Edgar Filing: COMMUNITY BANK SYSTEM INC

cbna201210q3rdqtr.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2012

	OR

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from to .
	Commission File Number: 001-13695

COMMUNITY BANK SYSTEM, INC.

(Exact name of registrant as specified in its charter)

Delaware		16-1213679
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

5790 Widewaters Parkway, DeWitt, New York		13214-1883
(Address of principal executive offices)		(Zip Code)
	(315) 445-2282
(Registrant's telephone number, including area code)

	NONE
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o.

Indicate by check mark whether the registrant has submitted electronically and posted to its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer x	Accelerated filer o	Non-accelerated filer o	Smaller reporting company o.
	(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o. No x.

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

39,586,191 shares of Common Stock, $1.00 par value, were outstanding on October 31, 2012.

TABLE OF CONTENTS

Part I.	Financial Information	Page

Item 1.	Financial Statements (Unaudited)

	Consolidated Statements of Condition
	September 30, 2012 and December 31, 2011	3

	Consolidated Statements of Income
	Three and nine months ended September 30, 2012 and 2011	4

	Consolidated Statements of Comprehensive Income
	Three and nine months ended September 30, 2012 and 2011	5

	Consolidated Statement of Changes in Shareholders’ Equity
	Nine months ended September 30, 2012	6

	Consolidated Statements of Cash Flows
	Nine months ended September 30, 2012 and 2011	7

	Notes to the Consolidated Financial Statements
	September 30, 2012	8

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	26

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	43

Item 4.	Controls and Procedures	45

Part II.	Other Information

Item 1.	Legal Proceedings	45

Item 1A.	Risk Factors	45

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	45

Item 3.	Defaults Upon Senior Securities	46

Item 4.	Mine Safety Disclosures	46

Item 5.	Other Information	46

Item 6.	Exhibits	46

Part I. Financial Information

Item 1. Financial Statements

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF CONDITION (Unaudited)

(In Thousands, Except Share Data)

	September 30,	December 31,
	2012	2011
Assets:
Cash and cash equivalents	$287,753	$324,878

Available-for-sale investment securities (cost of $2,051,431 and $1,453,461, respectively)	2,195,104	1,538,973

Held-to-maturity investment securities (fair value of $712,816 and $617,835, respectively)	641,540	553,495

Other securities, at cost	58,641	58,902

Loans held for sale, at fair value	113	532

Loans	3,812,457	3,471,025
Allowance for loan losses	(42,817)	(42,213)
Net loans	3,769,640	3,428,812

Goodwill, net	369,703	345,050
Core deposit intangibles, net	15,504	11,519
Other intangibles, net	3,191	3,995
Intangible assets, net	388,398	360,564

Premises and equipment, net	89,215	85,956
Accrued interest receivable	30,080	28,579
Other assets	109,889	107,584

Total assets	$7,570,373	$6,488,275

Liabilities:
Noninterest-bearing deposits	$1,098,135	$894,464
Interest-bearing deposits	4,610,494	3,900,781
Total deposits	5,708,629	4,795,245

Borrowings	728,116	728,281
Subordinated debt held by unconsolidated subsidiary trusts	102,067	102,048
Accrued interest and other liabilities	126,962	88,118
Total liabilities	6,665,774	5,713,692

Commitments and contingencies (See Note J)

Shareholders' equity:
Preferred stock $1.00 par value, 500,000 shares authorized, 0 shares issued	-	-
Common stock, $1.00 par value, 50,000,000 shares authorized; 40,369,948 and
37,794,532 shares issued, respectively	40,370	37,795
Additional paid-in capital	376,654	313,501
Retained earnings	438,912	411,805
Accumulated other comprehensive income	66,136	29,165
Treasury stock, at cost (798,515 and 808,123 shares, respectively)	(17,473)	(17,683)
Total shareholders' equity	904,599	774,583

Total liabilities and shareholders' equity	$7,570,373	$6,488,275

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(In Thousands, Except Per-Share Data)

		Three Months Ended		Nine Months Ended
		September 30,		September 30,
		2012	2011	2012	2011
Interest income:
	Interest and fees on loans	$48,590	$50,702	$143,305	$142,470
	Interest and dividends on taxable investments	16,762	14,278	48,487	41,147
	Interest and dividends on nontaxable investments	6,042	5,438	17,658	16,938
	Total interest income	71,394	70,418	209,450	200,555

Interest expense:
	Interest on deposits	4,402	6,887	14,291	19,684
	Interest on borrowings	7,535	7,466	22,648	22,146
	Interest on subordinated debt held by unconsolidated subsidiary trusts	682	1,497	2,056	4,447
	Total interest expense	12,619	15,850	38,995	46,277

Net interest income		58,775	54,568	170,455	154,278
Provision for loan losses		2,643	1,043	6,442	3,143
Net interest income after provision for loan losses		56,132	53,525	164,013	151,135

Noninterest income:
	Deposit service fees	12,057	11,134	33,461	31,307
	Mortgage and other banking services	1,405	1,499	3,295	3,920
	Benefit trust, administration, consulting and actuarial fees	8,912	7,685	26,549	23,722
	Wealth management services	3,194	2,904	9,427	7,866
	Gain (loss) on investment securities and debt extinguishments, net	291	(6)	291	8
Total noninterest income		25,859	23,216	73,023	66,823

Operating expenses:
	Salaries and employee benefits	28,126	26,543	82,395	75,185
	Occupancy and equipment	6,541	6,103	19,134	18,413
	Data processing and communications	6,078	5,330	17,429	15,278
	Amortization of intangible assets	1,212	1,161	3,343	3,251
	Legal and professional fees	1,710	1,640	5,723	4,286
	Office supplies and postage	1,345	1,300	4,195	3,873
	Business development and marketing	1,312	1,096	4,360	4,534
	FDIC insurance premiums	919	544	2,728	3,082
	Acquisition expenses	4,796	381	5,221	4,689
	Other	4,046	3,995	10,330	9,944
	Total operating expenses	56,085	48,093	154,858	142,535

Income before income taxes		25,906	28,648	82,178	75,423
Income taxes		7,539	8,640	23,914	21,269
Net income		$18,367	$20,008	$58,264	$54,154

Basic earnings per share		$0.46	$0.54	$1.48	$1.52
Diluted earnings per share		$0.46	$0.54	$1.46	$1.50
Dividends declared per share		$0.27	$0.26	$0.79	$0.74

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)

(In Thousands)

	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2012	2011	2012	2011

Other comprehensive income, before tax:
Change in accumulated unrealized gain or loss for pension and other post retirement obligations	$682	($18,157)	$2,047	($17,808)
Change in unrealized losses on derivative instruments used in cash flow hedging relationships	0	871	0	2,463
Unrealized gains on securities:
Unrealized holding gains arising during period	14,067	39,642	58,452	68,043
Reclassification adjustment for (gains) losses included in net income	(291)	6	(291)	(99)
Other comprehensive income, before tax:	14,458	22,362	60,208	52,599
Income tax expense related to other comprehensive income	(5,488)	(8,400)	(23,237)	(19,841)
Other comprehensive income, net of tax:	8,970	13,962	36,971	32,758
Net income	18,367	20,008	58,264	54,154
Comprehensive income	$27,337	$33,970	$95,235	$86,912

	Three Months Ended		Nine Months Ended
	September 30,		September 30,
	2012	2011	2012	2011

Tax Effect Allocated To Each Component Of Comprehensive Income:

Tax effect of unrealized loss for pension and other postretirement obligations	($264)	6,996	($794)	6,861
Tax effect of unrealized losses on derivative instruments used in cash flow hedging relationships	0	(336)	0	(949)
Tax effect of unrealized gains and losses on available-for-sale securities arising during period	(5,224)	(15,060)	(22,443)	(25,753)
Income tax (expense) related to other comprehensive loss	($5,488)	($8,400)	($23,237)	($19,841)

	As of
	September 30,	December 31,
	2012	2011
Accumulated Other Comprehensive Income By Component:

Unrealized loss for pension and other postretirement obligations	($38,430)	($40,477)
Tax effect	14,809	15,603
Net unrealized loss for pension and other postretirement obligations	(23,621)	(24,874)

Unrealized gain on available-for-sale securities	143,673	85,512
Tax effect	(53,916)	(31,473)
Net unrealized gain on available-for-sale securities	89,757	54,039
Accumulated other comprehensive income	$66,136	$29,165

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY (Unaudited)

Nine months ended September 30, 2012

(In Thousands, Except Share Data)

					Accumulated
	Common Stock		Additional		Other
	Shares	Amount	Paid-in	Retained	Comprehensive	Treasury
	Outstanding	Issued	Capital	Earnings	Income	Stock	Total

Balance at December 31, 2011	36,986,409	$37,795	$313,501	$411,805	$29,165	($17,683)	$774,583

Net income				58,264			58,264

Other comprehensive income, net of tax					36,971		36,971

Dividends declared:
Common, $0.79 per share				(31,157)			(31,157)

Common stock issued under employee stock plan,
including tax benefits of $1,013	455,224	445	7,511			210	8,166

Stock-based compensation			2,855				2,855

Common stock issuance	2,129,800	2,130	52,787				54,917

Balance at September 30, 2012	39,571,433	$40,370	$376,654	$438,912	$66,136	($17,473)	$904,599

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(In Thousands)

	Nine Months Ended September 30,
	2012	2011
Operating activities:
Net income	$58,264	$54,154
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation	8,487	8,608
Amortization of intangible assets	3,343	3,251
Net accretion of premiums and discounts on securities, loans, and borrowings	(4,167)	(1,356)
Stock-based compensation	2,855	3,038
Provision for loan losses	6,442	3,143
Amortization of mortgage servicing rights	536	667
Income from bank-owned life insurance policies	(833)	(581)
Gain on investment securities and debt extinguishments, net	(291)	(8)
Net loss/(gain) from sale of loans and other assets	229	(281)
Net change in loans held for sale	488	4,410
Change in other assets and liabilities	12,815	5,555
Net cash provided by operating activities	88,168	80,600
Investing activities:
Proceeds from sales of available-for-sale investment securities	5,378	13,371
Proceeds from maturities of available-for-sale investment securities	144,958	151,997
Proceeds from maturities of held-to-maturity investment securities	20,517	54,152
Proceeds from maturities of other investment securities	275	1,197
Purchases of available-for-sale investment securities	(745,074)	(176,188)
Purchases of held-to-maturity investment securities	(107,317)	(7,424)
Purchases of other securities	(14)	(3,075)
Net (increase) decrease in loans	(187,154)	9,038
Cash received from acquisition, net of cash paid of $0 and $20,704	600,972	6,197
Purchases of premises and equipment	(7,103)	(6,895)
Net cash (used in) provided by investing activities	(274,562)	42,370
Financing activities:
Net increase in deposits	115,422	133,154
Net decrease in borrowings	(165)	(19,884)
Issuance of common stock	62,873	2,273
Sale of treasury stock	210	0
Cash dividends paid	(30,084)	(24,828)
Tax benefits from share-based payment arrangements	1,013	355
Net cash provided by financing activities	149,269	91,070
Change in cash and cash equivalents	(37,125)	214,040
Cash and cash equivalents at beginning of period	324,878	211,837
Cash and cash equivalents at end of period	$287,753	$425,877
Supplemental disclosures of cash flow information:
Cash paid for interest	$39,355	$45,970
Cash paid for income taxes	16,217	14,750
Supplemental disclosures of noncash financing and investing activities:
Dividends declared and unpaid	10,682	9,575
Transfers from loans to other real estate	2,571	4,011
Acquisitions:
Fair value of assets acquired, excluding acquired cash and intangibles	165,885	815,828
Fair value of liabilities assumed	798,031	791,222

The accompanying notes are an integral part of the consolidated financial statements.

