Edgar Filing: CORTLAND BANCORP INC

Cortland Bancorp 10-Q

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: September 30, 2006


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

For the transition from to

Commission file number: 0-13814

Cortland Bancorp

(Exact name of registrant as specified in its charter)


Ohio		34-1451118

State or other jurisdiction of		(I.R.S.Employer
Incorporation or organization		Identification No.)


194 West Main Street, Cortland, Ohio		44410

(Address of principal executive offices)		(Zip code)

(330) 637-8040

(Registrant’s telephone number, including area code)

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act. (Check One): 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 November 2, 2006 4,410,735 Shares


PART I — FINANCIAL INFORMATION

Item 1.	Financial Statements

	Cortland Bancorp and Subsidiaries:

	Consolidated Balance Sheets — September 30, 2006 (unaudited) and December 31, 2005 (audited)	2

	Unaudited Consolidated Statements of Income — Nine months ended September, 30, 2006 and 2005 and Three months ended September 30, 2006 and 2005	3

	Unaudited Consolidated Statement of Shareholders’ Equity — Nine months ended September 30, 2006 and 2005	4

	Unaudited Consolidated Statements of Cash Flows — Nine months ended September 30, 2006 and 2005	5

	Unaudited Notes to Consolidated Financial Statements September 30, 2006	6-15

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations

	Consolidated Average Balance Sheets, Yields And Rates — Year to Date September 30, 2006, December 31, 2005 and September 30, 2005	16

	Consolidated Average Balance Sheets, Yields And Rates — Quarter to Date September 30, 2006, June 30, 2006 and September 30, 2005	17

	Selected Financial Data	18

	Financial Review	18-30

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	31-32

Item 4.	Controls and Procedures	33

PART II — OTHER INFORMATION

Item 1.	Legal Proceedings	34

Item 1A.	Risk Factors	34

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	34

Item 3.	Defaults Upon Senior Securities	34

Item 4.	Submission of Matters to a Vote of Security Holders	34

Item 5.	Other Information	34

Item 6.	Exhibits	35-37

Signatures		38
EX-31.1
EX-31.2
EX-32

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except share data)


	(Unaudited)			(Audited)
	SEPTEMBER 30,			DECEMBER 31,
	2006			2005
ASSETS
Cash and due from banks	$	9,168		$	14,587
Federal funds sold		8,650			4,650

Total cash and cash equivalents		17,818			19,237

Investment securities available for sale (Note 3)		107,632			113,247
Investment securities held to maturity (approximate market value of $123,082 at September 30, 2006 and $121,395 at December 31, 2005 (Note 3)		123,187			121,405
Total loans (Note 4)		198,764			188,202
Less allowance for loan losses (Note 4)		(2,209	)		(2,168	)

Net loans		196,555			186,034

Premises and equipment		4,413			4,088
Other assets		17,028			15,690


Total assets	$	466,633		$	459,701


LIABILITIES
Noninterest-bearing deposits	$	55,089		$	61,782
Interest-bearing deposits		298,551			288,593

Total deposits		353,640			350,375

Federal Home Loan Bank advances and other borrowings		59,925			58,111
Other liabilities		3,067			2,890

Total liabilities		416,632			411,376


SHAREHOLDERS’ EQUITY
Common stock — $5.00 stated value — authorized 20,000,000 shares; issued 4,504,576 shares in both 2006 and 2005 (Note 1)		22,523			22,523
Additional paid-in capital (Note 1)		19,933			20,211
Retained earnings		10,810			10,310
Accumulated other comprehensive income (loss) (Note 1)		(611	)		(877	)
Treasury shares at cost, 107,749 at September 30, 2006 and 155,945 at December 31, 2005		(2,654	)		(3,842	)

Total shareholders’ equity		50,001			48,325


Total liabilities and shareholders’ equity	$	466,633		$	459,701

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

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(Amounts in thousands, except share data)


	THREE					NINE
	MONTHS ENDED					MONTHS ENDED
	SEPTEMBER 30,					SEPTEMBER 30,
	2006			2005		2006			2005
INTEREST INCOME
Interest and fees on loans	$	3,780		$	3,285	$	10,538		$	9,626
Interest and dividends on investment securities:
Taxable interest income		1,507			1,079		4,374			3,081
Nontaxable interest income		506			538		1,555			1,624
Dividends		47			38		145			115
Interest on mortgage-backed securities		927			911		2,913			2,853
Other interest income		29			33		83			75

Total interest income		6,796			5,884		19,608			17,374


INTEREST EXPENSE
Deposits		2,174			1,569		6,135			4,416
Borrowed funds		806			628		2,281			1,810

Total interest expense		2,980			2,197		8,416			6,226

Net interest income		3,816			3,687		11,192			11,148
Provision for loan losses		45			160		175			410


NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		3,771			3,527		11,017			10,738


OTHER INCOME
Fees for other customer services		587			592		1,655			1,704
Investment securities gains — net					4		18			308
Gain on sale of loans — net		13			28		69			59
Loss on sale of OREO — net		(7	)				(35	)
Other non-interest income		116			108		356			352

Total other income		709			732		2,063			2,423


OTHER EXPENSES
Salaries and employee benefits		1,715			1,972		5,084			5,326
Net occupancy and equipment expense		444			482		1,350			1,422
State and local taxes		139			138		417			414
Bank exam and audit expense		115			82		365			292
Office supplies		100			85		274			254
Marketing expense		54			95		145			208
Other operating expenses		474			434		1,424			1,294

Total other expenses		3,041			3,288		9,059			9,210


INCOME BEFORE FEDERAL INCOME TAXES		1,439			971		4,021			3,951

Federal income taxes		296			120		627			710


NET INCOME	$	1,143		$	851	$	3,394		$	3,241


BASIC EARNINGS PER COMMON SHARE (NOTE 6)	$	0.26		$	0.20	$	0.77		$	0.75

DILUTED EARNINGS PER COMMON SHARE (NOTE 6)	$	0.26		$	0.20	$	0.77		$	0.75

CASH DIVIDENDS DECLARED PER SHARE	$	0.22		$	0.21	$	0.66		$	0.64

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

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (UNAUDITED)

(Amounts in thousands)


									ACCUMULATED						TOTAL
			ADDITIONAL						OTHER						SHARE-
	COMMON		PAID-IN			RETAINED			COMPREHENSIVE			TREASURY			HOLDERS’
	STOCK		CAPITAL			EARNINGS			INCOME			STOCK			EQUITY

NINE MONTHS ENDED SEPTEMBER 30, 2005:

BALANCE AT JANUARY 1, 2005	$	21,869	$	18,531		$	13,131		$	1,061		$	(5,194	)	$	49,398
Comprehensive income:
Net income							3,241									3,241
Other comprehensive income, net of tax:
Unrealized gains or (losses) on available- for-sale securities, net of reclassification adjustment										(1,296	)					(1,296	)

Total comprehensive income																1,945


Common stock transactions:
Treasury shares reissued				(120	)								1,063			943
Treasury shares purchased													(1	)		(1	)
Cash dividends declared							(2,772	)								(2,772	)


BALANCE AT SEPTEMBER 30, 2005	$	21,869	$	18,411		$	13,600		$	(235	)	$	(4,132	)	$	49,513


NINE MONTHS ENDED SEPTEMBER 30, 2006:

BALANCE AT JANUARY 1, 2006	$	22,523	$	20,211		$	10,310		$	(877	)	$	(3,842	)	$	48,325
Comprehensive income:
Net income							3,394									3,394
Other comprehensive income, net of tax:
Unrealized gains or (losses) on available- for-sale securities, net of reclassification adjustment										266						266

Total comprehensive income																3,660


Common stock transactions:
Treasury shares reissued				(278	)								1,188			910
Cash dividends declared							(2,894	)								(2,894	)


BALANCE AT SEPTEMBER 30, 2006	$	22,523	$	19,933		$	10,810		$	(611	)	$	(2,654	)	$	50,001


	SEPTEMBER 30,
	2006		2005

DISCLOSURE OF RECLASSIFICATION FOR AVAILABLE FOR SALE SECURITY GAINS AND LOSSES:
Net unrealized holding gains or (losses) on available-for-sale securities arising during the period, net of tax	$	278	$	(1,093	)
Less: Reclassification adjustment for net gains realized in net income, net of tax		12		203


Net unrealized gains (losses) on available- for-sale securities, net of tax	$	266	$	(1,296	)

