Cortland Bancorp
Annual Report 2003

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A N N U A L R E P O R T CONTENTS Chairnian’s M essage E Brief Description of the Business Rcporl of Indcpendenl Auditors Consolidatcd Statements of I ncoiiie Consolidated Balance Sheets Consolidated Statements of Sharcholdcrs’ Equity Consolidated Slalements of Cash Flows Notes to the C‘onsolidatcd Financial Statemenls Three Year Sumnary Averagc Halance Shcet, Yields and Rates Selected Financial Dala Manapenienl’s Discussion and Analysis Information iis lo Stock Prices and Dividends Cortland Bancorp Direclors and Officers Corlland Savings & Banking Directors and OHkers Offices and I>ocalions CH A 1 R M AN’S ME:SSAGE TO OUR SHAREHOLDERS: Martha Stewart wiis recently convicted of insidcr trading in the sale or her lmclone stock, right? Wrong. Thc fact is that the government was unable to bring ii case of insider trading against Ms. Stewart. The law and the Licts ol: the case simply would not support the charge. So they charged Martha with lying to the government, obstructing justice, conspiracy and some other trumped up charges that the judge found so creative that she tossed them right out of court. Investigators discovered that their initial suspicion-that Martha had bccn “tippcd” by Samuel Waksal, a close personal friend and 1 tnclonc’s founder-simply was not true. Undaunted, they chosc to indict hcr for lying about a crime, even though one had not actually bccn committed. This made it prophct of Justicc Ruth Bader Ginsburg who wrote in a 1996 Supreme Court case that “The prospect remains that an ovcrzcalous prosecutor or investigtator- aware that a pcrson has committed some suspicious acts, but unable to make a criminal casc-will crcate a crime by ing about those acts, and rccciv- surprising the subject, ing a false denial.” TI appears to be exactly what has happcncd to Martha. There was no underlying crime. Had Martha said nothing at all when confronted by federal investigators, shc would not now be facing the prospect of jail. Ironically, the one charge o n which the jury failed to convict was that Marthii’s broker had altered evidcnce by notaling after the fact that there wiis an agreement to sell Martha’s Imclone holdings i C the stock’s price fell to $60 or $61. On this point the jury found that they had reasonable doubt. Yet this was the very corncrstonc of the govern- ment’s case. If the jury had re:isonablc doubt on this critical point, they should have had reasonable doubt rcgarding thc rest of the government’s case. Unfortunatcly for Martha the jury never made this leap in logic, and Martha was found guilty. Perhiips the U.S. Attorney and tlic jurors considered this a victory Cor the “little guy.” But try cxplaining that to all of the “little guys” who were either employees or sharcholdcrs of Martha Stewart Living Onmimedia or K-Mart (21 major distribution channel and marketing outlet for Martha’s products). For thosc folks, this was a very expensive “vic- tory,” disrupting their livcs, undcrrnining their financial security and thrcatcning thcir very livelihood. Whereas before there had been no victim for therc was no crime, now there were plenty of real suffcring victims, all in the name of justice. Perhaps the U.S. Attorney and the jurors considered this ii victory to protect tlic intcgrity of our judicial system? It would “send a message,” cncouraging future suspects 10 tell the truth. More likely, iis suggested by Justicc Ginsburg’s 1996 opinion, it calls into question the very integrity of a system that would put so many innocent lives at-risk in the absence or any underlying crime. instead of encouraging “truth-telling,” the case reallirnis the old adage that “si- lence is golden.” Even i f une has the best legal representa- tion that money can huy, one may not be able to avoid trouble. Nearly evcry point on which Martha Stewart was convicted arose from actions that she took after having consulted with some of the finest legal minds in the land. Such i s the state of our judicial system, for all of its many strengths i t is extraordinarily complex, Craught with the risk of wrongful accusation, enttapmenl and self-incrimination. Although ours is a system where the accused is assumed innocent until proven guilty, the .judge and jury arc still human. Thc vcrdict may hingc on whcther thc defendant has disproved the accusations or whether thc dcfcndant is perceived iis a member of ii special, privilegcd class. Post- verdict commcnts by .jurors suggcst that this may have indccd occurred in Martha’s case, and that issues of class distinction may havc playcd a rolc in the deliberations. Perhaps we are particularly sensitive to Martha’s plight as we have bccn to court morc than a fcw timcs oursclvcs. While we haven’t yet had anyone trick us quitc as badly as what Martha experienced, we’ve had a Cew folks try. It’s not that hard. The real beauty or the American jurisprudence system is that, i f you have the filing fee, just about anybody can suc anyone else over just about anylhing for any amount they choose. Since 1993, the Company’s bank subsidiary has been a defendant in a class action lawsuit involving purchascd interests in two Ohio campgrounds. We knew that we hadn’t done anything wrong, yet we shod accused. In fact, wc had .joined with other financial institutions to help these campgrounds work through a difficult bankruptcy reorgani- zation. As ii result, the campgrounds rcmaincd opcn both during and aftcr tlic bankruptcy, cnabling the campers to enjoy without interruption the full benefit of thcir mcmbcr- ship. Yet we found ourselves accused of all sorts of vile and dastardly deeds, from racketeering to running a corrupt organiziilion. None of it was true, of course. All of it was contrived to “raise the stakes,” reduce our risk tolcrancc, and drive us to quickly settle. We were supposed to run (not walk) to the vault, withdraw a tidy sum, and lay ii largc lump of tnoncy on plaintiffs’ attorneys. Probleni was, they had pickcd on thc wrong folks this time. If settling was thc “smart” thing to do, then we were just way too stupid. Our roots arc firmly plantcd way back in the 19th Century. We believe in old-fashion valucs likc truth, hard work, honor, loyalty and intcgrity. Wc find that some things arc just worth fighting about. So when someone dares besmirch our charactcr and rcputation, it’s titne to “c;rll them out.” So we did. We fought thcm in the Northern Ilistrict of Ohio Eastern Division of the Fcdcral Court, and we won. We fought them in United States Court of Appeals for the Sixth Circuit, and we won. We I fought them in the Common Pleas Court or Trumbull County, and we won. Wc fought them in the I I t h District Court or Appeals, and on March 4, 2004 we were notificd that we had won again. It’s been ii long, tough fight, hut so Tar truth and .justice have won out. And ror that wc are grateful. The Sarhanes-Oxlcy Act, enacted in 2002 in responsc to numerous corporatc scandals itnd corporate governancc failures, is a meritorious attempt on the part or our govern- ment to rcstorc honesty, integrity and ethical behavior in the corporatc world. It established tough new standards and regulations regarding corporate responsibility, and in- creased civil and criminal penaltics, in an effort to restore public and inveslor confidencc. Wc have rrlready imple- iiiented many of the provisions of Sarbanes-Oxley. We will be spending considerably morc time, energy and money in 2004 to furthcr phase-in additional provisions of the Act to ensure invcstors of the effectiveness or our internal controls and procedurcs. While we salute the lofty goals of Sarhanes-Oxlcy, wc can’t help but wonder if Justice Gins- burg’s 1996 warning won’t find new applicability in thc legal plight of some future CEO or CFO? What if our government oficials were also held to thc same high standards as Sarbitnes-Oxley or Martha Stcwart, that lying to the American public was a criminal act? What i f i t wcrc a criminitl act to make false cartipaign promises? What il“ a candidate werc hcld pcrsonally liable Tor ractual inisrepresentaliom or making falsc accusations against a political opponent? What a difcrcnt world that would be! The campaign political rhetoric has alrcady started, and i t is having an effect on thc Amcrican public. Meitsures or consumer confidence had rallicd quite strongly during the second half of 2003. Now with the advent of the presidcn- tial primaries consuii~er confidence has notably wcakcned. This dip in confidence has much morc to do with the constant bashing of the economy by prcsidcntial contenders than any real weakness in business activity. Perhaps you may rccall that when young George’s fathcr was running for re-elcction, the challengers’ battle cry was “It’s thc Worst Econortiy in SO Years!” or the more insulting “It’s the Economy, Stupid!” Turns out it was a lic. Thc ccononiy wits growing at a very rapid pacc, but that wouldn’t he known for surc until aftcr the election. And unlike Martha, no onc was threatened with jail time rot lying. Fact is, the economy is beginning to do rathcr nicely. Congrcss and the Administration finally got it right last ycar with legislation that focused tax inccntivcs on capital spcnding and investment. The dollar was also finally al- lowed to decline against lhe Euro and thc Ycn, improving the competitiveness of manufaclurers and exporters. The Pcd remained accommodative as interest ratcs hcld at or near their 45-year lows. Fiscal policy .joined in, helping to prime-the-pump by rcplacing the economic drag or a large surplus with thc stimulus of it deficit. There are still sornc hurdles remaining: the high cost of energy, jobs and thc threat or terrorism and intcrnational turmoil. U.S. crude oil prices during 2003 averaged $31 per barrel, thc highest yearly average in morc than 20 years. The high cost of “black gold” helped push the price or real gold back over $400 an ounce, ncar its 14-year peak. Energy costs arc unlikely tu fall until morc capacity i s brought on-streatn or when alternative fuels are dcvcloped. The longer energy costs remain at such lofty lcvcls, the more exploration and research iire encouraged. Mcanwhile, gasoline prices in thc U.S. are expected to top $2 per gallon, and will likcly dampen growth in consumer spending. New jobs will be created once the economy begins lo consistcntly grow faster than the rate of productivity, which has bccn siniply phenomenal. Tndccd cconoiiiic growth did finally overtake productivity growth in the 4th quarter of 2003. Recently we have begun to sce a steady decline in initial uneinploymenl claims. Ncw .jobs will follow as ca- pacity utilization increases to mcct the demands of a growing economy. Remember, until recently the economy had been considered to hc at full employment when thc unemployment ratc was at 6.0%. The current unemploy- ment rate is 5.6%. The outlook for 2004 is basically positive. Howcvcr, interest rates arc likcly to remain ;it or near their 45-ycar lows for much if not all of the year. This will continue to keep the pressure on thc Company’s net interest margin, thc differ- ence hetwccn what it earns on its loans and invcstnients and what it pays for its deposits and borrowings. With interest ratcs hovcring just above zero, it is difficult to reduce further the cost or runds. The Company will attempt to offset this erect by incrcasing non interest income and controlling non intcrcst cxpense. Indeed our net intcrcst margin did narrow during 2003 to below recent historical norms. While the Company was unahle to achievc a 10th consecutive year of record profits, net income or $5.484 million was the third best in the Compiiny’s long history. Earnings per share of $1.34 checked in 3s the second bcst in history. At this time, I would also likc to recognize Neil J. Kahack, a partncr in thc CPA firm of Cohen &L Company, who rccently joined our Board. I would also like to cxtcnd a very special thanks to William A. Hagood for his 32 years or service. Bill will be retiring frotn thc Board as his term expires this April. Sincerely. Rodpcr W. Platt Chairman and President B R I E F DESCRIPTION OF THE BUSINESS COR‘I’LAN I) BANCORP Cortland Bancorp (the “Company”) was incorporated under the laws of the State of Ohio in 1984, as a one bank holding company registered under the Bank IIold- ing Company Act of 1956, as amended. On March 13, 2000, the Board of Chvcrnorq of the Federal Reserve system approved the Company’s application to become a financial holding company as authorixd by the C;ramm-I,each-Bliley Act o l 1999. Thc principal activ- ity of the Company is to own, m:inagc and wpervise the Cortland Savings and Banking Company (“Cortland Banks” or the “Rank’). The Company owns d l of tlic outstanding shareq of the Rank. The Company is subject to supervision m d regulation by the Board of Governors of thc Federal Reserve System (the “Federal Reserve Board”). Aq a financial holding company, the Company may cngagc in activities that are financial in nature or incidental to a financial activ- ity, as authorized by the Grainiii-Leach-Blilcy Act of 1999 (The Financial Services Reform Act). Under the Financial Services R e h m Act, tlic Company triay con- tinue to claim the benefits of financial holding company statuq as long as each depository institution that it controls rctnainq well capitalized and well managed. Thc Company is requircd to provide notice to the Board of Governors of the Federal Rcqcrve Systerii when it be- conies dware that any depository institution controlled by the Company ceases to be well capitaliyed or well managed. Furthermore, current regulation spccifieq that prior to initiating or engaging in any new activiticq that are authoriied for financial holding companics, thc Company’s insured depository instilutions must bc rated “satisfactory” or better under the Community Kcinvcst- ( C K A ) . 