6,532				77
Mortgage-backed and related securities			11,412				56				518				227				11,930				283
Trust preferred pools/collateralized debt obligations											12,080				8,250				12,080				8,250
		$	29,796			$	241			$	13,759			$	8,489			$	43,555			$	8,730

The above table comprises 55 investment securities where the fair 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, 2009:

		Less than 12 Months								12 Months or More								Total
		Fair				Unrealized				Fair				Unrealized				Fair				Unrealized
		Value				Losses				Value				Losses				Value				Losses
U.S. Government agencies and corporations		$	11,111			$	227			$				$				$	11,111			$	227
Obligations of states and political subdivisions			4,019				69				1,705				29				5,724				98
Mortgage-backed and related securities			32,696				272				2,130				256				34,826				528
Trust preferred pools/collateralized debt obligations											11,932				8,944				11,932				8,944
		$	47,826			$	568			$	15,767			$	9,229			$	63,593			$	9,797

The above table comprises 66 investment securities where the fair value is less than the related amortized cost.

The unrealized loss on Collateralized Debt Obligations (CDO’S) represents pools of trust preferred debt primarily issued by bank holding companies and insurance companies. The unrealized loss on these securities at March 31, 2010 was $8,250 as compared to a $8,944 loss at December 31, 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, 2010.

Among the Company’s numerous mortgage backed securities is one privately issued variable rate CMO. The security was valued on March 31 at $.64 on a dollar and is scheduled to reprice in February of 2011. The Company had the security tested by a third party for subprime mortgage containment and none was found. As government intervention takes hold and the market in general somewhat settled, the CMO market has begun a slow recovery. A year ago, this security priced at $.31 on a dollar, and at December 31, 2009, at $.62. The doubling of the value since March 2009 provides evidence that the impairment is temporary. General market liquidity has been improving, even with the government phasing out of its many assistive programs. The security carries a credit rating of “A” indicating little probability of default. Also, as a variable rate security, interest resets have been bringing the rate down, thus reducing the value. As interest rates rise in the next 9 to 12 months (as economists predict), and the rate resets higher, the price of the security should also recover relative to our book value. The security’s underlying delinquency rate is 6.92%. A current third party analysis of this security indicates at the current delinquency and default rates, no loss is projected on this security through its maturity. This CMO is in the held to maturity portfolio and it is not more likely than not that the Company will be required to sell the debt security before its anticipated recovery. As a result of all of the facts presented, the Company does not consider this investment to be other-than-temporarily impaired.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

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. The Company’s investment in FNMA and FHLMC is $6,151 and $5,950 respectively.

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.

Securities Deemed to be Other-Than-Temporarily Impaired

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 of 2010 in accordance with FASB ASC topic 320, Investments — Debt and Equity Securities. The purpose of this ASC is to provide greater clarity to investors about the credit and noncredit component of an OTTI event and to communicate more effectively when an OTTI event has occurred. This ASC amends the OTTI guidance in GAAP for debt securities and improves the presentation and disclosure of other-than-temporary impairment on investment securities and changes the calculation of the OTTI recognized in earnings in the financial statements. This ASC does not amend existing recognition and measurement guidance related to OTTI of equity securities.

For debt securities, ASC topic 320 requires an entity to assess whether (a) it has the intent to sell the debt security, or (b) it is more likely than not that it will be required to sell the debt security before its anticipated recovery. If either of these conditions is met, an OTTI on the security must be recognized.

In instances in which a determination is made that a credit loss (defined as the difference between the present value of the cash flows expected to be collected and the amortized cost basis) exists but the entity does not intend to sell the debt security and it is not more likely than not that the entity will be required to sell the debt security before the anticipated recovery of its remaining amortized cost basis (i.e., the amortized cost basis less any current-period credit loss), ASC topic 320 determines the presentation and amount of the OTTI recognized in the income statement.

In these instances, the impairment is separated into (a) the amount of the total impairment related to the credit loss, and (b) the amount of the total impairment related to all other factors. The amount of the total OTTI related to the credit loss is recognized in earnings. The amount of the total impairment related to all other factors is recognized in other comprehensive income (loss). The total OTTI is presented in the income statement with an offset for the amount of the total OTTI that is recognized in other comprehensive income (loss).

Through the impairment assessment process, the Company determined that the investments discussed below were other-than-temporarily impaired at March 31, 2010. The Company recorded impairment credit losses in earnings on available-for-sale securities of $544 for the quarter ended March 31, 2010. The non-credit portion of impairment included at March 31, 2010 recorded in Other Comprehensive Income (loss) was $4,067. In the quarter ended March 31, 2009, the Company recorded impairment credit losses in earnings on available for sale securities of $3,667. The $6,584 non- credit portion of impairment was recorded in Other Comprehensive Income (loss). For the year ended December 31, 2009 the Company recorded impairment credit losses of $14,502.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

		THREE MONTHS ENDED
		March 31,
		2010				2009
Impaired Losses Recognized in income on Other-Than-Temporarily Impaired Securities
Collateralized debt obligations		$	544			$	3,667
Total		$	544			$	3,667

Over the past eight quarters, the Company recognized $2,066 of other-than-temporary losses attributable to its General Motors Corporation Corporate Securities with a cost basis of $2,353. The impairment charges were recognized due to the fact that General Motors filed for government-assisted Chapter 11 bankruptcy protection on June 1, 2009. Pursuant to the reorganization, secured creditors of the newly emerged company were granted priority in the liability settlement process. Unsecured creditors, such as the Company’s position in these corporate bonds, are subject to much more restrictive settlement options still to be determined. Under this scenario, the market has priced these securities well below the par values. The Company did not expect the value to recover from this pricing level, thus recognized other- than-temporary impairment. Since the bond has traded recently above the reduced book value there was no additional impairment recognized during the current quarter.

