For the fiscal year ended December 31, 2003

OR

For the transition period from ____________to___________

(Exact name of Registrant as specified in its charter)

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes |X| No |_|

The aggregate market value of the voting stock held by non-affiliates of the Registrant on June 30, 2003, determined using a per share closing price on that date of $27.00, as quoted on the Nasdaq National Market was $87,842,556.

The number of outstanding shares of the Registrant’s common stock on March 1, 2004: 3,564,213 shares.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the proxy statement for the annual shareholders meeting to be held on May 11, 2004 (the “Proxy Statement”), are incorporated by reference in Part III.

TABLE OF CONTENTS

FORM 10-K ANNUAL REPORT
FOR THE YEAR ENDED
DECEMBER 31, 2003
ALLIANCE FINANCIAL CORPORATION

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PART I

        This Annual Report on Form 10-K contains certain forward-looking statements with respect to the financial condition, results of operations and business of Alliance Financial Corporation and its subsidiaries. These forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, involve certain risks and uncertainties. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) an increase in competitive pressure in the banking industry; (2) changes in the interest rate environment reduce margins; (3) changes in the regulatory environment; (4) general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (5) changes in business conditions and inflation; (6) changes in the securities markets; (7) the ability to maintain and increase market share and control expenses; and (8) other factors detailed from time to time in the Company’s SEC filings.

        The Company maintains a website at Alliancebankna.com. Annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and amendments to those reports, are available on the Company’s website free of charge as soon as reasonably practicable following the filing of those reports with the Securities and Exchange Commission.

Item 1 — Description of the Business

General

        Alliance Financial Corporation (the “Company”) is a New York-registered bank holding company formed on November 25, 1998 as a result of the merger of Cortland First Financial Corporation and Oneida Valley Bancshares, Inc., which were incorporated in May 30, 1986 and October 31, 1984, respectively. The Company is the parent holding company of Alliance Bank, N.A. (the “Bank”), which was formed as the result of a merger of First National Bank of Cortland and Oneida Valley National Bank as of the close of business, April 16, 1999. Unless the context otherwise provides, references herein to the “Company” mean Alliance Financial Corporation, Alliance Bank, N.A., and the Bank’s subsidiaries Alliance Preferred Funding Corp. and Alliance Leasing, Inc.

        The Company’s administrative offices are located on the 18th Floor, MONY Tower II, 120 Madison St., Syracuse, New York. Banking services are provided at the administrative offices as well as at 17 customer service facilities located in Cortland, Madison, Onondaga, and western Oneida counties.

        At December 31, 2003, the Company had 251 full-time employees and 30 part-time employees.

        The Bank is a member of the Federal Reserve System and the Federal Home Loan Bank System, and deposits are insured by the Federal Deposit Insurance Corporation up to applicable limits.

Services

        The Company offers full service banking with a broad range of financial products to meet the needs of its commercial, retail, government, and trust customers. Depository account services include interest and non-interest bearing checking accounts, money market accounts, savings accounts, time deposit accounts, and individual retirement accounts. The Company’s lending activities include the making of residential and commercial mortgage loans, business lines of credit, working capital facilities and business term loans as well as installment loans, home equity loans, student loans, and personal lines of credit to individuals. Trust and investment department services include personal trust, employee benefit trust, investment management, custodial, and financial planning. Through UVEST Financial Services, member NASD/SIPC, the Bank provides financial counseling and brokerage services. The Company also offers safe deposit boxes, travelers checks, money orders, wire transfers, collection services, drive-up banking facilities, 24-hour night depositories, automated teller machines, 24-hour telephone banking, and on-line internet banking. Commercial leasing services are offered through Alliance Leasing, Inc., a subsidiary of the Bank.

Competition

        The Company’s business is extremely competitive. The Company competes not only with other commercial banks but also with other financial institutions such as thrifts, credit unions, money market and mutual funds, insurance companies, brokerage firms, and a variety of other financial services companies.

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Supervision and Regulation

        The following discussion summarizes some of the laws and regulations applicable to bank holding companies and national banks and provides certain specific information relevant to the Company. This regulatory framework primarily is intended for the protection of depositors and the deposit insurance funds that insure bank deposits, and not for the protection of shareholders or creditors of bank holding companies and banks. To the extent that the following information describes statutory and regulatory provisions, it is qualified in its entirety by reference to those provisions. Moreover, Congress, state legislatures and regulatory agencies frequently propose changes to the law and regulations affecting the banking industry. The likelihood and timing of any changes and the impact such changes might have on the Company are impossible to accurately predict. A change in the statutes, regulations, or regulatory policies applicable to the Company or its subsidiaries may have a material adverse effect on their business.

        The Company is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, and is subject to supervision, regulation and examination by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). The Bank Holding Company Act and other federal laws subject bank holding companies to particular restrictions on the types of activities in which they may engage, and to a range of supervisory requirements and activities, including regulatory enforcement actions for violations of laws and regulations. The Bank Holding Company Act requires every bank holding company to obtain the prior approval of the Federal Reserve Board before it may acquire all or substantially all of the assets of any bank, or ownership or control of any voting shares of any bank, if after such acquisition it would own or control, directly or indirectly, more than 5% of the voting shares of such bank. In approving bank acquisitions by bank holding companies, the Federal Reserve Board is required to consider the financial and managerial resources and future prospects of the bank holding company and the banks concerned, the convenience and needs of the communities to be served, and various competitive factors. The Change in Bank Control Act prohibits a person or group of persons from acquiring “control” of a bank holding company unless the Federal Reserve Board has been notified and has not objected to the transaction. In addition, any entity is required to obtain the approval of the Federal Reserve Board under the Bank Holding Company Act before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of the Company’s outstanding common stock, or otherwise obtaining control or a “controlling influence” over the Company.

