Management's discussion and analysis of the significant changes in the results of operations, capital resources and liquidity presented in the accompanying consolidated financial statements for Codorus Valley Bancorp, Inc., (Codorus Valley or the Corporation) a bank holding company, and its wholly owned subsidiary, PeoplesBank, A Codorus Valley Company, (PeoplesBank) are provided below. Codorus Valley's consolidated financial condition and results of operations consist almost entirely of PeoplesBank's financial condition and results of operations. Current performance does not guarantee and may not be indicative of similar performance in the future.

Forward-looking statements

Management of the Corporation has made forward-looking statements in this Annual Report. These forward-looking statements may be subject to risks and uncertainties. Forward-looking statements include information concerning possible or assumed future results of operations of the Corporation and its subsidiaries. When words such as "believes," "expects," "anticipates" or similar expressions occur in this Form 10-K, management is making forward-looking statements.

Shareholders should note that many factors, some of which are discussed elsewhere in this report and in the documents that are incorporated by reference, could affect the future financial results of the Corporation and its subsidiaries, both individually and collectively, and could cause those results to differ materially from those expressed in the forward-looking statements contained or incorporated by reference in this Annual Report. These factors include the following:

• operating, legal and regulatory risks;
• prolonged economic downturn;
• political and competitive forces affecting banking, securities, asset management and credit services businesses; and
• the risk that management's analyses of these risks and forces could be incorrect and/or that the strategies developed to address them could be unsuccessful.

The Corporation undertakes no obligation to publicly revise or update these forward-looking statements to reflect events or circumstances that arise after the date of this report. Readers should carefully review the risk factors described in other documents that Codorus Valley files periodically with the Securities and Exchange Commission.

Critical accounting estimates

Disclosure of Codorus Valley's significant accounting policies is included in Note 1 to the consolidated financial statements of this Annual Report. Some of these policies are particularly important, requiring significant judgments, estimates and assumptions. Additional information is contained in Management's Discussion and Analysis for the most important of these issues, including the provision and allowance for loan losses, located on pages 19 and 33 of this report.

Management makes significant estimates in determining the allowance for loan losses. Management considers a variety of factors in establishing this estimate such as current economic conditions, diversification of the loan portfolio, delinquency statistics, results of internal loan reviews, financial and managerial strength of borrowers, adequacy of collateral, if collateral dependent, or present value of future cash flows and other relevant factors. Estimates related to the value of collateral also have a significant impact on whether or not management continues to accrue income on delinquent loans and on the amounts at which foreclosed real estate is recorded on the statement of financial condition.

Declines in the fair value of available-for-sale and held-to-maturity securities below their cost that are deemed to be other-than-temporary are reflected in earnings as realized losses. In estimating other-than-temporary impairment losses, management considers: 1) the length of time and the extent to which the fair value has been less than cost, 2) the financial condition and near-term prospects of the issuer, and 3) the intent and ability of the Corporation to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

Management discussed the development and selection of critical accounting estimates and related Management Discussion and Analysis disclosure with the Audit Committee. There were no material changes made to the critical accounting estimates during the periods presented within this report.

OVERVIEW

Executive summary

Throughout 2008, management and the Board of Directors continued to implement a series of initiatives, as guided by the Corporation's long-range strategic plan. Selected accomplishments for 2008 included a continued focus on the planned expansion of the Corporation's banking franchise. In November 2008, PeoplesBank opened its 17th full-service financial center. Located in Bel Air, Maryland, this new office follows the Bank's earlier expansion during 2008 into the Hunt Valley, Maryland and Hanover, Pennsylvania markets. Coincident with physical expansion, the Corporation recruited several experienced business bankers, which enhanced its business banking reputation. Asset growth achieved a new record in 2008 as total assets increased $108 million or 18 percent above the level of year-end 2007. In light of strong balance sheet growth, which caused capital ratios to trend down, the Corporation applied for $16.5 million in capital under the U.S. Department of the Treasury's Capital Purchase Program (CPP). The $16.5 million capital request was approved by the Treasury in December 2008, and the Corporation received the funds in January 2009 as described in the Shareholders' Equity and Capital Adequacy section of this report. The CPP capital injection enables the Corporation to proceed on its planned growth path.

