2. Earnings Per Share

The review that follows focuses on the significant factors affecting the financial condition and results of operations of Chemung Financial Corporation (the "Corporation") during the three and nine month periods ended September 30, 2004, with comparisons to the comparable periods in 2003, 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 2003 Annual Report on Form 10-K. 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 Management's Discussion and Analysis of Financial Condition and Results of Operations 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 our use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise you that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materi ally different from its expectations because of various factors, including credit risk, interest rate risk, competition, changes in the regulatory environment, and changes in general business and economic trends.

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. As a result, the Corporation is required to make certain estimates, judgements and assumptions that it believes are reasonable based upon the information available. These estimates, judgements 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 sig nificant 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, 2004 totaled $734.2 million, a decrease of $13.0 million or 1.7% since the beginning of the year. This reduction is reflected primarily in the $11.8 million decrease in cash and cash equivalents, due to the $12.4 million decrease in federal funds sold. This decrease is directly related to the decrease in period-end deposits, as will be further discussed in this analysis.

Total loans, net of unearned income and deferred fees and costs, decreased $12.0 million or 3.1% from December 31, 2003 to September 30, 2004. This decrease is primarily related to management's decision during the third quarter to sell the consumer credit card portfolio as well as certain non-performing and potential problem commercial loans. Accordingly, approximately $11.0 million of loans were reclassified during the quarter as held for sale. In regard to the consumer credit card portfolio, the Corporation entered into an agreement during the third quarter with TCM Bank, N.A. (TCM) to sell approximately $7.6 million in consumer credit card accounts. TCM specializes in credit card financing and administration. The decision to sell this portfolio was motivated by the increasing cost of processing and administration associated with the credit card portfolio, as well as TCM's ability to offer enhancements to our credit card holders. Following the sale, the Corporation, through a three-y ear participation agreement with TCM, will participate in the funding of 45.0% of the portfolio. This will provide the Corporation with ongoing revenue from the credit card portfolio, without the expense of processing and administration. We will also continue to offer credit cards under the Bank's name, acting as an agent for TCM. This sale will take place during the fourth quarter, and the Corporation expects to realize a total gain on the sale of this portfolio of approximately 16.5% of the amount sold.

As noted above, management also decided during the quarter to sell certain non-performing and potential problem commercial loans. Accordingly, during the quarter, these loans were written-down to the lower of cost or estimated fair value, which resulted in a charge to the allowance for loan losses of $772 thousand during the quarter. The carrying value of these loans, now classified as held for sale, totals $3.3 million. It is expected that these loans will be sold during the fourth quarter, and the Corporation does not anticipate this transaction to have a material impact on fourth quarter operating results. Aside from the impact of the above, loans were down $1.0 million since the beginning of the year. Approximately $5.2 million of this decrease was in commercial loans, including commercial mortgages, impacted in part by a $3.7 million decrease in floor plan balances. This decrease was primarily related to the sale of automobile dealerships during 2004 with whom we had a floor plan relationship. While mortgage activity has been fairly steady through the first nine months of 2004, total residential mortgages have decreased approximately $1.3 million since the end of 2003. In total, the consumer loan portfolio, excluding the transfer of consumer credit cards to held for sale, has grown $5.3 million during the first nine months of 2004, impacted primarily by increases in consumer installment and student loans of $2.1 million and $2.3 million, respectively. In addition to the above noted areas, home equity outstandings have increased $1.1 million since the beginning of the year.

The composition of the loan portfolio is summarized as follows:

The available for sale segment of the securities portfolio totaled $281.3 million at September 30, 2004, compared to $282.9 million at the end of 2003, a decrease of approximately $1.6 million or 0.6%. Unrealized appreciation related to the available for sale portfolio has increased $136 thousand since the beginning of the year. At amortized cost, the available for sale portfolio was down $1.7 million since December 31, 2003. This decrease is primarily reflected in a $14.4 million decrease in mortgage-backed securities, offset primarily by a $13.6 million increase in federal agency bonds. During the first nine months of 2004, the Corporation purchased approximately $44.8 million of federal agency bonds, with approximately $28.2 million of federal agency bonds being called. Additionally, the Corporation sold a $3.0 million federal agency bond in March, realizing a pre-tax gain on the sale of $219 thousand. Although the Corporation has purchased approximately $15.0 million of mortgage-backed securities du ring the first nine months of this year, this portfolio has declined due to the level of paydowns in the portfolio. The held to maturity segment of the portfolio, consisting primarily of local municipal obligations, totaled $15.4 million at amortized cost as of September 30, 2004, an increase of $2.3 million since December 31, 2003.

Deposits at September 30, 2004 totaled $527.2 million, a decrease of $23.8 million or 4.3% as compared to December 31, 2003. While period-end non-interest bearing demand deposits were down $4.1 million, most of the decrease in deposits was due to a $19.7 million reduction in interest bearing balances. This decrease in interest bearing balances was impacted primarily by lower insured money market, and time balances, offset to some extent by higher savings account balances. The decrease in interest bearing balances from December 31, 2003 to September 30, 2004 reflects the fact that in the absence of loan growth during the first nine months of 2004, the Corporation has not been aggressive in the pricing of these deposit products. The $11.0 million increase in securities sold under agreements to repurchase reflects an increase in security purchases leveraged with repurchase agreements through the Federal Home Loan Bank of New York.

