Back to GetFilings.com



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC  20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2005

Commission file number 0-15366

ALLIANCE FINANCIAL CORPORATION
(Exact name of Registrant as specified in its charter)
 
  New York     16-1276885
  (State or other jurisdiction of  (IRS Employer I.D. #)
   incorporation or organization)  
     
  120 Madison Street, Syracuse, New York 13202
  (Address of principal executive offices)  (Zip Code)
     
  Registrant’s telephone number including area code: (315) 475-4478

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 is an accelerated filer (as defined in Rule 12b-2 of the Act).
Yes  x    No o

The number of shares outstanding of the Registrant’s common stock on April 30, 2005: Common Stock, $1.00 Par Value – 3,597,758 shares.



CONTENTS
 
PART I. FINANCIAL INFORMATION
   
Item 1. Financial Statements (All Unaudited)
   
    Consolidated Statements of Condition as of March 31, 2005 and December 31, 2004
   
    Condensed Consolidated Statements of Income for the Three Months Ended March 31, 2005 and 2004
   
    Consolidated Statement of Changes in Shareholders’ Equity for the Three Months Ended March 31, 2005
   
    Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2005 and 2004
   
    Notes to Consolidated Financial Statements
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
   
Item 3. Quantitative and Qualitative Disclosures About Market Risk
   
Item 4. Controls and Procedures
   
PART II. OTHER INFORMATION
   
Item 1. Legal Proceedings
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
   
Item 3. Defaults Upon Senior Securities
   
Item 4. Submission of Matters to a Vote of Security Holders
   
Item 5. Other Information
   
Item 6. Exhibits
   
  Signatures

2


PART I.   FINANCIAL INFORMATION

Item 1.            Financial Statements

ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Condition
(Dollars in Thousands)

 
      March 31, 2005
(Unaudited)		   December 31, 2004
(Unaudited)		  
ASSETS            
   Cash and due from banks     $ 21,737   $ 21,258  
   Federal funds sold       6,800     —  
 
 
 
      Total cash and cash equivalents       28,537     21,258  
   Held-to-maturity investment securities       7,156     5,367  
   Available-for-sale investment securities       303,310     319,758  
 
 
 
      Total investment securities (fair value                
      $310,645 & $325,379, respectively)       310,466     325,125  
   Total loans and leases       536,149     522,788  
   Unearned income       (2,942 )   (2,055 )
   Allowance for loan and lease losses       (4,829 )   (5,267 )
 
 
 
       Net loans and leases       528,378     515,466  
                 
   Bank premises, furniture, and equipment       13,656     14,454  
   Accrued interest receivable       4,353     4,005  
   Intangible asset       7,518     —  
   Other assets       16,252     13,626  
 
 
 
       Total Assets     $ 909,160   $ 893,934  
 
 
 
                 
LIABILITIES                
   Non-interest-bearing deposits     $ 77,193   $ 74,549  
   Interest-bearing deposits       602,673     548,572  
 
 
 
      Total deposits       679,866     623,121  
   Borrowings       153,589     192,164  
   Accrued interest payable       1,504     1,451  
   Other liabilities       6,567     8,302  
 
 
 
                 
      Total Liabilities       841,526     825,038  
                 
SHAREHOLDERS’ EQUITY                
   Preferred stock (par value $25.00)
     1,000,000 shares authorized, none issued		                
   Common stock (par value $1.00)
     10,000,000 shares authorized
     3,968,358 and 3,947,140 shares issued;
     3,593,090 and 3,571,872 shares
       outstanding, respectively		       3,968     3,947  
   Surplus       10,953     10,298  
   Unamortized value of restricted stock       (1,670 )   (1,047 )
   Undivided profits       63,495     62,235  
   Accumulated other comprehensive income       (1,157 )   1,418  
   Treasury stock, at cost; 375,268 shares
      and 375,268 shares, respectively		       (7,955 )   (7,955 )
 
 
 
                 
      Total Shareholders’ Equity       67,634     68,896  
      Total Liabilities & Shareholders’ Equity     $ 909,160   $ 893,934  
 
 
 
 

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


3


ALLIANCE FINANCIAL CORPORATION
Condensed Consolidated Statements of Income
(Unaudited)
(Dollars in Thousands, except per share data)

 
      Three Months Ended
March 31, 		 
      2005   2004  
Interest Income:            
   Interest and fees on loans and leases     $ 7,699   $ 6,900  
   Interest on investment securities       2,886     3,084  
   Interest on federal funds sold       31     20  
 
 
 
                 
      Total Interest Income       10,616     10,004  
                 
Interest Expense:                
   Interest on deposits       2,629     1,993  
   Interest on borrowings       1,184     1,043  
 
 
 
         
      Total Interest Expense       3,813     3,036  
                 
      Net Interest Income       6,803     6,968  
                 
Provision for loan and lease losses       (544 )   14  
 
 
 
      Net Interest Income After Provision
        for Loan and Lease Losses		       7,347     6,954  
                 
Other Income       2,949     2,344  
 
 
 
                 
      Total Operating Income       10,296     9,298  
                 
Other Expenses       7,615     6,774  
 
 
 
      Income Before Income Taxes       2,681     2,524  
                 
Provision for income taxes       667     630  
 
 
 
                 
      Net Income     $ 2,014   $ 1,894  
 
 
 
                 
Net Income per Common Share – Basic     $ .56   $ .53  
 
 
 
                 
Net Income per Common Share – Diluted     $ .55   $ .52  
 
 
 
 

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


4


ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Changes in Shareholders’ Equity
For the Three Months Ended March 31, 2005
(Unaudited)
(Dollars in Thousands)

 
Issued
Common
Shares		 Common
Stock		 Surplus Unamortized
Value of
Restricted
Stock		 Undivided
Profits		 Accumulated
Other
Comprehensive
Income		 Treasury
Stock		 Total
                                                 
Balance at December 31, 2004   3,947,140   $ 3,947   $ 10,298     ($ 1,047 ) $ 62,235   $ 1,418     ($7,955 ) $ 68,896  
 
                                                 
Comprehensive income                                                
   Net Income                           2,014                 2,014  
                                                 
   Other comprehensive
        income, net of taxes:		                                                
                                                 
   Unrealized appreciation in
        available for sale
        securities, net of
        reclassification
       adjustment		                                 (2,575 )         (2,575 )
               
 
                                                 
   Comprehensive income                                             (561 )
                                                 
   Issuance of restricted stock   24,500     24     754     (778 )                     —  
                                                 
   Forfeiture of restricted stock   (3,282 )   (3 )   (99 )   94                       (8 )
                                                 
   Amortization of restricted
       stock		                     61                       61  
                                                 
   Cash dividend, $.21 per
       share		                           (754 )               (754 )
                                                 
 
Balance at March 31, 2005   3,968,358   $ 3,968   $ 10,953     ($ 1,670 ) $ 63,495     ($1,157 )   ($7,955 ) $ 67,634  
 