Earnings for the Corporation were negatively impacted by the economic forces that have affected the entire financial services industry. Net income for 2008 decreased 23 percent compared to 2007 (for comparative purposes, 2007 was reduced by the after-tax affect of a nonrecurring loan loss recovery in that year, which is described within the financial highlights section below), due to an increase in the provision for loan losses, net interest margin compression and increased operating expenses associated with franchise expansion. Accordingly, key financial ratios, such as return on average assets and return on average equity, also decreased, although Codorus Valley outperformed its peer group average for bank holding companies for the third Federal Reserve district for 2008. The Corporation has no direct loss exposure to subprime lending or investments collateralized by subprime mortgage collateral because it does not participate in the subprime lending market, nor does it invest in securities backed by subprime mortgages.

In the period ahead, management will remain focused on profitable balance sheet growth, acquiring and nurturing client relationships, risk management, and increasing noninterest income. Management expects the national and local economies to struggle throughout 2009 and possibly beyond. Risks and uncertainties include a deepened or prolonged weakness in economic and business conditions, which could increase credit-related losses, declines in the market value of investment securities considered to be other-than temporary, and continued downturn in the real estate markets.

Financial Highlights

The Corporation earned $4,465,000 or $1.13 per share ($1.12 diluted) for 2008, compared to $6,374,000 or $1.64 per share ($1.61 diluted) for 2007, and $5,322,000 or $1.38 per share ($1.35 diluted) for 2006. The $1,909,000 or 30 percent decrease in earnings for 2008 was primarily the result of a $2,424,000 pre-tax ($1,600,000 after-tax) increase in provision for loan losses. The current period provision was primarily increased to support strong loan growth in the Corporation's business loan portfolio and to account for increased risk associated with the ongoing economic recession. In contrast, during 2007 the Corporation recognized the positive financial impact of a one-time $839,000 pre-tax recovery ($554,000 after-tax) of loan losses that were incurred by PeoplesBank during 2002-2003. Due to the adequacy of the allowance for loan losses in 2007, the full amount of the recovery was recorded as a reduction to the loan loss provision at that time. On a comparable basis, net income for 2008 decreased $1,355,000 or 23 percent below 2007, as adjusted ($6,374,000 reported 2007 earnings less $554,000 for the after-tax effect of the loan loss recovery). Net income for the 2008 period was also constrained by net interest margin compression as yields on earning assets declined more rapidly than rates paid on deposits due in part to aggressive interest rate cuts by the Federal Reserve Bank to stimulate the struggling U.S. economy. Operating costs increased for the current period primarily as a result of corporate expansion and increased Federal Deposit Insurance Corporation deposit premiums. During 2008, PeoplesBank opened three full service financial centers. At year-end 2008, total assets were $703 million, an increase of approximately $108 million, or 18 percent, above year-end 2007. Asset growth occurred primarily in the business loan portfolio and secondarily in the home equity loan portfolio. Asset growth was funded by deposit growth, principally time deposits, and to a lesser degree overnight borrowings.

Comparatively, the Corporation earned $6,374,000 in 2007, a $1,052,000 or 20 percent increase above 2006. The increase was primarily attributable to a $2,438,000 or 13 percent increase in net interest income and a $1,204,000 decrease in loan loss provision, which more than offset a $2,478,000 or 16 percent increase in noninterest expense. The increase in net interest income reflected an increase in interest income from a larger volume of earning assets, principally business and home equity loans, and investment securities. The $720,000 or 57 percent increase in business loan fees for 2007 also contributed to the increase in net interest income. Approximately $612,000 ($403,000 after-tax) of the increase in fees came from selected business loan accounts, including a recovery of fees from a large delinquent account, which was unusually large as to amount. The net interest margin (tax equivalent basis), which was favorably impacted by the increase in loan fees, was 3.97 percent for 2007, the same as 2006. The significant decrease in the loan loss provision reflected the favorable impact of the onetime $839,000 ($554,000 after-tax) recovery of loan losses described earlier. The increase in noninterest expense was due in part to increased personnel costs, including staff additions associated with planned business growth, and increases in performance based compensation and benefits costs. The recognition of a $437,000 ($288,000 after-tax) prepayment penalty on the early pay off of a $5 million Federal Home Loan Bank advance also contributed to the increase in noninterest expense. The advance was due July 2014 and had an above market interest rate of 6.43 percent. The Corporation paid off the advance to reduce interest expense in future periods. At year-end 2007, total assets were $595 million, an increase of approximately $46 million, or 8 percent, above year-end 2006.