COMMUNITY BANK SYSTEM, INC.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

September 30, 2012

NOTE A: BASIS OF PRESENTATION

The interim financial data as of and for the three and nine months ended September 30, 2012 and 2011 is unaudited; however, in the opinion of Community Bank System, Inc. (the “Company”), the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods in conformity with accounting principles generally accepted in the United States of America (“GAAP”). The results of operations for the interim periods are not necessarily indicative of the results that may be expected for the full year or any other interim period.

NOTE B: ACQUISITIONS

On July 20, 2012, Community Bank, N.A. (the “Bank”), the wholly-owned banking subsidiary of the Company, completed its acquisition of 16 retail branches in Central, Northern and Western New York from HSBC Bank USA, N.A. (“HSBC”), acquiring approximately $106 million in loans and $697 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money markets accounts) and the purchased loans consist of in-market performing loans primarily residential real estate loans, Under the terms of the purchase agreement, the Bank paid First Niagara Bank, N.A. (“First Niagara”) (who acquired HSBC’s Upstate New York banking business and assigned its right to purchase the 16 branches to the Bank) a blended deposit premium of 3.4%, or approximately $24 million. The effect of the acquired assets and liabilities have been included in the consolidated financial statements since that date.

On September 7, 2012, the Bank completed its acquisition of three branches in Western New York from First Niagara, acquiring approximately $54 million of loans and $101 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money market accounts) and the purchased loans consist of in-market performing loans, primarily residential real estate loans. Under the terms of the purchase agreement, the Bank paid a blended deposit premium of 3.1%, or approximately $3 million. The effect of the acquired assets and liabilities have been included in the consolidated financial statements since that date.

In late January 2012, the Company completed a public common stock offering and raised $57.5 million through the issuance of 2.13 million shares. The net proceeds of the offering were approximately $54.9 million. The Company used the capital raised in this offering to support the HSBC and First Niagara branch acquisitions.

On November 30, 2011, the Company, through its Benefit Plans Administrative Services, Inc. (“BPAS”) subsidiary, acquired certain assets and liabilities of CAI Benefits, Inc. (“CAI”), a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey. The Company acquired $1.4 million of assets and $0.2 million of liabilities. The results of CAI’s operations have been included in the consolidated financial statements since that date. The transaction adds valuable service capacity and enhances distribution prospects in support of the Company’s broader-based employee benefits business, including daily valuation plan and collective investment fund administration.

On April 8, 2011, the Company acquired The Wilber Corporation (“Wilber”), parent company of Wilber National Bank, for approximately $103 million in stock and cash, comprised of $20.4 million in cash and the issuance of 3.35 million additional shares of the Company’s common stock. Based in Oneonta, New York, Wilber operated 22 branches in the Central, Greater Capital District, and Catskill regions of Upstate New York. Wilber was merged into the Company and Wilber National Bank was merged into the Bank. The Company acquired $462.3 million of loans, $297.6 million of investments, $771.6 million of deposits, and $19.7 million of borrowings. The results of Wilber’s operations have been included in the Company’s financial statements since that date.

The assets and liabilities assumed in the acquisitions were recorded at their estimated fair values based on management's best estimates using information available at the dates of acquisition. The following table summarizes the estimated fair value of the assets and liabilities.


(000s omitted)	2012	2011
Consideration paid (received):
Community Bank System, Inc. common stock	$0	$82,580
Cash	(595,462)	21,885
Total net consideration paid (received)	(595,462)	104,465
Recognized amounts of identifiable assets acquired and liabilities assumed:
Cash and cash equivalents	5,510	26,901
Investment securities	0	297,573
Loans	160,116	462,334
Premises and equipment	4,941	6,353
Accrued interest receivable	588	2,615
Other assets and liabilities, net	171	46,942
Core deposit intangibles	6,521	4,016
Other intangibles	0	1,595
Deposits	(797,962)	(771,554)
Borrowings	0	(19,668)
Total identifiable assets and liabilities, net	(620,115)	57,107
Goodwill	$24,653	$47,358

Direct costs related to the acquisitions were expensed as incurred. Merger and acquisition integration-related expenses amount to $4.8 million and $5.2 million during the three and nine months ended September 30, 2012, respectively, and $0.4 million and $4.7 million during the three and nine months ended September 30, 2011, respectively, and have been separately stated in the Consolidated Statements of Income.

Acquired loans that have evidence of deterioration in credit quality since origination and for which it is probable, at acquisition, that the Company will be unable to collect all contractually required payments were aggregated by comparable characteristics and recorded at fair value without a carryover of the related allowance for loan losses. Cash flows for each pool were determined using an estimate of credit losses and an estimated rate of prepayments. Projected monthly cash flows were then discounted to present value using a market-based discount rate. The excess of the undiscounted expected cash flows over the estimated fair value is referred to as the “accretable yield” and is recognized into interest income over the remaining lives of the acquired loans.

The following is a summary of the loans acquired in the Wilber acquisition at the date of acquisition:

(000’s omitted)	Acquired Impaired Loans	Acquired Non-Impaired Loans	Total Acquired Loans
Contractually required principal and interest at acquisition	$41,730	$680,516	$722,246
Contractual cash flows not expected to be collected	(20,061)	(31,115)	(51,176)
Expected cash flows at acquisition	21,669	649,401	671,070
Interest component of expected cash flows	(2,509)	(206,227)	(208,736)
Fair value of acquired loans	$19,160	$443,174	$462,334

The following is a summary of the loans acquired from HSBC and First Niagara at the date of acquisition:

(000’s omitted)	Acquired Impaired Loans	Acquired Non-Impaired Loans	Total Acquired Loans
Contractually required principal and interest at acquisition	$0	$201,745	$201,745
Contractual cash flows not expected to be collected	0	(3,555)	(3,555)
Expected cash flows at acquisition	0	198,190	198,190
Interest component of expected cash flows	0	(38,074)	(38,074)
Fair value of acquired loans	$0	$160,116	$160,116

The core deposit intangible and other intangible related to the Wilber and CAI acquisition are being amortized using an accelerated method over their estimated useful life of approximately eight to ten years,. The goodwill, which is not amortized for book purposes, was assigned to the Banking segment for the Wilber, HSBC branch and First Niagara branch acquisitions and to the Other segment for the CAI acquisition. The goodwill arising from the Wilber acquisition is not deductible for tax purposes while the goodwill arising from the CAI, HSBC branch and First Niagara branch acquisitions is deductible for tax purposes.

The fair value of checking, savings and money market deposit accounts acquired were assumed to approximate the carrying value as these accounts have no stated maturity and are payable on demand. Certificate of deposit accounts were valued as the present value of the certificates’ expected contractual payments discounted at market rates for similar certificates.

Supplemental pro forma financial information related to the HSBC and First Niagara acquisitions has not been provided as it would be impracticable to do so. Historical financial information regarding the acquired branches is not accessible and thus the amounts would require estimates so significant as to render the disclosure irrelevant.

NOTE C: ACCOUNTING POLICIES

The accounting policies of the Company, as applied in the consolidated interim financial statements presented herein, are substantially the same as those followed on an annual basis as presented on pages 54 through 60 of the Annual Report on Form 10-K for the year ended December 31, 2011 filed with the Securities and Exchange Commission (“SEC”) on February 29, 2012.

Critical Accounting Policies

Acquired loans

Acquired loans are initially recorded at their acquisition date fair values. The carryover of allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date. Fair values for acquired loans are based on a discounted cash flow methodology that involves assumptions and judgments as to credit risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate. Subsequent to the acquisition of acquired impaired loans, GAAP requires the continued estimation of expected cash flows to be received. This estimation requires numerous assumptions, interpretations and judgments using internal and market credit quality information. Changes in expected cash flows could result in the recognition of impairment through a provision for loan losses.

For acquired loans that are not deemed impaired at acquisition, credit discounts representing the principal losses expected over the life of the loan are a component of the initial fair value. Subsequent to the purchase date, the methods utilized to estimate the required allowance for loan losses for the non-impaired acquired loans is similar to originated loans, however, the Company records a provision for loan losses only when the required allowance exceeds any remaining pooled discounts for loans evaluated collectively for impairment. For loans individually evaluated for impairment, a provision is recorded when the required allowance exceeds any remaining discount on the loan.

Allowance for Loan Losses

Management continually evaluates the credit quality of the Company’s loan portfolio, and performs a formal review of the adequacy of the allowance for loan losses on a quarterly basis. The allowance reflects management’s best estimate of probable losses inherent in the loan portfolio. Determination of the allowance is subjective in nature and requires significant estimates. The Company’s allowance methodology consists of two broad components - general and specific loan loss allocations.

The general loan loss allocation is composed of two calculations that are computed on five main loan segments: business lending, consumer installment - direct, consumer installment - indirect, home equity and consumer mortgage. The first calculation determines an allowance level based on the latest 36 months of historical net charge-off data for each loan class (commercial loans exclude balances with specific loan loss allocations). The second calculation is qualitative and takes into consideration eight qualitative environmental factors: levels and trends in delinquencies and impaired loans; levels of and trends in charge-offs and recoveries; trends in volume and terms of loans; effects of any changes in risk selection and underwriting standards, and other changes in lending policies, procedures, and practices; experience, ability, and depth of lending management and other relevant staff; national and local economic trends and conditions; industry conditions; and effects of changes in credit concentrations. These two calculations are added together to determine the general loan loss allocation. The specific loan loss allocation relates to individual commercial loans that are both greater than $0.5 million and in a nonaccruing status with respect to interest. Specific losses are based on discounted estimated cash flows, including any cash flows resulting from the conversion of collateral or collateral shortfalls. The allowance levels computed from the specific and general loan loss allocation methods are combined with unallocated allowances and allowances needed for acquired loans, if any, to derive the total required allowance for loan losses to be reflected on the Consolidated Statement of Condition.