        The Federal Reserve Board has broad authority to prohibit activities of bank holding companies and their non-banking subsidiaries which represent unsafe and unsound banking practices or which constitute violations of laws or regulations, and can assess civil money penalties for certain activities conducted on a knowing and reckless basis. Bank holding companies and their affiliates are prohibited from tying the provision of certain services, such as extensions of credit, to other services offered by a holding company or its affiliates.

        Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to each of its banking subsidiaries and commit resources to their support. The Federal Reserve Board may charge the bank holding company with engaging in unsafe and unsound practices for failure to commit resources to a subsidiary bank when required. Any capital loans by the Company to its subsidiary bank would be subordinate in right of payment to depositors and to certain other indebtedness of the subsidiary bank.

        The Company’s ability to pay dividends to its shareholders is largely dependent on the ability of the Bank, the Company’s bank subsidiary, to pay dividends to the Company. The ability of both the Company and the Bank to pay dividends are limited by federal statutes, regulations and policies. For example, it is the policy of the Federal Reserve Board that bank holding companies should pay cash dividends on common stock only out of income available over the past year, and only if prospective earnings retention is consistent with the holding company’s expected future needs and financial condition. The policy provides that bank holding companies should not maintain a level of cash dividends that undermines the bank holding company’s ability to serve as a source of strength to its banking subsidiaries. Furthermore, the Bank must obtain regulatory approval for the payment of dividends if the total of all dividends declared in any calendar year would exceed the total of the Bank’s net profits, as defined by applicable regulations, for that year, combined with its retained net profits for the preceding two years. The Bank may not pay a dividend in an amount greater than its undivided profits then on hand after deducting its losses and bad debts, as defined by applicable regulations.

        The Federal Reserve Board has established risk-based capital guidelines that are applicable to bank holding companies. The guidelines established a framework intended to make regulatory capital requirements more sensitive to differences in risk profiles among banking organizations and take off-balance sheet exposures into explicit account in assessing capital adequacy. The Federal Reserve Board guidelines define the components of capital, categorize assets into different risk classes, and include certain off-balance sheet items in the calculation of risk-weighted assets. At least half of the total capital must be comprised of common equity, retained earnings and a limited amount of perpetual preferred stock, less goodwill (“Tier I capital”). Banking organizations that are subject to the guidelines are required to maintain a ratio of Tier I capital to risk-weighted assets of at least 4.00% and a ratio of total capital to risk-weighted assets of at least 8.00%. The appropriate regulatory authority may set higher capital requirements when an organization’s particular circumstances warrant. The remainder (“Tier 2 capital”) may consist of a limited amount of subordinated debt, limited-life preferred stock, certain other instruments and a limited amount of loan and lease loss reserves. The sum of Tier I capital and Tier 2 capital is “total risk-based capital.” The Company’s Tier I and total risk-based capital ratios as of December 31, 2003 were 14.72% and 15.95%, respectively.

        In addition, the Federal Reserve Board has established a minimum leverage ratio of Tier 1 capital to quarterly average assets less goodwill (“Tier I leverage ratio”) of 3.00% for bank holding companies that meet certain specified criteria, including that they have the highest regulatory rating. All other bank holding companies are required to maintain a Tier I leverage ratio of 3.00% plus an additional cushion of at least 100 to 200 basis points. The Company’s Tier I Leverage ratio as of December 31, 2003 was 8.93%, which exceeded its regulatory requirement of 4.00%. The guidelines provide that banking organizations experiencing internal growth or making acquisitions will be expected to maintain strong capital positions substantially above the minimum supervisory levels, without significant reliance on intangible assets.

        The Gramm-Leach-Bliley Act (“Gramm-Leach”) was signed into law on November 12, 1999. Gramm-Leach permits, subject to certain conditions, combinations among banks, securities firms and insurance companies. Under Gramm-Leach, bank holding companies are

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permitted to offer their customers virtually any type of financial service including banking, securities underwriting, insurance (both underwriting and agency), and merchant banking. In order to engage in these additional financial activities, a bank holding company must qualify and register with the Federal Reserve Board as a “financial holding company” by meeting certain higher standards for capital adequacy and management, with heavy penalties for non-compliance. Gramm-Leach establishes that the federal banking agencies will regulate the banking activities of financial holding companies and banks’ financial subsidiaries, the U.S. Securities and Exchange Commission will regulate their securities activities and state insurance regulators will regulate their insurance activities. Bank holding companies that wish to engage in expanded activities but do not wish to become financial holding companies may elect to establish “financial subsidiaries,” which are subsidiaries of national banks with expanded powers. Gramm-Leach permits financial subsidiaries to engage in the same types of activities permissible for non-bank subsidiaries of financial holding companies, with the exception of merchant banking, insurance and annuity underwriting and real estate investment and development. Merchant banking may be permitted after a five-year waiting period under certain regulatory circumstances. Gramm-Leach also provides new protections against the transfer and use by financial institutions of consumers’ nonpublic, personal information. At this time, the Company has not elected to become a financial holding company.