 

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


- 5 -


ALLIANCE FINANCIAL CORPORATION
Consolidated Statements of Cash Flow
(Unaudited)
 
(Dollars in thousands)   Three Months Ended
March 31,		  
2005   2004  
 
 
(dollars in thousands)  
OPERATING ACTIVITIES          
  Net Income   $ 2,014   $ 1,894  
  Adjustments to reconcile net income to net cash provided  
    by operating activities:  
  Provision for loan and lease losses     (544 )   14  
  Provision for depreciation     911     519  
  (Increase) decrease in surrender value of life insurance     (98 )   171  
  Realized investment security gains     —     (273 )
  Realized loss on the sale of assets     5     —  
  Accretion of investment security premiums and discounts, net     (46 )   (62 )
  Proceeds from the sale of mortgage loans     2,349     3,105  
  Origination of loans held for sale     (2,329 )   (3,065 )
  Gain on the sale of loans     (20 )   (40 )
  Amortization of mortgaging servicing rights     17     16  
  Restricted stock expense     61     38  
  Amortization of intangible asset     42     —  
  Change in other assets and liabilities     (2,855 )   (700 )
 
Net Cash (Used In) Provided by Operating Activities     (493 )   1,617  
   
LENDING AND INVESTING ACTIVITIES  
  Proceeds from maturities, redemptions, calls and principal
    repayments of investment securities, available-for-sale		     47,535     23,014  
  Proceeds from maturities, redemptions, calls and principal
    repayments of investment securities, held-to-maturity		     4,530     204  
  Purchase of investment securities, available-for-sale     (37,848 )   (37,409 )
  Purchase of investment securities, held-to-maturity     (6,319 )   (445 )
  Proceeds from the sale of investment securities     2,500     1,036  
  Net increase in loans and leases     (12,368 )   (8,445 )
  Purchase of premises and equipment     (123 )   (991 )
  Acquisition purchases     (7,560 )   —  
  Proceeds from the sale of premises and equipment     5     —  
 
Net Cash Used in Lending and Investing Activities     (9,648 )   (23,036 )
   
DEPOSIT AND FINANCING ACTIVITIES  
  Net increase in deposits     56,745     58,591  
  Net decrease in short-term borrowings     (33,575 )   (25,707 )
  Net decrease in long-term borrowings     (5,000 )   —  
  Proceeds from the exercise of stock options     —     246  
  Cash dividends     (750 )   (1,095 )
 
Net Cash Provided by Deposit and Financing Activities     17,420     32,035  
  Increase in Cash and Cash Equivalents     7,279     10,616  
  Cash and Cash Equivalents at Beginning of Year     21,258     21,824  
 
Cash and Cash Equivalents at End of Period   $ 28,537   $ 32,440  
   
  Supplemental disclosures of cash flow information:  
  Cash paid during the period for:  
    Interest on deposits and borrowings   $ 3,760   $ 3,125  
    Income taxes     100     275  
  Non-Cash Investing Activities:  
    Net unrealized loss available-for-sale securities     (4,307 )   (2,663 )
  Non-Cash Financing Activities:  
    Dividends declared and unpaid     755     748  
               

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


- 6 -


ALLIANCE FINANCIAL CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 
A.   Basis of Presentation
   
 
The accompanying unaudited financial statements were prepared in accordance with the instructions for Form 10-Q and Regulation S-X and, therefore, do not include information for footnotes necessary for a complete presentation of financial condition, results of operations, and cash flows in conformity with generally accepted accounting principles. The following material under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” is written with the presumption that the users of the interim financial statements have read, or have access to, the latest audited financial statements and notes thereto of the Company, together with Management’s Discussion and Analysis of Financial Condition and Results of Operations as of December 31, 2004 and for the three-year period then ended, included in the Company’s Annual Report on Form 10-K/A for the year ended December 31, 2004. Accordingly, only material changes in the results of operations and financial condition are discussed in the remainder of Part I. Certain amounts from prior year periods have been reclassified to conform to the current period presentation. These reclassifications had no effect on net income as previously reported.
 
 
All adjustments that in the opinion of management are necessary for a fair presentation of the financial statements have been included in the results of operations for the three months ended March 31, 2005 and 2004.
 
B. Acquisitions
   
 
On February 18, 2005, the Bank acquired certain personal trust accounts and related assets under management from HSBC, USA, N.A. The Bank assumed the successor trustee role from HSBC on approximately 1830 personal trust accounts and further assumed approximately $560,000,000 in assets under management. In connection with the acquisition, the Bank established an intangible asset in the amount of $7,560,000 representing approximately 80% of the purchase price. The balance of the intangible asset will be booked in the second quarter of 2005 following the completion and agreement of any closing adjustments.
 
C. Earnings Per Share
   
 
Basic earnings per share have been computed by dividing net income by the weighted average number of common shares outstanding throughout the three months ended March 31, 2005 and 2004, using 3,587,627 and 3,556,666 weighted average common shares outstanding for the three months ended March 31, 2005 and 2004, respectively. Diluted earnings per share gives the effect to weighted average shares which would be outstanding assuming the exercise of options using the treasury stock method. Weighted average shares outstanding for the three months ended March 31, 2005 and 2004, adjusted for the effect of the assumed exercise of stock options, were 3,663,242 and 3,645,914 for the three months ended March 31, 2005 and 2004, respectively. There were no antidilutive shares as of March 31, 2005.

- 7 -


D. Allowance for Loan and Lease Losses
   
 
The allowance for loan and lease losses represents management’s best estimate of probable loan and lease losses in the Company’s loan portfolio. Management’s quarterly evaluation of the allowance for loan and lease losses is a comprehensive analysis that builds a total reserve by evaluating the risks within each loan and lease type, or pool, of similar loans and leases. The Company uses a general allocation methodology for all residential and consumer loan pools. This methodology estimates a reserve for each pool based on the average loss rate for the time period that includes the current year and two full prior years. The average loss rate is adjusted to reflect the expected impact that current trends regarding loan growth, delinquency, losses, economic conditions, loan concentrations, policy changes, experience and ability of lending personnel, and current interest rates are likely to have. For commercial loan and lease pools, the Company establishes a specific reserve allocation for all loans and leases classified as being impaired in excess of $150,000, which have been risk rated under the Company’s risk rating system as substandard, doubtful, or loss. For all other commercial loans and leases, the Company uses the general allocation methodology that establishes a reserve for each risk-rating category. The general allocation methodology for commercial loans and leases considers the same factors that are considered when evaluating residential mortgage and consumer loan pools. The combination of using both the general and specific allocation methodologies reflects management’s best estimate of the probable loan and lease losses in the Company’s loan and lease portfolio.
 
 
A loan or lease is considered impaired, based on current information and events, if it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due accord­ing to the contractual terms of the loan or lease agreement. The measurement of impaired loans and leases is generally discounted­ at the historical effective interest rate, except­­ that all collateral-dependent loans and leases are measured­ for impairment based on fair value of the collateral.
 
