United States
Securities and Exchange Commission

FORM 10-Q

               For the quarterly period ended: March 31, 2004

or

               For the transition from           to          

               Commission file number: 0-13814

Cortland Bancorp

(330) 637-8040
(Registrant’s telephone number, including area code)

N/A

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [   ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [X] No [   ]

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands, except share data)

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

2

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands, except per share data)

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

3

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands)

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

4

CORTLAND BANCORP AND SUBSIDIARIES

(Amounts in thousands)

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

5

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

     1.) Basis of Presentation:

     The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring items) considered necessary for a fair presentation have been included. Operating results for the three months ended March 31, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2003.

     2.) Reclassifications:

     Certain items contained in the 2003 financial statements have been reclassified to conform to the presentation for 2004. Such reclassifications had no effect on the net results of operations.

     3.) Investment Securities:

     Securities classified as held to maturity are those that management has the positive intent and ability to hold to maturity. Securities held to maturity are stated at cost, adjusted for amortization of premiums and accretion of discounts, with such amortization or accretion included in interest income.

     Securities classified as available for sale are those that could be sold for liquidity, investment management, or similar reasons even though management has no present intentions to do so. Securities available for sale are carried at fair value using the specific identification method. Changes in the unrealized gains and losses on available for sale securities are recorded net of tax effect as a component of comprehensive income.

     Trading securities are principally held with the intention of selling in the near term. Trading securities are carried at fair value with changes in fair value reported in the Consolidated Statements of Income.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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

     Securities available for sale, carried at fair value, totaled $119,890 at March 31, 2004 and $125,841 at December 31, 2003 representing 57.0% and 56.5%, respectively, of all investment securities. These levels provide an adequate level of liquidity in management’s opinion.

     Investment securities with a carrying value of approximately $55,911 at March 31, 2004 and $43,909 at December 31, 2003 were pledged to secure deposits and for other purposes.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

     The amortized cost and estimated market value of debt securities at March 31, 2004, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because borrowers have the right to call or prepay certain obligations with or without call or prepayment penalties.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

     The amortized cost and estimated fair value of investment securities available for sale and investment securities held to maturity as of March 31, 2004, are as follows:

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

     The following provides a summary of the amortized cost and estimated fair value of investment securities available for sale and investment securities held to maturity as of December 31, 2003:

10

CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

     4.) Concentration of Credit Risk and Off Balance Sheet Risk:

     The Company currently does not enter into derivative financial instruments including futures, forwards, interest rate risk swaps, option contracts, or other financial instruments with similar characteristics. The Company also does not participate in any partnerships or other special purpose entities that might give rise to off-balance sheet liabilities.

     The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit, and financial guarantees. Such instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized on the balance sheet. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

     In the event of nonperformance by the other party, the Company’s exposure to credit loss on these financial instruments is represented by the contract or notional amount of the instrument. The Company uses the same credit policies in making commitments and conditional obligations as it does for instruments recorded on the balance sheet. The amount and nature of collateral obtained, if any, is based on management’s credit evaluation.

     Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Generally these financial arrangements have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of these commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

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

     There are no mortgage loans held for sale included in 1-4 family residential mortgages as of March 31, 2004, and $103 at December 31, 2003. These loans are carried, in the aggregate, at the lower of cost or estimated market value based on secondary market prices.

     The following table sets forth the aggregate balance of underperforming loans for each of the following categories at March 31, 2004 and December 31, 2003:

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

     The following shows the amounts of contractual interest income and interest income actually reflected in income on loans accounted for on a nonaccrual basis and loans considered troubled debt restructuring for the three months ended March 31, 2004 and 2003.

     A loan is placed on a nonaccrual basis whenever sufficient information is received to question the collectibility of the loan or any time legal proceedings are initiated involving a loan. When a loan is placed on nonaccrual status, any interest that has been accrued and not collected on the loan is charged against earnings. Cash payments received while a loan is classified as nonaccrual are recorded as a reduction to principal or reported as interest income according to management’s judgement as to collectibility of principal.

     A loan is returned to accrual status when either all of the principal and interest amounts contractually due are brought current and future payments are, in management’s opinion, collectable, or when it otherwise becomes well secured and in the process of collection. When a loan is charged-off, any interest accrued but not collected on the loan is charged against earnings.