        Transactions between the holding company and its subsidiary bank are subject to Section 23A of the Federal Reserve Act. In general, Section 23A imposes limits on the amount of such transactions, and also requires certain levels of collateral for loans to affiliated parties. It also limits the amount of advances to third parties which are collateralized by the securities or obligations of the Company or its subsidiaries. Affiliate transactions are also subject to Section 23B of the Federal Reserve Act which generally requires that certain transactions between the holding company and its affiliates be on terms substantially the same, or at least as favorable to the banks, as those prevailing at the time for comparable transactions with or involving other nonaffiliated persons. The restrictions on loans to directors, executive officers, principal shareholders and their related interests (collectively referred to herein as “insiders”) contained in the Federal Reserve Act and Regulation O apply to all insured institutions and their subsidiaries and holding companies. These restrictions include limits on loans to one borrower and conditions that must be met before such a loan can be made. There is also an aggregate limitation on all loans to insiders and their related interests. Insiders are subject to enforcement actions for knowingly accepting loans in violation of applicable restrictions.

        As a national bank, the Bank is subject to primary supervision, regulation, and examination by the Office of the Comptroller of the Currency (“OCC”) and secondary regulation by the FDIC and the Federal Reserve Board. The Bank is subject to federal statutes and regulations that significantly affect its business and activities. The Bank must file reports with its regulators concerning its activities and financial condition and obtain regulatory approval to enter into certain transactions. Other applicable statutes and regulations relate to insurance of deposits, allowable investments, loans, acceptance of deposits, trust activities, mergers, consolidations, payment of dividends, capital requirements, reserves against deposits, establishment of branches and certain other facilities, limitations on loans to one borrower and loans to affiliated persons, and other aspects of the business of banks. In addition, federal legislation has instructed federal agencies to adopt standards or guidelines governing banks’ internal controls, information systems, loan documentation, credit underwriting, interest rate exposure, asset growth, compensation and benefits, asset quality, earnings and stock valuation, and other matters. Regulatory authorities have broad flexibility to initiate proceedings designed to prohibit banks from engaging in unsafe and unsound banking practices.

        The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) substantially revised the depository institution regulatory and funding provisions of the Federal Deposit Insurance Act and made revisions to several other federal banking statures. Among other things, federal banking regulators are required to take prompt corrective action in respect of depository institutions that do not meet minimum capital requirements. FDICIA identifies the following capital categories for financial institutions: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized. Rules adopted by the federal banking agencies under FDICIA provide that an institution is deemed to be well capitalized if the institution has a total risk-based capital ratio of 10.0% or greater, a Tier I risk-based ratio of 6.0% or greater, and a leverage ratio of 5.0% or greater, and the institution is not subject to an order, written agreement, capital directive, or prompt corrective action directive to meet and maintain a specific level for any capital measure. FDICIA imposes progressively more restrictive constraints on operation, management, and capital distributions, depending on the capital category in which an institution is classified. At December 31, 2003, the Company and the Bank were in the well-capitalized category based on the ratios and guidelines noted above.

        The Bank must pay assessments to the FDIC for federal deposit insurance protection. The FDIC has adopted a risk-based assessment system as required by FDICIA. Under this system, FDIC-insured depository institutions pay insurance premiums at rates based on their risk classification. Institutions assigned to higher risk classifications pay assessments at higher rates than institutions that pose a lower risk. An institution’s risk classification is assigned based on its capital level and the level of supervisory concern the institution poses to the regulators. In addition, the FDIC can impose special assessments in certain instances. Under FDIC regulations, no FDIC-insured bank can accept brokered deposits unless it is well capitalized, or is adequately capitalized and receives a waiver from the FDIC. In addition, these regulations prohibit any bank that is not well capitalized from paying an interest rate on brokered deposits in excess of three-quarters of one percentage point over certain prevailing market rates.

        The Community Reinvestment Act of 1977 (“CRA”) and the regulations issued thereunder are intended to encourage banks to help meet the credit needs of their service area, including low and moderate income neighborhoods, consistent with the safe and sound operations of the banks. These regulations also provide for regulatory assessment of a bank’s record in meeting the needs of its service area when considering applications regarding establishing branches, mergers or other bank or branch acquisitions. The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 requires federal banking agencies to make public a rating of a bank’s performance under the CRA. In the case of a bank holding company, the CRA performance record of the banks involved in the transaction are reviewed in connection with the filing of an application to acquire ownership or control of shares or assets of a bank or to merge with any other bank holding company. An unsatisfactory record can substantially delay or block the transaction.

        The Bank is also subject to certain consumer laws and regulations that are designed to protect consumers in transactions with banks. These laws and regulations include, among others, the Truth in Lending Act, the Truth in Savings Act, the Electronic Funds Transfer Act, the Expedited Funds Availability Act, the Equal Credit Opportunity Act, the Fair Housing Act, the Home Mortgage Disclosure Act and the Real

5

Estate Settlement Procedures Act. These laws and regulations mandate certain disclosure requirements and regulate the manner in which financial institutions must deal with customers when taking deposits or making loans to such customers. The banks must comply with the applicable provisions of these consumer protection laws and regulations as part of their ongoing customer relations.

        The earnings of the Company are significantly affected by the monetary and fiscal policies of governmental authorities, including the Federal Reserve Board. Among the instruments of monetary policy used by the Federal Reserve Board to implement these objectives are open-market operations in U.S. Government securities and federal funds, changes in the discount rate on member bank borrowings and changes in reserve requirements against member bank deposits. These instruments of monetary policy are used in varying combinations to influence the overall level of bank loans, investments and deposits, and the interest rates charged on loans and paid for deposits. The Federal Reserve Board frequently uses these instruments of monetary policy, especially its open-market operations and the discount rate, to influence the level of interest rates and to affect the strength of the economy, the level of inflation or the price of the dollar in foreign exchange markets. The monetary policies of the Federal Reserve Board have had a significant effect on the operating results of banking institutions in the past and are expected to continue to do so in the future. It is not possible to predict the nature of future changes in monetary and fiscal policies, or the effect that they may have on the Company’s business and earnings.