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

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(Amounts in thousands)


	FOR THE
	NINE MONTHS ENDED
	SEPTEMBER 30,
	2006			2005
NET CASH FLOWS FROM OPERATING ACTIVITIES	$	2,595		$	1,461

CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities held to maturity		(8,385	)		(32,068	)
Purchases of securities available for sale		(6,332	)		(15,057	)
Proceeds from sales of securities available for sale		1,006			1,479
Proceeds from call, maturity and principal payments on securities		17,577			47,058
Net increase in loans made to customers		(10,424	)		(976	)
Proceeds from disposition of other real estate		135
Purchase of premises and equipment		(686	)		(289	)

Net cash flows from investing activities		(7,109	)		147


CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in deposit accounts		3,265			(1,836	)
Net increase in borrowings		1,814			6,226
Dividends paid		(2,894	)		(2,772	)
Purchases of treasury stock					(1	)
Treasury shares reissued		910			943

Net cash flows from financing activities		3,095			2,560


NET CHANGE IN CASH AND CASH EQUIVALENTS		(1,419	)		4,168

CASH AND CASH EQUIVALENTS
Beginning of period		19,237			12,897

End of period	$	17,818		$	17,065


SUPPLEMENTAL DISCLOSURES
Interest paid	$	8,285		$	6,317
Income taxes paid	$	870		$	950

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

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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 nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2005, included in our Form 10-K for the year ended December 31, 2005, filed with the United States Securities and Exchange Commission. The accompanying consolidated balance sheet at December 31, 2005, 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 2005 financial statements have been reclassified to conform to the presentation for 2006. 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.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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


	THREE MONTHS			NINE MONTHS
	September 30,			September 30,
	2006	2005		2006		2005
Proceeds on securities sold	$ None	$	None	$	1,006	$	1,479
Gross realized gains	None		None		6		287
Gross realized losses	None		None		None		None

Proceeds on securities called	$ None	$	4,000	$	480	$	12,050
Gross realized gains	None		4		12		21
Gross realized losses	None		None		None		None

Securities available for sale, carried at fair value, totaled $107,632 at September 30, 2006 and $113,247 at December 31, 2005 representing 46.6% and 48.3%, 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 $73,271 at September 30, 2006 and $64,082 at December 31, 2005 were pledged to secure deposits and for other purposes.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

The amortized cost and estimated market value of debt securities at September 30, 2006, 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.


Investment securities	AMORTIZED		ESTIMATED
available for sale	COST		FAIR VALUE
Due in one year or less	$	1,590	$	1,596
Due after one year through five years		9,488		9,384
Due after five years through ten years		3,711		3,415
Due after ten years		36,913		37,408

		51,702		51,803
Mortgage-backed securities		53,325		52,298

	$	105,027	$	104,101


Investment securities	AMORTIZED		ESTIMATED
held to maturity	COST		FAIR VALUE
Due in one year or less	$	749	$	752
Due after one year through five years		3,218		3,170
Due after five years through ten years		35,646		35,390
Due after ten years		62,280		62,810

		101,893		102,122
Mortgage-backed securities		21,294		20,960

	$	123,187	$	123,082

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

The amortized cost and estimated fair value of investment securities available for sale and investment securities held to maturity as of September 30, 2006, are as follows:


			GROSS		GROSS		ESTIMATED
Investment securities	AMORTIZED		UNREALIZED		UNREALIZED		FAIR
available for sale	COST		GAINS		LOSSES		VALUE
U.S. Government agencies and corporations	$	13,942	$	14	$	156	$	13,800
Obligations of states and political subdivisions		9,462		399				9,861
Mortgage-backed and related securities		53,325		177		1,204		52,298
Corporate securities		28,298		148		304		28,142

Total debt securities		105,027		738		1,664		104,101
Other securities		3,531						3,531

Total available for sale	$	108,558	$	738	$	1,664	$	107,632


			GROSS		GROSS		ESTIMATED
Investment securities	AMORTIZED		UNREALIZED		UNREALIZED		FAIR
held to maturity	COST		GAINS		LOSSES		VALUE
U.S. Treasury Securities	$	145	$	1	$		$	146
U.S. Government agencies and corporations		69,827		3		960		68,870
Obligations of states and political subdivisions		31,921		1,194		9		33,106
Mortgage-backed and related securities		21,294				334		20,960

Total held to maturity	$	123,187	$	1,198	$	1,303	$	123,082

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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, 2005:


			GROSS		GROSS		ESTIMATED
Investment securities	AMORTIZED		UNREALIZED		UNREALIZED		FAIR
available for sale	COST		GAINS		LOSSES		VALUE
U.S. Government agencies and corporations	$	14,010	$	34	$	196	$	13,848
Obligations of states and political subdivisions		11,372		506		6		11,872
Mortgage-backed and related securities		61,494		314		1,174		60,634
Corporate securities		24,307		50		857		23,500

Total debt securities		111,183		904		2,233		109,854
Other securities		3,393						3,393

Total available for sale	$	114,576	$	904	$	2,233	$	113,247


			GROSS		GROSS		ESTIMATED
Investment securities	AMORTIZED		UNREALIZED		UNREALIZED		FAIR
held to maturity	COST		GAINS		LOSSES		VALUE
U.S. Treasury Securities	$	148	$	2	$		$	150
U.S. Government agencies and corporations		66,057		5		943		65,119
Obligations of states and political subdivisions		32,842		1,307		23		34,126
Mortgage-backed and related securities		22,358		14		372		22,000

Total held to maturity	$	121,405	$	1,328	$	1,338	$	121,395

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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 or other special purpose entities 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
	September 30,		December 31,
	2006		2005
Financial instruments whose contract amount represents credit risk:
Commitments to extend credit:
Fixed rate	$	3,592	$	2,101
Variable		42,642		39,180
Standby letters of credit		830		1,195

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. 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. 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 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 September 30, 2006 totaled $9,883 and $6,191 at December 31, 2005. The total average daily balance of overdrafts used in 2006 was $147 and $126 in 2005, or approximately 1.5% of the total aggregate overdraft protection available to depositors at September 30, 2006 and 2.0% at December 31, 2005.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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:


	September 30,			December 31,
	2006			2005
1-4 family residential mortgages		31.8	%		31.8	%
Commercial mortgages		50.0	%		48.3	%
Consumer loans		3.9	%		3.6	%
Commercial loans		8.7	%		10.5	%
Home equity loans		5.6	%		5.8	%

There are $416 in mortgage loans held for sale included in 1-4 family residential mortgages as of September 30, 2006, and none at December 31, 2005. 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 September 30, 2006 and December 31, 2005:


	September 30,		December 31,
	2006		2005
Loans accounted for on a non-accrual basis	$	3,831	$	3,746

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)	NONE		NONE

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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 nine months ended September 30, 2006 and 2005.


	September 30,		September 30,
	2006		2005
Gross interest income that would have been recorded if the loans had been current in accordance with their original terms (contractual interest income)	$	304	$	245

Interest income actually included in income on the loans		34		36

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.

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. At September 30, 2006, the recorded investment in impaired loans was $1,679 while the related portion of the allowance for loan losses was $752. At December 31, 2005, there were $1,857 in loans considered impaired while the allocated portion of the allowance for loan losses for such loans was $714.

Loans in the amount of $14,091 as of September 30, 2006, and $5,304 as of December 31, 2005, 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 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)

The following is an analysis of the allowance for loan losses for the periods ended September 30, 2006 and September 30, 2005:


	THREE MONTHS						NINE MONTHS
	2006			2005			2006			2005
Balance at beginning of period	$	2,180		$	2,862		$	2,168		$	2,629
Loan charge-offs:
1-4 family residential mortgages		—			—			5			6
Commercial mortgages		—			679			20			685
Consumer loans and other loans		58			78			157			149
Commercial loans		2			80			39			88
Home equity loans		—			6			—			6

		60			843			221			934

Recoveries on previous loan losses:
1 - 4 family residential mortgages		—			—			—			—
Commercial mortgages		—			—			—			—
Consumer loans and other loans		42			24			81			86
Commercial loans		2			1			6			13
Home equity loans		—			—			—			—

		44			25			87			99

Net charge-offs		(16	)		(818	)		(134	)		(835	)

Provision charged to operations		45			160			175			410

Balance at end of period	$	2,209		$	2,204		$	2,209		$	2,204

Ratio of annualized net charge-offs to average loans outstanding		0.03	%		1.69	%		0.09	%		0.57	%

Charge-offs in the third quarter of 2005 primarily reflect impaired loans in the amount of $793 for which specific loss reserves had previously been established.

