Cortland Bancorp
Annual Report 2005

Plain-text annual report

2 *ANNUAL CONTENTS Chairman’s Message Brief Description of the Business Report on Management’s Awssnient of Internal Control Over Financial Renortinp lieport or Packer Thornas Independenl Registered Public Accounting Firm Consolidated Statements of Income Consolidated Balance Sheets Consolidatcd Statements o l Shareholders’ Hquily Consolidated Statements of Cash Flows Notes lo the Consolidatcd Financial Stalemenls Selected Financial Data Three Year Summary Average Balancc Shcet, Yields and Rales H Managemenl’s Discussion and Analysis Information as lo Stock Prices and Dividcnds of Corlland Baricorp Cortland Bancorp Directors and Officers Cortland Savings 6t Ranking Directors and Officers Ofilces and Locations CH A I R MAN’S MESSAGE TO OUR SHAREHOLDERS ANT) CUSTOMERS: This section of the annual report has long been reserved for the letter from thc Company’s President and Chief Executive OIliccr Kodger W. Platt. After forty-two years of employment with thc Cortland Savings and Banking Company, over twcnty-seven a s Company President and Chicf Executive OiIiccr, Rodger W. Platt complcted his service with the Company retiring November 1, 2005. During his tenurc, the Company has experienced many successes and h:ts led the charge through ii numbcr of challenging periods. As Bank President, Rodger hits committcd hi triself to the Company, its employees, customers and shareholders. I n fact, niany employccs, customers and sharcholders alike have known Rodger to be much more than the Company President - he has been a mentor to some, a counselor to othcrs and a friend to many. On behalf of tlie directors, officers and employees of the Company and thc banking subsidiary, wc congratulate Rodger on his retirement and wish him good health and prosperity as he begins a new chapter in his lifc. shall go on itnd the business at hand continucs. As such, a new chapter in the As is spoken many times -Me Company’s a n n d s begins. With this Chairman’s letter I :im at the beginning of my tcrm as Chairman of the Board. 1 would like to take this opportunity to thank tlie full bourd for thcir vote of coniidencc in nominating me to this position. Joining me in thc transition is a new Bank President and Chief Executive Officer. After eighteen years as the Company’s Chicf Financial Oiliczr, Treasurer and Corporatc Secretary, the Board of Directors appointed Lawrence A. Fantauzzi as its new President and Chief Executive Officer. As Board Chairman, I am looking forward to working with Mr. Pantauzzi its he takcs on his new responsibilities with the Company. Having had the opportunity to work with Larry as ;I fellow board tnemher over the last several years, I c:in assure our customers and shareholders that he will approach the responsibilities and challenges hc faces with the s m c dcdication and conimitmcnt as Rodger did. Joining Mr. Pantauui on the nianagetnent team is James M . Gasior, a Ccrtificd Public Accountant, who has been with the Company since 1990, most recently 8 s Senior Vice President and Chicf Lending Oilicer. Mr. Gasior will be assuming the responsibilities of Chief Financial Oilicer and Corporate Secrctary and has been appointed by the Board of Directors to fill the Director vacancy created by Mr. Platt’s retirement. One of the immcdiate challenges that the Company fxcs is the challenge of managing the net intercst margin. The Company’s net interest margin, which is the diffcrcnce between what it carns on its loans and invcstments and what it pays for its deposits and borrowings, iinprovcd slightly in the past ycar increasing from 3.74% to 3.83%. Despite tlic improvement, the Company’s margins continue to be nirected by short term and long tcrm interest rate pricing decisions of the Federal Rcscrve Board, the aggressive pricing strategics among our competitors and the continued lag in cconomic recovery throughout the geogrwphic areas of Norlheast Ohio in which our branches operate. Another challcnge that the Compmy continues to Lice is an increase in compliance requirements associated with provisions of thc Sarhanes-Oxley Act. Although there has been recent discussion that the coriipliance requircments of Sarbanes-Oxley may be limited or climinated for sinaller public companies in the future, addiiional expcnscs were recorded in 2005 :is ;I result of an incrcasc in professional servicc fees to perform thc compliance exitmin:itions. Despite these incrcxses, non-interest cxpcnses have been particularly well controlled during the last several years. Excluding certain management transition costs, non-interest cxpenses increased by lcss than 1.00% in 2005. Over the last iive years non-interest expcnscs increased at a compounded annual growth rate of less than 1.50%. The Company’s asset quality mcasures remain in a rangc that management considers acceptable. Howcver, adverse trends in delinquency, foreclosure and bankruptcies have impacted the Company’s loan portfolio. Additional provisions of $545,000 wcrc made to the allowance for loan losses to rcflect management’s evaluation of speciiic portfolio risks and probable loss expcrience on existing crcdits in the months ahead. The provisions, which are charged against income, represent an increase of $130,000 ovcr the previous year. Thc allowance now stands at $2.1 68 million or 1.15% of total loans. Prior to the charge oil’of scvcral problem credits in 2005, the allowance had been $2.629 million or I .37% of total loans in 2004. Net Incomc for 2005 WBS $4.334 million or $1.00 pcr share. The Compmy c:irned $4.843 million or $ 1 . I3 per share in 2004. Return on average assets was 0.98% and return on average equity was 8.73%. As of Dcccmher 31, 2005 tolit1 decrcascd ycar-over-year by $3.6 million or I .9% whilc deposits increased by $5.5 million or 1.6%. ets are $459 million as compared to $446 million at Deccmhcr 31, 2004. Total loans Total sliareholdcrs' cquity :it December 31, 2005 is $48.3 million, which is below the $49.4 million recorded at December 31, 2004. This decrease has primarily resulted from the $0.85 per share cash dividcnds, the $0.22 per share special dividend and thc 3% stock dividend. The ovcrall oullook 01 the local economy, the compression of the interest margin, increases in employee healthcare costs and other opcrational issues were considered as factors whcn preparing our annual performance budgets. As such, the actual 2005 operating rcsults were not signilicantly different from the expectations established at tlic bcginning ol' the year. Many of tlicsc same kictors will continue to att'ect our opcrating results in 2006. Faced with the challenge of addressing thcsc and other issues, the Board of Directors and tlic Company's management tcain is, nonetheless, committcd to improving upon the profit results realizcd in 2005. As planning for 200h begins, munagenient and the board havc hcgun to rocus on implementing short tcriii and loi~g term strategic initiativcs. Eventually these initiatives will be incorporated into a comprehensive corporatc strategic plan. Integral to thc plan will be specihc initiatives to grow loan and dcposit portfolios, maximize core earnings :ind enhance shareholder valuc. Arnong the strategic initiatives itre product enhancement stratcgics targeting loan and deposit growth. In regard to product enhanccmcnts in the lending area, a 10 year fixed rate commercial rcal estate product designed to attract new customers and to build portfolio balances is currently being marketed through tlic subsidiary bank. Initial lender ficld reports indicate that thcrc is considerable interest in this product. The rnortgagc :\rea of the bank will also continuc to promote the Wclcomc Honic program, a down payment assistance program offcred through the Federal Homc L o m Rank of Cincinnati. Additional enhancements to loan products will also be considered for thc homc cquity and consumcr loan areas. In terms of branching strategies, inanrtgement and the board arc pcrfnrming an assessment of each branching location. For some branch locations, tangible improvements are hcing made to existing hcilities so that thc offices are aesthetically appcaling and promote an invitation to hank with the Cortland Swings and Banking Company. For other branch localions, construction of more niodcrn facilities is being considered. Finally, opportunities to expand to new communities is also under consideration. Cash dividcnds, as adjusted to give retroactive eH*ect to the 3% stock dividend, or $1.07 per share in 2005 rcpresents a 5.26% yicld. In 2004, cash dividends, again adjusted to givc rctroactive eKect to the 3% stock dividcnd, were $1.04 per share, representing a 4.45% yield, Through thc ycars, shareholder value has been enhanccd through fiivorable dividend payouts including a special dividend paid in each of the lasl 12 years. Although the spccial dividend w ~ s never intended to be B pernianent dividend, it has hccome popular with shareholders, nonetheless. Although dividends for future periods will obviously be affected hy company performance, we anticipate that the dividends paid to our shareholders will be among soiiie of the better payouts for banks in our area. And of course, to add v:iluc, shareholders will continue to have the option to have their dividends automatically reinvested in the common stock of the Company. Whether the objective hc to improvc products, service or shareholder value, management and the hoard will continuc to evaluate and implcmcnt those initiatives that meet the short term and long tcrm performance goals of the Company. It is our intent to dcvclop a comprehensive strategic plan which dcfincs the Company's mission as a community bank and which will lead to prosperity in 2006 and for ycars to come. On behalf ol' the Board of Dircctors, I thank you for your continued conGdence and support. Sincerely, Karl R. Mahan Chairman BRIEF DESCRIPTION OF THE BUS1 N ESS CORTLAND BANCORP Cortland Bancorp (the “Company”) was incorporated under the laws of the Stale of Ohio in 1984, as :i one bank holding company registercd under the Bank Hold- ing Company Act of 1956, as amcnded. On March 13, 2000, the Board of Governors of thc Federal Reserve system approved thc Company’s application to becoine the financial holding cotnpany 23s authorized by :I Granim-Leach-Bliley Act of 1999. Thc principal activ- ity of the Company is to own, mmagc and supervise thc Cortland Savings and Banking Company (“Cortland Banks” or the “Bank”). The Company owns all of the outstanding shrircs of the Bank. The Company is subject to supervision and regulation by the Board of Govcrnors of the Federal Kcserve System (the “Federal Reserve Board”). As H financial holding company, the Company may engage in activities that are financial in nature or incidental to it iinancial activ- ity, as authorized by the Gramni-Leach-Bliley Act of 1999 (Thc Financial Serviccs Reform Act). Undcr the Financial Services Rerorm Act, the Company may con- tinue to claim the benefits of financial holding cotnpany status as long its each depository institution that it controls retnains well capitalized and well iiianagcd. The Company is required to providc notice to the Board of Governors of the Federal Reservc System when it bc- cotnes a w m that any depository institution controlled by the Company ccascs to be well capitalized or well managed. Furthermore, current regulation spccifies that prior to initiating or engaging in any new activitics that arc authorized for financial holding companies, the Company’s insured depository institutions must be rated “satisfactory” or bettcr under the Community Reinvest- tnent Act (CRA). As of Decenihcr 31, 2005, the Cornpany’s bank subsidiary was rated “satisfactory” for CKA purposes, and rcmained well capitalized and, in managetnent’s opinion, wcll managed. Cortland Bancorp owns no property. Operations are conducted at I94 West Main Strcct, Cortland, Ohio. The business of the Company and the Bank is not seasonal to any significant extent and is not dependent on any single customer or group of customers. NEW RESOIJRCES LEASING COMPANY New Resourccs Leasing Company was formed in December 19x8 as a separate cntity to handle thc function of coinmcrcial and consumcr lending. The inactive since wholly owned subsidiary has been incorporation. THE CORTLANL) SAVINGS AND BANKING COMPANY The Cortland Savings and Banking Coiiipiiny is a full service state bank engagcd i n commercial and retail banking and trust services. The Banks services include checking accounts, savings accounts, time dcposit ac- counts, cotnmercial, niortgagc and installment loans, night depository, automated teller services, safe deposit boxes and othcr tniscellaneous serviccs normally oKercd by coiiiniercial hanks. Cortland Banks also oKers a variety 01 Internet Banking produLts :IS wcll as discount brokcrage services. Business is conductcd at a total of thirteen offices, eight of which are located in Trutnbull County, Ohio. Two ofrices are located in the communities of Windh:im and Mantua, in Portage County, Ohio. One oflice is located in the community of Williatnsfield, Ashlahula County, Ohio, while two Lire locatcd in the community of Board- man, Mahoning County, Ohio. Cortland Bank’s main office (as described in its charter) is located at 194 West Main Street, Cortland, Ohio. Administrative ofices are locatcd at the main officc. The Brookfield, Windham, IIu bbard, Niles Park Plaza and both Boardtnan offices are leased, while all of the other oilices :ire owned by Cortland Banks. The Bank, as a state chartered banking organization and member of thc Federal Reserve System, is subject to periodic cxamination and regulation by both the Federd Reservc Hank of Cleveland and the State of Ohio Division of Financial Institutions. These exitininations, which include such areas as capital, liquidity, asset quality, mmagcment practices and otlicr aspects of the Bank‘s operations, are primarily for the protcction of the Bank’s depositors. In addition to these regular cxamina- tions, the Bank must furnish periodic reports to rcgula- tory authorities containing :I full and accurate statemcnt of its affairs. The Bank’s deposits are insured by thc Federal Deposit lnsuritnce Corporation (FDIC) u p to the statutory limit of $ 100,000 per customer. COMPETITION Cortland Banks activcly cornpetes with statc and na- tional banks located in Northeast Ohio rind Western Pennsylvania. It also coinpctcs for deposits, loans and other scrvice business with a large number of other finiincial institutions, such iis savings and loan associa- tions, crcdit unions, insurance companies, consumer finance companics and coiniiiercial financc companies. Also, inoney market mutual funds, hrokcrage houses and similar institutions provide in a relatively unregu- lated environtncnt tnany of the financial services ofl‘ered by banks. In thc opinion of managemcnt, the principal methods of cotnpctition are the rates of intcrest charged on loans, the rates of interest paid on deposit funds, the fccs charged for serviccs, and the convenience, availabil- ity, titneliness and quality of the customer services oKered. EMPLOYEES A5 of Decctnber 31, 2005 the Company through its subsidiq bank, employed 144 full-time and 30 part- time employees. The Coinpany provides its employees with a full range of benefit plans, and considers its relations with its ernployees to be satisfactory. REPORT ON MANAGEMENT’S ASSESSMENT OF INTERNAL CONTROL OVER FINANCIAL REPORTING Cortland Bancorp is responsible for the prepara- tion, integrity, and fair presentation of the consoli- dated financial statements included in this annual report. The consolidated financial statements and notes included in this annual report have bccn prepared in conformity with United States gener- ally accepted accounting principles and necessarily include some amounts that are based on manage- ment’s best estimates and judgments. We, as management of Cortland Bancorp, are responsible lor establishing and maintaining cffcc- live internal control over financial reporting that is designed to produce rcliablc financial statements in conl‘ormity with United States gcncrally accepted accounting principles. The system of internal con- trol over financial reporting ;is it relates to the financial statements is evaluated for effectiveness by management and tested for reliability through a program of internal audits. Actions are taken to correct polen tial deficiencies as they are identified. Any system of internal control, no matter how well designed, has inherent limitations, including the possibility that ;t control can be circumvented or overridden and misstatements due to error or fraud may occur and not be detected. Also, because of changes in conditions, internal control eff’ective- ness may vary over time. Accordingly, even an efiective system of internal control will provide only reasonable assurance with respect to financial statement preparation. Management assessed the Company’s system of internal control over financial reporting as ol‘ December 31, 2005, in relation to criteria for eflective internal control ovcr financial reporting as described in Intcrnul Control-Integrated Frume- work, issued by the Committee of Sponsoring Organization of the Treadway Commission. Based on this assessment, management concludes that, as of December 3 I , 2005, its system of internal con- trol over financial reporting is effective and meets the criteria of the lnlernd Control-lnlqruted F’runzeworX. Packer Thomas, independent regis- tered public accounting firm, has issued an attesta- tion report on management’s assessment of the Company’s financial reporting. control over internal Rodger W. Platt Interim President and Chief Executive Ofliccr James M. Gasior Sccrctary Chief Financial OlIicer Corlland, Ohio February 3 , 2006 REPORT OF PACKER TITOMAS LNDEPENDENT RGGTSTEKED PUBLTC ACCOUNTING FIRM SHAREHOLDERS AND BOAKD OF DIRECTOR3 Cort 1 and B ancorp We have audited the accompanying consolidatcd bal- ance sheets of Cortland Bancorp and subsidirirics 21s of December 31, 2005 and 2004, and the related consoli- dated statements of income, stockholders’ equity, and cash ilows for each of the ycars in the three-ycar period cnded December 31, 2005. We also have audited inan- agement’s assessment, included in the accompanying Report on Management’s hssesstncnt of Internal Con- trol Over Financial Reporting, that Cortland Bancorp and subsidiaries maintained eKectivc internal control ovcr financial reporting as of December 3 I , 2005, based on criteria established in lnlernnl Control-lntci~ri~lcil Frnrneuwrk issued by the Committee of Sponsoring Organizations 01 the Treadway Commission (COSO) . Cortland Kancorp’s management is responsible for these financial statemcnts, for maintaining effective internal control ovcr financial reporting, and for its asscssmcnt of the erectivcncss of internal control over financial rcport- ing. Our responsibility is to exprcss an opinion on thcsc financial slatemcnts, an opinion on rnanagement’s as- sessment, and an opinion on the cffcctiveness of the company’s internal control over financial rcporting based on our audits. We conducted our audits in accordance with the stan- dards of thc Public Company Accounting Ovcrsight Board (United States). Those standards rcquire that we plan and perform thc audits to obtain rcasonable assur- ancc about whether thc financial statemcnts are free or matcrial inisstatement and whether effcctive internal control over financial rcporting was maintained in all matcrial respects. Our audit of Iinancial statements included cxamining, on a test basis, evidence supporting the amounts and disclosurcs in the financial statements, assessing thc accounting principles used and significant estimates made by managemcnt, and evaluating the over:ill financial statement presentation. Our audit of intcrnal control over financial reporting included ob- taining an understanding of internal control over finan- cial rcporting, evaluating management’s assessment, testing and evaluating thc design and opcrating eff‘ec- tivencss of internal control, and performing such other procedurcs as WG considercd necessary in thc circum- stances. Wc believe thal our audits provide a rcasonahle b .’ . iisis for our opinions. A company’s internal control over Iinancial reporting is a process designed to provide reasonable assurance re- garding the rcliahility of financial reporting and thc preparation of financial stdteinents for external purposes in accordmce with gcnerally accepted accounting prin- ciples. A company’s internal control ovcr financial re- porting includes thosc policies and proccdures that ( 1 ) pertain to the inaintcnance of records that, in reasonable detdil, accuratcly and fairly reflect the trans- actions and dispositions of the asscts of the company; ( 2 ) provide reasonable assurancc that transactions are recordcd as necessary to pcrtnit preparation of financial statemcntq in accordunce with generally acceptcd ac- counting principles, and that recciptq and expenditurcs of the company are being made only in accordance with authoriLutions of managetnent and directors of the com- pany; and (3) provide reasonable assurance regmiling prevention or timcly detection of unauthorized acquisi- tion, use, or disposition of the company’q assets that could have :I material effect on the financial statements. B e c i ~ s e or its inhcrent limitations, intcrnal control over financial reporting may not prevent or detect misstate- ments. Also, projections of any evaluation of ett‘ective- ness to future periods arc subject to the risk that controls may become inadequatc because of changes i n condi- tions, or that the degree of compliance with ihc policies or procedures may deteriorate. In our opinion, the financial statcrnents relerred to above prcsent fairly, in all rn:itcrial respects, the cortqoli- dated financial position of Cortland Bancorp and subsid- iaries as of December 31, 2005 and 2004, and the consolidatcd results of its operations and its cash flowq for each of the years in the thrcc-year period endcd December 3 I , 2005 in conformity with accounting prin- ciples generally accepted in the United States of America. Also, in our opinion, managernent’s rncnt that Cortlmd Bancorp and subsidiarics rnaintined effective internd control over linancial reporting its of Deceiiibcr 31, 2005 is fairly qtated, in all inatcrial respects, haqed on criteria established in Inltwal Cow md-lntegrotecl Fruinmwik issucd hy the Committcc of Sponsoring Organizations of the Treadwdy Commission in our opinion, Cortland (COSO). Furthermore, Bancorp and subqidiaries maintained, in a11 material respects, eKectivc internal control ovcr financial report- ing as or Deccmbcr 31, 2005, based on criteria estab- liqhed in Internal Chrztrol-lntc~~~ilPd Fmrrieworh issued by the Committee of Sponsoring Org:ini7ations of the Treadway Commiwion (COS@). Youngstown, Ohio February 3, 2006 Packcr Thomas COKTLAND BANCORP AND S U B S I D I A R I E S CONSOLIDATED STATEMENTS OF INCOME Years cnded December 3 I . 2005. 2004 and 2003 (Amounts in thousands cxcept per share data) Interest income Interest and fees on loans . Interest and dividends on in 2005 2004 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12. 941 $12. 383 $13. 039 Taxable interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Nontaxable interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest on trading account securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other interest income . . . . . Total interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4. 387 2. 162 167 3. 810 119 23, 586 In teres t expense Deposits . . Borrowed f . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6, 159 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 506 Total interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8, 665 Net intercst income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14, 921 Provision for loan losses (Note 4 ) . . . . . . . . . . . . . . . . 545 Nct interest income after provision for loan losses . . . . . . . . . . . . . . . . . 14, 376 Other income Fees for other customer services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities gains - net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trading securities gains - nct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gain on sale of loans - net . . . . . . . . . . . . . . . . . Other real estate losses - net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other non-interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 254 308 89 (3) 467 3, 115 Other expenses Salaries and employee benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net occupancy and equipment expensc . . . . . . . . . . . . . . . . . . . . . . . . . State and local taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Office supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1. egal and litigation expense (Note 16) . . . . . . . . . . . . . . . . . . . . . . . . . Bank exam and audit expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . M arkeling expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7. 052 1. 870 548 338 119 427 245 1. 601 12. 200 3. 50 1 2. 553 135 3. 633 83 22. 288 5. 787 2. 223 8. 010 14. 278 41 5 13. 863 2. 327 1. Os2 54 (171) 569 3. 83 I 6. 722 1. 853 544 346 I03 5 1 s I82 1. 596 11. 861 3. 068 2. 473 132 4. 009 69 117 22. 907 5. 819 2.3 1.3 8. 132 14. 775 240 14. 535 1. 636 946 265 470 532 3. 849 6. 586 1. 963 524 347 152 349 177 1.431 11.529 Tncome before federal income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. 291 Federal income taxes (Note IO) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 957 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4, 334 Net income per share. both basic and diluted (Note 1 ) . . . . . . . . . . . . . $ 1.00 Dividends declared per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.07 5. 833 990 $ 4. 843 6. 855 1.371 $ 5. 484 $ 1.13 $ 1.26 $ 1.04 $ 1.01 See accompanying notes to consolidated financial statements CORTLAND BANCORP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS As of December 31. 2005 and 2004 (Amounts in thousands except pcr share data) ASSETS Cash and due lroin banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal funds sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 2004 $ 14. 587 4. 650 19. 237 $ 9. 397 3. 500 12. 897 113. 247 121. 348 Investmcnt securities available for sale (Note 2) . . . . . . . . . . . . . . . . . . . . . . . . . . lnvestment securities held to maturity (approximate market value or $121. 395 in 2005 and $106. 210 Total loans (Note 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Less allowance Cor loan losses (Note 4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment (Note 5 ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . in 2004) (Note 2) . . . . . . . . 121. 405 188. 2112 (2. 168) 186. 034 4. 088 15. 690 104. 493 I9 1 . 777 (2. 629) 189. 148 4. 369 14. 138 Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $459. 701 $446. 393 LTAHII. ITIES Noninterest-bearing deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tnterest-bearing deposits (Note 6 ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances and other borrowings (Note 7) . . . . . . . . . . Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 61, 782 288. 593 350. 375 58. 111 2. 890 41 1. 376 $ 58. 394 286. 525 344. 9 I9 47. 889 4. 187 396. 995 Coinrnitrnents and contingent liabilities (Notes 8 and 16) SHAREHOT . DERS’ EQIJTTY Common stock . $5.00 stated value . authorized 20.000. 000 shares; issued 4.504. 576 shares in 2005 and 4.373. 735 shares in 2004 (Note I ) . . . . . Additional paid-in capital (Note 1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other comprehensive (loss) income (Note I ) . . . . . . . . . . . . . . . . . Treasury stock. at cost. 155. 945 shares in 2005 and 204. 635 shares in 2004 . . . . Total shareholders’ equity (Noles 15 and 17) . . . . . . . . . . . . . . . . . . . . . . 22. 523 2421 1 IO. 3 I O (877) (3. 842) 48. 325 21. 869 18. 531 13. 131 1 . 06 1 ( 5 . 194) 49. 398 Total liabilities and shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . $459. 701 $446. 393 SIX accompanying noks to consolidated financial statcnients CORTLAND RANCORP AND SUBSIDTARTES CONSOLTDATED STATEMENTS OF SHAREHOLDERS' EQUITY Ycars cnded December 31, 2005, 2004 and 2003 (Amounts in thousands except per sharc data) Common Stock $20,617 . . . . . . . . . . Additiond Paid-In Capital $ 13,323 Accumulated Other Rctainctl Coiiivrehensive Earnings Incoiic (LOSS) $ 3,165 $ I 7 3 I0 Total Share- Treasury holders Stock Equity ~- $ (2,876) $52,039 Balance at December 31, 2002 Comprcheiisivc Income: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other comprehensive incomc, nct of tax: Unrealized losses on available for salc securities, net or reclassification adjustmcnt . . . . . . . . . . . . . . . . . . . . . . . . . Total comprehensive income Common Stock Transactions. Treasury shares repurchascd net of shares reissued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash dividends declared ($.7? per share) . . . . . Spccial cash dividend ($22 per share) . . . . . . . 3% stock dividend . . . . . . . . . . . . . . . . . . . . . . . . . Cash paid in lieu or rraclional shares . . . . . . . . . Balance at Tlecember 31, 2003 . . . . . . . . . . . . . . . . Comprehensive Tncome: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Othcr comprehensive income, net of tax: Unrealized losses on available for sale securities, net or reclassilicalion adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . Total comprehensive income Common Stock Transactions: . . . . . . . . . . Trcasury sharcs rcissu repurchased . . . . . . Cash dividends declar Special cash dividend 3% stock dividend . . . Cash paid in licu of fr Balancc at Dcccniher 31, Comprehensive Income: Net income . . . . . . . . Other comprehensive income, net of tax: Uiircalizcd losses on availahle for sale securities, iiet of rcclassification . . . . . . . . . irc) . . . . . ) . . . . . . . . . . . . . . . . . . . . . . 1 shares.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230 617 2 3 I6 2 I .234 16,469 30 635 2,032 2 1,869 18,531 5.484 (3,485) (864) (3,533) ( 1 1 ) 15,401 4.843 (3,547) (890) (2,667) (9) 13,131 4,334 (962) (2,550) 5.4x4 (962) 4.522 (2,320) (3,485) (864) 2.203 (11) -- (5,426) 49,881 (1,142) 4,843 (1,142) 3.701 232 262 (3,547) (890) 1,061 (9) -- 49,398 (5,194) (1,938) 4,334 (1,938 j 2,396 Common Stuck 'I'ransactions: Treasury shares reissued net of shares repurchased . . . . . . . . . . . . . . Cash dividciids declared ($85 Special cash dividend ( $ 2 2 per share) . . . . . . . 3% stock dividend. . . . . . . . . . . . . Cash paid in licu of fractional shares . . . . . . . . . . . . . . . . . . Balancc at Dcccmber 31, 2005 (184) 654 1,864 $22,523 $ 20.211 (3,701) (929 j (2,518) (7) $10,310 1)lSC'I .OSUKE OF RECLASSIFICATION FOR AVAILAB1,E FOR SATX SEC'UHI'I'Y GAlNS AND LOSSES: Unrealized holding (losses) on available for sale sccuritics arising during tlic pcriod nct of tax of $(894), $(231), and $( 174) . . . . . . . . . . . . . . . . . . . . . . . . . . Less: Kcclassification adjustrricnt for gains reali/ed in ne1 income, $ (877) $ (3,842 j $48,325 -- -- 2005 - - 2004 2003 - $(1,735) $ (448) $ (338) ne1 or tax of $105, $358, and $322, 203 Net unrealized (losscs) on available for sale securilies, net or tax. . . . . . . . . . . . . . . . . . $(1,938) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - - - - - - 694 $(1,142) 624 $ (962) See accompanying notcs to consolidated financial statements CORTLAND BANCOKP AND SUBSIDIARIES CONSOLIDATLD STATEMENTS OF CASH FLOWS Years cnded December 31. 2005. 2004 and 2003 (Amounts in thousands) Cash flows from operating activities Net incoiiic . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to reconcile net income to net cash flows froin operating activities: 200s 2004 2003 . . . . . . . . . . . . . . . $ 4. 334 $ 4. 843 $ 5. 484 Depreciation. amorti7ation and accretion . . . . . . . . . . . . . . . . Provision for loan loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dekrred tax expense (benefit) . . . . . . . . . . . . . . . . . . . . . . . . Investment securities gains . . . . . . . . . . . . . . . . . . . . . . . . . . . Gains on sales of loans . . . . . . . . . . . Othcr real estate losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans originated lor sale . . . . . . . . . . . . . . . . . . . . . Proceeds from sale of loans originated for sale . . . Changes in: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tn teres1 and fees receivable Inkrcst payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other assets and liabilities . . . . N e t cash flows froin opcratin . . . . . . . . . . . 1. 469 545 50 (308) (89) 3 (341) (30) Cash flows from investing activities Purchases of securities available for sale . Purchases of securities hcld to maturity . . Proceeds from sales of securities available for sale . . . . Procceds from cull, maturity and principal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . payments on securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net decrease (increase) in loans made to customers . . . . . . . . . . Proceeds from disposition ol' other real estate . . . . . . . . . . . . . . . . Purchases of premises and equipment ...................... Net cash Ilows from investing activities . . . . . . . . . . . Cash flows from financing activities Net increasc (decrease) in dcposit accounts . . . . . . . . . . . . . . . . . Net increasc (decrease) in borrowings . . . . . . . . . . . . . . . . . . . . . . Dividends paid . . . . . . . . . . . . . . . . . . . . . Purchases of treasury stock . . . . . . . . . . . . . . . . . . . . . . Treasury shares reissued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net cash flows lrom financing activities . . Net change in cash and cash equivalents . . . . . . . . . . . . . . . . . . . (19, 593) (47, 280) 53, 082 2, 462 22 (316) (10, 144) 5, 456 10, 222 1, 171 6, 340 2. 176 41 5 ( I 29) ( 1. OS?) (54) 171 (3. 993) 4. 150 (68. I 46) (43. 601) 32. 523 7. 363 3 (4. 446) ( I . 032) 1. 294 3. I82 3. I50 2. 382 240 135 ( 946 1 (470) (25. 757) 28. I46 131 49 (2. 346) 7. 048 (64. 960) (62. 165) 8. I14 93. 982 (866) 21 (333) (26. 207) 1. 798 1. 217 (4. 360) (3. 641) I . 321 ( 3 . 6 6 5 ) (22. 824) Cash and cash equivalents Beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . End of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12, 897 $ 19. 237 9. 747 $ 12. 897 32. 571 $ 9. 747 See accompanying notes to consolidated linancial statements I NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS C'ORTLAND BANCORP AND SUBSIDIARIES Years ended December 3 1 , 2005, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACX'OUNTING POLICIES Principles of Consolidation: The consolidated financial statements include the accounts of Cortland Bancorp (the Coinpimy) 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. lndustry 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 comincrcial loans and offers a variety of saving plans to customers located primarily in the Northeastern Ohio and Western Pennsylvania area. Use of Estimates: The preparation of financial statements in conforinity with generally accepled accounting principlcs requires management to make estimates and assumptions that all'cct the reported amounts of assets and liabilities and disclosure of contingent ussets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could difier 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 one-day pcriods. Thc Company reports net cash flows for customer loan transactions, deposit transactions and deposits made with other financial institutions. The Company paid interest of $8,695,000, $8, I2 1,000, and $8,083,000 in 2005, 2004 and 2003, respectively. Cash paid for income taxes was $993,000 in 2005, $1,005,000 in 2004 and $1,320,000 in 2003. Transfers of loans to other real estate were, $107,000 in 2005, $196,000 in 2003 and none in 2004. Investment Securities: Investments in debt and equity securities arc classified ;is held to maturity, trading or available for sale. Securities classified as held to maturity are thosc that management has the positive intent and ability to hold to maturity. Securities classified as available for sale are those that could be sold for liquidity, investment management, or similar reasons, even though management has no present intentions to do so. Securilics hcld to maturity are stated at cost, adjusted for amortiLation of premiums and accretion of discounts, with such arnortization or accretion included in interest income. Securities available for sale are carried at fair value with u n r e a l i d gains and losses recorded as a separate component of shareholders' equity, net of tax effects. Realiyed gains or losses on dispositions are based on net proceeds and the adjusted carrying amount of securities sold, using the specific identification rnethod. Interest on securities is accrued and credited to operations based on the principal balance Outstanding, adjusted for amortiLation of premiums and accretion of discounts. Unrealiyed losses on corporate bonds have not been recognized into income. 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 hcld with the intention of selling in the near term and are carried at market value. Realized and unrealiLcd 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 December 3 1, 2005 or 2004. 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 2005 or 2004. Loans: Loans are stated at the principal amount outstanding net of the unamortiLcd biilancc of dclcrred 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 amount of principal outstanding. The accrual of interest is (Continued) COHTLAND BANCORP AND SUBSIDIARIES NOTES TO TI IE CONSOLIDATED FINANCIAL STATEMENTS Ycars ended Deccmber 31, 2005, 2004 and 2003 NOTE 1 - SUMMARY 01; SIC~NIFTC‘ANT ACCOUNTING POLICIES (Continued) discontinued on ;1 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 suficient information is received to question the collectability of the loan or any time lcgal proceedings are initiated involving a loan. Interest income accrued up to lhc date a loan is placed on nonaccrual is reversed through interest income. Cash payments received while a loan is classified as nonaccrual are recorded as a reduction to principal or reported ;is interest income according lo management’s judgmcnt as to the collectibility of principal. A loan is returned to accrual status when either all of the principal and interest amounts contractually due are brought current and future payments are, in management’s judgment, collectable, or when it olherwise becomes well secured and in the process of colleclion. When a loan is charged-oll; any interest accrued but not collected on the loan is charged against earnings. Loans Held for Sale: The Company originates certain residential mortgage loans for 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, the Company may periodically idenlily other loans which may be sold. These loans are classified as loans hcld for sale, and carried, in the aggregate, at the lower of cost or estimated market value based on secondary market priccs. To mitigate interest rate risk, the Coiiipany may obtain fixed commitments to sell such loans at the time loans are originated or identified as being held for sale. Such a commitment would be referred lo as ;I derivative loan commitment if the loan that will result from exercise of the commitment will be held for sale upon funding under Statement of Financial Accounting Standards No. 133 (“SFAS I33”), Accounting j o r Dwivative lnsfruni~nts and Hedging Aclivitiex, as amended by Stateinenl of Financial Accounting Standards No. I49 (“SFAS 149”), Amendnion/ of Statenrcrzt I33 ori Derivative Instrunients and H d g i n g Activities. No such commitments cxisted as of December 31, 2005. Allowance for Loan Losses and Allowance for Losses on Lending Related Commitments: 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-off loans. Keductions to the allowance result from the charge-off of loans deemed uncollectable by management. Alter a loan is charged-off, collection efforts continue and future recoveries may occur. A loan is considered impaired when it appears probable that all principal and interest amounts will not he collected according to the loan contract. Allowances for loan losses on impaired loans are determined using the estimated luture cash flows of the loan, discounted to their present value using the loan’s effective interest rate. Allowances for loan losses for impaired loans thal arc collateral dependent are generally determined bascd on the estimated fair value ol the underlying collate~il. Smaller balance homogeneous loans are evaluated for impairment in the aggregate. Such loans include one-to-four family residential, home equily and consumer loans. Commercial loans and coinmercial mortgage loans are evaluated individually for impairment. Impaired loans are gcnerally 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 cover possible losses that are currently anticipated. Management evaluates the portfolio in light of economic conditions, changes in the nature and volume of the portlolio, industry standards and other relevant factors. Specific factors considered by management in determining the amounts charged to operations include previous loss experience; the status of past due interest and principal payments; the qudity of financial inforiiiation supplied by customers; the cash flow coverage and trends evidenced by financial information supplied by customers; thc naturc and estimated value of any collatcral supporting specific loan credits; risk classifications determined (Conlinucd) CORTLANI) BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended December 31, 2005, 2004 and 2003 NOTE I - SIJMMARY OF SIGNIFICANT ACCOUN‘I’ING POLITIES (Continued) by the Company’s loan review systems or as the result of rcgulatory examination process; and general in the lending area of the Company’s bank subsidiary. Key risk factors and economic conditions assumptions are dynamically updated to reflect actual experience and changing circumstances. While management may periodically allocate portions of the allowancc for specific problem loans, the entire allowance is available for any charge-olTs that occur. The Company maintains an allowance for losses on unfunded commercial lending commitments to provide for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowancc for loan losses. This allowance is reported as a liability on the balance slicet within accrued expenses and other liabilities, while the corresponding provision for these losses is recorded as a component of other expense. Certain asset-specific loans are evaluatcd individually for impairment, based on management’s best estimate of discounted cash repayments and the anticipated proceeds from liquidating collateral. The actual timing and amount of repayments and the ultimate r e a b a b l e value ol the collateral may d i l k r from managcmcnt’s estimatcs. The expected loss for certain other commercial credits utili7es internal risk ratings. These loss estimates arc sensitive to changes in the custoiiier’s risk profile, the reali~ablc value o l collatcral, othcr risk factors and the related loss experience of other credits ol similar risk. Consumer credits generally employ statistical loss factors, adjusted for other risk indicators, applied to pools of similar loans stratified by asset type. These loss esliiiiatcs arc scnsitive to changes i n delinquency status and shifts in the aggregate risk profile. Premises and Equipment: Premises and equipment are slated at cost lcss accuniulatcd depreciation. Depreciation is computed generally on the straight-line incthod over the estimated useful lives of the various assets. Maintenance and repairs are expensed and major improvements are capitalized. Other Real Estate: Real estate acquired through foreclosure or dccd-in-lieu of foreclosure 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 from the carrying value of the rclatcd loan to fair value at the time of acquisition is accounted for as a loan loss. Any subscqucnt reduction in fair market value is reflected as a valuation allowance through ;I charge to income. Costs of significant property improvements are capitalized, whereas costs relating to holding and maintaining the property are charged lo expcnsc. Intangible Asset: A core deposit intangible asset resulting from a branch acquisition is being amortized over a IS year period. The intangible asset, net of accumulated amortization, was $171,000 and $208,000 at December 3 I , 2005 and 2004, respectively, and is included in othcr assets. The annual expense was $37,000 at December 31, 2005, 2004 and 2003. The estimated aggregate amortization expense for the next four years is $37,000 per year, and $23,000 in the fifth year. Cash Surrender Value of Life Insurance: Bank-owned life insurance (“BOLT”) represents life insurance on the lives of certain Company employccs, officers and directors who have provided positive consent allowing the Company to be the co-beneficiary of such policies. Since the Company is the owner of the insurance policies, increases in the cash value of the policies, as well as its share of insurance proceeds received, are recorded in other noninterest income, and are not subjcct to income taxes. The cash value of the policies is included in other assets. The Company revicws the financial strength of the insurance carriers prior to the purchase of BOLT and quarterly thereafter. The amount of’ BOLI with any individual carrier is limited to IS% of Tier T Capital. The Company has purchased BOLT to provide a long-term asset to offset long-term benefit liabilities, while generating coinpctitive investment yields. (Continued) I ~ I I I I I I I I CORTLANI) BANCORP AND SURSlDlRRIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Deccniber 31, 2005, 2004 and 2003 NOTE 1 - SUMMARY OF SIC;NIFTCAN‘l AC‘COUNTING POLICIES (Continued) Advertising: The Company expenses advertising costs as incurred. Income Taxcs: A deferred tax liability or asset is determined at each balance sheet date. It is nieasurcd by applying currently enaclcd tax laws to future amounls that result from dift‘erences in the financial statement and tax bases of assets and liabilities. Other Comprehensive Tncome: Accumulated other comprehensive income lor the Company is comprised solely of unrealiyed holding gains (losses) on available for sale securities, net of tax. Per Share Amounts: The Board of Directors dcclared 3% coinmon stock dividends payable as of January 1, 2006, 2005 and 2004. The 3% common stock dividend issued on January 1, 2006 resulted in the issuance of 130,841 shares of comnion stock, which have been included in the 4,504,576 shares reported as issued at December 31, 2005. Basic and diluted earnings per sharc are based on weighted average shares outstanding. Average shares outstanding and per share amounts have been restated to give retroactive effecl lo the 3% common stock dividend of January 1, 2006. Average shares outstanding an3 per share amounts similarly reflecl the impact of the Company’s stock repurchase program (see N o k 17). The following table sets forth the computation of basic earnings per common sharc and diluted earnings per conimon sharc: Years Ended December 3 1, 2004 2005 2003 Net income ($000 omitted) . . . . . . . . . . . . . . . . Weighted average coninion . . . . . . . . . $ 4,334 $ 4,843 $ 5,484 shares outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Basic earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Diluted earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,330,483 1.00 1.00 !