SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549 FORM 10-K x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THESECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2006ORo
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THESECURITIES EXCHANGE ACT OF 1934For the transition period from __ to __Commission file number 0-15366ALLIANCE FINANCIAL CORPORATION(Exact name of Registrant as specified in its charter)  New York


16-1276885(State or
  Other Jurisdiction of Incorporation or Organization)


(I.R.S. Employer Identification No.)120 Madison
  Street, Tower II, 18th Floor, Syracuse, NY 13202


13202(Address of
  principal executive offices)


(ZIP Code) Registrants telephone number including area
code: (315) 475-4478 Securities registered pursuant to Section
12(b) of the Act: Title of Each Class: Common Stock, $1.00 par
value per share
Name of each exchange on which registered: The NASDAQ Stock Market LLC Securities registered pursuant to Section
12(g) of the Act: None Indicate by
check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.
 Yes o
No x  Indicate by
check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Exchange Act.
 Yes o
No x  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 if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrants knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form 10-K. x Indicate by
check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of accelerated filer and
large accelerated filer: in Rule 12b-2 of the Exchange Act. Large Accelerated Filer o
Accelerated Filer x
Non-accelerated
  filer o Indicate by
check mark whether the registrant is a shell company (as defined in Rule 12b-2
of the Exchange Act). Yes   o No x As of June 30,
2006, the aggregate market value of the voting stock held by nonaffiliates of
the registrant was $100.0 million based on the closing sale price as reported
on the NASDAQ Global Market. The number of
outstanding shares of the Registrants common stock, $1 par value per share, on
March 7, 2007 was 4,791,309 shares. DOCUMENTS INCORPORATED BY REFERENCE Portions of
the proxy statement for the annual shareholders meeting to be held on May 15,
2007 (the Proxy Statement) are incorporated by reference in Part III of this
Annual Report on Form 10-K. Exhibit index
is located on page 59 of 61.    TABLE OF CONTENTS

FORM 10-K ANNUAL REPORT
FOR THE YEAR ENDED
DECEMBER 31, 2006
ALLIANCE FINANCIAL CORPORATION

PagePART IItem
  1.
Business

3Item
  1A.
Risk
  Factors

7Item
  1B.
Unresolved
  Staff Comments

9Item
  2.
Properties

9Item
  3.
Legal
  Proceedings

9Item
  4.
Submission
  of Matters to a Vote of Security Holders

9PART IIItem
  5.
Market for the
Registrants Common Equity,
  Related Stockholder Matters and Issuer Purchases of Equity Securities

10Item
  6.
Selected
  Financial Data

13Item
  7.
Managements
  Discussion and Analysis of Financial Condition and Results of Operations

15Item
  7A.
Quantitative
  and Qualitative Disclosures about Market Risk

27Item
  8.
Financial
  Statements and Supplementary Data

29Item
  9.
Changes
  in and Disagreements with Accountants on Accounting and Financial Disclosure

56Item
  9A.
Controls
  and Procedures

56Item
  9B.
Other
  Information

58PART IIIItem
  10.
Directors
  and Executive Officers of the Registrant and Corporate Governance

58Item
  11.
Executive
  Compensation

58Item
  12.
Security
Ownership of Certain Beneficial
  Owners and Management and Related Stockholder Matters

58Item
  13.
Certain
  Relationships, Related Transactions and Director Independence

58Item
  14.
Principal
  Accountant Fees and Services

58PART IVItem
  15.
Exhibits
  and Financial Statement Schedules

59PART 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 include: statements of
our goals, intentions and expectations; statements regarding our business plans
and prospects and growth and operating strategies; estimates of our risks and
future costs and benefits. 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: an increase in competitive pressure in the
banking industry; changes in the interest rate environment reduce margins;
changes in the regulatory environment; general economic conditions, either
nationally or regionally, are less favorable than expected, resulting in, among
other things, a deterioration in credit quality; changes in business conditions
and inflation; fluctuations in the securities markets; changes occur in
technology used in the banking business; the ability to maintain and increase market
share and control expenses; the possibility that our trust business may fail to
perform as currently anticipated; the possibility that we may fail to realize
the anticipated benefits of the acquisition of Bridge Street Financial Inc.;
and other factors detailed from time to time in the Companys SEC filings.