E. Stock Based Compensation
   
 
The Company’s stock-based compensation plan is accounted for based on the intrinsic value method set forth in Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees, and related interpretations. Compensation expense for employee stock options is generally not recognized at the time of the grant if the exercise price of the option equals or exceeds the fair value of the stock on the date of the grant. Compensation expense for restricted share awards is ratably recognized over the period of vesting, usually the restricted period, based on the fair value of the stock on the grant date. Stock options that have been granted by the Company vest based on a combination of years of service and the achievement of certain stock price targets.
 
 
The following table illustrates the effect on net income and earnings per share as if the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, as amended, had been applied to the Company’s stock-based compensation plan: 

- 8 -


For Quarter Ended
March 31, 2005 March 31, 2004
 
               
Net Income (in thousands)          
   As reported   $ 2,014   $ 1,894  
   Less: Total stock-based employee compensation
      expense determined under Black-Scholes option
      pricing model, net of tax effect		     (9 )   (7 )
 
Pro forma net income   $ 2,005   $ 1,887  
 
   
Pro forma net income per share:  
   Basic - as reported   $ 0.56   $ 0.53  
   Basic - pro forma     0.56     0.53  
   Diluted - as reported     0.55     0.52  
   Diluted - pro forma     0.55     0.52  
   
 
The fair value of stock options granted was estimated at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option pricing model was originally developed for use in estimating the fair value of traded options, which have different characteristics from the Company’s employee stock options. The model is also sensitive to changes in assumptions, which can materially affect the fair value estimate. Since changes in the subjective input assumptions can materially affect the fair value estimates, the existing model, in management’s opinion, does not necessarily provide a single reliable measure of the fair value of its stock options. In addition, the pro-forma effect on reported net income and earnings per share for the periods presented should not be considered necessarily representative of the pro forma effects on reported net income and earnings per share for future periods.
 
 
In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123R, Share-Based Payment (SBP) that will require the Company to expense the value of employee stock options and similar awards. Under FAS 123R, the fair value of SBP awards is required to be included as compensation expense in the income statement beginning on the date that the Company grants awards to employees. For vested awards that are outstanding on the effective date of FAS 123R, the Company will not be required to record any additional compensation expense. For unvested awards that are outstanding on the effective date, compensation expense will be recognized in the income statement over the remainder of the vesting period for each option. Since the majority of employee stock options issued by the Company are vested and restricted stock awards are currently being recorded as compensation expense, the Company expects that the effect of FAS 123R on its financial statements will be minimal. FAS 123R is effective for the Company’s interim and annual periods beginning January 1, 2006. Until that date, the Company will continue to account for stock-based compensation in accordance with Accounting Principles Board (APB) Opinion 25, Accounting for Stock Issued to Employees.
 
F. Post-Retirement Benefits
   
 
The Company provides post-retirement medical and life insurance benefits through an unfunded plan to qualifying employees. Benefits are available to full-time employees who have worked 15 years and attained age 55. Retirees and certain active employees with more than 20 years of service to the Company continue to receive benefits in accordance with plans that existed at First National Bank of Cortland and Oneida Valley National Bank, prior to the merger of the banks in 1999. The Company does not have a pension plan.

- 9 -


                The components of the plan’s net periodic cost for the periods indicated are as follows:
 
For Quarter Ended
 
   
(Dollars in thousands) March 31, 2005 March 31, 2004
 
   
                   
  Service cost   $ 30   $ 33    
  Interest cost     64     77    
  Amortization of unrecognized prior
   service cost		     18     25    
 
   
  Net periodic benefit cost   $ 112   $ 135    
 
   
   
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 

General

Throughout this analysis, the term “the Company” refers to the consolidated entity of Alliance Financial Corporation, its wholly-owned banking subsidiary, Alliance Bank, N.A. (the “Bank”), and the Bank’s subsidiaries, Alliance Preferred Funding Corp. and Alliance Leasing, Inc. 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 following discussion presents material changes in the Company’s results of operations and financial condition during the three months ended March 31, 2005, which are not otherwise apparent from the consolidated financial statements included in this report.

This discussion and analysis contains certain forward-looking statements (within the meaning of the Private Securities Litigation Reform Act of 1995) 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 contemplated by such forward-looking statements include, among others, the following possibilities: (1) an increase in competitive pressures in the banking industry; (2) changes in the interest rate environment that reduce margins; (3) changes in the regulatory environment; (4) general economic conditions, either nationally or regionally, that 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) changes occur in technology used in the banking business; (8) an inability to maintain and increase market share and control expenses; (9) the possibility that the


- 10 -


expansion of the Company’s trust business may fail to perform as currently anticipated; and (10) other factors detailed from time to time in the Company’s SEC filings.

Operating results for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.

RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 2005

Earnings Summary and Executive Overview

Net income was $2,014,000, or $0.55 per diluted share, for the first quarter of 2005 compared with $1,894,000, or $0.52, per diluted share, for the same period in 2004. Net income increased $120,000, or 6.3%, while diluted earnings per share were up $0.03, or 5.8% for the comparable periods. The return on average assets and return on average shareholder’s equity were 0.91% and 11.66%, respectively, for the three months ended March 31, 2005, compared with 0.90% and 11.19%, respectively, for the first quarter of 2004. The 2005 first quarter was highlighted by the Company’s acquisition of $560 million of trust assets under management from HSBC Bank USA, N.A., continued improvement in the quality indicators of the loan portfolio resulting in a credit to the provision expense, deposit growth of 9%, and growth in the indirect auto loan and commercial lease portfolios.

Analysis of Net Interest Income and the Net Interest Margin

For the three months ended March 31, 2005 compared with the three months ended March 31, 2004, net interest income declined $165,000, or 2.4%, to $6,803,000. The decline was primarily the result of an increase in the Company’s cost of funds, reflecting the rise in market interest rates over the past twelve months, and the short-term re-pricing characteristics of a large percentage of the Company’s interest-bearing liabilities. Over the past twelve months, the average rate paid on interest-bearing liabilities increased 36 basis points compared to a 4 basis point rise in the average yield of interest-bearing assets, reducing the net interest spread by 32 basis points. For the comparable three month periods, the positive impact on net interest income from a $43,012,000, or 5.4%, increase in average earning assets provided a considerable offset to the negative impact from the spread reduction. As a result of the rate, volume and mix changes over the past year, the net interest margin declined 25 basis points from 3.72% in the first quarter of 2004 to 3.47% in the current quarter.

