Cortland Bancorp (CLDB) 10-Q 2005 Q3 Quarterly report

United States Securities and Exchange Commission

Washington, D. C. 20549

FORM 10-Q

þ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended: September 30, 2005

or

o Transition Report Pursuant to Section 13 or 15(d) of the Securities 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 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

(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. Yesþ Noo

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yesþ Noo

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

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 October 26, 2005 4,222,416 Shares

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Cortland Bancorp and Subsidiaries:
Consolidated Balance Sheets — September 30, 2005 (Unaudited) And December 31, 2004 (Audited)	2
Unaudited Consolidated Statements of Income — Nine months ended September 30, 2005 and 2004 and Three months ended September 30, 2005 and September 30, 2004	3
Unaudited Consolidated Statement of Shareholders’ Equity — Nine months ended September 30, 2005 and 2004	4
Unaudited Consolidated Statements of Cash Flows — Nine months ended September 30, 2005 and 2004	5
Notes to Unaudited Consolidated Financial Statements September 30, 2005	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, 2005, December 31, 2004 and September 30, 2004	16
Consolidated Average Balance Sheets, Yields Rates — Quarter to Date September 30, 2005, March 31, 2005 and September 30, 2004	17
Selected Financial Data	18
Financial Review	19 — 29
Item 3. Quantitative and Qualitative Disclosures about Market Risk	30 — 31
Item 4. Controls and Procedures	32
PART II — OTHER INFORMATION
Item 1. Legal Proceedings	33
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 3. Defaults Upon Senior Securities	33
Item 4. Submission of Matters to a Vote of Security Holders	33
Item 5. Other Information	33
Item 6. Exhibits	33 — 34
Signatures	35
EX-31.1
EX-31.2
EX-32

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (SEE NOTES 1 & 2)

(Amounts in thousands, except share data)

	(Unaudited)			(Audited)
	SEPTEMBER 30			DECEMBER 31
	2005			2004
ASSETS
Cash and due from banks	$	11,265		$	9,397
Federal funds sold		5,800			3,500
Total cash and cash equivalents		17,065			12,897
Investment securities available for sale (Note 3)		113,697			121,348
Investment securities held to maturity (approximate market value of $109,028 in 2005 and $106,210 in December 2004 (Note 3)		108,368			104,493
Total loans (Note 4)		192,398			191,777
Less allowance for loan losses (Note 4)		(2,204	)		(2,629	)
Net loans		190,194			189,148
Premises and equipment		4,195			4,369
Other assets		16,060			14,138
Total assets	$	449,579		$	446,393
LIABILITIES
Noninterest-bearing deposits	$	59,458		$	58,394
Interest-bearing deposits		283,625			286,525
Total deposits		343,083			344,919
Federal Home Loan Bank advances and other borrowings		54,115			47,889
Other liabilities		2,868			4,187
Total liabilities		400,066			396,995
SHAREHOLDERS’ EQUITY
Common stock — $5.00 stated value — authorized 20,000,000 shares; issued 4,373,735 shares in 2005 and December 2004 (Note 1)		21,869			21,869
Additional paid-in capital (Note 1)		18,411			18,531
Retained earnings		13,600			13,131
Accumulated other comprehensive income (loss) (Note 1)		(235	)		1,061
Treasury shares at cost, 162,785 in 2005 and 204,635 in December 2004		(4,132	)		(5,194	)
Total shareholders’ equity		49,513			49,398
Total liabilities and shareholders’ equity	$	449,579		$	446,393

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

2

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

(Amounts in thousands, except per share data)

	THREE					NINE
	MONTHS ENDED					MONTHS ENDED
	SEPTEMBER 30,					SEPTEMBER 30,
	2005		2004			2005		2004
INTEREST INCOME
Interest and fees on loans	$	3,285	$	3,103		$	9,626	$	9,278
Interest and dividends on investment securities:
Taxable interest income		1,079		921			3,081		2,573
Nontaxable interest income		538		663			1,624		1,925
Dividends		38		31			115		96
Interest on mortgage-backed securities		911		914			2,853		2,722
Other interest income		33		17			75		34
Total interest income		5,884		5,649			17,374		16,628
INTEREST EXPENSE
Deposits		1,569		1,469			4,416		4,302
Borrowed funds		628		555			1,810		1,662
Total interest expense		2,197		2,024			6,226		5,964
Net interest income		3,687		3,625			11,148		10,664
Provision for loan losses		160		175			410		275
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES		3,527		3,450			10,738		10,389
OTHER INCOME
Fees for other customer services		592		628			1,704		1,720
Investment securities gains — net		4		366			308		674
Gain on sale of loans — net		28		18			59		41
Other real estate losses — net				(3	)				(171	)
Other non-interest income		108		134			352		437
Total other income		732		1,143			2,423		2,701
OTHER EXPENSES
Salaries and employee benefits		1,972		1,697			5,326		5,007
Net occupancy and equipment expense		482		460			1,422		1,403
State and local taxes		138		136			414		431
Office supplies		82		76			254		263
Bank exam and audit expense		85		175			292		364
Marketing expense		95		26			208		130
Other operating expenses		434		416			1,294		1,264
Total other expenses		3,288		2,986			9,210		8,862
INCOME BEFORE FEDERAL INCOME TAXES		971		1,607			3,951		4,228
Federal income taxes		120		292			710		690
NET INCOME	$	851	$	1,315		$	3,241	$	3,538
BASIC EARNINGS PER COMMON SHARE (NOTE 6)	$	0.20	$	0.31		$	0.77	$	0.85
DILUTED EARNINGS PER COMMON SHARE (NOTE 6)	$	0.20	$	0.31		$	0.77	$	0.85
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