Loan losses are charged off against the allowance, while recoveries of amounts previously charged off are credited to the allowance. A provision for loan losses is charged to operations based on management’s periodic evaluation of factors previously mentioned.

Investment Securities

The Company has classified its investments in debt and equity securities as held-to-maturity or available-for-sale. Held-to-maturity securities are those for which the Company has the positive intent and ability to hold until maturity, and are reported at cost, which is adjusted for amortization of premiums and accretion of discounts. Securities not classified as held-to-maturity are classified as available-for-sale and are reported at fair value with net unrealized gains and losses reflected as a separate component of shareholders' equity, net of applicable income taxes. None of the Company's investment securities have been classified as trading securities at September 30, 2012. Certain equity securities are stated at cost and include restricted stock of the Federal Reserve Bank of New York and Federal Home Loan Bank of New York.

Fair values for investment securities are based upon quoted market prices, where available. If quoted market prices are not available, fair values are based upon quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. See Notes D and K for more information.

The Company conducts an assessment of all securities in an unrealized loss position to determine if other-than-temporary impairment (“OTTI”) exists on a quarterly basis. An unrealized loss exists when the current fair value of an individual security is less than its amortized cost basis. The OTTI assessment considers the security structure, recent security collateral performance metrics, if applicable, external credit ratings, failure of the issuer to make scheduled interest or principal payments, judgment about and expectations of future performance, and relevant independent industry research, analysis and forecasts. The severity of the impairment and the length of time the security has been impaired is also considered in the assessment. The assessment of whether an OTTI decline exists is performed on each security, regardless of the classification of the security as available-for-sale or held-to-maturity and involves a high degree of subjectivity and judgment that is based on the information available to management at a point in time.

An OTTI loss must be recognized for a debt security in an unrealized loss position if there is intent to sell the security or it is more likely than not the Company will be required to sell the security prior to recovery of its amortized cost basis. In this situation, the amount of loss recognized in income is equal to the difference between the fair value and the amortized cost basis of the security. Even if management does not have the intent and it is not more likely than not that the Company will be required to sell the securities, an evaluation of the expected cash flows to be received is performed to determine if a credit loss has occurred. For debt securities, a critical component of the evaluation for OTTI is the identification of credit-impaired securities, where the Company does not expect to receive cash flows sufficient to recover the entire amortized cost basis of the security. In the event of a credit loss, only the amount of impairment associated with the credit loss would be recognized in income. The portion of the unrealized loss relating to other factors, such as liquidity conditions in the market or changes in market interest rates, is recorded in accumulated other comprehensive income.

Equity securities are also evaluated to determine whether the unrealized loss is expected to be recoverable based on whether evidence exists to support a realizable value equal to or greater than the amortized cost basis. If it is probable that the amortized cost basis will not be recovered, taking into consideration the estimated recovery period and the ability to hold the equity security until recovery, OTTI is recognized in earnings equal to the difference between the fair value and the amortized cost basis of the security.

The specific identification method is used in determining the realized gains and losses on sales of investment securities and OTTI charges. Premiums and discounts on securities are amortized and accreted, respectively, on the interest method basis over the period to maturity or estimated life of the related security. Purchases and sales of securities are recognized on a trade date basis.

Income Taxes

The Company and its subsidiaries file a consolidated federal income tax return. Provisions for income taxes are based on taxes currently payable or refundable as well as deferred taxes that are based on temporary differences between the tax basis of assets and liabilities and their reported amounts in the financial statements. Deferred tax assets and liabilities are reported in the financial statements at currently enacted income tax rates applicable to the period in which the deferred tax assets and liabilities are expected to be realized or settled.

Benefits from tax positions should be recognized in the financial statements only when it is more likely than not that the tax position will be sustained upon examination by the appropriate taxing authority having full knowledge of all relevant information. A tax position meeting the more-likely-than-not recognition threshold should be measured at the largest amount of benefit for which the likelihood of realization upon ultimate settlement exceeds 50 percent.

Intangible Assets

Intangible assets include core deposit intangibles, customer relationship intangibles, and goodwill arising from acquisitions. Core deposit intangibles and customer relationship intangibles are amortized on either an accelerated or straight-line basis over periods ranging from 8 to 20 years. The initial and ongoing carrying value of goodwill and other intangible assets is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires use of a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, expected equity market premiums, peer volatility indicators and company-specific risk indicators.

The Company evaluates goodwill for impairment on an annual basis, or more often if events or circumstances indicate there may be impairment. The implied fair value of a reporting unit’s goodwill is compared to its carrying amount and the impairment loss is measured by the excess of the carrying value over fair value. The fair value of each reporting unit is compared to the carrying amount of that reporting unit in order to determine if impairment is indicated.

Retirement Benefits

The Company provides defined benefit pension benefits to eligible employees and post-retirement health and life insurance benefits to certain eligible retirees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees, officers and directors. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including discount rate, rate of future compensation increases and expected return on plan assets.

NOTE D: INVESTMENT SECURITIES

The amortized cost and estimated fair value of investment securities as of September 30, 2012 and December 31, 2011 are as follows:

	September 30, 2012				December 31, 2011
		Gross	Gross	Estimated		Gross	Gross	Estimated
	Amortized	Unrealized	Unrealized	Fair	Amortized	Unrealized	Unrealized	Fair
(000's omitted)	Cost	Gains	Losses	Value	Cost	Gains	Losses	Value
Held-to-Maturity Portfolio:
U.S. Treasury and agency securities	$547,962	$63,606	$0	$611,568	$448,260	$56,800	$0	$505,060
Obligations of state and political subdivisions	66,484	6,155	0	72,639	69,623	5,088	0	74,711
Government agency mortgage-backed securities	24,147	1,459	0	25,606	35,576	2,452	0	38,028
Corporate debt securities	2,929	56	0	2,985	0	0	0	0
Other securities	18	0	0	18	36	0	0	36
Total held-to-maturity portfolio	$641,540	$71,276	0	$712,816	$553,495	$64,340	$0	$617,835

Available-for-Sale Portfolio:
U.S. Treasury and agency securities	$986,602	$99,151	$0	$1,085,753	$463,922	$56,626	$0	$520,548
Obligations of state and political subdivisions	672,775	34,587	41	707,321	543,527	29,721	236	573,012
Government agency mortgage-backed securities	267,673	20,622	0	288,295	310,541	20,840	2	331,379
Pooled trust preferred securities	63,970	0	13,133	50,837	68,115	0	24,269	43,846
Government agency collateralized mortgage obligations	35,897	1,116	38	36,975	45,481	1,572	110	46,943
Corporate debt securities	24,163	1,403	17	25,549	21,495	1,360	0	22,855
Marketable equity securities	351	84	61	374	380	92	82	390
Total available-for-sale portfolio	$2,051,431	$156,963	$13,290	$2,195,104	$1,453,461	$110,211	$24,699	$1,538,973

Other Securities:
Federal Home Loan Bank common stock	$38,113			$38,113	$38,343			$38,343
Federal Reserve Bank common stock	15,451			15,451	15,451			15,451
Other equity securities	5,077			5,077	5,108			5,108
Total other securities	$58,641			$58,641	$58,902			$58,902

A summary of investment securities that have been in a continuous unrealized loss position for less than, or greater, than twelve months is as follows:

As of September 30, 2012

	Less than 12 Months			12 Months or Longer			Total
			Gross			Gross			Gross
		Fair	Unrealized		Fair	Unrealized		Fair	Unrealized
(000's omitted)	#	Value	Losses	#	Value	Losses	#	Value	Losses
Available-for-Sale Portfolio:
Obligations of state and political subdivisions	19	$10,679	$41	1	$562	$0	20	$11,241	$41
Pooled trust preferred securities	0	0	0	3	50,837	13,133	3	50,837	13,133
Government agency collateralized mortgage obligations	2	403	3	8	3,866	35	10	4,269	38
Corporate debt securities	1	2,947	17	0	0	0	1	2,947	17
Marketable equity securities	0	0	0	1	140	61	1	140	61
Total available-for-sale/investment portfolio	22	$14,029	$61	13	$55,405	$13,229	35	$69,434	$13,290

As of December 31, 2011

	Less than 12 Months			12 Months or Longer			Total
			Gross			Gross			Gross
		Fair	Unrealized		Fair	Unrealized		Fair	Unrealized
(000's omitted)	#	Value	Losses	#	Value	Losses	#	Value	Losses
Available-for-Sale Portfolio:
Obligations of state and political subdivisions	2	$211	$0	6	$6,038	$236	8	$6,249	$236
Government agency mortgage-backed securities	3	2,415	2	0	0	0	3	2,415	2
Pooled trust preferred securities	0	0	0	3	43,846	24,269	3	43,846	24,269
Government agency collateralized mortgage obligations	17	6,648	110	0	0	0	17	6,648	110
Marketable equity securities	1	123	78	3	12	4	4	135	82
Total available-for-sale/investment portfolio	23	$9,397	$190	12	$49,896	$24,509	35	$59,293	$24,699

Included in the available-for-sale portfolio are pooled trust preferred, class A-1 securities with a current total par value of $65.3 million and unrealized losses of $13.1 million at September 30, 2012. The underlying collateral of these assets is principally trust preferred securities of smaller regional banks and insurance companies. The Company’s securities are in the super-senior cash flow tranche of the investment pools. All other tranches in these pools will incur losses before the super senior tranche is impacted. As of September 30, 2012, an additional 38% - 42% of the underlying collateral in these securities would have to be in deferral or default concurrently to result in an expectation of non-receipt of contractual cash flows.

A detailed review of the pooled trust preferred securities was completed for the quarter ended September 30, 2012. This review included an analysis of collateral reports, a cash flow analysis, including varying degrees of projected deferral/default scenarios, and a review of various financial ratios of the underlying banks and insurance companies that make up the collateral pool. Based on the analysis performed, significant further deferral/defaults and further erosion in other underlying performance conditions would have to exist before the Company would incur a loss. Therefore, the Company determined OTTI did not exist at September 30, 2012. To date, the Company has received all scheduled principal and interest payments and expects to fully collect all future contractual principal and interest payments. The Company does not intend to sell and it is not more likely than not that the Company will be required to sell the underlying securities. Subsequent changes in market or credit conditions could change those evaluations.

