2. Earnings Per Share

10. Subsequent Event

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

The discussion that follows focuses on the significant factors affecting the financial condition and results of operations of the Corporation during the three and nine-month periods ended September 30, 2006, with comparisons to the comparable periods in 2005, 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 2005 Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission on March 15, 2006. 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.

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 September 30, 2006 totaled $732.1 million, an increase of $14.0 million or 2.0% since December 31, 2005. As discussed in greater detail below, this increase is reflected primarily in a $48.3 million increase in loans, net of deferred fees and costs and unearned income, somewhat offset primarily by a $36.2 million decrease in investment securities.

The available for sale segment of the securities portfolio totaled $197.2 million at September 30, 2006, compared to $233.0 million at December 31, 2005, a decrease of approximately $35.8 million or 15.4%. At amortized cost, the available for sale portfolio was down approximately $35.9 million, with unrealized appreciation related to the available for sale portfolio increasing $144 thousand. Federal agency bonds declined $20.0 million, as during the first nine months of 2006, $20.0 million of bonds were called. Other major factors in this decrease included a $13.9 million decrease in mortgage-backed securities and a $2.1 million decrease in municipal bonds. The decrease in mortgage-backed securities reflects principal payments received during the first nine months of 2006. The held to maturity portion of the portfolio, consisting primarily of local municipal obligations, was down $440 thousand from $8.6 million at December 31, 2005 to $8.1 million at September 30, 2006.

A $2.0 million decrease in Federal Home Loan Bank and Federal Reserve Bank stock is primarily due to net redemptions of shares by the Federal Home Loan Bank of New York ("FHLB").

Other significant changes since December 31, 2005 include a $2.1 million increase in premises and equipment, net, and a $1.6 million increase in other assets. The $2.1 million increase in premises and equipment is due primarily to renovations at both our main office and the property housing the Ithaca Station office, which was opened during the second quarter of 2006, as well as ongoing investments in equipment. The $1.6 million increase in other assets was impacted primarily by an increase in Other Real Estate Owned ("OREO").

Since December 31, 2005, total deposits have increased $55.2 million or 10.5% from $524.9 million to $580.1 million. While non-interest bearing demand deposits were up $5.0 million, the majority of the increase was in interest-bearing deposits, which increased $50.2 million. Approximately $32.1 million of the increase in interest-bearing deposits was in public fund balances, principally reflected in higher time deposit, insured money market and Now account balances. The balance of the increase in interest-bearing balances was due primarily to higher personal time deposit balances and non-personal insured money market balances, offset to some extent primarily by lower period-end personal savings, insured money market and Now balances. A $23.4 million decrease in securities sold under agreements to repurchase reflects the fact that during the first nine months of this year, repurchase agreement advances from the FHLB totaling $19.0 million matured, and repurchase agreement advances totaling $7.5 million were called. Additionally, a $10.0 million long term advance from the FHLB was called.

Proceeds from the increase in deposits, as well as the decrease in securities were used to fund the above noted loan growth and reduction in securities sold under agreements to repurchase, as well as to reduce borrowings under our line of credit with the FHLB, which were down $9.4 million since December 31, 2005.

The following table summarizes the Corporation's non-performing assets:

In addition to non-performing loans, as of September 30, 2006, the Corporation has identified 15 commercial loan relationships totaling $10.8 million in potential problem loans, as compared to $9.3 million (15 commercial loan relationships) at December 31, 2005. This increase resulted primarily from the identification of one commercial relationship as a potential problem loan. 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 economic conditions may worsen or other 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, overall portfolio quality, and current economic conditions that may affect the borrowers' ability to pay. With the level of non-performing relationships having declined, the Corporation has reduced its provision for loan losses during the first nine months of 2006 to $125 thousand as compared to $975 thousand during the first nine months of 2005. At September 30, 2006, the Corporation's allowance for loan losses totaled $9.220 million, resulting in a coverage ratio of allowance to non-performing loans of 139.5%. 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 nine months of 2006 totaled $683 thousand as compared to $1.239 million during the first nine months of 2005, this decrease primarily due to a $545 thousand decrease in net commercial loan charge-offs. The allowance for loan losses to total loans at September 30, 2006 was 1.97% as compared to 2.34% as of December 31, 2005.