3

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, 2004:
BALANCE AT JANUARY 1, 2004	$	21,234	$	16,469		$	15,401		$	2,203			($5,426	)	$	49,881
Comprehensive income:
Net income							3,538									3,538
Other comprehensive income, net of tax:
Unrealized gains or (losses) on available-for-sale securities, net of reclassification adjustment										(534	)					(534	)
Total comprehensive income																3,004
Common stock transactions:
Treasury shares reissued				80									956			1,036
Treasury shares purchased													(1,032	)		(1,032	)
Cash dividends declared							(2,657	)								(2,657	)
BALANCE AT SEPTEMBER 30, 2004	$	21,234	$	16,549		$	16,282		$	1,669			($5,502	)	$	50,232
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

	SEPTEMBER 30,
	2005			2004
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		($1,093	)		($  90	)
Less: Reclassification adjustment for net gains realized in net income, net of tax		203			444
Net unrealized gains (losses) on available- for-sale securities, net of tax		($1,296	)		($534	)

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

4

CORTLAND BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(Amounts in thousands)

	FOR THE
	NINE MONTHS ENDED
	SEPTEMBER 30,
	2005			2004
NET CASH FLOWS FROM OPERATING ACTIVITIES	$	1,461		$	6,406
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of securities held to maturity		(32,068	)		(33,018	)
Purchases of securities available for sale		(15,057	)		(47,725	)
Proceeds from sales of securities available for sale		1,479			18,675
Proceeds from call, maturity and principal payments on securities		47,058			62,777
Net (increase) decrease in loans made to customers		(976	)		(5,852	)
Proceeds from disposition of other real estate					815
Purchase of premises and equipment		(289	)		(76	)
Net cash flows from investing activities		147			(4,404	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net (decrease) increase in deposit accounts		(1,836	)		8,333
Net increase (decrease) in borrowings		6,226			(3,146	)
Dividends paid		(2,772	)		(2,657	)
Purchases of treasury shares		(1	)		(1,032	)
Treasury shares reissued		943			1,036
Net cash flows from financing activities		2,560			2,534
NET CHANGE IN CASH AND CASH EQUIVALENTS		4,168			4,536
CASH AND CASH EQUIVALENTS
Beginning of period		12,897			9,747
End of period	$	17,065		$	14,283
SUPPLEMENTAL DISCLOSURES
Interest paid	$	6,317		$	6,018
Income taxes paid	$	950		$	750

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

5

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, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. These interim unaudited consolidated financial statements should be read in conjunction with our annual audited financial statements as of December 31, 2004, included in our Form 10-K for the year ended December 31, 2004, filed with the United States Securities and Exchange Commission. The accompanying consolidated balance sheet at December 31, 2004, 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 2004 financial statements have been reclassified to conform to the presentation for 2005. 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.

6

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,
	2005		2004		2005		2004
Proceeds on securities sold	$		$	9,252	$	1,479	$	18,675
Gross realized gains				357		287		663
Gross realized losses								10
Proceeds on securities called	$	4,000	$	7,681	$	12,050	$	9,731
Gross realized gains		4		9		21		21
Gross realized losses

     Securities available for sale, carried at fair value, totaled $113,697 at September 30, 2005 and $121,348 at December 31, 2004 representing 51.2% and 53.7%, 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 $45,949 at September 30, 2005 and $48,114 at December 31, 2004 were pledged to secure deposits and for other purposes.

7

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, 2005, 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	$	50	$	50
Due after one year through five years		11,079		11,071
Due after five years through ten years		3,387		3,087
Due after ten years		34,265		34,682
		48,781		48,890
Mortgage-backed securities		61,924		61,459
	$	110,705	$	110,349

Investment securities	AMORTIZED		ESTIMATED
held to maturity	COST		FAIR VALUE
Due in one year or less	$	396	$	398
Due after one year through five years		2,206		2,161
Due after five years through ten years		30,669		30,595
Due after ten years		54,273		55,390
		87,544		88,544
Mortgage-backed securities		20,824		20,484
	$	108,368	$	109,028

8

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, 2005, 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	$	14,075	$	59	$	144	$	13,990
Obligations of states and political subdivisions		11,385		578		4		11,959
Mortgage-backed and related securities		61,924		369		834		61,459
Corporate securities		23,321		46		426		22,941
Total debt securities		110,705		1,052		1,408		110,349
Other securities		3,348						3,348
Total available for sale	$	114,053	$	1,052	$	1,408	$	113,697