Management does not believe any individual unrealized loss as of September 30, 2012 represents OTTI. The unrealized losses reported pertaining to government guaranteed mortgage-backed securities relate primarily to securities issued by GNMA, FNMA and FHLMC, which are currently rated AAA by Moody’s Investor Services, AA+ by Standard & Poor’s and are guaranteed by the U.S. government. The obligations of state and political subdivisions are general purpose debt obligations of various states and political subdivisions. The unrealized losses in the portfolios are primarily attributable to changes in interest rates. The Company does not intend to sell these securities, nor is it more likely than not that the Company will be required to sell these securities prior to recovery of the amortized cost.

The amortized cost and estimated fair value of debt securities at September 30, 2012, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Securities not due at a single maturity date are shown separately.

	Held-to-Maturity		Available-for-Sale
	Amortized	Fair	Amortized	Fair
(000's omitted)	Cost	Value	Cost	Value
Due in one year or less	$19,247	$19,616	$40,005	$40,831
Due after one through five years	269,744	299,886	247,590	268,526
Due after five years through ten years	244,657	273,315	946,581	1,015,277
Due after ten years	83,745	94,393	513,334	544,826
Subtotal	617,393	687,210	1,747,510	1,869,460
Government agency collateralized mortgage obligations	0	0	35,897	36,975
Government agency mortgage-backed securities	24,147	25,606	267,673	288,295
Total	$641,540	$712,816	$2,051,080	$2,194,730

NOTE E: LOANS

The segments of the Company’s loan portfolio are disaggregated into classes that allow management to monitor risk and performance. Consumer mortgages consist primarily of fixed rate residential instruments, typically 15 – 30 years in contractual term, secured by first liens on real property. Business lending is comprised of general purpose commercial and industrial loans including agricultural-related and dealer floor plans, as well as mortgages on commercial property. Consumer installment – indirect consists primarily of loans originated through selected dealerships and are secured by automobiles, marine and other recreational vehicles. Consumer installment – direct are all other loans to consumers such as personal installment loans and lines of credit. Home equity products are consumer purpose installment loans or lines of credit most often secured by a first or second lien position on residential real estate with terms of 15 years or less. Loans are summarized as follows:

	September 30,	December 31,
(000's omitted)	2012	2011
Consumer mortgage	$1,390,130	$1,214,621
Business lending	1,233,928	1,226,439
Consumer installment - indirect	642,196	556,955
Consumer installment - direct	173,710	149,170
Home equity	372,493	323,840
Gross loans, including deferred origination costs	3,812,457	3,471,025
Allowance for loan losses	(42,817)	(42,213)
Loans, net of allowance for loan losses	$3,769,640	$3,428,812

The outstanding balance related to credit impaired acquired loans was $23.3 million and $25.9 million at September 30, 2012 and December 31, 2011, respectively. The changes in the accretable discount related to the credit impaired acquired loans are as follows:

Balance at December 31, 2011	$2,610
Accretion recognized, to-date	(1,195)
Net reclassification to accretable from nonaccretable	396
Balance at September 30, 2012	$1,811

Credit Quality

Management monitors the credit quality of its loan portfolio on an ongoing basis. Measurement of delinquency and past due status are based on the contractual terms of each loan. Past due loans are reviewed on a monthly basis to identify loans for non-accrual status. The following is an aged analysis of the Company’s past due loans, by class as of September 30, 2012:

Legacy Loans (excludes loans acquired after January 1, 2009)

(000’s omitted)	30 - 89 Days	90+ Days Past Due and Still Accruing	Nonaccrual	Troubled Debt Restructure	Total Past Due	Current	Total Loans
Consumer mortgage	$13,705	$2,050	$8,210	$0	$23,965	$1,256,381	$1,280,346
Business lending	5,055	679	10,394	1,986	18,114	966,180	984,294
Consumer installment - indirect	8,335	141	0	0	8,476	621,304	629,780
Consumer installment – direct	1,384	31	0	0	1,415	154,824	156,239
Home equity	2,112	137	1,143	0	3,392	275,811	279,203
Total	$30,591	$3,038	$19,747	$1,986	$55,362	$3,274,500	$3,329,862

Acquired Loans (includes loans acquired after January 1, 2009)

(000’s omitted)	30 - 89 Days	90+ Days Past Due and Still Accruing	Nonaccrual	Total Past Due	Acquired Impaired(1)	Current	Total Loans
Consumer mortgage	$1,875	$294	$1,554	$3,723	$0	$106,061	$109,784
Business lending	3,162	17	3,742	6,921	14,623	228,090	249,634
Consumer installment - indirect	451	0	0	451	0	11,965	12,416
Consumer installment – direct	545	0	0	545	0	16,926	17,471
Home equity	796	0	341	1,137	0	92,153	93,290
Total	$6,829	$311	$5,637	$12,777	$14,623	$455,195	$482,595

(1)

Acquired impaired loans were not classified as nonperforming assets as the loans are considered to be performing under ASC 310-30. As a result interest income, through the accretion of the difference between the carrying amount of the loans and the expected cashflows, is being recognized on all acquired impaired loans.

The following is an aged analysis of the Company’s past due loans by class as of December 31, 2011:

Legacy Loans (excludes loans acquired after January 1, 2009)

(000’s omitted)	30 - 89 Days	90+ Days Past Due and Still Accruing	Nonaccrual	Total Past Due	Current	Total Loans
Consumer mortgage	$16,026	$2,144	$5,755	$23,925	$1,111,795	$1,135,720
Business lending	4,799	389	10,966	16,154	953,745	969,899
Consumer installment – indirect	8,847	32	0	8,879	527,030	535,909
Consumer installment – direct	1,912	95	0	2,007	138,500	140,507
Home equity	2,269	218	864	3,351	290,093	293,444
Total	$33,853	$2,878	$17,585	$54,316	$3,021,163	$3,075,479

Acquired Loans (includes loans acquired after January 1, 2009)

(000’s omitted)	30 - 89 Days	90+ Days Past Due and Still Accruing	Nonaccrual	Total Past Due	Acquired Impaired(1)	Current	Total Loans
Consumer mortgage	$985	$27	$765	$1,777	$0	$77,124	$78,901
Business lending	3,473	10	9,592	13,075	17,428	226,037	256,540
Consumer installment – indirect	737	0	2	739	0	20,307	21,046
Consumer installment – direct	167	0	0	167	0	8,496	8,663
Home equity	465	175	341	981	0	29,415	30,396
Total	$5,827	$212	$10,700	$16,739	$17,428	$361,379	$395,546

(1)

The Company uses several credit quality indicators to assess credit risk in an ongoing manner. The Company’s primary credit quality indicator for its business lending portfolio is an internal credit risk rating system that categorizes loans as “pass”, “special mention”, or “classified”. Credit risk ratings are applied individually to those classes of loans that have significant or unique credit characteristics that benefit from a case-by-case evaluation. The following are the definitions of the Company’s credit quality indicators:

Pass	In general, the condition of the borrower and the performance of the loans are satisfactory or better.

Special Mention	In general, the condition of the borrower has deteriorated although the loan performs as agreed.

Classified	In general, the condition of the borrower has significantly deteriorated and the performance of the loan
	could further deteriorate, if deficiencies are not corrected.

Doubtful	In general, the condition of the borrower has deteriorated to the point that collection of the balance is
	improbable based on currently facts and conditions.

The following table shows the amount of business lending loans by credit quality category:

	September 30, 2012			December 31, 2011
(000’s omitted)	Legacy	Acquired	Total	Legacy	Acquired	Total
Pass	$776,559	$161,508	$938,067	$732,873	$157,494	$890,367
Special mention	102,855	38,093	140,948	118,800	47,890	166,690
Classified	104,880	35,410	140,290	118,226	33,728	151,954
Doubtful	0	0	0	0	0	0
Acquired impaired	0	14,623	14,623	0	17,428	17,428
Total	$984,294	$249,634	$1,233,928	$969,899	$256,540	$1,226,439

All other loans are underwritten and structured using standardized criteria and characteristics, primarily payment performance, and are normally risk rated and monitored collectively on a monthly basis. These are typically loans to individuals in the consumer categories and are delineated as either performing or nonperforming. Performing loans include current, 30 – 89 days past due and acquired impaired loans. Nonperforming loans include 90+ days past due and still accruing and nonaccrual loans.

The following table details the balances in all other loan categories at September 30, 2012:

Legacy loans (excludes loans acquired after January 1, 2009)

(000’s omitted)	Consumer Mortgage	Consumer Indirect	Consumer Direct	Home Equity	Total
Performing	$1,270,086	$629,639	$156,208	$277,923	$2,333,856
Nonperforming	10,260	141	31	1,280	11,712
Total	$1,280,346	$629,780	$156,239	$279,203	$2,345,568

Acquired loans (includes loans acquired after January 1, 2009)

(000’s omitted)	Consumer Mortgage	Consumer Indirect	Consumer Direct	Home Equity	Total
Performing	$107,936	$12,416	$17,471	$92,949	$230,772
Nonperforming	1,848	0	0	341	2,189
Total	$109,784	$12,416	$17,471	$93,290	$232,961

The following table details the balances in all other loan categories at December 31, 2011:

Legacy loans (excludes loans acquired after January 1, 2009)

(000’s omitted)	Consumer Mortgage	Consumer Indirect	Consumer Direct	Home Equity	Total
Performing	$1,127,821	$535,877	$140,412	$292,362	$2,096,472
Nonperforming	7,899	32	95	1,082	9,108
Total	$1,135,720	$535,909	$140,507	$293,444	$2,105,580

Acquired loans (includes loans acquired after January 1, 2009)

(000’s omitted)	Consumer Mortgage	Consumer Indirect	Consumer Direct	Home Equity	Total
Performing	$78,109	$21,044	$8,663	$29,880	$137,696
Nonperforming	792	2	0	516	1,310
Total	$78,901	$21,046	$8,663	$30,396	$139,006

All loan classes are collectively evaluated for impairment except business lending, as described in Note B. A summary of individually evaluated impaired loans as of September 30, 2012 and December 31, 2011 follows:

	September 30,	December 31,
(000’s omitted)	2012	2011
Loans with allowance allocation	$605	$4,118
Loans without allowance allocation	11,350	2,308
Carrying balance	11,955	6,426
Contractual balance	16,004	8,527
Specifically allocated allowance	311	895

In the course of working with borrowers, the Company may choose to restructure the contractual terms of certain loans. In this scenario, the Company attempts to work-out an alternative payment schedule with the borrower in order to optimize collectability of the loan. Any loans that are modified are reviewed by the Company to identify if a troubled debt restructuring (“TDR”) has occurred, which is when, for economic or legal reasons related to a borrower’s financial difficulties, the Company grants a concession to the borrower that it would not otherwise consider. Terms may be modified to fit the ability of the borrower to repay in line with its current financial standing and the restructuring of the loan may include the transfer of assets from the borrower to satisfy the debt, a modification of loan terms, or a combination of the two. With regard to determination of the amount of the allowance for loan losses, troubled debt restructured loans are considered to be impaired. As a result, the determination of the amount of allowance for loan losses related to impaired loans for each portfolio segment within troubled debt restructurings is the same as detailed previously.