Annual cash dividends per share, as adjusted, totaled $.51 for 2008, compared to $.56 for 2007. A five percent stock dividend was distributed in both 2008 and 2007. Book value per share, as adjusted, was $12.99 for year-end 2008, compared to $12.33 for year-end 2007.

Net income as a percentage of average total assets (return on assets or ROA), was 0.71 percent for 2008, compared to 1.11 percent for 2007. Net income as a percentage of average shareholders' equity (return on equity or ROE), was 8.91 percent for 2008, compared to 13.91 percent for 2007. The efficiency ratio

(noninterest expense as a percentage of net interest income plus noninterest income on a tax equivalent basis) was 70.6 percent for 2008, compared to 67.4 percent for 2007.

At December 31, 2008, nonperforming assets as a percentage of total loans and net foreclosed real estate was 1.83 percent, compared to 2.25 percent at year-end 2007. Information regarding nonperforming assets is provided in the Risk Management section of this report, including Table 11-Nonperforming Assets. The allowance for loan losses as a percentage of total loans was .82 percent for year-end 2008 and .77 percent for year-end 2007. Information regarding the allowance is provided in the Risk Management section of this report, including Tables 12 - Analysis of Allowance for Loan Losses and 13 - Allocation of Allowance for Loan Losses. Through its evaluation of probable loan losses and the current loan portfolio, management believes that the allowance is adequate to support losses inherent in the portfolio at December 31, 2008.

Throughout 2008, the Corporation maintained a capital level above minimum regulatory quantitative requirements. Currently, there are three federal regulatory definitions of capital that take the form of minimum ratios. Table 10-Capital Ratios, shows that the Corporation and PeoplesBank were well capitalized on December 31, 2008.

A more detailed analysis of the factors and trends affecting earnings follows.

INCOME STATEMENT ANALYSIS

Net Interest Income

The Corporation's principal source of revenue is net interest income, which is the difference between interest income earned on loans and investment securities, and interest expense incurred on deposits and borrowed funds. Fluctuations in net interest income are caused by changes in interest rates, volumes and the composition or mix of interest rate sensitive assets and liabilities.

For analytical purposes, Tables 1, 2, and 3 are presented on a tax equivalent basis to make it easier to compare taxable and tax-exempt assets. Income from tax-exempt assets, primarily loans to or securities issued by state and local governments, is increased by the amount of federal income taxes which would have been incurred if the income was taxable at the rate of 34 percent. Unless otherwise noted, the discussion that follows is based on interest income and interest expense as reported in the consolidated statements of income, not on a tax equivalent basis.

Net interest income for 2008 was $20,923,000, an increase of $243,000 or 1 percent above 2007. The increase was primarily the result of an increase in the volume of earnings assets. The net interest margin, on a tax equivalent basis, was 3.68 percent, compared to 3.97 percent for 2007. Net interest margin is net interest income (tax equivalent basis) as a percentage of average earning assets.

For 2008, total interest income decreased $2,437,000 or 6 percent compared to 2007 due primarily to a decrease in market interest rates. Earning assets averaged $587 million and yielded 6.38 percent (tax equivalent basis) for 2008, compared to $537 million and 7.42 percent, respectively, for 2007. The $50 million or 9 percent increase in the average balance of earning assets was primarily the result of growth in the business and home equity loan portfolios. During 2008, yields on earnings assets, particularly loan yields indexed to WSJ Prime and LIBOR rates, declined to a greater degree than rates paid on deposits. The decrease in the WSJ Prime reflected aggressive interest rate cuts by the Federal Reserve Bank as one of its many tactics to stimulate the U.S. economy out of the current recession. The sharp decrease in LIBOR rates reflected the global economic crises, including dysfunctional credit markets. The current period yield on earning assets was also affected by a $992,000 decrease in loan fees compared to 2007. Prior year loan fees were unusually high due to the inclusion of approximately $612,000 in loan fees

from selected business loan accounts, including a recovery of fees from a large delinquent account. For 2008, interest income from investment securities decreased $312,000 or 8 percent due primarily to a $4 million decrease in the average balance of the portfolio as management deployed investable funds to higher yielding loan portfolios.

