FORWARD LOOKING INFORMATION

This Quarterly Report on Form 10-Q contains forward-looking statements that are based on assumptions and may describe future plans, strategies and expectations of Penseco Financial Services Corporation and its direct and indirect subsidiaries. These forward-looking statements are generally identified by use of the words "believe," "expect," "intend," "anticipate," "estimate," "project" or similar expressions. Penseco Financial Services Corporation's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse effect on the operations include, but are not limited to, changes in interest rates, national and regional economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. government, including policies of the U.S. Department of Treasury and the Federal Reserve System, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in Penseco Financial Services Corporation's market area, changes in the values of real estate and other collateral, particularly in our market area, changes in relevant accounting principles and guidelines and inability of third party service providers to perform.

These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, Penseco Financial Services Corporation does not undertake, and specifically disclaims any obligation, to release publicly the result of any revisions that may be made to any forward-looking statements to reflect events or circumstances after the date of the statements or to reflect the occurrence of anticipated or unanticipated events.

Unless the context indicates otherwise, all references in this Quarterly Report to "Company," "we," "us" and "our" refer to Penseco Financial Services Corporation and its direct and indirect subsidiaries.

The following commentary provides an overview of the financial condition at June 30, 2012, including any significant changes from December 31, 2011, and significant changes in the results of our operations for the three and six month periods ended June 30, 2012 and June 30, 2011.

Critical Accounting Policies

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Provision and Allowance for loan and lease losses-The provision for loan and lease losses charged to operating expense represents the adjustment that, in management's judgment, is necessary to maintain the allowance for loan and lease losses at a level that is adequate to absorb probable losses inherent in the Company's loan portfolio. The allowance for loan and lease losses is determined based on a documented and consistently applied methodology. This methodology considers all significant factors that affect the collectability of the loans within our portfolio, including past loan loss experience, management's evaluation of the probable loss in the current loan portfolio under current economic conditions and such other factors as, in management's best judgment, merit recognition in estimating loan and lease losses.

Actuarial assumptions associated with pension, post-retirement and other employee benefit plans-These assumptions include discount rate, rate of future compensation increases and expected return on plan assets.

Income taxes-The calculation of the provision for federal income taxes is complex and requires the use of estimates and judgments. Deferred federal income tax assets or liabilities represent the estimated impact of temporary differences between the recognition of assets and liabilities under GAAP, and how such assets and liabilities are recognized under the federal tax code. The Company uses an estimate of future earnings to support management's position that the benefit of the deferred tax assets will be realized. If projected income is not recognized, at all or in the amounts predicted, the asset may not be realized and net income will be reduced. Deferred tax assets are described further in Note 18 of the "Notes to Consolidated Financial Statements" in the Company's most recent Annual Report on Form 10-K.

The Company and its subsidiary file income tax and other returns in the U.S. Federal jurisdiction, Pennsylvania state jurisdiction and certain local jurisdictions.

Management evaluated the Company's tax positions and concluded that the aggregate liabilities related to taxes are appropriately reflected in the consolidated financial statements. With few exceptions, the Company is no longer subject to income tax examinations by the U.S. Federal, state or local tax authorities for years before 2008.

Fair Value Measurements-Fair values of financial instruments are estimated using relevant market information and other assumptions. Fair value estimates involve uncertainties and matters of significant judgment regarding interest rates, credit risk, prepayment speeds and other factors. Changes in assumptions or in market conditions could significantly affect the estimates. Fair value measurements are classified within one of three levels within a valuation hierarchy based on the transparency of inputs to each valuation as of the fair value measurement date. The three levels are defined as follows:

Level I-quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level II-inputs include quoted prices for similar assets and liabilities in active markets, quoted prices of identical or similar assets or liabilities in markets that are not active, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.

Level III-inputs that are unobservable and significant to the fair value measurement. Financial instruments are considered Level III when values are determined using pricing models, discounted cash flow methodologies, or similar techniques, and at least one significant model assumption or input is unobservable.

Other-than-temporary impairment of investments-Investments are evaluated periodically to determine whether a decline in their value is other than temporary. Management utilizes criteria such as the magnitude and duration of the decline, in addition to the reasons underlying the decline, to determine whether the loss in value is other than temporary. The term "other-than-temporary" is not intended to indicate that the decline is permanent. It indicates that the prospects for a near term recovery of value are not necessarily favorable, or that there is a lack of evidence to support fair values equal to, or greater than, the carrying value of the investment. Once a decline in value is determined to be other-than-temporary, the value of the security is reduced and a corresponding charge to earnings is recognized.

Premium amortization-The amortization of premiums on mortgage-backed securities is done based on management's estimate of the lives of the securities, adjusted, when necessary, for advanced prepayments in excess of those estimates.