$ $ 4,278,628 1.13 $ 1.13 $ 4,331,412 $ 1.26 $ 1.26 Ol‘f Balance Sheet Financial Instruments: Financial instrunicnts include OK-balance sheet credit instru- ments, such as commitmenls to make loans and commercial letters of credit, issued lo meet customer financing needs. The face amount for these items represents the exposure to loss, before considering customer collateral or ability to repay. Such financial instruments are recorded when they are funded. Reclassifications: Certain items in the Iinancial statements for 2004 and 2003 have been reclassified to conform to the 2005 prescntation. New Accounting Standards: In November 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff‘ Position (FSP) I I5-and 124- I , “The Mcaning of Othcr-Than-Temporary Tmpairinent and its Application to Certain Investments”. This FSP provides guidance on when an invcstment in a debt or eyuity security should be considered impaired, when that impairment should be considered other-lhan- temporary, and measurement of the impairment loss. An investmenl is considered impaired if the fair value of the investment is less than its cost. If, after consideration ol‘ all available evidence to evaluate the realizable value of the inveslmcnt, impairment is determined to be othcr-than-temporary, then an impairment loss should be recognized equal to the difference between the investment’s cost and its fair value. The guidance also clarifies that an impairment loss should be recognized no later than when the impairment is deerncd other-than-temporary, even if a decision to sell has not been made. This F S P nullifies certain provisions of Emerging Tssues Task Force (EITF) Issue No. 03-1, “The Meaning of Other- Than-Temporary Impairment and Its Application to Certain Investments,” while retaining the disclosure (Continued) CORTLAND RANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Ycars ended Deceinher 31, 2005, 2004 and 2003 NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLIClES (Continued) rcquirements of’ ETTF 03-1 which werc adopted in 2003. FSP 115-1 and 124-1 is cffective for reporting periods beginning after Deccinber 15, 2005. The Company applied thc guidance in this FSP in 2005. In May 2005, the FASB issued Statcmcnt of Financial Accounting Standurds (SFAS) No. 154 “Accounting Changes and Error Correclions,” ;I replacement of APB Opinion No. 20, “Accounting Changes” and FASB Statement No. 3, “Rcporting Accounting Changes in Interim Financial Statements.” SFAS No. I54 applies to all voluntary changes in accounting principle and changes thc accounting for and reporting of a changc in accounting principle. SFAS No. 154 rcquires retrospective application to prior pcriods’ financial statements of a voluntary change in accounting principle unless it is impracticable. APB No. 20 previously required that iiiost voluntary changes in accounting principlc bc recognized by including in net income of the period ofthe change the cumulative effect of changing to the new accounting principle. SFAS No. 154 is elfcctivc for accounting changes iiiade in fiscal ycars beginning after December I 5 , 2005. The Company does not bclieve there will be any material impact on its earnings, cash flows and/or financial position upon adoption of’ SFAS No. 154. (Continued) COKTLAND RANCORP AND SUBSIDIARIES NOTES TO THE CONSO1,IDATED FTNANCIAL STATEMENTS Years ended Dccernber 31, 2005, 2004 and 2003 NOTE 2 - INVESTMENT SECURITIES The following is a summary of investment securities: (Amounts in thousands) Amortized cost Gross Unrealized Gains Gross Unrealizcd Losses Estiniatcd Fair Value December 31, 2005 Investment securities available for sale U.S. Government agencies and corporations . . . . . Obligations of slates and political subdivisions. . . . Mortgage-hacked and related securitics . . . . . . . . . Corporate securities . . . . . . . . . . . . . . . . . . . . . . . . . . Total debt securities. . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total available for sale . . . . . . . . . . . . . . . Investment securities held tu maturity U S . Trcasury securities . . . . . . . . . . . . . . . . . . . . . . L J S . Government agencics and corporations . . . . . Obligations of states and political subdivisions. . . . Mortgage-backed and related securities . . . . . . . . . Total held to maturity . . . . . . . . . . . . . . . . December 31, 2004 Investment securities available for sale U.S. Treasury securitics . . . . . . . . . . . . . . . . . . . . . . U.S. Government agencies and corporations . . . . . Obligations of states and political subdivisions. . . . Mortgage-backed and related securitics . . . . . . . . . Corporate securitics . . . . . . . . . . . . . . . . . . . . . . . . . . Total debt securities. . . . . . . . . . . . . . . . . . Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total available for sale . . . . . . . . . . . . . . . Investment securities held to maturity U.S. Treasury securities . . . . . . . . . . . . . . . . . . . . . . U S . Governincnt agencies and corporations . . . . . Obligations of states and political subdivisions. . . . Mortgage-backed and related sccurities . . . . . . . . . Total held to maturity . . . . . . . . . . . . . . . . $ 14,010 11,372 61,494 24,307 1 1 1,183 3,393 $1 14,576 $ 148 66,057 32,842 22,358 $121,405 $ 1,192 21,687 10,900 66,643 16.0X 1 1 16,503 3.240 $1 19,743 $ 152 46,2 I0 34,048 24,083 $104,493 $ 2 5 1,307 14 $1,328 $ 254 21 5 74 1 802 22 2,034 $2,034 $ 5 172 1,870 103 $2,150 $ 34 506 314 50 904 $ 196 6 1,174 857 2,233 $ 904 $2,233 $ 943 23 372 $1,338 $ 13,848 11,872 60,634 23,500 109,854 3,393 $ I 13,247 $ 150 65,119 34,126 22,000 $I 21,395 $ 40 302 87 - 429 $429 - - $ 1,446 21,862 11,641 67,143 16,016 lI8,lOX 3,240 $121,348 $ $ 157 46,190 192 35,897 21 23.966 220 ~ - $106,210 $433 A1 Dccember 3 I , 2005 and 2004, other securities consisted of $3,167,000 and $3,014,000 in Federal Home Loan Bank (FHLB) stock, respeclively, and $226,000 in Federal Reserve Board (FED) stock. Each investment i s curried at cost, and thc Company is required to hold such investments as a condition of mcmbcrship in order to transact business with the FHLB and the FED. (Continued) CORTLAND BANCOKP A N D SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Decenlber 31, 2005, 2004 and 2003 NOTE 2 - INVESTMENT SECURITIES (Continued) The nmorliml cost and estimated market value of debt securities at December 3 I , 2005, by contraclual maturity, are shown below. Actual maturities will dift'er from contractual maturities because issuers may havc the right to call or prepay obligations with or without call or prepayment penallics. (Amounts in thousands) necember 31, 2005 Amortized cost Estimated Fair Value Investment securities available for sale Due in one year or less.. . . . . . . . . . . . . . . . . . . . . . . . . Due alter one year through five years.. . . . . . . . . . . . . Due after five years through ten years . . . . . . . . . . . . . Due after ten y e a r s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-backed securities . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securities held to maturity Due in one year or less.. . . . . . . . . . . . . . . . . . . . . . . . . Due a f k r one year through five years.. . . . . . . . . . . . . Due after five years through ten years . . . . . . . . . . . . . Due after ten y e a r s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mortgage-hacked securities . . . . . . . . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1 1,082 3,381 35,226 49,689 61,494 $1 11,183 $ 48 3,217 34,453 61,329 99,047 22,358 $121,405 $ 1 1,001 2,690 35,529 49,220 60,634 $109,854 $ 47 3,145 34,256 6 1,947 99,395 22,000 $121,395 The following table sets h t h the proceeds, gains and losses realized on sccurities sold or called for each of the years ended Dcccmber 3 1 : (Amounts in thousands) 2005 2004 2003 Proceeds.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . tiross realized gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . Gross realized losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,563 308 $43,339 1,074 22 $20,115 948 2 I vestment securities with a carrying value of approxirnately $64,082,000 at December 31, 2005 and $48, I 14,000 at December 3 I , 2004 were pledged to secure deposits and for other purposes. (Continued) COKTLANT) BANCORP AND SUBSTDIAKlES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Decernbcr 31, 2005, 2004 and 2003 NOTE 2 - INVESTMENT SECURITIES (Continued) The following is a surnmary ol‘ the fair value of’ securities with unrealiml losses and an aging of those unrealized losscs at December 3 I , 2005: (Amounts in thousands) Less than 12 Months Unrealized Losses Fair Value 12 Months or More Unrealized Fair Losses Value Total Fair Value Unrealized Losses U S . Government agencies and corporations.. . . . . . . . $53,229 Obligations of slates and $ 734 $19,359 $ 405 $ 72,588 $1,139 political subdivisions . . . . . Mortgage-backed and related securities . . . . . . . . . . . . . . . Corporate securities . . . . . . . . . . 893 33,976 9,928 8 522 840 857 21 1,750 29 32,556 2,996 1,024 17 66,532 12,924 1,546 857 $98,026 $2,104 $55,768 $1,467 $153,794 $3,571 The Mowing is a summary of the fair value of sccurities with unrcalized losses and an aging of those unrealbed losscs at December 31, 2004: (Amounts in thousands) Less than 12 Months U n r e a l i d Losses Fair Value 12 Months or More Unrealized Fair Losses Value Total Fair Value U n r e a l i d Losses U .S . Government agencies and corporations . . . . . . . . . $14,692 $135 $ 8,099 $ 97 $ 22,791 $232 Obligations of states and political subdivisions . . , , . Mortgage-backed and related securities . . . . . . . . . . . . . . . . . . . . . . . Corporate securities 27,3 17 7,004 $49,013 ss9 21 859 21 247 61 - $443 - - $30,549 19,591 2,000 - 26 275 46,908 9,004 $419 - - $ 79,562 522 87 - $862 - - The above table represents 207 investment securities wherc the current value is less than the related a n l o r l i d cost. The unrealiLed losses on the Bank’s investment in mortgage-backed and relaled securities were caused by interest rate increases. Accordingly, it is expected that the sccurities would not be settled at a price less than the amortized cost o f t h e Bank’c investment because the decline in market value is attributable to changes in interest rates and not credit quality, and because the Company has the ability and intent to hold those investmcnts until a recovery of fair value, which may be maturity. The Bank does not consider those investrncnts to be other than temporarily impaired 31 December 31, 2005. The Bank’s unrealized loss on investments in corporate securities relates to 3 $2,350,000 investment in the General Motors Corporation. The unrealiLcd loss was primarily caused by ( a ) a recent decrease in profitability and profit forecasts by industry analysts resulting from intense competitivc pressure in thc automotive industry and (b) recent sector downgrade by industry analysts. The contractual terms of those investments do not permit General Motors Corporation to settle the security at a price less than the (Continucd) CORTLAND BANC'ORP A N D SUBSIDIARIES NOTES TO THE CONSOLIDATED FTNANCIAL STATEMENTS Years ended December 31, 2005, 2004 and 2003 NOTE 4 - ALLOWANCE FOR LOAN LOSSES (Continued) December 3 I , 2003, the recorded investment in impaired loans was $ I,857,000, $2,985,000 and $87 1,000 while the allocated portion of the allowance for loan losses for such loans was $714,000, $1,355,000 und $177,000, respectively. Tnterest income recognized on impaired loans using the cash basis was $5 1,000 lor 2005, $100,000 for 2004 and $42,000 for 2003. There were no renegotiated loans lor which interest has been reduced and that arc still accruing interest at December 31, 2005, December 31, 2004 and December 31, 2003. As of December 3 I , 2005, 2004 and 2003, there were $5,304,000, $5,622,000 and $2, I 13,000 in loans that were neither classified as nonaccrual nor considered impaired, but which can be considered potential problem loans. Any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed above do not ( i j represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (ii) represent material credils about which management is aware of m y information which causes management to have serious doubts as to thc ability of such borrowers to comply with the loan repayment terms, NOTE 5 - PREMTSPS AND EQIJTPMENT The following is ;-L summary of prcinises and equipment: (Amounts in thousands) Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Leasehold improvements . . . . . . . . . . . . . . . . . . . . . . Less accumulated depreciation . . . . . . . . . . . . . . . . . Net book v a l u e . . . . . . . . . . . . . . . . . . . . . . December 3 I . 2005 2004 !# 703 5,668 9,430 281 16,082 11,994 $ 4,088 $ 692 5,550 9,263 28 1 15,786 11.417 $ 4,369 Depreciation expense was $597,000 for 2005, $630,000 for 2004 and $737,000 for 2003. (Continued) ... CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FlNANCIAL STATEMENTS Years cnded December 31, 2005, 2004 and 2003 NOTE 6 - DEPOSITS The following is a summary of intercst-hearing deposits: (Amounts in thousands) December 31. 2005 2004 D e m a n d . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Money Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 29,677 17,866 86,359 $ 28,723 I x,97 I 90,432 Time: In denominations under $100,000. . . . . . . . . . . . . In denominations of $100,000 or more . . . . . . . . Total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,488 45,203 $288,593 11 3,522 34,877 $286,525 The following is a summary ol time deposits of $100,000 or more by remaining maturities: (Amounts in thousands) Decembcr 31, 2005 2004 Certificates Other Time of Deposit Deposits Total Certificates Othcr Time or Deposit Deposits Total Three months or less . . . . . . . . . . . $10,760 $ 100 $10,860 $ 7,480 $ 805 $ 8,285 Three to six months . . . . . . . . . . . . 11,521 Six to twelve months . . . . . . . . . . . 6,428 One through five years . . . . . . . . . . 7,195 Over five years.. . . . . . . . . . . . . . . . Total . . . . . . . . . . . . . . . . . 1,829 $37,733 334 350 1,647 5,039 $7,470 11,855 6,778 8,842 4,397 4,490 9,250 263 100 4,660 4,590 1,523 10,773 ~~ 1,899 6,868 4,670 $45,203 $27,516 $7,361 ~~ -~ 6,569 $34,877 (Continued) CORTLAND BANCORP A N D SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Decemher 3 I , 2005, 2004 and 2003 NOTE 7 - FEDERAL HOME T2OAN BANK ADVANCES AND OTHER BORROWINGS The following is a summary of total Federal Home Loan Rank advances and other borrowings: (Amounts i n thousands) Federal Home Loan Rank advances Variable rate Prime based Fcderal Home Loan Bank advances, with monthly interest payments: Due in 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed rale and convertible fixed rate Federal Home Loan Bank advances, with monthly interest payments: . . . . . . . . . . . . . . . . . . . . . . . . . . . Duc in 2006 Due in 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Due in 2008 . . . . . . . . . . . . . . Due in 2009 . . . . . . . . . . . Due in 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Duc in 2011 . . . . . . . . . . . . . . . . Total Federal Home Loan Bank advances . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings Sccuritics sold under repurchase agreeinenis . . . . . . . . . . . . . . . . . . . U S . Treasury interest-bearing demand note, . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other borrowings. . , Total Federal Home Loan Bank advances and other borrowings. . . . . . . . . . . . . . . . . . Weighted Average Interest Rate December 3 1 , 2005 2004 4.6000% 4.6600% 4.2580% 5.6340% 5.1600% 5.9293% 4.9553% 5.12359% 2.9570% 3.9520% 3.2049% 2,000 10,000 5,000 io,oon 13,500 9,500 55,000 2,336 775 3,111 6,000 5,000 10,000 13,500 9,500 44,000 2,675 1,214 3,889 5.0207% $58,111 $47,889 Securities sold under repurchase agreements represent arrangements that the Bank has entered into with certain deposit customers wilhin its local market areas. These borrowings are collateralixd with securities. There are $6.8 million in securitics, allocated for this purpose, owned by the Bank and held in sakkccping accounts at independent correspondent banks. Federal Home Loan Bank (FHLB) advances are collateralized by the FHLB stock owned by lhc Bank, which had a carrying value of $3,167,200 al December 31, 2005, and a blanket lien against the Rank's qualified mortgage loan portfolio, $17,097,000 in collateralized mortgage obligations and $5,415,000 in Federal Agency Securities. Maximum borrowing capacity from the FHLR totaled $60,8 14,000 at Dcccm- ber 3 I , 2005. As of both December 3 I , 2005 and 2004, $38,000,000 of the FHLB fixed rate advances are convertible lo quarterly LTBOR floating rate advances on or after certain specified dates at the option of the FHLB. Should the FHLB elect to convert, the Company acquires the right to prepay any or all of the borrowing a t the time of conversion and on any interest payment due date, thereafter, without penalty. NOTE 8 - C'OMMITMENTS The Hank occupies ollicc facilities under operating leases extending lo 2008. Most of these leases contain an option to renew at the then fair rental value for periods of five and ten years. Thesc options enable the Bank to retain use of facilities in desirable operating areas. In most cases, inanagenienl expects that in thc normal course of business, leases will be renewed or replaced by other leases. Rental and lease expense was (Continued) CORTLAND BANCORP AND SUBSIDlAlilES NOTES TO THE CONSOLlDATED FINANCIAL STATEMENTS Years ended Dccernber 3 I , 2005, 2004 and 2003 NOTE 8 - COMMITMEN'I'S (Continued) $295,000 for 2005, $287,000 for 2004, and $286,000 for 2003. The rollowing is a summary of remaining future minimum lease payments under current noncancelable operating leases for office facilities: (Amounts in thousands) Y cars ending: December 3 1, 2006. . . . . . . . . . . . . . . . . . $188 December 3 1, 2007. . . . . . . . . . . . . . . . . . 83 December 3 1, 2008 . . . . . . . . . . . . . . . . . . 27 Tot a1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . $298 ~ ~ ~ At December 3 I , 2005, the Bank was required to maintain aggregate cash reserves amounting to $5,290,000 in order to witisfy federal 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 adversely impacted by downturns in local economic and employment conditions. Approximately 3.31% of total loans are unsecured at December 3 1, 2005, compared to 2.84% at December 3 I , 2004. 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 Company, through its subsidiary bank, is ;i party to financial instruments with ofi-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby lcttcrs of credit and financial guarantees. Such instruments involve, to varying degrees elements ol' credit risk in excess of the amount recognized on the balance sheet. The contract or notional amounts or thosc instruments reflect the extent of involvement the Company has in particular classes of financial instruments. In the event of nonperformance by the other party, thc Company's exposure to credit loss on these financial instruments is represented by the contract or notional amount of the instrument. The Company uses the same credit policies in making commitments and conditional obligations as it docs for instruments recorded on the balance sheet. Thc amount and nature ol'collatcral obtained, if any, is based on management's credit cvaluation. (Continued) COKTLAND E A N C O R P AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Deccrnbcr 31, 2005, 2004 and 2003 NOTE 8 - COMMITMENTS (Continued) The following is a summary of such contractual commitments: (Amounts in thousands) December 31, 2005 2004 Financial instruments whose contract amounts represent credit risk: Commitments to extend credit Fixed rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Variable rate Standby letters of credit . . . . . . . . . . . . . . . . . . $ 2,101 39,180 1,195 $ 1,506 30,400 1,455 Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Generally these financial arrangements have fixed expiration dates or other termination clauses and may require payment of a fee. Standby letters of’ credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Since many of the commitments are expected lo expire without being drawn upon, the total commitment amounts do not necessarily represent fu lure cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Collateral held varies but may include accounts receivable, inventory, properly, plant and equipment and income-producing commercial properlies. The Company’s subsidiary bank also oNcrs limited overdraft protection as a non-contractual courtesy which is available to individually/joinlly owned accounts in good standing for personal or household use. The Company reserves the right lo discontinue this service without prior notice. The available amount of overdraft protection on depositors’ accounts at December 3 I , 2005, totaled $6, I9 1,000. The total average daily balance of overdrafts used in 2005 was $1 26,000, or approximately 2%1 of the total aggregate overdraft protection available to depositors. NOTE 9 - BENEFIT P U N S The Bank has a contributory defined contribution retirement plan ( a 401 (k) plan) which covers substantially all employees. Total expense under the plan was $224,000 for 2005, $215,000 for 2004 and $211,000 for 2003. 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 $14,000, 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 bencfit plans for the benefit of certain officers and non officer directors. The plan for officers is designed to provide post-retirement benefits to supplement other sources of rctircment income such as social security and 401 (k) benefits. The benefits will bc paid for a period of 15 years after retirement. The amount of each officer’s benefit is determined by their salary at retircment as wcll ;IS their other sources of retirement income. Director Relireinent Agreements provide for 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 (Continued) CORTLAND BANCORP AND SUBSIDlARIES NOTES TO THE CONSOLIDATED FlNANClAL STATEMENTS Years ended December 31, 2005, 2004 and 2003 NOTE 9 - BENEFTT PLANS (Continued) following retirement. The Bank and Bancorp accrue the cost of thcse post-retircment benefits during the working careers o f t h e oficcrs and directors. At December 31, 2005, the cumulative expense accrued for these b e n c h totaled $1,283,000, with $ I ,052,000 accrued for the officers’ plan and $231,000 for the directors’ plan. Thc Bank has purchased insurance contracts on the lives of the participants in the supplemental retirement benefit plan and has named the Bank as the beneficiary. Similarly, the Bancorp has purchascd insurance contracts on the lives of the directors with the Bancorp ;is beneficiary. While no direct linkage exists between the supplemental retirement benefit plan and the life insurance contracts, it is management’s current intent that the revenuc from the insurance contracts be used as ;I funding sourcc for the plan. At December 31, 2005, the cumulative income accrued on these contracts totaled $1,681,000 on ;1 tax cquivalent basis, with $1.166,000 accrued on the officers’ contracts and $51 5,000 on thc directors’ contracts. NOTE 10 - F‘EDERAT, INCOME TAXES The composition of income tax expense is as follows: (Amounts in thousands) Current . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferrcd . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . T o t a l . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Years Ended December 3 I , 2004 $1,119 (129) $ 990 2005 $ 907 SO $ 957 2003 $1,236 135 $1,371 Thc following is a summary of net deferred taxes included in other assets (liabilities): (Amounts in thousands) December 3 I , 2004 2005 2003 Gross deferred tax assets: Provision for loan and other real estatc losses. . . A M T credit.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other itcms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loan origination cost - net . . . . . . . . . . . . . . . . . . Unrcalized loss (gain) on available for sale securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 413 29 64 1 28 $ 570 29 494 6 452 (547) Gross deferred tax liabililies: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other i t e m s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (387) (498) Net deferred tax asset (liability) . . . . . . . $ 678 $ (389) (434) (271) The Company has an alternative ininimum tax credit which can be carried forward indefinitely. (Conlinucd) COKTLAND BANCORP AND SUBSlDlARTES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended December 3 1 , 2005, 2004 and 2003 NOTE 10 - FEDERAL INCOME TAXES (Continued) The following is ;i reconciliation between tax expense using the statutory tax rate of34% and the income tax provision: (Amounts in thousands) Years Ended December 3 1, 2004 2003 2005 Statutory t a x . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effect ol' non-taxable income . . . . . . . . . . . . . . . . . . ElTect of non-deductible expense . . . . . . . . . . . . . . . $ 1,798 (921) 80 Total income t a x e s . . . . . . . . . . . . . . . . . . . $ 957 $ 1,983 (1,084) 91 $ 2,331 ( I ,052) 92 $ 990 $ 1,371 The relatcd income tax expense on investment securities gains and losses amounted to $105,000 for 2005, $358,000 for 2004 and $321,000 for 2003, and is included in the total federal income lax provision. NOTE 1 1 - FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts and estimated fair values of the Company's financial instruments arc as follows: (Amounts in thousands) December 31, 2005 December 31, 2004 Carrying Amount Estimated Fair Value Carrying Amount Estimated Fair Value ASSETS: Cash and cash equivalents . . . . . . . . . . . . . . . . . . $ 14,587 Federal Funds sold . . . . . . . . . . . . . . . . . . . . . . . . 4,650 lnvestment securities . . . . . . . . . . . . . . . . . . . . . . . 234,652 Loans, net of allowancc for loan losses.. . . . . . . 186,034 LTARTLTTIES: Demand and savings deposits . . . . . . . . . . . . . . . . $195,684 154,691 Time deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 FHLB advances . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 t her borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . 3,111 $ 14,587 4,650 234,642 184,389 $195,684 154,608 54,957 3,111 $ 9,391 3,500 225,841 89,148 96,520 48,399 44,000 3,889 $ 9,397 3,500 2 2 7 3 58 188,508 $196,520 150,362 44,305 3,889 For purposes of the above disclosures of estimated fair value, the following assumptions were used as of' December 31, 2005 and 2004. The estimated fair value for cash and cash equivalents is considered lo approximate cost. The estimated fair value for securities is bascd on quoted iiiarket values for individual securities or for equivalent securities when specific quoted prices are 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 wilhdrawal. The fair values ol' loans, FHLB advances and other borrowings and time deposits that reprice less frequently are approximated by a discounl rate (Continued) CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIIIATED FINANCIAL STATEMENTS Years ended December 31, 2005, 2004 and 2003 NOTE 11 - FAIR VAT.'CJli: OF FINANCTAL 1NSTRUMENTS (Continued) valuation tcchnique utili~ing estimated market intcrest rates as of December 3 I , 2005 and 2004. The fair value of unrecorded commitments at Decembcr 31, 2005 and 2004, is not material. In addilion, other assets and liabilities of the Company that are not defined as financial inslrurncnts are not includcd in the above disclosures, such as property and equipment. Also, non-financial instruments typically not recognized in financial statements nevertheless may have value but arc not included in thc above disclosures. These include, among other items, the estimated earning power of core deposit accounts, the trained work force, customer goodwill and similar items. Accordingly, the aggregate fair value ainounls presented do not rcpresent the underlying value of the Company. NOTE 12 - REGULATORY MATTERS The Company is subjecl to various regulatory capital requirements administered by the l'ederal ban king agencics. Failure to meet minimuni capital rcquirements can initiate certain actions by regulators that, il' undertaken, could have a direct material effect on Ihc Company's financial statements. Undcr capital adequacy guidelines and the regulatory framework for prompt corrective action, the Coinpany must meet spccific capital guidelines that involve quantitative nieasures of the Company's assets, liabilities, and certain off'-balance sheet items as calculated under regulatory accounting practices. The Company's capital amounts and classifications are also subject to qualitative judgments by lhc regulators about componcnts, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy rcquire the Company to maintain: ( I ) a minimum ratio of 4% both for total Tier 1 risk-based capital to risk-weighted assets 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 thc regulatory framework for prompt corrective action, the Company is categorized as well capitaliLed, which requires minimum capital ratios of 10% for total risk-based capilal to risk-weighted assets, 6% for Tier T risk-based capital to risk-weighted assets, and 5% for Tier 1 risk-based capital to average assets (also known as the leverage ratio). There are no conditions or events since the most recent communication from regulators that management believes would change the Company's category. (Amounts in thousands) December 31, 2005 December 3 I , 2004 Amount Ratio Amount Ratio Total Risk-Based Capital. . . . . . . . . . . . . . Ratio to Risk-Weighted Assets. . . . . . . Tier T Risk-Based Capital . . . . . . . . . . . . . Ratio to Risk-Wcighted Assets. . . . . . . Ratio to Average Assets . . . . . . . . . . . . $51,220 $49,031 $50,7133 $48,129 21.16% 20.25% 11.05% 22.07% 20.9 1 % 10.88% Tier 1 risk-based capital is shareholders' equity less intangibles and the unrealized market value adjustment of investment securities available for sale. Total risk-based capital is Tier T risk-based capital plus the qualifying portion of the allowance for loan losses. Assets and certain off balance sheet itcriis adjusted in (Con tinucd) CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years ended Dccember 31, 2005, 2004 and 2003 NOTE 12 - REGUT.ATORY MATTERS (Continued) accordance with risk classificalion comprise risk-weighted assets of $242,106,000 and $230, I 33,000 as of December 31, 2005 and 2004, respectively, Assets less intangibles and the net unrealized rnarkct value adjuslrnent of investment securities available for sale averaged $443,677,000 and $442,428,000 for the years endcd Dccemher 3 I , 2005 and 2004, rcspectively. NOTE 13 - RELATED PARTY TRANSACTIONS Certain directors, executive officers and companies with which they are iilliliatcd were loan customers during 2005. The following is an analysis of such loans: (Amounts in thousands) Total loans at Deccmber 31, 2 0 0 4 . . . . . . . . . . . . . . . . . . . . . $ 630 New loans.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,335 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (115) Repayments or othcr Total loans at December 31, 2005 . . . . . . . . . . . . . $1,850 NOTE 14 - CONDENSED FINANCIAL INI~ORMATION Below is condensed financial information of Cortland Bancorp (parcnt company only). In this information, the parent’s investment i n subsidiaries is slalcd at cost, including equity in the undislributed earnings of the subsidiaries since inception, adjusted for any unrealized gains or losses on available for sale securities. BALANCE S H E E T S (Amounts in thousands) Assets: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment securitics available for sale . . . . . . . . Investment in bank subsidiary. . . . . . . . . . . . . . . . Investment in non-bank subsidiary . . . . . . . . . . . . Other assets.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . December 3 I , - 2005 2004 $ 3,102 587 42,435 15 2,447 $48,586 $ 3,201 836 43,368 15 2,336 $49,756 Liabilities: Other liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 261 $ 358 Shareholders’ equity: Common stock (Note 1 ) . . . . . . . . . . . . . . . . . . . . Additional paid-in capital (Note 1) . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . Accumulated other coiiiprchcnsive income.. . . . Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total shareholders’ equity. . . . . . . . . . . . . 22,523 20,211 10,310 (877) (3,842) 48,325 $48,586 21,869 18,531 13,131 1,061 (5,194) 49,398 $49,756 (Continued) CORTLAND BANCORP AND SUBSIDlAKlES NOTES TO Tt I E CONSOLIDATED FINANCIAL STATEMENTS Years cndcd December 31, 2005, 2004 and 2003 NOTE 14 - CONDENSED FTNANCTAL TNFORMATION (Continucd) S T A T E M E N T S OF TNCOME (Amounts in thousands) Dividends from bank subsidiary . . . . . . . . . . . lnleresi and dividend income . . . . . . . . . . . . . lnvestmcnt securities gains . . . . . . . . . . . . . . . Olher incomc.. . . . . . . . . . . . . . . . . . . . . . . . . . Other expenses . . . . . . . . . . . . . . . . . . . . . . . . . Income before income tax and equity in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . undistributed net income of subsidiaries Income tax benefit (expense) . . . . . . . . . . . . . . Equity in undistributed nct income of subsidiaries . . . . . . . . . . . . . . . . .................... .................... . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Years ended December 3 I. 2005 2004 $ 3,500 $ 3,500 I66 56 0 88 70 8 1 (270 (299) 2003 $ 4,000 180 192 77 (184) 3,356 72 904 $ 4,334 3,536 12 1,295 $ 4,843 4,265 (63) 1,282 $ 5,484 S T A T E M E N T S OF CASH FLOWS (Amounts in thousands) Cash flows from operating activities Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjustments to rcconcile net income to net cash flows from operating activities: Equity in Undistributed net income of subsidiaries . . . . . . . . . . . . Investment securities gains . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accretion on securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deferred tax benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Change in other assets and liabilities ....................... Net cash flows from operating activities . . . . . . . . . . . . . . . . Cash flows from investing activities Purchases of invcstment securities available for sale . . . . . . Purchases of investment securities held to maturity . . . . . . . Proceeds from sales of' securities available for salc . . . . . . . . Proceeds from call, maturity and principal payments on securitics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . * Net cash flows from investing activities . . . . . . . . . . . . . . . . . . . . Years ended December 31, 2005 2003 2004 $ 4,334 $I 4,843 $ 5,484 (906) 3 (7) (148) 3,276 (356) ( 1,295) (88) 38 (7 (570 2.92 I ( 1,282) (I 92) 31 (24 95 4,l 12 (3,007 2,295 1,204 450 94 2,295 1.305 (498) Cash flows from financing activities Dividends paid. . Net treasury shar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . repurchased) reissued. . . . . . . . . . . . . . . . . . . . Net cash flows from financing activities.. . . . . . . . . . . . . . . . Net change in c a s h . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (4,637) 1,168 (3,469) (99) (4,446) 262 (4,184) 1,032 (4,360) (2,320) (6,680) (3,066) Cash Beginning ol' year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . End of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,2O 1 $ 3,102 2,169 $ 3,201 5,235 $ 2,169 (Continued) CORTLAND BANCORP AND SUBSIDIARIES NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Years endcd December 3 1, 2005, 2004 and 2003 NOTE 15 - DIVIDEND RESTRTCTTONS The Bank is sub-ject to regulations ol thc Ohio Division of Banks which restricl dividcnds to retained carnings (as defined by statule) ol thc current and prior two years. Under this rcstriction, at December 3 I , 2005, approximately $3,482,000 is available for the payment of dividends by thc Bank without seeking prior regulatory approval. In addition, dividend payments may not rcduce capital levels below iiiinimum regulatory guidelines. NOTE 16 - TdTIGATION The Rank is involvcd in other legal actions arising in thc ordinary course of business. In the opinion of managemenl, thc outcomes from these other mattcrs, cither individually or in the aggregate, arc not expected to havc any material effect on the Company. NOTE 17 - STOCK REPIJRCHASE PROGRAM On February 6 , 2004, the Company concluded the fourth consecutive year of stock repurchase programs. These programs were approved and authoriLed cach year by the Company’s Board ol Directors. The following table shows the resulls of these programs. Program Date Board Authorized Date Expired Number o f Shares Repurchased Cost of Shares Repurchased Weighted Average Price Per Share “2000 Program” . . . . . January 26, 2000 February 3, 2001 138,218 $ 2,284 $16.51 “2001 Program” . . . . . January 23, 2001 February 6, 2002 51,321 987 19.32 “2002 Program” . . . . . January 22, 2002 February 6, 2003 114,073 2,848 25.02 “2003 Program” . . . . . Total . . . . . . . . . . . . January 28, 2003 February 6, 2004 137,869 4,170 30.24 441,481 $10,289 $23.3 1 Currently, there is no stock repurchase program in effect. (Continued) COKTLAND BANCORP AND SUBSIDIARIES SELECTED FTNANCIAL DATA (Tn thousands of dollars. except for ratios and per share amounts) 2005 . . . . . . . $ 23. 586 SUMMARY OF OI’ISRATIONS Total Interest Income . . . . . . Total Interesl Expcnsc . . . . . N E T lNTEREST INCOME Provision for Loan Losses . . . . N I I hftcr Loss Provisioii . . . . Security gains (losses) . . . . . . . . . . . Ciain on salc of loans . . . . . . . . Total Othcr Income . . . . . . . . . . . . . 2. 718 INCOME BEFORE EXPENSE . . . . . . . . . . . . . . . 17. 491 Total Other Expenses . . . . . . . . . . . . . . 12. 200 INCOME BEFORE T A X . , . . . . . . . . . . . . . . . . . . . 5. 291 Federal lnconie Tax . . . . . . . . . . . . . . . 957 . . . . . . . $ 4. 334 NET INCOME . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. 376 Years Ended Decembcr 3 1. 2004 2003 2002 $ 22. 288 $ 26. 911 $ 22. 907 8. 132 8. 010 10. 004 14. 775 14. 278 16. 907 41 5 240 460 14. 535 16. 447 13. 863 946 215 470 318 2.433 2. I67 19. 147 18. 384 I I . 520 I I . 826 7. 32 I 6. 855 1. 371 1. 579 $ 5. 484 $ 5. 742 54 2.725 17. 694 11. 861 5. 833 990 $ 4. 843 I . 052 HALANCE SHEP3’ DATA hsscts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . lnvcstrnents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for luiin losscs . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Sharcholders’ Equity . . . . . . : . . . . . . . . . . . . . . . . . . . AVEKAGEBALANC‘ES Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . lnvcstrnents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Borrowings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Share holders’ Equity . . . . . . . . . . . . . . . . . . . . . . . . . . $459, 701 234, 652 188, 202 2, 168 350, 375 58, 111 48, 325 $444, 487 221, 844 190, 329 341, 575 49, 932 49, 665 $446. 393 225. 841 I9 I . 777 2. 629 344. 919 47. 889 49. 398 $444. 275 216. 560 191. 428 343. 969 46. 093 49. 828 $43X. 392 222. 775 189. 262 2. 408 337. 556 47. 886 40. 88 I $436. 239 204. 599 188. 360 335. 133 44. 905 5 I . 807 $437. 598 199. 903 19 1. 477 3. I34 335. 758 46. 669 52. 039 $439. 730 197. 679 198. 049 336. 702 47. 5 I8 5 I. 797 200 I !$ 29. 199 13. 823 15. 976 220 15. 756 386 269 2. 068 18. 479 11. 205 7. 274 1. 728 5. $ 5 4 6 $439. 921 193. 424 206. 255 2. 998 337. 661 49. 362 50. 524 $434. 830 189. 672 205. 585 33 I. 449 49. 646 50.000 1’KR COMMON SHARE DATA ( I ) Net Income. both Basic and Diluted . . . . . . . . . . . . $ Cash Dividends Ileclarcd . . . . . . . . . . . . . . . . . . . . . . Book Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ASSET QUALITY RATIOS Loans 30 days or inore bcyond their contractual duc dale as a perccrit of total loiins . . . . . . . . . . . . Underperforniing Assets as ii Percentage of: Total Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity plus Allowance for Loan Losses . . . . . . Tier I Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . FINANCIAL RATTOS Return on Average Equity . . . . . . . . . . . . . . . . . . . . . Return on Average hsscts . . . . . . . . . . . . . . . . . . . . . EA’ectivc Tax Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . Avcrage Equity to Average Assets . . . . . . . . . . . . . . Equity lo Asset Ratio . . . . . . . . . . . . . . . . . . . . . . . . . Tangible Equity to Tangible hssct Ratio . . . . . . . . . Cash Dividend Payout Ratio . . . . . . . . . . . . . . . . . . . Net Tnlerest Margin Ratio . . . . . . . . . . . . . . . . . . . . . 1.00 1.07 11.11 $ 1.13 I . 04 I I S O $ 1.26 1.01 1 1 . 0 5 $ 1.30 0.98 11.92 $ 1.25 0.88 11.45 2.95% 2.45% 1.77% 1.89% 1.38% 0.83 7.58 7.81 8.73% 0.98 18.09 11.17 10.51 10.48 107.00 3.83 0.76 6.52 7.05 9.72% I . 09 16.97 11.22 11.07 11.02 91.45 _ . . . 3 74 0.70 5.84 6. 44 10.59% I . 26 20.00 I 1.88 11.38 11.33 79.85 3.94 0.5 1 4.07 4.62 11.09% 1.31 21.56 1 1.78 11.89 I I . x4 74.83 4.39 0.26 2.12 2.34 1 1 . 09% 1.28 23.76 1 1 . 50 1 1 . 48 1 1.42 70.92 4.14 ( I ) Basic and diluted earnings per coiiiinon shiirc are based on wcighled average s h a m outstanding d j u s t c d relroactively for stock dividends . Clash dividends per cornmon share are hascd on actual cash dividcnds declared. ndjustcd rclroactively for thc stock dividends . Hook v;ilue per conitnoti share i s based on sharcs outstanding at cach period. adjustcd rclroactively for thc stock dividends . THREE YEAR SUMMARY AVEKAGE BALANCE SHEET, YIELDS AND RATES The following schedules show average balances of interest-earning and non interest-earning assets and liabilities, and Shareholders’ equity for the years indicated. Also shown :ire the related amounts or interest earned or paid and the related average yields or interest ritks paid [or the years indicated. The averages iire based on daily balances. (Fully taxable equivalent basis in thousands of dollars) 2005 lntcrest learned Outstanding or Paid Average Halance Yield or Rate ~ . . . . . . . . . $ 3.619 $ 119 3.3% . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,402 3,259 4.8% 84,928 3,810 4.5% Interest-earning assets: Federal funds sold and other money markets.. . . . . . . . . . . . . . . . . . Investment securities: L J S Treasury and other U.S. Government agencies and corporations .................... L J S Government mortgage-backed pass through certificates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . States of the IJ.S. and political subdivisions (Note I , 2, 3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other securitics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . TOTAT. INVESTMENT SECURITIES , . , , , . , , , . , , , , , , , , Loans (Note 2, 3, 4 ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Trading Account Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . ‘TOTAL IN‘lERES’T-EARNING ASSETS . . . . . . . . . . . . . . . . Non interest-earning assets: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash and due fro111 banks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premises and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Othcr . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ‘I’O‘L’AL ASSE’L’S . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest-bearing liabilities: Deposits: Intcrest-bearing demand deposits. . . . . . . . . . . . . . . . . . . . . Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings under one yea Other borrowings over one year TOTAL BORROWINGS TOTAL INTEREST-BEARING LIABILITIES Non interest-hearing liabilities: Othcr liabilities TOTAT. 1.TABIT.ITIES AND SHAREHO Net intcrcst income Net interest rate spread (Note 5 ) Nct interest tnargin (Notc 6) . . . . . . . . . . . . . . . . . . . . . . . . . . . . - . . - . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,756 24,758 221,844 192,873 3,1154 1,294 I 1,547 13,040 7.1% 5.2% 5.2% 6 . m 418,336 $24,706 5.9% 9,417 4,316 12,418 $444,487 $ 49,355 89,107 144.793 283.255 428 2,540 599 46.365 49,932 333,187 515,320 3,315 49,665 $444,487 $ 389 647 5.123 6.159 15 59 21 2.411 2.506 $ 8,665 0.8% 0.7% 3.5% 2.2% 3.5% 2.3% 3.5% 5.2% 5.0% 2.6% $16,041 3.3% I - 3.8% - Note I - Includes both taxable and tax cxcrnpt sccuritics Note 2 - The amounts are presented on B fully taxahle equivalent hasis using the statutory tax rate of 34% i n 2005, 2004 and 2003, and have been adjusted to reflect the etrect of disallowed interest expense related to carrying tax exempt assets. Tax-free incornc from states of the US. and political subdivisions, and loans uniounted to $2,156 and $204 for 2005, $2,545 and $1Y3 for 2004 and $2,466 and $214 for 2003, respectively. Note 3 - Average balance outstanding includes the average amount outstanding of all nonaccrual inveslinenl securilies and loans. States m d political subdivisions consist of average total principal adjusted for amortization of premium and accretion of discount lcss iivcragc allowum lor estimated losses, and include both taxable and tax exempt securities. Loans consist of average total loans less average unearned income. (Fully taxable equivalent basis in thousands of dollars) 2004 Interest F,arned Outstanding or Paid Avcragc Balance Yield or Rate - 2003 Interest Earned Outstanding or Paid Average Balance Yield or Rate - $ 5,623 $ 83 1.5% $ 10,338 $ 118 1.1% 62,418 2,920 4.7% 85,351 3,634 4.3% 53,832 14,953 21 6,560 193,927 3,764 716 1 1,034 12,474 7.0% 4.8% 5.1% 6.4% 416.1 10 $2339 I 5.7% 9,276 4,637 14,252 $444,275 $ 48,945 90,584 147,662 287.191 289 2,698 2,7X1 40,325 46,093 333,284 56,778 4,385 49,828 $444,275 $ 263 50 1 5,023 5,787 4 26 37 2,156 2,223 $ 8,010 0.5% O h % 3.4% 2.0% I .4% 1 .0% 1.3% 5.3'70 4.8% 2.4% 52,587 2,640 5.0% 89,652 4,009 4.5% 5 1,363 10,997 204,599 191,392 1,190 407,5 I9 3,649 559 10,857 13,141 68 $24,184 7.1%) 5.1% 5.3% 6.9'70 5.7% 5.9% 10,140 5,119 13.461 $436,239 $ 50,714 88,953 139,568 279,235 51 1,YY9 3,671 39,178 44,905 324,140 55,898 4,394 51,807 $436,239 $ 249 540 5,030 5,819 1 17 I60 2,135 2,3 I3 $ 8,132 0.5% 0.6% 3.6% 2.1% 1.8% 0.9% 4.4% 5.4'70 5.2% 2.5% $15,581 $1 6,052 3.3% - - 3.7% - - 3.4% - - 3.9% - ~ Note 4 - Interest earned on loans includes net loan lees or $242 in 2005, $203 i n 2004 and $241 in 2003. Note 5 - Net interest rate spread represents the diffcrcncc between the yield on earning assets and the rate paid on interest hearing liabilities. Note 6 - Net interest iiiargin is calculatcd by dividing the diweerence between total interest carncd and total interest expensed by total intcrcst-carni ng assets, CORTLAND BANCORP AND SUBSIDIARIES MANAGEMENT’S DISCUSSION A N D ANALYSIS (In ihousands of dollars, except for per share amounts) FINANCIAL REVIEW The following is management’s discussion and analysis of the financial condition and results of operations of Cortland Bancorp (the “Company”). The discussion should be read in conjunction with the Consolidated Financial Statements and related notes and summary financial information included elsewhere in this annual report. NOTE REGARDING PORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for forward-looking statements. In addition to historical information, certain information includcd in this discussion and other material filed or to be filed by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company) may contain forward-looking statements that involve risks and uncertainties. The words “believes,” “expects,” “may,” “will,” “should,” “projects,” “contemplates,” “antici- pates,” “forecasts,” “intends,” or similar terminol- ogy identify fonvard-looking statements. These statements reflect management’s beliefs and as- sumptions, and are based on inlormation currently available to management. Economic circumstances, the Company’s opera- tions and actual results could diflcr significantly from those discussed in any lorward-looking state- ments. Some ol the factors that could cause or contribute to such differences are changes in the economy and interest rates either nationally or in the Company’s market area; changes in customer preferenccs and consumer behavior; increased competitive pressures or changes in either the nature or composition of competitors; changes in the legal and regulatory environment; changes in factors influcncing liquidity such as expectations regarding the rate of inflation or deflation, currency exchange rates, and other factors influencing mar- ket volatility; unlorcseen risks associated with other global economic, political and financial factors. While actual results may differ significantly from the results discussed in the forward-looking state- ments, the Company undertakes no obligation to update publicly any lorward-looking statement for if new information becomes any rcason, even available. CERTAIN NON GAAP MEASURES Ccrtain financial information has been determined by methods other than Generally Accepted Ac- counting Principles (GAAP) . Specifically, certain financial measures arc based on core earnings rather than net income. Core earnings exclude jncoiiic, expense, gains and losses that either are not reflective of ongoing operations or that are not expected to reoccur with any regularity or rcoccur with a high degree of uncertainty and volatility. Such information may be useful to both investors and management, and can aid them i n understand- ing the Company’s current performance trends and financial condition. Core earnings are a supple- mental tool for analysis and not a substitulc for GAAP from ntl income. Reconcilialion GAAP net income to the non GAAP measure of core earnings is shown as part of management’s discussion and analysis of quarterly and year-to- date financial results of oper a t’ ions. OVERVIEW and OUTLOOK Net income for 2005 was $4,334. The perforimnce represented a decrease ol $509 from the $4,843 earned in 2004. Earnings per share measured $1 .OO, down $0. I 3 or 11.5% from $ I . I3 in 2004. Core earnings, which exclude the net gains on loans sold and investment securities either sold or called, loss on other real estate, and cerlain other non recurring items, were $4.234 million in 2005, compared to the $4.238 million earned in 2004. Core earnings per share were $0.98 in 2005 and $0.99 in 2004, down $0.01 or I .0%. CORTLAND BANCORP AND SUBS1 DIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS (In thousands of dollars, except Tor per sharc amounts) The following is a reconciliation between corc earnings and earnings under generally accepted accounting principles in the United States (GAAP carnings) : pcr share decreased by $0.39 to $1 I .I 1. The price of the Company’s common stock decreased during the year, trading in a range between a fourth quarter low of $17.50 and a first quarter high o l $22.58, closing the year at $ I 8.25 per share. The Company continued its aggressive cash dividend policy, paying out 107.0% of 2005 earnings in cash dividends, compared to 91.5% in the prior year. Dividends per sharc increased by 2.9%, reflecting the effect of the annual stock dividend. * lncludcs one-time cash bonus declared in recog- nition o l the Bank‘s performance under the retir- ing C.E.O. Years Ended December 3 I , 2005 2004 - - GAAP earnings . . . . . . . . . . . . . $4,334 $4,843 (308) (1,052) Investment security gains . . . . . Gain on sale of loans.. . , . . . . . (89) (54) The Company is committed to investing in tech- 3 Other real estate loss.. . , . . . . . 171 nology such that its infrastructure effectively deliv- 19 Other non-recurring items”. . . . 243 Tax effect ol adjuslments . . . . . 31 I ers to consumers and small-to-medium-sid 51 - - business owners leading edge financial products Core earnings . . . . . . . . . . . . . . . $4,234 $4,238 - - -~ and services. The Company’s integrated approach to technology includes intcrnct banking services; an Integraled Voice Response system that provides customers with remote access to banking services; platform products that enhance both productivity and customer service; and check and document- imaging products, which further capitalize on the Company’s Internet banking cash iiianagemenl in- itiative. Technology is a cote ingredient for the Company, enabling it to extend services to custom- ers beyond geographic boundaries, while increasing employee productivity. Thcsc llcxiblc and robust product solutions also offer customers capabilities which enable them to streamline their own opcra- tions and to bank around the clock. The Company did experience a moderate improve- ment in its net interest margin in 2005. The Com- pany’s net interest margin, on a fully taxable equivalent basis, increased by $460,000 from the proceeding year, as the net interest niargin ratio improved from 3.74% to 3.83%. Thus lar however, the yield remains relatively flat as long-term rates have not followed the same course as short term rates which increased from 1.00% to 4.25% over the eighteen month period ending December 31, 2005. As a result of the sustained flattening of the yield curve, the Com- pany anticipates that continued pressure on the net interest margin will continue into 2006. As of December 31, 2005, the ratio of equity capital to total asscts remained well above regula- tory minimums at 10.51’76, but down from 11.07% a year ago, primarily due to a decline in the amount of the unrealized gain in available-for-sale securities. Risk-based capital measured 21.16% compared to 22.07% at December 31, 2004. All capital ratios continue to register well in excess of required regulatory minirnums. Kelurn on average cquity was 8.73% in 2005 com- pared to 9.72% in 2004, while the return on average assets decreased from 1.09% to 0.98%. Book value The Company’s Internet based banking solution, NelTcllcr, delivers interactive information by pro- viding customcrs the following capabilities: access to account information, statement information and check imaging; on-line bill payment and electronic loan payments; and the ability to remotely transfer money betwccn accounts and to initiate wire trans- fers and ACH transactions. Consumers, retail and commercial customers, alike, are olkrcd such services 24 hours a day, 365 days a year with a high functionality, security and msc o l level of oper a t. ion. The Check Clearing lor the 21st Century Act, or “Check 21” as it is commonly known, became effective October 28, 2004. Check 21 facilitales check collection by creating a new negotiable in- CORTLAND BANCORP A N D SUBSIDIARIES MANAGEMENT’S DISCUSSTON AND ANALYSIS (In thousands ol‘ dollars, except for per share amounts) strunicnt called a “substitute check,” which per- mits, but does not require, banks to replace original checks with substitute checks or information from the original check and process check information electronically. Ranks that do use substitute checks must coiiiply with cerlain notice and recredit rights. Check 21 is expected to cut the lime and cost involved in physically transporting paper items and reduce float, i.c., the time between the deposit of a check in a bank and its actual payment, in those cases whcrc items are not already being delivered same-day or overnight. The Company intends to utilize the Check 21 authority and expects to incur additional cosls for technology to information necessary electronically . process check BALANCE SHEET COMPOSITION The following table illustrates, during the years presented, the mix of the Company’s funding sourccs and the assets in which those funds are invested as a percentage of the Company’s avcragc total assets for the period indicated. Average assets totaled $444,487 in 2005 cornpared to $444,275 in 2004 and $436,239 in 2003. mand deposits. Average non-interest hearing de- posils totalcd 17.1% of total average deposits in 2005 compared to 16.5% in 2004 and 16.7% in 2003. (Also scc section captioned “Deposits” in- cluded elsewhere in this discussion). The Company primarily invests funds in loans and securities. Securities have been the largest compo- nent of the Company’s mix of invested assets since 2003. During 2005 average securities increased by $5,284 or 2.496, while average loans decreased by $ I ,054 or 0.5%. The Company has also purchased bank owned life jnsurance policies on the lives of directors, certain employees and key members of management in conjunction with the Company’s benefit plans. The average balance increased from $8,366 in 2003 to $ I 1,145 in 2005, reflecting the purchasc of addi- tional policies and the buildup of cash surrender value. (See additional information regarding the Company’s loan and securities portfolio in the sections captioned “Loan Portfolio” and “Invest- ment Securities” this discussion.) included elsewhere in ASSET QUAJ,ITY 2003 ~ - ZOOS 2004 - Sources of Funds: Deposits: Non-in teres[-bearing Inlcrcsl-hcaring Federal funds purchascd and repu rch ase agree rile ii t s Long-term debt and other borrowings Olhcr non-intcrcsl-heanng liabilities Equity capilal Total LJscs of I.‘unds: Loans Securilies Fcdcral funds sold, ;md olhcr money mnrket instruments Bank owned life insurance Olher nuii-interes(-earniiig [issets Tohl 13.1% 63.7 12.8% 64.6 12.8% 64.0 0.7 0.7 0.5 10.6 0.7 11.2 9.7 1 .0 11.2 9.8 1 .O 11.9 100.0%> 100.0% 100.0% 43.4% 43.1% 43.96 49.9 48.7 47.1 0.8 2.5 3.4 1.3 2.3 4.0 2.4 1.9 4.7 1U0.0% I00.0% I00.0o/c Deposits continue to be the Company’s primary source of funding. During 2005, the relative mix of deposits has remained steady with interest-bearing being the main source. However, the Company has been able to increase its non-interest bearing de- The Company’s managciiicnt regularly monitors and evaluates trends and developments in asset quality. Loan rcvicw systems require detailed monthly analysis of delinquencies, nonperforming assets and other sensitive credits. Mortgage, com- mercial and consumer loans are moved to nonac- crual status once they reach 90 days past due or when analysis of a borrower’s creditworthiness in- dicates the collection of interest and principal is in doubt. loans, In addition total to nonperforming nonperforming assets include nonperforming in- vestment securities and real estate acquircd in satisfaction of debts previously contracted. Total undcrperforming assets add to this amount loans which have been restructured lo provide for a reduction of interest or principal because of a deterioration in the financial condition of the bor- rower. Also included as underperforming assets are CORTLAND BANCORP AND SUBSIDIAKlES MANAGEMENT’S DTSCUSSION AND ANALYSIS ( I n thousands of dollars, cxccpt for per share amounts) loans which are more than 89 days past due that continue to accrue interest income. The following table depicts the trend in these potentially prob- 1 e 111 at i c asset categories. 2005 - 2004 2003 2002 2001 ~ Nonaccrual loans: 1-4 residenlial inorlgiges (:ornmcrcial niorlgages 2,472 2,734 1,538 Corn rricrcial t o m s Cons u n r cr 1 oa n s Home equily loans 210 41 304 $ 719 $ hhl $ 529 $ 414 $ 293 368 129 32 I S21) 170 600 327 5 Total Nonaccrual Loans 3,746 3.395 2,067 1,406 S l l Other real estate owned 986 82 Notiperforming Asscts Loans ninety days past due and still accruing inleresl Reslruclured loans 3,828 3,395 3,053 2,217 999 26 134 LJnderperforming Assets $3,828 $3,395 $3,053 $2,243 $1,133 The following table provides a numher of asset quality ratios based on this data. Overall, assel qualily reflected the cumulative effects of general economic weakness evidenced since 2001 in the local area markets where the Company operates, but remained within limits that management con- siders acceptable. 2005 2004 2003 2002 2001 - ~ Nonpcrroriiiing loans tis a percentage d 10i;d loalis 1.99% 1.77% 1.09% 0.73% 0.40% Nonperforiiiing assets :is R pcrccntagc d ioi;d ~ e l s 0.83% 0.769) u.70% 0.5 I % 0.23% Underpcrforrning ;issets ;is a percentage of total ;1ssels 0.83% 0.76% 0.70% 0.51% 0.26% Underper~mning assets as a pcrccnlage 01‘ equily capital plus allowance I‘or loan losses ism 6.520/0 5.84% 4.01% 2.12% Gross income that would have been recorded in 2005 on thcsc loans, had they been in compliance with their original terms, was $32 1,000. Interest ~ ~ income that actually was included in income on these loans amounted to $55,000. - although not to classified Additionally, as part of the Company’s loan review loans process, management seeks either which, nonperforming or underperforming asscts, contain inherent weaknesses that suggcst that they can be considered potential problem loans. The amount of such loans totalled $5,304 as of December 31,2005 compared to $5,622 as of December 31, 2004. identify as ~ RESULTS OF OPERATTONS Corninon comparative ratios for results of opera- tions are the return on average equity and the return on average assets. The return on average equity amounted to 8.7%, 9.7% and 10.6% lor 2005, 2004 and 2003, respectively. The return on average assets amounted to 1.0% in 2005, 1.1% in 2004 and 1.3% in 2003. Net interest income, the principal source ol‘ the Company’s earnings, is the amount by which inter- est and fees generated by interest-earning assets, primarily loans and investment securities, exceed the interest cost of deposits and borrowed funds. The net interest margin ratio registercd 3.X% in 2005, 3.770 in 2004 and 3.9% in 2003. ~ - Cornpression in the Company’s net interest margin during 2005 and 2004 resulted from the increased levels of nonperforming assets which has occurred over the past three years and a sustained flattening of the yield curve. The significant increase in refinancing activity considerably accelerated the rate at which the Company’s earning assets repriced. Meanwhile, interest bearing liabilities bumped up against a natural limit in their ability to reprice as short term rates approached Lero. CORTLANI) BANCORP A N D SUBSIDIARIES MANAGEMENT'S DISCUSSTON AND ANALYSIS (In thousands of dollars, except for per shurc aniounts) NET INTEREST MARGIN FOR YEAR ENDED Decetnher 31, 2005 Dcccrnbcr 31, 2004 INTEREST-EARNING ASSETS Federal funds sold arid other money m'irkel funds Investment securities( 1) (2) Eoans(2) (3) Total interest-earning aswts INTEREST-REAHIN G LIABILITIES Interest-bearing dcrriiind deposits Savings Time Tutal interest-hearing deposits bedern1 l'unds purchased Other borrowing\ Total intcrcst-bearing liabilities Net interest iticotne Net interest rate sprcad(4) Net interest rnurgin( 5 ) Average Balance(1) Interest Rate Average Balance( 1) Interest ~- - - Average Rate Average $ $ 3,619 119 221,844 11,547 192,873 13,040 5.9% ~- - - $418,336 $24,706 3.3% 5.2% 6.8% ~~ $ 83 11,034 12,474 $ 5,623 216,560 193,927 -~ 5.7% -~ $416,1 10 1.5'70 5.1% 6.4% $23,591 ~~ $ 0.8% 0.7% 3.5% 389 647 5,123 $ 4X,945 90,584 141,662 $ 49,355 89,107 144,793 - - ~ 283,255 428 49,504 5,787 4 2,219 ~- $333,284 $ 8,010 ~~ $333,187 $ 8,665 2.6% ~~ ~~ $ 263 501 5,023 287,191 280 45,804 2.2% 3.58 5.0% 6,159 15 2,491 2.0% 1.4% 4.8% 0.5% 0.6% 3.4% 2.48 ~~ ~~ ~~ $1644 1 $15,581 3.3% - - 3.8% - ~ 3.3% - 3.7% ~ ~ ~ ( I ) Includes both taxable and tax exempt securities. ( 2 ) Tax excnipt interest is shown on a tax equivalent basis for proper comparison using a statutory federal iricornc tax rate of 34%. ( 8 ) Includes loan origination and commitment fees. (4) Interest rate sprcnd rcprcscnts the diKerence between the yield on earning assets and the rate paid on interest bearing liabilities. ( 5 ) Interest margin is culculated by dividing the difference hetween total interest earned and total iritcrcst cxpcnscd by total interest- carning nsscis. The increase in net interest income was the prod- uct of a 0.5% year-over-year increase in average earning assets and a 24 basis point increase in interest rates earned. The average rate paid on interest sensitive liabili- ties increased by 20 basis points ycar-over-year. The averuge balance of intcrest sensitive liabilities decreased by only $97. Compared lo last year, average borrowings increased by $3,839 while the average rate paid on borrowings increased by 20 basis points. Average interest-bearing demand deposits and money market accounts increased by $41 0, while savings dccrcascd by $1,477. The average rate paid on these products increased by 20 basis poinls in the aggregate. The avcragc balance on time deposit products dccreased by $2,869, as the average rate paid increased by 14 basis points, from 3.4% to 3.5%. Interest and dividend income on securities regis- tcred an increase of $704, or 7.29r0, during the year ended December 3 1, 2005 when compared to 2004. On a fully tax equivalent basis, income on invcst- nient securities increased by $513, or 4.6%. The average invested balances increased by $5,284 from the levels of a year ago. The increase in the average balance of investment securities was ac- companied by a I I basis point increase in the lax equivalent yield of the porlfolio. Interest and fees on loans increased by $566 on a fully tax equivalent basis, or 4.5%, loor the twclvc months of 2005 compared to 2004. A $1,054 de- crease in the average balance of the loan portfolio, or O S % , was accompanied by a 33 basis point increase in the portfolio's tax equivalent yield. Other interest income increased by $36 from the same period a year ago. The average balance of Federal Funds sold and other money market funds decreased by $2,004, or 35.6%. The yield increased by 181 basis points during 2005 cornpared to 2004. CORTLAND BANCORP ANI) S U B S I D I A I I I E S MANAGEMENT’S D I S C U S S I O N A N D ANALYSTS (In thousands of dollars, except for per share amounts) The following table provides ;1 detailed analysis of changes in net interest income, identifying that portion of the change that is due to a change in the volume of average assets and liabilities outstanding versus that portion which is due to a change in the average yields on earning assets and average rates on interest- bearing liabilities. Changes in interest due to both rate and volume which cannot be segregated have been allocated to rate and volume changes in proportion lo the relationship of the absolute dollar amounts of the change in each. Analysis of Nct Interest Income Changes (Taxable Equivalent Basis) Increase (Dccrease) in Interest Income: Federal funds sold and other inoney markets . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment Securities 2005 Compared to 2004 2004 Coinpared lo 2003 Volume Rate Total Volume Rate Total $ (38 $ 74 $ 36 $ (64) $ 29 $ ( 3 5 U.S. Treasury and other U S . Government agencies and corporations . . . . . . . . . . . . . . . . . . . . . . U.S. Government morlgagc-backed pass-through certificates . . . . . . . . . . . States of the U S . and political subdivisions . . . . . . . . . . . . . . . . . . . . . . Other securities. . . . . . . . . . . . . . . . . . . . . Trading account securities . . . . . . . . . . . . . . Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239 (18 (645 507 100 194 65 71 339 176 (580) 578 634 566 469 (188 173 191 (68 I72 280 (375 115 157 (68 (667 Total Interest Incoine Change . . . . . . . . . . . . (23) 1,138 1,115 685 (1,278) (593) Increase (Decrease) in Interest Expense: Interest-bearing deinand deposits . . . . . . . . Savings deposits . . . . . . . . . . . . . . . . . . . . . . Time deposits ........................ Federal funds purchased . . . . . . . . . . . . . . . Securities sold under agreements to repurchase . . . . . . . . . . . . . . . . . . . . . . . . . Other borrowings under one year. . . . . . . . Other borrowings over onc year . . . . . . . . . Total Interest Expense Change. . . . . . . . . . . . 2 (8) (99) 3 (1) (44) 315 168 I24 154 199 8 34 28 (60) 487 126 146 100 11 33 (16) 255 655 23 (49) (290) (9) 10 283 3 14 (39) (7) 3 324 (446) (122) Increase (Decrease) in Net Interest income on a Taxable Equivalent Basis. , , , . . , , . . $(191) 9; 651 $ 460 $ 361 $ (832) $(471) CORTLAND BANCORP AND SUBSIDIARIES M A N A G E M E N T' S D I SC'U SS 1 ON AN D AN ALY S I S ( I n thousands of dollars, cxccpt for pcr share amounts) Total other income for 2005 decreased $716, or 18.7% compared to a decrease of $18, or 3.7% in 2004. Fees for customer services decreased by $73 or 3.1% compared to an increase of $691 in the prior year, which was primarily due to the intro- duction OS a new deposit product first offered to customers late in the third quarter of 2003. This years decrease is primarily due to a decline in service charge income. Loans originated for sale in the secondary market showed gains of $89 in 2005, compared to $54 and $470 in 2004 and 2003, respectively. In 2003 gains on the sale of trading securities amounted to $265, with no activity in 2005 or 2004. The early call of held to maturity securities, and transactions involving availa- ble for sale securities, combined to produce net gains of $308 in 2005, $1,052 in 2004 and $946 in 2003. Other real cstatc losses amounted to $3 in 2005 and $171 in 2004 with no losses on other real estate recorded in 2003. Other non-interest income de- creased by $102 during 2005 following a $37 in- crease in 2004. This income category is subject to fluctuation due to nonrecurring items, but the difference in 2005 is due mainly to a $103 decrease in non-taxable income on bank owned 1iSe insur- ance policies. 