For 2008, total interest expense decreased $2,680,000 or 14 percent compared to 2007 due primarily to a decrease in market interest rates, which lowered the weighted average rate paid on deposits and borrowings. Total interest bearing liabilities averaged $528 million at an average rate of 2.99 percent for 2008, compared to $481 million and 3.84 percent, respectively, for 2007. The $47 million or 10 percent increase in the average volume of interest bearing liabilities occurred primarily in short-term fixed rate CDs. Current period deposit growth was attributable to rate promotions, the addition of three financial centers and continued volatility within the capital markets. During 2008 customers replaced floating rate money market and time deposits with higher yielding fixed rate time deposits to increase their return. In spite of decreasing short-term market interest rates during 2008, short-term CD rates remained relatively high as a result of competitive pricing pressures. Interest expense on long-term debt decreased $700,000 or 34 percent from the prior year due to a decrease in volume, which resulted from a scheduled maturity in 2007 that was not refinanced and the pay-off of two borrowings that totaled $6.5 million prior to maturity that also occurred in 2007.

Comparatively, net interest income for 2007 was $20,680,000, an increase of $2,438,000 or 13 percent above 2006. The increase was primarily the result of an increase in the volume of earning assets. Earning assets averaged $537 million and yielded 7.42 percent (tax equivalent basis) for 2007, compared to $471 million and a yield of 7.17 percent, respectively, for 2006. The $66 million or 14 percent increase in earning assets was the result of growth in business and home equity loans, investment securities and overnight investment in federal funds sold. The $720,000 or 57 percent increase in business loan fees for 2007 contributed to the increase in the yield on average assets. Approximately $612,000 of the increase in fees was from selected business loan accounts, including a recovery of fees from a delinquent account that was unusually large as to amount. Interest bearing liabilities averaged $481million at an average rate of 3.84 percent for 2007, compared to $418 million and 3.60 percent, respectively, for 2006. The $63 million or 15 percent increase in the average volume of interest bearing liabilities occurred primarily in short-term fixed rate CDs and money market deposits. Current period deposit growth was primarily attributable to rate promotions. Consumer perceptions regarding the greater volatility of capital markets was also a likely contributing factor to overall deposit growth. The cost of servicing long-term corporate debt declined 5 percent in 2007, compared to the preceding year due to a decrease in volume. The Corporation paid off approximately $6.5 million in above-market rate corporate debt in 2007; however, the effect of this reduction in debt was offset by the full years' impact of adding $7 million in trust preferred debt in June 2006 as a capital strategy to support planned balance sheet growth. The net interest margin, on a tax equivalent basis, was 3.97 percent for both 2007 and 2006. Excluding the impact of the aforementioned nonrecurring business loan fees, the margin for 2007 would have been 3.86 percent.

Table 1-Net Interest Income (tax equivalent basis)


                                                                                                  5 Year
(dollars in thousands)           2008         2007         2006         2005         2004         CAGR*

Total interest income          $  36,732    $  39,169    $  33,319    $  25,572    $  20,469       13.0 %
Tax equivalent adjustment            679          634          482          257          231        n/a
Adjusted total interest
income                            37,411       39,803       33,801       25,829       20,700       13.1 %
Total interest expense            15,809       18,489       15,077        9,149        6,545      -18.0 %
Net interest income            $  21,602    $  21,314    $  18,724    $  16,680    $  14,155       10.2 %


Average earning assets         $ 586,837    $ 536,612    $ 471,251    $ 400,632    $ 353,390       12.7 %

Average interest bearing
liabilities                    $ 528,196    $ 481,245    $ 418,353    $ 351,949    $ 314,398       12.7 %

Yield on earning assets             6.38 %       7.42 %       7.17 %       6.45 %       5.86 %
Rate on interest bearing
liabilities                         2.99 %       3.84 %       3.60 %       2.60 %       2.08 %
Interest rate spread                3.39 %       3.58 %       3.57 %       3.85 %       3.78 %
Net interest margin                 3.68 %       3.97 %       3.97 %       4.16 %       4.01 %

* Compound annual growth rate (CAGR) is the average annual rate of growth over the five-year period beginning in 2003.