			GROSS		GROSS		ESTIMATED
Investment securities	AMORTIZED		UNREALIZED		UNREALIZED		FAIR
held to maturity	COST		GAINS		LOSSES		VALUE
U.S. Treasury Securities	$	149	$	4	$		$	153
U.S. Government agencies and corporations		54,106		60		447		53,719
Obligations of states and political subdivisions		33,289		1,403		20		34,672
Mortgage-backed and related securities		20,824				340		20,484
Total held to Maturity	$	108,368	$	1,467	$	807	$	109,028

9

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, 2004:

			GROSS		GROSS		ESTIMATED
Investment securities	AMORTIZED		UNREALIZED		UNREALIZED		FAIR
available for sale	COST		GAINS		LOSSES		VALUE
U.S. Treasury Securities	$	1,192	$	254	$		$	1,446
U.S. Government agencies and corporations		21,687		215		40		21,862
Obligations of states and political subdivisions		10,900		741				11,641
Mortgage-backed and related securities		66,643		802		302		67,143
Corporate securities		16,081		22		87		16,016
Total debt securities		116,503		2,034		429		118,108
Other securities		3,240						3,240
Total available for sale	$	119,743	$	2,034	$	429	$	121,348

			GROSS		GROSS		ESTIMATED
Investment securities	AMORTIZED		UNREALIZED		UNREALIZED		FAIR
held to maturity	COST		GAINS		LOSSES		VALUE
U.S. Treasury Securities	$	152	$	5	$		$	157
U.S. Government agencies and corporations		46,210		172		192		46,190
Obligations of states and political subdivisions		34,048		1,870		21		35,897
Mortgage-backed and related securities		24,083		103		220		23,966
Total held to maturity	$	104,493	$	2,150	$	433	$	106,210

10

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,
	2005		2004
Financial instruments whose contract amount represents credit risk:
Commitments to extend credit:
Fixed rate	$	2,754	$	1,506
Variable		35,274		30,400
Standby letters of credit		1,445		1,455

     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 individually/jointly owned accounts in good standing for 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 at September 30, 2005 totaled $6,307. The total average daily balance of overdrafts used in 2005 was $126, or approximately 2% of the total aggregate overdraft protection available to depositors.

11

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,
	2005			2004
1-4 family residential mortgages		31.5	%		31.9	%
Commercial mortgages		48.6	%		49.0	%
Consumer loans		3.5	%		3.2	%
Commercial loans		10.5	%		10.0	%
Home equity loans		5.9	%		5.9	%

     There are $587 in mortgage loans held for sale included in 1-4 family residential mortgages as of September 30, 2005, and none at December 31, 2004. 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, 2005 and December 31, 2004:

	September 30,		December 31,
	2005		2004
Loans accounted for on a nonaccrual basis	$	3,535	$	3,395
Loans contractually past due 90 days or more as to interest or principal payments (not included in nonaccrual loans above)	NONE		NONE
Loans considered troubled debt restructurings (not included in nonaccrual loans or loans contractually past due above)	NONE		NONE

12

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 nonaccrual basis and loans considered troubled debt restructuring for the nine months ended September 30, 2005 and 2004.

	September 30,		September 30,
	2005		2004
Gross interest income that would have been recorded if the loans had been current in accordance with their original terms	$	245	$	190
Interest income actually included in income on the loan		36		58

     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, 2005 the recorded investment in impaired loans was $2,191 while the related portion of the allowance for loan losses was $815. At December 31, 2004, there were $2,985 in loans considered impaired while the allocated portion of the allowance for loan losses for such loans was $1,355.

     Loans in the amount of $8,232 as of September 30, 2005, and $5,622 as of December 31, 2004, 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.

13

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, 2005 and September 30, 2004:

	THREE MONTHS						NINE MONTHS
	2005			2004			2005			2004
Balance at beginning of period	$	2,862		$	2,496		$	2,629		$	2,408
Loan charge-offs:
1-4 family residential mortgages		—			56			6			77
Commercial mortgages		679			—			685			—
Consumer loans and Other loans		78			21			149			42
Commercial loans		80			—			88			10
Home equity loans		6			—			6			—
		843			77			934			129
Recoveries on previous loan losses:
1-4 family residential mortgages		—			—			—			—
Commercial mortgages		—			—			—			—
Consumer loans and Other loans		24			14			86			50
Commercial loans		1			—			13			4
Home equity loans		—			—			—			—
		25			14			99			54
Net charge-offs		(818	)		(63	)		(835	)		(75	)
Provision charged to operations		160			175			410			275
Balance at end of period	$	2,204		$	2,608		$	2,204		$	2,608
Ratio of annualized net charge-offs to average loans outstanding		1.69	%		0.13	%		0.57	%		0.05	%

     The $843 in charge-offs in the third quarter of 2005 primarily reflects 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 dynamically updated to reflect actual experience and changing circumstances.

14

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,
	2005		2004			2005		2004
Net Income	$	851		$	1,315	$	3,241		$	3,538
Weighted average common shares outstanding *		4,210,954			4,156,969		4,199,582			4,149,410
Basic earnings per share *	$	0.20		$	0.31	$	0.77		$	0.85
Diluted earnings per share *	$	0.20		$	0.31	$	0.77		$	0.85
Dividends declared per share*	$	0.22		$	0.21	$	0.66		$	0.64

* Average shares outstanding and resultant per share amounts have been restated to give retroactive effect to the 3% stock dividend of January 1, 2005.