0 t h Income 2005 - - - 2003 2004 Fees for other custoiiier services Gain on salc of loans Gain on sale of trading securities Other real cstatc losses Other operating income Investment securities net gains Total other incoriie $2,254 $2,327 $1,636 470 89 54 ( 3 ) ~~~ 467 2,807 (171) 569 2,779 265 532 2,903 Total other expenses increased by $339 or 2.9% in 2005. This compares to an increase of $332 or 2.9% in 2004. Full time equivalent cmploymcnt wcr- aged I62 employees in 2005. During 2005, expend- itures for salaries and employee benefits increased by $330 or 4.9%. This increasc is a combination of regular staff salary and benefit increases and a onc- time cash bonus of $243 awarded to the retiring President and CEO in recognition of 42 years of service to the bank and the growth and profitability achieved by the bank under his leadership. Occu- pancy and equipment expense increased by $17 or 0.9% during 2005. Legal and litigation expense in 2005 increased by $ I6 compared to a decrease of $49 in 2004. State and local taxes increased $4. Rank exam and audit expense decreased by $88 or 17. I % compared to an increase of $166 in 2004 primarily due to expenses associated with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002. Marketing ex- pense increased by $63 or 34.696, primarily due to a n increase in expenses related to a customer testimonial advertising campaign initiated mid year. All other categories of non-interest expense decreased by $3 in 2005 or 0. I % in the aggregate. This expense category is subject to fluctuation due to non-recurring items. Non-Interest Expense Salaries and benefits Net occupancy and 2005 ~~~ 2004 2003 $ 7,052 $ 6,722 $ 6,586 cquiprnent cxpcnsc State and local taxcs Officc supplies Markcting cxpcnsc Legal and litigation Bank exam and audit Other operating expense Total other expenses 1,870 548 338 245 119 427 1,601 1,963 524 341 111 152 349 1,431 $12,200 $1 1,861 $ I 1,529 1,853 544 346 182 103 515 1,596 308 1~0.52 346 - ~ - $3,115 $3,831 $3,849 ~~~ COKTLAND BANCOKI’ 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) Salaries and employee benefits represented 57.8% ol all non-interest expenses in 2005. Salaries and employee benefits increased by $330 in 2005 fol- lowing an increase of $ I 36 in 2004. The following details components of these increases: Analysis of Changcs in Salaries & Bcncfits Amounts 2005 2004 2005 2004 Percent 2003 2003 Origination 79 42 ~~- $3ao $136 $(212) 4.9% 2.1% (55) 23.3 30.5 27.0 ( 3 . i ~ ~ ) 2003. Excluding the $243 bonus, the average would be $32,444 in 2005. Full-time equivalent employment averaged 162 employees in 2005 and 2004 and 167 employees in 2003. Average earning assets per employee measured $2,582 in 2005, $2,569 in 2004 and $2,440 in 2003. Income before income tax expense amounted to $5,291 lor the year ended 2005 compared to $5,833 and $6,855 lor the similar periods of 2004 and 2003 respectively. The eflkctivc tax rate was 18.1% in 2005 compared to 17.0% and 20.0% in 2004 and 2003 respectively, resulting in income tax expenses of $957, $990 and $1,371, respectively. The provi- sion for income taxes differs from the amount of income tax determined applying the applicable Provision at statutory r a t e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Add (Deduct) : I Tax effect of non-taxable income. . . . . . . . . . . . . . . . . . . . . . . . . . . Tax erecl of non-deductible expense ~~~ 2005 $1,798 Ilecember 3 I , 2004 $ 1,983 2003 $ 2,331 (921) 80 (1,084) 91 (1,052) I Federal income t a x e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....................... ~ - - $ 1,371 $ 957 990 $ Net income registered $4,334 in 2005 compared to $4,843 in 2004 and $5,484 in 2003, representing per share amounts of $1.00 in 2005, $1.13 in 2004 and $1.26 in 2003. Dividends declared per share were $1.07 in 2005, $1.04 in 2004 and $1.01 in 2003. Per share amounts have been restated to give retroactive effect to the 3% common stock divi- dends of January I , 2006. CORTLAND BANCORP AND SUBSIDIARIES MANAGbMENT’S DISCUSSION A N D ANALYSIS (In thousands of dollars, cxcept for per share amounts) The following table shows financial results by quarter for the years ending December 31, 2005 and 2004: FINANCIAL RESULTS BY QIJARTER (Unaudited) March 31 Dec. 31 - - ~ $ 5,661 $ 6,212 2.005 2,439 - - ~ 3,656 3,773 (135) (112) 302 - - - - June 30 Dcc. 3 I $ 5,660 $ 5,439 1,974 2,046 - - - - 3,465 3,614 (25) (140) 378 76 June 30 $ 5,829 2,024 3,805 (138) 2 March 3 I $ 5,540 1,066 3,574 ( 7 5 ) 232 2004 For the Quarter Urldcd Sept. 30 $ 5,649 2,024 3,625 (175) 366 2005 Fnr thc Quarter Elided Sept. 30 $ 5,884 2,197 3,687 (160) 4 28 9 13 22 30 (3) 679 665 (2,990) (2,950) - ~ - 1,340 1,584 247 326 - ~ - $ 1,258 $ 1,093 $ 0.2’) $ 0.25 !b 1,053 $ 1,075 12 ( 5 2 ) 104 (2,919) 1,261 I79 $ 1,082 $ 0.25 $ 1,058 18 (3) 162 (2,086) 1,607 292 $ 1,315 $ 0.31 $ 1,064 677 (2,972 j 1,396 264 $ 1,132 $ 0.26 $ 1,116 7 39 (2,999) 1,605 300 $ 1,305 $ 0.30 $ 1,047 700 (3,288 j 97 1 120 $ 851 $ U.20 $ 990 I1 ( 1 16) 69 1 (2,957) 1,360 219 $ 1,141 $ 0.27 $ 1,057 $ 0.25 $ 0.23 !$ 0.26 $ 0.24 $ 0.25 $ 0.24 $ 0.25 $ 0.25 Interest Tncoine Interest Expense Net Interest lntume Loan Loss Provision Net Securily Gains Trading Securities Gain Net Gain on I,uaiis Other red estate losscs Othcr Income Other Expcnses liicomc Before Tax bederal lncorne Tax Net Income Net lncoinc Pcr Share Ne1 Core Income Net Corc Income Per Share Nct Intcrest Income (tax cquivalent basic) $ 4,049 3.3% 3.8% Net Interest Ratc Sprcad Net Tnleresl Margin $ 3,964 3.3% 3.8% $ 4,088 3.4% 3.9% $ 3,939 3.2% 3.8% $ 3,936 3.3% 3.7% $ 3,960 3.3% 3.8% $ 3,793 3.2% 3.6% $ 3,892 3.3% 3.8% LOAN LOSS EXPERlENCE For each year presented in the table on the following page, the provision for loan losses charged to operations is based on management’s judgment alter taking into consideration all known factors connected with the collectability of the existing portfolio. Management evaluates the portfolio in light o l economic conditions, changes in the nature and volume of the portfolio, industry standards and other relevant f‘r-ictors. Specific factors considered by management i n determining thc amounts charged to operations include previous loan loss experience; the status of past due interest and principal payments; the qualily of financial inlormation supplied by customers; the cashflow coverage and trends evidenced by financial inlormation supplicd by customers; the nature and estimated value of‘ any collateral supporting specific loan crcdits; risk classifications determined by the Company’s loan review systems or as the result of the regulatory cxamination process; and general economic conditions in the lending area ol the Company’s bank subsidiary. Key risk factors and assumptions are dynamically updatcd to reflect actual experiencc and changing circumstances. The Company iiuintains an allowance for losses on unfunded commercial lending commitments to providc for the risk of loss inherent in these arrangements. The allowance is computed using a methodology similar to that used to determine the allowance for loan losses. This allowance is reported as a liability on the balance sheet within accrued expenses and other liabilities, while the corresponding provision lor these losses is recorded as ;I component of other expense. C O K T L A N D B A N C O R P A N D SUBSIDIARIES M A N A G E M E N T ’ S DISCUSSION AND ANALYSIS (In Ihousands of dollars, except for per share amounls) Certain asset-specific loans are evaluated individually for impairment, based on management’s best estimate o l discounted cash repayments and the anticipated proceeds lrom liquidating collateral. The actual tinling and amount of repayments and the ultimate realizable value of the collateral may differ from iiianagement’s estimates. The expected loss for certain other commercial crcdits utilizes internal risk ratings. These loss estimates are sensitive to changes in the customer’s risk profile, the realizable value of collateral, other risk lactors and the related loss experience ol other credits of similar risk. Consumer credits generally employ statistical loss factors, adjusted for other risk indicators, applied to pools ol similar loans stratified by asset type. These loss estimates are sensitive to changes in delinquency status and shifts in the aggregate risk profile. Salancc at bcginning of year . . . . . . . . . . . . . . . Loan losses: I -4 hniily residential mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial mortgages Consumer and other 1o:ins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Coin in ercial 1 oans Home equity hxm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005 - ~~- - $ 2,629 !$ 3,134 $2,974 $2,408 $2,9?X 2003 2002 2004 2001 (97) (80) (108) (66) (10) (87) (101) (734) (589) (203) (160) (270) ( 8 9 ) (6) - ~ - ~ (1,120) (264) - - (1,119) (157) (187) (441) (168) (94) (3) (275) (10) Recoveries on previous loan losscs: 1-4 family residential mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . C‘ommercial niortgagcs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Consumer and other loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial loms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equity loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 13 65 5 ~~ 40 108 6 93 24 5 69 3 2 Net loan losscs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Provision charged lo operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance at end of year . . . . . . . . . . . . . . . . . . . . . . . Ratio of ne1 loan losses lo average net loans uulslanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ratio of loan loss allowance to total loans . . . . . . . . . . . . . . . . . . . . . . 113 ( I ,onti) 545 $ 2,168 I 0 I I7 I54 ~- (966) -~ (324) 460 (104) 240 415 ~~ $2,629 ~~ ~- $ 2,408 - - -~ 79 (196 -~ 220 -~ $3,134 $2,998 - - - - 0.10% - 0,53% - ~ ~ - - 1.15% - - - - ~ - - ~ - ~ ~ 0.10% 1.45% 0.16% 1.64% 1.37% 0.51% 1.276 ~ - ~ The spike in charge-olh during 2005 and 2003 primarily reflected certain impaired commercial loan credits for which specific loss reserves had previously been established. Bascd on its analysis and review of all known lactors, management has determined the currenl levcl of the allowance to he adequate. COKTLAND BRNCORP AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALY SlS (In thousands of dollars, except lor pcr share amounts) The following is an allocation of the allowance for loan losses. The allowance has been allocated according to the amount deemed to be reasonably necessary to provide for the possibility ol losses being incurred within the following categories of loans as of December 31, for the years indicated: Types of I.oans 1-4 family residenlial inortgagcs Commercial mortgages. . . . . . . . . . . . . . . . . . . . . . . . . . . Consurncr loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Commercial loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Home equily lwns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . IJnallocated portion . . . . . . . . . . . . . . . . . . . 2005 2004 2003 2002 200 I $ 203 1,173 149 322 3 318 $2,168 $ 238 1,623 42 475 I 250 $2,629 $ 217 1,740 48 I44 1 258 $2,408 $ 338 2,047 I00 359 21 269 $3,134 $ 401 1,927 162 312 20 170 $2,998 The allocations of the allowance as shown in the table abovc should not be interpreted as an indication that future loan losses will occur in the same proportions or that the allocations indicate future loan loss trends. Furthermore, the portion allocated to each loan category is not the total amount available for future losses that might occur within such categories since the total allowance is applicable to the entire portfolio. CORTLAND BANCOKP AND SUBSIDIARIES MANAGEMENT’S DISCUSSION ANI3 ANALYSIS ( I n thousands of dollars, except rbr per share amounts) __ . LOAN PORTFOLIO The following table represents the composition of the loan portfolio as of December 31, for the years indicated: 2005 Balance % 2004 Balance % 2003 2002 Balance YO Bitlance clo 200 I Balance % Typcs of Loans 1-4 family residential mortgagcs . . . . . . . . . . . . . . Commercial mortgages. . . . . Consumer loans.. . . . . . . . . . Commercial loans . . . . . . . . . Home equily loans . . . . . . . . 1-4 family residential loans $ 59,910 31.8 $ 61,238 31.9 $ 57,854 30.6 $ 62,365 32.6 $ 77,478 37.6 83,753 40.6 92,822 49.0 14,850 7.2 7,231 3.8 22,230 10.8 21,711 11.5 3.8 7,044 9,541 5.0 86,929 45.4 9,792 5.1 22,016 11.5 4.4 94,019 49.0 6,087 3.2 19,IXR 10.0 11,245 5.9 90,983 48.3 6,714 3.6 19,767 10.5 i n , m 5.8 8,353 held for sale.. . . . . . . . . . . 103 0.1 2,022 1.0 Total loans . . . . . . . . . . . . . . $188,202 $1 91,777 $189,262 $191,477 $206,255 The following schedule sets forth maturities based on remaining scheduled repayments of principal or next repricing opportunity for loans (excluding mortgage and consumer loans) as of December 31, 2005: 1 Year or Less 1 to 5 Years Over 5 Years Tvoes of Loans Commercial loans ........................ Home Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1 2,416 10,828 Total loans (excluding mortgage and $5,550 $1,801 Total $19,767 10,828 consumer loans) . . . . . . . . . . . . . . . . . . . . $23,244 $5,5511 $1,801 $30,595 The lollowing schedule sets lorth loans as ol December 31, 2005 based on next repricing opportunity for floating and adjustable intcrcst rate products, and by remaining scheduled principal payments for loan products with fixed rates of interest. Mortgage and consumer loans have again been excluded. 1 Year or 1,ess Types of Loans Floating or adjustable rates of interest . . . . . . . $21,063 Fixed rates o l interesl . . . . . . . . . . . . . . . . . . . 1.166 . $22,229 Total loans . . . . . . . . . . . . . . . . . . . . . . . . . Over 1 Year $3,192 5.174 $8,366 Total $24,255 6,340 $30,595 CORTLAND RANCORP AND SUBSIDTARIES MANAGEMENT’S DISCUSSION AND ANA1,YSIS ( I n thousands of dollars, except for per share amounts) The Company recorded 21 decrease of $3,575 in the loan portfolio l‘roin the level of $191,777 recorded at December 3 I ~ 2004. The following shows the disposition ol‘ mortgage loans originated during 2005 and 2004 (in millions): Between 2004 and 2005, the balance of residential mortgage loans remained relatively unchanged. I -4 family residential mortgages represent 3 I .8% ol‘ total loans in the loan portfolio coinpared to 3 I .9% in 2004. The portion of the loan portfolio repre- sented by commercial loans (including commer- cial real estate) decreased from 59.0% to 58.8%. Consumer loans (including home equity loans) increased from 9.1% to 9.4%. Real estate loans which include residential loans and comniercial loans continue to comprise the largest share of the Company’s loan portfolio. At the end of 2005, residential loans and commercid loans comprised a combined 90.6% of the portloolio, compared to 87.7% five years ago. Home cquity loans at 5.8% and consumer installment at 3.6% comprise the remainder of the portfolio in 2005. Five years ago in 2000, home equity loans com- prised 3.6% of the overall loan portfolio, while consumer installment loans comprised 8.7%. LOAN PORTFOLIO COMPOSITION (In Percentages) Home Eauitv 1-4 Farnilv Home Eouitv 1-4 Familv 58 8 46.5 2005 2000 During 2005, approximately $14.2 million in new mortgage loans were originated by the Company, an increase of $2.2 million from 2004. The Com- pany’s product offerings continue to include a ser- vice release sales program, which permits the Company to ofler competitive long-term fixed in- terest rates without incurring additional credit or interest rate risk. Ketained in Porllblio . . . . . . . , , . . . . . . Loans Sold lo Investors with Servicing Rights Released . . . . . . . . . . . . . . . . . 2005 2004 ~- $7.6 $X.O $6.6 $4.0 During 2005, the Company originated and retained in poril‘olio ;I larger percentage of residential mort- gage loans than it sold in the secondary market. These retained loans met the Company’s asset quality criteria. A It h oug h man agemenl anticipates that secondary market originations will continue as an important aspect ol‘ loan administration, loans which are retained by the Bank portfolio will become more predominant as porlfolio lcnding strategies are developed to enhance overall cus- tomer relationships. The Rank is also active in home cquity financing. Home Equity term loans and credit lines remain popular with consumers wishing to finance home improvements, educational costs, vacations and consumer good purchases at favorable interest rates. Tn order to improve custonicr retention and provide better ovcrall balance, management also will con- tinuc to revamp and reposition the Company’s In- Portfolio product offerings during 2006. Thc balance of the commercial loan portfolio as 01 December 31, 2005 was $110,750, a decrease of $2,457 from the balance of $113,207 recorded at December 3 I , 2004. Short tcrm, asset based, coin- rnercial loans including lines of credit increased by $579. Commercial real estate loans decreased by $3,036 during the same period. The competitive interest rate environment had a direct cil’cct on commercial loan financing products, particularly on commercjal real estate loans. Management is expanding commercial real estate product offerings in an elTort to establish new business relationships and capture more of the market share. Loan personnel will continue to aggressively pursue both coinmcrcial and small business opportunities supportcd by product incen- tives and marketing eflorts. The Bank’s lending CORTLAND BANCORP AND SUBSIDIARIES M A N ACi E M E N T'S D 1 SC U SSlON AND ANALYSIS (In thousands ol' dollars, except l'or per share amounts) function continues to provide business services to a wide array of medium and small businesses, in- cluding but not limited to commercial and residen- real estate builders, automobile dealers, tial manufacturers, trucking companies, nursing homes, physicians and medical groups, funeral homes, general contractors, service contractors, restaurants, hotels/motels, retailers, wholesalers, as well as area educational institutions and other political subdivisions. For those businesses electing to Gnance business assets through a lease instru- ment the Bank also offers lease financing through a third party vendor. Small business loans are originated by loan person- nel assigned to the Community Bank offices. These loans are processed through the Commercial Loan Department in accordance with established busi- ness loan underwriting standards and practices. The following table provides an overview of corn- mercial loans by various business sectors reflecting the areas of largest concentration. Tt should be noted that these are open balances and do not reflect existing comniitrncnts that may be currenily outstanding but unfunded. Commercial Loan C'oncentrations 2005 % of 2004 %I of Balances Portfolio Balances Portl'olio Sector - ~~~~ HotcldMotcls Eating Placcs Stcel Relatcd Industrics Nursing Hoinc 62 PCEUIK~ car^ Mcdical Doctors NewNJsed Car Dealers Funeral Services SlS,00S 5,669 13.6% 5.16% $1 6,043 5,818 14.2% 5.1% 5,317 4.84% 7,183 6.3% 3,721 1,747 1,366 135 3.38% 1.59% 4,370 3,690 1.24% 0.12% 1,898 2.623 3.9% 3.3% 1.7% 2.3% The single largest customer balance at year end had ;t balance ol $4.5 million in 2005 compared to $4.7 million in 2004. This balance rcprcscntcd approximately 4.1 % of the total commercial portfo- lio, compared to 4.2% in 2004. purchases: fixed rate amortizing mortgage products that consumers utilize for home improvements; the purchase of consumer goods of all types; education, travel and other personal expenditures. The consol- idation of credit card and other existing debt into term payout continues to remain a popular financ- ing option among consumers. Additional information regarding the loan portfolio can be l o u d in the Notes to the Consolidated Financial Statements (NOTES I , 3, 8, I I and 13). IN V ICSTMENT SEC'URTTTES In accordance with Statement of Financial Ac- counting Standards No. 115 (SFAS I Is), "Ac- counting for Certain Investments in Debt and Equity Securities," investment securities are segre- gated into three separate portfolios: held lo matur- ity, available for sale, and trading. Each porllolio type has its own method of accounting. Held to iiiaturity securities are recorded at histori- cal cost, adjusted lor amortization of premiums and accrction of discounts. Trading securities are marked-to-market, with any gain or loss reflected in the determination of income. Securities desig- nated as available for sale are similarly carried at their fair market value. However, any unreali7ed gain or loss (net of tax) is recorded as an adjust- ment to shareholders' equity as a component ol Other Comprehensive Income. One cll'ect of SFAS 115 is to expose shareholders' equity to lluctuations resulting from market volatil- ity related to the available for sale portfolio. The potential advcrse impact of this volatility is some- what mitigated as bank regulatory agencies mea- sure capital adequacy for regulatory purposes without regard to the cll'ccts o l SFAS 115. Securities designated by the Company as held to maturity tend to be higher yielding but less liquid either due to maturity, si7e or other characteristics of the issue. The Company must have both the intent and the ability to hold such securities to maturity. In the consumer lending area, the Company pro- for a variety of consumer vides financing Securities the Company has designated as availa- ble for sale may be sold prior to niaturity in order CORTLAND BANCORP AND SUBSIDIAKIES MANAGEMENT'S DISCUSSION AND ANALYSIS (In thousands of dollars, except for per share amounts) lo fund loan demand, lo adjust for interest rate sensitivity, lo reallocate bank resourccs, or to repo- sition the portfolio lo reflect changing economic conditions and shifts in the relative values of mar- kct sectors. Available for sale securities tend to be more liquid investments and generally exhibit less price volatility as interest rates fluctuate. The following table shows the book value of invcstrnent securities by type of obligation at the dates indicated: Deceinber 3 1 . 2004 2005 2003 U S . Treasury and other U S . Government agencies and corporations . . . . . $ 80,053 $ 69,670 $ 62,524 92,499 U S . Government mortgage-backed pass-through certificates . . . . . . . . . . . . Stales of llie U S . and political subdivisions . . . . . . . . . . . . . . . . . . . . . . . . . . 53,503 14,249 Other securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $234,652 $225,841 $222,115 9 I ,226 45,689 19,256 82,992 44,714 26,893 A summary of securities held at December 31, 2005, classified according to the earlier o l ncxt repricing or the maturity date and the weighted average yield for each range of maturities, is set forth below. Fixed rate mortgage-backed securities are classified by their estimated contractual cash llow, adjusted for current prepayment assumptions. Actual maturities may difier froni contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepaynicnt penalties. 'l'ype and Maturity Grouping Ikcember 31, 2005 Weighted Average Yield (1) Bouk Vnluc U.S. Treasury and other 1J.S. Government agencies and corporations: Maturing within on Maturing after one Maturing after five Maturing aftcr ten Total U.S. Treas overiimcnt agencies and corporations , , . U.S. Government m States of the U.S. a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other sccurities: Maturing within one yea Maturing after one year Maturing after five years Maturing after ten years.