During the nine months ended September 30, 2012, the Company modified one business lending agreement that was on nonaccrual, via an increase in the term without a change in interest rate or forgiveness of principal or contractually required accrued interest, which it considers to be a TDR. The balance of the modified loan arrangement is included in the loans without allowance allocation above. There were no TDRs that subsequently defaulted during the three and nine months ended September 30, 2012. There were no commitments as of September 30, 2012 to borrowers who have terms modified in a TDR.

Allowance for Loan Losses

The following presents by class the activity in the allowance for loan losses:

	Three Months Ended September 30, 2012
	Consumer	Business	Consumer	Consumer	Home		Acquired
(000’s omitted)	Mortgage	Lending	Indirect	Direct	Equity	Unallocated	Impaired	Total
Beginning balance	$6,313	$18,698	$8,670	$3,223	$1,392	$3,112	$420	$41,828
Charge-offs	(293)	(1,100)	(1,460)	(344)	(39)	0	0	(3,236)
Recoveries	17	454	850	259	2	0	0	1,582
Provision	730	510	1,340	220	40	(390)	193	2,643
Ending balance	$6,767	$18,562	$9,400	$3,358	$1,395	$2,722	$613	$42,817

	Three Months Ended September 30, 2011
	Consumer	Business	Consumer	Consumer	Home		Acquired
(000’s omitted)	Mortgage	Lending	Indirect	Direct	Equity	Unallocated	Impaired	Total
Beginning balance	$3,286	$20,949	$10,277	$3,878	$911	$3,230	$0	$42,531
Charge-offs	(157)	(249)	(1,294)	(283)	(43)	0	0	(2,026)
Recoveries	2	88	668	151	6	0	0	915
Provision	1,056	105	(210)	(224)	126	(53)	243	1,043
Ending balance	$4,187	$20,893	$9,441	$3,522	$1,000	$3,177	$243	$42,463

	Nine Months Ended September 30, 2012
	Consumer	Business	Consumer	Consumer	Home		Acquired
(000’s omitted)	Mortgage	Lending	Indirect	Direct	Equity	Unallocated	Impaired	Total
Beginning balance	$4,651	$20,574	$8,960	$3,290	$1,130	$3,222	$386	$42,213
Charge-offs	(712)	(4,327)	(3,633)	(1,074)	(220)	0	0	(9,966)
Recoveries	34	787	2,674	613	20	0	0	4,128
Provision	2,794	1,528	1,399	529	465	(500)	227	6,442
Ending balance	$6,767	$18,562	$9,400	$3,358	$1,395	$2,722	$613	$42,817

	Nine Months Ended September 30, 2011
	Consumer	Business	Consumer	Consumer	Home		Acquired
(000’s omitted)	Mortgage	Lending	Indirect	Direct	Equity	Unallocated	Impaired	Total
Beginning balance	$2,451	$22,326	$9,922	$3,977	$689	$3,145	$0	$42,510
Charge-offs	(501)	(1,819)	(3,249)	(904)	(174)	0	0	(6,647)
Recoveries	28	406	2,461	545	17	0	0	3,457
Provision	2,209	(20)	307	(96)	468	32	243	3,143
Ending balance	$4,187	$20,893	$9,441	$3,522	$1,000	$3,177	$243	$42,463

Despite the above allocation, the allowance for loan losses is general in nature and is available to absorb losses from any loan type.

NOTE F: GOODWILL AND IDENTIFIABLE INTANGIBLE ASSETS

The gross carrying amount and accumulated amortization for each type of identifiable intangible asset are as follows:

	September 30, 2012			December 31, 2011
	Gross		Net	Gross		Net
	Carrying	Accumulated	Carrying	Carrying	Accumulated	Carrying
(000's omitted)	Amount	Amortization	Amount	Amount	Amortization	Amount
Amortizing intangible assets:
Core deposit intangibles	$38,961	($23,457)	$15,504	$32,437	($20,918)	$11,519
Other intangibles	9,429	(6,238)	3,191	9,429	(5,434)	3,995
Total amortizing intangibles	$48,390	($29,695)	$18,695	$41,866	($26,352)	$15,514

The estimated aggregate amortization expense for each of the five succeeding fiscal years ended December 31 is as follows:

Oct - Dec 2012	$1,264
2013	4,441
2014	3,597
2015	2,804
2016	2,095
Thereafter	4,494
Total	$18,695

Shown below are the components of the Company’s goodwill at September 30, 2012:

(000’s omitted)	December 31, 2011	Acquisition	September 30, 2012
Goodwill	$349,874	$24,653	$374,527
Accumulated impairment	(4,824)	0	(4,824)
Goodwill, net	$345,050	$24,653	$369,703

NOTE G: MANDATORILY REDEEMABLE PREFERRED SECURITIES

The Company sponsors two business trusts, Community Statutory Trust III and Community Capital Trust IV (“Trust IV”), of which 100% of the common stock is owned by the Company. The trusts were formed for the purpose of issuing company-obligated mandatorily redeemable preferred securities to third-party investors and investing the proceeds from the sale of such preferred securities solely in junior subordinated debt securities of the Company. The debentures held by each trust are the sole assets of that trust. Distributions on the preferred securities issued by each trust are payable quarterly at a rate per annum equal to the interest rate being earned by the trust on the debentures held by that trust and are recorded as interest expense in the consolidated financial statements. The preferred securities are subject to mandatory redemption, in whole or in part, upon repayment of the debentures. The Company has entered into agreements which, taken collectively, fully and unconditionally guarantee the preferred securities subject to the terms of each of the guarantees. The terms of the preferred securities of each trust are as follows:

	Issuance	Par		Maturity
Trust	Date	Amount	Interest Rate	Date	Call Price
III	7/31/2001	$24.5 million	3 month LIBOR plus 3.58% (4.03%)	7/31/2031	Par
IV	12/8/2006	$75 million	3 month LIBOR plus 1.65% (2.04%)	12/15/2036	Par

On December 8, 2006, the Company established Trust IV, which completed the sale of $75 million of trust preferred securities. At the time of the offering, the Company also entered into an interest rate swap agreement to convert the variable rate trust preferred securities into fixed rate securities for a term of five years at a fixed rate of 6.43%. The interest rate swap agreement expired December 15, 2011. Additional interest expense of approximately $0.9 million and $2.6 million was recognized during the three and nine months ended September 30, 2011, respectively, due to the interest rate swap agreement.

NOTE H: BENEFIT PLANS

The Company provides a qualified defined benefit pension to eligible employees and retirees, other post-retirement health and life insurance benefits to certain retirees, an unfunded supplemental pension plan for certain key executives, and an unfunded stock balance plan for certain of its nonemployee directors. The Company accrues for the estimated cost of these benefits through charges to expense during the years that employees earn these benefits. The net periodic benefit cost for the three and nine months ended September 30, 2012 and 2011 are as follows:

	Pension Benefits				Post-retirement Benefits
	Three Months Ended		Nine Months Ended		Three Months Ended		Nine Months Ended
	September 30,		September 30,		September 30,		September 30,
(000's omitted)	2012	2011	2012	2011	2012	2011	2012	2011
Service cost	$848	$735	$2,544	$2,205	$0	$0	$0	$0
Interest cost	1,098	1,191	3,295	3,344	29	38	86	115
Expected return on plan assets	(2,299)	(2,167)	(6,897)	(6,101)	0	0	0	0
Amortization of unrecognized net loss	922	474	2,765	1,422	3	2	9	6
Amortization of prior service cost	(37)	(37)	(110)	(112)	(206)	(264)	(617)	(793)
Net periodic benefit cost	$532	$196	$1,597	$758	$(174)	($224)	($522)	($672)

Effective September 30, 2011, the Wilber National Bank Retirement Plan, with $20.5 million in assets, was merged into the Community Bank System, Inc. Pension Plan and, as required, the assets and liabilities of the combined plan were revalued for financial reporting purposes.

NOTE I: EARNINGS PER SHARE

Basic earnings per share are computed based on the weighted-average of the common shares outstanding for the period. Diluted earnings per share are based on the weighted-average of the shares outstanding adjusted for the dilutive effect of restricted stock and the assumed exercise of stock options during the year. The dilutive effect of options is calculated using the treasury stock method of accounting. The treasury stock method determines the number of common shares that would be outstanding if all the dilutive options (those where the average market price is greater than the exercise price) were exercised and the proceeds were used to repurchase common shares in the open market at the average market price for the applicable time period. There were approximately 0.5 million weighted-average anti-dilutive stock options outstanding at September 30, 2012, compared to approximately 0.6 million weighted-average anti-dilutive stock options outstanding at September 30, 2011, that were not included in the computation below.

The following is a reconciliation of basic to diluted earnings per share for the three and nine months ended September 30, 2012 and 2011.

	Three Months Ended September 30,		Nine Months Ended September 30,
(000's omitted, except per share data)	2012	2011	2012	2011
Net income	$18,367	$20,008	$58,264	$54,154
Income attributable to unvested stock-based compensation awards	(125)	(147)	(372)	(414)
Income available to common shareholders	18,242	19,861	57,892	53,740

Weighted-average common shares outstanding – basic	39,384	36,679	39,095	35,436
Basic earnings per share	$0.46	$0.54	$1.48	$1.52

Net income	$18,367	$20,008	$58,264	$54,154
Income attributable to unvested stock-based compensation awards	(125)	(147)	(372)	(414)
Income available to common shareholders	18,242	19,861	57,892	53,740

Weighted-average common shares outstanding	39,384	36,679	39,095	35,436
Assumed exercise of stock options	486	362	496	403
Weighted-average shares – diluted	39,870	37,041	39,591	35,839
Diluted earnings per share	$0.46	$0.54	$1.46	$1.50

Stock Repurchase Program

On July 22, 2009, the Company announced an authorization to repurchase up to 1,000,000 of its outstanding shares in open market transactions or privately negotiated transactions in accordance with securities laws and regulations through December 31, 2011. Any repurchased shares will be used for general corporate purposes, including those related to stock plan activities. The timing and extent of repurchases will depend on market conditions and other corporate considerations as determined at the Company’s discretion. At its December 2011 meeting, the Board approved extending the stock repurchase program authorizing the repurchase, at the discretion of senior management, of up to 1,500,000 shares through December 31, 2012. There were no treasury stock purchases in 2011 or 2012.