     Impaired loans are generally included in nonaccrual loans. Management does not individually evaluate certain smaller balance loans for impairment as such loans are evaluated on an aggregate basis. These loans include 1 - 4 family, consumer and home equity loans. Impaired loans were evaluated using the fair value of collateral as the measurement method. At March 31, 2004 the recorded investment in impaired loans was $1,181 while the related portion of the allowance for loan losses was $ 265. At December 31, 2003, there were $871 in loans considered impaired while the allocated portion of the allowance for loan losses for such loans was $177.

     Loans in the amount of $1,982 as of March 31, 2004, and $2,113 as of December 31, 2003, were not included in any of the above categories and were not currently considered impaired, but which can be considered to be potential problem loans.

     Any loans classified for regulatory purposes as loss, doubtful, substandard, or special mention that have not been disclosed above do not (i) represent or result from trends or uncertainties which management reasonably expects will materially impact future operating results, liquidity, or capital resources, or (ii) represent material credits about which management is aware of any information which causes management to have serious doubts as to the ability of such borrowers to comply with the loan repayment terms.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

     The following is an analysis of the allowance for loan losses for the three-month periods ended March 31, 2004 and March 31, 2003:

     The decrease in charge-offs in 2004 primarily reflects the effect of an impaired commercial loan credit charged off in 2003 for which a specific loss reserve had previously been established.

     For each of the periods presented above, the provision for loan losses charged to operations is based on management’s judgment after taking into consideration all known factors connected with the collectibility of the existing portfolio. Management evaluates the portfolio in light of economic conditions, changes in the nature and volume of the portfolio, industry standards and other relevant factors. Specific factors considered by management in determining the amounts charged to operations include previous loan loss experience, the status of past due interest and principal payments, the quality of financial information supplied by customers and the general economic conditions present in the lending area of the Company’s bank subsidiary.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands)

5.) Legal Proceedings:

     Since 1993 the Company’s subsidiary bank has been a defendant in a class action lawsuit, Frank Slentz, et al. v. Cortland Savings and Banking Company, involving purchased interests in two campgrounds.

     On September 30, 2002 the registrant received notice that The Court of Common Pleas in Trumbull County, Ohio had ordered the dismissal of all Plaintiffs’ claims in Slentz, et al (Plaintiffs) versus Cortland Savings and Banking Company (Defendant), and a related case, McDonagh, et al (Plaintiffs) versus Cortland Savings and Banking Company (Defendant), and granted registrant’s subsidiary bank, Cortland Savings and Banking Company, Summary Judgment on all counts of Plaintiffs’ Complaint in both cases.

     These two class action cases originated in 1993 with filings in the Northern District of Ohio Eastern Division of the Federal Court system. In addition to their alleged Federal claims, Plaintiffs had alleged State law claims which were included as pendent causes of action. On October 20, 1997 the federal judge presiding over these cases filed a judgment entry dismissing all federal claims against the registrant’s subsidiary bank without prejudice. The judgment of the district court was appealed by Plaintiffs. On March 2, 1999 the United States Court of Appeals for the Sixth Circuit affirmed the decision of the district court to grant summary judgment in favor of the defendant bank and dismissing all of Plaintiffs’ Federal Claims. While awaiting the ruling of the Sixth Circuit Court of Appeals, the Plaintiffs asserted their alleged State law claims by filing suit in the Common Pleas Court of Trumbull County seeking damages of approximately $4.3 million.

     Plaintiffs appealed the judgment rendered by the Common Pleas Court of Trumbull County. The Company and the Plaintiffs filed all permitted briefs with the 11th District Court of Appeals and oral arguments were made before the Court of Appeals on October 20,2003. On March 4, 2004, the Company received notice that the 11th District Court of Appeals had upheld the decision of the Court of Common Pleas in Trumbull County, Ohio in favor of the registrant and its subsidiary bank. Plaintiffs have appealed the 11th District Courts decision to the Ohio Supreme Court. While it is not feasible to predict the ultimate resolution of this matter, an outcome unfavorable to the Company’s bank subsidiary could have a material effect on the Company’s quarterly and annual operating results for that period in which such a judgment might be rendered. It remains the Company’s intent to vigorously defend these actions.