        As a publicly-held corporation, the Company is subject to the Sarbanes-Oxley Act of 2002, a law that addresses, among other issues, corporate governance, auditing and accounting, executive compensation, and enhanced and timely disclosure of corporate information. The Nasdaq Stock Market has also adopted corporate governance rules concerning, among other things, director independence, audit committee composition and charter, officer compensation and director nominations.

Item 2 — Properties

The Company operates the following branches as of December 31, 2003:

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Item 3 — Legal Proceedings

        In December of 1998, the Oneida Indian Nation (“The Nation”) and the U.S. Justice Department filed a motion to amend a long-standing land claim against the State of New York to include a class of 20,000 unnamed defendants who own real property in Madison County and Oneida County. An additional motion sought to include the Company as a representative of a class of landowners. On September 25, 2000, the United States District Court of Northern New York rendered a decision denying the motion to include the landowners as a group, and thus, excluding the Company and many of its borrowers from the litigation. The State of New York, the County of Madison and the County of Oneida remain as defendants in the litigation. This ruling may be appealed by The Nation, and does not prevent The Nation from suing landowners individually, in which case the litigation could involve assets of the Company. On August 3, 2001, the Justice Department moved to amend its complaint to drop landowners as defendants.

        In February 2002, the State of New York, the Nation and the Counties of Madison and Oneida announced that they had reached a tentative agreement to settle the land claim. Among other things, this settlement would pay the three Oneida tribes $500 million for their lost land. However, the proposed settlement required the approval of governments from county legislatures to the United States Congress. In October 2003, the media reported that the United States Department of Interior would not fund the $250,000,000 federal contribution contemplated by the proposed settlement, although it was willing to consider other alternatives to find funds for the settlement. Even if such approvals are received, a final agreement is expected to be years away as the parties work out numerous details. Moreover, the other two Oneida tribes, from Wisconsin and Ontario, which did participate in the settlement negotiations, have indicated that they do not intend to go along with the settlement. The Wisconsin tribe subsequently filed new law suits against individual landowners, and have publicly stated its intention to continue to file other new suits against landowners. Management believes that, ultimately, the State of New York will be held responsible for these claims and this matter will be settled without adversely impacting the Company.

        There are no other pending legal proceedings, other than routine litigation incidental to the business of the Bank, to which the Company or the Bank is a party or to which their property is the subject. In management’s opinion, no pending action, if adversely decided, would materially affect the Company’s financial condition.

Item 4 — Submission of Matters to a Vote of Security Holders

No matter was submitted to a vote of the Company’s security holders during the fourth quarter of the year ended December 31, 2003.

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PART II

Item 5 — Market for Registrant’s Common Stock and Related Shareholder Matters

Common Stock Data:

The common stock of the Company is listed for quoting in the Nasdaq National Market System under the symbol “ALNC”. Market makers for the stock are Ryan, Beck & Company (800-342-2325), Sandler O’Neill & Partners, LP (800-635-6851), McConnell Budd & Romano (800-538-6957), and Dain Rauscher (800-343-3036). There were 741 shareholders of record as of December 31, 2003. The following table presents stock prices for the Company for 2003 and 2002. Stock prices below are based on daily high and low closing prices for the quarter, as reported on the Nasdaq National Market System. These over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions.

*  Includes a special cash dividend of $0.10 per share

The transfer agent for the Company’s stock is American Stock Transfer & Trust Company (“ASTC”). ASTC can be contacted at the following address:

Registrar and Transfer Agent
American Stock Transfer & Trust Company
59 Maiden Lane
New York, NY 10038

Automatic Dividend Reinvestment Plan

The Company has an automatic dividend reinvestment plan. This plan is administered by ASTC, as agent. It offers a convenient way for shareholders to increase their investment in the Company. The plan enables certain shareholders to reinvest cash dividends on all or part of their common stock in additional shares of the Company’s common stock without paying brokerage commissions or service charges. Shareholders who are interested in this program may receive a Plan Prospectus and enrollment card by calling ASTC Dividend Reinvestment at 1-800-278-4353, or writing to the following address:

Dividend Reinvestment
American Stock Transfer & Trust Company
59 Maiden Lane
New York, NY 10038

The Company has historically paid regular quarterly cash dividends on its common stock, and the Board of Directors presently intends to continue the payment of regular quarterly cash dividends, subject to the need for those funds for debt service and other purposes. However, because substantially all of the funds available for the payment of dividends are derived from the Bank, future dividends will depend upon the earnings of the Bank, its financial condition and its need for funds. Furthermore, there are a number of federal banking policies and regulations that would restrict the Company’s ability to pay dividends. In particular, because the Bank is a depository institution whose deposits are insured by the FDIC, it may not pay dividends or distribute capital assets if it is in default on any assessment due the FDIC. Also, as a national bank, the Bank is subject to OCC regulations which impose certain minimum capital requirements that would affect the amount of cash available for distribution to the Company. In addition, under Federal Reserve policy, the Company is required to maintain adequate regulatory capital, is expected to serve as a source of financial strength to the Bank and to commit resources to support the Bank. These policies and regulations may have the effect of reducing the amount of dividends that the Company can declare to its shareholders.

