2. Earnings Per Share

Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations

The review that follows focuses on the significant factors affecting the financial condition and results of operations of the Corporation during the three and six-month periods ended June 30, 2007, with comparisons to the comparable periods in 2006, as applicable. The following discussion and the unaudited consolidated interim financial statements and related notes included in this report, should be read in conjunction with our 2006 Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 15, 2007. The results for the periods presented are not necessarily indicative of results to be expected for the entire fiscal year or any other interim period.

Forward-looking Statements

This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The Corporation intends its forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forward-looking statements. These statements can sometimes be identified by the Corporation's use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing our growth, competition, changes in the regulatory environment, and changes in general business and economic trends.

Critical Accounting Policies, Estimates and Risks and Uncertainties

Critical accounting policies include the areas where the Corporation has made what it considers to be particularly difficult, subjective or complex judgments in making estimates, and where these estimates can significantly affect the Corporation's financial results under different assumptions and conditions. The Corporation prepares its financial statements in conformity with accounting principles generally accepted in the United States of America. As a result, the Corporation is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statement and the reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates.

Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the inherent uncertainty in evaluating the level of the allowance required to cover probable credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions, the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses.

Consolidated assets at June 30, 2007 totaled $781.3 million, an increase of $42.3 million or 5.7% since December 31, 2006. As discussed in greater detail below, this increase is reflected primarily in a $51.8 million increase in loans, net of deferred fees and costs and unearned income, and a $5.0 million increase in intangible assets, net, offset principally by a $15.4 million decrease in investment securities.

As noted above, total loans, net of deferred fees and costs and unearned income increased $51.8 million or 10.8% from December 31, 2006 to June 30, 2007. Growth was exhibited in all segments of the loan portfolio, with total consumer loans increasing $24.3 million, residential mortgages increasing $16.3 million and commercial loans (including commercial mortgages) increasing $11.2 million. The increase in consumer loans was principally due to a $24.4 million increase in installment loans, due in large part to a significant increase in indirect auto financing originations during the second quarter of this year, driven primarily by pricing. Activity in both residential mortgages and commercial loans has been strong throughout the first half of the year, impacted in part by the Corporation's expansion into Tompkins County, with total residential mortgages and commercial loans in this market increasing $8.2 million and $7.8 million, respectively.

The composition of the loan portfolio is summarized as follows:

The available for sale segment of the securities portfolio totaled $169.9 million at June 30, 2007, down approximately $15.0 million or 8.1% from December 31, 2006. At amortized cost, the available for sale portfolio was down approximately $15.8 million, with unrealized appreciation related to the available for sale portfolio increasing $888 thousand. The decrease in this portfolio was principally due to paydowns on mortgage-backed securities totaling $7.5 million, maturities and calls of corporate bonds totaling $4.8 million, and maturities and principal reductions of municipal bonds totaling $3.7 million. Proceeds from the above were used to support the loan growth during the first six months of this year. The held to maturity portion of the portfolio, consisting primarily of local municipal obligations, was down approximately $405 thousand from $6.9 million at December 31, 2006 to $6.5 million at June 30, 2007.

A $5.0 million net increase in intangibles is due to the Corporation's acquisition on May 3, 2007 of the trust business of Partners Trust Financial Group, Inc. ("Partners Trust") at a purchase price of approximately $5.2 million or 1.49% of the fair value of the business acquired, which is being amortized over a 15 year period. At that time, the Corporation acquired $351 million of trust assets under administration at fair value.

A $1.3 million increase in Federal Home Loan Bank and Federal Reserve Bank stock is due primarily to an increase in the Corporation's ownership of Federal Home Loan Bank of New York ("FHLB") stock, which is reflective of the increase in FHLB borrowings since the end of 2006.

Since December 31, 2006, total deposits have increased $12.0 million or 2.1% from $585.1 million to $597.1 million. Non-interest bearing demand deposits increased $3.7 million due to an increase in period-end personal account balances. An $8.3 million increase in interest bearing balances was reflected primarily in a $15.8 million increase in time deposits, due in large part to an increase in municipal time deposits, offset in part by lower personal investment certificate balances. The increase in time deposits was offset to some extent by an $8.7 million decrease in insured money market accounts due to lower period-end non-personal account balances.

With loan growth during the first six months of this year exceeding funding provided through the increase in deposits and the reduction in the securities portfolio, short term borrowings under our line of credit with the FHLB have increased $27.9 million from $7.9 million at December 31, 2006 to $35.8 million at June 30, 2007.