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.

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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.

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				NINE MONTHS ENDED
	September 30,				September 30,
	2006		2005		2006		2005
Net Income	$	1,143	$	851	$	3,394	$	3,241
Weighted average common shares outstanding*		4,396,835		4,336,914		4,384,064		4,325,202

Basic earnings per share*	$	0.26	$	0.20	$	0.77	$	0.75
Diluted earnings per share*	$	0.26	$	0.20	$	0.77	$	0.75
Dividends declared per share*	$	0.22	$	0.21	$	0.66	$	0.64


*		Average shares outstanding and the resulting per share amounts have been restated to give retroactive effect to the 3% stock dividend of January 1, 2006.

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED AVERAGE BALANCE SHEETS,
YIELDS AND RATES (UNAUDITED)

(Fully taxable equivalent basis in thousands of dollars)


	YEAR TO DATE AS OF
	September 30, 2006							DECEMBER 31, 2005							September 30,2005
	Average				Average			Average				Average			Average				Average
	Balance (1)		Interest		Rate			Balance (1)		Interest		Rate			Balance (1)		Interest		Rate
ASSETS
Federal funds sold and other money market funds	$	2,306	$	83		4.8	%	$	3,619	$	119		3.3	%	$	3,354	$	75		3.0	%
Investment securities (1) (2)		236,304		9,705		5.5	%		221,844		11,547		5.2	%		218,254		8,443		5.2	%
Loans (2) (3)		193,522		10,607		7.3	%		192,873		13,040		6.8	%		193,641		9,700		6.7	%

Total interest-earning assets		432,132	$	20,395		6.3	%		418,336	$	24,706		5.9	%		415,249	$	18,218		5.8	%

Cash and due from banks		8,872							9,417							9,334
Bank premises and equipment		4,154							4,316							4,368
Other assets		12,070							12,418							12,459

Total non-interest-earning assets		25,096							26,151							26,161

Total Assets	$	457,228						$	444,487						$	441,410


LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest-bearing demand deposits	$	47,121	$	527		1.5	%	$	49,355	$	389		0.8	%	$	48,940	$	253		0.7	%
Savings		83,735		643		1.0	%		89,107		647		0.7	%		89,826		440		0.7	%
Time		158,296		4,965		4.2	%		144,793		5,123		3.5	%		143,400		3,723		3.5	%

Total interest-bearing deposits		289,152		6,135		2.8	%		283,255		6,159		2.2	%		282,166		4,416		2.1	%
Federal funds purchased		640		25		5.2	%		428		15		3.5	%		356		8		3.0	%
Other borrowings		58,427		2,256		5.1	%		49,504		2,491		5.0	%		47,773		1,802		5.0	%

Total interest-bearing liabilities		348,219	$	8,416		3.2	%		333,187	$	8,665		2.6	%		330,295	$	6,226		2.5	%

Demand deposits		56,985							58,320							58,011
Other liabilities		3,083							3,315							3,225
Shareholders’ equity		48,941							49,665							49,879

Total liabilities and Shareholders’ equity	$	457,228						$	444,487						$	441,410

Net interest income			$	11,979						$	16,041						$	11,992

Net interest rate spread (4)						3.1	%						3.3	%						3.3	%

Net interest margin (5)						3.7	%						3.8	%						3.8	%

Ratio of interest-earning assets to interest-bearing liabilities						1.24							1.26							1.26


(1)		Includes both taxable and tax exempt securities

(2)		Tax exempt interest is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 34%. The tax equivalent income adjustment for loans and investment is $69 and $718 for 2006, $99 and $1,021 for December 2005, and $74 and $770 for September 2005, respectively.

(3)		Includes loan origination and commitment fees, net of origination costs, amortized over the life of the loan.

(4)		Interest rate spread represents the difference between the yield on earning assets and the rate paid on interest bearing liabilities.

(5)		Interest margin is calculated by dividing the difference between total interest earned and total interest expensed by total interest-earning assets.

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

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED AVERAGE BALANCE SHEETS,
YIELDS AND RATES (UNAUDITED)

(Fully taxable equivalent basis in thousands of dollars)


	QUARTER TO DATE AS OF
	September 30, 2006							June 30, 2006							September 30, 2005
	Average				Average			Average				Average			Average				Average
	Balance (1)		Interest		Rate			Balance (1)		Interest		Rate			Balance (1)		Interest		Rate

ASSETS
Federal funds sold and other money market funds	$	2,058	$	29		5.3	%	$	1,366	$	16		4.9	%	$	3,821	$	33		3.4	%
Investment securities (1) (2)		233,177		3,218		5.5	%		237,486		3,265		5.5	%		217,572		2,819		5.2	%
Loans (2) (3)		199,105		3,800		7.4	%		193,071		3,474		7.2	%		193,659		3,309		6.8	%

Total interest-earning assets		434,340	$	7,047		6.5	%		431,923	$	6,755		6.3	%		415,052	$	6,161		5.9	%

Cash and due from banks		8,678							8,717							9,550
Bank premises and equipment		4,201							4,143							4,280
Other assets		12,339							12,161							12,732

Total non-interest-earning assets		25,218							25,021							26,562

Total Assets	$	459,558						$	456,944						$	441,614

LIABILITIES AND
SHAREHOLDERS’ EQUITY
Interest-bearing demand deposits	$	46,971	$	182		1.5	%	$	48,028	$	183		1.5	%	$	49,286	$	108		0.9	%
Savings		81,850		212		1.0	%		84,130		216		1.0	%		88,402		180		0.8	%
Time		161,001		1,780		4.4	%		156,426		1,628		4.2	%		142,222		1,281		3.6	%

Total interest-bearing deposits		289,822		2,174		3.0	%		288,584		2,027		2.8	%		279,910		1,569		2.2	%

Federal funds purchased		438		6		5.5	%		1,396		19		5.2	%		382		3		3.8	%
Other borrowings		60,252		800		5.3	%		57,455		737		5.1	%		49,235		625		5.0	%

Total interest-bearing liabilities		350,512	$	2,980		3.4	%		347,435	$	2,783		3.2	%		329,527	$	2,197		2.6	%

Demand deposits		56,513							57,600							58,804
Other liabilities		3,135							3,039							3,092
Shareholders’ equity		49,398							48,870							50,191

Total liabilities and Shareholders’ equity	$	459,558						$	456,944						$	441,614

Net interest income			$	4,067						$	3,972						$	3,964

Net interest rate spread (4)						3.1	%						3.1	%						3.3	%

Net interest margin (5)						3.7	%						3.7	%						3.8	%

Ratio of interest-earning assets to interest-bearing liabilities						1.24							1.24							1.26


(1)		Includes both taxable and tax exempt securities

(2)		Tax exempt interest is shown on a tax equivalent basis for proper comparison using a statutory federal income tax rate of 34%. The tax equivalent income adjustment for loans and investment is $20 and $231 for September 2006, $22 and $240 for June 30, 2006, and $24 and $253 for September 2005.

(3)		Includes loan origination and commitment fees, net of origination costs, amortized over the life of the loan.

(4)		Interest rate spread represents the difference between the yield on earning assets and the rate paid on interest bearing liabilities.

(5)		Interest margin is calculated by dividing the difference between total interest earned and total interest expensed by total interest -earning assets.