     The Bank is also involved in other legal actions arising in the ordinary course of business. In the opinion of management, the outcomes from these other matters, either individually or in the aggregate, are not expected to have any material effect on the Company.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands except per share data)

6.) Earnings Per Share and Capital Transactions:

     The following table sets forth the computation of basic earnings per common share and diluted earnings per common share.

*Average shares outstanding and resultant per share amounts have been restated to give retroactive effect to the 3% stock dividend of January 1, 2004.

7.) Stock Repurchase Program

     On January 23, 2001, the Company’s Board of Directors approved a Stock Repurchase Program (the “2001 Program”), which allowed the Company to repurchase up to 187,000 shares (or approximately 4.9% of the 3,815,125 shares outstanding as of January 31, 2001) of the Company’s outstanding common stock. The program expired February 6, 2002. On January 22, 2002, the Company’s Board of Directors approved a new program (the “2002 Program”), which allowed the Company to repurchase up to 193,000 shares (or approximately 4.9% of the 3,943,151 shares outstanding as of January 31, 2002) of the Company’s outstanding common stock. This program expired on February 6, 2003. On January 28, 2003, the Company’s Board of Directors once again approved a new program (the “2003 Program”) which allowed the Company to repurchase up to 196,000 shares (or approximately 4.9% of the 3,998,191 shares outstanding as of January 28, 2003) of the Company’s outstanding common stock. This program expired on February 6, 2004. Repurchased shares are designated as treasury shares, available for general corporate purposes, including possible use in connection with the Company’s dividend reinvestment program, employee benefit plans, acquisitions or other distributions.

     Repurchase amounts are effected through open market transactions or in privately negotiated agreements in accordance with applicable regulations of the Securities and Exchange Commission. Under the 2001 program based on the value of the Company’s stock on January 31, 2001, the commitment to repurchase the stock over the next year was approximately $3,179. The Company repurchased 51,321 shares under the 2001 Program.

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CORTLAND BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(Dollars in thousands except per share data)

     Under the 2002 Program, based on the value of the Company’s stock on January 31, 2002, the commitment to repurchase the stock over the next year was $4,053. The Company repurchased 114,073 shares under the 2002 program.

     Under the 2003 Program, based on the value of the Company’s stock on January 28, 2003, the commitment to repurchase the stock over the next twelve months was $5,037. The Company repurchased 34,605 shares between January 1, 2004 and February 6, 2004 bringing the total repurchased shares to 137,869 under the 2003 Program. The Company also reissued 16,629 shares to existing shareholders through its dividend reinvestment program in January 2004, bringing the total number of shares reissued during the 2003 Program to 43,750.

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CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

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

Note Regarding Forward-looking Statements

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

Critical Accounting Policies and Estimates

     The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow general practices within the industries in which it operates. The most significant accounting policies followed by the Company are presented in “Notes to Consolidated Financial Statements Summary of Significant Accounting Policies” in the 2003 annual report on Form 10-K. Application of these principles requires management to make estimates, assumptions and judgments that affect the amounts reported in the financial statements and accompanying notes. Some of these policies and related

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CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

methodologies are more critical than others. There has been no material change in critical accounting estimates since those presented in the 2003 annual report on Form 10-K.

Liquidity

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

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

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

     Cash and cash equivalents increased compared to levels at year-end 2003, as the Company moved to increase its level of Federal Funds Sold. Operating activities provided cash of $1,013 and $2,764 during the three months ended March 31, 2004 and 2003, respectively. Key difference stems mainly from 1) loans held for sale decreased by $103 at March 31, 2004 as compared to a decrease of $890 at March 31, 2003, which favorably impacts the proceeds and gains on loans realized in 2003; 2) trading account securities used $2,787 in funds in the first quarter of 2003 and none in the first quarter of 2004 , and 3) the net increase in securities to settle and securities sold to settle in March 2003 was $3,295, while in March 2004, there was no increase, which results in a positive impact on cash flows from operating activities. Refer to the Consolidated Statements of Cash Flows for a summary of the sources and uses of cash for March 31, 2004 and 2003.