Asset Quality

Non-performing loans at June 30, 2007 totaled $2.833 million as compared to $3.610 million at December 31, 2006, a decrease of $777 thousand, reflected primarily in a $691 thousand decrease in non-accrual loans. During the first six months of 2007, five commercial loans with outstanding balances at June 30, 2007 totaling $301 thousand were placed in non-accrual status, offset primarily by the upgrade of two commercial relationships totaling $357 thousand from non-accrual to accruing status, as well as principal reductions on other non-accruing commercial loans totaling $505 thousand and a $144 thousand decrease in non-accruing mortgages. A $70 thousand decrease in accruing loans 90 days or more past due is primarily due to lower period-end mortgage and consumer loan delinquencies. Other Real Estate Owned has decreased $1.715 million since December 31, 2006, primarily due to the sale of two commercial properties during the first six months of this year.

In addition to non-performing loans, as of June 30, 2007, the Corporation has identified 15 commercial loan relationships totaling $11.9 million in potential problem loans, as compared to $12.0 million (15 commercial loan relationships) at December 31, 2006. Potential problem loans are loans that are currently performing, but where known information about possible credit problems of the related borrowers causes management to have serious doubts as to the ability of such borrowers to comply with the present loan repayment terms, and which may result in the disclosure of such loans as non-performing at some time in the future. At the Corporation, potential problem loans are typically loans that are performing but are classified in the Corporation's loan rating system as "substandard". Management cannot predict the extent to which any factors may impact borrowers and the potential problem loans. Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on non-accrual, become restructured, or require increased allowance coverage and provisions for loan losses.

Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the historical loan loss experience, review of specific problem loans (including evaluation of the underlying collateral), changes in the composition and volume of the loan portfolio, recent charge-off experience, overall portfolio quality, and current economic conditions that may affect the borrowers' ability to pay. While the level of non-performing loans has continued to decline, during the second quarter of this year, the Corporation charged off a commercial loan against the allowance for loan losses for which no previous allocation to the allowance had been made. This was the principal factor in the $475 thousand increase in both the second quarter and year-to-date provision when compared to the corresponding periods in 2006. At June 30, 2007, the Corporation's allowance for loan losses totaled $8.031 million, resulting in a coverage ratio of allowance to non-performing loans of 283.5%. The allowance for loan losses is an amount that management believes will be adequate to absorb probable loan losses on existing loans. Net loan charge-offs for the first six months of 2007 totaled $552 thousand as compared to $639 thousand during the first six months of 2006, this decrease primarily due to decreases in net commercial loan and consumer loan charge-offs of $63 thousand and $37 thousand, respectively. The improvement in net commercial loan charge-offs was principally the result of payments totaling $162 thousand related to the balance of a commercial loan that had been charged off during 2006. The allowance for loan losses to total loans at June 30, 2007 was 1.52% as compared to 1.67% as of December 31, 2006.

Activity in the allowance for loan losses was as follows:

Net income for the second quarter of 2007 totaled $1.818 million, an increase of $21 thousand or 1.2% as compared to second quarter 2006 net income of $1.797 million. Earnings per share increased 4.1% from $0.49 per share to $0.51 per share on 58,461 fewer average shares outstanding. This improvement in second quarter net income resulted principally from increases in net interest income and non-interest income, partially offset by increases in the provision for loan losses and operating expenses, as well as a higher effective tax rate.

Net interest income increased $302 thousand or 5.0% from $6.094 million during the second quarter of 2006 to $6.396 million during the second quarter of 2007, with the net interest margin increasing 3 basis points from 3.66% to 3.69%. This improvement resulted from a $28.7 million or 4.3% increase in average earning assets, and a 34 basis point increase in average yield as compared to the second quarter of 2006, offset to some extent by a 38 basis point increase in the average cost of interest bearing liabilities. The increase in average earning assets was due to a $70.2 million or 15.8% increase in average loans, offset primarily by a $39.2 million or 17.9% decrease in the average securities portfolio. The increase in average loans is reflective of growth in all segments of the loan portfolio, with average mortgages increasing $37.7 million, average consumer loans increasing $29.2 million and average commercial loans increasing $3.3 million. As loans have grown, principal reductions in the securities portfolio have been reinvested in these higher yielding loans, a significant factor in the decrease in the average securities portfolio. The growth in average earning assets, coupled with the increase in average yield, resulted in a $1.007 million or 10.3% increase in total interest income from $9.813 million in the second quarter of 2006 to $10.820 million in the second quarter of this year.