15

CORTLAND BANCORP AND SUBSIDIARIES

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

CONSOLIDATED AVERAGE BALANCE SHEETS,
YIELDS AND RATES (UNAUDITED)

(Fully taxable equivalent basis in thousands of dollars)

	YEAR TO DATE AS OF
	September 30, 2005							December 31, 2004							September 30, 2004
	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	$	3,354	$	75		3.0	%	$	5,623	$	83		1.5	%	$	4,099	$	34		1.1	%
Investment securities (1) (2)		218,254		8,443		5.2	%		216,560		11,034		5.1	%		215,911		8,229		5.1	%
Loans (2) (3)		193,641		9,700		6.7	%		193,927		12,474		6.4	%		194,288		9,345		6.4	%
Total interest-earning assets		415,249	$	18,218		5.8	%		416,110	$	23,591		5.7	%		414,298	$	17,608		5.7	%
Cash and due from banks		9,334							9,276							9,250
Bank premises and equiptment		4,368							4,637							4,702
Other assets		12,459							14,252							14,322
Total non-interest-earning assets		26,161							28,165							28,274
Total Assets	$	441,410						$	444,275						$	442,572
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest-bearing demand deposits	$	48,940	$	253		0.7	%	$	48,945	$	263		0.5	%	$	48,045	$	179		0.5	%
Savings		89,826		440		0.7	%		90,584		501		0.6	%		90,444		381		0.6	%
Time		143,400		3,723		3.5	%		147,662		5,023		3.4	%		147,080		3,742		3.4	%
Total interest-bearing deposits		282,166		4,416		2.1	%		287,191		5,787		2.0	%		285,569		4,302		2.0	%
Federal funds purchased		356		8		3.0	%		289		4		1.4	%		386		4		1.2	%
Other borrowings		47,773		1,802		5.0	%		45,804		2,219		4.8	%		46,268		1,658		4.8	%
Total interest-bearing liabilities		330,295	$	6,226		2.5	%		333,284	$	8,010		2.4	%		332,223	$	5,964		2.4	%
Demand deposits		58,011							56,778							56,365
Other liabilities		3,225							4,385							4,311
Shareholders’ equity		49,879							49,828							49,673
Total liabilities and Shareholders’ equity	$	441,410						$	444,275						$	442,572
Net interest income			$	11,992						$	15,581						$	11,644
Net interest rate spread (4)						3.3	%						3.3	%						3.3	%
Net interest margin (5)						3.8	%						3.7	%						3.7	%
Ratio of interest-earning assets to interest-bearing liabilities						1.26							1.25							1.25

(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%.
(3)	Includes loan origination and commitment fees.
(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 diffence between total interest earned and total interest expensed by total interest-earning assets.

16

CORTLAND BANCORP AND SUBSIDIARIES
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CONSOLIDATED AVERAGE BALANCE SHEETS,
YIELDS AND RATES (UNAUDITED)

(Fully taxable equivalent basis in thousands of dollars)

	QUARTER TO DATE AS OF
	September 30, 2005							June 30, 2005							September 30, 2004
	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	$	3,821	$	33		3.4	%	$	3,901	$	28		2.9	%	$	4,846	$	17		1.4	%
Investment securities (1) (2)		217,572		2,819		5.2	%		217,100		2,825		5.2	%		218,530		2,842		5.2	%
Loans (2) (3)		193,659		3,309		6.8	%		194,350		3,259		6.7	%		195,159		3,125		6.4	%
Total interest-earning assets		415,052	$	6,161		5.9	%		415,351	$	6,112		5.9	%		418,535	$	5,984		5.7	%
Cash and due from banks		9,550							9,462							9,264
Bank premises and equiptment		4,280							4,391							4,574
Other assets		12,732							12,060							13,369
Total non-interest-earning assets		26,562							25,913							27,207
Total Assets	$	441,614						$	441,264						$	445,742
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest-bearing demand deposits	$	49,286	$	108		0.9	%	$	50,762	$	79		0.6	%	$	50,430	$	78		0.6	%
Savings		88,402		180		0.8	%		90,573		140		0.6	%		90,549		132		0.6	%
Time		142,222		1,281		3.6	%		141,367		1,209		3.4	%		148,414		1,259		3.4	%
Total interest-bearing deposits		279,910		1,569		2.2	%		282,702		1,428		2.0	%		289,393		1,469		2.0	%
Federal funds purchased		382		3		3.8	%		80		1		3.2	%		30
Other borrowings		49,235		625		5.0	%		47,219		595		5.1	%		45,504		555		4.9	%
Total interest-bearing liabilities		329,527	$	2,197		2.6	%		330,001	$	2,024		2.5	%		334,927	$	2,024		2.4	%
Demand deposits		58,804							58,558							57,100
Other liabilities		3,092							2,938							4,200
Shareholders’ equity		50,191							49,767							49,515
Total liabilities and Shareholders’ equity	$	441,614						$	441,264						$	445,742
Net interest income			$	3,964						$	4,088						$	3,960
Net interest rate spread (4)						3.3	%						3.4	%						3.3	%
Net interest margin (5)						3.8	%						3.9	%						3.8	%
Ratio of interest-earning assets to interest-bearing liabilities						1.26							1.26							1.25

(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%.
(3)	Includes loan origination and commitment fees.
(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 diffence between total interest earned and total interest expensed by total interest-earning assets.