Loans purchased-Loans purchased as a result of the Merger were recorded at the acquisition date fair value. Management made three different types of fair value adjustments in order to record the loans at fair value. An interest rate fair value adjustment was made comparing current weighted average rates of the acquired loans to stated market rates of similar loan types. A general credit fair value adjustment was made on similar loan types based on historical loss projections plus a discount for the weak economic environment. A specific credit fair value adjustment was made to loans identified by management as being problematic. The specific loans have been discounted by management based on collateral values and expected cash flows. The interest rate and general credit fair value adjustments are being accreted over an eight year period based on a sum-of-the-years-digits basis. The specific credit fair value adjustment is reduced only when cash flows are received or loans are charged-off or transferred to other real estate owned.

Loan servicing rights-Mortgage servicing rights are evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest and expected future prepayment rates. For purposes of measuring impairment, the rights must be stratified by one or more predominant risk characteristics of the underlying loans. The Company stratifies its capitalized mortgage servicing rights based on the product type, interest rate and term of the underlying loans. The amount of impairment recognized is the amount, if any, by which the amortized cost of the rights for each stratum exceed the fair value.

Time deposits-Time deposits acquired through the Merger have been recorded at their acquisition date fair value. The fair value of time deposits represents the present value of the time deposits' expected contractual payments discounted by market rates for similar deposits. The fair value adjustment is amortized monthly based on a level yield methodology.

Securities sold under agreements to repurchase-The Company also offers securities sold under agreements to repurchase as an alternative to conventional savings deposits for its customers. The securities sold under agreements to repurchase are accounted for as a collateralized borrowing with a one day maturity and are collateralized by U.S. Agency securities.

Core deposit intangible-The fair value assigned to the core deposit intangible asset represents the future economic benefit of the potential cost savings from acquiring core deposits in the Merger compared to the cost of obtaining alternative funding, such as brokered deposits, from market sources. Management utilized an income approach to present value the expected after tax cash flow benefits of the acquired core deposits. The core deposit intangible is being amortized over ten years on a sum-of-the-years-digits basis.

Goodwill-Goodwill is reviewed by management for possible impairment at least annually or more frequently upon the occurrence of an event or when circumstances indicate that its carrying amount exceeds fair value. Management has obtained a professionally prepared qualitative test for goodwill impairment as of December 31, 2011. Market conditions that could negatively impact the value of goodwill in the future are essentially those Risk Factors discussed in

Depreciation-Provision for depreciation and amortization, computed principally on the straight-line method, is charged to operating expenses over the estimated useful lives of the assets.

Comparison of Operating Results



                                            Three Months Ended June 30,             Six Months Ended June 30,
                                            2012                 2011 *               2012              2011 *
Interest Income                         $       9,476         $       9,949       $      19,135        $  19,989
Interest Expense                                1,407                 1,922               2,888            3,819

Net Interest Income                             8,069                 8,027              16,247           16,170

Provision for loan and lease losses               114                   899                 306            1,268

Non-Interest Income                             2,626                 3,055               5,529            6,359

Non-Interest Expenses                           7,261                 6,936              14,601           14,451

Net Income                              $       2,599         $       2,562       $       5,329        $   5,288

Total Revenue (1)                       $      12,102         $      13,004       $      24,664        $  26,348

Net Interest Margin (2)                          4.14 %                4.04 %              4.17 %           4.10 %
Return on Assets (ROA)                           1.13 %                1.11 %              1.15 %           1.15 %
Return on Equity (ROE)                           8.01 %                8.33 %              8.24 %           8.36 %

* as restated see Note 18

(1) Total revenue is the sum of interest income and non-interest income.

(2) The net interest margin is equal to tax equivalent net interest income divided by average interest-earning assets.

The Company reported net income for the three months ended June 30, 2012 of $2599, an increase of $37, or 1.4%, to $0.79 per basic and dilutive earnings per share, compared with $2,562, or $0.78 per basic and dilutive earnings per share, from the year ago period. Pre-provision net interest income increased $42, or 0.5%. Net interest income, after provision for loan and lease losses, increased $827, or 11.6%, during the 2012 period, due to a reduction in interest expense of $515, or 26.8%, from lower funding costs and a $785, or 87.3%, decrease in the provision for loan and lease losses, offset by a decrease in interest income of $473, or 4.8%. The decrease in interest income was primarily attributable to investment and loan cash flows being reinvested at historically low yields, including excess reserve deposits held at the Federal Reserve Bank of Philadelphia. Non-interest income decreased $429, or 14.0%, largely due to decreased net realized gains on securities and lower net gains on the sale of other real estate owned property. Non-interest expenses increased $325, or 4.7%, due to higher compensation expenses of $177, Pennsylvania shares tax expenses of $469 and other real estate owned expenses, offset by lower premise and equipment expenses, FDIC insurance expenses and merchant transaction expenses.