NOTE J: COMMITMENTS, CONTINGENT LIABILITIES AND RESTRICTIONS

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments consist primarily of commitments to extend credit and standby letters of credit. Commitments to extend credit are agreements to lend to customers, generally having fixed expiration dates or other termination clauses that may require payment of a fee. These commitments consist principally of unused commercial and consumer credit lines. Standby letters of credit generally are contingent upon the failure of the customer to perform according to the terms of an underlying contract with a third party. The credit risks associated with commitments to extend credit and standby letters of credit are essentially the same as that involved with extending loans to customers and are subject to the Company’s normal credit policies. Collateral may be obtained based on management’s assessment of the customer’s creditworthiness.

The contract amount of commitments and contingencies are as follows:

(000's omitted)	September 30, 2012	December 31, 2011
Commitments to extend credit	$680,780	$572,393
Standby letters of credit	24,552	25,279
Total	$705,332	$597,672

The Company and its subsidiaries are subject in the normal course of business to various pending and threatened legal proceedings in which claims for monetary damages are asserted. As of September 30, 2012, management, after consultation with legal counsel, does not anticipate that the aggregate ultimate liability arising out of litigation pending or threatened against the Company or its subsidiaries will be material to the Company’s consolidated financial position. On at least a quarterly basis the Company assesses its liabilities and contingencies in connection with such legal proceedings. For those matters where it is probable that the Company will incur losses and the amounts of the losses can be reasonably estimated, the Company records an expense and corresponding liability in its consolidated financial statements. To the extent the pending or threatened litigation could result in exposure in excess of that liability, the amount of such excess is not currently estimable. Although the Company does not believe that the outcome of pending litigation will be material to the Company’s consolidated financial position, it cannot rule out the possibility that such outcomes will be material to the consolidated results of operations for a particular reporting period in the future.

The Bank was named a defendant in a class action proceeding filed July 20, 2012 in the United States District Court for the Middle District of Pennsylvania which seeks to establish and represent a class of customers allegedly harmed by the Bank’s overdraft practices. The complaint alleges that the Bank failed to adequately disclose the processing order of customer transactions from highest dollar value to lowest dollar value which unfairly resulted in increasing the number of overdraft charges. The claims asserted against the Bank include breach of contract and breach of covenant of good faith and fair dealing, common law unconscionability, conversion, unjust enrichment and violation of the Pennsylvania Unfair Trade Practices and Consumer Protection Law. The plaintiffs seek recovery of any overdraft fees wrongfully paid by plaintiffs, damages, expenses of litigation, attorneys’ fees, and other relief deemed equitable by the court. This case is substantially similar to cases filed against more than 100 other banks across the United States. At this stage of the proceeding, it is too early to determine if the matter would reasonably be expected to have a material adverse effect on our financial condition.

NOTE K: FAIR VALUE

Accounting standards allow entities an irrevocable option to measure certain financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. The Company has elected to value loans held for sale at fair value in order to more closely match the gains and losses associated with loans held for sale with the gains and losses on forward sales contracts. Accordingly, the impact on the valuation will be recognized in the Company’s consolidated statement of income. All mortgage loans held for sale are current and in performing status.

Accounting standards establish a framework for measuring fair value and require certain disclosures about such fair value instruments. It defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (i.e. exit price). Inputs used to measure fair value are classified into the following hierarchy:

·	Level 1 – Quoted prices in active markets for identical assets or liabilities.
·	Level 2 – Quoted prices in active markets for similar assets or liabilities, or quoted prices for identical or similar assets or liabilities in markets that are not active, or inputs other than quoted prices
	that are observable for the asset or liability.
·	Level 3 – Significant valuation assumptions not readily observable in a market.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The following tables set forth the Company’s financial assets and liabilities that were accounted for at fair value on a recurring basis. There were no transfers between any of the levels for the periods presented.

	September 30, 2012
(000's omitted)	Level 1	Level 2	Level 3	Total Fair Value
Available-for-sale investment securities:
U.S. Treasury and agency securities	$896,521	$189,232	$0	$1,085,753
Obligations of state and political subdivisions	0	707,321	0	707,321
Government agency mortgage-backed securities	0	288,295	0	288,295
Pooled trust preferred securities	0	0	50,837	50,837
Government agency collateralized mortgage obligations	0	36,975	0	36,975
Corporate debt securities	0	25,549	0	25,549
Marketable equity securities	374	0	0	374
Total available-for-sale investment securities	896,895	1,247,372	50,837	2,195,104
Mortgage loans held for sale	0	113	0	113
Total	$896,895	$1,247,485	$50,837	$2,195,217

	December 31, 2011
(000's omitted)	Level 1	Level 2	Level 3	Total Fair Value
Available-for-sale investment securities:
U.S. Treasury and agency securities	$311,958	$208,590	$0	$520,548
Obligations of state and political subdivisions	0	573,012	0	573,012
Government agency mortgage-backed securities	0	331,379	0	331,379
Pooled trust preferred securities	0	0	43,846	43,846
Government agency collateralized mortgage obligations	0	46,943	0	46,943
Corporate debt securities	0	22,855	0	22,855
Marketable equity securities	390	0	0	390
Total available-for-sale investment securities	312,348	1,182,779	43,846	1,538,973
Mortgage loans held for sale	0	532	0	532
Total	$312,348	$1,183,311	$43,846	$1,539,505

The valuation techniques used to measure fair value for the items in the table above are as follows:

Available for sale investment securities – The fair value of available-for-sale investment securities is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using quoted market prices for similar securities or model-based valuation techniques. Level 1 securities include U.S. Treasury obligations and marketable equity securities that are traded by dealers or brokers in active over-the-counter markets. Level 2 securities include U.S. agency securities, mortgage-backed securities issued by government-sponsored entities, municipal securities and corporate debt securities that are valued by reference to prices for similar securities or through model-based techniques in which all significant inputs, such as reported trades, trade execution data, LIBOR swap yield curve, market prepayment speeds, credit information, market spreads, and security’s terms and conditions, are observable. Securities classified as Level 3 include pooled trust preferred securities in less liquid markets. The value of these instruments is determined using multiple pricing models or similar techniques from third party sources as well as significant unobservable inputs such as judgment or estimation by the Company in the weighting of the models. See Note D for further discussion of the fair value of investment securities.

Mortgage loans held for sale – Mortgage loans held for sale are carried at fair value, which is determined using quoted secondary-market prices of loans with similar characteristics and, as such, have been classified as a Level 2 valuation. The unpaid principal value of mortgage loans held for sale at September 30, 2012 was approximately $113,000, which approximated fair value. Unrealized gains and losses on mortgage loans held for sale, when they occur, are recognized in other banking services income in the consolidated statement of income.

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following tables:

	Three Months Ended September 30,
	2012	2011
(000's omitted)	Pooled Trust Preferred Securities	Pooled Trust Preferred Securities	Commitments to Originate Real Estate Loans for Sale	Total
Beginning balance	$48,786	$48,972	$142	$49,114
Total gains (losses) included in earnings (1)(2)	32	23	(142)	(119)
Total gains (losses) included in other comprehensive income(3)	2,769	(1,627)	0	(1,627)
Principal reductions	(750)	(345)	0	(345)
Ending balance	$50,837	$47,023	$0	$47,023

(1) Amounts included in earnings associated with the pooled trust preferred securities relate to accretion of related discount and are reported in interest and dividends on taxable investments. (2) Amounts included in earnings associated with the commitments to originate real estate loans for sale are reported as a component of other banking service fees. (3) Amounts included in other comprehensive income associated with the pooled trust preferred securities are relate to changes in unrealized loss and are reported as a component of unrealized gains on securities in the Statement of Comprehensive Income.
	Nine Months Ended September 30,
	2012	2011
(000's omitted)	Pooled Trust Preferred Securities	Pooled Trust Preferred Securities	Commitments to Originate Real Estate Loans for Sale	Total
Beginning balance	$43,846	$41,993	$58	$42,051
Total gains (losses) included in earnings (1)(2)	176	71	(258)	(187)
Total gains included in other comprehensive income(3)	11,136	6,052	0	6,052
Principal reductions	(4,321)	(1,093)	0	(1,093)
Commitments to originate real estate loans held for sale, net	0	0	200	200
Ending balance	$50,837	$47,023	$0	$47,023

(1) Amounts included in earnings associated with the pooled trust preferred securities relate to accretion of related discount and are reported in interest and dividends on taxable investments. (2) Amounts included in earnings associated with the commitments to originate real estate loans for sale are reported as a component of other banking service fees. (3) Amounts included in other comprehensive income associated with the pooled trust preferred securities are relate to changes in unrealized loss and are reported as a component of unrealized gains on securities in the Statement of Comprehensive Income.

Assets and liabilities measured on a non-recurring basis:

	September 30, 2012				December 31, 2011
(000's omitted)	Level 1	Level 2	Level 3	Total Fair Value	Level 1	Level 2	Level 3	Total Fair Value
Impaired loans	$0	$0	$294	$294	$0	$0	$4,118	$4,118
Other real estate owned	0	0	3,384	3,384	0	0	2,682	2,682
Mortgage servicing rights	0	0	1,178	1,178	0	0	1,747	1,747
Total	$0	$0	$4,856	$4,856	$0	$0	$8,547	$8,547

Loans are generally not recorded at fair value on a recurring basis. Periodically, the Company records nonrecurring adjustments to the carrying value of loans based on fair value measurements for partial charge-offs of the uncollectible portions of those loans. Nonrecurring adjustments also include certain impairment amounts for collateral-dependent loans calculated when establishing the allowance for credit losses. Such amounts are generally based on the fair value of the underlying collateral supporting the loan and, as a result, the carrying value of the loan less the calculated valuation amount does not necessarily represent the fair value of the loan. Real estate collateral is typically valued using independent appraisals or other indications of value based on recent comparable sales of similar properties or assumptions generally observable in the marketplace, adjusted for non-observable inputs. Thus, the resulting nonrecurring fair value measurement are generally classified as Level 3. Estimates of fair value used for other collateral supporting commercial loans generally are based on assumptions not observable in the marketplace and, therefore, such valuations classify as Level 3.