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CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

Capital Resources

     The capital management function is a continuous process which consists of providing capital for both the current financial position and the anticipated future growth of the Company. Central to this process is internal equity generation, particularly through earnings retention. Internal capital generation is measured as the annualized rate of return on equity, exclusive of any appreciation or depreciation relating to available for sale securities, multiplied by the percentage of earnings retained. Internally generated capital retained by the Company measured 2.2% for the three months ended March 31, 2004 and 4.7% for the three months ended March 31, 2003. Overall capital (a figure which reflects earnings, dividends paid, common stock issued, treasury shares purchased, treasury shares reissued and the net change in the estimated fair value of available for sale securities) increased at an annual rate of 1.0%. Capital ratios remained well in excess of regulatory minimums.

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

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

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

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CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

     The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) required banking regulatory agencies to revise risk-based capital standards to ensure that they adequately account for the following additional risks: interest rate, concentration of credit, and non traditional activities. Accordingly, regulators will subjectively consider an institution’s exposure to declines in the economic value of its capital due to changes in interest rates in evaluating capital adequacy. The table below illustrates the Company’s risk weighted capital ratios at March 31, 2004 and December 31, 2003.

(*) Includes off-balance sheet exposures.

     Assets, less intangibles and the net unrealized market value adjustment of investment securities available for sale, averaged $435,310 for the three months ended March 31, 2004 and $433,513 for the year ended December 31, 2003.

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CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

First Three Months of 2004 as Compared to First Three Months of 2003

     During the first three months of 2004, net interest income after provision for loan losses decreased by $267 compared to the first three months of 2003. Total interest income decreased by $398 or 6.7%, from the level recorded in 2003. This was accompanied by a decrease in interest expense of $131 or 6.2%, with no change in the provision for loan losses.

     The average rate paid on interest sensitive liabilities decreased by 24 basis points year-over-year. The average balance of interest sensitive liabilities increased by $6,623 or 2.1%. Compared to the first three months of last year, average borrowings increased by $3,033 while the average rate paid on borrowings decreased by 57 basis points. Average interest bearing demand deposits decreased by $903, while savings and money market accounts decreased by $4,125. The average rate paid on these products decreased by 22 basis points in the aggregate. The average balance on time deposit products increased by $8,618 as the average rate paid decreased by 33 basis points, from 3.77% to 3.44%.

     Interest and dividend income on securities registered a decrease of $15, or 0.6%, during the first three months of 2004 when compared to 2003, while on a fully tax equivalent basis income on investment securities decreased by $30, or 1.1 %. The average invested balances increased by $23,383 from the levels of a year ago. The increase in the average balance of investment securities was accompanied by a 67 basis point decline in the tax equivalent yield of the portfolio.

     Interest and fees on loans decreased by $321, or 9.5%, for the first three months of 2004 compared to 2003. A $1,632 decrease in the average balance of the loan portfolio, or 0.8%, was accompanied by a 68 basis point decline in the portfolio’s tax equivalent yield.

     Interest on trading account securities measured $13 at March 31, 2003. There was no trading account activity in the first three months of 2004. Other interest income decreased by $49 from the same period a year ago. The average balance of Federal Funds sold and other money market funds decreased by $16,187 or 89.7%. The yield on federal funds decreased by 23 basis points compared to 2003.

     The composite tax equivalent yield on earning assets decreased by 51 basis points from the same quarter a year ago. The tax equivalent yield of the investment portfolio and the trading account measured 5.1 %, a 67 basis point decrease from the same quarter a year ago, while the loan portfolio yielded 6.5 %, down 68 basis points from last year’s rate. Meanwhile, the rate paid on interest-bearing liabilities decreased 24 basis points compared to a year ago. The net effect of these changes was that the tax equivalent net interest margin decreased to 3.8%, a decrease of 33 basis points from that achieved during last year’s first quarter.