Table 2-Rate/Volume Analysis of Changes in Net Interest Income (tax equivalent basis)

                                       Year ended                2008 compared to 2007
                                      December 31,          Increase
(dollars in thousands)              2008        2007       (Decrease)      Volume       Rate

Interest Income
Interest bearing deposits with
banks                             $      3    $      8    $         (5 )  $      2    $     (7 )
Federal funds sold                     331       1,149            (818 )      (537 )      (281 )
Investment securities
Taxable                              2,431       2,799            (368 )      (296 )       (72 )
Tax-exempt                           1,833       1,733             100         115         (15 )
Loans
Taxable                             32,469      33,764          (1,295 )     5,136      (6,431 )
Tax-exempt                             344         350              (6 )        (6 )         -
Total interest income               37,411      39,803          (2,392 )     4,414      (6,806 )
Interest Expense
Interest bearing deposits
NOW, money market                    2,177       6,054          (3,877 )      (816 )    (3,061 )
Savings                                119         111               8           8          (1 )
Time deposits less than
$100,000                             7,056       7,083             (27 )     1,197      (1,224 )
Time deposits $100,000 or more       5,002       3,169           1,833       2,377        (544 )
Short-term borrowings                   83           -              83           -          83
Long-term debt                       1,372       2,072            (700 )      (502 )      (197 )
Total interest expense              15,809      18,489          (2,680 )     2,264      (4,944 )
Net interest income               $ 21,602    $ 21,314    $        288    $  2,150    $ (1,862 )




                                           Year ended             2007 compared to 2006
                                          December 31,         Increase
(dollars in thousands)                   2007       2006      (Decrease)    Volume     Rate

Interest Income
Interest bearing deposits with banks   $      8   $     10   $         (2 ) $    (2 ) $     -
Federal funds sold                        1,149        520            629       657       (27 )
Investment securities
Taxable                                   2,799      2,699            100       (96 )     196
Tax-exempt                                1,733      1,105            628       777      (149 )
Loans
Taxable                                  33,764     29,156          4,608     3,162     1,446
Tax-exempt                                  350        311             39        67       (28 )
Total interest income                    39,803     33,801          6,002     4,565     1,438
Interest Expense
Interest bearing deposits
NOW, money market                         6,054      4,829          1,225       740       485
Savings                                     111        116             (5 )      (5 )       -
Time deposits less than $100,000          7,083      5,746          1,337       964       373
Time deposits $100,000 or more            3,169      2,075          1,094       918       176
Short-term borrowings                         -        133           (133 )    (133 )       -
Long-term debt                            2,072      2,178           (106 )    (147 )      41
Total interest expense                   18,489     15,077          3,412     2,337     1,075
Net interest income                    $ 21,314   $ 18,724   $      2,590   $ 2,228   $   363

Changes which are due to both volume and rate are allocated in proportion to their relationship to the amount of change attributed directly to volume or rate. Taxable loans include net loan fees of $981,000 in 2008, $1,973,000 in 2007, and $1,253,000 in 2006.

Table 3-Average Balances and Interest Rates (tax equivalent basis)


                                      2008                               2007                             2006
(dollars in              Average                             Average                          Average
thousands)               Balance     Interest      Rate      Balance    Interest     Rate     Balance    Interest     Rate

Assets
Interest bearing
deposits with banks     $     170    $       3      1.82 %  $     133   $       8     5.71 % $     171   $      10     5.85 %
Federal funds sold         12,049          331      2.75       22,622       1,149     5.08       9,992         520     5.20
Investment
securities
Taxable                    48,351        2,431      5.03       54,066       2,799     5.18      56,061       2,699     4.81
Tax-exempt                 31,644        1,833      5.79       29,669       1,733     5.84      17,420       1,105     6.34
Total investment
securities                 79,995        4,264      5.33       83,735       4,532     5.41      73,481       3,804     5.18

Loans
Taxable (1)               489,237       32,469      6.64      424,645      33,764     7.95     383,098      29,156     7.61
Tax-exempt                  5,386          344      6.39        5,477         350     6.39       4,509         311     6.90
Total loans               494,623       32,813      6.63      430,122      34,114     7.93     387,607      29,467     7.60
Total earning assets      586,837       37,411      6.38      536,612      39,803     7.42     471,251      33,801     7.17
Other assets (2)           44,339                              38,873                           36,575
Total assets            $ 631,176                           $ 575,485                        $ 507,826

Liabilities and
Shareholders' Equity
Interest bearing
deposits
NOW, money market         171,329        2,177      1.27 %    198,008       6,054     3.06 %   171,693       4,829     2.81 %
Savings                    19,986          119      0.59       18,657         111     0.60      19,428         116     0.60
Time deposits less
than $100,000             185,624        7,056      3.80      158,789       7,083     4.46     135,968       5,746     4.23
. . .