Other real estate owned is valued at the time the loan is foreclosed upon and the asset is transferred to other real estate owned. The value is based primarily on third party appraisals, less costs to sell. The appraisals are sometimes further discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and client’s business. Such discounts are significant, ranging from 3% to 64% at September 30, 2012 and result in a Level 3 classification of the inputs for determining fair value. Other real estate owned is reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above. The Company recovers the carrying value of other real estate owned through the sale of the property. The ability to affect future sales prices is subject to market conditions and factors beyond our control and may impact the estimated fair value of a property.

Originated mortgage servicing rights are recorded at their fair value at the time of sale of the underlying loan, and are amortized in proportion to and over the estimated period of net servicing income. In accordance with GAAP, the Company must record impairment charges, on a nonrecurring basis, when the carrying value of a stratum exceeds its estimated fair value. The fair value of mortgage servicing rights is based on a valuation model incorporating inputs that market participants would use in estimating future net servicing income. Such inputs include estimates of the cost of servicing loans, appropriate discount rate, and prepayment speeds and are considered to be unobservable and contribute to the Level 3 classification of mortgage servicing rights. The amount of impairment recognized is the amount by which the carrying value of the capitalized servicing rights for a stratum exceeds estimated fair value. Impairment is recognized through a valuation allowance. There is a valuation allowance of approximately $430,000 at September 30, 2012.

The Company evaluates goodwill for impairment on an annual basis, or more often if events or circumstances indicate there may be impairment. The fair value of each reporting unit is compared to the carrying amount of that reporting unit in order to determine if impairment is indicated. If so, the implied fair value of the reporting unit’s goodwill is compared to its carrying amount and the impairment loss is measured by the excess of the carrying value of the goodwill over fair value of the goodwill. In such situations, the Company performs a discounted cash flow modeling technique that requires management to make estimates regarding the amount and timing of expected future cash flows of the assets and liabilities of the reporting unit that enable the Company to calculate the implied fair value of the goodwill. It also requires use of a discount rate that reflects the current return expectation of the market in relation to present risk-free interest rates, expected equity market premiums, peer volatility indicators and company-specific risk indicators. The Company did not recognize an impairment charge during 2011 or the nine months ended September 30, 2012.

The significant unobservable inputs used in the determination of fair value of assets classified as Level 3 on a recurring or non-recurring basis as of September 30, 2012 are as follows:

(000's omitted)	Fair Value at September 30, 2012	Valuation Technique	Significant Unobservable Inputs	Significant Unobservable Input Range (Weighted Average)

Pooled trust preferred securities	$50,837	Consensus pricing	Weighting of offered quotes	60.3% - 85.6% (77.8%)

Impaired loans	294	Fair value of collateral	Discount	25%

Other real estate owned	3,384	Fair value of collateral	Discount	3%-64% (27%)

Mortgage servicing rights	1,178	Discounted cash flow	Weighted average constant prepayment rate	20.5% - 36.0% (31.1%)
			Weighted average discount rate	2.40% - 3.17% (2.98%)
			Adequate compensation	$7/loan

The Company determines fair values based on quoted market values, where available, estimates of present values, or other valuation techniques. Those techniques are significantly affected by the assumptions used, including, but not limited to, the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, may not be realized in immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from fair value disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.

The carrying amounts and estimated fair values of the Company’s other financial instruments that are not accounted for at fair value at September 30, 2012 and December 31, 2011 are as follows:

	September 30, 2012		December 31, 2011
	Carrying	Fair	Carrying	Fair
(000's omitted)	Value	Value	Value	Value
Financial assets:
Net loans	$3,812,457	$3,835,406	$3,471,025	$3,491,729
Financial liabilities:
Deposits	5,708,629	5,716,925	4,795,245	4,810,856
Borrowings	728,116	827,739	728,281	828,018
Subordinated debt held by unconsolidated subsidiary trusts	102,067	93,154	102,048	73,211

The following is a further description of the principal valuation methods used by the Company to estimate the fair values of its financial instruments.

Loans have been classified as a Level 3 valuation. Fair values for variable rate loans that re-price frequently are based on carrying values, less a credit mark. Fair values for fixed rate loans are estimated using discounted cash flows and interest rates currently being offered for loans with similar terms to borrowers of similar credit quality for the same remaining maturity.

Deposits have been classified as a Level 2 valuation. The fair value of demand deposits, interest-bearing checking deposits, savings accounts and money market deposits is the amount payable on demand at the reporting date as rates re-price frequently and, therefore, are deemed to approximate market interest rates. The fair value of time deposit obligations is determined using a discounted cash flow analysis based on current market rates for similar products.

Borrowings have been classified as a Level 2 valuation. Fair values for long-term borrowings are estimated using discounted cash flows and interest rates currently being offered on similar borrowings.

Subordinated debt held by unconsolidated subsidiary trusts have been classified as a Level 2 valuation. The fair value of subordinated debt held by unconsolidated subsidiary trusts are estimated using discounted cash flows and interest rates currently being offered on similar securities.

Other financial assets and liabilities – Cash and cash equivalents have been classified as a Level 1 valuation, while accrued interest receivable and accrued interest payable have been classified as a Level 2 valuation. The fair values of each approximate the respective carrying values because the instruments are payable on demand or have short-term maturities and present low credit and interest rate risk.

NOTE L: SEGMENT INFORMATION

Operating segments are components of an enterprise, which are evaluated regularly by the “chief operating decision maker” in deciding how to allocate resources and assess performance. The Company’s chief operating decision maker is the President and Chief Executive Officer of the Company. The Company has identified Banking as its reportable operating business segment. Community Bank, N.A. operates the banking segment that provides full-service banking to consumers, businesses and governmental units in northern, central and western New York as well as Northern Pennsylvania.

Other operating segments of the Company’s operations, which do not have similar characteristics to the banking segment and do not meet the quantitative thresholds requiring disclosure, are included in the “Other” category. Revenues derived from these segments include administration, consulting and actuarial services to sponsors of employee benefit plans, investment advisory services, asset management services to individuals, corporate pension and profit sharing plans, trust services and insurance commissions from various insurance related products and services. The accounting policies used in the disclosure of business segments are the same as those described in the summary of significant accounting policies (See Note A, Summary of Significant Accounting Policies of the most recent Form 10-K for the year ended December 31, 2011 filed with the SEC on February 29, 2012).

Information about reportable segments and reconciliation of the information to the consolidated financial statements follows:

(000's omitted)	Banking	Other	Eliminations	Consolidated Total
Three Months Ended September 30, 2012
Net interest income	$58,730	$45	$0	$58,775
Provision for loan losses	2,643	0	0	2,643
Noninterest income	13,462	12,647	(541)	25,568
Gain on investment securities, net	291	0	0	291
Amortization of intangible assets	958	254	0	1,212
Other operating expenses	44,796	10,618	(541)	54,873
Income before income taxes	$24,086	$1,820	$0	$25,906
Assets	$7,546,153	$41,303	($17,083)	$7,570,373
Goodwill	$359,207	$10,496	$0	$369,703

Three Months Ended September 30, 2011
Net interest income	$54,539	$29	$0	$54,568
Provision for loan losses	1,043	0	0	1,043
Noninterest income	12,632	11,022	(432)	23,222
Loss on investment securities, net	(6)	0	0	(6)
Amortization of intangible assets	908	253	0	1,161
Other operating expenses	38,449	8,915	(432)	46,932
Income before income taxes	$26,765	$1,883	$0	$28,648
Assets	$6,480,206	$35,965	($12,317)	$6,503,854
Goodwill	$333,948	$10,281	$0	$344,229

Nine Months Ended September 30, 2012
Net interest income	$170,329	$126	$0	$170,455
Provision for loan losses	6,442	0	0	6,442
Noninterest income	36,754	37,608	(1,630)	72,732
Gain on investment securities, net	291	0	0	291
Amortization of intangible assets	2,536	807	0	3,343
Other operating expenses	121,902	31,243	(1,630)	151,515
Income before income taxes	$76,494	$5,684	$0	$82,178

Nine Months Ended September 30, 2011
Net interest income	$154,202	$76	$0	$154,278
Provision for loan losses	3,143	0	0	3,143
Noninterest income	35,225	32,947	(1,357)	66,815
Gain on investment securities & debt extinguishments, net	8	0	0	8
Amortization of intangible assets	2,529	722	0	3,251
Other operating expenses	114,776	25,865	(1,357)	139,284
Income before income taxes	$68,987	$6,436	$0	$75,423

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

Introduction

This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) primarily reviews the financial condition and results of operations of Community Bank System, Inc. (the “Company” or “CBSI”) as of and for the three and nine months ended September 30, 2012 and 2011, although in some circumstances the second quarter of 2012 is also discussed in order to more fully explain recent trends. The following discussion and analysis should be read in conjunction with the Company's Consolidated Financial Statements and related notes that appear on pages 3 through 25. All references in the discussion to the financial condition and results of operations are to those of the Company and its subsidiaries taken as a whole. Unless otherwise noted, the term “this year” refers to results in calendar year 2012, “third quarter” refers to the quarter ended September 30, 2012, and earnings per share (“EPS”) figures refer to diluted EPS.

This MD&A contains certain forward-looking statements with respect to the financial condition, results of operations and business of the Company. These forward-looking statements involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those proposed by such forward-looking statements are set herein under the caption, “Forward-Looking Statements,” on page 43.

Critical Accounting Policies

As a result of the complex and dynamic nature of the Company’s business, management must exercise judgment in selecting and applying the most appropriate accounting policies for its various areas of operations. The policy decision process not only ensures compliance with the latest generally accepted accounting principles (“GAAP”), but also reflects management’s discretion with regard to choosing the most suitable methodology for reporting the Company’s financial performance. It is management’s opinion that the accounting estimates covering certain aspects of the business have more significance than others due to the relative importance of those areas to overall performance, or the level of subjectivity in the selection process. These estimates affect the reported amounts of assets, liabilities and shareholders’ equity and disclosures of revenues and expenses during the reporting period. Actual results could differ from those estimates. Management believes that critical accounting estimates include:

Acquired loans – Acquired loans are initially recorded at their acquisition date fair values. The carryover of allowance for loan losses is prohibited as any credit losses in the loans are included in the determination of the fair value of the loans at the acquisition date. Fair values for acquired loans are based on a discounted cash flow methodology that involves assumptions and judgments as to credit risk, prepayment risk, liquidity risk, default rates, loss severity, payment speeds, collateral values and discount rate. Subsequent to the acquisition of acquired impaired loans, GAAP requires the continued estimation of expected cash flows to be received. This estimation requires numerous assumptions, interpretations and judgments using internal and third-party credit quality information. Changes in expected cash flows could result in the recognition of impairment through provision for credit losses.

evaluated collectively for impairment. For loans individually evaluated for impairment, a provision is recoded when the required allowance exceeds any remaining discount on the loan.