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

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SELECTED FINANCIAL DATA FOR QUARTER ENDED
(In thousands of dollars, except for ratios and per share amounts)


	September 30,			June 30,			March 31,			December 31,			September 30,
	2006			2006			2006			2005			2005

SUMMARY OF OPERATIONS
Total interest income	$	6,796		$	6,493		$	6,319		$	6,212		$	5,884
Total interest expense		2,980			2,783			2,653			2,439			2,197

NET INTEREST INCOME (NII)		3,816			3,710			3,666			3,773			3,687
Provision for loan losses		45			64			66			135			160

NII after loss provision		3,771			3,646			3,600			3,638			3,527
Security gains (losses)		—			18			—			—			4
Gain on sale of loans		13			42			14			30			28
Total other income		709			732			622			692			732
Total other expense		3,041			3,049			2,969			2,990			3,288

Income before tax		1,439			1,329			1,253			1,340			971
Net income	$	1,143		$	1,076		$	1,175		$	1,093		$	851

Core earnings (1)	$	1,139		$	1,057		$	1,021		$	1,075		$	990


Net income (Rolling 4 Quarters) (2)	$	4,487		$	4,195		$	4,251		$	4,334		$	4,546
Core earnings (Rolling 4 Quarters)	$	4,292		$	4,143		$	4,202		$	4,234		$	4,206

PER COMMON SHARE DATA (3)
Net income, both basic and diluted	$	0.26		$	0.24		$	0.27		$	0.25		$	0.20
Net income, both basic and diluted (Rolling 4 Quarters)		1.03			0.96			0.98			1.00			1.05
Core income, both basic and diluted		0.26			0.24			0.23			0.25			0.23
Core income, both basic and diluted (Rolling 4 Quarters)		0.98			0.95			0.97			0.98			0.97
Cash dividends declared		0.22			0.22			0.22			0.44			0.21
Cash dividends declared (Rolling 4 Quarters)		1.10			1.09			1.08			1.07			1.07
Book value		11.37			11.10			11.11			11.11			11.41

BALANCE SHEET DATA
Assets	$	466,633		$	460,552		$	456,658		$	459,701		$	449,579
Investments		230,819			233,365			236,551			234,652			222,065
Net loans		196,555			195,856			187,529			186,034			190,194
Deposits		353,640			343,480			346,888			350,375			343,083
Borrowings		59,925			65,458			58,228			58,111			54,115
Shareholders equity		50,001			48,659			48,565			48,325			49,513

AVERAGE BALANCES
Assets	$	459,558		$	456,944		$	455,359		$	453,622		$	441,614
Investments		233,177			237,486			238,304			232,498			217,572
Net loans		196,915			190,897			186,083			188,426			191,060
Deposits		346,335			346,184			345,887			345,722			338,714
Borrowings		60,690			58,851			57,627			55,286			49,617
Shareholders equity		49,398			48,870			48,770			49,039			50,191

ASSET QUALITY RATIOS
Underperforming assets as a percentage of:
Total assets		0.83	%		0.88	%		0.78	%		0.83	%		0.81	%
Equity plus allowance for loan losses		7.44			7.95			6.98			7.58			7.04
Tier I capital		7.70			8.07			7.12			7.81			7.35

FINANCIAL RATIOS
Return on average equity		9.26	%		8.81	%		9.64	%		8.92	%		6.78	%
Return on average equity (Rolling 4 Quarters)		9.17			8.52			8.60			8.72			9.08
Return on average assets		0.99			0.94			1.03			0.96			0.77
Return on average assets (Rolling 4 Quarters)		0.98			0.93			0.95			0.97			1.03
Effective tax rate (4)		20.56			19.04			17.80			18.43			12.36
Net interest margin ratio		3.69			3.68			3.70			3.79			3.83


(1)		Core earnings are earnings before gains on loans sold, investment securities sold or called, trading security gains, other real estate losses and certain other non recurring items.

(2)		Rolling 4 quarters is calculated by using the current quarter plus the preceding 3 quarters.

(3)		Basic and diluted earnings per share are based on weighted average shares outstanding adjusted retroactively for stock dividends. Cash dividends per common share are based on actual cash dividends declared, adjusted retroactively for the stock dividends. Book value per common share is based on shares outstanding at each period , adjusted retroactively for the stock dividends.

(4)		The effective tax rate for March 2006 is calculated before the $145 adjustment to the tax accrual estimate made in the first quarter of 2006.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Dollars in thousands)

Financial Review

The following is management’s discussion and analysis of the financial condition and results of operations of Cortland Bancorp (the “Company”). The discussion should be read in conjunction with the Consolidated Financial Statements and related notes included elsewhere in this report.

Note Regarding Forward-looking Statements

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. In addition to historical information, certain information included in this Quarterly Report on Form 10-Q and other material filed or to be filed by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company) may contain herein, the forward-looking statements that involve risks and uncertainties. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “anticipates,” “forecasts,” “intends,” or similar terminology identify forward-looking statements. These statements reflect management’s beliefs and assumptions, and are based on information currently available to management. Economic circumstances, the Company’s operations and actual results could differ significantly from those discussed in any forward-looking statements. Some of the factors that could cause or contribute to such differences are changes in the economy and interest rates either nationally or in the Company’s market area; changes in customer preferences and consumer behavior; increased competitive pressures or changes in either the nature or composition of competitors; changes in the legal and regulatory environment; changes in factors influencing liquidity such as expectations regarding the rate of inflation or deflation, currency exchange rates, and other factors influencing market volatility; unforeseen risks associated with other global economic, political and financial factors. While actual results may differ significantly from the results discussed in the forward-looking statements, the Company undertakes no obligation to update publicly any forward-looking statement for any reason, even if new information becomes available.

Certain Non GAAP Measures

Certain financial information has been determined by methods other than Generally Accepted Accounting Principles (GAAP). Specifically, certain financial measures are based on core earnings rather than net income. Core earnings exclude income, expense, gains and losses that either are not reflective of ongoing operations or that are not expected to reoccur with any regularity or reoccur with a high degree of uncertainty and volatility. Such information may be useful to both investors and management, and can aid them in understanding the Company’s current performance trends and financial condition. Core earnings are a supplemental tool for analysis and not a substitute for GAAP net income. Reconciliation from GAAP net income to the non GAAP measure of core earnings is shown as part of management’s discussion and analysis of quarterly and year-to-date financial results of operations.

Critical Accounting Policies and Estimates

The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. The most significant accounting policies followed by the Company are presented in “Notes to Consolidated Financial Statements Summary of Significant Accounting Policies” in the 2005 annual report on Form 10-K. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. Some of these policies and related methodologies are more critical than others. There has been no material change in critical accounting estimates since those presented in the 2005 annual report on Form 10-K.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

The Company has identified its policy on the allowance for loan losses as being critical because it requires management to make particularly difficult, subjective and/or complex judgments about matters that are inherently uncertain, and because of the likelihood that materially different amounts would be reported under different conditions or by using different assumptions. In determining the appropriate amount to reserve for potential credit losses, the Company’s banking subsidiary also considers unfunded commitments, such as loan commitments, letter of credit and unused lines of credit. In 2005 the Company refined its approach to reserving for such unfunded credit commitments, incorporating the same off-balance sheet assumptions prescribed for determining risk-based capital.

Liquidity

The central role of the Company’s liquidity management is to (1) ensure sufficient liquid funds to meet the normal transaction requirements of its customers, (2) take advantage of market opportunities requiring flexibility and speed, and (3) provide a cushion against unforeseen liquidity needs.

Principal sources of liquidity for the Company include assets considered relatively liquid, such as interest-bearing deposits in other banks, federal funds sold, cash and due from banks, as well as cash flows from maturities and repayments of loans, investment securities and mortgage-backed securities.

Along with its liquid assets, the Company has other sources of liquidity available to it, which help to ensure that adequate funds are available as needed. These other sources include, but are not limited to, the ability to obtain deposits through the adjustment of interest rates, the purchasing of federal funds, borrowings from the Federal Home Loan Bank of Cincinnati and access to the Federal Reserve Discount Window.

Cash and cash equivalents increased slightly from September 30, 2005 and decreased from levels measured at year-end. The average balance measured $11,178 at September 30, 2006, $13,036 at December 31, 2005 and $12,688 at September 30, 2005. Operating activities provided cash of $2,595 and $1,461 during the nine months ended September 30, 2006 and 2005, respectively. Key differences stem mainly from: 1) an increase in net income of $153 compared to September 30, 2005; 2) loans held for sale increased by $416 at September 30, 2006 as compared to an increase of $587 at September 30, 2005; 3) gains on the sale of investments was $308 at September 30, 2005 where there was only $18 at September 30, 2006; 4) amortization on securities was $388 in 2006 compared to $708 in 2005; 5) provision for loan loss was $175 at September 30, 2006 compared to $410 at September 30, 2005; 6) a liability for Securities to Settle totaled $1,270 at December 31, 2004, while there was no liability at September 30, 2006, December 31, 2005 and September 30, 2005; and 7) other real estate losses of $35 were recorded at September 30, 2006 and none at September 30, 2005. Refer to the Consolidated Statements of Cash Flows for a summary of the sources and uses of cash for September 30, 2006 and 2005, and the following table which details the cash flows from operating activities.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)


	For the Nine
	Months Ended September 30,
	2006			2005
Net Income	$	3,394		$	3,241
Adjustments to reconcile net income to net cash flows from operating activities:
Depreciation, amortization and accretion		746			1,171
Provision for loan loss		175			410
Investment securities gains		(18	)		(308	)
Other real estate losses		35
Impact of loans held for sale		(416	)		(587	)
Changes in:
Securities to settle and securities sold to settle					(1,270	)
Other assets and liabilities		(1,321	)		(1,196	)

Net cash flows from operating activities	$	2,595		$	1,461

Capital Resources

The capital management function is a continuous process which consists of providing capital for both the current financial position and the anticipated future growth of the Company. Central to this process is internal equity generation, particularly through earnings retention. Internal capital generation is measured as the annualized rate of return on equity, exclusive of any appreciation or depreciation relating to available for sale securities, multiplied by the percentage of earnings retained. Internally generated capital retained by the Company measured 1.3% for both of the nine months ended September 30, 2006 and September 30, 2005. Overall capital (a figure which reflects earnings, dividends paid, common stock issued, treasury shares purchased, treasury shares reissued and the net change in the estimated fair value of available for sale securities) increased at an annual rate of 4.6%. Capital ratios remained well in excess of regulatory minimums.