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Total other securities . t6 2,048 I7,02 I 26,895 34,089 $8 0 , 0 5 3 $49,272 30,940 1,430 1,350 $8 2,9 9 2 $ 47 932 5,108 38,627 $44,714 $13,946 8,007 1,547 3.393 $26,893 3.670% 4.421 5.382 5.842 5.330% - - 4.716% 4.759 4.620 4.520 ~ 4.727% ~ 8.178% 7.845 7.376 7.270 ~ 7.295% ~ 5.885% 5.344 7,182 5.809 5.789% - - ( I ) The weighted average yield has been computed by dividing the total interest income adjusted for amortization of premium or accrction of discount over the lift: of the security by the amortized cost ol' the securities outstanding. The wcightcd average yield of tax-exempt obligations of states of the U S . and political subdivisions has been calculated on a fully taxable equivalent basis. The amounts of adjustments to inlerest which are based on the slatulory lax rate of 34% were $I, $23, $1 18 and $862 lor thc four ranges of maturities. CORTLAN D BANCORP AND SUBSIDIARIES MANAGEMENT'S DlSCUSSION AND ANALYSIS (In thousands o f dollars, except for per share amounts) As of December 31, 2005, there were $2,017 in callable U S . Government Agencies, $6,273 in callable obligations of states and political subdivi- sions that given current and expected interest rate environments are likely to be called within the onc year time horimn. These securities are Categorized according to their contractual maturities, with $3,620 classified as maturing alter live years but within ten years, and $4,670 classified as maturing after 10 years. Additionally, as of December 3 1 , 2005, there were $17,122 in callable U S . Government Agencies and $26,326 in callable obligations ol' states and politi- cal subdivisions that given current and expected interest rate environments are likcly to be called within the time frame defined as after one year but within five years. These securities are categorized according to their contractual maturities, with $5,864 maturing after live years but within ten years and $37,584 maturing al'tcr 10 years. As of December 3 I , 2005, the carrying value of all investmenl securities, both available for sale and held to maturity, tallied $234,652, an increase of $8,8 1 1 or 3.90% from the prior year. The allocation between single maturity investment securities and mortgage-backed securities shifted to a 64/36 split versus the 59/41 division of the previous year, as morlgagc-backed securities decreased by $8,234, or 9.0%. Holdings of obligations of states and political sub- divisions showed a decreasc of $975 or 2.1%. this sale its holdings of The Company decrcascd U S . Treasury securities by approximately $1,450, or 90.7%, as a U.S. Treasury Security was sold during the year to reduce the portfolio's duration in response to shifting monetary policy. The proceeds on totaled $1,478. Investments in U.S. government agencies and sponsorcd corpora- tions increased by approximately $1 1,833, or 17.4%. The Company also purchased $8,275 in corporate debt securities during 2005 to take ad- vantage of the floating rate repricing characteristics of some ol' the securities and the high yield that was obtained on three General Motors Corporate issues. The purchases were partially olTset by an $808 unrealized loss on the General Motors bonds at Deceniber 31, 2005. The net result was an increase in the corporate portfolio of $7,484. Holdings of other securities increased by $153 primarily reflecting stock dividends received from the Federal Home Loan Bank of Cincinnati. The mix ol' mortgage-backed securities remained weighted in favor of fixed rate securities in 2005, although at a reduced lcvel. The portion of the mortgage-backed portfolio allocated to lixed rate securities l'cll to 64% in 2005 versus 69% in 2004. Floating rate and adjuslable rate mortgage-hacked securities provide some degree of protection against rising interest rates, while lixed rate securi- ties perform better in periods 01 stable to slightly declining interest rates. Included in the mortgage- backed securities portfolio are investments in col- lateralized mortgage obligations which totalled $20,554 and $22,963 at December 31, 2005 and 2004, rcspcctivcly. No collateralized mortgage ob- ligations were sold in 2005. At December 31, 2005, a net unreabed loss of $877, net of tax, was included in shareholders' equity as a component of Other Coniprchcnsive Income, as compared to a net unrealized gain ol' $1,061, net ol' lax, as of December 31 , 2004. This $1,938 decrease reflects the decreased market value of debt securities resulting from rising short and intermediate term interest rates over most of the year, as well as the credit quality concerns of the General Motors issues. Lower interest rates generally translate into more favorable market prices for debt securities; conversely rising interest rates generally result in a depreciation in the mar- ket value of debt securities. Thc Company had $8,680 in investments consid- ered to be structured notes as of December 31, 2005. The Company had no investments in inverse floating rate securities or other derivative products. Additional inlormation regarding investments can be found in the Notes to the Consolidated Finan- cial Statements (NOTES 1 and 2). COKTLAND BANCORP AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS ( I n thousands of dollars, except Tor pcr share amounts) DEPOSITS The Company's deposits are derived from the individuals and businesses located in its primary market area. Total deposits at year-end exhihited an increase of 1.6% to $350,375 at December 3 I , 2005, as compared to $344,919 at December 31, 2004. The Company's deposit hase consists of dcmand deposits, savings, money market and time deposit accounts. Average noninterest-bearing deposits in- creased 2.7% during 2005, while avcrage interest- bearing deposits decreased by 1.4%. During 2005, noninterest-bearing deposits aver- aged $58,320 or 17.1% of total average deposits as compared to $56,778 or 16.5% of total deposits in 2004. Core dcposits averaged $306,626 for the year ended December 31, 2005, a decrease of $4,674 from the average level of 2004. During 2004, core deposits had averaged $311,300, an increase of $3,028 from the preceding year. Historically, the deposit base of the C'ompany has been characterized by a significant aggregate amount of core deposits. Core deposits represented 89.8% of average lotal deposits in 2005 cornpared to 90.5% in 2004 and 92.0% in 2003. Over the past five years, the Company has success- fully increased the share of deposits represented by noninterest-bearing and NOW checking accounts. Thesc products now comprise 25.8% of total de- posits compared to 23.4% five years ago. The following depicts how the deposit mix has shifted during this five-year time frame. AVERAGE DEPOSIT MIX (In Percentages) rnbo GO s Jumbo CD s 2005 2000 Additional information regarding interest-bearing deposits is presented in the Notes to the Consoli- dated Financial Statemenls (NOTE 6). FOURTH QUARTER 2005 A S COMPARED TO FOURTH QUARTER 2004 Tax equivalent net interest inconie for the Coin- pany during the fourth quarter of 2005 increased by $ I 13, a 2.9% increase from the fourth quarter of 2004. The yield on earning assets increased by 38 basis points while fourth quarter avcragc earning assets increased by 1.4%, or $6 million, when compared to a year ago. Thc result was an increase in tax equivalent interest income of $506. The rate paid on interest-bearing liabilities increased by 41 basis points, whilc h r t h quarter average interesl- bearing liabilities increased by $5.3 million when compared to a year ago, resulting in an increase in total interest expense of $393. The net interest margin for the quarter registered 3.79%, up 5 basis points from the same quarter a year ago. CORTLAND BANCORP AND S U B S I D l h K l E S MANACiEMbNT’S DISCUSSTON A N D ANALYSIS (Tn thousands of dollars, except for per share amounls) ([Jnsuditcd) INTEREST-EARNING ASSETS Federal funds sold and olher iiioncy iriarkct funds Investment securities( 1 ) ( 2 ) Loans(2) ( 3 ) Total interest-earning assets NET INTEREST MARGIN FOR QllAHTER ENDED December 31, 2005 Ilecember 31, 2004 Avernge Unlnnce(1) Average Interest Rate ~~ Average Ralancc( I ) lntcrest ~~ Average Rate . . . . $ 4,409 . . . . 232,498 . . . . 190,592 -~ $ 44 3,104 3,341) 3.9%) 5.3% 7.0% $ 10,159 218,495 192,851 ~~ 48 $ 2,805 3,129 1.9% 5.2% 6.4o/m . . . . $427,499 $6,488 6.1% ~~ ~~ $421,505 -~ - - $5,Y82 5.7% INTER EST- BEARIN C; LMSILI’I’IES Interest-hearing demand deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Savin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . T i m . . . . $ 50,587 . . . . 86,974 . . . . 148,925 ~~ ‘Iota1 interest-bcaring dcposits Federal funds purchased Other borrowings Total interest-bearing liabilities $ 136 209 1,398 1,743 ~ 7 689 1.1% 1.0% 3.7% 2.4% 4.2% 5.0% $ 51,625 91,001 149,395 $ 84 127 1,274 0.6% 0.6% 3.4% 292,021 1,485 - 2.0% 44,419 561 5.0% ~~ ~~ . . $341,772 - - - - $2,439 2.8% $336,440 $2,046 2.4% ~~ ~~ . . . . . . . . . . . . . . 286,486 . . . . . . . . . . . . . . . . . . . . . . 644 54,642 Net intcrcst income . . . . . . . . . . . . . . . . . . $4,049 ~ ~ Net interesl rale spreud(4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Net interest riinrgin ( 5 ) . . . . . . . . . . . . . . . ~ 3.3% - 3.8% - ~ ~ $3,936 - 3.3% ~ ~ 3.7% - ~ ( 1 ) Includes bolh kixable aiid lax exeiiipt securities. (2) Tax exempt inlerest is shown on ;I lax equivulenl basis for proper coriiparison using a statutory federal income tax rate of 34%. (3) Includes loan origination and conitnilmen1 fees. (4) Iritcrcst rate spread represents the diflerence between the yield on earning assels and the ratc paid on interest hearing liabilities. ( 5 ) Merest iniirgin is calculatcd by dividing the difference between total interest eariied and Lola1 interesl expensed by total interest- earning asqets. Loan charge-offs during the quarter were $185 in 2005 compared to $ I35 in 2004, while the recovery of previously chargcd-olT loans amounted to $14 during the fourth quarter of 2005 compared to $16 in the same period of 2004. The Company’s provi- sion for loan losses during the quartcr was $135 compared to $ I40 a year ago. Other income decreased by $74 from a year ago, due primarily to a decline in service charge income of $52 and a $22 decrease in non-taxable income on bank owned life insurance policies, reflecting declines in the investment yields associated with these policies. Investment securities gains of $378 were realized in 2004, compared to none realized in the fourth quarter of 2005. The net gain on loans sold during the quarter amounted to $30, coin- pared to $13 a year ago. Total other non-intcrcst cxpcnscs in the fourth quarter were $2,990 in 2005 compared to $2,999 in 2004, a decrease of $9 or 0.3%. Salaries and I increase, or 0.6%. Oc- beneliis constituted an $ 1 cupancy and equipment, office supplies and mar- keting expenses decreased by $16 or 2.7%. State and local tax assessments increased by $21 or 18.6%. Bank exam and audit fees decreased by $21 or 13.5% mainly due to the expense associated with thc implementation of the requirements of Sec- tion 404 of the Sarbunes-Oxley Act of 2002 in 2004. Other cxpcnscs decreased by $4 or 0.9%. Income before income tax during the fourth quar- ter amountcd to $1,340 in 2005 compared to $1,605 in 2004. Income tax expense for the fourth quarter of’ 2005 was $247 as compared to $300 in 2004. Fourth quartcr net income was $1,093 in 2005 compared to $1,305 in 2004, representing n decrease of $212, or 16.2%. Earnings per share for the fourth quartcr, adjustcd for the 3% stock dividend paid January I , 2006, were $0.25 in 2005 and $0.30 in 2004. CORTLAND BANCORP AND SUBSIDIAKIES MANAGEMENT'S DISCUSSION AND ANALYSIS (In thousands ol' dollars, cxccpt for per share amounts) Fourth Quarter of 2005 Compared to 2004 (Unaudited) ~ Interest lncoine . . . . . . . . . . . . $6,212 Interest Expense . . . . . . . . . . . 2,439 Net Interest Income . . . . . . . . 3,773 Loan Loss Provision . . . . . . . . (135) Net security gains . . . . . . . . . . Net gain on loans . . . . . . . . . . 30 Other real estate loss . . . . . . . (3) Otlier Income . . . . . . . . . . . . . 665 Olher Expenscs . . . . . . . . . . . . (2,990) h o m e Before T a x . . . . . . . . . 1,340 Federal Income Tax . . . . . . . . 247 Net Income . . . . . . . . . . . . . . . $1,093 Net lncomc Per S h a r e . . . . . . $ 0.25 Three Months h d c d Dcc 31, 2004 - - 2005 $5,660 2,046 ~- 3,614 (140) 378 13 739 (2,999) ~- 1,605 300 ~- $1,305 - - ~- $ 0.30 Core earnings (earnings before gains on loans sold, investment securities sold or called and ccrtain other non recurring items) increased by 2.7% in the fourth quarter of 2005 compared to 2004. Core carnings for the fourth quarter of 2005 were $ I .075 million compared to last year's $1.047 mil- lion. Core earnings per share were $0.25 in 2005 and 2004. Thc following is a reconciliation between core earnings and earnings under generally ac- ccptcd accounting principles in the United Stales (GAAP earnings) : GAAP Earnings . . . . . . . . . . . . $1,093 Investment security gains . . . . Gain on sale of loans.. ...... Other real estate loss . . . . . . . . Tax effecl of adjusliiients . . . . Core Earnings.. . . . . . . . . . . . . $1,075 (30) 3 9 Three Months Ended Dcccmhor 3 I , 2004 - - 2005 $1,305 ( 3 7 8 ) ( 1 3 ) I33 $1,047 ~- Realized gains or losses on securities are based on net proceeds and the adjusled carrying amount of the securities, using the specific identification method. The table below sets forth the proceeds, gains and losses realized on securities sold or called for the period ended: Three Mvnths 2005 Twelve Months 200s Uecembcr 31, Dcccmbcr 31, Proceeds on securities sold or called.. . . . . . . Gross realized gains . . . . Gross realiad losses. . . . $34 $13,563 308 CORTLAND BANCORP A N D 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, cxccpt for per share amounts) ASSET-LIABILITY MANAGEMENT The Company’s executive management and Board of Direclors roulinely review the Company’s balance sheet structure for stability, liquidity and capital adequacy. The Company has defined a set of key control paraiiieters which provide various measures of the Company’s exposure to changes in interest rates. The Company’s asset-liability management goal is to produce a net interest margin that is relatively stable despite interest rate volatility while maintaining an acceptable level of earnings. Net Tnterest Margin is the dift‘erence between total interest earned on a fully taxable equivalent basis and total interest expensed, The Net Interest Margin Ratio expresses this difference as a percenhgc of average earning assets. In the past five years, the net interest margin ratio has averaged 4.01% ranging between 3.74% and 4.39%. Included among the various measurement techniques used by the Company to identify and manage exposure to changing interest rates is the use ol‘ computer based simulation models. Computerized simulation techniques enable the Company lo explore and measure net interest income volatility under alternative asset deployment strategies, different interest rate environments, various product offerings and changing growth patterns. G A P TABLE December 31, 2005 Interest-Earning Assets lnvcstincnts . . . . . . . . . . . . . . . . . . . . . . Loans & Leases . . . . . . . . . . . . . . . . . . Federal Fund Sold . . . . . . . . . . . . . . . . Total Earning Assets . . . . . . . . . . . . . . . . Other Assets.. . . . . . . . . . . . . . . . . . . . . . Total Assets . . . . . . . . . . . . . . . . . . . . . . . Interest-Bearing Liabilities Interest-hearing Checking . . . . . . . . . . Money Market Accounts. . . . . . . . . . . Passbook Savings . . . . . . . . . . . . . . . . . Time Deposits < I00,OOO. . . . . . . . . . . Time Dcposits 2 100,000. . . . . . . . . . . Repurchase Agreements . . . . . . . . . . . U.S. Treasury Demand . . . . . . . . . . . . Other Borrowings . . . . . . . . . . . . . . . . . Total Interest-Bearing Liabilities . . . . . . Demand Deposits . . . . . . . . . . . . . . . . . . . Olher Liabilities . . . . . . . . . . . . . . . . . . . . Sharcholdcrs’ Equity . . . . . . . . . . . . . . . . Total Liabilities & Equity . . . . . . . . . . . . Rate Sensitivity Gap . . . . . . . . . . . . . . . . Maturity or Repricing Interval 3 Months 3 to 12 or Less Months 1 to 5 Years Non Rate Sensitive or >5 Years $ 38,991 64,554 4,650 108,195 $ 34,612 $100,348 70,717 31,478 $ 60,701 21,453 66,090 171,065 82,154 $108,195 $ 66,090 $171,065 32, I97 $114,351 $ 29,677 17,866 86,359 21,390 11,338 2,336 775 5,000 174,741 $ $ $ 34,150 18,633 33,941 8,364 20,007 6,868 2,000 54,783 38,500 80,805 $174,741 $ (66,546) $ 54,783 $ 80,805 $ 11,307 $ 90,260 9,500 36,375 61,782 2,890 48,325 $149,372 $ 45,779 Total $234,652 188,202 4,650 427,504 32,197 $459,701 $ 29,677 17,866 86,359 109,488 45,203 2,336 775 55,000 346,704 61,782 2,890 48.325 $459,701 Cumulative Gap . . . . . . . . . . . . . . . . . . . . Cumulative Gap to Total Assets . . . . . . $(66,546) $(55,239) $ 35,021 $ 80,800 (14.5) % (12.0) % 7.6% 17.6% C O R T L A N D RANCORP AND SUBSIDIARIES M A N A G E M E N T ' S D I S C U S S l O N A N D ANALYSTS (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 intcrcst- hearing liabilities. Assets are dislributcd according to the earlier of interest rate repricing opportunity or expected cash flows. Time deposits and liabili- ties with dclincd maturities are distributed accord- ing to the earlier of the repricing interval or contractual maturity. Other core deposit accounts (Interest-bearing checking, Money Market and Savings accounts) are shown as being available for repricing in the earliest time frame, although man- agement can exert considerable inlluencc over the timing and manner ol' repricing such core deposits. Therefore, these accounts may reprice in later time intervals and reflect smaller incremental changes than other interest-earning assets and intcrcst- bearing liabilities. Since management may reprice these accounts at its discretion, the impact of changing rates on net interest income is likely to be considerably different than inferred by this table. interest rate sensitivity. Because the repricing of the various categories of assets and liabilities is subject to competitive pressures, customer prel'er- ences and other factors, such assets and liabilities may in fact reprice in different time periods and in different increments than assumed. The computerized simulation techniques uti1 i7ed by management provide a more sophisticated mea- sure of the degree lo which lhe Company's intcrest sensilive assets and liabilities may be impacted by changes in ihe gencral level of interest rates. These malyscs show the Company's net interest income 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 relatively stable in the range of 3.74% to 4.39% over the past five years, despite significant shifts in the mix ol' carn- jng assets and the direction and level ol' intcrcst rates. During 2005, the effective maturities of earning assets tended to lengthen as short and inlermediate rates in the credit markets rose sharply. Federal Reserve policy makers increased short-term inter- est rates eight times during the year, l'rom 2.25% to 4.25% in an attempt to avoid an unwelcome rise in inflation. Wiih rates rising throughout the year, the volume ol' invcstincnt securities eligible to be called decreased significantly, while prepaymen tc on loans and mortgage-backed securities similarly decreased, causing the effective niaturities of ex- isting earning assets to lengthen. Accordingly, in order to maintain duration, management invested excess overnight funds (federal funds sold bal- ances), and increased the allocation towards hy- brid adjustable rule mortgage-backed securities, adjustable and U.S. Government agencies purchased at a discount that contain a lock-out period prior to the first call date. corporate bonds rate While the preceding Gap Table provides a general indication ol' the potential effect that changing inleresl rates may have on net interest income, it does not by itself present a complete picture of NET INTEREST MARGIN RATIO (In Percentages) 4.39 2005 2004 2003 2002 2001 5.0 4.5 4.0 3.5 3.0 2.5 2.0 JJQUIDITY The central role of the Company's liquidity man- agement is to ( 1 ) ensure sufticient liquid funds to meet the normal transaction requirements of its customers, (2) take advantage of market opportu- nities requiring flexibility and speed, and ( 3 ) pro- vide a cushion againsl unforeseen liquidity nccds. Principal sources ol' liquidity lor the Company include assets considered relatively liquid, such as interest-bearing deposits in other banks, federal funds sold, cash and due from banks, as well as cash flows from maturilies and repayments of C O K T L A N D B A N C O R P AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS (In lliousands ol' dollars, cxccpt for per share amounts) loans, inveslnient securities and mortgage-backed securitics. Cash and cash equivalents, which includes federal funds sold increased by $6,340 compared to ycar- end 2004. Anlicipatcd principal repayments on mortgage-backed securities along with investment securities maturing, repricing, or expected to be called in one year or less amounted lo $73,603 at December 31 , 2005, representing 31.4% of the total combined portfolio, as compared to $96,471 or 42.7% of the portfolio a ycar ago. Along with its liquid assets, the Company has other sources of liquidity available to it which help lo cnsurc that adequate funds are available as needed. These other sources include, but are not limited to, the ability to obtain deposits through the adjustment of interest rates, the purchasing of federal funds, and access to the Federal Keservc Discount Window. The Company is also a member of the Federal Home Loan Bank of Cincinnati, which provides yet another source of liquidity. Cash and cash equivalents increased from $9,747 in 2003, $12,897 in 2004 to $19,237 in 2005 as the Company increased its level of Federal Funds Sold. Operating activities provided cash of $4,275 in 2005, $7,382 in 2004 and $7,048 in 2003. Key differences stern mainly from: I ) a decrease in nct income of $509 between 2005 and 2004 and $641 between 2004 and 2003; 2) there were no loans held for sale at December 31, 2005 and 2004, $103 at 2003 and $2,022 at December 31, 2002, which favorably inipacts the proceeds and gains on loans realized in 2004 by $103 and 2003 by $1,919; 3) gains on the sale of investments was $308 at to $1,052 at December 31, 2005, compared December 31, 2004 and $946 at December 31, 2003; 4 ) amortization on securities was $872 in December 31, 2005 compared to $1,546 in 2004 and $1,644 in 2003; 5) loss on the sale of other real estate totaled $171 in 2004 compared to $3 in 2005 and none in 2003; 6) 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 compared to $0.5 million in 2004 and nunc in 2005; 7 ) a liability for securities totaled $1,270 ai purchased yet December 31, 2004, with none at December 31, 2005 or 2003. Refer to the Consolidated State- incnts of Cash Flows for a summary of the sources and uses of cash for 2005, 2004 and 2003, and the following table which details the cash flows from operating activities. to settle Net iiicoiiie Adjustments to reconcile net incomc to net cash llows from operating activities: Depreciation, amortization and ticcre tion Provision for loan loss Investment securities gains Other real estate losses Iiiipact of loans held for sale Changes in: Securities to wttlc and securities sold to settle Purchase of insurancc con t r8c t s Other assets and liabilities Net cash flows from operating activities Ilcccmbcr 3 I. 2003 -~~ 2004 2005 $ 4,334 $ 4,843 $ 5,484 1,469 545 (308) 3 2,176 415 (1,052) 171 103 2,382 240 (946) l,Yl9 (1,270) 1,270 (500) (44) -~ (2,500) 469 (498) $ 1,275 $ 7,382 $ 7,048 -~~ -~~ CONTRACTUAL OBLIGATIONS ANT) COMMTTMENI'S The Corporation has various obligations, including contractual obligations and commitments that [nay require future cash payments. table Contractual Obligations: The following presents, as of December 31, 2005, significant fixed and determinable contractual obligations to third parties by payment date. Further discussion of the nature ol' cach obligation is included in the refer- enced note financial statements. the consolidated to CORTLAND BANCOKP AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS (In thousands of dollars, exccpt for per share amounts) See Note ~ Non-interest bearing deposits, . . . . . . . . . . . lnlerest bearing dcposits(a) . . . . . . . . . . . . . Average Ratc(b) . Certificates of' depo Fcderal funds purch Avcrage Rate (b) . . . . . . . . . . . . . . . . . . . . U S . Treasury interest-hearing demand note (a) . . . . . . . . . . . . . . . . . . . . Average IMe(b) . . . . . . . . . . . . . . . . . . . . Federal Home Loan Bank advances(a) . . , Avcragc Rate (b) . . . . . . . . . . . . . . . . . . . . 6 7 Operating leases . . . . . . . . 