17

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,
	2005			2005			2005			2004			2004
SUMMARY OF OPERATIONS
Total interest income	$	5,884		$	5,829		$	5,661		$	5,660		$	5,649
Total interest expense		2,197			2,024			2,005			2,046			2,024
NET INTEREST INCOME (NII)		3,687			3,805			3,656			3,614			3,625
Provision for loan losses		160			138			112			140			175
NII after loss provision		3,527			3,667			3,544			3,474			3,450
Security gains (losses)		4			2			302			378			366
Gain on sale of loans		28			22			9			13			18
Total other income		700			677			679			739			759
Total other expense		3,288			2,972			2,950			2,999			2,986
Income before tax		971			1,396			1,584			1,605			1,607
Net income	$	851		$	1,132		$	1,258		$	1,305		$	1,315
Core earnings (1)	$	990		$	1,116		$	1,053		$	1,047		$	1,064
Net income (Rolling 4 Quarters) (2)	$	4,546		$	5,010		$	4,960		$	4,843		$	4,878
Core earnings (Rolling 4 Quarters)	$	4,206		$	4,280		$	4,188		$	4,192		$	4,239
PER COMMON SHARE DATA (3)
Net income, both basic and diluted	$	0.20		$	0.27		$	0.30		$	0.31		$	0.31
Net income, both basic and diluted (Rolling 4 Quarters)		1.08			1.20			1.19			1.17			1.17
Core income, both basic and diluted		0.24			0.27			0.25			0.25			0.26
Core income, both basic and diluted (Rolling 4 Quarters)		1.00			1.02			1.01			1.01			1.02
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		11.76			11.92			11.71			11.85			11.85
BALANCE SHEET DATA
Assets	$	449,579		$	439,287		$	442,067		$	446,393		$	446,334
Investments		222,065			214,336			217,025			225,841			220,718
Net loans		190,194			191,003			192,939			189,148			192,328
Deposits		343,083			337,337			340,303			344,919			345,889
Borrowings		54,115			48,526			47,379			47,889			44,740
Shareholders equity		49,513			50,058			49,069			49,398			50,232
AVERAGE BALANCES
Assets	$	441,614		$	441,264		$	441,486		$	449,348		$	445,742
Investments		217,572			217,100			220,117			218,495			218,530
Net loans		191,060			191,584			190,260			190,223			192,684
Deposits		338,714			341,260			340,578			350,029			346,493
Borrowings		49,617			47,299			47,446			44,419			45,534
Shareholders equity		50,191			49,767			49,905			50,289			49,515
ASSET QUALITY RATIOS
Underperforming assets as a percentage of:
Total assets		0.81	%		0.93	%		0.86	%		0.76	%		0.74	%
Equity plus allowance for loan losses		7.04			7.69			7.31			6.52			6.25
Tier I capital		7.35			8.24			7.74			7.05			6.84
FINANCIAL RATIOS
Return on average equity		6.78	%		9.10	%		10.08	%		10.38	%		10.62	%
Return on average equity (Rolling 4 Quarters)		9.08			10.04			9.98			9.73			9.89
Return on average assets		0.77			1.03			1.14			1.16			1.18
Return on average assets (Rolling 4 Quarters)		1.03			1.13			1.11			1.09			1.11
Effective tax rate		12.36			18.91			20.58			18.69			18.17
Net interest margin ratio		3.83			3.93			3.79			3.74			3.79

(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.

18

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 2004 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 2004 annual report on Form 10-K.

19

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. During the current year the Company refined its approach to reserving for such unfunded credit commitments, incorporating into its reserve calculations 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 from September 30, 2004 and from levels at year-end as the Company increased its level of Federal Funds Sold. Operating activities provided cash of $1,461 and $6,406 during the nine months ended September 30, 2005 and 2004, respectively. Key differences stem mainly from: 1) a decrease in net income of $297 compared to September 30, 2004; 2) loans held for sale increased by $587 at September 30, 2005 as compared to a decrease of $103 at September 30, 2004, which favorably impacted the proceeds on loans in 2004; 3) gains on the sale of investments was $308 at September 30, 2005 compared to $674 at September 30, 2004; 4) amortization on securities was $463 in 2005 compared to $1,213 in 2004; 5) loss on the sale of other real estate totaled $171 in 2004 and none in 2005; 6) a liability for Securities to Settle totaled $1,521 at September 30, 2004 with none at December 31, 2003, an increase of $1,521 while there was no liability at September 30, 2005, a decrease of $1,270 from December 31, 2004. Refer to the Consolidated Statements of Cash Flows for a summary of the sources and uses of cash for September 30, 2005 and 2004, and the following table which details the cash flows from operating activities.