Total interest income for the quarter ended March 31, 2005 increased $612,000, or 6.1%, compared with the quarter ended March 31, 2004, with the increase primarily attributable to the higher level of earning assets. Loan and lease income increased $799,000, or 11.6%, over the prior period, influenced most by increased volume and improved yields in the commercial loan and lease portfolio. Average net loans and leases increased $47,143,000, or 9.9%, over the comparable periods, with 45% of the growth reported in indirect auto loans and 40% of the growth in commercial loans and leases. For the comparable periods, the average yield on the loan portfolio increased 10 basis points. In addition to the loan and lease portfolio, the average yield also increased in the consumer loan portfolio, which is dominated by variable rate home equity loans, while yields were lower in the indirect auto and residential mortgage loan portfolios. The change in the overall mix of average loans over the past twelve months reflected an increase in the indirect auto and commercial loan and lease categories and a decline in the primarily longer-term fixed rate residential mortgage loans category. Investment income declined $198,000, or 6.4%, versus the comparable period, due to a 21 basis point decline in the average tax-equivalent yield on the portfolio. The decline in the portfolio yield reflected the purchase of investments over the past twelve months at current market yields significantly lower than those that matured during the period. The level of average investments showed little change versus the comparable period.


- 11 -


Total interest expense increased $777,000, or 25.6%, for the quarter ended March 31, 2005 compared to the same period in 2004, with the increase primarily relating to higher rates paid on both deposits and borrowings. Deposit expense increased $636,000, or 31.9%, the result of a 31 basis point increase in the average rate paid and costs relating to a $46,439,000, or 8.7%, increase in average interest-bearing deposits over the comparable period. Over 50% of the increase in deposit expense was attributable to higher rates paid on, and growth of balances in, the money market category. A $31,249,000, or 13.5%, increase in average time deposit balances for the comparable periods also significantly contributed to the increased deposit expense. Growth in average time deposits was the result of increases in average consumer deposits and brokered certificates of deposit. For the comparable periods, there was little change in the average deposit mix. Interest expense on borrowings rose $141,000, or 13.5%, impacted by a 64 basis point increase in the average rate paid. The increase in the average rate paid on borrowings reflected the variable rate re-pricing characteristics of the borrowings. Average borrowings declined by $18,665,000, or 10.6% versus the comparable period.

The following table sets forth information concerning average interest-earning assets and interest-bearing liabilities and the average yields and rates thereon for the periods indicated. 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.


- 12 -


For the three months ended March 31, 2005   2004  
 
(Dollars in thousands)                            
  Avg.
Balance 		  Amt of
Interest 		  Avg. Yield/
Rate Paid 		  Avg.
Balance 		  Amt of
Interest 		  Avg. Yield/
Rate Paid 		 
 
   
 
 
   
 
Assets:                          
Interest earning assets:  
     Federal Funds Sold   $ 5,604   $ 32     2.28 % $ 8,702   $ 20     0.92 %
     Taxable Investment Securities   $ 226,308   $ 2,082     3.68 % $ 233,955   $ 2,322     3.97 %
     Nontaxable Investment Securities   $ 78,081   $ 1,218     6.24 % $ 71,467   $ 1,155     6.46 %
     Real Estate Loans   $ 175,571   $ 2,647     6.03 % $ 172,875   $ 2,690     6.22 %
     Commercial Loans   $ 149,632   $ 2,452     6.55 % $ 142,177   $ 2,075     5.84 %
     Taxable Leases (net of unearned        discount)   $ 12,533   $ 246     7.85 % $ 3,033   $ 50     6.59 %
     Non-Taxable Leases (net of        unearned discount)   $ 2,017   $ 47     9.31 % $ —   $ —     0.00 %
     Indirect Loans   $ 121,036   $ 1,382     4.57 % $ 99,932   $ 1,278     5.12 %
     Consumer Loans   $ 63,064   $ 941     5.97 % $ 58,693   $ 808     5.51 %
 
       Total Interest-earning Assets     833,846     11,047     5.30 %   790,834     10,398     5.26 %
             
Noninterest earning assets:                                      
     Other Assets     59,297                 53,291              
     Less: Allowance for Loan Losses     (5,413 )               (6,179 )            
Net unrealized gains/(losses) on
       available-for-sale portfolio		     1,825                 7,073              
   
             
             
        Total   $ 889,555               $ 845,019              
   
             
             
             
Liabilities and Shareholders’ Equity:  
Interest bearing assets:                                      
     Demand Deposits   $ 83,780   $ 60     0.29 % $ 84,638   $ 56     0.26 %
     Saving and MMDA Deposits   $ 233,987   $ 802     1.37 % $ 217,939   $ 462     0.85 %
     Time Deposits   $ 261,900   $ 1,768     2.70 % $ 230,651   $ 1,475     2.56 %
     Borrowings   $ 156,727   $ 1,183     3.02 % $ 175,392   $ 1,043     2.38 %
 
       Total Interest Bearing Liabilities     736,394     3,813     2.07 %   708,620     3,036     1.71 %
             
Noninterest bearing liabilities:                                      
     Demand deposits     75,435                 59,856              
     Other liabilities     8,636                 8,850              
     Shareholders’ equity     69,090                 67,693              
   
             
             
       Total   $ 889,555               $ 845,019              
   
             
             
Net interest earnings (FTE)         $ 7,234               $ 7,362        
 
Net yield on interest-earning assets                 3.47 %               3.72 %
 
Net interest spread                 3.23 %               3.55 %
 
Federal tax exemption on non-taxable                                      
  investment securities included in     interest income         $ 431               $ 394        
   

The following table sets forth the dollar volume of increase (decrease) in interest income and interest expense resulting from changes in the volume of earning assets and interest-bearing liabilities, and from changes in rates for the periods indicated. Volume changes are computed by multiplying the volume difference by the prior period’s rate. Rate changes are computed by multiplying the rate difference by the prior period’s balance. The change in interest income and expense due to both rate and volume has been allocated equally between the volume and rate variances.


- 13 -


  FOR THE QUARTER END
MARCH 31, 2005 COMPARED TO MARCH 31, 2004
INCREASE (DECREASE) DUE TO		  
VOLUME RATE NET CHG
 
(Dollars in thousands)                  
Interest earned on:            
Federal funds sold $ (12 ) $ 24   $ 12  
Taxable investment securities   (73 )   (167 )   (240 )
Non-taxable investment securities   105     (42 )   63  
Real estate loans   41     (84 )   (43 )
Commercial loans   117     260     377  
Taxable leases (net of unearned discount)   171     25     196  
Non-taxable leases (net of unearned discount)   23     24     47  
Indirect loans   256     (152 )   104  
Consumer loans   63     70     133  
 
Total interest-earning assets $ 691   $ (42 ) $ 649  
                     
Interest paid on:                  
Interest-bearing demand deposits $ (2 ) $ 6   $ 4  
Savings and money market deposits   45     294     339  
Time deposits   206     87     293  
Borrowings   (126 )   267     141  
 
Total interest-bearing liabilities $ 123   $ 654   $ 777  
                   
 
Net interest earnings (FTE) $ 568   $ (696 ) $ (128 )
 
 