4s of December 31, 2003, thc inent Act Company’s bank whsidiary was rated “satisluctory” for CRA purposes, and remaincd well capitalized and, in management’s opinion, well managcd. Cortland Rancorp owns no property. Operations are conducted at I94 Wcst Main Strcct, Cortland, Ohio. Tlic husincss of the Company and the Bank i q not seasonal to any qignificant extent and is not depcndcnt on any single customcr or group of customers. NEW RESOURCES LEASING COMPANY New Resources Leasing Company was formed in December 1988 a s ii separatc cntity to handle the function of conimercial and consumer lcnding The wholly owncd whsidiary has been inactive sincc incorporation. THE CORTT,AND SAVINGS AND BANKING COMPANY The Cortland Savings and Banking Coriipany is it lull service state bank engaged in commercial and retail banking and trust services. Thc Bank’s services include checking accounts, savings accountq, time deposit ac- counts, commercial, mortgage and installment loans, leasing, night depository, wtorniited teller scrviccs, safe dcposit boxes and other miscellaneous services normally offered by commercial banks. Cortlmd Banks also oKers ii variety of Tntcrnet Banking products as well as dis- count brokerage services. Business is conducted at a total of thirteen ofices, eight of which are located in Trumbull County, Ohio. Two offices are located in the comiiiunities of Windham and Mantua, in Portage County, Ohio. One office is locatcd in the community of Willianislield, hshtahula County, Ohio, while two are located in the community of Board- man, Mahoning County, Ohio. Cortland Banks niain office (as described in its charter) is located at 194 Wcqt Main Street, Cortland, Ohio. Administrative ollices are located at the main office. The Brookfield, Windham, IIubbard, Boardman and Niles Park P l a ~ a ollices are leased, while all of thc other offices are owned by Cortland Banks. The Bank, as a state chartered banking organization and member ol‘ the Federal Reserve Systcm, is subject to periodic examination and regulAon by both the Federal Reserve Bank o l Cleveland and thc State of Ohio Division of Banks. These examinations, which includc wch areas as capital, liquidity, asset quality, managc- inent practiccs and other aspects of the Bmk’s operit- tions, lire primarily for thc protcction of the Banks depositors. In addition io these regular cxaminations, the Bank must furnish periodic reports to regulatory authorities containing u lull and accuratc statcment of its affairs. The Bank‘s deposits are insured by tlic Pcd- era1 Deposit Insurance Corporation (FDIC) up to tlic statutory limit of $100,000 per customer. COMPETIlION Cortland Banks actively competes with state and na- tional banks located in Northeast Ohio and Western Pennsylvania. It also competeq for deposits, loans and other service business with a largc number of other financial institutions, such as savings and loan associa- tions, credit unions, insurance companies, consunicr finance conipanies and commercial linance and lcasing companics. Also, money market m u t u d funds, broker- age houscq and si tnilar institutions provide in a relatively unregulatcd cnvironment many of the financial services ofered by hanks. I n the opinion of management, the principal methods of compctition are the rates o l inter- est charged on loitns, the rates of intcrcst paid on deposit funds, the fees charged for services, and tlic conve- nicncc, availability, timeliness and quality of thc cus- tonier scrviccq offered. EMPLOYEES As of Dccctnher 31, 2003 the Company through its subsidiary hank, cmployed 144 full-time and 39 part- time ernployces. The Company provides its employees with a full rangc of benefit plans, and considers its relations with its ctnployces to be satisfactory. KEPOKT OF I’ACKEK THOMAS I N D E P E N D E N T A U D I T O R S SHAREHOLDERS AND BOARD OF DIRECTORS Cortland Bancorp We have audited the accompanying consolidated balance sheets of Cortland Rancorp and subsjdiar- ies as of December 31, 2003 and 2002 and the related consolidated statements of income, share- holders’ equity and cash flows lor each ol‘ the three years in the period ended December 31, 2003. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with audit- ing standards generally accepted in the United States of America. Those standards require thai we plan and perform the audit to obtain reasonable assurance about whcthcr the financial statements arc free of material misstatement. An audit in- in cludes examining, on a test basis, evidence sup- the porting the amounts and disclosures consolidated financial statements. A n audit in- cludes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement pres- entation. We believe that our audits provide a reasonable basis for our opinion. I n our opinion, the consolidated financial state- ments referred to above present fairly, in all mate- rial respects, the consolidated financial position of Cortland Bancorp and subsidiaries at Decen- ber 31, 2003 and 2002, and the consolidated rcsults of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted the United States of America. in Youngstown, Ohio January 30, 2004, Except for Note 16, as to which the date is March 04, 2004 Packer Thomas CORTLAND BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME Years ended December 31. 2003. 2002 and 2001 (Amounts in lhousands except per share data) Interest income Interest and fees on loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest and dividends on investrncnt sccurilies: . . Taxable interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nontaxablc intcrcst . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . Interest on trading account securities . . . . . . . . . . . . . . . . . . . . . . . . . . . Other interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowed funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nct interesl incoine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision for loan losses (Note 4) . . . . . . . . . . . . . . . . . . . . . Net interest income after provision for loan losses Other income . . Fees for other customer services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities gains . net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trading securities gains . net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of' loans . net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses Salaries and employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net occupancy and equipment expense . . . . . . . . . . . . . . . . . . . . . . . . . State and local taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Lcgal and litigation expense (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . Marketing expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. 068 2. 473 132 4. 009 69 117 22. 907 5. 819 2.313 8. 132 14. 775 240 14. 535 1. 636 946 265 470 532 3. 849 6. 586 1. 963 524 347 152 177 1. 780 11. 529 6. 855 Income before federal income taxes Federal income taxes (Note 10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1. 371 $ 5. 484 Net income Net income per share. both basic and diluted (Note 1 ) . . . . . . . . . . . . . $ 1.34 See accompanying notes to consolidated linancial statements 2003 2002 200 I . . $13. 039 $15. 434 $17. 689 3. 272 2. 487 I70 5. 322 3. 733 2. 032 269 5. 708 226 26.91 1 368 29. 799 7. 534 2. 470 IO. 004 16. 907 460 16. 447 1. 362 21 5 318 805 2.700 6. 798 2. 077 505 363 138 161 1.784 1 1 . 826 7. 321 1. 579 $ 5. 742 1 1 . 176 2. 647 13. 823 IS. 976 220 15. 756 I . 537 386 269 531 2.723 6. 283 2. 109 605 411 143 160 I . 494 1 I. 205 7. 274 I. 728 $ 5. 546 $ 1.38 $ 1.33 CORTLAND BANCOKP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS As ol‘ December 31. 2003 and 2002 (Amounts in thousands except per share data) 2003 2002 ASSETS Cash and due from banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9, 747 9, 747 12. $ 5 7 1 20. 000 32. 571 Investment securities available for sale (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities held to maturity (approximate markct valuc of $98. 451 in 2003 and $85. 957 in 2002) (Note 2) . . . . . . . . . . . Total loans (Notc 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less allowance for loan losses (Note 4 ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment (Note 5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Olher assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125. 841 1 7 9 5 15. 96. 934 189. 262 (2. 408) 186. 854 4. 872 14. 144 84. 108 191. 477 (3. 134) 188. 343 5. 277 1 1 . 504 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $438. 392 $437. 598 LIABILITIES Noninterest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest-bearing deposits (Note 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Rank advances and other borrowings (Note 7 ) Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 57. 632 279. 924 337. 556; 47. 886 3. 069 388. 511 55. $ 7 4 5 280.01 3 335. 758 46. 669 3. 132 385. 559 Commitments and contingent liabilities (Notes 8 and 16) SHAREHOLDERS’ EQIJTTY Common stock . $5.00 stated value . authorized 20.000. 000 shares; issued 4.246. 747 shares in 2003 and 4.123. 437 shares in 2002 (Nole 1) . . . . . Additional paid-in capital (Note I ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income (Note 1 ) . . . . . . . . . . . . . . . . . . . . . . . Treasury stock. at cost. 212. 838 shares in 2003 and 131. 544 shares in 2002 . . . . Total shareholders’ equity (Notes 15 and 17) . . . . . . . . . . . . . . . . . . . . . . Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . 21. 234 16. 469 15. 401 2. 203 (5. 426) 49. 881 20. 6 I7 13. 323 17. XI0 3. I65 (2. 876) 52. 039 $438. 392 $437. 598 See accompanying notes to consolidated financial statements E CORTLAND BANCOKI-' AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF Si1 AREHOLDEKS' EQUITY Years ended December 31, 2003, 2002 and 2001 (Amounts in thousands excepl per share data) Additional Paid-In Capital $ 4,271 30 Accuiiiulated Other Retined Comprehensive Treasury Earnings Income (Loss) $19,789 Total Shnre- holders Equity Stock ~- $(1,657) $47,736 896 $ 5,546 938 5,546 938 6,484 210 240 (3,355) (573) 1,834 - - (8) (I ,447) 50,524 5,742 1,331 5,742 1,331 7.073 583 1,644 . . . . . . . . . -~ 20,020 10,945 (3,355) (573) (2,227) (8) 19,172 Coininon Stock Balance at Decemher 31, 2000 . . . . . . . . . . . . . . . . $19,437 Comprehensive Income: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive income, net of tax: Unrealized gains on available for sale securities, net of reclassification adjustment Total comprehensive income Common Stock Transactions: Treasury shares reissued net or shures repurchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared ($81 per sh:ire) Special cash dividend ($.I3 per share) . . . . . . . . 3% stock dividend . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid in lieu of fractional shares Balancc at Deceniber 31, 2001 . . . . . . . . Comprehcnsivc Income: Net income.. ..................... Other comprehensive income, net of tax: [Jnrealized gains on availahle for sale securities, net of reclas Total comprehensive income Common Stuck Transactions: Treasury shares rcpurchascd net of shares rcissued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared ($.83 per share) . . . . . Special cash dividend ($.21 per shurc) . . . . . . . . 3% stock dividend . . . . . . . . . . . . . . . . Cash paid in lieu of fractional shares I65 597 2,213 (3,430) (855) (1,429) (1,264) (3,430) (855) (9) -~ 52,039 (2,876) Balance at December 31, 2002 Comprchensive Income: Net income.. . . . . . . . . . . . . . . . Other comprehensive income, net of tax: Ilnrealized losses on available lor sule securities, net of reclassification adjustment ~~ 2O,6 I7 13,323 17,810 3,165 5,484 Told coinprchcnsivc inconic Common Stock Transactions: Treasury shares repurchased net of shares reissued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends dec Special cash divide 3% stock dividend Cash paid in lieu o Balance at Decemher DISCLOSURE OF RECLASSIE'ICAI'ION FOR AVA1LARX.E FOR SALE SECURJTY GAINS AND 1.OSSES: 230 (2,550) 617 2,916 ~~ $21,234 ~~ ~~ $ 16,469 (3,485) (864) (3,533) (11) $15,401 5.484 (962) 4,522 (2,320) (3,485) ( 864 ) Unrealized holding (losses) or gains on available for sale securities arising during the period net of tax of$(174), $758 and $615 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Reclassification adjustment for gains realized in net income, nct of tax of $322, $74 and $131 624 Net unrealized (losscs) or gains on available for sale securities, net of lax . . . . . . . . . . $ (962) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ~~~ 141 $ 1,331 255 938 $ (11) ~~ -~ $ (5,426) $49,881 - - $ 2,203 2003 $ (338) $ 1,472 $ 1,193 - - ~ See accompanying notes to consolidatcd financial statements CORTLAND BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31. 2003. 2002 and 2001 (Amounts in thousands) Cash flows from operating activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash flows from operating activities: 2003 2002 200 I $ 5. 484 $ 5. 742 $ 5. 546 Depreciation. amortization and accretion . . . . . . . . . . . . . . . . Provision for loan loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . Investment securities gains . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains on sales of loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other real estate losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans originated for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of loans originatcd for sale . . . . . . . . . . . Gain on sale of fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . Changes in: Interest and fees receivable ....................... Interest payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . Net cash flows from operating activities . . . . . . . . . . Cash flows from investing activities Purchases of securities available for sale . . . . . . . . . . . . . . . . . . . . Purchases of securities held to maturity . . . . . . . . . . . . . . . . . . . . . Proceeds from salcs of securities available for sale . . . . . . . . . . . . Proceeds from call. maturity and principal . . paymenls on secunties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net (increase) decrease in loans made to customers . . . . . . . . . . Proceeds from disposition of other real estate . . . . . . . . . . . . . . . . Proceeds from sale of fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of premises and equipment ...................... Net cash flows froiii investing activilics . . . . . . . . . . . Cash flows from financing activities Net increase (decrease) in deposit accounts . . . . . . . . . . . . . . . . . Net increase (decrease) in borrowings . . . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchases of treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Treasury shares reissued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash flows from financing activities . . . . . . . . . . . Net change in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . 2. 382 240 135 (946) (470) (25. 757) 28. 146 131 49 (2. 346) 7. 048 (64. 960) (62. 165) 8. 114 93. 982 (866) 21 (333) (26. 207) 1. 798 1. 217 (4. 360) (3. 641) 1. 321 (3. 665) (22. 824) I . 345 460 (151) (21 5) (318) 9 ( 2 1. 6 12) 19. 908 21 8 (57) 9 5. 338 I . 269 220 (2) (386) (269) 17 ( 17. 000) 17. 269 (45) 393 (158) (676) 6. 178 (32. 144) (56. OXO) 1. 305 (34. 805) (35. 6 15) 3. 998 82. 185 15. 656 170 (425) IO. 667 (1. 903) (2. 693) (4. 294) (2. 460) 1. 196 (IO. 154) 5. 851 70. 434 (1. 672) 2 78 (675) I. 745 7. 712 (106) (3. 936) (999) 1. 239 3. 910 11. 833 Cash and cash equivalents Beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . End of year ............................................ 32. 571 $ 9. 747 26. 720 $ 32. 571 14. 887 $ 26. 720 See accompanying notes to consolidated financial slaleinenls 1 L I I t C O K T L A N D B A N C O R P A N D S U B S I D I A R I E S NOTES TO T H E CONSUL1 DATED FINANC‘JAJ, STATEMENTS Ycars endcd Dccernber 31, 2003, 2002 and 2001 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of Cortland Bancorp (the Company) and its wholly-owned subsidiaries, Cortland Savings and Banking Company (the Bank) and New Resources Leasing Co. All significant intercompany balances and transactions have been eliminated. lnduslry Segment Information: The Company and its subsidiaries operate in the domestic banking industry which accounts for substantially all of the Company’s assets, revenues and operating income. The Company, through its subsidiary bank, grants residential, consumer, and commercial loans and offers a variety of saving plans to customers located primarily in the Northcastcrn Ohio and Western Pennsylvania area. Use of Estimates: The preparation of financial statements in conformity with gcncrally accepted accounting principles requires management to make estimales and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the datc of the financial statements and the reported amounts of revenue and expenses during the reporling period. Actual results could differ from those estimates. Cash Flow: Cash and cash equivalents include cash on hand, amounts due from banks and federal funds sold. Generally, federal funds are purchased and sold for onc-day periods. The Company reports net cash flows for customer loan transactions, deposit transactions and dcposits made with other financial institutions. The Company paid interest of $8,083,000, $I0,061,000 and $ I3,9& 1,000 in 2003, 2002 and 200 1, respectively. Cash paid for income taxes was $1,320,000 in 2003, $1,722,000 in 2002 and $1,695,000 in 2001. Transfers of loans to othcr real estate were $196,000, $820,000 and $204,000 in 2003, 2002 and 2001, respectively. Investment Securities: - Investments in debt and equity securities are classified as held to maturity, trading or available for sale. Securities classified as held to maturity are those that management has the positive intent and ability to hold to maturity. Securities classified as available for sale are those that could be sold for liquidity, invcstiiicnt management, or similar reasons, even though management has no present intentions to do so. Securities held to maturity are staled at cost, adjusted for amortization of premiums and accretion of discounts, with such amortimtion or accretion included in interest income. Securities available for sale are carried at fair value with unrcalized gains and losses recorded as a separate component of shareholders’ equity, net of tax effects. RealiLcd gains or losses on dispositions are based on net proceeds and the adjusted carrying amount of securities sold, using the specific identification method. Interest on securities is accrued and credited to operalions bascd on the principal balance outstanding, adjusted for amortimtion of premiums and accrelion of discounts. Unrealized losses on corporate bonds have not been recognized into income because the issuer’s bonds are of invcslment grade quality. Management has the intent and ability to hold these securities for the foreseeable future. The fair value is expected to recover as the bonds approach their maturity date and/or market conditions become more favorable to the bonds’ intrinsic value. Trading Securities: Trading securities are principally held with lhe intention of selling in the ncar term and are carried at markct value. Realized and unrealiied gains and losses on trading account securities are recognized in the Statement of Income as they occur. The Company did not hold any trading securities at Dcccmber 31, 2003 or 2002. During 2003, trading activity produced purchases of $23,680,000 and sales of $23,945,000, resulting in a net gain of $265,000. There was no trading activity in 2002. Loans: Loans are stated at the principal amount outstanding net of the unamortized balance of deferred loan origination fees and costs. Deferred loan origination fees and costs are amortized as an adjustment to the related loan yield over the contractual life using the level yield method. Interest income on loans is accrued over the term of the loans based on the aniount of principal outstanding. The accrual of interest is I (Continued) COKTLAND RANCORP A N D SUBSlDlAKlES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Ycars cnded December 31, 2003, 2002 and 2001 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POIJCIES (Continued) discontinued on a loan when management determines that the collection of interest is doubtful. Generally a loan is placed on nonaccrual status once the borrower is 90 days past due on payments, or whenever sufficicnl information is received to question the collectability of the loan or any time legal proceedings are initiated involving a loan. Interest income accrued up to the date a loan is placed on nonaccrual i s reversed through interest income. Cash payments received while a loan is classified as nonaccrual are recorded as a reduction to principal or reported as interest income according to management's judgment as to the collectibility of principal. A loan is returned to accrual status when either all of the principal and inlerest amounts contractually due are brought current and futurc payments are, in management's judgment, collectable, or when it otherwise becomcs well secured and in the process of collection. When a loan is charged-ofT, any interest accrued but not collected on the loan is charged against earnings. Loans Held for Sale: The Company originates certain residential mortgage loans lor sale in the secondary mortgage loan market. For the majority of loan sales, the Company concurrently sells the rights to service the related loans. In addition, thc Company may periodically identify other loans which may be sold. These loans are classified as loans held for salc, and carried, in the aggregate, at the lower ol" cost or estimated market value based on secondary market prices. To mitigate interest rate risk, the Company may obtain fixed coinmitiuents to sell such loans at the time loans are originated or identified as bcing held lor sale. No such commitments exisled as of December 31, 2003. Allowance for Loan Losses: Because some loans may not be repaid in full, an allowance for loan losses is recorded. Increases to the allowance consist of provisions for loan losses charged to expense and recoveries of previously charged-ofi loans. Reductions to the allowance result from the charge-off of loans deemed uncollcctablc by management. After a loan is charged-off', collection efforts continue and future recovcrics may occur. A loan is considered impaired when it appears probable that all principal and interest amounts will not be collected according to the loan contract. Allowances for loan losses on impaired loans are determined using the estimated futurc cash flows of the loan, discounted to their present value using the loan's eff-ective interest rate. Allowances for loan losses for impaired loans that are collateral depcndcnt are generally determined based on the estimated fair value of the underlying collateral. Smaller balance homogeneous loans arc evaluated for impairment in the aggregate. Such loans include one-to-four family residential, hoiiic equity and consumer loans. Commercial loans and commercial mortgage loans are evaluated individually for impairment. Impaired loans are gcncrally classified as nonaccrual loans. Estimating the risk of loss and the amount of loss on any loan is necessarily subjective. Accordingly, the allowance is maintained by management at a level considered adequate to covcr possible losses that are currently anticipated based on past loss experience, general economic conditions, information about specific borrower situations, including their financial position and collateral values, and other factors and estimates which are subject to change over time. While management may periodically allocate portions of the allowance for specific problem loans, thc entire allowance is available for any charge-ofis that occur. Premises and Equipment: Premises and equipment are stated a t cost less accumulated deprcciation. Depreciation is computed generally on the straight-linc method over the estimated useful lives of the various assels. Maintenance and repairs are expensed and major improvements are capitalized. Other Real Estate: Real estate acquircd through foreclosure or deed-in-lieu of forcclosure is included in other assets. Such real estate is carried at the lower of cost or fair value less estimated costs to sell. Any reduction h m the carrying value ofthe related loan to fair value at the time of acquisition is accounted for as a loan loss. Any subsequent reduction in fair market value is reflected as a valuation allowance through a (Continued) C O R T L A N D B A N C O R P A N D S U B S I D I A R I E S NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 2003, 2002 and 2001 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUN'I'lNG POLICIES (Continucd) charge to income. Costs of significant property improvements are capitalized, whereas costs rclating to holding and maintaining the property are charged to expense. Tntangible Asset: A core deposit intangible asset resulting from a branch acquisition is being amortiLed over a 15 year period. The intangible asset, net of accumulated amortization, was $244,000 and $281,000 at December 31, 2003 and 2002, respectively, and is included in other assets. The aggregate amortization expense was $37,000 at December 31,2003 and 2002. The estimated aggregate amortization expense for the next five ycars is $37,000 pcr ycar. Advertising: The Company expenses advertising costs as incurred. Income Taxcs: A dcfcrrcd tax liability or assct is determined ut each balance sheet date. Tt is measured by applying currently enacted tax laws to future amounts that result from differences in the financial statement and tax bases o l asscls and liabilities. Other Comprehensive Tncome: Accumulated other comprehensive income for the Company is compriscd solely ol unrealiLed holding gains (losses) on available for sale securities, net of tax. Per Share Amounts: The Board of Directors declared 3% common stock dividends payable as ol January 1, 2004, 2003 and 2002. The 3% conimon stock dividend issued on January 1, 2004 resulted in the issuance of 123,310 shares of common stock, which have been included in the 4,246,747 shares reported as issued at December 3 I , 2003. Basic and diluted earnings per share are based on weighted averagc sharcs outstanding. Average shares outstanding and per share amounts havc been rcstatcd to givc rctroactive effect to the 3% common stock dividend of January 1, 2004. Avcragc sharcs outstanding and per share amounts similarly reflect the impact of the Company's stock repurchase program (see Note 17). The following table sets forth the computation of basic earnings per common sharc and diluted earnings per common share: Years Ended December 3 I, 2002 2003 200 1 . . . . . . . . . . . . . . $ 5,484 $ 5,142 $ 5,546 Net income ($000 omitted) . . . . . . . . . . Weighted average comiiion sharcs outstanding . . . Basic earnings per sharc Diluted carnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,089,237 1.34 $ 1.34 . . $ 4,147,036 1.38 $ 1.38 $ 4,167,318 1.33 $ 1.33 $ Reclassifications: Certain items in the financial statements for 2002 and 2001 have bccn reclassified to conforni to the 2003 presentation. New Accounting Standards: On December 11, 2003, the SEC staff announced its intention to release a Staff Accounting Bullctin that would require all registrants to account for mortgage loan interest rate lock commitments related to loans held for sale as written options, eff'ectivc no latcr than lor commitrncnts entered into after March 31, 2004. This guidance, if issued, would require the Company to recognize a liability on its balance sheet equal to the fair value of the commitment at the time the loan commitment is issued. As a result, this guidance would delay the recognition of any revenue related to these conimitments until such time as the loan is sold. Howcvcr, the new accounting standard would have no effect on the ultimate amount of revenue or the cash flows recognized over time. The adoption of this pending guidance is not expected to have a material impact on the Company's financial position or results of operation. (Continued) CORTLAND BANCOKI’ A N D SUBSIDIARIES NOTES TO THE CONSOLIDATED FTNANCIAL STATEMENTS Years ended December 31, 2003, 2002 and 2001 NOTE 2 - INVESTMENT SECURITIES The following is a summary of investment securities: (Amounts in thousands) Amortized cost Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value . . December 31, 2003 Investment securities available for sale U.S. Treasury sccurities . . . . . . . . . . . . . . . . . . . . . . US. Government agcncies and corporations . . , . . Obligations of states and political subdivisions. . . Mortgage-backed and related securitics . . . . . . . . Corporate securities . . . . . . . . . . . . . . . . . . . . . . . . . Total debt securities . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total available for sale . . . . . . . . . . . . . . Investment securities held to maturity U S . Trcasury securities . . . . . . . . . . . . . . . . . . . . . U.S. Govcrnrnent agencies and corporations . . . . Obligations of states and political subdivisions. . . Mortgage-backed and relatcd securities . . . . . . . . Total hcld to maturity. . . . . . . . . . . . . . . December 31, 2002 Investment securities available for sale U.S. Treasury securities . . . . . . . . . . . . . . . . . . . U S . Government agencies and corporations. . . . . . Obligations of states and political subdivisions . . . . Mortgage-backed and related securitics . . . . . . . . . . Total debt securities . . . . . . . . . . . . . . . . . . Marketable equity securities . . . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total available for sale . . . . . . . . . . . . . . . Investment securities held to maturity US. Government agencies and corporations. . . . . . Obligations of states and political subdivisions . . . . Mortgage-backcd and related securities. . . . . . . . . . Total held to maturity . . . . . . . . . . . . . . . . $ 4,635 31,843 19,727 52,396 10.786 119,387 3.119 $122,506 $ 156 24,976 32,730 39,072 $ 96,934 $ 5,093 2S,SX5 22,032 55,261 1 07,97 1 28 3,006 $ 1 11,005 $ 22,190 31,517 30,401 $ 134,108 $ 336 621 1,062 1,174 397 3,540 $ 43 16 I43 53 255 $3,590 $ 255 $ 4 230 1,653 62 $1,949 $ 592 1,150 723 2,256 4,721 113 $4,834 $ 645 1,078 237 $1,960 $ 62 47 323 $ 432 $ 1 17 26 44 $ 44 $ x1 30 $ 1 1 1 $ 4,971 32,421 20,773 53,427 11.130 122,722 3,l I9 $ I25,84 I $ 160 25, I44 34,336 38.811 $ 98,451 $ 5,685 26,734 22,738 57,491 1 12,648 141 3,006 $1 15,795 $ 22,835 323 14 30.608 $ 85,957 At December 3 I , 2003 and 2002, other securities consisted of $2,893,000 and $2,780,000 in Federal Home Loan Bank (FHLB) stock, respectivcly, and $226,000 in Federal Reserve Board (FED) stock. Each investment is carried at cost, and the Company is required to hold such invcstmcnts as a condition of rnembcrship in order to transact business with the FHLB and the FED. (Continued) CORTLAND BANCORP AND SUBSIDIAKIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Ycars ended December 31, 2003, 2002 and 2001 NOTE 2 - INVESTMENT SEClJ RlTIES (Continued) The amortiLed cost and estimated market value of debt securities at December 31, 2003, by contractual maturity, are shown below. Actual maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. (Amounts in thousands) December 31. 2003 Amortized cost Estimated Pair Value Tnvestment securities available for sale Due in one year or less., . . . . . . . . . . . . . . . . . . . . . . . . Due d t e r one year through tive years. . . . . . . . . . . . . . Due after five years through ten years . . . . . . . . . . . . . Due after ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities held to maturity Due in one year or less.. . . . . . . . . . . . . . . . . . . . . . . . . Due after one year through five years.. . . . . . . . . . . . . Due after fivc years through ten years . . . . . . . . . . . . . Due after ten years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sub t o t a1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,506 7,605 23,936 33.944 66,99 I 52,396 $1 19,387 $ 2,088 197 12,081 43,496 57,862 39,072 $ 96,934 $ 1,514 8,103 24,525 35,153 69,295 53,427 $122,722 $ 2,093 21 0 12,230 45,107 59,640 38,811 $ 911,451 The following table sets forth the proceeds, gains and losses realized on securities sold or called for each of the years ended December 31: (Amounts in thousands) 2003 2002 200 1 Proceeds.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross realized gains Gross realized losscs . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,115 948 2 $17,085 329 114 $23,919 54 I 155 Investment securities with a carrying value of approximately $43,909,000 at December 3 1, 2003 and $38,126,000 at December 3 1, 2002 were pledged to securc deposits and for other purposes. (Continued) Years cnded Deceinbcr 31, 2003, 2002 and 2001 NOTE 2 - INVESTMENT SECURITIES (Continued) The following is a summary of the fair value of securities with unrealiled losses and an aging of those unrealiLed losses at December 31, 2003: (Amounts in thousands) Less than 12 Months IJnrealized T.osscs Fair Value 12 Months or More Unrealized Fair Losses Value Total Fair Value Unrealized Losses U.S. Government agencies and corporations . . . . . . . . . $ 9,221 $1 05 $ Obligations of states and political subdivisions . . . . . . . . Mortgage-backed and related securities . . . . . . . . . . . . . . . . Corporate securities. . . . . . . . . 3,498 48 42,036 2,528 $57,283 452 53 ~ $658 ~ ~ $ 15 14 1,713 2,208 $3,921 $29 - - $ 9,221 $105 5,211 63 44,244 2,528 466 53 - $687 $6 1,204 - - The abovc table represents 66 investment securities where the current value is less than the related amortized cost. The unrealiLed losses do not reflect any deterioration of the credit worthiness of the issuing cntities. No security has a current rating that is below investment grade, and 61 of the securities are rated “AAA”. Thc lowest rated security is rated A-. Thc unrealized losses on these sccurities are a result of changes in interest rates Lor fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities, changcs in market spreads as a result of shifts in supply and demand, and changes in the level of prepayment activity for mortgage related sccurities. NOTE 3 - LOANS RECEIVABLE The following is a suinmary of loans: (Amounts in thousands) 1-4 family rcsidential mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial mortgage loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Conimercial loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity loans.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1-4 family residential mortgage loans held for sale . . . . . . . . . . . . . . . Total loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 31, 2003 2002 $ 57,854 92,822 7,231 21,711 9,541 103 $189,262 $ 62,365 86,929 9,792 22,o I 6 8,353 2,022 $191,477 (Continued) COKTLAND BANCORP AND SUBSlDIARlES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 2003, 2002 and 2001 NOTE 4 - ALLOWANCE POR LOAN LOSSES The following is an analysis of changes in the allowance lor loan losses for the year ended: (Amounts in thousands) December 3 1. 2002 2003 Balance at beginning o l year. . . . . . . . . . . . . . . . . . . . . . . . . . . Loan charge-offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Recoveries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loan charge-ofb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision charged to operations. . . . . . . . . . . . . . . . . . . . . . . . . Balance at end of y e a r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . !$ 3,134 (1,120) 154 (966) 240 $ 2,408 $2,9138 (441 1 117 (324) 460 $3,134 200 I $2,974 (275) 79 (196) 220 $2,998 Loans on which the accrual of intcrest has been discontinued because circumstances indicate that collection is questionable amounted to $2,067,000, $1,406,000 and $829,000 at December 31, 2003, 2002 and 2001, respectively. Interest income on these loans, if accrued, would have increased pretax income by approxi- mately $135,000, $69,000 and $52,000 for 2003, 2002 and 2001, respectively. Impaired loans are generally included in nonaccruul loans. Management does not individually evaluate certain smaller balance loans for impairment as such loans are evaluated on an aggrcgatc basis. These loans generally include I -4 family, consumer and home equity loans. Impaired loans are generally evaluated using the fair value of collateral as the measurement method. At December 31, 2002 and 2001, there were no loans considered impaired. At December 3 I , 2003, thc recorded investment in impaircd loans was $87 1,000 while the allocated portion of the allowance for loan losses for such loans was $177,000. Interest income recognized on impaired loans using the cash basis was $42,000 for 2003. The remaining principal balance of renegotiated loans for which intercst has been reduced and that arc still accruing intercst totaled $26,000 and $134,000 at December 31, 2002 and 2001, respectively, and none at Tlecember 31, 2003. Interest income rccognized on these loans wits $18,000 for 2002 and $22,000 for 2001. Interest income that would have been recognized under the original terms was $23,000 for 2002 and $27,000 for 2001. As of December 31, 2003, 2002 and 2001, there were $2,1 13,000, $2,058,000 and $1,504,000 in loans that were neither classified as nonaccrual nor considered impaired, but which can be considered potential problem loans. Any loans classified lor 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 rcsources, or (ii) represent inaterial 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. (Continued) CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Dcccmber 31, 2003, 2002 and 2001 NOTE 5 - PREMISES AND EQUIPMENT The following is a summary of premises and equipment: (Amounts in thousands) December 3 1, 2003 2002 Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . $ 692 5,527 9,161 279 15,659 Less accumulated depreciation . . . . . . . . . . . . . . . . . 10,787 $ 4,872 Net book v a l u e . . .................... $ 6 9 2 5,5 I8 8,838 279 15,327 10,050 $ 5,277 Depreciation expense was $737,000 for 2003, $858,000 for 2002 and $934,000 for 2001 NOTE 6 - DEPOSITS The following is a summary of interest-bearing deposits: (Amounts in ihousands) December 3 1. 2003 2002 Demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 29,153 17,376 89,830 $ 31,816 23,7 I5 87,676 Timc: In denominations under $100,000. . . . . . . . . . . . . In denominations of $100,000 or more . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114,485 29,080 $279,924 11 1,113 25,693 $280,0 I 3 The Mowing is a summary of timc deposiis of $100,000 or more by remaining maturities: (Amounts in thousands) December 31, 2003 2002 Certificates Other Time of Deposit Thrcc nionths or less . . . . . . . . . . . $ 3,936 4,999 Three to six months . . . . . . . . . . . . Six to twelve months . . . . . . . . . . . 4,020 Onc through five years . . . . . . . . . . 8,631 Over five years.. . . . . . . . . . . . . . . . 1,132 $22,718 To tal . . . . . . . . . . . . . . . . . Deposits $ 409 4,204 $6,3h2 1,749 (Continued) Certificates Other Time of Deposit Deposits 3,469 $ 6,233 $ 540 500 Total $ 4,345 4,999 4,020 10,380 5,336 3,097 742 $5,860 $29,080 $19,833 ~~ -~ 3,213 6,176 1,601 122 ~~ Total $ 6,713 3,969 3,335 7,777 3,839 $25,693 CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FlNANCTAL STATEMENTS Years ended Decernbcr 3 I , 2003, 2002 and 2001 NOTE 7 - FEDERAL HOME LOAN BANK ADVANCES AND OTHER BORROWlNGS The following is a summary of total Federal Home Loan Bank advances and other borrowings: (Amounts in thousands) Federal Home Loan Bank advances Variable rate LIBOR based Fedcral Home Loan Bank advanccs, with monthly interest payments: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . fixed ratc Federal Home Loan Bank advances, with monthly intcrcst payinenls: Due in 2003 . . . . . . . . . . . Due in 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due in 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due in 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Federal Home Loan Bank advances . . . . . . . . . . . . . . . Other borrowings Securities sold under repurchase agreements . . . . . . . . . . . . . . . . . . . U S . Trcasury interest-bearing demand note. Fedcral Funds Purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other borrowings. . . . . Total Federal Home Loan other borrowings. . . . . . . . . . Weighted Average Interest Rate December 3 I. 2003 2002 1.310% !$ 5,000 $ 6*3700% 5.6340% 5.1600% 5.9293% 4.9553% 4.9957% 0.7978% 0.7280% 1.1875% 0.8865% 1,000 5,000 10,000 13,500 9,500 44,000 2,243 643 1,000 3,886 4,000 1,000 5,000 10,000 13,500 9,500 43,000 1,680 1,9x9 3,669 4.6622% 9; 4 7,s 8 6 $46,669 Securities sold under repurchase agreements rcpresent arrangements that the Hank has entered into with ccrtain deposit customers within its local market areas. These borrowings are collateralized with securitics. There are $6.S million in securities, allocated for this purpose, owned by the Bank and held in safekeeping accounts at independent correspondent banks. Fedcral Home Loan Bank (FHLB) advances are collateralized by the FHLB stock owned by the Bank, which had a carrying value of $2,893,000 at December 31, 2003, and a blanket lien against the Bank’s qualified mortgage loan portfolio and $10,836,000 in collateralized mortgage obligations. Maximum borrowing capacity from the FHLB totaled $SO,I80,000 at Deccrnber 31, 2003. As of both December 3 I , 2003 and 2002, $38,000,000 of the FHLB fixed rate advanccs are convertible to quarterly LIBOR floating rate advances on or after certain specified dales at the option of the FHLB. Should the FHLB clect to convert, the Company acquires the right to prepay any ox all of the borrowing at the time of conversion and on any interest payrncnt due date, thereafter, without penalty. I NOTE 8 - COMMITMENTS The Bank occupies ollice facilities under operating leases extending to 2008. Most of these leases contain an option to renew at the then faair rental value for periods of five and ten years. These options enable the Bank to retain use of facilities in desirable operating areas. I n most cases, management expccls that in the normal course of business, leases will be renewed or replaced by other leases. Rental expense was $286,000 for (Continued) t C O R T L A N D BANCORP A N D SUBSlDlARIES N O T E S TO T H E CONSOLIDATED F I N A N C I A L STATEMENTS Ycars ended December 3 1 , 2003, 2002 and 2001 NOTE 8 - COMMITMENTS (Continued) 2003, $295,000 for 2002 and $251,000 for 2001. The following is a summary of remaining future minimum lease payments under current noncancelable operating leases for office facilities: (Amounts in thousands) Years ending: December 3 I , 2004. . . . . . . . . . . . . . . . . . $191 December 31, 2005.. . . . . . . . . . . . . . . . . 191 December 31, 2006.. . . . . . . . . . . . . . . . . 187 December 31, 2007.. . . . . . . . . . . . . . . . . 82 27 December 31, 2008. . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . $678 - ~ At December 31, 2003, thc Bank was rcquircd lo maintain aggregate cash reserves amounting to $5,006,000 in order to satisfy fcdcral rcgulatory requirements. These amounts do not earn interest. The Bank grants commercial and industrial loans, commercial and residential mortgages, and consumer loans to customers in Northeast Ohio and Western Pennsylvania. Although the Bank has a diversified portfolio, exposure to credit loss can be advcrscly impacted by downturns in local economic and employment conditions. Approximately 2.60% of total loans are unsecured at December 3 1, 2003, compared to 3.10% at December 31, 2002. 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 shcct liabilities. The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet thc financing nccds of' its cuslomers. 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 Bank's exposure to credit loss in the event of nonperformance by the other party to these financial instruments is rcprcscnted by the contractual amount of the instruments. The Bank uses the same credit policies in making commitments and conditional obligations as i t does for instruments recorded on the balance sheet. The amount and nature of collateral obtained, if any, is based on management's credit evaluation. (Continued) CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Ycars cndcd Dcccmbcr 31, 2003, 2002 and 2001 NOTE 8 - COMMITMENTS (Continued j The following i s a summary of such contractual commitments: (Amounts in thousands) December 3 1. 2003 2002 Financial instruments whose contract amounts represent credit risk: Commitments to extend credit Fixed rate ............................ Variable rate . . . . . . . . . . . . . . . . . . . . . . . . . . Standby letters of credit . . . . . . . . . . . . . . . . . . $ 96 29,411 761 859 $ 36,890 615 Commitments to extend credit are agreements to lend lo a customer as long as there is no violation of any condition established in the contract. Coininilments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of credit arc conditional commit- ments issued by the Bank to guarantee the performance of a customer to ;I third party. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the countcrparty. Collateral held varies but may include accounts receivable, inventory, property, plant and equipmcnt and income-producing commercial properties. NOTE 9 - BENEFIT PLANS The Bank has a contributory defined contribution retirement plan (a 401 (k) plan) which covers substantially all employees. Total expense undcr the plan was $21 1,000 for 2003, $219,000 for 2002 and $205,000 for 2001. The Bank matches participants’ voluntary contributions up to 5% of gross pay. Participants may make voluntary contributions to the plan up to a maximum of 15% of gross wages or $12,000, whichever is less. The Bank makes monthly contributions to this plan equal to amounts accrued for plan expense. The Bank and Bancorp provide supplemental retirement benefit plans for the benefit of certain officers and non officer directors. The plan for ollicers is designed to provide post-retirement benefits to supplement other sources of retirement income such as social security and 401 (k) benefits. The bcncfits will be paid for a period of 15 years after retirement. The amount of each officer’s benefit is determined by their salary at retirement as well as their other sources of retirement income. Director Relirement Agreements provide lor a benefit of $10,000 annually on or after the director reaches normal retirement age, which is based on a combination of age and years of service. Director retirement benefits are paid over a period of 10 years following retirement. The Bank and Bancorp accrue the cost of these post-retirement bcnefits during the working careers of the olliccrs and directors. At Dcccmber 31, 2003, thc cumulative cxpense accrued for these benefits totaled $677,000, with $487,000 accrued for the officers’ plan and $190,000 for the directors’ plan. The Bank has purchased insurance contracts on the lives of the participants in the supplcmcntal retirement benefit plan and has named the Bank as the beneficiary. Similarly, the Bancorp has purchased insurance (Conlinued) COKTLAND BANCORP AND SUBSIDIARIES NOTES TO T H E CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 2003, 2002 and 2001 NOTE 9 - BENEFIT PLANS (Continued) contracts on the lives of‘ the directors with the Bancorp as beneficiary. Whilc no direct linkagc exists between ihc supplemental retirement bencfit plan and thc life insurance contracts, it is management’s current intent that the rcvenue from thc insurance contracts be used as a f‘unding source for the plan. At Deccinber 3 I , 2003, the cumulative income accrued on these contracls totaled $936,000 on a tax equivalent basis, with $6 13,000 accrued on the officers’ contracts and $323,000 on the directors’ contracts. NOTE 10 - FEDERAL INCOME TAXES The composition of income tax cxpense is as follows: (Amounts in thousands) Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deleerred Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Years Ended December 31. 2002 2001 $1,730 (151) $1,579 $1,730 (2) $1,728 2003 $1,236 135 $1,371 The following is a summary of net deferred taxes included in other liabilities: (Amounts in thousands) December 31, 2002 2003 200 I Gross deferred tax assets: Provision for loan and other real estate losscs. . . Other items . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . !$ 495 386 $ 742 240 $ 696 121 Gross defcrred tax liabilities: Unrealiied gain on available lor sale securilics.. Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan origination cost - net Other itcms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net deferrcd tax liability.. . . . . . . . . . . . . !$ . . . . . . . . . . . . . . . . . . (1,135) (343) (2) (389) (988) (1,631) (339) 6 (367) (945) (355) (3 (328) $(1,349) $ (814) (Continucd) CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Deccmher 31, 2003, 2002 and 2001 NOTE 10 - I4EDERAL INCOME TAXKS (Continued) The following is a reconciliation between tax expense using the statutory tax rate of34% and the income tax provision: (Amounts in thousands) Years Ended December 31, 2002 2003 Statutory t a x . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . EiTcct of non-taxable interest and dividends . . . . . . $2,331 (960) Total incomc taxes., . . . . . . . . . . . . . . . . . $1,371 $2,489 (910) $1,579 200 I $2,473 (745) $1,728 The related income tax expense on investment securities gains and losses amounted to $321,000 for 2003, $73,000 for 2002 and $131,000 for 2001, and is included in the total federal income tax provision. NOTE: 11 - FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts and estimated fair values of the Company’s financial instruments are as lollows: (Amounts in thousands) December 31, 2003 December 3 I , 2002 Carrying Amount Estimated Fair Value Carrying Amount Estirnatcd Fair Value ASSETS: Cash and cash equivalents . . . . . . . . . . . . . . . . . . $ 9,747 Federal Funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities Loans, net of allowance for loan losses . . . . . . . . LIABILITIES: Demand and savings dcposits Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings . . . . . . . . . . . . . . . . . . . . . . . . . $193,991 143,565 44,000 3,886 . . . . . . . . . . . . . . . . 222,775 186,854 $ 9,747 224,292 186,869 $193,991 145,407 44,632 3,886 $ 12,571 20,000 199,903 188,343 $198,952 136,806 43,000 3,669 $ 12,571 20,000 201,752 188,304 $198,952 139,158 44,128 3,669 For purposes of thc above disclosures of estimated fair value, the following assumptions were used as or December 31, 2003 and 2002. The estimated fair value for cash and cash equivalents is considered to approximate cost. l h e estimated fair value for securities is based on quoted market values for individual sccurities or for equivalent sccurities when specific quoted prices arc not available. Carrying value is considered to approximate fair value for loans, FHLB advances and other borrowings that reprice frequently and for deposit liabilities subject to immediate withdrawal. The fair values of loans, FHLB advances and other borrowings and time dcposits that reprice less frequently are approximated by a discount rate valuation technique utilizing estimated market interest rates as of December 3 I , 2003 and 2002. The fair value of unrecordcd commitments ut December 31, 2003 and 2002, is not material. (Continued) - CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 2003, 2002 and 2001 NOTE 11 - FATR VALUE OF FTNANCIAL INSTRUMENTS (Continued) In addition, other asscts and liabilities of the Company that are not defined as financial instruments are not included in the above disclosures, such as property and equipment. Also, non-financial instruments typically not recogniLed in financial statements nevertheless may have value but are not included in the above disclosures. These include, among other items, the estimated carning power of core deposit accounts, the trained work force, customer goodwill and similar items. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company. NOTE 12 - REGULATORY MATTERS The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital rcquirements can initiate certain actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities, and certain off-balance shcet items as calculated under regulatory accounting practices. The Company’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company to maintain: ( I ) a iiiinimum ratio of4% both for total Tier I risk-based capital to risk-weighted asscts and for Tier I risk-based capital to average assets, and (2) a minimum ratio of 8% for total risk-based capital to risk-weighted assets. Under the regulatory framework for prompt corrective action, the Coiiipany is categoriLed as well capitalized, which rcquires minimum capital ratios of 10% for total risk-based capital to risk-weighted assets, 6% for Tier I risk-based capital to risk-weightcd assets, and 5% for Tier T risk-based capital to average assets (also known as the leverage ratio). Thcre are no conditions or events since the most recent communication from regulators that inanagcment believes would change the Company’s category. (Amounts in thousands) December 31, 2003 Amount Ratio December 31, 2002 Katio Amount -~ $5 1,415 Total Risk-Based Capital. . . . . . . . . . . . . . Ratio to Risk-Weighted Assets. . . . . . . Tier T Risk-Based Capital . . . . . . . . . . . . . Ratio to Risk-Weighted Assets. . . . . . . Ratio to Average Assets . . . . . . . . . . . . $49,841 $47,433 21.57% 20.53% 10.94% $48,593 23.23% 21.95% 11.12% Tier I capital is shareholders’ equity less intangibles and the unrealized market value adjustment of investment securities available for sale. Total risk-based capital is Tier I capital plus the qualifying portion of the allowance for loan losses. Assets and certain off balance shcct items ad-justed in accordance with risk classification comprise risk-weighted assets of $23 1,034,000 and $221,332,000 as of Deccmber 3 1 , 2003 and 2002, respectively. Assets less intangibles and the net unrealized market value adjustment of investment (Continued) CORTLAND BANCORP AND SUBSIDIARTES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years cnded December 31, 2003, 2002 and 2001 NOTE 12 - REGIJLATORY MATTERS (Continued) securities available for sale averaged $433,513,000 and $437,149,000 for the years ended December 31, 2003 and 2002, respectively. NOTE, 13 - RELATED PARlY TRANSACTTONS Certain directors, executive officers and companies with which thcy are afiliated were loan customers during 2003. The following is an analysis of such loans: (Amounts in thousands) Total loans at December 31, 2002 . . . . . . . . . . . . . . . . . . . . . New loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Kepayments or other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,497 193 393 Total loans at December 3 I , 2003 . . . . . . . . . . . . . $1,297 NOTE 14 - CONDENSED FINANCTAL INFORMATION Below is condensed financial information of Cortland Bancorp (parent company only). Tn this information, the prcnt’s investment in subsidiaries is stated at cost, including equity in the undistributed earnings of the subsidiaries since inception, adjusted for any unrealired gains or losses on available for sale securities. BALANCE SHEETS (Amounts in thousands) Assets: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tnvestment securities available for sale . . . . . . . . Investment securities held to maturity . . . . . . . . . Investment in bank subsidiary. . . . . . . . . . . . . . . . Investment in non-bank subsidiary . . . . . . . . . . . . Other assets.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 3 I . 2003 2002 $ 2,169 3,218 43,125 15 1,668 $50,195 $ 5,235 1,307 1,305 42,770 15 1,597 $52,229 Liabilities: Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 314 $ 190 Shareholders’ equity: Common stock (Notc 1 ) . . . . . . . . . . . . . . . . . . . . Additional paid-in capital (Note 1 ) . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive income.. . . . Treasury stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total shareholders’ equity. . . . . . . . . . . . . 2 1,234 16,469 15,401 2,203 (5,426) 49,881 $50,195 20,6 17 13,323 17,8 I0 3, I65 (2,876) 52,039 $52,229 (Continued) CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLlDATED FlNANClAL STATEMENTS Years cnded December 31, 2003, 2002 and 2001 NOTE 14 - CONDENSED JWANClAL INFORMATION (Continued) STATEMENTS OF INCOME (Amounts in thousands) Dividends from bank subsidiary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tnterest and dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tnvestrnent securilies gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tncome before income lax and equity in Undistributed net income of subsidiaries . . . . . . . . . . . . . . . . . . . . Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity in undistributed net income o l subsidiaries . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Years ended Decembcr 31, 200 I 2002 2003 $ 4,400 $ 7,000 $ 4,000 185 202 180 33 21 192 77 87 76 (176) (149) (184) 4,265 (63) 1,282 $ 5,484 4,550 (24) 1,216 $ 5,742 7,129 (13) (1,570) $ 5,546 STATEMENTS OF CASH FLOWS (Amounts in thousands) Years ended December 31, 2002 2003 200 1 Cash flows from operating activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash flows horn $ 5,484 $ 5,742 $ 5,546 operating activities: Equity in undistributed net income of subsidiaries . . . . . . . . . . . . Investment securities gains . . Accretion on sccurities Deferred tax benefit Change in other assets and liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash flows lrom operating activities . . . . . . . . . . . . . . . . Cash flows from investing activities Purchases of investment securilies availablc for sale . . . . . . . . . . . . Purchases of investment securities held to maturity . . . . . . . . . . . . . Proceeds from sales of securities available for sale. . . . . . . . . . . . . . Proceeds from call, maturity and principal payments on securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash flows from investing activities.. . . . . . . . . . . . . . . . Cash flows from financing activities Dividends paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net treasury shares (repurchased) reissued .................... Net cash flows lrom financing activities.. . . . . . . . . . . . . . . . Net change in c a s h . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash . . Reginning o l year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . E n d o f y e a r . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (1,282) (192) 31 (24) 95 4,112 (3,007) 1,204 1,305 (498) (4,360) (2,320) (6,680) (3,066) (1,216) (21 1 8 (23) (3) 4,487 ~ (250) (2,042) 1,570 (33) 3 (17) 36 7,105 (356) 1,550 (742) 3,767 3,41 I (4,294) ( 1,264) (5,558) (1,813) (3,936) 240 (3,696) 6,820 5,235 !fi 2,169 7,048 $ 5,235 228 $ 7,048 (Continued) CORTLAND BANCORP AND SUBSIDTARIES NOTES TO THE CONSOLIDATED FTNANCIAL STATEMENTS Ycars ended December 31, 2003, 2002 and 2001 NOTE 15 - DlVInEND RESTRICTIONS The Bank i s subject to regulations of the Ohio Division of Ranks which restrict dividends to retained earnings (as defined by statute) of the currcnt and prior two years. Under this restriction, at Dcceinber 31, 2003, approximately $928,000 is available for the payment of dividends by the Bank without seeking prior regulatory approval. In addition, dividend payments may not reduce capital levels below minimuni regulatory guidelines. NOTE 16 - LITIGATION Since 1993 the Company’s subsidiary bank has been a defendant in a class action lawsuit, Frunk Slentz. et al. v. Cnrtlund Swings and Banking Company, involving purchased interests in two campgrounds. On September 30, 2002 the registrant received notice that The Court of Common Pleas in Trumbull County, Ohio had ordered the dismissal of all Plaintiff’s’ claims in Slcntz, et ul (Plaintifly) versus Cortland Savings and Banking Company (Defendunt), and a related case, McDonugh, et a1 (PlaintiJs) versus C’orthnd Savings and Bunking Cnnipany (Drfkndant), and granted registrani’s subsidiary bank, Cortland Savings and Banking Company, Summary Judgment on all counts of Plaintiffs’ Complaint in both cases. These two class action cases originaled in 1993 with filings in the Northern District of Ohio Eastern Division of the Federal Court system. In addition to their alleged Federal claims, Plaintifis had alleged State law claims which were included as pendent causes of action. On October 20, 1997 the federal judge presiding over these cases filed a judgment cntry dismissing all federal claims against the registrant’s subsidiary bank without prejudice. The judgment of the district court was appealed by Plaintiffs. On March 2, 1999 the United States Court of Appeals for the Sixth Circuit affirmed the decision of the district court to grant suinniary judgment in hvor of the defendant bank and dismissing all of Plaintiffs’ Federal Claims. While awaiting the ruling of the Sixth Circuit Court of Appeals, the Plaintiffs asserted lheir alleged Stale law claims by filing suit in the Common Pleas Court of Trumbull County seeking damages of approximately $4.3 million. Plainliffs appealed the judgment rendered by the Common Pleas Court of Trumbull County. Thc Company and Plaintiffs filed all pcrmilted briefs with the 11th District Court of Appeals and oral arguments were made before the Court of Appeals on October 20, 2003. On March 4, 2004, the Company received notice that the 1 I th District Court of Appeals had upheld the decision of the Court of Common Pleas in Trumbull Counly, Ohio, in fwor of the registrant and its subsidiary bank. Plaintiffs have the right to appeal lhe I 1 th District Court’s decision to the Ohio Supreme Court. While it is not feasible to predict the ultimate resolution of this mailer, an outcome unhvorable to the Company’s bank subsidiary could have a material effect on the Company’s quarterly and annual operating results for that period in which such a judgment might be rendered. It remains the Company’s intent to vigorously defend these actions. The Bank is also involved in other legal actions arising in the ordinary course of business. In the opinion of management, the outcome of thesc matters i s not expected to have material effect on thc Company, NOTE 17 - STOCK REPURCHASE PROGRAM On January 23,2001, the Company’s Board of Directors approved a Stock Repurchase Program (the “2001 Program”), which allowed the Company to repurchase up to 187,000 shares (or approximately 4.9% of the 3,815, I25 shares outstanding as of January 3 I , 2001 ) of the Company’s outstanding common stock. The Program expired on February 6, 2002. On January 22, 2002 the Company’s Board of Directors approved a new Program (the “2002 Program”), which allowed the Company to repurchase up to 193,000 shares (or approximately 4.9% o l lhe 3,943,151 shares outstanding as of January 31, 2002) of the Company’s outstanding common stock. This program expired on February 6, 2003. On January 28, 2003, thc (Continued) CORTLAND BANCORP ANT) SURSTDTARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Decembcr 31, 2003, 2002 and 2001 NOTE 17 - STOCK REPURCHASE PROGRAM (Continued) Company’s Board of Directors once again approved a new program (the “2003 Program”) which allows the Company to repurchase up to 196,000 shares (or approximately 4.9% of the 3,998,191 shares outstanding as of January 28,2003) of the Company’s outstanding common stock. This program will expire on February 6, 2004. Repurchased shares arc designated as treasury shares, available for general corporate purposes, including possible use in connection with thc Company’s dividend reinvestment program, employee benefit plans, acquisitions or other distributions. Repurchase amounts are effected through open market transactions or in privately negotiated agreements in accordance with applicable regulations of the Securities and Exchange Commission. Under the 2001 program based on the value of the Company’s stock on January 31, 2001, the commitment to repurchase the stock ovcr thc next year was approximately $3,179,000. The Company repurchased 51,321 shares under the 2001 Program. Under thc 2002 Program, based on the value of the Company’s stock on January 31,2002, the commitment to repurchase the stock over the next year was $4,053,000. The Company repurchased 19,745 shares between January 1 and February 6, 2003, bringing the total repurchased shares to 114,073 under thc 2002 Program. The Company also reissued 20,592 shares to existing shareholders through its dividend rcinvest- ment program in January 2003, bringing the total number of shares reissued during the 2002 Program to 52,647. Under the 2003 Program, based on the value of the Company’s stock on January 28,2003, the commitment to rcpurchasc the stock over the next twelve months was $5,037,000. As of December 31, 2003, the Company has repurchased 103,264 shares under the 2003 Program. The Company also reissued 27,121 shares to existing shareholders through its dividend reinvestment program. The 3% common stock dividend paid January I , 2004 increased treasury shares by an additional 5,998 shares. Based on the price of the Company’s stock at December 31, 2003, the remaining commitment to repurchase the stock was approximately $2,089,000. THREE YEAK SUMMARY AVERAGE BALANCE SHEET, YIELDS AND RATES The following schedules show average balances of interest-earning and non interest-earning assets and liabilities, and Shareholdcrs' equity for the years indicated. Also shown are the related amounts or interest earned or paid and the related avcrage yields or interest rates paid for the years indicatcd. The averages arc based on daily balances. (Fully taxahlc equivalent basis in thousitnds of dollars) Interest-earning assets: Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Othcr Cash Mnnagenient Funds . . . . . . . Investment securities: . . . . . . U.S. Treasury and other U.S. eminent agencies and corporatio overnrnent morlgage-hacked through certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . of the U.S. and polilical . . . . . . . . . . . . . . . . . . . . . . . . . . . subdivisions (Nolc I , 2, 3 ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other sccurities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL INVESTMENT SEC?URITJES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans (Note 2, 3, 4 ) . Truding Account Securities . . . . . . . 'TOTAL IN'lXREST-EARNING ASS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2003 Interest Earned Outstanding or Paid Average Balance Yield vr Ratc $ 10,201 137 $ 117 1 1.1% 0.7% 52,587 2,640 5.0% 89,652 4,009 4.5% 7.1% 51,363 3,649 5.1% 10,997 559 ~- 5.3% 204,599 10,857 6.9% 191,392 13.141 5.7% 1,190 68 - - 5.9% 407,519 $24,184 Non interest-earning assets: Cash and due froin bat Preiniscs and equiprnet . . . . . . Othcr . TOTAL, ASSETS . . . . . Interest-hearing liabilities: Deposits: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.140 Si119 13,461 $436,239 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.5% $ 50,714 88,953 0.6% - - 3.6% 139,568 2.1% 279,235 - - $ 249 540 5,030 5,819 57 1,999 3,671 39,178 44,905 324,140 1 17 160 2,135 2,313 $ 8,132 1.8% 0.9% 4.4% 5.4% 5.2% 2.5% ~- . . . . . TOTAL INTEREST-BEARING DEPOSITS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowings: Federal funds purchased . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Securities sold under agrccrnent to r Other borrowings under one year. . . . . Other borrowings over one year.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAL BORROWINGS. TOTAL INTEREST-BEARING LIABTI~ITIES . . . . . Non interest-hearing liabilities: . . . . . . . . . . . . . . . . . . . TOTAL J6AB1LI'l'IF.S AND SHAREHOLDERS EQ Net interest income . . . . Net interest rate sprcad (Note 5 ) Net interest margin (Notc 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,898 4,394 51,807 . . . . . . . . . . . . . . . $436,239 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,052 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.4% - - 3.9% - - Notc 1 - Includcs both laxable nnd Lax exempt securities. Notc 2 - The amounts are presented on 3 fully taxablc equivalent basis using the statutory tax rale of 34% in 2003, 2002 and 2001, and have been iidjusted to reflect the elrect of disnllowcd interest expense related to carrying tax exempt assets. Tax-free income l'rom states of thc LIS. and political subdivisions, and loans atnounled to $2,466 and $214 Ior 2003, $2,480 and $178 for 2002 and $2,026 and $1 32 lor 2001, respectively. Notc 3 - Average halance outstanding includes the uvcrage ainount outstanding of all nonaccrual investment seourities and loans. States and political subdivisions consist of' average total principal adjusled for amortization of premium and accretion or discount less average allowance for estiinLited losses, and include both taxahle and tax exempt securities. Loans consist of average total louns less averugc unearned income. I (Fully taxable equivalent hasis in thousands of dollars) Avcrage Balance Outstanding 2002 Intcrest Earned vr Paid $ 14,184 115 $ 226 2 Yicld or - Kale I .6% I ,770 200 1 Interest Earned Outslanding or Paid Avcrage Balance $ 10,907 44 $ 368 2 Yicld or - IIale 3.4% 4.5% 5 I ,630 3,272 6.3% 91,536 5,322 5.8'70 5 1,052 3,461 197,679 201,106 3,647 168 12,409 15,518 7.1% 4.9'70 6.3% 1.7% 413,084 $28,155 6.8% 10,172 5,614 10,860 $439,730 .