Risk-based standards for measuring capital adequacy require banks and bank holding companies to maintain capital based on “risk-adjusted” assets. Categories of assets with potentially higher credit risk require more capital than assets with lower risk. In addition, banks and bank holding companies are required to maintain capital to support, on a risk-adjusted basis, certain off-balance sheet activities such as standby letters of credit and interest rate swaps.

These standards also classify capital into two tiers, referred to as Tier 1 and Tier 2. The Company’s Tier 1 capital consists of common shareholders’ equity (excluding any gain or loss on available for sale debt securities) less intangible assets and the net unrealized loss on equity securities with readily determinable fair values. Tier 2 capital is the allowance for loan and lease losses reduced for certain regulatory limitations.

Risk based capital standards require a minimum ratio of 8% of qualifying total capital to risk-adjusted total assets with at least 4% constituting Tier 1 capital. Capital qualifying as Tier 2 capital is limited to 100% of Tier 1 capital. All banks and bank holding companies are also required to maintain a minimum leverage capital ratio (Tier 1 capital to total average assets) in the range of 3% to 4%, subject to regulatory guidelines.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required banking regulatory agencies to revise risk-based capital standards to ensure that they adequately account for the following additional risks: interest rate, concentration of credit, and non traditional activities. Accordingly, regulators will subjectively consider an institution’s exposure to declines in the economic value of its capital due to changes in interest rates in evaluating capital adequacy. The table below illustrates the Company’s risk weighted capital ratios at September 30, 2006 and December 31, 2005.


	September 30, 2006			December 31, 2005
Tier 1 Capital	$	50,468		$	49,031
Tier 2 Capital		2,236			2,189

TOTAL QUALIFYING CAPITAL	$	52,704		$	51,220


Risk Adjusted Total Assets (*)	$	255,755		$	242,106

Tier 1 Risk-Based Capital Ratio		19.73	%		20.25	%

Total Risk-Based Capital Ratio		20.61	%		21.16	%

Tier 1 Risk-Based Capital to Average Assets (Leverage Capital Ratio)		11.01	%		11.05	%


(*)		Includes off-balance sheet exposures.

Assets, less intangibles and the net unrealized market value adjustment of investment securities available for sale, averaged $458,245 for the nine months ended September 30, 2006 and $443,677 for the year ended December 31, 2005.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

In management’s opinion, as supported by the data in the table below, the Company met all capital adequacy requirements to which it was subject as of September, 30, 2006 and December 31, 2005. As of those dates, Cortland Bancorp was “well capitalized” under regulatory prompt corrective action provisions.


	Actual Regulatory						Regulatory Capital Ratio
	Capital Ratios as of:						requirements to be:
	September 30,			Dec 31,			Well			Adequately
	2006			2005			Capitalized			Capitalized
Total risk-based capital to risk-weighted assets		20.61	%		21.16	%		10.00	%		8.00	%

Tier 1 capital to risk-weighted assets		19.73	%		20.25	%		6.00	%		4.00	%

Tier 1 capital to average assets		11.01	%		11.05	%		5.00	%		4.00	%

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

First Nine Months of 2006 as Compared to First Nine Months of 2005

During the first nine months of 2006, net interest income after provision for loan losses increased by $279 compared to the first nine months of 2005. Total interest income increased by $2,234 or 12.9%, from the level recorded in 2005. Contributing to the increase in interest income in 2006 was $136 in back interest and loan fees collected on two loans, both of which had been in foreclosure. This increase in income was accompanied by an increase in interest expense of $2,190 or 35.2%, and a decrease in the provision for loan losses of $235. On a fully taxable equivalent basis, net interest income after provision for loan losses increased by $222.

The increase in net interest income after provision was aided by a 4.1% year-over-year increase in average earning assets and a 45 basis point increase in the rate earned on assets. Never the less, the Company’s tax equivalent net interest margin for the first nine months of 2006 narrowed to 3.69% from 3.84% in the same period of 2005.

The average rate paid on interest sensitive liabilities increased by 71 basis points year-over-year. The average balance of interest sensitive liabilities increased by $17,924 or 5.4%. Compared to the first nine months of last year, the average borrowings increased by $10,938, while the average rate paid on borrowings increased by 12 basis points.

Average interest-bearing demand deposits and balances on money market accounts decreased by $1,819, while savings deposits decreased by $6,091. The average rate paid on these products increased by 53 basis points in the aggregate. The average balance on time deposit products increased by $14,896, while the average rate paid increased by 72 basis points.

Interest and dividend income on securities registered an increase of $1,314, or 17.1%, during the first nine months of 2006 when compared to 2005, while on a fully tax equivalent basis income on investment securities increased by $1,262 or 14.9%. The average invested balances increased by $18,050 from the levels of a year ago. The increase in the average balance of investment securities was accompanied by a 32 basis point increase in the tax equivalent yield of the portfolio.

Interest and fees on loans increased by $912, or 9.5%, for the first nine months of 2006 compared to 2005, while on a fully tax equivalent basis income on loans increased by $907 or 9.4%. A $119 decrease in the average balance of the loan portfolio, or 0.1%, was accompanied by a 65 basis point increase in the portfolio’s tax equivalent yield.

Other interest income increased by $8 from the same period a year ago. The average balance of Federal Funds sold and other money market funds decreased by $1,048 or 31.2%. The yield on federal funds and other money market funds, increased by 182 basis points compared to the same period of 2005.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

Other income from all sources decreased by $360 from the same period a year ago. Gains on 1-4 residential mortgage loans sold in the secondary mortgage market increased by $10 from the same period a year ago. Gains on securities called and net gains on the sale of available for sale investment securities decreased by $290 from year ago levels. Fees for other customer services decreased by $49 due mainly to a $39 decrease in service charge income on deposits. A loss on the sale of other real estate of $35 was recognized in the first nine months of 2006 with none in the same period a year ago. Other sources of non-recurring non-interest income increased by $4 from the same period a year ago. This income category is subject to fluctuation due to non-recurring items.

Loan charge-offs during the first nine months were $221 in 2006 compared to $934 in 2005, while the recovery of previously charged-off loans amounted to $87 in 2006 compared to $99 in 2005. The decrease in charge-offs primarily reflects impaired loan credits in 2005 for which specific loss reserves had previously been established. A provision for loan loss of $175 was charged to operations in 2006 and $410 in 2005. Non-accrual loans at September 30, 2006 represented 1.9% of the loan portfolio and 2.0% at December 31, 2005. At both September 30, 2006 and September 30, 2005, the loan loss allowance of $2,209 and $2,204, respectively, represented approximately 1.1% of outstanding loans.

Total other expenses in the first nine months were $9,059 in 2006 compared to $9,210 in 2005, a decrease of $151, or 1.6%. Full time equivalent employment averaged 160 during the first nine months of 2006 and 163 at September 30, 2005. Salaries and benefits decreased by $242 or 4.5%, compared to the similar period a year ago. This decrease is a combination of regular staff salary and benefit increases, a decline in retirement expense of $78 due to the retirement of the retiring CEO in 2005, a decline in full-time equivalent employment, an increase in unemployment expense and workman compensation expense of $16 and a one-time cash bonus of $243 awarded to the retired CEO in the third quarter of 2005.