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CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

     Other income from all sources decreased by $152 from the same period a year ago. Gains on 1-4 residential mortgage loans sold in the secondary mortgage market decreased by $125 from the same period a year ago. Gains on securities called and net gains on the sale of available for sale investment securities decreased by $36 from year ago levels. Gains on trading account securities in 2003 were $120 with no activity recorded in 2004. Fees for other customer services increased by $197, primarily due to the introduction of a new deposit product first offered to customers late in the third quarter of 2003. In the first quarter of 2004, losses on other real estate owned of $116 were recorded with none in the same quarter of 2003. Other sources of non-recurring non-interest income increased by $48 from the same period a year ago. This income category is subject to fluctuation due to nonrecurring items.

     Loans net of the allowance for losses increased by $3,421 during the 12-month period from March 31, 2003 to March 31, 2004, and by $6,693 from year-end. This result reflects the effect of a $6.0 million dollar purchase of residential mortgage loans in the first quarter of 2004. Gross loans as a percentage of earning assets stood at 47.8% as of March 31, 2004 as compared to 46.9% at March 31, 2003. The loan to deposit ratio at the end of the first three months of 2004 was 58.3% compared to 57.8% at the end of the same period a year ago. The investment portfolio represented 62.5% of each deposit dollar, up from 60.4% a year ago.

     Loan charge-offs during the first three months were $44 in 2004 in contrast to $156 in 2003, while the recovery of previously charged-off loans amounted to $20 in 2004 compared to $29 in 2003. The higher level of charge-offs during 2003 primarily reflects an impaired commercial loan credit for which a specific loss reserve had previously been established. A provision for loan loss of $75 was charged to operations in both 2004 and 2003. Non-accrual loans at March 31, 2004 represented 1.0% of the loan portfolio compared to 1.1% at December 31, 2003 and 0.6% a year ago. At March 31, 2004, the loan loss allowance of $2,459 represented 1.3% of outstanding loans.

     Total other expenses in the first three months were $2,957 in 2004 compared to $2,894 in 2003, an increase of $63, or 2.2%. Full time equivalent employment during the first three months averaged 165 employees in 2004, a 2.4% decrease from the 169 employed in the same period of 2003. Salaries and benefits decreased by $14, or 0.8%, compared to the similar period a year ago.

     For the first three months of 2004, state and local taxes increased by $16 or 12.1%. Occupancy and equipment expense decreased by $20, or 4.1%. Office supplies increased by $17, due mainly to increased postage & supply costs. Marketing expense also increased by $17. All other expense categories increased by 9.8%, or $47 as a group.

     Income before income tax expense amounted to $1,360 for the first three months of 2004 compared to $1,842 for the similar period of 2003. The effective tax rate for the first three months was 16.1% in 2004 compared to 20.6% in 2003, resulting in income tax expense of $219 and $380, respectively. The decline in the effective tax rate reflects a decline in taxable income, while income exempt from taxation from all sources remained little changed. The provision for income taxes differs from the amount of income tax determined applying the applicable U.S. statutory federal income tax rate to pre-tax income as a result of the following differences:

     Net income for the first three months registered $1,141 in 2004 compared to $1,462 in 2003, representing per share amounts of $0.28 in 2004 and $0.36 in 2003. Dividends declared per share were $0.22 in 2004 and $0.21 in 2003.

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CORTLAND BANCORP AND SUBSIDIARIES

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

(Dollars in thousands)

Regulatory Matters

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

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

New Accounting Standards

     On March 9, 2004, the SEC staff released Staff Accounting Bulletin No. 105 – Application of Accounting Principles to Loan Commitments. This bulletin requires all registrants to account for mortgage loan interest rate lock commitments related to loans held for sale as written options, effective no later than for commitments entered into after March 31, 2004. This guidance requires the Company to recognize a liability on its balance sheet equal to fair value of the commitment at the time the loan commitment is issued. As a result, this guidance delays the recognition of any revenue related to these commitments until such time as the loan is sold. However, the new accounting standard has no effect on the ultimate amount of revenue or the cash flows recognized over time. The adoption of this guidance is not expected to have a material impact on the Company’s financial position or results of operation.