% 55,586 85,712 142,199 283,497 $ 557 1,050 5,927 7,534 2,222 2,393 42,903 47,518 331,015 30 I52 2,288 2,470 $10,004 1.08 I .2% 4.2% 2.7% 1.4% 6.4% 5.3'70 5.2'70 3.0% 53,295 3,623 5 1,197 $439,730 54,468 3,733 6.9% 89,254 5,708 6.4% 41,779 4,171 189,672 208,614 2,942 267 12,650 17,749 7.0% 6.4% 6.7% 8.5% 409,237 $30,769 7.5% 9,643 5,962 9,988 $434,830 $ 52,252 78,915 150,807 28 1.974 71 3,688 1,441 44,446 49,646 33 1,620 49,475 3,735 50,000 $434,830 $ 1,071 1,684 8,421 11,176 4 138 70 2,435 2,647 $13,823 2.0'70 2.1% 5.6% 4.0% 5.6% 3.7% 4.9% 5.58 5.38 4.2'70 $18,151 $16,946 3.8% __ - 4.4% - - 3.3'70 - - - I_ 4,1% Note 4 - Interest eurncd on loans includes nel loan fees ol' $241 i n 2003, $277 in 2002 and $180 in 2001. Note 5 - Net interest rate spread represents thc diwerencc between the yield on earning assets and the rutc paid on intcrest hearing 1: b' ' ' 5 Years $ 53,127 14,432 67,559 26,355 $ 93,914 $ 29,153 17,376 89,830 25,705 5,439 2,243 643 1,000 5,000 176.389 $ $ $ 37,22 I 9,700 35,280 8,606 16,279 5,335 46,921 6,000 49,886 $ 46,921 $ 23,164 $ 49,886 $128,320 33.000 54,6 I4 57,632 3,069 49,881 $165,196 $ 12,945 - Total $222,775 189,262 412,037 26,355 $438,392 $ 29,153 17,376 89,830 1 14,485 29,080 2,243 643 1,000 44,000 327,X I O 57,632 3,069 49,88 1 $438,392 Cumulative Gap . . . . . . . . . . . . . . . . . . . . $(80,202) $(57,038) $ 71,282 $ 84,227 Curnulative Gap lo Total Assets . . . . . . (18.3)’ro ( I 3.0)% 16.3% 19.2% CORTLAND BANCORP AND SUBSIDIARIES M A N A G E M E N T ’ S DISCUSSION A N D A N A L Y S I S (In thousands of dollars, except for per share amounts) The preceding Gap Table presents an analysis of the Company’s earliest repricing opportunity for each of its interest-earning assets and interest- bearing liabilities. Assets are distributed according lo the earlier ol interest rate repricing opportunity or expected cash flows. Time deposits and liabili- ties with defined maturities are distribu ted accord- ing to the earlier of the repricing intcrval or contractual maturity. Other core deposit accounts (Tnterest-bearing checking, Money Market and Savings accounts) are shown as being available for repricing in the earliest time frame, although man- agcmcnt can exert considerable influence over the timing and manner of repricing such core deposits. Therefore, these accounts may reprice in later time intervals and reflect smaller incremental changes than other intcrest-earning assets and interest- bearing liabilities. Since management may reprice thcsc accounts at its discretion, the impact of changing rates on net interest income is likely to be considerably different than inferred by this table. Tluring 2003, the effective maturities o l earning assets tended to shorten as interest rates in the credit markets stayed low during the year. Federal Reserve policy makers reduced short-term interest rates one time during the year, from 1.25% to 1.00% in an attempt to avoid an unwelcome sub- stantial fall in inflation. The Federal Keserve also encouraged investors to increase their interest rate risk by repeatedly reassuring investors that interest rates could remain low for ‘‘a considerable period.” With credit market rates remaining low throughout the year, the volume of investment securities eligi- ble to be called remained high, while prepayments on loans and iiiortgage-backed securities similarly increased, causing the effective maturities o l cx- isting earning assets to shorten. Accordingly, man- agement sought to extend duration by investing excess overnight funds (federal funds sold bal- ances) and by extending the maturity and increas- ing the convexity of reinvested funds. While the preceding Gap Table provides a general indication of the potential effect that changing interest rates may have on net interest incoiue, i t does not by itself present a complete picture of interest rate sensitivity. Because the repricing of the various categories of assets and liabilities is subject to competitive pressures, customer prefer- ences and other factors, such assets and liabilities may in I‘act repricc in diflerent lime periods and in different increments than assumed. The computeriLed simulation techniques utiliLed by management provide a more sophisticated mca- sure o l the dcgrcc to which the Company’s interest sensitive assets and liabilities may be impacted by changes in the general level o l inkrest rates. Thcsc analyses show the Company’s net interest inconic remaining relatively neutral within the economic and interest rate scenarios anticipated by manage- ment. In fact, as previously noted, the Company’s net interest margin has remained rclativcly stable in the range of 3.94% to 4.39% over the past five years, despite significant shifts in the mix of earn- ing assets and the direction and level of interest rates. I I 5.01 NET INTEREST MARGIN RATIO (In Percentages) 4.39 4.30 4.31 I -’” 2003 2002 2001 2000 1999 LTQIJTnTTY The central role of the Company’s liquidity man- agement is to ( I ) ensure sufficient liquid funds to meet the normal transaction requireiiients of its customers, (2) take advantage of market opportu- nities requiring flexibility and speed, and (3) pro- vide a cushion against unloresecn liquidity nccds. Principal sources o l liquidity for the Company include assets considered relatively liquid, such as interest-bearing deposits in other banks, federal lunds sold, cash and duc from banks, as well as cash flows from maturities and repayments of loans, investment securities and mortgagc-backed securities. CORTLAND BANCORP A N D SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS ( I n thousands ol' dollars, except lor per share amounts) Cash and cash equivalents, which includes federal funds sold decreased by $22,824 compared to year- end 2002. Anticipated principal repayments on mortgagc-backed securities along with investment securities maturing, repricing, or expected to be called in onc year or less amounted to $60,533 at December 31, 2003, representing 27.2% of the total conibincd portfolio, as compared to $79,453 or 34.7% ol' the portfolio a year ago. Along with its liquid assels, 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 deposils through the adjuslment of' interest rates, the purchasing of federal funds, and access to the Federal Reserve Discount Window. The Company is also a member of the Federal Home Loan Bank ol' Cincinnati, which providcs yet another source ol liquidity. Operating activities provided cash ol' $7,048 in 2003, $5,338 in 2002 and $6,178 in 2001. Kcy diffcrences stem mainly from 1) loans held for sale at December 31, 2003 totaled $103, as compared to $2,022 at December 31, 2002 and none a t December 31, 2001 which favorably impacts the proceeds and gains on loans r e a b e d in 2003; 2) the purchase of an additional $2.5 million insurance contracts on the lives of the participants in the supplemental post retirement benefit plan in 2003; 3) $946 gains on the sale of investments as compared to $215 in 2002 and $386 in 2001; and 4 ) the increase in amortization on securities of $1,644 in 2003 compared to $487 in 2002 and $335 in 2001. Refer to the Consolidated Statements ol' Cash Flows for a summary of the sources and uses ol' cash in 2003, 2002 and 2001. CONTRACTUAL OBLIGATIONS AND COMMITMENTS The Corporation has various obligations, including contractual obligations and comrnitincnts that may require future cash payments. Contractual Obligations: The following table presents, as of' December 3 1, 2003, significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of' the nature ol' each obligation is included in the refer- financial enced note statements. the consolidated to Non-interest hearing deposits Interest bearing deposits(a) Avg. Rate(b) Certificates of deposil ( a ) A v ~ . Rcitc ( b ) Federal funds purchascd and security repurchase agreemenls(a) Avg. Ratc(b) U .S. Trcasury interest-bearing demand nole (a) Avg. Rale(b) Federal Home Loan Bank advances (a) Avg. Rate(b) Operating leases See Note - One Year nr Less $ 51,632 136,359 0.4 I 9'0 61,045 Payments Due in Three to Five Years Over Five Years One to Three Ycars $ $ $ Total $ 51,632 136,359 0.41 % 44,362 15,935 22,223 143,565 2.45% 4.71% 4.50% 5.01% 3.46% 3,243 0.92% 643 0.73% 3,243 0.92% 643 0.73% 5,000 6,000 33,000 44,000 1.31% 378 5.76% 109 5.42% 5.00% 678 8 I91 6 6 7 7 7 (a) Excludes present and future accrucd inkrest. (b) Variahle rate obligations reflect idlcrcst rates in elkct at Tlecembrr 31, 2003 CORTLAND BANCORP AND SUBSIDIARIES MANAGEMENT’S DISCUSS ION AND ANALYSIS (In thousands of dollars, except for per share amounts) The Corporation’s operating lease obligations rep- resent short and long-krm lease and rental pay- ments for the subsidiary bank’s branch facilities. The Corporation also has obligations under its supplemental retirement plans as described in Note 9 to the consolidated financial statements. The postretiremcnt benefil payments represent ac- tuarially determined Juture benefit payments to eligible plan participants. The Corporation does not have any commitments or obligations to the (401 (k) defined contribution plan) at December 31, 2003 due to the funded status of the plan. Scc further discussion in Note 9. retirement plan Commitments: The table on the following page details the amounts and expected maturities of significant commitments as of December 3 1, 2003. Further discussion of these commitments is in- cluded in Note 8 to the consolidated financial statements. Oiic to Thrcc Onc to Five Thrcc Ycnr or 1 . e ~ Yearn Yews Ovcr Kive Yews ‘l‘nlsl Coiiiniitmcnts tu cxlcnil crcdil: Cointnercinl Residential real estate Revolving hoinc cyuity 0tht.r Standby lcllcrs or crcciil $18,469 $858 $ $1,018 $20,345 8,452 710 761 R,4S2 710 761 Commitments to extend credit, including loan cornmilmenis, standby letters of credit, and com- mercial letters of credit do not necessarily repre- sent future cash requirements, these comniitnients often expire without being drawn upon. that in CAPITAL RESOURCES Regulatory standards for measuring capital ade- quacy require banks and bank holding companies to maintain capital based on “risk-adjusted’’ assets so that categories of assets of potentially highcr credit risk require more capital hacking than asscts with lower risk. In addition, banks and bank hold- ing companies are required to maintain capital to support, on a risk-adjusted basis, certain on-bal- ance sheet activities such ;IS standby letters of credit and interest rate swaps. The risk-based standards classify capital into two tiers. Tier 1 capital consists of common sharchold- ers’ cyuity, noncumulative and cumulative perpct- ual preferred stock, and minority interests less goodwill. Tier 2 capital consists of a limited amount of the allowance for loan and lease losses, perpetual preferred stock (not included in Tier l ) , hybrid capital term subordinated instruments, debt, and intermediate- term preferred stock. The following graph, which is not “risk-adjusted,” depicts Tier 1 capital as a percentage of total average assets over the past several years. This measure of capital adequacy is known as the “lev- erage ratio.” The ratio decreased from 11.12% in 2002 to 10.94% in 2003. hut rcrnains well above regulatory minimums. LEVERAGE RATIO (In Percentages) 12 11 10 9 8 7 6 The Federal Deposit Insurance Corporation Im- provement Act of 1991 (FDICIA) required bank- ing regulatory agencies to revise risk-based capital standards to ensure that they take adequate account of interest rate risk. Accordingly, regulators subjcc- tively consider an institution’s exposure to declines in the economic value of its capital due lo changes in interest rates in evaluating capital adequacy. The table on the following page illustrates the Company’s risk-weighted capital ratios at Decem- ber 31, 2003 and 2002. Banks are required to maintain a minimum ratio of 8% of qualifying lotal capital lo risk-adjusted total assets. The Tier 1 capital ratio must be at least 4%. Capital qualilying as Tier 2 capital is limited to 100% o l Tier 1 capital. As the table indicates, the Company main- tains both Tier 1 and total risk-based capital well CORTLAND BANCORP AND SUBSIDIARIES MANAGEMENT’S DISCUSSTON AND ANALYSIS (In thousands ol‘ dollars, except for per share amounls) in excess of the required regulatory minimum ratios. Risk-Based Capital I_ Ikcember 31, 2003 $ 47,433 2,4ux December 3 I 2002 $ 48,593 2,822 $ 49,841 $ 51,415 Tier I Capital Tier 2 Capital QUALIFY 1NG CAPITAL Risk-Adjusted Total Assets( *) $231,034 $221,332 Ticr 1 Risk-Based Capital Ratio Total Risk-Based Capital Ratio Total Leverage C‘apitd Ratio 20.53% 21.57% 10.948 21.95% 23.23% 11.12% (*) Includes or-balance shcct cxposures SFAS I 15, “Accounting for Certain Investments in Debt and Equity Securities,” requires that investments designated as available for sale be marked-to-market with corresponding entries to the deferred tax account and shareholders’ equity. Regulatory agcncies, however, exclude these ad- justments in computing risk-based capital, as their inclusion would tend to increase the volatility of this important mcasure of capital adequacy. Addi- tional inforimtion regarding regulatory matters can be found in the Notes to the Consolidatcd Finan- cial Statements (NOTE 12.) REGULATORY MATTERS On March 13, 2000, the Board of Governors ofthe Federal Reserve System approved the Company’s application to become a financial holding com- pany. As a financial holding company, the Com- pany may engage in activities that are financial in nature or incidental to a financial activity, as au- thorized by the Gramm-Leach-Rliley Act of 1999 (The Financial Services Reform Act). Under the Financial Services Reform Act, the Company may continue to claim the bencfits of financial holding company status as long as each depository institu- tion that it controls remains well capitalized and well managcd. The Company is required to provide noticc to the Board of Governors of the Federal Rcscrve System when it hecomes aware that any depository institution controlled by the Company ccascs to be well capitalized or well managcd. Furthermore, current regulation specifies that prior to initiating or engaging in any new activities that are a u t h o r i d for financial holding companies, the Company’s insured depository institutions must be rated “satisfactory” or better undcr the Commu- nity Reinvestment Act (CRA). As of Decem- ber 31, 2003, the Company’s bank subsidiary was rated “satisfactory” for CRA purposes, and re- mained well capitalized and well managed, in managemcnt’s opinion. MARKET RISK Management considers interest rate risk to be the Company’s principal source of market risk. Inter- est rate risk is measured as the impact of interesl rate changes on the Company’s net inleresl in- come. Components of interest rate risk comprise repricing risk, basis risk and yield curve risk. Repricing risk arises due lo timing differences in the repricing of assets and liabilities as interest rate changes occur. Basis risk occurs when repricing assets and liabilities reference different kcy rates. Yield curve risk arises when a shift occurs in the relationship among key rates across the maturity spectrum. The effective management of intcrest rate risk seeks to limit the adverse impact of interest rate changes on thc Company’s net interest margin, providing the Company with the best opportunity for maintaining consistent earnings growth. To- ward this end, managemcnt uses computer simula- financial tion 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 Company’s to modcl The simulation model allows managemcnt to test and evaluate alternative responses to a changing interest rate environment. Typically when con- fronted with a heightened risk of rising interest rates, the Company will evaluate stralegies that shorten investment and loan repricing inlervals and CORTLAND BANCORP AND SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS (Tn thousands of dollars, except [or pcr share amounts) maturities, emphasix the acquisition of floating rate over fixed rate assets, and lengthen the maturj- ties of liability funding sources. When the risk ol‘ falling rates is perceived, management will con- sider strategies that shorten the maturities of fund- ing sources, lengthen the rcpricing intervals and maturities of