For the first nine months of 2006, state and local taxes increased by $3. Occupancy and equipment expense decreased by $72 or 5.1%. This is due mainly to a $104 decrease in depreciation expense as some assets are now fully depreciated, and a $61 increase in equipment and building maintenance. Office supplies increased by $20. Marketing expense decreased by $63,with much of this decrease due to the timing of marketing expenditures. Bank exam and audit expense increased by $73, due to differences in the timing of expenditures, and as costs associated with Sarbanes-Oxley compliance continue to mount. All other expense categories increased by 9.1%, or $130 as a group. This is due partly to an increase in collection and foreclosure expense of $34, and a one-time sundry charge-off of $22. This expense category is subject to fluctuation due to non-recurring items.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

Income before income tax expense amounted to $4,021 for the first nine months of 2006 compared to $3,951 for the similar period of 2005. The effective tax rate for the first nine months was 15.6% in 2006 compared to 18.0% in 2005, resulting in income tax expense of $627 and $710 respectively. The decrease in the effective tax rate reflects a one time adjustment to tax expense of $145 due to a change in tax accrual estimate. The effective tax rate before the $145 adjustment was 19.2%. The provision for income taxes differs from the amount of income tax determined applying the applicable U.S. statutory federal income tax rate to pre-tax income as a result of the following differences:


	September 30,
	2006			2005
Provision at statutory rate	$	1,367		$	1,343
Add (Deduct):
Tax effect of non-taxable income		(678	)		(689	)
Tax effect of non-deductible expense		83			56
Tax effect of change in estimate*		(145	)		—

Federal income taxes	$	627		$	710


*		A one-time adjustment to tax accrual estimate made in the first quarter of 2006.

Net income for the first nine months registered $3,394 in 2006 compared to $3,241 in 2005, representing per share amounts of $0.77 in 2006 and $0.75 in 2005. Dividends declared per share were $0.66 in 2006 and $0.64 in 2005.

Core earnings (earnings before gains on loans sold, investment securities sold or called, other real estate losses and certain other non-recurring items) increased by $58, or 1.8% in the first nine months of 2006 compared to 2005. Core earnings for the nine months of 2006 were $3,217 compared to last year’s $3,159. Core earnings per share were $0.73 in both 2006 and 2005. The following is reconciliation between core earnings and earnings under generally accepted accounting principles in the United States (GAAP earnings):


	Nine Months Ended
	September 30
	2006			2005
GAAP Earnings	$	3,394		$	3,241
Investment security gains		(18	)		(308	)
Gain on sale of loans		(69	)		(59	)
Loss on sale of other real estate		35
Loss on disposition of fixed assets		3
Other non-recurring items*		(145	)		243
Tax effect of adjustments		17			42

Core Earnings	$	3,217		$	3,159


Core earnings per share	$	0.73		$	0.73


*		Includes a one-time change in tax accrual estimate made in the first quarter of 2006, and a one-time cash bonus declared in the third quarter of 2005 in recognition of the subsidiary Bank’s performance under the leadership of the retiring CEO.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

Third Quarter of 2006 as Compared to Third Quarter of 2005

During the third quarter of 2006 net interest income after provision for loan losses increased by $244 as compared to third quarter 2005. Year-over-year average earning assets increased by $19,288 or 4.6% and average interest-bearing liabilities increased by $20,985 or 6.4%. Average loans increased by 2.8%, while average investments increased by 7.2%. Average interest-bearing deposits increased by 3.5% while borrowings increased by 22.3%.

The composite tax equivalent yield on earning assets increased by 47 basis points from the same quarter a year ago. The tax equivalent yield of the investment portfolio measured 5.5%, a 34 basis point increase from the same quarter a year ago, while the loan portfolio yielded 7.4%, up 63 basis points from last year’s rate. The average rate on federal funds sold and other money market funds was 5.3%, up 197 basis points from the same quarter last year.

The rate paid on interest-bearing liabilities increased 72 basis points compared to a year ago. The average rate paid on interest-bearing deposits was 3.0% up 75 basis points from last year and the average rate paid on federal funds purchased and other borrowings was 5.3% up 24 basis points from last year. The net effect of these changes was that the tax equivalent net interest margin decreased by 14 basis points from 3.8% to 3.7%.

Loans net of the allowance for losses increased by $6,361 during the 12-month period from September 30, 2005 to September 30, 2006, and increased by $10,521 from year-end. The most notable increase in the portfolio has been in loans secured by commercial real estate. The Commercial lending area has originated $26,251 in commercial loans, during the first nine months of 2006, $14,064 of which originated from products with fixed rates of interest for the initial five year or ten year period developed specifically to attract new business account relationships. Gross loans as a percentage of earning assets stood at 45.4% as of September 30, 2006 and 45.8% at September 30, 2005. The loan to deposit ratio at the end of the first nine months of 2006 was 56.2% and 56.1% for the same period a year ago. The investment portfolio represented 65.3% of each deposit dollar at September 30, 2006 and 64.7% at September 30, 2005.

Total interest income increased by $912 or 15.5% from the same quarter a year ago. Included in interest income in the third quarter of 2006 is $136 in recaptured interest and loan fees collected on two loans, one of which had been in foreclosure and the second of which represented a loan workout. This increase in interest income was also accompanied by a $783 increase in interest expense reflecting higher balances on interest-bearing liabilities and increased interest rates and a $115 decrease in the provision for loan losses.

Loan charge-offs during the third quarter were $60 in 2006 and $843 in 2005, while the recovery of previously charged-off loans amounted to $44 during the third quarter of 2006 compared to $25 in the same period of 2005. The $843 in charge-offs during 2005 primarily reflects impaired loans of $793 for which specific loss reserves had previously been established.

Other income for the quarter decreased by $23 or 3.1% compared to the same period a year ago. The net gain on loans sold during the quarter decreased by $15 compared to a year ago. There was $4 in gains on investment and trading securities transactions in the third quarter of 2005 compared to none realized in 2006. Fees from other customer services decreased by $5. A loss on other real estate of $7 was realized in the third quarter of 2006, while none was incurred during the comparable period of 2005. Other sources of non-recurring non-interest income increased by $8 from the same period a year ago.

Total other expenses in the third quarter were $3,041 in 2006 and $3,288 in 2005, a decrease of $247 or 7.5%. Employee salaries and benefits decreased by $257. The decrease is mainly due to a one-time cash bonus of $243 awarded to the retiring CEO in the third quarter of 2005. Occupancy and equipment expense showed a $38 decrease, or 7.9%. Bank exam and audit expense showed an increase of $33, partly due to timing and increased external and internal audit expense. Other expenses as a group increased by $15 or 2.0%, compared to the same period last year.

Income before tax for the quarter increased by 48.2% to $1,439 in 2006 from the $971 recorded in 2005. Net income for the quarter of $1,143 represented a 34.3% increase from the $851 earned a year ago. Earnings per share amounted to $0.26 for the third quarter of 2006 and $0.20 for 2005. Dividends declared per share were $0.22 in 2006 and $0.21 in 2005.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

Core earnings (earnings before gains on loans sold, investment securities sold or called, other real estate losses and certain other non recurring items) increased by 15.1% in the third quarter of 2006 compared to 2005. Core earnings for the third quarter of 2006 were $1,139 compared to last year’s $990. Core earnings per share were $0.26 in 2006 and $0.23 in 2005. The following is a reconciliation between core earnings and earnings under generally accepted accounting principles in the United States (GAAP earnings):


	Three Months Ended
	September 30,
	2006			2005
GAAP Earnings	$	1,143		$	851
Investment security gains					(4	)
Gain on sale of loans		(13	)		(28	)
Other real estate losses		7
Other non-recurring items*					243
Tax effect of adjustment		2			(72	)

Core Earnings	$	1,139		$	990


Core earnings per share	$	0.26		$	0.23


*		Includes one-time cash bonus declared to the retiring CEO in the third quarter of 2005.

Regulatory Matters

On March 13, 2000, the Board of Governors of the Federal Reserve System approved the Company’s application to become a financial holding company. As a financial holding company, the Company may engage in activities that are financial in nature or incidental to a financial activity, as authorized by the Gramm-Leach-Bliley Act of 1999 (The Financial Services Reform Act). Under the Financial Services Reform Act, the Company may continue to claim the benefits of financial holding company status as long as each depository institution that it controls remains well capitalized and well managed.