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Item 6 — Selected Financial Data

Five-Year Comparative Summary

(Dollars in thousands except per-share data)

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Introduction

        The Company is a New York corporation, which was formed in November 1998 as a result of the merger of Cortland First Financial Corporation and Oneida Valley Bancshares, Inc.. The Company is a bank holding company that operates one wholly owned banking subsidiary, Alliance Bank, N.A., which provides a full range of financial services in the Central New York marketplace.

        The following discussion and analysis reviews the Company’s business, and provides information that is intended to provide the reader with a further understanding of the consolidated financial condition and results of operations of the Company and its operating subsidiaries. This discussion should be read in conjunction with the consolidated financial statements and accompanying notes, and other information included elsewhere in this Annual Report on Form 10-K.

Application of Critical Accounting Policies

        The Company’s consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States and follow practices within the banking industry. Application of these principles requires management to make estimates, assumptions, and judgements that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgements are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgements. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgements and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgements are necessary when assets and liabilities are required to be recorded at fair value or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and information used to record valuation adjustments for certain assets and liabilities are based on quoted market prices or are provided by other third-party sources, when available. When third party information is not available, valuation adjustments are estimated in good faith by management.

        The most significant accounting policies followed by the Company are presented in Note 1 to the consolidated financial statements included elsewhere in this Annual Report on Form 10-K. These policies, along with the disclosures presented in the other financial statement notes and in this discussion, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan and lease losses and accrued income taxes to be the accounting areas that require the most subjective and complex judgements, and as such could be the most subject to revision as new information becomes available.

        The allowance for loan and lease losses represents management’s estimate of probable loan and lease losses inherent in the loan and lease portfolio. Determining the amount of the allowance for loan and lease losses is considered a critical accounting estimate because it requires significant judgement and the use of estimates related to the amount and timing of expected future cash flows on impaired loans and leases, estimated losses on pools of homogeneous loans and leases based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan and lease portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for loan and lease losses, and a discussion of the factors driving changes in the amount of the allowance for loan and lease losses is included in this report.

        The Company estimates its tax expense based on the amount it expects to owe the respective tax authorities. Taxes are discussed in more detail in Note 9 of the Consolidated Financial Statements section of this report. Accrued taxes represent the net estimated amount due or to be received from taxing authorities. In estimating accrued taxes, management assesses the relative merits and risks of the appropriate tax treatment of transactions taking into account statutory, judicial and regulatory guidance in the context of the Corporation’s tax position. If the final resolution of taxes payable differs from our estimates due to regulatory determination or legislative or judicial actions, adjustments to tax expense may be required.

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RESULTS OF OPERATIONS

Earnings Summary and Executive Overview

        Net income for 2003 was $8,011,000, an increase of $1,100,000, or 15.9%, compared to net income of $6,911,000 in 2002. Earnings per share for 2003, on a fully diluted basis, were $2.23, an increase of 12.6%, or $0.25 per share, compared to $1.98 per share in 2002. Basic earnings per share of $2.28 for the year ended December 31, 2003, compared to $2.00 for the year ended December 31, 2002.

        Strong growth in the Bank’s earning assets continued in 2003, with average loans up 10.4% generating additional revenues that helped to offset the pressure of a declining net interest margin. Combined with funds management strategies that balanced deposit growth with cost effective borrowings, a significant reduction in the Bank’s cost of funds resulted in increased net interest income. The Bank’s announced strategic initiative, to focus future branch expansion in Onondaga County, New York, was set in motion with the 2003 second quarter sale of its only Broome County, New York branch and followed with the fourth quarter announcement of the expected opening of two de-novo branches in Onondaga County during the first quarter of 2004. The net premium received from the branch sale contributed $950,000 to net income in 2003, and will support the investment in the 2004 branch expansion. The bank reorganized its retail brokerage business unit during the year positioning it to add value to the growing branch banking network, and additional strategic initiatives of the Company were launched in 2003 that look to provide merchant banking services to an expanding upstate New York market area.

Selected Performance Measures

        Return on average assets, return on average equity, dividend payout, and equity to asset ratios for the years indicated are as follows:

Net Interest Income

        The net interest income of the Bank is the Company’s principal source of operating income for payment of overhead and providing for loan and lease losses. It is the amount that interest and fees on loans and leases, investments, and other earning assets exceeds the cost of deposits and other interest-bearing liabilities. Net interest income increased $623,000, or 2.3%, to $27,393,000 in 2003. Growth in net interest income in 2003 resulted from a combination of strong growth in higher yielding loans and a significant decline in the cost of funds. The Company’s net interest margin (federal tax-equivalent net interest income divided by average earning assets) for 2003 at 3.91% was down 14 basis points compared to the 4.05% margin reported for 2002. The 2003 margin was up during the fourth quarter of 2003 after declining during the first three quarters of the year. The 2002 net interest margin was unchanged from that reported in 2001. By comparison, net interest income increased $3,611,000, or 15.6%, during 2002 with that growth primarily driven by increased revenues from double-digit growth in earning assets.

        Interest income for 2003 at $40,220,000, was down $2,494,000 compared to 2002, with the 2003 tax-equivalent yield on average earning assets at 5.65%, declining 70 basis points during the 12 months ended December 31, 2003. Similar to 2002, asset yields again declined in 2003 as new loans and investments were booked during the year at market rates significantly lower than the yields on the assets that matured or prepaid during the year. Average earning assets for 2003 were $738,864,000, up $45,310,000, or 6.5%, compared to 2002, and represented 93.5% of total average assets in 2003. By comparison, average earning assets increased $89,503,000, or 14.8%, in 2002 compared to 2001, and for the comparable periods, the tax-equivalent yield on average earning assets declined 101 basis points. Average earning assets in 2002 were 93.4% of total average assets.