Activity in the allowance for loan losses was as follows:

Despite a $3.2 million increase in average earning assets as compared to the third quarter of 2005, net interest income was down $102 thousand or 1.6% from $6.281 million to $6.179 million, as the net interest margin declined 7 basis points from 3.77% to 3.70%. This reduction has been caused by higher short term interest rates and a flat to inverted yield curve, with a 53 basis point increase in yield on earning assets from 5.49% to 6.02%, offset by an 87 basis point increase in the cost of interest bearing liabilities from 2.31% to 3.18%. The increase in average earning assets was due to a $45.9 million increase in average loans offset by a $36.8 million decrease in the average securities portfolio and a $6.0 million decrease in average federal funds sold and interest bearing deposits. The increase in average loans reflects growth in all segments of the loan portfolio, with average mortgages increasing $26.6 million, and average consumer loans and commercial loans increasing $12.8 million and $6.5 million, respectively. The decrease in average securities has been impacted by the flat to inverted yield curve, and the resulting inability to leverage quality securities purchases at acceptable interest rate spreads.

Total average funding liabilities, including non-interest bearing demand deposits, increased $3.1 million or 0.5% compared to third quarter 2005 averages, as a $42.8 million increase in average deposits and a $5.6 million increase in average overnight borrowings under the Corporations line of credit with the FHLB, were partially offset by a $31.1 million decrease in average term repurchase agreements funded by the FHLB and a $15.0 million decrease in average term advances from the FHLB. While average non-interest bearing demand deposits increased $9.4 million, average interest bearing deposits were up $33.4 million. The increase in interest bearing deposits was reflected primarily in higher average time deposits and insured money market deposits of $37.5 million and $9.8 million, respectively, somewhat offset primarily by a $9.5 million decrease in average savings account balances and a $4.4 million decrease in average Now accounts. The decreases in average securities sold under agreements to repurchase and term advances from the FHLB reflects the maturity or call of advances that had been utilized to leverage securities purchases. While average interest bearing liabilities decreased $6.3 million or 1.3%, interest expense increased $1.029 million or 36.0%, as the average cost of interest bearing liabilities rose 87 basis points from 2.31% to 3.18%, reflective of the fact that the increase in average deposits was primarily due to an increase in higher cost time and insured money market deposits.

As discussed more fully under the Asset Quality section of this report, the $325 thousand decrease in the provision for loan losses reflects the adequacy of the allowance for loan losses and the continuing decline in non-performing loans.

Non-interest income during the third quarter of 2006 compared to the third quarter of 2005 increased $362 thousand or 10.7%. This increase was impacted to a great extent by a $155 thousand increase in service charges on deposit accounts as well as a $149 thousand increase in revenue generated by OREO, these being properties acquired through foreclosure proceedings. The increase in service charges was due primarily to an increase in fees for insufficient funds, as this fee was increased during the first quarter of 2006. The increase in revenue generated by OREO was due primarily to the operation of a golf course which the Corporation acquired through foreclosure in the first quarter of this year. While this property is for sale, management determined that the marketability of the course would be enhanced by its ongoing operation as opposed to sitting vacant. Additionally, the revenue generated through the operation of the course has helped to offset maintenance costs which would have been incurred whether or not the golf course was in operation. In addition to the foregoing, other significant increases included a $38 thousand increase in debit card interchange income as well as the receipt of an $88 thousand insurance experience rebate related to credit life and disability insurance on consumer loans.

Third quarter 2006 operating expenses were $758 thousand or 11.5% higher than the comparable period last year. Areas having the greatest impact on this increase include a $207 thousand increase in costs associated with OREO, a $156 thousand increase in salaries and wages, a $100 thousand increase in net occupancy costs and an $87 thousand increase in data processing and software costs. The increase in OREO expense is due primarily to the above mentioned operation of the golf course acquired through foreclosure. The salary increase was impacted by merit increases effective in January of 2006 as well as increased compensation costs related to the Corporation's expansion into the New York State counties of Tompkins and Broome. The increase in net occupancy costs was impacted to a great extent by the above mentioned expansion, while the increase in data processing and software costs was related principally to higher software maintenance and license costs, an increase in Trust and Investment Center data processing fees and an increase in debit card processing costs.