Allowance for loan losses – The allowance for loan losses reflects management’s best estimate of probable loan losses in the Company’s loan portfolio. Determination of the allowance for loan losses is inherently subjective. It requires significant estimates including the amounts and timing of expected future cash flows on impaired loans and the amount of estimated losses on pools of homogeneous loans which is based on historical loss experience and consideration of current economic trends, all of which may be susceptible to significant change.

Investment securities – Investment securities are classified as held-to-maturity, available-for-sale, or trading. The appropriate classification is based partially on the Company’s ability to hold the securities to maturity and largely on management’s intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on available-for-sale securities are recorded in accumulated other comprehensive income or loss, as a separate component of shareholders’ equity and do not affect earnings until realized. The fair values of investment securities are generally determined by reference to quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments, or a discounted cash flow model using market estimates of interest rates and volatility. Investment securities with significant declines in fair value are evaluated to determine whether they should be considered other-than-temporarily impaired (“OTTI”). An unrealized loss is generally deemed to be other-than-temporary and a credit loss is deemed to exist if the present value of the expected future cash flows is less than the amortized cost basis of the debt security. The credit loss component of an OTTI write-down is recorded in earnings, while the remaining portion of the impairment loss is recognized in other comprehensive income (loss), provided the Company does not intend to sell the underlying debt security, and it is not more likely than not that the Company will be required to sell the debt security prior to recovery of the full value of its amortized cost basis.

Retirement benefits – The Company provides defined benefit pension benefits to eligible employees and post-retirement health and life insurance benefits to certain eligible retirees. The Company also provides deferred compensation and supplemental executive retirement plans for selected current and former employees and officers. Expense under these plans is charged to current operations and consists of several components of net periodic benefit cost based on various actuarial assumptions regarding future experience under the plans, including, but not limited to, discount rate, rate of future compensation increases, mortality rates, future health care costs and expected return on plan assets.

Provision for income taxes – The Company is subject to examinations from various taxing authorities. Such examinations may result in challenges to the tax return treatment applied by the Company to specific transactions. Management believes that the assumptions and judgments used to record tax related assets or liabilities have been appropriate. Should tax laws change or the taxing authorities determine that management’s assumptions were inappropriate, an adjustment may be required which could have a material effect on the Company’s results of operations.

Intangible assets – As a result of acquisitions, the Company has acquired goodwill and identifiable intangible assets. Goodwill represents the cost of acquired companies in excess of the fair value of net assets at the acquisition date. Goodwill is evaluated at least annually, or when business conditions suggest impairment may have occurred and will be reduced to its carrying value through a charge to earnings if impairment exists. Core deposits and other identifiable intangible assets are amortized to expense over their estimated useful lives. The determination of whether or not impairment exists is based upon discounted cash flow modeling techniques that require management to make estimates regarding the amount and timing of expected future cash flows. It also requires them to select a discount rate that reflects the current return requirements of the market in relation to present risk-free interest rates, expected equity market premiums, peer volatility indicators and company-specific market and performance metrics, all of which are susceptible to change based on changes in economic conditions and other factors. Future events or changes in the estimates used to determine the carrying value of goodwill and identifiable intangible assets could have a material impact on the Company’s results of operations.

A summary of the accounting policies used by management is disclosed in Note A, “Summary of Significant Accounting Policies” on pages 54-60 of the most recent Form 10-K (fiscal year ended December 31, 2011) filed with the Securities and Exchange Commission on February 29, 2012.

Executive Summary

The Company’s business philosophy is to operate as a community bank with local decision-making, principally in non-metropolitan markets, providing a broad array of banking and financial services to retail, commercial and municipal customers. The Company’s banking subsidiary is Community Bank, N.A. (the “Bank” or “CBNA”), which operates in Pennsylvania under the name First Liberty Bank and Trust.

The Company’s core operating objectives are: (i) grow the branch network, primarily through a disciplined acquisition strategy, and certain selective de novo expansions, (ii) build high-quality, profitable loan and deposit portfolios using both organic and acquisition strategies, (iii) increase the noninterest income component of total revenues through development of banking-related fee income, growth in existing financial services business units, and the acquisition of additional financial services and banking businesses, and (iv) utilize technology to deliver customer-responsive products and services and continually improve operating efficiency.

Significant factors management reviews to evaluate achievement of the Company’s operating objectives and its operating results and financial condition include, but are not limited to: net income and earnings per share; return on assets and equity; net interest margins; noninterest income; operating expenses; asset quality; loan and deposit growth; capital management; performance of individual banking and financial services units; liquidity and interest rate sensitivity; enhancements to customer products and services; technology advancements; market share; peer comparisons; and the performance of acquisition activities.

On April 8, 2011, the Company acquired The Wilber Corporation (“Wilber”), the parent company of Wilber National Bank, for $103 million in stock and cash, comprised of $20.4 million in cash and the issuance of 3.35 million additional shares of the Company’s common stock. Based in Oneonta, New York, Wilber operated 22 branches in the Central, Greater Capital District and Catskills regions of Upstate New York. The acquisition added approximately $462 million of loans, $298 million of investment securities and $772 million of deposits.

On November 30, 2011, the Company, through its BPAS subsidiary, acquired certain assets and liabilities of CAI Benefits, Inc. (“CAI”) a provider of actuarial, consulting and retirement plan administration services, with offices in New York City and Northern New Jersey. The transaction adds valuable service capacity and enhances distribution prospects in support of the Company’s broader-based employee benefits business, including daily valuation plan and collective investment fund administration.

On July 20, 2012, Community Bank, N.A. (the” Bank”), the wholly-owned banking subsidiary of the Company, completed its acquisition of 16 retail branches in central, northern and western New York from HSBC Bank USA, N.A. (“HSBC”), acquiring approximately $106 million in loans and $697 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money market accounts) and the purchased loans consist of in-market performing loans primarily residential real estate loans. Under the terms of the purchase agreement, the Bank paid First Niagara Bank, N.A. (“First Niagara”) (who acquired HSBC’s Upstate New York banking business and assigned its right to purchase the 16 branches to the Bank) a blended deposit premium of 3.4%, or approximately $24 million.

On September 7, 2012, the Bank completed its acquisition of three branches in central New York from First Niagara, acquiring approximately $54 million of loans and $101 million of deposits. The assumed deposits consist primarily of core deposits (checking, savings and money market accounts) and the purchased loans consist of in-market performing loans, primarily residential real estate loans. Under the terms of the purchase agreement, the Bank paid a blended deposit premium of 3.1%, or approximately $3 million.

Third quarter 2012 net income of $18.4 million decreased $1.6 million or 8.2% as compared to the third quarter of 2011, while earnings per share for the quarter of $0.46 were $0.08 or 14.8% lower than the third quarter of the prior year. The current year results included $4.8 million of acquisition-related expenses, or $0.08 per share, compared with $0.4 million in the prior year period. September year-to-date net income of $58.3 million was $4.1 million or 7.6% higher than the respective prior year period. Year-to-date earnings per share were $1.46, a decrease of $0.04 from the equivalent prior year period. The year-to-date results for both periods include $0.09 of acquisition related expenses. Both quarterly and year-to-date results experienced higher net interest income generated from earning asset growth resulting from the HSBC and First Niagara branch acquisitions, combined with the Wilber acquisition in the second quarter of 2011 and organic loan growth, partially offset by a lower net interest margin. Also contributing to higher net income was growth of noninterest income due to incremental deposit service fees from the HSBC, First Niagara and Wilber acquisitions, higher debit card-related revenue, higher employee benefits administration and consulting revenues, primarily driven by the CAI acquisition and solid revenue growth from the wealth management businesses, which benefitted from more favorable market conditions. These were partially offset by higher provisions for loan losses, higher operating expenses due in large part to the additional operating costs and one-time acquisition related expenses from the HSBC, First Niagara and Wilber acquisitions, and a higher effective income tax rate. Additionally, earnings per share were impact by the 2.13 million shares issued in January 2012 in support of the HSBC and First Niagara branch acquisitions and the 3.35 million shares issued in April 2011 in conjunction with the Wilber acquisition.

Asset quality in the third quarter of 2012 remained stable and favorable in comparison to averages for peer financial organizations. Third quarter loan net charge-off ratios were higher than those experienced in the third quarter of 2011, but lower than the level of net charge-offs in the first and second quarters of 2012. Nonperforming loan ratios were higher than experienced in the third quarter of last year, but lower than the first and second quarter of 2012. The current quarter provision for loan losses was higher than the third quarter of 2011 as a result of organic loan growth and the need for an allowance on loans acquired during the third quarter of 2012. Delinquency ratios increased from the third quarter of 2011, but were below those experienced in the fourth quarter of 2011. The Company generated year-over-year growth in average interest-earning assets for the quarter, reflective of the pre-investment of approximately $600 million of expected liquidity from the HSBC branch acquisition, as well as organic loan growth. Average deposits in the third quarter of 2012 were higher than the third quarter of 2011 and the fourth quarter of 2011, driven by the HSBC and First Niagara acquisitions as well as organic deposit growth. Average borrowings decreased during the third quarter of 2012, as the Company extinguished all overnight obligations upon the completion of the branch acquisitions.

Net Income and Profitability

As shown in Table 1, net income for the third quarter and September YTD of $18.4 million and $58.3 million decreased 8.2% versus the third quarter of 2011 and increased 7.6% compared to the first nine months of 2011. Earnings per share for the third quarter of $0.46 were $0.08 lower that the EPS generated in the third quarter of 2011, and earnings per share of $1.46 for the first nine months of 2012 decreased $0.04 from the amount earned in the first nine months of 2011. Included in these results were $4.8 million and $5.2 million of acquisition expenses for the three and nine months ending September 30, 2012, respectively, as compared to $0.4 million and $4.7 million for the comparative periods of 2011. Earnings per share for both periods were impacted by the public common stock offering in January 2012 in support of the branch acquisitions and the issuance of 3.35 million shares in conjunction with the Wilber acquisition in the second quarter of 2011.