For the quarter ended March 31, 2010, the Company recognized OTTI of $544 attributable to twelve CDO’s with a cost basis of $14,675. For the year ended December 31, 2009, the Company recognized OTTI of $13,687 attributable to eighteen CDO’s with a cost basis of $21,618. For the quarter ended March 31, 2009, the Company recognized OTTI of $3,667 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. See Note 8, Fair Value for additional discussion of CDO impairment.

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.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

		CONTRACT OR NOTIONAL AMOUNT
		March 31,				December 31,
		2010				2009
Financial instruments whose contract amount represents credit risk:
Commitments to extend credit:
Fixed rate		$	557			$	933
Variable rate			31,484				33,959
Standby letters of credit			498				703

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, 2010 totaled $10,541 and $10,553 at December 31, 2009. The total average daily balance of overdrafts used at March 31, 2010 was $120 and $139 at December 31, 2009, or approximately 1.1% of the total aggregate overdraft protection available to depositors at March 31, 2010 and 1.3% at December 31, 2009. The balance at March 31, 2010 of all deposit overdrafts included in total loans was $125, with the balance at December 31, 2009 of $129.

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

		March 31,				December 31,
		2010				2009
1-4 Family residential mortgages			25.2	%			24.5	%
Commercial mortgages			55.6	%			51.0	%
Consumer loans			3.2	%			3.1	%
Commercial loans			9.8	%			15.5	%
Home equity loans			6.2	%			5.9	%

There are $308 in mortgage loans held for sale included in 1-4 family residential mortgages as of March 31, 2010, and none at December 31, 2009. 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, 2010 and December 31, 2009:

		March 31,				December 31,
		2010				2009
Loans accounted for on a non-accrual basis		$	988			$	1,230
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)			612				920

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, 2010 and 2009.

		March 31,				March 31,
		2010				2009
Gross interest income that would have been recorded if the loans had been current in accordance with their original terms (contractual interest income)		$	30			$	23
Interest income actually included in income on the loans			9				9

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, or portions thereof, are charged off when deemed uncollectible.

Impaired loans were as follows:

		March 31,				December 31,
		2010				2009
Balance of impaired loans with no allocated allowance		$	101			$	855
Balance of impaired loans with an allocated allowance			186				401
Total recorded investment in impaired loans		$	287			$	1,256
Amount of the allowance allocated to impaired loans		$	108			$	156
Average balance of impaired loans		$	772			$	1,078

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 $2 for the three months ended March 31, 2010 and $52 for the twelve months ended December 31, 2009.

Loans in the amount of $7,809 as of March 31, 2010, and $16,354 as of December 31, 2009 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, 2010 and March 31, 2009:

		THREE MONTHS ENDED
		March 31,
		2010				2009
Balance at beginning of period		$	2,437			$	2,470
Loan charge-offs:
1-4 family residential mortgages			22				7
Commercial mortgages			137				—
Consumer loans and other loans			35				57
Commercial loans			1				2
Home equity loans			—				—
			195				66
Recoveries on previous loan losses:
1-4 family residential mortgages			1				—
Commercial mortgages			—				1
Consumer loans and other loans			26				29
Commercial loans			—				—
Home equity loans			3				—
			30				30
Net charge-offs			(165	)			(36	)
Provision charged to operations			175				151
Balance at end of period		$	2,447			$	2,585
Ratio of annualized net charge-offs to average loans outstanding			0.27	%			0.06	%

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,
		2010				2009
Net income (loss)		$	894			$	(1,397	)
Weighted average common shares outstanding*			4,525,550				4,525,326
Basic earnings (loss) per share*		$	0.20			$	(0.31	)
Diluted earnings (loss) per share*		$	0.20			$	(0.31	)

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

7.) 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 issued by the trust. The securities bear interest at the 3-month LIBOR rate plus 1.45%. The rate at March 31, 2010 was 1.71% and at December 31, 2009 was 1.70%. The Company issued subordinated debentures to the trust in exchange for the proceeds of the trust preferred offering. The debentures represent the sole 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 ASC, Topic 942, Financial Services – Depository and Lending 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.

8.) Fair Value

Measurements

Accounting guidance under ASC Topic 820, Fair Value Measurements and Disclosures, affirms that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction, and clarifies and includes additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active. ASC Topic 820 requires an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.