investments and loans, and enipha- size the acquisition of fixed rate assets over floating rate assets. The most Significant assumptions used in the sirnu- lation relate to the cash flows and repricing charac- teristics of the Company’s balance sheet. Repricing and runoff ratc assumptions are based upon spe- cific product parameters modified by historical trends and internal projections. These assumptions are periodically reviewed and benchmarked against historical results. Actual results may differ froni simulated results not only due to the timing, mag- nitude and frequency of interest rate changes, but also due to changcs in general economic condi- tions, changes in customer prefercnces and behav- ior, and changes in strategies by both existing and poten tiiil competitors. The following table shows the Company’s current estimate of interest rate sensitivity based on the composition of its balance sheet ut December 3 I , 2003. For purposes of this analysis, short term interest rates as measured by the federal funds rate and the prime lending ralc are assumed to increase (decrease) gradually over the next twelvc months reaching a level 300 basis points higher (lower) than the rates in effect at December 31, 2003. Undcr both the rising rate scenario and the falling ratc sccnario, the yield curve is assumed to exhibit a pardlel shift. During 2003, the Fcderal Reserve decreased its target rate for overnight federal funds by 25 points. A1 year end December 31, 2003, the diff‘erence between the yield on the ten year Treasury and the three month Treasury had increased to a positive 332 basis points from thc positive 26 I basis points that existed at December 31, 2002. The yield curve is positively sloping, as intcrest rates now increase with a lengthcning of maturities, with rates peaking at the long-end of the Treasury curve. The base case against which interest ralc scnsitiv- ity is mcasurcd 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 $15,363 for the year ending December 31, 2004. Sirnubated Net liiterest lncome Sensitivity For the Twelve Months Endiiig December 31, 2004 Change in lnlerevl Rutei Graduated increase of +300 basis points Short term rate\ Net lnterevt lncumr ~~~ $ Change % Change $14,955 $(408) (2.7)% unchanged (base case) 15,363 Graduated decreaw or -300 basis points 14,700 (663) (4.3)% The level of interest rate risk indicated is within limits that management considers acceptable. However, given that interest ratc movements can be sudden and unanticipated, and are increasingly influenced by global events and circumstances beyond the purview of the Fcderal Reserve, no assurances can be made that interest rate move- ments will not impact key assumptions and parani- eters in a manner not presently embodied by the model. Tt i s management’s opinion that hedging instru- ments currently available are not a cost effcctive means of controlling intcrcst rate risk for the Com- pany. Accordingly, the Company does not cur- rently use financial derivatives, such as interest rate options, swaps, caps, floors or other similar instruments. CRlTlCAL ACCOUNTING POT,TC:IES AND ESTIMATES The Company’s consolidatcd financial statements are prepared in accordance with accounting princi- ples 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.” Ap- plication of these principles requires management CORTLAND BANCORP AND SUBSIDIARIES MANAGEMENT’S T)lSCUSSION AND ANALYSIS ( I n thousands of dollars, exccpt for pcr share amounts) to make estimates, :issumptions and judgments that affect the amounts reporlcd in the financial statements and accompanying notes. Soinc of these policies and related methodologies are more critical than others. The Company has identificd its policy on the allowance for loan losses as bcing critical because it requires management to make particularly difficult, subjectivc and/or complex judgments about matters that are inherently uncer- tain and because of the likelihood that matcrially different amounts would be reported under differ- ent condilions or by using different assumptions. The allowance for loan losses represents managc- ment’s estimate of probable credit losses inhercnt in the loan portfolio. Determining the amount of the allowance for loan losses is considercd a critical accounting estimate because it requires significant judgment and the use of subjective measurements including management’s assessment of the internal risk classifications of loans, changes in the nature of the loan portfolio, industry concentrations and the impact of current local, regional and national economic factors on the quality of the loan portfo- lio. Changes in these estiinutes and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidily. Accordingly, the Company has developed and maintains 3 comprehensive, systematic and con- sistently applied process to determine thc appropri- ate amounts of the allowance for loan losses, and rcsultant provision for loan losses, necessary to absorb estimated credit losses inherent in the loan portfolio. The allowance for loan losses represcnts management’s best estimate from within an ac- ccptable range of estimated losses that it considers appropriate and prudent, but not excessive. While management’s evaluation of the allowance for loan losses ;is of December 3 I , 2003 has deter- mined the allowance to bc adequate, under ad- vcrsely difierenl conditions or assumptions, the Company would most likely necd to increase the allowance. The assumptions and estimates used by the Company in its internal review of non-perform- ing loans and potential problem loans, as well as the associated evaluation of the related collateral coverage for these loans, can have a significant irnpacl on the overall assessment of the adequacy of the allowance for loan losses. While manage- ment has concluded that the current valuation of loan collatcral is reasonable under present circum- stances, if collateral valuations were significantly reduced due to either new informalion or other changing circumstances, additional provisions to the allowance for loan losses would most likely be necessary. All accounting policies are important and the reader of these financial statements is encouraged to review the summary of significant accounting policies described in Note I of the Consolidated Financial Statements, in order to gain a bettcr understanding of how the Company’s financial per- formance is reported. For additional information regarding the allowance for loan losses, its relation to the provision for loan losses and risk related to asset quality, see sections ofthe “Notes to the Consolidated Financial Slate- ments” and “Management Discussion and Analy- sis” related to the allowance for loan losses. IMPACT OF INFLATION Consolidated financial information included herein has been prepared in accordance with gcnerally accepted accounting principles, which require the Company to measure financial position and operat- ing results in terms of historical dollars. Changes in the relative value of money due to inflation are generally not considered. Neither the price, timing nor the magnitude of changes directly coincide with changes in interest rates. INFORMATION AS TO STOCK PRICES AND DIVIDENDS OF CORTLAND BANCORP OTHER INFORMATlON (Forms The Company files quarterly reports, 10-Q, an annual report (Form IO-K), current reports on Form 8-K and all amendments to those reports with the Securities and Exchange Commis- sion (SEC) pursuant to section 13(a) or (15)d of the Exchange Act. In 2004 the quarterly reports will be filed within 40 days of tlic end of each quarter, while the annual report is filed within 75 days of the end of the year. Any individual request- ing copies of such reports may obtain these h e of charge, as soon as reasonably practicable aficr such material is electronically tiled with or furnished to the S E C by visiting our web site at www.cortland- banks.com or by writing to: Deborah L. Eazor Cortland Bancorp 194 West Main Street Cortland, Ohio 44410 The S E C also maintains an Internet site that contains reports, proxy and information state- ments, and other information regarding issuers that file electronically with the SEC at www.scc.gov. The Company’s stock trades on the NASDAQ OTC market under the symbol CLDB. The follow- ing brokerage firms are known to be relatively active in trading the Company’s stock Community Banc Investments, Inc. Columbus, Ohio Contact: Greig A. McDonald Telephone: I -800-224- IO1 3 McDonald & Company Securities, Tnc. 6575 Sevillc Drive 2nd Floor P.O. Box 119 Canfield, Ohio 44406 Telephone: 1-330-746-2993 Salornon Smith Barney, Inc. 5048 Belmont Avc. Youngstown, Ohio 44505 Telephone: I-800-535-0017 UBS Financial Services 3701 Boardman Canfield Rd P.O. Box 100 Canfield, Ohio 44406 Telephone: 330-533-7191 The following table shows the prices at which the coiiimon stock of the Company has actually been purchased and sold in market transactions during the periods indicated. The range ol‘ market price is compiled from data provided by brokers based on limited trading. Also shown in the table are the dividends per share on the outstanding common stock. All figures shown have been ad- .justed to givc retroactive effect to the 3% stock dividend paid as of January 1, 2004, 2003 and 2002. The Company currently has approximately 1,748 shareholders. 2003 Fourth Quarter Third Quartcr Second Quarter First Qorrter 2002 Fourth Quiirter Third Quarter Second Quartcr First Quarter 2001 Fourlh Quarler Third Quarler Sccond Quartcr First Quartcr Price Per Sharc High ~ 1.nw - Cash Dividends Per Shnre $30.58 32.53 mo 26.46 $24.75 25.92 25.69 20.97 $19.80 19.91 20.15 16.51 $29.00 29.31 26.22 24.61 $22.78 23.33 20.26 18.86 $16.73 16.50 15.79 I S S S $0.44 0.21 0.21 0.21 $0.44 0.20 0.20 0.20 $0.37 0.19 0. I 9 0.19 For the convenience of shareholders, the Company has established a plan whereby shareholders may have their dividends automatically reinvested in the common stock of Corlland Bancorp. Participa- tion in the plan is completely voluntary and share- holders may withdraw at any time. For current stock prices you may access our honic page at www.cortland-banks.com. For more information on the dividend reinvest- ment plan, you may contact Deborah L. Eazor at the following telephone number: (330) 637-8040 Ext. 130 or E-mail address DEAZOR@cortland- banks.com. CORTLAND BANCORP BOARD OF DIRECTORS RODGER W, PLATT Chairman DAVTD C. COLE LAWRENCE A. FANTAUZZI GEORGE E. GESSNER WILLTAM A. HAGOOD JAMES E. HOFFMAN 111 NEIL J. KABACK K. RAY MAHAN RICHARD B. THOMPSON TIMOTHY K. WOOFTER OFFICERS RODGER W. PLATT Chairman and President LAWRENCE A. FANTAUZZT Senior Vice President Controller Chief Financial Officer and Secretary-Treasurer JAMES M. GASTOR Senior Vice President Chief of Administration and Lending THE CORTLAND SAVINGS AND BANKING COMPANY BOARD OF DIRECTORS DAVID C. COLE General Manager C O ~ C Valley Motor Company LAWRENCE A. FANTAUZZI Senior Vicc president GEORGE E. GESSNER Atlorney WILLIAjV A. HAGOOD President, Tri-City Mobile Homes, Inc. JAMES E. HOFFMAN IT1 Attorney N E I L J. KABACK Partner, Cohen & C:onipany K. R A Y MAHAN Presidenl, Malian Packing Co. RODGER W. PLATT President and Chairman RJCHAKD B. THOMPSON Exccutive, 'Therm-0-Link, Inc. TIMOTHY K. WOOFTER Prcsident, Stan-Wade Metal Products PAUL C. BOWERS Director Erneritus I * * * * OFFICERS KODGER W . PLATT President, Chairman and Chief Executive Officer LAWRENCE A. FANTAUZZI Senior Vice President, Secrelary-'rreasurer and Chief Financial Oficer JAMES M. GASTOR Senior Vice Prcsidenl and Chief Lending OfIiccr STEPHEN A. TELBGO, SR. Senior Vict: President and Director of 1Iunian Resources and Chrporatc hdministrnticm TlMOTllY CAKNEY Senior Vice Pi-csident & Chief Operations Ofliccr CHARLES J. COMMONS Vice President GERALD L. THOMPSON Vice Prcsidenl MARLENE LENTO Vice Presiden( EMMA J E A N WOLLAM Vice President ROBERT J. HORVATH Vice President DANNY 1,. W l i l T E Vice President JUDY RUSSELL Vice President JAMES DUFF Vice President PKANK R. SEJIALL Vice President DOUGLAS BLAY Vice President KEITH MROZEK Vicc President CRAIG I'HYTHYON Vice President DEBORAH L. EAZOK Vice President GERARD F. KANE Assistant Vicc Presidcnt MARK GOVERNOR Assistant Vice President MARCEL P. AKNAL tant Vice Prcsidenl J. BACOT ice Prcsidenl BEVERLY KOSTOFP Assistant Vice President PTETKQ PASCALE Assistrtnl Vice Presidenl SHIKLEY F. ROOT Assistant Vice Presidcnt DARLENE MACK Assistant Vice President and Trust Olficer KAREN CLOWER Assistant Vice Prcsidenl BARBAKA R. SANDROCK Assistant Vicc Presidcnt KIMBERLY S. V O G l Assistant Vice President JANET K. HOUSER Assistant Vice Prcsident RUSSELL E. TAYLOR Assistant Vice Prcsident SOAN M. FRANGIAMORE Assistant Vicc Presidcnt JUDY A. LARSON Assistant Vice President DAVTD MAY Assistant Vice President BAKBARA McK ENZlH Assistanl Vice Presidenl STEVE 5. M A C K Assistanl Secrelary-Treasurer LANA M U l R Assistant Secret~~ry-Treasu*cr JAMES H U G H E S Assislant Secretaiy-Trcasurer WILLIAM J. HOLLAND Assistant Secretary KAREN MII,LER Assistint Sccretrtry MATTHEW LAUTHER Assistant Sccretary CORTLAND BANKS OFFlCES AND LOCATIONS Thirteen OfJes Serving These Fine Communities BOARDMAN 85x0 South Avenue Youngstown, Ohio 44514 330-758-5X84 HUBBARD 890 West Liberty Strcct Hubbard, Ohio 44425 330-534-2265 VIENNA 4434 Warren -Sharon Road Vienna, Ohio 44473 330-394-1 438 BOARDMAN Victor Hills Playa 6538 South Avenue Boardman, Ohio 4451 2 330-629-9151 BRISTOL 6090 State Routc 45 Bristolville, Ohio 44402 330-889-3062 BROOKFIELD 7325 Warren-Sharon Road Brookfield, Ohio 44403 330-448-6814 MANTUA 11661 State Route 44 Mantua, Ohio 44255 330-274-3111 WARREN 2935 Elm Road Warren, Ohio 44483 330-372- 1 S20 NILES PARK PLAZA 8 I5 Youngstown-Warren Road Suite 1 Niles, Ohio 44446 330-652-X700 W ILL1 A MSFIELD 5917 U S . Route 322 Williamsfield, Ohio 44093 440-293-7502 CORTLAND 194 Wcst Main Street Cortland, Ohio 44410 330-637-8040 NORTH BLOOMFIELD X837 Stale Route 45 North Rloomfield, Ohio 44450 440-685-473 1 WTNDHAM 9690 Bast Center Street Windham, Ohio 44288 330-326-2340 Member Federal Reserve System and Federal Deposit Insurance Corporation Visit us at our home page on the world wide web at www.cortland- ban ks.com or e-mail us at cbinfo~~cortland-banks.com

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