20

CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

	Nine Months Ended
	September 30,
	2005			2004
Net Income	$	3,241		$	3,538
Adjustments to reconcile net income to net cash flows from operating activities:
Depreciation, amortization and accretion		1,171			1,687
Provision for loan loss		410			275
Investment securities gains		(308	)		(674	)
Other real estate losses					171
Impact of loans held for sale		(587	)		103
Changes in:
Securities to settle and securities sold to settle		(1,270	)		1,521
Other assets and liabilities		(1,196	)		(215	)
Net cash flows from operating activities	$	1,461		$	6,406

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 the nine months ended September 30, 2005 and 2.5% for the nine months ended September 30, 2004. 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 0.3%. 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.

21

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, 2005 and December 31, 2004.

	September 30, 2005			December 31, 2004
Tier 1 Capital	$	49,568		$	48,129
Tier 2 Capital		2,215			2,664
TOTAL QUALIFYING CAPITAL	$	51,783		$	50,793
Risk Adjusted
Total Assets (*)	$	240,938		$	230,133
Tier 1 Risk-Based
Capital Ratio		20.57	%		20.91	%
Total Risk-Based
Capital Ratio		21.49	%		22.07	%
Tier 1 Risk-Based
Capital to Average Assets (Leverage Capital Ratio)		11.24	%		10.88	%

(*) Includes off-balance sheet exposures.

     Assets, less intangibles and the net unrealized market value adjustment of investment securities available for sale, averaged $440,833 for the nine months ended September 30, 2005 and $442,428 for the year ended December 31, 2004.

22

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, 2005 and December 31, 2004. 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
	2005			2004			Capitalized			Capitalized
Total risk-based capital to risk-weighted assets		21.49	%		22.07	%		10.00	%		8.00	%
Tier 1 capital to risk-weighted assets		20.57	%		20.91	%		6.00	%		4.00	%
Tier 1 capital to average assets		11.24	%		10.88	%		5.00	%		4.00	%

23

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 2005 as Compared to First Nine Months of 2004

     During the first nine months of 2005, net interest income after provision for loan losses increased by $349 compared to the first nine months of 2004. Total interest income increased by $746 or 4.5%, from the level recorded in 2004. This was accompanied by an increase in interest expense of $262 or 4.4%, and an increase in the provision for loan losses of $135. On a fully taxable equivalent basis, net interest income after provision for loan losses increased by $213.

     The increase in net income was the product of a 0.2% year-over-year increase in average earning assets and improvement in the Company’s net interest margin. The Company’s tax equivalent net interest margin for the first nine months of 2005 measured 3.8% and 3.7% in the same period of 2004.

     The average rate paid on interest sensitive liabilities increased by 12 basis points year-over-year. The average balance of interest sensitive liabilities decreased by $1,929 or 0.6%. Compared to the first nine months of last year, average borrowings increased by $1,474 while the average rate paid on borrowings increased by 27 basis points.

     Average interest-bearing demand deposits and balances on money market accounts increased by $895, while savings deposits decreased by $618. The average rate paid on these products increased by 13 basis points in the aggregate. The average balance on time deposit products decreased by $3,680, while the average rate paid increased by 7 basis points.

     Interest and dividend income on securities registered an increase of $357, or 4.9%, during the first nine months of 2005 when compared to 2004, while on a fully tax equivalent basis income on investment securities increased by $214 or 2.6%. The average invested balances increased by $2,343 from the levels of a year ago. The increase in the average balance of investment securities was accompanied by an 8 basis point increase in the tax equivalent yield of the portfolio.

     Interest and fees on loans increased by $348, or 3.8%, for the first nine months of 2005 compared to 2004,while on a fully tax equivalent basis income on loans increased by $355 or 3.8%. A $647 decrease in the average balance of the loan portfolio, or 0.3%, was accompanied by a 25 basis point increase in the portfolio’s tax equivalent yield.

     Other interest income increased by $41 from the same period a year ago. The average balance of Federal Funds sold and other money market funds decreased by $745, or 18.2%. The yield on federal funds and other money market funds, increased by 188 basis points compared to the same period of 2004.

24

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 $278 from the same period a year ago. Gains on 1-4 residential mortgage loans sold in the secondary mortgage market increased by $18 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 $366 from year ago levels. Fees for other customer services decreased by $16. In the first nine months of 2004, losses on other real estate owned of $171 were recorded with none in the similar period of 2005. Other sources of non-recurring non-interest income decreased by $85 from the same period a year ago. This income category is subject to fluctuation due to non-recurring items, but the difference is due mainly to an $81 decrease in non-taxable income on bank owned life insurance policies.

     Loan charge-offs during the first nine months were $934 in 2005 compared to $129 in 2004, while the recovery of previously charged-off loans amounted to $99 in 2005 compared to $54 in 2004. The increase in charge-offs during 2005 primarily reflects impaired loan credits for which specific loss reserves had previously been established. A provision for loan loss of $410 was charged to operations in 2005 and $275 in 2004. Non-accrual loans at September 30, 2005 and December 31, 2004 represented 1.8% of the loan portfolio. At September 30, 2005, the loan loss allowance of $2,204 represented approximately 1.1% of outstanding loans.