8 Contractual Obligations BS of Uccemhcr 31, 2005 Pnymcnln Duc in Three to Five Years s $3 Onc to Three Years ~~~ $ Over Fivc Years One Year or I,css $ 61,782 133,902 1.16% 'I'ntal $ 61,782 133,902 1.16% 76,857 40,739 3.44% 4.02% 9,69X 4.35'170 27,397 154,691 4.X4%) 3.90% 2,336 2.96% 775 3.95% 2,000 4.66% I88 20,000 4.69% 110 23,500 5.60% 9,500 4.96%) 2,336 2.96% 775 3.95% 55,000 5.12% 298 ( a ) Excludes present and liilurc accrued interest. (h) Variable rate obligations reHcct inlcrcsl rates in clTcct a1 rkce1nher 3 I, 2005 The Corporation's operating lease obligations rep- resent short and long-term lease and rental pay- ments for the subsidiary bank's branch facilities. Expected Maturities of Cominitmciirs as ef Uecernher 31, 2005 One l o Three Three Icr Five One Over Year Five 'I'lBtdI ~~~~- or LCSS Ycars Years Yews The Corporation also has obligations under its supplemental retirement plans as described in Note 9 to the consolidated financial statements. The postretirement benefit payments represent ac- tuarially determined future benefit payiiients to eligible plan participants. The Corporation does not have any commitments or obligations to the (401 (k) defined contribution plan) at December 31, 2005 due to the funded status of the plan. in Note 9.) (Scc further discussion retirement plan Commitments: The following table details the amounts and expected maturities of significant commitiiients as of December 31, 2005. (Further discussion of thcsc commitments is included in Note 8 to the consolidated financial statements.) Cuiiimitiiieiits to extend crcdil: C'ummcrcial Kcsidcnlial rcal cslatc Rcvulving humc cquity OvcnlrCdl prulcclion Other Standhy lellcrs or crcdil $28,473 $1,024 $ 10 $1,799 $31,306 306 9,102 6,191 567 1.195 306 9, I02 6,19 I 567 1,195 Commitments to extend credit, including loan commitments, standby letters of credit, and com- mercial letters of credit do not neccssarily repre- sent future cash requirements, these commitments 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 catcgorics of assets of potentially higher credit risk require more capital backing than assets with lower risk. In addition, banks and bank hold- ing companies are required to maintain capital to CORTLAND BANCOKP A N D SUBSIDIARIES MANAGEMENT’S DlSCUSSION AND ANALYSTS (In thousands ol‘ dollars, except for per share amounts) support, on a risk-adjusted basis, certain off-balance sheet activities such as standby letters of credit and inlcrest rate swaps. The risk-based standards ciassil‘y capital into two tiers. Tier 1 capital consists of common sharehold- ers’ equity, noncumulative and cumulative perpel- ual preferred stock, and minority interests less goodwill. Ticr 2 capital consists of a limitcd amount of the allowance for loan and lease losses, perpetual preferrcd stock (not included i n Tier I ) , hybrid capital term subordinated instruments, debt, and intermediate-term preferred stock. Thc following graph, which is not “risk-adjusted,” dcpicts 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 increased from 10.88% in 2004 to 11.05% in 2005, and remains well above regulatory minimums. LEVERAGE RATIO (In Percentages) 12 11 10 9 8 7 6 2005 - 2004 2003 2002 2001 The Fcderal Deposit lnsurance Corporation 1111- provement Act of 1991 (FDTCTA) required bank- ing regulatory agencics to revise risk-based capital standards to ensure that they take adcquate account of inlcrest rate risk. Accordingly, regulators sub-jec- tively consider an institution’s exposurc to declines in the economic value of its capital due to changes in interest rates in evaluating capital adequacy. The following table illustrates the Company’s risk- weighted capital ratios at Deccmber 3 I , 2005 and 2004. Bunks are required to maintain a minimum ratio ol‘ 8% of qualifying total capital to risk- adjusted total asscts. The Tier 1 capital ratio niusl be ai least 4%. Capital qualifying as Tier 2 capital is limited to 100% of Tier 1 capital. As the table indicates, the Company maintains both Ticr 1 and total risk-based capital well in excess of the re- quired regulatory minimum ratios. ~ ~ Risk-Based Capital Ticr I CapilaI Ticr 2 Capital QUALIFYING CAPITAL Risk-Adjusted Total Asselr( *) Tier I Risk-Bascd Capital Katio Tolal Risk-Sascd Capital Ratio Total 1,evcragc Capital Deccmlier 31, Tlecember 31 2005 $ 49,031 2,189 2004 $ 48,129 2,664 $ 51,220 $ 50,793 $242,106 $230,133 20.25% 20.9 1 % 21.16% 22.07% Katio I I .05% 10.88% ( * ) lncludcs off-balance sheet exposures In management’s opinion, as supported by the data in the table below, the Cornpany met all capital adequacy reyuiremcnts to which it was subject as of December 3 1, 2005 and December 3 1, 2004. As of those dates, the Company was “well capital- ized” under regulatory prompt corrective action provisions. Actual Rcculatoq (’apital Ratins as of: Dec. 31, ZOIIS ---. Regulatory rapital Ratio requirements ti1 he: Wcll Adequately (:apitalized C‘apitalizcd Ilec. 31, 2004 Tolal risk-based capital to risk- weighted assets Tier I capital to risk-weighted assc1s Tier 1 capital to averaee assets 21.1610 22.07%) 10.00% 8.00% 20.25% 20.91 B 6.00W 4.00%) 11.05% 10.88% 5.00% 4.00%) SFAS I IS, “Accounting for Certain lnvestments in Debt and Equity Securities,” requires that investments designated as availablc for sale be marked-to-markct with corresponding entries to the deferred tax account and shareholders’ equity. Regulatory agencies, however, exclude these ad- justments in computing risk-based capital, as their inclusion would tend to increase thc volatility . . . . ... . -- CORTLAND BANCOKP A N D SUBSIDIARIES MANAGEMENT’S DISCUSSION AND ANALYSIS (In thousands ol‘ dollars, except for per share amounts) of this important measure of capital adequacy. Additional information regarding regulalory mat- ters can be found in the Notes to the Consolidated Financial Stateiiients (NOTE 12.) REGU1,AI’ORY MATTERS On March 13, 2000, the Board o l Governors of the Federal Reserve System approved the Company’s application to bccomc a financial holding com- pany. As a financial holding company, the Com- pany may engage i n activities that are financial in nature or incidental to a financial activity, as au- thorired by thc Gramm-Leach-Bliley Act of 1999 (The Financial Services Reform Act). Under thc Financial Services Reform Act, the Company may continue to claim the benefits of financial holding company status as long as each dcpository institu- tion that it controls remains well capitalized and well managed. The Company is rcquired to provide notice to thc Board of Governors of the Federal Reserve System when it becomes aware that any depository institution controlled by the Company ceases to be wcll capitalized or well managed. Furthermore, current regulation specifies thal prior to initiating or engaging in any new activities that are authorized for financial holding companies, the Company’s insured deposilory institutions must be rated “satisfactory” or better under the Commu- nity Reinvestment Act (CRA). As of Decem- ber 31, 2005, the Company’s bank subsidiary was rated “satisfactory” for C K A purposes, and re- mained well capitalized and wcll managed, in management’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 ol interest rate changes on the Company’s net interest in- come. Components of interest rate risk comprise repricing risk, basis risk and yield curve risk. Rcpricing risk arises due to timing differences in the repricing of assets and liabilities as interest rate changes occur. Basis risk occurs when repricing assets and liabilities reference different key rates. Yield curve risk arises when a shift occurs in the relationship among key rates across the maturity spectrum. The effective management of interest rate risk seeks to limit the adverse impact of interest rate changes on the Company’s net interest margin, providing the Company with the best opportunity for maintaining consistent earnings growth. To- ward this end, management uses computer simula- tion financial performance under varying interest rate scenarios. These scenarios may reflect changes in thc level of interest rates, changes in the shapc of the yield curve, and changes in interest rate relationships. the Company’s to model The simulation model allows management to test and evaluate alternative responses to n changing interest rate environment. Typically when con- fronted with a heightened risk of rising intcrest rates, the Company will evaluate strategies that shorten investment and loan repricing intervals and maturities, emphasiye the ucquisition of floating rate over fixed rate assets, and lengthen the maturi- ties of liability funding sourccs. When the risk of falling rates is perceived, management will con- sider stratcgics that shorten the maturities of fund- ing sourccs, lengthen the repricing intervals and maturities of investments and loans, and cmpha- size the acquisition ol fixed rate assets over floating rate assets. Thc most significant assumptions used in the simu- lation relate to the cash flows and repricing charac- teristics of the Company’s balance shcct. Repricing and runoff rate assumptions are based upon spe- cific product paramctcrs modified by historical trends and internal projections. These assumptions are periodically reviewed and benchmarked against historical results. Actual results may difler from siniulated results not only due to the timing, mag- nitude and frequency o l intcrcst rate changes, but also due to changes in general economic condi- tions, changes in customer preferences and behav- ior, and changes in strategies by both existing and potential competitors. COKTLAND BANCORP ANI) SUBSIDIARIES MANAGEMENT’S DISCUSSION A N D ANALYSIS (In thousands of dollars, except for per sharc amounts) The following table shows the Company’s current estimate of interest rate sensitivity based on the composition ol its balance shcct at Decembcr 3 1 , 2005. For purposes of this analysis, short term interest ratcs as measured by the federal funds rate and the prinic lending rate are assumed to increase (decrease) gradually over the next twelvc months reaching a level 300 basis points higher (lower) than the rates in eflect at December 31, 2005. Under both the rising rate scenario and the falling rate sccnario, the yield curve is assumed to exhibit a parallel shift. During 2005, the Federal Reserve incrcased its target rate for overnight federal funds by 200 basis points. At year end Decembcr 31, 2005, Ihc differ- ence betwccn the yield on the ten year Treasury and the thrce month Treasury had decrcased to a positive 31 basis points from the positive 202 basis points that existed at Deccmber 31, 2004, indicat- ing that the yield curve was “flattening.” At De- cember 31, 2005, the yield curve was inverted, as intercst rate yields €or three years through ten years were below those of the two year yield. Howcver, rates did peak at the long-end of the Treasury yield curve. The base case against which interest rate sensitiv- ity is nieasured assumes no change in short term rates. Thc base case also assumes no growth in assets and liabilities and no change in asset or liability mix. Under lhcse simulated conditions, Ihc base case prqjects net interest incomc of $1 5,377 for thc year ending Dccernber 31, 2006 Simulated Net Interest Income Sensitivity For the Twelve Months Ending Dcccmher 31, 2006 rhatige in Intcrcat Kate< Graduated increasc of +300 hasis points Short term rates Nct Interest Incumc S C hungc S (’hange -_ I_ $15,385 $ x 0.1% unchanged (base casc j 15,377 Graduatcd decrease of -300 basis points 14,043 (734) (4.8j‘% The level of interest rate risk indicaled is within limits that managcment considcrs acceptablc. However, given that interest rate movements can bc sudden and unanticipated, and are increasingly influenced by global events and circumstances beyond the purview of the Federal Reserve, no assurances can be made that inlercst rate niove- ments will not impact key assumptions and param- cters in a manncr not presently ciiibodied by thc model. Tt is management’s opinion that hedging instru- ments currently available are not a cost effective means ol controlling inlerest rate risk lor the Com- pany. Accordingly, the Company does not cur- rcntly use financial derivatives, such as interest ratc options, swaps, caps, floors or other similar instruments. CRITTCAL ACCOIJNTING POLICIES AND ESTIMATES The Company’s consolidated financial statements arc prepared in accordance with accounting princi- ples generally accepted in the United States and lollow 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 - Suinmary of Significant Accounting Policics.” Ap- plication of these principles requires management to rnake estimates, assumptions mid judgments that aflcct the amounts reported in thc financial statements and accompanying notes. Some of thesc policies and related methodologies are more critical than others. The Company has identified its policy on the allowance for loan losscs as being critical hecause it requires management to make particularly dillicult, subjective and/or complex judgments about matters that arc inherently uncer- tain and because of the likelihood that materially different amounts would be reported under differ- cnt conditions or by using dinerent assumptions. The allowance for loan losses represents manage- ment’s estimate of probable credit losses inherent in thc loan portlolio. Determining thc amount of the allowance for loan losses is considered a critical accounting estimate because it requires significant judgment and the use of sub-jective measurements including management’s assessment of the internal CORTLAND BANCOKI’ AND SUBSTDTARIES MANAGEMENT’S DISCUSSION AND ANALYSIS (In thousands of dollars, except for per sharc amounts) 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 estimates and assumptions are reasonably possible and may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity. Accordingly, the Company has developed and maintains a comprehensive, systematic and con- sistently applied process to dctcrmine the appropri- ate amounts of the allowance for loan losses, and resultant provision for loan losses, necessary to absorb estimated credit losses inherent in the loan portfolio. The allowance for loan losses represents management’s best estimate from within an ac- ceptable range of estimated losses that it considers appropriate and prudent, but no1 excessive. While management’s evaluation of the allowance for loan losses as of Dcccmber 3 I , 2005 has deter- mined the allowancc to be adequate, under ad- versely different conditions or assumptions, the Company would most likely need to increase the allowance. The assumptions and estimates uscd by the Company in its internal review of non-perform- ing loans and potential problem loans, as well as thc associated evaluation of the related collaleral coverage for these loans, can have a significant impact on the overall assessment of the adequacy of the allowance for loan losscs. While manage- ment has concluded that thc current valuation of loan collateral is reasonable under present circum- stances, if collateral valuations were significantly reduced due to either new information or other changing circumstances, additional provisions to the allowance for loan losses would most likely be necessary. All accounting policies arc important and the reader of thcsc financial statements is encouraged to review the summary of significant accounting policies described in Note 1 of the Consolidated Financial Statements, in order to gain a better underslanding of how the Company’s financial per- formance is reported. For additional information regarding the allowance for loan losses, its rclation to the provision for loan losses and risk related to asset quality, see sections of the “Notes to the Consolidated Financial Slate- rnents” and “Managemcnt Discussion and Analy- sis” rclated to the allowance for loan losses. IMPACT OF TNFLATTON Consolidated financial information included herein has been prepared in accordance with generally accepted accounting principles, which require the Company to measure financial position and operat- ing results i n terms of historical dollars. Changes in the relative value of money due to inflation are generally not considered. Neither the price, timing nor the inagnilude of changes directly coincide with changes in interest ratcs. INFORMATION AS TO STOCK PRICES AND DIVIDENDS OF COKTLAND BANCORP OTHER 1NPORMATION Thc Company filcs quarterly reports, (Forins 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 ol‘ the Exchange Act. In 2006, the quarterly reports will be tiled within 40 days of the end of each quarter, while the annual report is filed within 75 days of the end of lhc year. Any individual request- ing copies of such reports may obtain these free of charge, as soon as reasonably prxticable allcr such material is electronically filed with or furnished to the SEEC by visiting our web site at wwwxortland- banks.com or by writing to: Deborah L. Eazor Cortland Bancorp 194 West Main Street Cortland, Ohio 4441 0 The SEC also maintains an Internet site that contains reports, proxy and inforination state- ments, and other information regarding issuers that file eleclronically with the SGC at www.scc.gov. The Company’s slock trades on the NASDAQ OTC market under the symbol CLDB. The follow- ing brokerage lirms are known to be relalively active in trading the Company’s stock: Community Bane Investments, lnc. Columbus, Ohio Contact: Greig A. McDonald Telephone: I -800-224- I O I 3 McDonald 62 Company Securities, Inc. 6575 Sevillc Drive 2nd Floor P.O. Box 119 Canfield, Ohio 44406 Telephone: 1-330-746-2993 Smith Barney Citigroup, Inc. 5048 Belmont Ave. Youngstown, Ohio 44505 Telephone: I-800-535-0017 Stifel, Nicholas & Co., Tnc. 655 Metro Place South Suite 200 Dublin, Ohio 43017 Telephone: 1-877-875-9352 UBS Financial Services 3701 Roardman Canfield Rd P.O. Box 100 Canfield, Ohio 44404 Tclephone: 330-533-7 19 I The following table shows the prices at which the comiiion stock of the Company has actually been purchased and sold in market transactions during the periods indicated. The range of 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 give retroactive effect to the 3% stock dividend paid as of January I, 2006, 2005 and 2004. The Company currently has approximately 1,733 shareholders. HIGH OR LOW ‘I KAlllNG PRICE PER QI .JARTER I’nce Pel Share High I - L O W (?ash Dividends Per Sharc 2005 Fourth Qunrtcr Third Quarter Second Quarter First Quarter 2004 Fourth Quarter Third Quurler Sccond Quarter First Quarter 2003 Fourth Quarter Third Quarter Second Quarter First Quarter $20.39 20.39 21.75 22.58 $23.57 23.33 25.69 28.76 $28.83 30.67 29.98 24.94 $17.50 18.45 19.42 20.58 $20.41 19.94 20.74 24.52 $27.34 27.69 24.72 23.21 $0.44 0.21 0.21 0.21 60.44 0.20 0.20 0.20 $0.44 0.19 0.19 0. I9 For the convenience ol‘ shareholders, the Company has established a plan whereby shareholders may have their dividends automatically reinvested in the common stock of Cortland 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 home page at wwwxortland-hanks.com. For more information on the dividend reinvestment plan, you may contact Deborah L. Eazor at the (330) 637-8040 following telephone number: Ext. 130 or E-mail address DLEAZOR@cortland- banks.com. CORTLAND BANCORP BOARD OF DIRECTORS K. RAY MAHAN Chilirman JERRY A. CARLETON DAVlD C. COLE LAWRENCE A. FANTAUZZI JAMES M. GASTOR GEORGE E. GESSNER JAMES E. HOFFMAN 111 NETL J. KABACK RICHARD R. THOMPSON TIMOTHY K. WOOFTER WlLLlAM A. HAGOOD Director Emeritus RODGER W. PLATT Director Emeritus OFFICERS LAWRENCE A. FANTAUZZl President and Chief Executive Officer JAMES M. GASIOR Senior Vice President Chief Financial Officer and Corporate Secretary CRAIG M. PHYTHYON Senior Vice President Chief Investment Officer and Treasurer THE CORTLAND SAVINGS AND BANKTNG COMPANY BOARD OF DIRECTORS J E R R Y A. C A R L E T O N Presidcnt, Carleton Enterprises Inc. 13AVID C. C O L E Partner and President (:(>IC Valley Motor Cotnpany I A W R E N C E A. F A N T A U Z Z I Prcsidml and Chief Executive O l k c r J A M E S M. GASTOR Scnior VicC President, Chief I.'inancial Ollicer mid Secretxy G E O R G E E . G E S S N E R Attorney J A M E S E. H O F F M A N I11 Altorney N E 1 I. J . K A B A C K Partner, Cohcn 6: Company K . R A Y M A H A N President, M a l m Packing Co. and Chairrnan of thc Road R I C H A R D €3. T H O M P S O N Executive, 'l'herm-0-l.ink, Inc. TTMOTllY K. W O O F T E R President, Stan-Wade Mclal Producls * * * * * WTl,I,IAM A. HAGOOTI Director Emeritus IZO13GER W . P L A T T Director Emeritus * * * * * OFFICERS L A W R E N C E A. F A N T A U Z Z I President and Chief Execulive Officer J A M E S M. GASIOR Senior Vicc Prcsidenl, Chief Financial Oflicer and Secretaly S T E P H E N A. T E L F G O , S R . Scriior Vice President and Director ol' Human Resources arid Corporate Administration T l M O T H Y C A R N l-;Y Scnior Vice President & Chief Opcralions Olficer C K A I G M. P H Y T H Y O N Scnior Vice President, Chief Investment Ollicer and Treasurer D A N N Y I,. W I I I T E Senior Vice President and C:hicf Ixnding Officer C H A R L E S J . C O M M O N S Vice President G E K A L D L. T H O M P S O N Vice President M A K L E N E LENTO Vice President E M M A S E A N WOI,I,AM Vice President ROBERT J. H O K V A T H Vice President .IIJDY R U S S E T L Vice Prcsidcnt J A M E S D U F F Vicc Prcsidenl K E I T H M R O Z E K Vice President D E B O R A H L . E A Z O R Vice President K A K E N C L O W E R Vice President K O B E R T A. COC;GESHAI,I, Vice President G R E G Y U R C O Vice President M A R C E L P. ARNAT, Assistant Vice President G R A C E J. R A C O T Assistant Vicc Presided S H I R L E Y F. R O O T Assistant Vice Prcsidcril D A R L E N E MACK Assistant Vice Prcsidcnt a n d Trust Officer HARBARA R . S A N D R O C K Assistanl Vice President J A N E T K. H O I J S E R Assistant Vice Presidcnt K U S S E L L E. T A Y L O R Assistant Vice President .JOAN M . F l i A N G l A M O R E DAVII) M A Y Assistant Vice Prcsidcnt A R A McKF,NLIE tant Vicc President S T E V E J . M A C K Assislanl Vice President J A M E S H U G H E S Assistant Vice Prcsidcnl W I L L I A M .I. H O L L A N I> Assistant Vice President J E N N I F E R H A N I G O S K Y Assislanl Vice President P A T R I C K J. M c E L H A N E Y Assistant Vice President L A N A MUTR Assistant Secretaty-'l'rcasurcr H E A T H E R J. H O W S E R tant Secrctary-Trcasurcr K A R E N MTLLEIZ Assistant Secretary CORTLAND BANKS OFFICES AND LOCATIONS Thirteen Ofices Sewing These Fine Communities BOARDMAN 8580 South Avenue Youngstown, Ohio 445 14 330-758-5884 HUBBARD 890 West Liherly Slreet H uhbard, Ohio 44425 330-534-2265 VTENNA 4434 Warren-Sharon Road Vienna, Ohio 44473 330-394-1438 BOARDMAN Victor Hills P l a ~ a 6538 South Avenue Roardman, Ohio 44512 330-629-9 15 1 BRTSTOL 6090 Statc Routc 45 Rristolville, Ohio 44402 330-889-3062 BROOKFlELD 7 3 25 Warren- Sharon Road Brookfield, Ohio 44403 330-448-6814 M A N T U A 11661 Statc Routc 44 Mantua, Ohio 44255 330-274-31 11 W A R R E N 2935 Elm Road Warren, Ohio 44483 330-372-1 520 NILES PARK PLAZA 81 5 Youngstown-Warren Road Suite I Nilcs. Ohio 44446 330-652-8700 WTLLTAMSFTELD 5917 U S . Route 322 Williamsfield, Ohio 44093 440-293-7502 CORTLAND 194 West Main Street Cortland, Ohio 4441 0 330-637-8040 NORTH BLOOMFTELD 8837 Statc Route 45 North Bloomfield, Ohio 44450 440-685-473 1 WINDHAM 9690 East Center Streel Windham, Ohio 44288 330-326-2340 Mern ber Federal Reserve System and Federal Deposit lnsurance Corporation Visit us at our home page on the world wide web at www.cortland-banks.com or e-mail us at cbinf~(!cortland-banks.com 

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