Analysis of the Provision and Allowance for Loan and Lease Losses

The Bank’s 2005 first quarter evaluation of the adequacy of the allowance for loan and lease losses concluded that continued improvement in loan quality indicators supported a reduction in the level of the allowance for loan and lease losses compared to December 31, 2004. Non-performing loans and leases at March 31, 2005 were 0.16% of total loans and leases, down from 0.53% at year-end 2004 and 0.91% at March 31, 2004. The decline in the level of nonperforming loans was the result of the sale of nearly $2,000,000 in notes connected with a nonperforming commercial loan relationship during the 2005 first quarter. For the first quarter of 2005, the Bank reported a 0.08% net loan and lease recovery as a percentage of average loans and leases, compared to a 2004 first quarter percentage of 0.16%. Improvement in the loss rate was influenced most by net recoveries in the commercial loan portfolio. Improvement in the loss rate was also attributable to a 2005 first quarter loss rate in the indirect auto loan portfolio that was less than half that reported in first quarter of 2004, and 29% less than the loss rate reported for the full year of 2004. The indirect auto loan portfolio loss rate has declined each year since 2001, with the decline attributable to stronger underwriting guidelines that have focused on the applicant’s FICO credit score since that time. As a percentage of the amount of indirect auto loans originated in the first quarter of 2005, 93% were originated in the Bank’s premium (>719 FICO score) or level A (>678 FICO score) categories. Of that total, 80% were premium. At March 31, 2005, 87% of the balance of the indirect auto loan portfolio consisted of loans to borrowers with credit scores in the premium or level A categories compared to 84% at March 31, 2004. Loan delinquency, as measured by the percentage of loans past due 30 days or more and non-accruing to total loans, also improved, declining from 1.33% at the quarter end a year ago to 0.81% at the end of the 2005 first quarter. The improvement in the delinquency rate versus the comparable periods was primarily the result of the sale of the notes connected with the nonperforming commercial loan relationship in the 2005 first quarter. As a result of the improvement in the loan and lease portfolio quality indicators, the Company recorded a credit to its provision for loan and lease loss expense of $544,000 during the 2005 first quarter compared to a charge of $14,000 during the first quarter of 2004.


- 14 -


The following tables present loan quality ratios for the periods indicated and a summary of the changes in the allowance for loan and lease losses arising from loans charged off and recoveries on loans previously charged off and additions to the allowance, which have been charged to expense for the periods indicated.
 
    Three months ended
March 31,		  
    2005     2004  
   
   
 
             
Net Loans and Leases (Recovered) Charged-off to Average Loans and            
   Leases, Annualized   (0.08 %)   0.16 %
Provision for Loan and Lease Losses to Average Loans and Leases, Annualized   (0.42 %)   0.01 %
Provision for Loan and Lease Losses to Net Loans and Leases            
    Recovered/Charged-off   513.21 %   7.37 %
Allowance for Loan and Lease Losses to Period-end Loans and Leases   0.91 %   1.21 %
Allowance for Loan and Lease Losses to Nonperforming Loans and Leases   583.92 %   132.83 %
Allowance for Loan and Lease Losses to Net Loans and Leases
    (Recovered)		            
    Charged-off, Annualized   (1138.92 %)   773.75 %
Nonperforming Loans and Leases to Period-end Loans and Leases   0.16 %   0.91 %
Nonperforming Assets to Period-end Assets   0.10 %   0.52 %

(Dollars in thousands)      
    Three months ended March 31,  
    2005     2004  
   
   
 
Allowance for Loan and Lease Losses, Beginning of Period $ 5,267   $ 6,069  
             
Loans and Leases Charged-off   (148 )   (308 )
Recoveries of Loans and Leases Previously Charged-off   254     118  
 
      Net Loans and Leases Recovered (Charged-off)   106     (190 )
 
             
Provision for Loan and Lease Losses   (544 )   14  
 
      Allowance for Loan and Lease Losses, End of Period $ 4,829   $ 5,893  
 
 
The following table presents net charge-offs as a percentage of average loans by portfolio type:
 
For the quarter ended   March 31,
2005 		    December 31,
2004		     September 30,
2004 		    June 30,
2004 		    March 31,
2004 		 
Net (recoveries) charge-offs as a percentage of
   average loans by portfolio type follow:
    Commercial loans   (0.42 %)   3.42 %   0.01 %   (0.12 %)   (0.01 %)
    Leases   0.00 %   0.00 %   0.00 %   0.00 %   0.00 %
    Real estate loans   (0.01 %)   0.11 %   0.03 %   0.00 %   0.12 %
    Indirect auto loans   0.20 %   0.32 %   0.31 %   0.08 %   0.42 %
    Consumer loans   (0.03 %)   0.14 %   0.40 %   0.13 %   0.27 %
Total ( net recoveries) net charge-offs to average
  loans and leases outstanding		   (0.08 %)   1.12 %   0.13 %   0.00 %   0.16 %

- 15 -


Non-interest Income

The following table sets forth certain information on non-interest income for the periods indicated:
 
(Dollars in thousands)        
      Three Months ended March 31,  
      2005   2004   Change  
 
Trust and brokerage income     $ 1,219   $ 409   $ 810     198.04 %
Service charges on deposit accounts       657     739     (82 )   -11.10 %
Bank owned life insurance       98     294     (196 )   -66.67 %
Gain on the sale of loans       43     69     (26 )   -37.68 %
Rental income from operating leases       542     177     365     206.21 %
Other non-interest income       395     383     12     3.13 %
 
   Core non-interest income     $ 2,954   $ 2,071   $ 883     42.64 %
Investment securities gains       —     273     (273 )   0.00 %
Gain/(loss) on disposal of assets       (5 )   —     (5 )   0.00 %
 
   Total non-interest income     $ 2,949   $ 2,344   $ 605     25.81 %
 
 

Growth in total non-interest income for the three months ended March 31, 2005 compared with the three months ended March 31, 2004 reflected an increase in the core components and a decrease in the non-core components. Core non-interest income for the comparable periods increased on growth in trust income that was attributable to the February 18, 2005 acquisition of a portion of the personal trust business from HSBC, USA, N.A.. Service charge on deposits income was lower for the comparable periods, primarily in the business account category as an increase in the earnings credit rate on balances offset a greater portion of service fees. For the period ended March 31, 2004, income from bank owned life insurance included both increases in cash value and death benefits, with only increases in cash value reflected in the current period. The increase in rental income from operating leases was attributable to the early payoff of an operating lease during the current period. The Company had no security sales during the first quarter of 2005 and accordingly had no gains or losses.