     Total other expenses in the first nine months were $9,210 in 2005 compared to $8,862 in 2004, an increase of $348, or 3.9%. Full time equivalent employment during the first nine months of both 2005 and 2004 averaged 163 employees. Salaries and benefits increased by $319 or 6.4%, compared to the similar period a year ago. This increase is a combination of regular staff salary and benefit increases and a one-time cash bonus of $243 awarded to the President and CEO in recognition of 42 years of service to the bank, 29¹/2 years as President and CEO and 18 years as Chairman of the Board and the growth and profitability achieved by the Bank under his leadership.

     For the first nine months of 2005, state and local taxes decreased by $17 or 3.9%. Occupancy and equipment expense increased by $19 or 1.4%. Office supplies decreased by $9. Marketing expense increased by $78. Much of this increase is due to the timing of marketing expenditures which should slow in the fourth quarter. Bank exam and audit expense decreased by $72, due to higher costs in 2004 associated with the implementation of the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. All other expense categories increased by 2.4%, or $30 as a group. This expense category is subject to fluctuation due to non-recurring items.

     Income before income tax expense amounted to $3,951 for the first nine months of 2005 compared to $4,228 for the similar period of 2004. The effective tax rate for the first nine months was 18.0% in 2005 compared to 16.3% in 2004, resulting in income tax expense of $710 and $690, respectively. The increase in the effective tax rate reflects an increase in taxable income, while income exempt from taxation from all sources decreased. 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,
	2005			2004
Provision at statutory rate	$	1,343		$	1,438
Add (Deduct):
Tax effect of non-taxable income		(689	)		(816	)
Tax effect of non-deductible expense		56			68
Federal income taxes	$	710		$	690

Net income for the first nine months registered $3,241 in 2005 compared to $3,538 in 2004, representing per share amounts of $0.77 in 2005 and $0.85 in 2004. Dividends declared per share were $0.66 in 2005 and $0.64 in 2004.

25

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) decreased by $20, or 0.6% in the first nine months of 2005 compared to 2004. Core earnings for the nine months of 2005 were $3,159 compared to last year’s $3,179. Core earnings per share were $0.76 in both 2005 and 2004. The following is a reconciliation between core earnings and earnings under generally accepted accounting principles in the United States (GAAP earnings):

	Nine Months Ended
	September 30,
	2005			2004
GAAP Earnings	$	3,241		$	3,538
Investment security gains		(308	)		(674	)
Gain on sale of loans		(59	)		(41	)
Other real estate losses					171
Other non-recurring items*		243
Tax effect of adjustments		42			185
Core Earnings	$	3,159		$	3,179
Core earnings per share	$	0.76		$	0.76

* Includes one-time cash bonus declared in recognition of the Bank’s performance under the retiring C.E.O.

26

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 2005 as Compared to Third Quarter of 2004

     During the third quarter of 2005 net interest income after provision for loan losses increased by $77 as compared to third quarter 2004. Year-over-year average earning assets decreased by $3,483 or 0.8% and average interest-bearing liabilities decreased by $5,400 or 1.6%. Average loans decreased by 0.8%, while average investments decreased by 0.4%.

     The composite tax equivalent yield on earning assets increased by 21 basis points from the same quarter a year ago. The tax equivalent yield of the investment portfolio measured 5.2%, a 2 basis point decrease from the same quarter a year ago, while the loan portfolio yielded 6.8%, up 42 basis points from last year’s rate. Meanwhile, the rate paid on interest-bearing liabilities increased 24 basis points compared to a year ago. The average rate on federal funds sold and other money market funds was 5.0%, up 18 basis points from last year’s rates. The net effect of these changes was that the tax equivalent net interest margin was unchanged at 3.8%.

     Loans net of the allowance for losses decreased by $2,134 during the 12-month period from September 30, 2004 to September 30, 2005, and increased by $1,046 from year-end. Gross loans as a percentage of earning assets stood at 45.8% as of September 30, 2005 and 46.3% at September 30, 2004. The loan to deposit ratio at the end of the first nine months of 2005 was 56.1% and 56.4% for the same period a year ago. The investment portfolio represented 64.7% of each deposit dollar, up from 63.8% a year ago.

     Total interest income increased by $235 or 4.2% from the same quarter a year ago. This was accompanied by a $173 increase in interest expense and a $15 decrease in the provision for loan losses.

     Loan charge-offs during the third quarter were $843 in 2005 and $77 in 2004, while the recovery of previously charged-off loans amounted to $25 during the third quarter of 2005 compared to $14 in the same period of 2004. 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 $411, or 36.0% compared to the same period a year ago. The net gain on loans sold during the quarter increased by $10 compared to a year ago. There was $366 in gains on investment and trading securities transactions in the third quarter of 2004 compared to the $4 gain realized in 2005. Fees from other customer services decreased by $36, primarily due to a decline in service charge income. A loss on other real estate of $3 was realized in the second quarter of 2004, while none was incurred during the comparable period of 2005. Other sources of non-recurring non-interest income decreased by $26 from the same period a year ago. This is due mainly to a $24 decrease in non-taxable income on bank owned life insurance policies, reflecting declines in the investment yields associated with these policies.