The Company is required to provide notice to the Board of Governors of the Federal Reserve System when it becomes aware that any depository institution controlled by the Company ceases to be well capitalized or well managed. Furthermore, current regulation specifies that prior to initiating or engaging in any new activities that are authorized for financial holding companies, the Company’s insured depository institutions must be rated “satisfactory” or better under the Community Reinvestment Act (CRA). The Company’s bank subsidiary is rated “satisfactory” for CRA purposes, and remains well capitalized and well managed in Management’s opinion.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

New Accounting Standards

In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) 115-and 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”. This FSP provides guidance on when an investment in a debt or equity security should be considered impaired, when that impairment should be considered other-than-temporary, and measurement of the impairment loss. An investment is considered impaired if the fair value of the investment is less than its cost. If, after consideration of all available evidence to evaluate the realizable value of the investment, impairment is determined to be other-than-temporary, then an impairment loss should be recognized equal to the difference between the investment’s cost and its fair value. The guidance also clarifies that an impairment loss should be recognized no later than when the impairment is deemed other-than-temporary, even if a decision to sell has not been made. This FSP nullifies certain provisions of Emerging Issues Task Force (EITF) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” while retaining the disclosure requirements of EITF 03-1 which were adopted in 2003. FSP 115-1 and 124-1 is effective for reporting periods beginning after December 15, 2005. The Company applied the guidance in this FSP in 2005.

In May 2005, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154 “Accounting Changes and Error Corrections,” a replacement of APB Opinion No. 20, “Accounting Changes” and FASB Statement No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154 applies to all voluntary changes in accounting principle and changes the requirements for accounting for and reporting a change in accounting principle. SFAS No. 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. APB No. 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. SFAS No. 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company’s adoption of SFAS No. 154 did not have a material impact on its earnings, cash flows and/or financial position.

In June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in Income Taxes”, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes”. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of adopting this interpretation.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The provisions of this standard apply to other accounting pronouncements that require or permit fair value measurements. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company believes that the adoption of SFAS No. 157 will not have a material impact on the financial statements.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS (CONTINUED)

(Dollars in thousands)

In October 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” SFAS No. 158 requires an employer to recognize the funded status of each of its defined pension and postretirement benefit plans in the balance sheet, to recognize changes in the funded status in the year in which changes occur through comprehensive income, and to measure the funded status as of the balance sheet date. The requirement to recognize the funded status of benefit plans and the disclosure requirements are effective for fiscal years ending after December 15, 2006. The requirement to measure the funded status as of the date of the balance sheet is effective for fiscal years ending after December 15, 2008. The Company is currently evaluating the impact of adopting this standard.

Available Information

The Company files an annual report on Form 10K, quarterly reports on Form 10Q, current reports on Form 8K and amendments to those reports with the Securities and Exchange Commission (SEC) pursuant to Section 13 (a) or (15)d of the Exchange Act. The Company’s Internet address is www.cortland-banks.com. The Company makes available through this address, free of charge, the reports filed, as soon as reasonably practicable after such material is electronically filed, or furnished to, the SEC. The SEC also maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

(Dollars in thousands)

Management considers interest rate risk to be the Company’s principal source of market risk. Interest rate risk is measured as the impact of interest rate changes on the Company’s net interest income. Components of interest rate risk comprise re-pricing risk, basis risk and yield curve risk. Re-pricing risk arises due to timing differences in the re-pricing of assets and liabilities as interest rate changes occur. Basis risk occurs when re-pricing assets and liabilities reference different key rates. Yield curve risk arises when a shift occurs in the relationship among key rates across the maturity spectrum.

The effective management of interest rate risk seeks to limit the adverse impact of interest rate changes on the Company’s net interest margin, providing the Company with the best opportunity for maintaining consistent earnings growth. Toward this end, Management uses computer simulation to model the Company’s financial performance under varying interest rate scenarios. These scenarios may reflect changes in the level of interest rates, changes in the shape of the yield curve, and changes in interest rate relationships.

The simulation model allows Management to test and evaluate alternative responses to a changing interest rate environment. Typically when confronted with a heightened risk of rising interest rates, the Company will evaluate strategies that shorten investment and loan re-pricing intervals and maturities, emphasize the acquisition of floating rate over fixed rate assets, and lengthen the maturities of liability funding sources. When the risk of falling rates is perceived, Management will typically consider strategies that shorten the maturities of funding sources, lengthen the re-pricing intervals and maturities of investments and loans, and emphasize the acquisition of fixed rate assets over floating rate assets.

The most significant assumptions used in the simulation relate to the cash flows and re-pricing characteristics of the Company’s balance sheet. Re-pricing and runoff rate assumptions are based on a detailed interface with actual customer information and investment data stored on the subsidiary bank’s information systems. Consensus prepayment speeds derived from an independent third party source are used to adjust the runoff cash flows for the impact of the specific interest rate environments under consideration. Simulated results are benchmarked against historical results. Actual results may differ from simulated results not only due to the timing, magnitude and frequency of interest rate changes, but also due to changes in general economic conditions, changes in customer preferences and behavior, and changes in strategies by both existing and potential competitors.

The table on the following page shows the Company’s current estimate of interest rate sensitivity based on the composition of the balance sheet at September 30, 2006, and December 31, 2005. For purposes of this analysis, short term interest rates as measured by the federal funds rate and the prime lending rate are assumed to increase (decrease) gradually over the subsequent twelve months reaching a level 300 basis points higher (lower) than the rates in effect at September 30, 2006 and December 31, 2005 for the respective simulations. Under both the rising rate scenario and the falling rate scenario, the yield curve is assumed to exhibit a parallel shift.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

(CONTINUED)

(Dollars in thousands)

Over the past twelve months, the Federal Reserve has increased its target rate for overnight federal funds by 200 basis points. At September 30, 2006, the difference between the yield on the ten-year Treasury and the three-month Treasury had declined to a negative 25 basis points from the positive 31 basis points that existed at December 31, 2005. The yield curve overall has inverted since December 31, 2005 as interest rates in the six month time frame now exceed those through thirty years.

The base case against which interest rate sensitivity is measured assumes no change in short-term rates. The base case also assumes no growth in assets and liabilities and no change in asset or liability mix. Under these simulated conditions the base case projects net interest income of $14,975 for the twelve month period ending September 30, 2007.

Simulated Net Interest Income (NII) Scenarios
Fully Taxable Equivalent Basis
For the Twelve Months Ending


	Net Interest Income				$ Change in NII						% Change in NII
Changes in	Sept 30,		Dec. 31,		Sept 30,			Dec. 31,			Sept 30,			Dec. 31,
Interest Rates	2007		2006		2007			2006			2007			2006
Graduated increase of +300 basis points	$	15,088	$	15,385	$	113		$	8			0.8	%		0.1	%
Short term rates unchanged		14,975		15,377
Graduated decrease of -300 basis points		14,798		14,643		(177	)		(734	)		(1.2	)%		(4.8	)%

The level of interest rate risk indicated is within limits that Management considers acceptable. However, given that interest rate movements can be sudden and unanticipated, and are increasingly influenced by global events and circumstances beyond the purview of the Federal Reserve, no assurance can be made that interest rate movements will not impact key assumptions and parameters in a manner not presently embodied by the model.

It is Management’s opinion that hedging instruments currently available are not a cost effective means of controlling interest rate risk for the Company. Accordingly, the Company does not currently use financial derivatives, such as interest rate options, floors or other similar instruments.

CORTLAND BANCORP AND SUBSIDIARIES

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. With the supervision and participation of management, including the Company’s principal executive officer and principal financial officer, the effectiveness of disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)) has been evaluated as of the end of the period covered by this report. Based upon that evaluation, the Company’s principal executive officer and principal financial officer have concluded that such disclosure controls and procedures are, to the best of their knowledge, effective as of the end of the period covered by this report to ensure that material information relating to the Company and its consolidated subsidiaries is made known to them, particularly during the period for which our periodic reports, including this report, are being prepared.

Changes in Internal Control Over Financial Reporting. Our Chief Executive Officer and Chief Financial Officer have concluded that there have been no significant changes during the period covered by this report in the Company’s internal control over financial reporting (as defined in Rules 13a-13 and 15d-15 of the Exchange Act) that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

CORTLAND BANCORP AND SUBSIDIARIES

PART II — OTHER INFORMATION

Item 1. Legal Proceedings

See Note (5) of the financial statements.