The Company reported net income for the six months ended June 30, 2012 of $5,329, an increase of $41, or 0.8%, or $1.63 per basic and dilutive earnings per share, compared with $5,288, or $1.61 per basic and dilutive earnings per share, from the year ago period. Pre-provision net interest income increased $77, or 0.5%. Net interest income, after provision for loan and lease losses, increased $1,039, or 7.0%, during the 2012 period, due to a reduction in interest expense of $931, or 24.4%, from lower funding costs and a $962, or 75.9%, decrease in the provision for loan and lease losses, offset by a decrease in interest income of $854, or 4.3%. The decrease in interest income was primarily attributable to investment and loan cash flows being reinvested at historically low yields, including excess reserve deposits held at the Federal Reserve Bank of Philadelphia. Non-interest income decreased $830, or 13.1%, largely due to income recorded on the reversal of a contingent liability of $500 during the quarter ended March 31, 2011 and decreased net realized gains on securities. Non-interest expenses increased $150, or 1.0%, due to higher compensation expenses, Pennsylvania shares tax expenses and other real estate owned expenses, offset by lower premise and equipment expenses, FDIC insurance expenses and merchant transaction expenses.

We have defined our "core operations" to exclude the reversal, in the three months ended in March 31, 2011, of a contingent liability recorded in connection with the acquisition of Old Forge Bank. Net income from core operations increased $371 or 7.5% for the six months ended June 30, 2012 to $5,329, compared to $4,958 for the same period in 2011. Net income from core operations is a non-GAAP measure of net income. A reconciliation of the net income from core operations and disclosure of the non-GAAP return on assets, return on equity and dividend payout ratio derived from that measure are described in the non-GAAP reconciliation included in this Quarterly Report on Form 10-Q.

The following table reflects net income from accretion and amortization, net of taxes, of acquisition date fair value adjustments relating to the Merger included in the Company's financial results during the periods indicated.

                                                                     Three Months Ended
                                                                June 30,            June 30,
                                                                  2012                2011
Homogeneous loan pools (interest income)                       $       98          $       128
Time deposits (interest expense)                                        7                   25
Core deposit intangible expense (other operating expense)             (42 )                (49 )

Net income from acquisition fair value adjustment              $       63          $       104


                                                                      Six Months Ended
                                                                June 30,            June 30,
                                                                  2012                2011
Homogeneous loan pools (interest income)                       $      219          $       279
Time deposits (interest expense)                                       18                   55
Core deposit intangible expense (other operating expense)             (91 )               (104 )

Net income from acquisition fair value adjustment              $      146          $       230

Accretion of the loan pools credit fair value adjustment and market rate fair value adjustment is calculated on a sum-of-the-years-digits basis over an eight year period. The fair value market rate adjustment of the time deposits is amortized monthly based on a level yield methodology over five years. The core deposit intangible established in connection with the 2009 acquisition of Old Forge Bank is being amortized over ten years from the date of acquisition on a sum-of-the-years-digits basis.

Net Interest Income and Net Interest Margin

Net interest income, the principal component of the Company's earnings, is defined as the difference between interest and fees earned on interest-earning assets and interest paid on deposits and other borrowings. Average interest-earning assets are composed primarily of loans and investments while deposits and short-term and long-term borrowings represent interest-bearing liabilities. Variations in the volume and mix of these assets and liabilities, as well as changes in the yields earned and rates paid, are determinants of changes in net interest income.

Net interest income (before the provision for loan and lease losses) increased $42, or 0.5%, to $8,069 for the three months ended June 30, 2012 compared to $8,027 for the three months ended June 30, 2011. The average yield on interest-earning assets decreased 12 basis points, or 2.4%.

The net interest margin represents the Company's net yield on its average interest-earning assets and is calculated as net interest income divided by average interest-earning assets. For the three months ended June 30, 2012, net interest margin (tax equivalent basis) increased 10 basis points to 4.14% from 4.04% in the same period of 2011.

The most significant impact on net interest income between periods is derived from the interaction of changes in the volume of, and rates earned or paid on, interest-earning assets and interest-bearing liabilities. The volume of earning dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in net interest income between periods.

Total average interest-earning assets and average interest-bearing liabilities decreased from the three months ended June 30, 2011. Due to historically low interest rates, the Bank is reluctant to portfolio long-term, thirty year, mortgage loans and commit to long-term investment securities and has decided to allow these assets to runoff or refinance out of the Bank's portfolio. Average interest-earning assets decreased $16.5 million or 1.9%, from $851.6 million for the three months ended June 30, 2011 to $835.1 million for the corresponding period in 2012 and average interest-bearing liabilities decreased $33.9 million, or 5.0%, from $677.0 million to $643.1 million over the same periods. As a percentage of average assets, average interest-earning assets, including bank-owned life insurance (BOLI), decreased for the three months ended June 30, 2012 and 2011, respectively, to 92.4% from 93.7%.