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

In addition to non-performing loans, as of September 30, 2004, the Corporation, through its loan review function, has identified 22 commercial loan relationships totaling $11.626 million in potential problem loans, as compared to $16.874 million (22 commercial loan relationships) at December 31, 2003. The $5.248 million decrease in these loans is primarily related to the upgrading during the third quarter of one commercial relationship which totaled $4.999 million at December 31, 2003 and the write-down to its estimated fair value of one relationship now categorized as held for sale, this write-down totaling $544 thousand. 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 Corporatio n, 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 which 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. During 2002 and 2003, the Corporation significantly increased the allowance for loan losses through an increased provision for loan loss expense in light of continuing loan quality issues related to the impact of a weak local economic environment on several large commercial relationships. With the level of non-performing relationships beginning to stabilize, and seeing some positive indications of improving business conditions for these clients, the Corporation reduced its provision for loan losses during the third quarter of 2004 to $333 thousand as compared to $2.15 milli on during the third quarter of 2003. The year-to-date provision of $1.167 million is down $3.183 million compared to the first nine months of 2003. At September 30, 2004, the Corporation's allowance for loan losses totaled $9.769 million, resulting in a coverage ratio of allowance to non-performing loans of 89.2%. 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 2004 totaled $1.246 million as compared to $2.240 million during the first nine months of 2003. This $994 thousand decrease was due primarily to lower commercial loan charge-offs. The allowance for loan losses to total loans at September 30, 2004 was 2.51% as compared to 2.52% as of December 31, 2003.

Net interest income before the provision for loan losses was down $91 thousand or 1.4%. As compared to the third quarter of 2003, average earning assets decreased $3.9 million or 0.6%, with total interest and dividend income decreasing $407 thousand or 4.3% from $9.480 million in the third quarter of 2003 to $9.073 million in the third quarter of 2004, as the yield on earning assets declined 18 basis points from 5.44% to 5.26%, primarily the result of lower average loan balances and loan yields. Due primarily to decreases in loans throughout 2003, average loan balances were down $17.3 million or 4.2% compared to third quarter 2003 averages, with the yield down 43 basis points to 6.09%. The average balance of the securities portfolio increased $28.2 million or 10.7%, with the yield on these investments up 8 basis points to 4.21%. Average federal funds sold and interest-bearing deposits were down $14.8 million, with the yield up 42 basis points to 1.34%.

Total average funding liabilities decreased $10.6 million or 1.6% when compared to the third quarter of 2003 due to a $21.7 million decrease in average deposits, offset to some extent primarily by a $9.7 million increase in average securities sold under agreements to repurchase funded through the Federal Home Loan Bank of New York. Average non-interest bearing demand deposits were up $8.7 million due to increases in both personal and non-personal average balances. Average time deposits decreased $21.2 million, primarily due to lower average personal balances. Average insured money market and Now accounts declined $5.7 million and $6.9 million, respectively, primarily due to lower public fund and personal average balances. The above decreases were offset to some extent by a $3.4 million increase in average savings balances, primarily in personal accounts. In total, average interest bearing liabilities decreased $19.3 million or 3.6% compared to third quarter 2003 averages, and interest expense decreased $ 316 thousand or 10.5% as the cost of funds, including the impact of non-interest bearing funding sources (such as demand deposits), was down 16 basis points to 1.65%. The resulting net interest margin for the third quarter of 2004 of 3.70% was 2 basis points lower than the third quarter 2003 margin of 3.72%.

As discussed more fully under the Asset Quality section of this report, with non-performing loans beginning to stabilize, the provision for loan losses during the third quarter of 2004 totaled $333 thousand as compared to $2.15 million during the third quarter of 2003, a decrease of $1.817 million.

Non-interest income during the quarter ended September 30, 2004 compared to the quarter ended September 30, 2003, was down $327 thousand or 9.6%. This decrease was impacted to a great extent by a $235 thousand decrease in gains on the sale of securities. Excluding this item, all other sources of non-interest income declined $92 thousand, primarily due to a $162 thousand decrease in gains on the sale of mortgages as well as a $65 thousand decrease in service charges on deposit accounts. These decreases were offset in part primarily by a $56 thousand increase in fees generated by our Trust and Investment Center and a $45 thousand increase in merchant discount fees.