        Loans and leases continued to represent the majority of the Company’s interest earning assets and increased to 60% of average earning assets in 2003 from 58% in 2002. Average loans and leases increased $41,453,000 in 2003 with yields declining 71 basis points to 6.33%. Interest income on loans and leases was down $226,000, or 0.8%, in 2003 compared to 2002. The Company’s residential mortgage loan portfolio reported an increase of $13,619,000, or 9.2%, in average loans when comparing the year 2003 to 2002. The average yield on the residential mortgage loan portfolio declined 57 basis points from 7.39% in 2002 to 6.82% in 2003, influenced by newly originated loans, and an increased refinancing of existing portfolio loans, being booked at the lower market rates in effect in 2003. Average consumer loans for the comparable periods increased 5.4%, or $2,975,000, on strong growth in home equity lines of credit. The average yield declined 113 basis points from 7.1% to 5.9% in 2003, influenced significantly by new home equity lines that were indexed to the prime rate and booked at discounted introductory rates throughout the year. Average indirect auto loans increased 31.1%, or $19,522,000, during 2003. Average

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yields declined 159 basis points in 2003 compared to 2002, as the new loan volume that included a higher level of refinancings originated at the lower market rates in 2003, pushed the average yield lower. Average commercial loans and leases for 2003 increased $5,337,000, or 4%, when compared to the prior year. The growth rate remained low and declined slightly compared with the 5.7% growth rate in 2002, as continued weakness in the economy contributed to a lower demand for commercial loans and leases in 2003. The commercial portfolio, which primarily reprices with short-term market rate indexes that remained relatively stable in 2003, reported a decline in the average yield of 26 basis points, from 6.5% to 6.2%.

        Average loans and leases in 2002 increased $46,736,000 compared to 2001 while average loan and lease yields declined 118 basis points. Interest income on loans and leases was down $851,000, or 2.9%, in 2002 compared to 2001. For the comparable periods, average residential mortgage loans increased $19,783,000, or 15.3%, average consumer loans increased $6,226,000, or 12.7%, average indirect auto loans increased $13,338,000, or 27%, and average commercial loans and leases increased $7,241,000, or 5.7%.

        Although average investments in 2003 increased by $2,791,000, tax-equivalent interest income from investments declined $2,127,000, or 13.4%, compared to 2002. In comparison, average investment securities increased $48,481,000 in 2002 compared to 2001, with tax-equivalent interest income up $827,000, or 5.5%. The average tax-equivalent yield of the portfolio declined 77 basis points, from 5.43% in 2002 to 4.66% in 2003. The decline in the 2003 yield is partially attributable to an increase in amortization expense, associated with premiums previously paid on mortgaged-backed securities. The increase in amortization expense resulted as the securities were prepaid at accelerated rates during 2003. Lower yields on the reinvestments also pushed the 2003 average yield down. Investment income was negatively impacted in the last half of 2003 by the Federal Home Loan Bank of New York’s (FHLB) suspension of the dividend on its stock. Anticipated dividends of $90,000 were not received as a result of the FHLB action. The average tax-equivalent yield on the portfolio had declined 74 basis points in 2002, when compared to 2001. Interest income in 2003 from the sale of federal funds was comparable with that reported in the prior year, with little change in the average balances.

        During 2003, average interest-bearing liabilities increased by $36,666,000, or 5.9%, to $658,952,000. As a result of a continuation of lower market interest rates and repricing characteristics associated with the Company’s liabilities, the average cost of interest-bearing liabilities declined 61 basis points from 2.56% in 2002 to 1.95% in 2003. The Company’s interest expense, which is a function of the volume of and rates paid for interest-bearing liabilities, reported a significant decline of $3,117,000, or 19.6%, in 2003 compared to 2002. Interest expense on deposits declined $2,387,000 in 2003 compared with 2002, although average interest bearing deposits increased $19,380,000, or 4%. A 57 basis point decline in the average rate paid on deposits for the comparable periods, influenced mostly by a 73 basis point decline in the average rate paid on the Bank’s sizeable time deposit category, drove the interest expense lower. Interest expense on borrowings declined $730,000, as the average rate paid on borrowings declined an even greater 84 basis points. Rates on both new and renewal borrowings reflected the lower market interest rates. By comparison, interest expense declined $4,021,000, or 20.1%, in 2002 compared to 2001, resulting primarily from a 117 basis point decline in the average cost of interest-bearing liabilities. Average interest-bearing liabilities increased $87,551,000, or 16.4%, during the 12 months ended December 31, 2002.

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        The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the yields and rates thereon. Interest income and yield information is adjusted for items exempt from federal income taxes and assumes a 34% tax rate. Nonaccrual loans have been included in the average balances. Securities are shown at average amortized cost.

Average Balances and Net Interest Income

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NonInterest Income

        The Company’s noninterest income is primarily derived from its subsidiary Bank, and is comprised of core components that include service charges on deposits, fees from trust and brokerage services, mortgage banking operations that include gains from sales and income from servicing, and other recurring operating income fees from normal banking operations, along with non-core components that primarily consist of net gains or losses from sales of investment securities.

        The following table sets forth certain information on noninterest income for the years indicated:

NonInterest Income

        Noninterest income in 2003 increased 37.3% compared to 2002, as a result of increases in both core and non-core items. The Company’s core noninterest income increased 13.7% for the comparable periods. The most significant contribution to the Company’s core noninterest income in 2003 was derived from an increase in Bank service charges on deposit, primarily in the form of increased overdraft fees. During the year, the Bank commenced the offering of an overdraft protection program to its customers that was met with a high level of success. The program increased service charge income by 28.3%. Core noninterest income was also pushed higher as income from an increased volume of mortgage loans sold and serviced grew.