Total average funding liabilities, including non-interest bearing demand deposits, increased $40.6 million or 6.4% compared to second quarter 2006 averages, due primarily to a $25.6 million increase in average deposits and a $14.3 million increase in total average borrowings and securities sold under agreements to repurchase funded by the FHLB. Average non-interest bearing demand deposits increased $12.8 million, with average interest bearing deposits also up $12.8 million. The increase in average interest bearing deposits was reflected primarily in higher average time deposits and insured money market deposits of $13.9 million and $4.8 million, respectively, somewhat offset primarily by a $5.7 million decrease in average savings account balances. The increase in average borrowings and securities sold under agreements to repurchase with the FHLB was directly impacted by funding requirements to support the aforementioned increase in average loans. While average interest bearing liabilities increased $27.8 million or 5.6%, interest expense increased $705 thousand or 19.0%, as the average cost of interest bearing liabilities rose 38 basis points from 3.01% to 3.39%.

As discussed more fully under the Asset Quality section of this report, the $475 thousand increase in the provision for loan losses reflects managements evaluation of the adequacy of the allowance for loan losses based upon a number of factors including an analysis of historical loss factors, the evaluation of collateral, recent charge-off experience, overall credit quality and loan growth.

Non-interest income during the second quarter of 2007 compared to the second quarter of 2006 increased $550 thousand or 14.8%. Major factors in this increase include a $298 thousand increase in Trust and Investment Center fee income, impacted to a great degree by the acquisition in May of this year of the trust department business of Partners Trust, and a $193 thousand gain recognized on the sale of a commercial property held in Other Real Estate Owned ("OREO") that had previously been acquired through foreclosure proceedings. Additionally, during the second quarter of this year, we accelerated charitable donations to non-profit organizations that we fund through the donation of appreciated stock, resulting in a $63 thousand increase in non-taxable gains associated with these donations. Management's decision to accelerate these donations was based upon an increase in the market value of SLM Corporation ("SLM") stock following the announcement early in the second quarter of the proposed sale of SLM to an investment group for $60.00 per share. Following that announcement, the market value per share of SLM rose from the mid $40 range to the mid $50 range, thereby making it advantageous to the Corporation to accelerate these donations at that time. Other significant factors included a $60 thousand increase in service charges, due primarily to an increase in fee income related to checks presented against insufficient funds, as well as increases in check card interchange fee income and credit card merchant earnings of $38 thousand and $33 thousand respectively. These increases were somewhat offset primarily by a $162 thousand decrease in revenue from the Corporation's equity investment in Cephas Capital Partners, LP ("Cephas") and a $51 thousand decrease in revenue from OREO properties. The decrease in revenue from Cephas was due primarily to a decrease in realized gains on the sale of equity positions taken in companies to which Cephas had provided financing.

Second quarter 2007 operating expenses were $277 thousand or 3.8% higher than the comparable period last year. Areas having the greatest impact on this increase include a $401 thousand increase in salaries and wages, an $82 thousand increase in net occupancy costs, a $63 thousand loss on the disposal of fixed assets, a $63 thousand increase in donation expense and a $59 thousand increase in amortization of intangible assets. The increase in salaries and wages reflects higher base pay related to additions to staff during the second half of 2006, as well as the addition of former Partners Trust employees in May of this year, merit increases effective in January of this year and an increase in incentive compensation. The net occupancy expense increase includes higher depreciation expense, real estate taxes, rent expense and buildings and grounds maintenance costs. The loss on the disposal of fixed assets resulted from the write-off of the remaining book balance of a reader-sorter that was no longer being utilized following our conversion to electronic branch capture for daily processing. The $63 thousand increase in donation expense is directly related to the above mentioned acceleration of donations of appreciated stock, with the $59 thousand increase in amortization expense related to the amortization of the purchased intangible associated with the acquisition of the trust department business of Partners Trust. The above mentioned increases were offset to some extent primarily by a $225 thousand decrease in costs associated with OREO and a $185 thousand decrease in pension and other employee benefits. The decrease in OREO costs was due to the sale during the first quarter of a commercial property that had previously been acquired through foreclosure proceedings, while the decrease in the cost of employee benefits is primarily due to lower pension expense accruals resulting from an increase in the expected return on plan assets associated with the Corporation's $10 million contribution to this plan in the fourth quarter of 2006.