Operating Expenses

The following table sets forth certain information on operating expenses for the periods indicated:
 
(Dollars in thousands)        
      Three Months ended March 31,  
      2005   2004   Change  
 
Salaries, wages, and employee benefits     $ 3,911   $ 3,700   $ 211     5.70 %
Building, occupancy, and equipment       1,722     1,218     504     41.38 %
Communication expense       163     153     10     6.54 %
Stationary and supplies expense       118     131     (13 )   -9.92 %
Marketing expense       183     244     (61 )   -25.00 %
Amortization of intangible asset       42     —     42     0.00 %
Other operating expense       1,476     1,328     148     11.14 %
 
   Total operating expenses     $ 7,615   $ 6,774     841     12.42 %
 
 

The increase in total operating expense for the three months ended March 31, 2005 compared with the prior year period reflected a rise in overhead costs associated with growth in the Bank’s trust, leasing, and retail banking business. Salary and employee benefit expense rose for the comparable three month periods primarily reflecting costs associated with increased staff in the trust area, related to the acquisition of the HSBC trust


- 16 -


business, as well as increases in the commercial loan and lease businesses. The increase in building, occupancy and equipment expense in the current period was significantly impacted by an impairment loss on equipment related to an operating lease. The charge represented 60% of the total increase in the building, occupancy, and equipment category. Costs were also higher in the current period for building lease expense and equipment service contract costs. The decline in marketing expense for the comparable periods reflected the higher 2004 costs associated with new branch openings in that period. The rise in other operating expense related to growth in the trust business, an increase in the reserve for loan commitments, and increased audit expense.

Income taxes

The Company’s effective tax rate was 24.9% for the three months ended March 31, 2005, comparable with the 25% rate reported for the three months ended March 31, 2004.

ANALYSIS OF FINANCIAL CONDITION

Total assets increased $15,226,000, or 1.7%, from $893,934,000 at December 31, 2004 to $909,160,000 at March 31, 2005. For the three months ended March 3, 2005, total loans and leases increased $13,361,000, or 2.6%, to $536,149,000. Growth occurred during the first quarter of 2005 in the indirect auto, commercial loan, and lease portfolios. Since December 31, 2004, indirect auto loans increased 8.1%, with much of the growth coming from expansion of the market area into western New York State. A 28.7% increase in commercial lease outstandings over the last three months reflected successes of a new management team in the leasing company. Declines in the real estate and consumer loan categories reflect first quarter seasonal weakness.

The following table sets forth the composition of the Bank’s loan and lease portfolio at the dates indicated:
 
(Dollars in thousands)     March 31, 2005   December 31, 2004   September 30, 2004   June 30, 2004   March 31, 2004  
 
      Amount   Amount   Amount   Amount   Amount  
 
                                   
Commercial loans     $ 151,183   $ 148,821   $ 145,697   $ 146,854   $ 144,976  
Leases       20,359     15,817     7,174     4,938     4,526  
Real estate loans       174,711     176,666     174,757     174,914     172,032  
Indirect auto loans       127,143     117,622     117,209     113,910     103,185  
Consumer loans       62,753     63,862     62,450     59,990     58,364  
 
Gross Loans & Leases     $ 536,149   $ 522,788   $ 507,287   $ 500,606   $ 483,083  
 

The investment portfolio as of March 31, 2005, in the amount of $310,466,000, declined $14,659,000, or 4.5%, since December 31, 2004. At March 31, 2005, 98% of the investment portfolio was classified as available for sale and included a $1,850,000 unrealized loss.


- 17 -


The following table sets forth the amortized cost and market value for the Company’s held-to-maturity investment securities portfolio:
March 31, 2005   December 31, 2004   March 31, 2004  
(Dollars in thousands) Amortized
Cost		   Market
Value		   Amortized
Cost		   Market
Value		   Amortized
Cost		   Market
Value		  
 
    (Dollars in thousands)
  
Obligations of states and
    political subdivisions		 $ 7,156   $ 7,335   $ 5,367   $ 5,621   $ 6,997   $ 7,402  
 
Total $ 7,156   $ 7,335   $ 5,367   $ 5,621   $ 6,997   $ 7,402  
 
 
The following table sets forth the amortized cost and market value for the Company’s available-for-sale investment securities portfolio:
 
March 31, 2005   December 31, 2004   March 31, 2004  
(Dollars in thousands) Amortized
Cost		   Market
Value		   Amortized
Cost		   Market
Value		   Amortized
Cost		   Market
Value		  
    (Dollars in thousands)  
U.S. Treasury and other                        
   U.S. government agencies $ 79,539   $ 77,592   $ 98,197   $ 97,572   $ 119,065   $ 121,750  
Mortgage-backed securities   140,899     139,016     135,431     135,089     112,647     113,463  
Obligations of states and
     political subdivisions		   73,317     75,275     70,688     74,076     65,290     70,326  
Federal Home Loan Bank and
    Federal Reserve Bank stock		   6,457     6,457     8,037     8,037     5,901     5,901  
Other equity securities   4,948     4,970     4,948     4,984     3,960     3,948  
 
Total $ 305,160   $ 303,310   $ 317,301   $ 319,758   $ 306,863   $ 315,388  
 
Net unrealized gains/(losses) on
     available-for-sale securities		 $ (1,850 )       $ 2,457         $ 8,525        
 
Total Carrying Value $ 303,310         $ 319,758         $ 315,388        
 
 

For the three months ended March 31, 2005, deposits increased $56,745,000, or 9.1%. Since the end of 2004, consumer deposits increased $12,238,000, or 3.5%, with the majority of the deposit growth in the Bank’s Onondaga County branches. Consumer deposit growth was most significant in money market savings and time deposits. Commercial deposits increased $3,076,000, or 2.8%. During the period, government deposits increased $41,401,000, or 40.8%, reflecting the annual receipt of tax revenues by our public entity customers. Brokered deposits were unchanged during the quarter. With the growth in deposits greater than growth in total assets, the Bank reduced total borrowings by $38,575,000, or 20.1%, during the quarter. The Bank, however, reported an increase in the retail repurchase component of the borrowing category during the period, in the amount of $5,025,000, or 21.6%, as commercial customers increased usage of the cash management product.


- 18 -


The following table sets forth the composition of the Bank’s deposits by business line at the dates indicated:
 
March 31,
2005		 December 31,
2004		 September 30,
2004		 June 30,
2004		 March 31,
2004
(Dollars in thousands) Balance Balance Balance Balance Balance
 
Commercial Deposits                    
                               
Noninterest-bearing demand deposits $ 54,530   $ 53,762   $ 60,160   $ 54,029   $ 42,797  
Interest-bearing demand deposits   7,225     8,229     8,029     8,735     7,193  
Savings and money market deposits   33,053     31,271     33,410     26,935     29,483  
Time deposits   18,845     17,315     18,406     16,686     16,261  
 
    Total Commercial Deposits $ 113,653   $ 110,577   $ 120,005   $ 106,385   $ 95,734  
 
                               
Consumer Deposits                              
                               
Noninterest-bearing demand deposits $ 14,274   $ 15,862   $ 13,003   $ 14,181   $ 11,415  
Interest-bearing demand deposits   55,961     60,644     58,475     60,617     58,878  
Savings and money market deposits   125,522     113,411     121,954     127,314     109,907  
Time deposits   165,613     159,215     154,134     144,272     149,380  
 