Operating expenses were $298 thousand or 4.6% lower than the comparable period last year. Salaries and pension and other employee benefits decreased $76 thousand and $110 thousand, respectively. The $76 thousand decrease in salaries reflects the fact that during the third quarter of last year we expensed approximately $262 thousand related to severance costs associated with a severance agreement with a former employee. The $110 thousand decrease in pension and other employee benefits resulted primarily from decreases in pension and post-retirement medical benefits of $169 thousand and $87 thousand, respectively, offset to some extent primarily by a $127 thousand increase in health insurance costs. The decrease in post-retirement medical benefits includes recognition during the third quarter of this year of $49 thousand of reduced 2004 periodic costs related to Medicare Part D coverage, which becomes effective in 2006. Net occupancy expenses increased $33 thousand, impacted by higher real estate taxes, bu ilding depreciation and maintenance costs. The $124 thousand decrease in other operating expenses is primarily related to decreases in loan and ORE expenses and donation expenses, offset to some extent primarily by an increase in professional services fees.

The $625 thousand increase in income tax expense is primarily a function of the higher level of pre-tax income.

Net income for the nine month period ended September 30, 2004 totaled $6.222 million, an increase of $1.804 million or 40.8% as compared to results for the nine month period ended September 30, 2003. Earnings per share increased 41.4% from $1.16 to $1.64 per share on 42,253 fewer average shares outstanding. Similar to the third quarter results, the improvement in year-to-date earnings has been impacted primarily by a reduction in the provision for loan loss expense as well as a decrease in operating expenses.

Net interest income before the provision for loan losses was down $267 thousand or 1.4%, with the net interest margin declining 8 basis points from 3.75% to 3.67%, reflective of both lower interest rates and average loan balances. As compared to the first nine months of 2003, average earning assets increased $5.1 million or 0.7%. However, total interest and dividend income decreased $1.986 million or 6.8% as the yield on earning assets declined 43 basis points to 5.25%. As noted in the above discussion of third quarter results, due primarily to decreases in loans throughout 2003, average loan balances during the first nine months of 2004 were down $30.6 million or 7.3% compared to comparable period averages during 2003, with the yield down 52 basis points to 6.16%. While the average balance of the securities portfolio increased $46.1 million or 18.7%, the yield on these investments was down 18 basis points to 4.26%. Average federal funds sold and interest-bearing deposits were down $10.4 million, with t he yield down 13 basis points to 0.99%.

Total average funding liabilities for the nine month period ended September 30, 2004, declined $1.1 million or 0.2% when compared to the first nine months of last year due primarily to a $7.6 million decrease in average deposits, offset to some extent primarily by a $6.9 million increase in average securities sold under agreements to repurchase funded through the Federal Home Loan Bank of New York. Average non-interest bearing demand deposits were up $9.2 million as both personal and non-personal average balances increased. Average interest-bearing deposits decreased $16.8 million, impacted primarily by a $21.5 million decrease in average time deposits, offset to some extent primarily by a $5.0 million increase in average savings balances. While total average interest bearing liabilities decreased $10.3 million or 1.9% compared to the first nine months of 2003, interest expense decreased $1.718 million or 17.3%, as the cost of funds, including the impact of non-interest bearing funding sources (such as dem and deposits), was down 35 basis points to 1.66%.

Due to decreases in both the second quarter and third quarter provision for loan loss expense, the year-to-date provision for loan loss expense has decreased $3.183 million from $4.35 million to $1.167 million.

Non-interest income for the first nine months of 2004 was down $223 thousand when compared to the comparable period in 2003, impacted to a great extent by a $966 thousand decrease in net gains on securities transactions. With the exception of this decrease, all other sources of non-interest income increased $743 thousand or 8.4%. Major factors impacting this increase include a $265 thousand increase in fee income generated by our Trust and Investment Center, a $241 thousand increase in service charges on deposit accounts, and a $177 thousand increase in earnings from our equity investment in Cephas Capital Partners, L.P. In addition to the above, credit card merchant discount fees increased $121 thousand, and revenue generated by CFS Group, Inc. was up $85 thousand. The above were offset to some extent primarily by a $199 thousand decrease in gains on the sale of mortgages, as the volume of mortgages sold in the secondary mortgage department is down significantly from a year ago.

Operating expenses were $162 thousand or 0.8% lower than a year ago. As was noted above, a $260 thousand decrease in salaries reflects the fact that during the third quarter of last year, the Corporation recognized approximately $262 thousand in expense related to a severance agreement with a former employee. Pension and other employee benefits were down $29 thousand, primarily the result of decreases in pension and post-retirement medical benefits of $189 thousand and $87 thousand, respectively, offset to some extent primarily by a $234 thousand increase in health insurance costs. Net occupancy expenses increased $140 thousand, impacted by higher real estate taxes, building depreciation, maintenance costs and utilities. Excluding the above mentioned items, all other operating expenses decreased $12 thousand impacted primarily by decreases in loan and ORE expenses, stationery and supplies and postage expense, offset primarily by higher professional services fees and credit card and merchant deposit servic es processing costs.

Income tax expense increased $1.051 million, primarily due to the increased level of pre-tax income during the first nine months of 2004.

For the purpose of these computations, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. No tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions.

The following table sets forth for the periods indicated, a summary of the changes in interest and dividends earned and interest paid resulting from changes in volume and changes in rates (in thousands of dollars):