A $55 thousand decrease in income tax expense resulted primarily from a $173 thousand reduction in pre-tax income, with the effective tax rate decreasing from 29.7% in the third quarter of 2005 to 29.5% in the third quarter of 2006.

Compared to the first nine months of 2005, net interest income declined $131 thousand or 0.7% from $18.481 million to $18.350 million, with the net interest margin down 5 basis points from 3.74% to 3.69%. Average earning assets increased $4.5 million or 0.7%, as an increase in average loans of $43.3 million was offset by decreases in the average securities portfolio and federal funds sold and interest bearing deposits of $27.2 million and $11.6 million, respectively. The $43.3 million increase in average loans reflects growth in all segments of the loan portfolio with average mortgages increasing $18.2 million, average consumer loans increasing $13.6 million and average commercial loans up $11.5 million. As mentioned above, the decrease in the average securities portfolio has been impacted by the flat to inverted yield curve and resulting inadequate spreads available on these investments. While average earning assets increased 0.7%, total interest and dividend income increased $2.700 million or 10.1%, as the yield rose 50 basis points from 5.39% to 5.89%.

Total average funding liabilities for the nine-month period ended September 30, 2006 increased $4.5 million or 0.7% when compared to the first nine months of 2005, the result of a $35.8 million increase in average deposits, as well as a $9.4 million increase in average short term borrowings under the Corporation's line of credit with the FHLB. These increases were somewhat offset primarily by decreases in average securities sold under agreements to repurchase funded by the FHLB and term advances from the FHLB totaling $30.2 million and $11.0 million, respectively. The increase in average deposits was impacted greatly by a $35.5 million increase in average time deposits, as these deposits represented a significant funding source for average loan growth during the first nine months of this year. In addition to this increase, average demand deposits and insured money market balances were up $7.4 million and $5.4 million respectively, offset by decreases in average savings balances of $8.5 million, and interest-bearing Now accounts of $4.0 million. As was noted above, the decreases in average securities sold under agreements to repurchase and term advances from the FHLB reflects the maturity or call of advances that had been utilized to leverage securities purchases. While average interest bearing liabilities decreased $2.9 million or 0.6%, total interest expense increased $2.831 million or 34.8%, as the average cost of interest bearing liabilities increased 78 basis points to 2.98%, impacted primarily by a 93 basis point increase in the cost of interest bearing deposits.

As noted above and discussed more fully under the Asset Quality section of this discussion, with the level of non-performing loans declining, and given the adequacy of the Corporation's allowance for loan losses, the provision for loan losses during the first nine months of 2006 totaled $125 thousand as compared to $975 thousand during the first nine months of 2005, a decrease of $850 thousand.

Non-interest income for the first nine months of 2006 increased $1.127 million or 11.8% when compared to the comparable period of 2005. The major factors behind this increase were the same as reported under third quarter results, with the most significant factors including a $531 thousand increase in service charges on deposit accounts and a $241 thousand increase in revenue generated from the operation of OREO. Other significant factors included a $162 thousand increase in revenue from our equity investment in Cephas Capital Partners, LP, a Small Business Investment Company limited partnership, and a $102 thousand increase in debit card interchange income.

Operating expenses for the first nine months of 2006 increased $1.878 million or 9.5% compared to the corresponding period in 2005. As was the case with the third quarter operating expense increase, and for reasons discussed above, the areas having the greatest impact on this increase include a $442 thousand increase in costs associated with OREO, a $450 thousand increase in salaries and wages, a $315 thousand increase in net occupancy costs and a $348 thousand increase in data processing and software costs.

Income taxes for the first nine months of 2006 were $21 thousand higher than last year, with the effective tax rate increasing from 28.5% to 28.9%.