A $79 thousand increase in income tax expense reflects an increase in income subject to federal and state income taxes as well as a reduction in the future tax benefit associated with deferred tax assets related to the decrease in the statutory New York State tax rate from 7.5% to 7.1%, resulting in an effective tax rate of 30.4% for the second quarter of this year compared to 28.4% for the second quarter of 2006.

Net income for the six-month period ended June 30, 2007 totaled $3.518 million, an increase of 3.7% as compared to net income of $3.393 million for the six-month period ended June 30, 2006. Earnings per share were up 5.4% from $0.93 per share to $0.98 per share on 58,231 fewer average shares outstanding. Similar to second quarter results, this increase in year-to-date income resulted primarily from increases in net interest income and non-interest income, partially offset by increases in the provision for loan losses and operating expenses, as well as a higher effective tax rate.

Net interest income increased $344 thousand or 2.8% from $12.171 million for the first six months of 2006 to $12.515 million for the six months ended June 30, 2007, with the net interest margin declining 2 basis points from 3.69% to 3.67%. The improvement in net interest income resulted from a $21.2 million or 3.2% increase in average earning assets, and a 40 basis point increase in average yield from 5.83% to 6.23%, offset by a 52 basis point increase in the average cost of interest bearing liabilities. The increase in average earning assets is due to a $64.7 million or 14.8% increase in average loans, offset primarily by a $43.4 million or 19.1% decrease in the average securities portfolio. As was the case in the second quarter, the increase in average loans reflects growth in all segments of the loan portfolio, with average mortgages increasing $37.2 million, average consumer loans increasing $21.0 million and average commercial loans up $6.5 million. The decrease in the average securities portfolio has been impacted by loan growth, with principal reductions in the securities portfolio being reinvested in higher yielding loans. The growth in average earning assets and yield resulted in a $1.967 million or 10.2% increase in total interest and dividend income from $19.247 million for the six months ended June 30, 2006 to $21.214 million for the six months ended June 30, 2007.

Total average funding liabilities, including non-interest bearing demand deposits increased $32.0 million or 5.1% when compared to the first six months of last year, the result of a $35.1 million increase in average deposits, offset primarily by lower total average borrowings and securities sold under agreements to repurchase funded through the FHLB. While average demand deposits increased $10.5 million, average interest bearing deposits increased $24.6 million. Similar to second quarter results, the increase in average interest bearing deposits was due to higher average time deposits and insured money market balances of $26.0 million and $6.7 million, respectively, offset primarily by a $7.0 million decrease in average savings balances. While average interest bearing liabilities increased $21.5 million or 4.4%, total interest expense increased $1.623 million or 22.9%, as the average cost of interest bearing liabilities increased 52 basis points to 3.40%.

A $475 thousand increase in the provision for loan losses is due to the increase during the second quarter of this year as noted above and discussed more fully under the "Asset Quality" section of this report.

Non-interest income for the first half of 2007 increased $1.111 million or 16.0% when compared to the comparable period in 2006. Similar to the second quarter results, a $653 thousand increase in gains on the sale of OREO, as well as a $312 thousand increase in Trust and Investment Center fee income, contributed significantly to this increase. The increase in gains on the sale of OREO resulted from the sale of two commercial properties during the first half of this year, while the increase in Trust and Investment Center fee income was due in large part to the purchase of the trust business from Partners Trust in May of this year. As was noted above, the acceleration of charitable donations funded with appreciated stock resulted in an increase of $69 thousand in non-taxable gains. Other areas impacting this increase included increases in credit card merchant earnings and check card interchange fee income of $65 thousand and $53 thousand, respectively. As was the case in the second quarter, and for reasons noted above, these increases were somewhat offset primarily by a $170 thousand decrease in revenue from the Corporation's equity investment in Cephas.

Operating expenses for the first six months of this year increased $696 thousand or 4.9% compared to the corresponding period in 2006. As was the case with the second quarter operating expense increase, and for reasons discussed above, areas impacting this increase include a $763 thousand increase in salaries and wages, a $155 thousand increase in net occupancy costs, a $68 thousand increase in donations expense, a $63 thousand loss on the disposal of fixed assets and a $59 thousand increase in amortization of intangible assets. These increases were somewhat offset by a $414 thousand decrease in pension and other employee benefits and a $154 thousand decrease in costs associated with OREO.

Income taxes for the first six months of 2007 were $160 thousand higher than last year, principally due to a higher level of taxable income and the aforementioned reduction in the future tax benefit associated with deferred tax assets due to the decrease in the statutory New York State tax rate, resulting in an increase in the effective tax rate from 28.5% in 2006 to 30.1% this year.