        In non-core components, investment security gains in 2003 increased by $351,000 compared to 2002, as the Company’s total return to portfolio management approach indicated greater benefits would result by capturing gains on the sales of selected securities, with the

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reinvestment in new securities that better matched the current needs of the portfolio. During the second quarter of 2003, the Bank sold its only Broome County, New York branch that was located in Whitney Point. The branch sale included all deposits and fixed assets, along with a selected portfolio of consumer loans. The net premium on the branch sale included an 11% premium on the sale of the deposits.

        By comparison, noninterest income declined 3.3% in 2002 compared to 2001, primarily the result of a decline in investment security gains for the comparable periods. Core noninterest income however, rose by 4.9%, on increases in mortgage banking operations and growth in recurring customer service fees. Service charge income had declined 3.8% for the comparable periods on weakness in overdraft fees and declining volumes.

NonInterest Expense

        The following table sets forth certain information on noninterest expense for the years indicated:

Noninterest Expense

        Operating expense of $23,528,000 for the 12 months ended December 31, 2003, increased $1,151,000, or 5.1%, when compared to 2002. The increase compared to a $2,410,000, or 12.1%, increase, when comparing 2002 to 2001. Salaries and associated benefit expenses in 2003 were up $944,000, or 7.5%, compared to a $1,254,000, or 11.1% increase in 2002 over 2001, and represented 82% of the 2003 increase in total operating expense. Salary and employee benefit expenses increased in 2003 compared to 2002 as a result of staff growth in the Bank’s retail brokerage, risk management, and corporate support departments, as well as year-over-year salary adjustments that approximated 3.5% and increased incentive compensation plan payments reflective of the Company’s increased earnings. The number of the Company’s employees (full time equivalent) increased from 269 at the end of 2002 to 276 at the end of 2003. The Company’s occupancy and equipment expense increased $110,000, or 3.2%, in 2003 compared to 2002, following a 9.2% increase in the prior year. The higher expense in 2003 was the result of increased depreciation and amortization expense in connection with the purchase and development of systems designed to build efficiency in processing and provide improved customer service. The increase in occupancy expense in 2002 compared with 2001, was primarily the result of higher lease expense along with increased costs associated with depreciating and amortizing investments in technology equipment and software. Other operating expense in 2003 increased $97,000, or 1.5%, compared to the prior year. Improvements in overall expense management, led by a significant reduction in costs associated with the purchase of stationary and office supplies, reduced the growth rate in other operating expense dramatically from the prior year. In 2002, other operating expense increased $866,000, or 15.6%, compared with 2001. In 2002 significant increases in other operating expenses related to the Company’s development and launch of a new corporate branding campaign, including a change in Company logo and image. Operating expense in 2002 also increased as costs of audits and examinations rose compared with 2001, the increase associated with the Company’s commitment to maintaining a strong program of internal controls. The growth in other operating expense also continues to reflect the costs associated with servicing the growth in average assets, which increased 6.5% in 2003, following a 14.8% increase in 2002.

Provision For Income Tax

        The Company’s 2003 provision for income taxes increased by $441,000, or 18.8%, when compared to the 2002 expense, as result of higher pretax earnings and a slight increase in the effective tax rate. The 2003 expense of $2,792,000 resulted in an effective tax rate of 25.8%, compared to the 2002 expense of $2,351,000 that reflected an effective tax rate of 25.4%. The Company’s effective tax rate is lower than the statutory tax rate as a result of its investment in tax exempt securities and from its use of other tax savings strategies.

ANALYSIS OF FINANCIAL CONDITION

Investment Securities

        The investment portfolio is designed to provide a favorable total return utilizing low-risk, high quality investments while at the same time assisting in meeting the liquidity needs of the Bank’s loan and deposit operations, and supporting the Company’s interest risk objectives. The Company classifies the majority of its investment securities as available-for-sale. The Company does not engage in securities trading or derivatives activities in carrying out its investment strategies.

        The book value of the Company’s investment debt securities declined $8,642,000, or 2.9%, in the 12 months ended December 31, 2003, to a total of $290,129,000, compared to an increase of $33,964,000, or 12.8%, during the year 2002. The average tax-equivalent yield of the portfolio in 2003 declined 77 basis points, to 4.66% from 5.43% in 2002. On a comparative basis, the average portfolio yield declined 74

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basis points in 2002 compared to 2001. When comparing year-end 2002 to year-end 2003, the tax-equivalent portfolio yield declined 81 basis points, from 5.21% to 4.40%.

        The low interest rate environment in 2003 continued to positively impact the value of the Company’s fixed-rate investment securities, and resulted in the Company’s available-for-sale investment debt securities reflecting a market value that was 2% greater than the portfolios’ book value. In compliance with SFAS 115, the Company reflects net unrealized gains and losses on its available-for-sale portfolio in its financial statement investment securities total, as well as the after-tax effect of the gains and losses in the accumulated other comprehensive income section of its shareholders’ equity. The Company’s December 31, 2003 investment portfolio reflects an unrealized gain on available-for-sale debt securities of $5,876,000, with an after-tax effect of $3,526,000 being reflected as an increase in shareholders’ equity. At December 31, 2002, the Company reported unrealized gains in its available-for-sale portfolio of $10,778,000 and an increase in shareholders’ equity of $6,467,000. The decline in both the unrealized gain and the after tax effect in accumulated other comprehensive income for the comparable periods, is the result of a higher level of interest rates at year-end 2003 compared to year-end 2002, as well as changes in the portfolio’s investment mix and maturity schedule. Based on amortized cost, the Company classified 98% of its investment portfolio as available-for-sale at year-end 2002.