    Total Consumer Deposits $ 361,370   $ 349,132   $ 347,566   $ 346,384   $ 329,580  
 
                               
Government Deposits                              
                               
Noninterest-bearing demand deposits $ 8,390   $ 4,925   $ 4,741   $ 5,997   $ 3,416  
Interest-bearing demand deposits   11,293     13,018     17,071     12,919     10,643  
Savings and money market deposits   99,824     62,053     63,437     73,390     108,998  
Time deposits   23,410     21,520     27,184     36,431     36,665  
 
    Total Government Deposits $ 142,917   $ 101,516   $ 112,433   $ 128,737   $ 159,722  
 
                               
Brokered Deposits                              
                               
 
Time deposits $ 61,926   $ 61,896   $ 61,926   $ 44,955   $ 34,955  
 
                               
 
TOTAL DEPOSITS $ 679,866   $ 623,121   $ 641,930   $ 626,461   $ 619,991  
   

Liquidity

The Company’s liquidity primarily reflects the Bank’s ability to provide funds to meet loan and lease requests, to accommodate possible outflows in deposits, and to take advantage of market interest rate opportunities. Funding loan and lease requests, providing for liability outflows, and managing of interest rate fluctuations require continuous analysis in order to match the maturities of specific categories of short-term loans and leases and investments with specific types of deposits and borrowings. Liquidity is normally considered in terms of the nature and mix of the Bank’s sources and uses of funds. The Asset Liability Committee (“ALCO”) of the Bank is responsible for implementing the policies and guidelines for the maintenance of prudent levels of liquidity. Management believes, as of March 31, 2005, that liquidity as measured by the Bank is in compliance with its policy guidelines.

The Bank’s principal sources of funds for operations are cash flows generated from earnings, deposits, loan and lease repayments, borrowings from the Federal Home Loan Bank of New York (“FHLB”), and securities sold under repurchase agreements. During the three months ended March 31, 2005, cash and cash equivalents increased by $7,279,000, as net cash provided by deposit and financing activities of $17,420,000 was more than the net cash used by lending, investing and operating activities of $10,141,000. Net cash provided by financing activities reflects a net increase in deposits of $56,745,000, and a net decrease in borrowings of $38,575,000. Net cash used in lending and investing activities reflects a net increase in loans and leases of $12,368,000, a net decrease in investment securities of $10,398,000, and a net increase in acquisitions of $7,560,000.

As a member of the FHLB, the Bank is eligible to borrow up to an established credit limit against certain residential mortgage loans and investment securities that have been pledged as collateral. As of March 31,


- 19 -


2005, the Bank’s credit limit with the FHLB was $174,579,000. The total of the Bank’s outstanding borrowings from the FHLB on that date was $115,000,000.

Capital Resources

During the three months ended March 31, 2005, shareholders equity declined $1,262,000 to $67,634,000, and book value per share declined $0.47 to $18.82. The decline in both the equity and book value was the result of a $2,575,000 a decline in the market value (after-tax) of the Company’s available for sale component of its investment portfolio, and was attributable to a rise in market interest rates during the quarter. Shareholders’ equity was positively impacted during the first three months of the year by net income after the payment of dividends of $1,260,000 and $53,000 from the exercise of stock options and amortization of restricted stock.

On December 19, 2003, the Company formed a wholly owned subsidiary, Alliance Financial Capital Trust I (“AFCT”), a Delaware business trust. AFCT issued $10,000,000 of 30-year floating rate Company-obligated pooled capital securities (trust preferred securities) that qualify as Tier I capital of the Company. On March 11, 2005, the Federal Reserve Board (FRB) announced approval of its final rule that allows the continued inclusion of outstanding and prospective issuances of trust preferred securities in the Tier 1 capital of bank holding companies. Under the final rule, bank holding companies may continue to treat trust preferred securities as Tier 1 capital up to the current 25% core capital limit until March 31, 2009. After March 31, 2009, the 25% limit will be calculated net of goodwill (net of any associated deferred tax liability).

In accordance with the Financial Accounting Standards Board (“FASB”) Interpretation No. 46 (“FIN 46”) Consolidation of Variable Interest Entities, the Company does not consolidate the assets and liabilities or income and expense of AFCT (a Variable Interest Entity) with the Company’s financial statements.

The Company and its banking subsidiary are subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company must meet specific capital guidelines that involve quantitative measures of the Company’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and its subsidiary bank to maintain minimum amounts and ratios (set forth in the tables below) of total and Tier 1 Capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier 1 Capital (as defined) to average assets (as defined).

As of December 31, 2003, the most recent notification from the Office of the Comptroller of the Currency categorized the Bank as “well-capital­ized,” under the regulatory framework for prompt corrective action. To be categorized as “well-capitalized,” the Bank must maintain total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the tables below. Management believes that, as of March 31, 2005, the Company and its subsidiary Bank met all capital adequacy requirements to which they were subject to.

The following table compares the Company’s actual capital amounts and ratios with those needed to qualify for the “well capitalized” category, which is the highest capital category as defined in the regulations.


- 20 -


(Dollars in thousands)
Actual To be Well
Capitalized Under
Prompt Corrective
Action Provisions
 
Amount Ratio Amount Ratio
 
As of March 31, 2005                
Total Capital (to Risk-Weighted Assets) $ 76,303     13.72 % $ 55,604     >10.00 %
Tier I Capital (to Risk-Weighted Assets)   71,243     12.81 %   33,362     >6.00 %
Tier I Capital (to Average Assets)   71,243     8.01 %   44,478     >5.00 %
As of December 31, 2004                        
Total Capital (to Risk-Weighted Assets) $ 82,858     15.34 % $ 54,015     >10.00 %
Tier I Capital (to Risk-Weighted Assets)   77,461     14.34 %   32,409     >6.00 %
Tier I Capital (to Average Assets)   77,461     8.70 %   44,493     >5.00 %
 

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 judgments 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 in the 2004 Annual Report on Form 10-K/A (“the Consolidated Financial Statements”). 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 judgments, 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 judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans and leases, if the loan is not collateral –dependent and measured based on the fair value of the collateral. It also requires estimates of losses on pools of homogeneous loans and leases based on historical loss experience and consideration of current economic trends and conditions, both 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 C to the Consolidated Financial Statements in this Quarterly Report on Form 10-Q describes the methodology used to determine the


- 21 -


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. 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 Company’s tax position. If the final resolution of taxes payable differs from the Company’s estimates due to regulatory determination or legislative or judicial actions or any other reason, adjustments to tax expense may be required.