Item 1A Risk Factors

There have been no material changes from the risk factors previously disclosed in response to Item 1A of Part 1 of Form 10-K filed March 16, 2006

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable

Item 3. Defaults upon Senior Securities

Not applicable

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable

Item 5. Other Information

Not applicable

CORTLAND BANCORP AND SUBSIDIARIES

PART II — OTHER INFORMATION (CONTINUED)

Item 6. Exhibits


		Exhibit 2		Not applicable

		Exhibit 3.1		Restated Amended Articles of Cortland Bancorp reflecting amendment dated May 18, 1999. Note: filed for purposes of SEC reporting compliance only. This restated document has not been filed with the State of Ohio. (1)

		Exhibit 3.2		Code of Regulations, as amended (1)

		Exhibit 4		The rights of holders of equity securities are defined in portions of the Articles of Incorporation and Code of Regulations as referenced in 3.1 and 3.2. (1)

		* Exhibit 10.1		Group Term Carve Out Plan dated February 23,2001 and form of endorsement entered into in 2001 by The Cortland Savings and Banking Company with each executive officer other than Rodger W. Platt and with selected other officers, as amended by the August 2002 letter amendment (1)

		* Exhibit 10.2		Group Term Carve Out Plan Amended Split Dollar Policy Endorsement entered into by The Cortland Savings and Banking Company on December 15, 2003 with Stephen A. Telego, Sr. (1)

		* Exhibit 10.3		Director Retirement Agreement between Cortland Bancorp and Jerry A. Carleton, dated as of July 26, 2005 (1)

		* Exhibit 10.4		Director Retirement Agreement between Cortland Bancorp and David C. Cole, dated as of March 1, 2001, as amended by letter amendment dated February 12, 2004 (1)

		* Exhibit 10.5		Director Retirement Agreement between Cortland Bancorp and George E. Gessner, dated as of March 1, 2001, as amended by letter amendment dated February 12, 2004 (1)

		* Exhibit 10.6		Amended Director Retirement Agreement between Cortland Bancorp and William A. Hagood, dated as of October 12, 2003 (1)

		* Exhibit 10.7		Director Retirement Agreement between Cortland Bancorp and James E. Hoffman III, dated as of March 1, 2001, as amended by letter amendment dated February 12, 2004 (1)

		* Exhibit 10.8		Director Retirement Agreement between Cortland Bancorp and Neil J. Kaback, dated as of March 1, 2004 (1)

		* Exhibit 10.9		Director Retirement Agreement between Cortland Bancorp and K. Ray Mahan, dated as of March 1, 2001 (1)

		* Exhibit 10.10		Amended and Restated Director Retirement Agreement between Cortland Bancorp and Richard B. Thompson, dated as of May 1, 2004 (1)

		* Exhibit 10.11		Director Retirement Agreement between Cortland Bancorp and Timothy K. Woofter, dated as of March 1, 2001, as amended by letter amendment dated February 12, 2004 (1)

		* Exhibit 10.12		Form of Split Dollar Agreement entered into by Cortland Bancorp and each of Directors David C. Cole, George E. Gessner, William A. Hagood, James E. Hoffman III, K. Ray Mahan, and Timothy K. Woofter as of February 23, 2001, as of March 1, 2004 with Director Neil J. Kaback, and as of October 1, 2001 with Director Richard B. Thompson; and Split Dollar Agreement and Endorsement entered into by Cortland Bancorp as of July 26, 2005 with Director Jerry A. Carleton (1)

CORTLAND BANCORP AND SUBSIDIARIES

PART II — OTHER INFORMATION (Continued)


		* Exhibit 10.13		Split Dollar Agreement between The Cortland Savings and Banking Company and Rodger W. Platt dated of as February 23, 2001, as amended on August 15, 2002 and September 29, 2005 (1)

		* Exhibit 10.14		Endorsement Split Dollar Agreement between The Cortland Savings and Banking Company and Rodger W. Platt dated as of September 29, 2005 (1)

		* Exhibit 10.15		Form of Indemnification Agreement entered into by Cortland Bancorp with each of its directors as of May 24, 2005 (1)

		* Exhibit 10.16		Amended Salary Continuation Agreement between The Cortland Savings and Banking Company and Rodger W. Platt, dated as of August 15, 2002 (1)

		* Exhibit 10.17		Second Amended and Restated Salary Continuation Agreement between The Cortland Savings and Banking Company and Timothy Carney, dated as of December 17, 2003 (1)

		* Exhibit 10.18		Second Amended and Restated Salary Continuation Agreement between The Cortland Savings and Banking Company and Lawrence A. Fantauzzi, dated as of December 16, 2003 (1)

		* Exhibit 10.19		Second Amended and Restated Salary Continuation Agreement between The Cortland Savings and Banking Company and James M. Gasior, dated as of December 15, 2003 (1)

		* Exhibit 10.20		Amended Salary Continuation Agreement between The Cortland Savings and Banking Company and Marlene Lenio, dated as of September 9, 2002 (1)

		* Exhibit 10.21		Salary Continuation Agreement between The Cortland Savings and Banking Company and Craig Phythyon, dated as of December 15, 2003 (1)

		* Exhibit 10.22		Second Amended and Restated Salary Continuation Agreement between The Cortland Savings and Banking Company and Stephen A. Telego, Sr., dated as of December 15, 2003 (1)

		* Exhibit 10.23		Second Amended and Restated Salary Continuation Agreement between The Cortland Savings and Banking Company and Danny L. White, dated as of December 15, 2003 (1)

		* Exhibit 10.24		Second Amended Split Dollar Agreement and Endorsement between The Cortland Savings and Banking Company and Timothy Carney, dated as of December 17, 2003 (1)

		* Exhibit 10.25		Second Amended Split Dollar Agreement and Endorsement between The Cortland Savings and Banking Company and Lawrence A. Fantauzzi, dated as of December 16, 2003 (1)

		* Exhibit 10.26		Second Amended Split Dollar Agreement and Endorsement between The Cortland Savings and Banking Company and James M. Gasior, dated as of December 15, 2003 (1)

		* Exhibit 10.27		Amended Split Dollar Agreement between The Cortland Savings and Banking Company and Marlene Lenio, dated as of September 9, 2002 (1)

CORTLAND BANCORP AND SUBSIDIARIES

PART II — OTHER INFORMATION (Continued)


		* Exhibit 10.28		Split Dollar Agreement and Endorsement between The Cortland Savings and Banking Company and Craig Phythyon, dated as of December 15, 2003 (1)

		* Exhibit 10.29		Second Amended Split Dollar Agreement and Endorsement between The Cortland Savings and Banking Company and Stephen A. Telego, Sr., dated as of December 15, 2003 (1)

		* Exhibit 10.30		Second Amended Split Dollar Agreement and Endorsement between The Cortland Savings and Banking Company and Danny L. White, dated as of December 15, 2003 (1)

		* Exhibit 10.31		Severance Agreement Due to Change in Control of Cortland Bancorp entered by Cortland Bancorp and The Cortland Savings and Banking Company in January 2001 with each of Timothy Carney, Lawrence A. Fantauzzi, James M. Gasior, and Stephen A. Telego, Sr. (1)

		* Exhibit 10.32		Severance Agreement Due to Change in Control of Cortland Bancorp entered by Cortland Bancorp and The Cortland Savings and Banking Company in January 2001 with each of Marlene Lenio, Barbara Sandrock, and Danny L. White (1)

		Exhibit 11		See Note (6) of the Financial Statements

		Exhibit 15		Not applicable

		Exhibit 18		Not applicable

		Exhibit 19		Not applicable

		Exhibit 22		Not applicable

		Exhibit 23		Not applicable

		Exhibit 24		Not applicable

		Exhibit 31.1		CEO certification (Filed herewith)

		Exhibit 31.2		CFO certification (Filed herewith)

		Exhibit 32		Certifications of Chief Executive Officer and Chief Financial Officer required under Section 906 of Sarbanes-Oxley Act of 2002 (Filed herewith)


*		Management contract or compensatory plan or arrangement

(1)		Filed previously as an Exhibit to form 10-K filed on March 16, 2006

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.



		Cortland Bancorp

		(Registrant)

DATED: November 2, 2006		/s/ Lawrence A. Fantauzzi

		Lawrence A. Fantauzzi
		President
		(Chief Executive Officer)

DATED: November 2, 2006		/s/ James M. Gasior

		James M. Gasior
		Secretary
		(Chief Financial Officer)

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