        The following table sets forth the amortized cost and market value for the Company’s held-to-maturity investment securities portfolio:

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Weighted average yields on the tax-exempt obligations have been computed on a fully tax-equivalent basis assuming a marginal federal tax rate of 34%. These yields are an arithmetic computation of interest income divided by average balance and may differ from the yield to maturity which considers the time value of money.

        The Company’s investment portfolio also includes $9,796,000 in stock and mutual funds, that are held in connection with the Company’s membership in the Federal Reserve Bank of New York and the Federal Home Loan Bank of New York (FHLB), and that also support its Community Reinvestment Act goals. Effective October 2003, the FHLB suspended payment of the dividend on its stock as a result of investment portfolio losses that negatively impacted its capital account. At year-end 2003, the Company owned stock in the FHLB in the amount of $5,950,000. On January 15, 2004, the FHLB announced that it declared a dividend at a rate of 1.45% based on improvement in its 2003 fourth quarter earnings, to be paid on January 30, 2004.

Loans and leases

        The loan and lease portfolio is the largest component of the Bank’s earning assets and accounts for the greatest portion of total interest income. The Bank provides a full range of credit products delivered through its branch network. Consistent with the focus on providing community banking services, the Bank generally does not attempt to diversify geographically by making a significant amount of loans or leases to borrowers outside of the primary service area. Loans and leases are internally generated and lending activity is primarily confined to Cortland, Madison, Onondaga, and western Oneida Counties of New York. The Bank does not engage in highly leveraged transactions or foreign lending activities.

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        The following table sets forth the composition of the Bank’s loan and lease portfolio at the dates indicated:

Composition of the Loan and Lease Portfolio

        On December 31, 2003, gross loans and leases were $477,071,000, increasing $62,794,000, or 15.2%, during the year. By comparison, loans increased $38,435,000, or 10.2%, in 2002. The Bank reported slight changes in the mix of its loan portfolio during 2003, with indirect auto loans increasing as a percentage of total loans, while other categories declined. The Bank continued to report growth in all components of the loan portfolio during 2003.

        Residential mortgage loans, which represented 36.5% of gross loans at December 31, 2003, increased $20,815,000, or 13.6%, during 2003 compared to an increase of $10,841,000, or 7.6%, in 2002. The mortgage portfolio at December 31, 2003 consists of 89% in fixed-rate loans, and 11% in loans that have adjustable-rate features. The Bank originated $98,246,000 in residential mortgage loans in 2003 compared to $53,439,000 in 2002. The 84% growth rate in 2003 originations resulted as mortgage loan rates plunged during the year and pushed refinancings to record levels. The Bank originated record levels of new loans in Cortland, Madison and Onondaga counties. The Bank’s goal to hold stable the percentage of residential mortgage loans to total loans during 2003 resulted in an increase in the amount of loans sold during the year. During 2003 the Bank sold $25,987,000 in mortgage loans and as of year-end 2003, was servicing loans with balances of $42,135,000. The servicing portfolio increased 64.5% during 2003. On a comparative basis, the Bank sold $14,059,000 in mortgage loans in 2002.

        Loans and leases in the commercial category consist primarily of short-term and/or floating-rate loans, lines of credit, as well as commercial mortgage loans, and commercial leases made to small- and medium-sized companies. Commercial loans and leases in 2003 increased $12,558,000, or 9.3%, to $147,142,000. By comparison, commercial loans and leases increased $7,783,000, or 6.1%, in 2002. In spite of a Central New York State economy that has remained weak for the past two years, the Bank continued to report growth in Cortland, Madison, and Onondaga counties. Alliance Leasing, Inc., formed as a subsidiary of the Bank in the first quarter of 2002, contributed 40% of the total growth in commercial loans and leases during 2003. The leasing company specializes in information technology, municipal, health care, energy and utilities, education, and equipment leases.

        Consumer loans, which include home equity lines of credit, direct installment, and revolving credit loans, increased 1.9%, or $1,069,000, in 2003. The consumer loan growth rate in 2003 lagged that of the past several years, as consumers refinanced and consolidated significant amounts of their consumer debt along with mortgage refinancings during the year. During 2003, the Bank continued it prior year focus on building a high credit quality consumer loan portfolio, promoting its home equity line of credit product. Throughout 2003, the Bank offered the variable prime rate based product, at a discounted introductory rate for six months. As a result, the Bank increased home equity line of credit outstanding balances by $6,979,000, or 21.4%, in 2003 compared to 2002. Offsetting most of the growth in home equity line balances, direct installment consumer loans, with a higher risk profile, declined $5,218,000, or 25.1% in 2003 compared to 2002. The Bank’s consumer loan portfolio does not contain credit card loans. By comparison, the consumer loan portfolio increased $7,371,000, or 14.6%, in 2002.

        Indirect auto loans in 2003 increased $28,352,000, or 41.2%, over the prior year, following an increase of $12,440,000, or 22.1%, in 2002 compared to 2001. The rate of growth in 2003 continued strong without compromising or reducing credit quality standards, in the face of a weak economy and strong incentives offered by the automotive manufacturer’s financing program alternatives. As a percentage of loans originated in 2003, 90% were originated in the Bank’s Premium or Level A (FICO score 679 or above) credit quality categories. By comparison, in 2002, 83% of the loans were originated in these categories. The Bank originated loans from, and provides service to, a network of Central New York auto dealers.

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