Other Information

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 denied the motion to include the landowners as a group, 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 $500,000,000 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 not participate in the settlement negotiations, have indicated that they do not intend to go along with the settlement. The Wisconsin tribe subsequently filed new lawsuits against individual landowners, and has 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.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

Market risk is the risk of loss in a financial instru­ment arising from adverse changes in market rates or prices such as interest rates, foreign currency exchange rates, commodity prices, and equity prices. The Company’s market risk arises principally from interest rate risk in its lending, deposit and borrowing activities. Other types of market risks do not arise in the normal course of the Company’s business activities.

The Asset Liability Committee (ALCO) is responsible for reviewing the interest rate sensitivity position and establishing policies to monitor and limit exposure to interest rate risk. The policies and guidelines established by ALCO are reviewed and approved by the Company’s Board of Directors.

Interest rate risk is monitored primarily through the use of two complementary measures: earnings simulation modeling and net present value estimation. Both measures are highly assumption-dependent and change regularly as the balance sheet and business mix evolve; however, the Company believes that taken together they represent a reasonably comprehensive view of the magnitude of interest rate risk, the distribution of risk along


- 22 -


the yield curve, the level of risk through time, and the amount of exposure to changes in certain interest rate relationships. The key assumptions employed by these measures are analyzed regularly and reviewed by ALCO.

Earnings Simulation Modeling

Net interest income is affected by changes in the absolute level of interest rates and by changes in the shape of the yield curve. In general, a flattening of the yield curve would result in a decline in earnings due to the compression of earning asset yields and funding rates, while a steepening of the yield curve would result in increased earnings as investment margins widen. The model requires management to make assumptions about how the Bank’s balance sheet is likely to evolve through time in different interest rate environments. Loan and deposit growth rate assumptions are derived from historical analysis and management’s outlook, as are the assumptions used to project yields and rates for new loans and deposits. Securities portfolio maturities and prepayments are assumed to be reinvested in similar instruments. Mortgage loan prepayment assumptions are developed from industry median estimates of prepayment speeds in conjunction with the historical prepayment performance of the Bank’s own loans. Non-contractual deposit growth rates and pricing are modeled on historical patterns. Interest rates of the various assets and liabilities on the balance sheet are assumed to change proportionally, based on their historic relationship to short-term rates. The Bank’s guidelines for risk management call for preventative measures to be taken if the simulation modeling demonstrates that an instantaneous 2% increase or decrease in short-term rates over the next twelve months would adversely affect net interest income over the same period by more than 15% when compared to the stable rate scenario. The low level of short-term interest rates since the beginning of 2003, necessitated a modification of the standard 2% rate change scenario, to an instantaneous decrease of 1% scenario over the next twelve months with an adverse effect no greater than 7.5%. At March 31, 2005, based on the results of the Bank’s simulation model, and assuming that management does not take action to alter the outcome, the Bank would expect net interest income to decrease 10.6% if short term interest rates increase by 2%, and to increase 4.8% if short term interest rates decline by 1%.

Net Present Value Estimation

The Net Present Value of Equity (NPV) measure is used for discerning levels of risk present in the balance sheet that might not be taken into account in the earnings simulation model due to the shorter time horizon used by that model. The NPV of the balance sheet, at a point in time, is defined as the discounted present value of the asset cash flows minus the discounted value of liability cash flows. Interest rate risk analysis using NPV involves changing the interest rates used in determining the cash flows and in discounting the cash flows. The Bank’s NPV analysis models both an instantaneous 2% increasing and 2% decreasing interest rate scenario comparing the NPV in each scenario to the NPV in the current rate scenario. The resulting percentage change in NPV is an indication of the longer-term repricing risk and options risk embedded in the balance sheet. The NPV measure assumes a static balance sheet versus the growth assumptions that are incorporated into the earnings simulation measure, and an unlimited time horizon instead of the one-year horizon applied in the earnings simulation model. As with earnings simulation modeling, assumptions about the timing and the variability of balance sheet cash flows are critical in NPV analysis. Particularly important are assumptions driving mortgage prepayments in both the loan and investment portfolios, and changes in the noncontractual deposit portfolios. These assumptions are applied consistently in both models. Based on the March 31, 2005 NPV estimation, a 2% instantaneous increase in interest rates was estimated to decrease NPV by 9.3%. NPV was estimated to increase by 3% if rates immediately declined by 1%. Policy guidelines limit the amount of the estimated increase/decline to 25% in a 2% rate change scenario, and 12.5% in a 1% rate change scenario. As with the earnings simulation modeling, due to the low level of interest rates since the beginning of 2003, the Bank modified its standard decreasing rate scenario to a 1% rate decline at year end.


- 23 -


Item 4.    Controls and Procedures

The management of the Company is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of March 31, 2005, an evaluation was performed under the supervision of and with the participation of the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the CEO and the CFO concluded that the Company’s disclosure controls and procedures as of March 31, 2005 were effective in ensuring that information required to be disclosed in this Quarterly Report on Form 10-Q was recorded, processed, summarized, and reported within the time period required by the United States Securities and Exchange Commission’s rules and forms.

There has been no change in the Company’s internal control over financial reporting that occurred during the most recent fiscal quarter that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II.        OTHER INFORMATION

 
Item 1.   Legal Proceedings
   
  Not applicable.
   
Item 2. Unregistered Sales of Equity Securities  and Use of Proceeds
   
  Not applicable
   
Item 3. Defaults Upon Senior Securities
   
  Not applicable.
   
Item 4. Submission of Matters to a Vote of Security Holders
   
  Not applicable.
   
Item 5.    Other Information
   
  Not applicable.
   
Item 6. Exhibits
   
  Exhibits required by Item 601 of Regulation S-K:
   
  Ex. No. Description
     
  3.1 Amended and Restated Certificate of Incorporation of the Company(1)
     
  3.2 Amended and Restated Bylaws of the Company(2)
     
  31.1 
Certification of Jack H. Webb, Chairman of the Board, President and Chief Executive Officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(3)
     
  31.2
Certification of David P. Kershaw, Treasurer and Chief Financial Officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002(3)

- 24 -


  32.1
Certification of Jack H. Webb, Chairman of the Board, President and Chief Executive Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(3)
     
  32.2
Certification of David P. Kershaw, Treasurer and Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002(3)
     
  (1)
Incorporated herein by reference to the exhibit with the same number to the Registration Statement on Form S-4 (Registration No. 333-62623) of the Company filed with the Securities and Exchange Commission on August 31, 1998.
     
  (2)
Incorporated herein by reference to exhibit number 3-2 to the Current Report of Form 8-K of the Company (File No. 0-15366) filed with the Commission on September 3, 2004.
     
  (3) Filed herewith.
     
   

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
ALLIANCE FINANCIAL CORPORATION
 
 
Dated  May 5, 2005 /s/  Jack H. Webb
 
  Jack H. Webb
  Chairman of the Board,
President and  Chief Executive Officer
   
   
Dated  May 5, 2005 /s/ David P. Kershaw
 
  David P. Kershaw
  Treasurer and Chief Financial Officer

- 25 -