See accompanying notes to unaudited consolidated financial statements.

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 Chemung Financial Corporation (the "Corporation") during the three month period ended March 31, 2005, with comparisons to the comparable period in 2004, 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 2004 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

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 March 31, 2005 totaled $710.2 million, a decrease of $12.3 million or 1.7% since December 31, 2004. This reduction is reflected primarily in a $15.7 million decrease in federal funds sold and a $6.6 million decrease in available for sale securities, partially offset primarily by a $10.0 million increase in loans, net of deferred fees and costs and unearned income.

As noted above, total loans, net of deferred fees and costs and unearned income, increased $10.0 million or 2.6% from December 31, 2004 to March 31, 2005, primarily the result of a $10.8 million increase in commercial loans (including commercial mortgages). This increase was impacted to a large extent by an increase in commercial line of credit usage. Additionally, residential mortgage balances increased $481 thousand. These increases were partially offset by a $1.3 million decrease in total consumer loans, primarily due to a $2.4 million decrease in installment loans, a $514 thousand decrease in home equity outstandings and a $378 thousand decrease in consumer credit card balances, somewhat offset by a $1.9 million increase in student loans.

The composition of the loan portfolio is summarized as follows:

The available for sale segment of the securities portfolio totaled $242.7 million at March 31, 2005, compared to $249.3 million at the end of 2004, a decrease of approximately $6.6 million or 2.6%. Unrealized appreciation related to the available for sale portfolio has decreased $3.6 million since the beginning of the year, reflecting the impact of an increase in mid to long-term rates on the bond portfolio. At amortized cost, the available for sale portfolio was down $3.0 million since December 31, 2004. Federal agency bonds were down $10.0 million, as during the quarter, purchases totaling $20.0 million were offset by $30.0 million of federal agency bond calls. A $4.7 million increase in mortgage-backed securities reflects purchases during the quarter totaling $9.1 million, partially offset by paydowns. Additionally, investments in corporate and municipal bonds increased $1.2 million and $1.9 million, respectively. A $970 thousand decrease in the stock portfolio was due to the redem ption during the quarter by the Federal Home Loan Bank of New York of 9,750 shares of FHLB stock. The held to maturity segment of the portfolio, consisting primarily of local municipal obligations, totaled $12.5 million at amortized cost as of March 31, 2005, an increase of approximately $332 thousand since December 31, 2004.

Deposits at March 31, 2005 totaled $526.0 million, an increase of $6.4 million or 1.2% as compared to December 31, 2004. While period-end non-interest bearing demand deposits were down $3.4 million due primarily to lower period-end non-personal balances, this was offset by a $9.8 million increase in interest bearing balances. This increase in interest bearing balances was reflected in a $3.7 million increase in savings accounts, a $1.5 million increase in insured money market accounts, a $2.9 million increase in Now accounts and a $1.9 million increase in total time deposits. A $16.5 million decrease in securities sold under agreements to repurchase was due to the maturity during the quarter of $19.5 million in advances from the Federal Home Loan Bank of New York. These advances had been utilized to leverage the purchase of federal agency bonds which were called during the first quarter of 2004.

The following table summarizes the Corporation's non-performing assets including non-accruing loans held for sale (in thousands of dollars):

In addition to non-performing loans, as of March 31, 2005, the Corporation, through its loan review function, has identified 21 commercial loan relationships totaling $11.072 million in potential problem loans, as compared to $11.367 million (22 commercial loan relationships) at December 31, 2004. 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 which may impact borrowers and the potential problem loans. Accordingly, there can be no as surance 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 continuing to decline, the Corporation reduced its provision for loan losses during the first quarter of 2005 to $325 thousand as compared to $500 thousand during the first quarter of 2004. At March 31, 2005, the Corporation's allowance for loan losses totaled $10.248 million, resulting in a coverage ratio of allowance to non-performing loans of 99.6%. 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 three months of 2005 totaled $60 thousand as compared to $80 thousand during the first three months of 2004. This $20 thousand decrease was due primarily to lower net consumer loan charge-offs. The allowance for loan losses to total loans at March 31, 2005 was 2.62% as compared to 2.62% as of December 31, 2004.