The Company groups assets and liabilities recorded at fair value into three levels based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. A financial instrument’s level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement (with level 1 considered highest and level 3 considered lowest). A brief description of each level 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 table presents the assets reported on the consolidated balance sheets at their fair value as of March 31 2010 and December 31, 2009 by level within the fair value hierarchy. 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 3/31/10 Using
						Quoted Prices in
						Active Markets				Significant Other				Significant
						for Identical Assets				Observable				Unobservable
Description		3/31/10				(Level 1)				Inputs (Level 2)				Inputs (Level 3)
U. S. Government agencies and corporations		$	35,583			$				$	35,583			$
Obligations of states and political subdivisions			13,455								13,455
Mortgage-backed and related securities			92,190								92,190
Trust preferred pools/collateralize debt obligations			12,273												12,273
Corporate securities			287				—				287				—
Total		$	153,788			$	—			$	141,515			$	12,273

		Fair Value Measurements at 12/31/09 Using
						Quoted Prices in
						Active Markets for				Significant Other				Significant
						Identical Assets				Observable				Unobservable
Description		12/31/09				(Level 1)				Inputs (Level 2)				Inputs (Level 3)
U. S. Government agencies and corporations		$	20,553			$				$	20,553			$
Obligations of states and political subdivisions			12,498								12,498
Mortgage-backed and related securities			92,062								92,062
Trust preferred pools/collateralize debt obligations			12,124												12,124
Corporate securities			287				—				287				—
Total		$	137,524			$	—			$	125,400			$	12,124

The following tables present the changes in the Level 3 fair value category for the three months ended March 31, 2010. 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.

																						Losses included
																						in net income
						Net realized/Unrealized																for the period
						gains/(losses) included in																relating to assets
						Non-				Other				Transfers				Purchases				held at
		January l,				interest				Comprehensive				in and/or				Issuance				March 31,				March 31,
Net Unrealized		2010				Income				Income				out of Level 3				and settlements				2010				2010
Trust preferred Pools/CDO’s		$	12,124			$	(544	)		$	693			$				$				$	12,273			$	(544	)

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

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 statements 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 a determination that 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. 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 all of which require considerable judgment.

Collateralized debt obligations are accounted for under FASB ASC Topic 325 Investments Other. The Company evaluates current available information in estimating the future cash flows of 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 deferrals and defaults, and other relevant market information.

The Company owns 32 collateralized debt obligation securities (CDO) totaling $35,142 (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. Beginning the second half of 2008 and through the first quarter of 2010, 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, or regulatory actions. As a result of changes in these and various other factors during 2009 and the first quarter of 2010, Moody’s Investors Service, Fitch Ratings and Standards and Poors downgraded multiple CDO securities, including securities held by the Company. All of the CDO securities held by the Company are now considered to be below investment grade. The deteriorating economic, credit and financial conditions experienced in 2008 and through the first quarter of 2010 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. The Company determined that for fourteen 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 fourteen securities. The Company does not consider the investment in these assets to be other-than-temporarily impaired at March 31, 2010. 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, 2010 analysis, our model indicated other-than-temporary impairment on the remaining eighteen securities, all of which experienced additional defaults or deferrals during the period. These eighteen securities had impairment losses of $18.3 million, of which $14.2 million was recorded as expense ($544 in the current quarter) and $4.1 million was recorded in other comprehensive income (loss). These eighteen securities remained classified as available for sale at March 31, 2010, and together, the 32 securities subjected to FASB ASC Topic 320 accounted for the entire $8.3 million of gross unrealized losses in the trust preferred pools/collateralized debt obligations category at March 31, 2010.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands, except for per share amounts)

The following table details the eighteen debt securities with other-than-temporary impairment, their credit ratings at March 31, 2010 and the related losses recognized in earnings:

						Amount of other-
						than-temporary
						impairment								Amount of other-than-
		Moody’s/				related to credit								temporary impairment
		Fitch				loss at								related to credit loss at
		Rating				January 1, 2010				Addition				March 31, 2010
PreTSL II Mezzanine		Ca/C				$	816			$	364			$	1,180
PreTSL VIII B-3			C/C				1,390				0				1,390
PreTSL XVI D		NR/C					518				0				518
PreTSL XVI D		NR/C					991				0				991
Alesco Preferred Funding VIII Class E Notes 1		Ca/C					1,500				0				1,500
Tropic CDO V Class B-1L			C/C				4,425				1				4,426
MM Community Funding III Class B		Baa3/B					6				5				11
PreTSL IX Class B-2		Ca/C					247				0				247
PreTSL XVII Class D		NR/C					930				0				930
PreTSL XXV Class D		NR/C					1,001				0				1,001
PreTSL XXVI Class D		NR/C					464				0				464
PreTSL XVIII Class D		NR/C					513				0				513
Trapeza CDO II Class C-1		Ca/C					317				31				348
PreTSL XVII Class C		Ca/C					94				56				150
PreTSL XV Class B-3		Ca/C					84				40				124
PreTSL XXIII Class C-FP			C/C				204				7				211
PreTSL I Mezzanine		Caa1/C					103				1				104
PreTSL XV Class B-2		Ca/C					84				39				123
Total						$	13,687			$	544			$	14,231