     Total other expenses in the third quarter were $3,288 in 2005 and $2,986 in 2004, an increase of $302 or 10.1%. Employee salaries and benefits increased by $275 or 16.2%. This increase is a combination of regular staff salary and benefit increases and a one-time cash bonus of $243 awarded to the retiring President and CEO in recognition of 42 years of service to the bank, 29¹/2 years as President and CEO and 18 years as Chairman of the Board and the growth and profitability achieved by the bank under his leadership. Occupancy and equipment expense showed a $22 increase, or 4.8%. Other expenses, as a group increased by $5, or 0.6%, compared to the same period last year.

27

CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

     Income before tax for the quarter decreased by 39.6% to $971 in 2005 from the $1,607 recorded in 2004. Net income for the quarter of $851 represented a 35.3% decrease from the $1,315 earned a year ago. Earnings per share amounted to $0.20 for the third quarter of 2005 and $0.31 for 2004. Dividends declared per share were $0.22 in 2005 and 0.21 in 2004.

     Core earnings (earnings before gains on loans sold, investment securities sold or called, other real estate losses and certain other non-recurring items) decreased by 7.0% in the third quarter of 2005 compared to 2004. Core earnings for the third quarter of 2005 were $990 compared to last year’s $1,064. Core earnings per share were $0.24 in 2005 and $0.26 in 2004. 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,
	2005			2004
GAAP Earnings	$	851		$	1,315
Investment security gains		(4	)		(366	)
Gain on sale of loans		(28	)		(18	)
Other real estate losses					3
Other non recurring items*		243
Tax effect of adjustments		(72	)		130
Core Earnings	$	990		$	1,064
Core earnings per share	$	0.24		$	0.26

* Includes one-time cash bonus declared in recognition of the Bank’s performance under the retiring C.E.O.

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.

28

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

     Emerging Issues Task Force (“EITF”) Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”), provides application guidance to determine when an investment is considered impaired, whether that impairment is other-than-temporary, and whether recognition of an impairment loss is required. The guidance also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than–temporary impairments. In September 2004, the Financial Accounting Standards Board (FASB) staff issued FASB Staff Position (FSP) EITF No. 03-1-1, which delayed full implementation of the accounting requirements of EITF 03-1, with the exception of certain disclosure requirements. The Company does not believe that EITF No. 03-1 will have a material impact on its financial position and results of operation.

     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 the retrospective application to prior periods’ financial statements of the direct effect of a voluntary change in accounting principle unless it is impracticable. APB No. 20 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. FASB stated that SFAS No. 154 improves the financial reporting because its requirements enhance the consistency of financial information between periods. SFAS No. 154 is effective for fiscal years beginning after December 31, 2005. The Company does not believe there will be any material impact on its earnings, cash flows and/or financial position upon adoption of SFAS No. 154 on January 1, 2006.

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 iswww.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 atwww.sec.gov.

29

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 prepayments 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, 2005, and December 31, 2004. 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, 2005 and December 31, 2004 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.

30

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, 2005, the difference between the yield on the ten-year Treasury and the three-month Treasury had decreased to a positive 79 basis points from the positive 202 basis points that existed at December 31, 2004. The change denotes a “flattening” of the yield curve. The yield curve, however, remains positively sloping, as interest rates increase with a lengthening of maturities, with rates peaking at the long-end of the Treasury curve.

     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 $15,682 for the twelve month period ending September 30, 2006.

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	2006		2005		2006			2005			2006			2005
Graduated increase of +300 basis points	$	16,196	$	16,018	$	514		$	251			3.3	%		1.6	%
Short term rates unchanged		15,682		15,767
Graduated decrease of - -300 basis points		15,304		14,896		(378	)		(871	)		(2.4	)%		(5.5	)%

     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, swaps, caps, floors or other similar instruments.

31

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.

32

CORTLAND BANCORP AND SUBSIDIARIES

PART II — OTHER INFORMATION

Item 1.Legal Proceedings

     See Note (5) of the financial statements.

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

Item 6.Exhibits

2. Not applicable

3.i. Articles of Incorporation of the Corporation as currently in effect and any amendments thereto, (incorporated by reference to Registrant’s Registration Statement on Form S-3 filed on October 28, 1993, exhibit A).

3.ii. Bylaws and/or Code of Regulations of the Corporation as currently in effect incorporated herein by reference to Registration Statement on Form S-3 on October 28, 1993, exhibit B).

4.	Not applicable
10.	Not applicable
11.	See Note (6) of the Financial Statements
15.	Not applicable
18.	Not applicable
19.	Not applicable
22.	Not applicable
23.	Not applicable
24.	Not applicable

33

CORTLAND BANCORP AND SUBSIDIARIES

PART II — OTHER INFORMATION (CONTINUED)

31.1	CEO certification (Filed herewith)
31.2	CFO certification (Filed herewith)
32.	Certifications of Chief Executive Officer and Chief Financial Officer required under Section 906 of Sarbanes-Oxley Act of 2002 (Filed herewith)

34

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: October 26, 2005	/s/ Lawrence A. Fantauzzi
	Lawrence A. Fantauzzi
	President
	(Chief Executive Officer)
DATED: October 26, 2005	/s/ James M. Gasior
	James M. Gasior
	Secretary
	(Chief Financial Officer)

35