Available Information

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

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CORTLAND BANCORP AND SUBSIDIARIES

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

(Dollars in thousands)

     Management considers interest rate risk to be the Company’s principal source of market risk. Interest rate risk is measured as the impact of interest rate changes on the Company’s net interest income. Components of interest rate risk comprise repricing risk, basis risk and yield curve risk. Repricing 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. Toward this end, management uses computer simulation to model the Company’s financial performance under varying interest rate scenarios. These scenarios may reflect changes in the level of interest rates, changes in the shape of the yield curve, and changes in interest rate relationships. The Company has recently upgraded its simulation model to provide increased operating efficiency and to enable more effective risk measurement and balance sheet management. The new model enables management to better evaluate the impact of individual strategies and transactions, the effects of changing conditions such as prepayment speeds, and provides greater flexibility in modeling management’s response to changing conditions.

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

     The most significant assumptions used in the simulation relate to the cash flows and repricing characteristics of the Company’s balance sheet. Repricing and runoff rate assumptions are based upon specific product parameters modified by historical trends and internal projections. These assumptions are based upon specific product parameters modified by historical trends and internal projections. These assumptions are periodically reviewed and benchmarked against historical results. Actual results may differ from simulated results not only due to the timing, magnitude and frequency of interest rate changes, but also due to changes in general economic conditions, changes in customer preferences and behavior, and changes in strategies by both existing and potential competitors.

     The table on the following page shows the Company’s current estimate of interest rate sensitivity based on the composition of the balance sheet at March 31, 2004 and December 31, 2003. Simulated results are based on the Company’s new simulation model for both periods. For purposes of this analysis, short term interest rates as measured by the federal funds rate and the prime

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CORTLAND BANCORP AND SUBSIDIARIES

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

(CONTINUED)

(Dollars in thousands)

lending rate are assumed to increase (decrease) gradually over the subsequent twelve months reaching a level 300 basis points higher (lower) than the rates in effect at March 31, 2004. Under both the rising rate scenario and the falling rate scenario, the yield curve is assumed to exhibit a parallel shift.

     Over the past twelve months, the Federal Reserve has decreased its target rate for overnight federal funds by 25 basis points. At March 31, 2004, the difference between the yield on the ten-year Treasury and the three-month Treasury had decreased to a positive 291 basis points from the positive 332 basis points that existed at December 31, 2003. The change denotes a “flattening” of the yield curve. The yield curve, however, remains positively sloping, as interest rates increase with a lengthening of maturities, with rates peaking at the long-end of the Treasury curve.

     The base case against which interest rate sensitivity is measured assumes no change in short term rates. The base case also assumes no growth in assets and liabilities and no change in asset or liability mix. Under these simulated conditions the base case projects net interest income of $15,403 for the twelve month period ending March 31, 2005.

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

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

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

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CORTLAND BANCORP AND SUBSIDIARIES

ITEM 4. CONTROLS AND PROCEDURES

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

     In addition, there were no significant changes during the period covered by this report in the Company’s internal control over financial reporting (as defined in Rules 13a-15 and 15d-15 of the Exchange Act) that have materially affected, or are reasonably likely to materially affect, internal control over financial reporting.

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CORTLAND BANCORP AND SUBSIDIARIES

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

     See Note (5) of the financial statements.

Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

Company’s Common Stock. The following table shows information relating to the repurchase of shares of its common stock during the three months ended March 31, 2004:

   *The “2003” Program expired on February 6, 2004. See Note 7.

Item 3. Defaults upon Senior Securities

     Not applicable

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

     Not applicable

Item 5. Other Information

     Not applicable

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CORTLAND BANCORP AND SUBSIDIARIES

PART II – OTHER INFORMATION (CONTINUED)

Item 6. Exhibits and Reports on Form 8-K

     (a) Exhibits

     (b) Reports on Form 8-K

          Form 8-K was filed with the United States Securities and -Exchange Commission, dated February 10, 2004. The 8-K applied to Item 12 – Results of Operations and Financial Condition, per the 8-K instructions, and announced fourth quarter and year-end results for the year ended December 31, 2003.

          Additionally, a form 8-K was filed with the United States Securities and Exchange Commission, dated February 25, 2004. The 8-K applied to Item 9 – Regulation FD Disclosure, per the 8-K instructions, and announced the Board appointment of Neil J. Kaback and the declaration of a $0.22 per share dividend payable on April 1, 2004.

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SIGNATURES

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

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