Net interest income before the provision for loan losses was down $462 thousand or 7.1%. As compared to the first quarter of 2004, average earning assets decreased $37.4 million or 5.3%, with total interest and dividend income decreasing $682 thousand or 7.4% from $9.273 million in the first quarter of 2004 to $8.591 million in the first quarter of 2005. Along with the decrease in average earning assets, the decrease in interest and dividend income was also impacted by a 7 basis point decline in yield from 5.32% to 5.25%. The decrease in average earning assets was due to a $52.6 million decrease in the average securities portfolio, partially offset by increases in average federal funds sold and interest bearing deposits and loans of $12.1 and $3.2 million, respectively. The decrease in the average securities portfolio as compared to the first quarter of 2004 was impacted by the continuing low interest rate environment throughout much of the past twelve months, and the Corporation's reluctance to increase it's investments in bonds during this time given the expectation for higher rates going forward. However, during the later part of February, we began to see the mid to long-term bond rates rise, and during February and March purchased approximately $20.0 million of federal agency bonds, $9.1 million of mortgage-backed securities and a $1.2 million corporate bond.

Total average funding liabilities decreased $37.2 million or 5.6% when compared to the first quarter of 2004, impacted by a $24.0 million decrease in average deposits and a $15.1 million decrease in average securities sold under agreements to repurchase funded through the Federal Home Loan Bank of New York. The decrease in average deposits was primarily related to lower insured money market and time deposit balances of $18.8 million and $14.6 million, respectively, partially offset primarily by a $9.3 million increase in average demand deposits. The above decreases in average insured money market and time balances is due to the fact that absent loan growth during 2004, and given the continuing low yields on investments, we were not aggressive in the pricing of these deposit products. The decrease in average securities sold under agreements to repurchase reflects the fact that during January of this year, $19.5 million of advances matured. In total, average interest bearing liabilities decreased $46.5 mil lion or 8.5% compared to first quarter 2004 averages, and interest expense decreased $220 thousand or 7.8% with the cost of funds, including the impact of non-interest bearing funding sources (such as demand deposits), down 3 basis points to 1.67%. The resulting net interest margin for the first quarter of 2005 of 3.67% was 4 basis points lower than the first quarter 2004 margin of 3.71%.

As discussed more fully under the Asset Quality section of this report, with the level of non-performing loans continuing to show improvement, the provision for loan losses during the first quarter of 2005 totaled $325 thousand as compared to $500 thousand during the first quarter of 2004, a decrease of $175 thousand.

Non-interest income during the first quarter of 2005 compared to the first quarter of 2004 decreased $286 thousand or 8.8%. This decrease was impacted to a great extent by a $219 thousand decrease in gains on the sale of securities. Excluding this item, all other sources of non-interest income declined $67 thousand or 2.2%, primarily due to a $186 thousand decrease in service charges on deposit accounts. The decrease in service charges was due primarily to lower net NSF fees, as well as the Corporation's expansion of its free checking programs. This decrease was partially offset primarily by an increase in revenue from our equity investment in Cephas Capital Partners, LP of $35 thousand, a $32 thousand increase in checkcard interchange fee income, and a $30 thousand increase in credit card merchant earnings. Additionally, recognition of deferred gains on the 2004 sale of our consumer credit portfolio and revenue generated by CFS Group, Inc. increased $26 thousand and $16 thousand, respectively.

Operating expenses were $333 thousand or 5.5% higher than the comparable period last year. Areas having the greatest impact on this increase include a $147 thousand increase in salaries and wages, as well as increases in net occupancy costs and marketing and advertising expenses of $65 thousand and $96 thousand, respectively. The increase in salaries and wages was due primarily to merit compensation increases effective in January of 2005. The increase in occupancy costs was impacted primarily by higher depreciation, maintenance, utilities and rent. The increase in marketing and advertising expenses is primarily the result of higher print, radio and TV, direct mail and production costs.

A $322 thousand decrease in income tax expense is primarily a function of the lower level of pre-tax income.

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.