Changes in the mix of both interest-earning assets and funding sources also impacted net interest income in the three months ended June 30, 2012 and 2011. Average loans as a percentage of average interest-earning assets increased from 72.3% for the three months ended June 30, 2011 to 76.5% for the corresponding period in 2012. Average investment securities decreased $16.3 million, or 8.0%, period over period, and as a percentage of interest-earning assets, decreased to 22.5% for the three months ended June 30, 2012 from 24.0% for the three months ended June 30, 2011. Average short-term investments, federal funds sold, FHLB stock and interest-bearing balances with banks, decreased as a percentage of average assets to 0.9% for the three months ended June 30, 2012 from 3.5% for the three months ended June 30, 2011. Average time deposits decreased $46.5 million, or 18.7%, from $248.2 million, or 36.7%, of interest-bearing liabilities for the three months ended June 30, 2011 to $201.7 million, or 31.4%, of interest-bearing liabilities for the corresponding period of 2012. Also, during the three months ended June 30, 2012, average securities sold under agreements to repurchase decreased $11.8 million, or 54.6%, and average long-term borrowings decreased $10.8 million, or 17.0%.

Shifts in the interest rate environment to lower rates and local competition for loans and deposits affected the rates paid for funds as well as the yields earned on assets. The investment securities tax equivalent yield decreased 55 basis points from 4.04% for the three months ended June 30, 2011 to 3.49% for the three months ended June 30, 2012. Also, average loan yields decreased 23 basis points from 5.50% for the three months ended June 30, 2011 to 5.27% for the three months ended June 30, 2012.

The average time deposit costs decreased 26 basis points from 1.60% for the three months ended June 30, 2011 to 1.34% for the three months ended June 30, 2012. In addition, the average cost of money market accounts decreased 13 basis points from 0.47% for the three months ended June 30, 2011 to 0.34% for the three months ended June 30, 2012.

Interest expense for the three months ended June 30, 2012 totaled $1,407, compared to $1,922 in 2011, a decrease of $515 or 26.8%. The average rate paid on interest-bearing liabilities for the three months ended June 30, 2012 decreased to 0.88%, compared to 1.14% in 2011. Average savings deposits increased $6.9, or 5.9%. Average time deposits decreased $46.5, or 18.7%, for the three months ended June 30, 2012 due primarily to the redemption of brokered certificates of deposit. Average demand non-interest bearing deposits increased $18.2, or 15.4%.

The historically low interest rates continue to stress our margin as funding costs have reached a low point and asset yields for the most part continue to price downward. The Dodd-Frank Act, which was enacted in July 2010, and the regulations that have been and will be promulgated under the Act, are reducing our non-interest income, such as overdraft fees, and increasing compliance and regulatory costs.

Distribution of Assets, Liabilities and Stockholders' Equity / Interest Rates and Interest Differential

The table below presents average balances, interest income on a taxable equivalent basis and interest expense, as well as average rates earned and paid on the Company's major asset and liability items for the three months ended June 30, 2012 and June 30, 2011.

                                                  June 30, 2012                            June 30, 2011 *
                                        Average       Revenue/      Yield/        Average       Revenue/      Yield/
                                        Balance       Expense        Rate         Balance       Expense        Rate
ASSETS
Investment Securities
Available-for-sale:
U.S. Agency obligations                $ 105,169     $      430        1.64 %    $  98,834     $      483        1.95 %
States & political subdivisions           60,941            650        6.47 %       62,802            720        6.95 %
Other                                      1,061             12        4.52 %        5,366             15        1.12 %
Held-to-maturity:
U.S. Agency obligations                   19,192            185        3.86 %       26,089            262        4.02 %
States & political subdivisions            1,339             17        7.77 %       10,868            137        7.66 %
Loans, net of unearned income:
Real estate mortgages                    290,395          3,379        4.65 %      318,282          4,054        5.09 %
Commercial real estate                   189,955          2,304        4.85 %      178,131          2,216        4.98 %
Commercial                                56,922            765        5.38 %       39,589            555        5.61 %
Consumer and other                       101,461          1,731        7.75 %       79,441          1,503        8.24 %
Federal funds sold                            -              -           -           1,868             -           -
Federal Home Loan Bank stock               5,356              1        0.07 %        5,578             -           -
Interest on balances with banks            3,334              2        0.24 %       24,717              4        0.06 %

Total Interest-Earning Assets/Total
Interest Income                          835,125     $    9,476        4.82 %      851,565     $    9,949        4.94 %

Cash and due from banks                   18,089                                    10,393
Bank premises and equipment               14,231                                    13,356
Accrued interest receivable                3,026                                     3,350
Goodwill                                  26,398                                    26,398
Bank owned life insurance                 17,284                                    15,550
. . .