Item 1 Business

Available
Information

The Company files annual reports, quarterly reports,
proxy statements and other documents with the Securities and Exchange
Commission (SEC) under the Securities Exchange Act of 1934 (Exchange Act). The
public may read and copy any materials that the Company files with the SEC at
the SECs Public Reference Room at 100 F. Street, N.E., Room 1580, Washington,
D.C. 20549. The public may obtain information on the operation of the Public
Reference Room by calling the SEC at 1-800-SEC-0330. Also, the SEC maintains a
website that contains reports, proxy and information statements, and other
information regarding issuers, including the Company, that file electronically
with the SEC. The public can obtain any documents that the Company files with
the SEC at www.sec.gov.

The Company also makes
available free of charge through its website (www.alliancebankna.com) the
Companys Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current
Reports on Form 8-K, and, if applicable, amendments to those reports filed or
furnished pursuant to the Exchange Act as soon as reasonably practicable after
the Company electronically files such material with, or furnishes it to, the
SEC.

General

Alliance Financial Corporation (the Company or
Alliance) is a New York corporation and a registered financial 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 May 30, 1986 and October 31, 1984, respectively. The Company is
the holding company of Alliance Bank, N.A. (the Bank), which was formed as
the result of the merger of First National Bank of Cortland and Oneida Valley
National Bank on April 16, 1999.

The Bank provides financial
services from 29 customer service facilities in the New York counties of
Cortland, Madison, Oneida, Onondaga, Oswego, and from a Trust Administration
Center in Buffalo, NY, in Erie County. Primary services include commercial,
retail and municipal banking, consumer finance, mortgage financing and
servicing, and trust and investment management services. The Bank has a
substantially wholly-owned subsidiary, Alliance Preferred Funding Corp., which
is engaged in residential real estate activity, and a wholly-owned subsidiary,
Alliance Leasing, Inc., which is engaged in commercial leasing activity in over
thirty states.

The Company formed Alliance
Financial Capital Trust I and Alliance Financial Capital Trust II (collectively
Capital Trusts) for the purpose of issuing corporation-obligated mandatorily
redeemable capital securities to third-party investors and investing the
proceeds from the sale of such capital securities solely in junior subordinated
debt securities of the Company.

The Companys administrative
offices are located on the 18th Floor, AXA Tower II, 120 Madison
St., Syracuse, New York. Banking services are provided at the administrative
offices as well as at 29 customer service facilities located in Cortland,
Madison, western Oneida, Onondaga, Oswego, and Erie counties.

On October 6, 2006, Alliance completed its acquisition
of Bridge Street Financial, Inc. (Bridge Street) and its wholly-owned
subsidiaries, Oswego County National Bank (OCNB) and Ladds Agency Inc.
(Ladds), an insurance agency. In connection with the acquisition, Alliance
issued approximately 1,292,000 shares of common stock valued at $38.1 million,
and paid cash of $13.2 million for total merger consideration of $51.3 million.
At the time of the acquisition, Bridge Street had $219.3 million in assets,
$148.3 million in gross loans, and $169.2 million in deposits. In the
acquisition, Bridge Street was merged into Alliance, Ladds became a
wholly-owned subsidiary of Alliance, and Oswego County National Bank was merged
into the Bank.

On February 18, 2005, the
Bank acquired a portfolio of personal trust accounts and related assets under
management from HSBC, USA, N.A. The Bank assumed the successor trustee role
from HSBC on approximately 1,800 personal trust accounts and further assumed
approximately $560 million in assets under management. Combined with its
existing trust business the Bank now manages over 2,200 trust accounts and
approximately $928 million of related investment assets. In connection with the
acquisition, the Bank hired 13 trust professionals from HSBC and opened an
office in Buffalo, New York, to manage the acquired accounts.

At December 31, 2006, the Company had 324 full-time
equivalent employees, up from 265 full-time equivalent employees on December
31, 2005.

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, and
personal lines of credit to individuals. Trust and investment department

3

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 equipment leasing
services are offered through Alliance Leasing, Inc., a subsidiary of the Bank.
Personal and commercial insurance products are offered on an agency basis
through Ladds Agency, Inc., a multi-line insurance agency.

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 agencies and companies, brokerage firms, and a variety of
other financial services companies.

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
elected to become a financial holding company on June 21, 2006. As such, it 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 and financial 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. A bank holding
company that qualifies as a financial holding company can expand into a wide
variety of services that are financial in nature, if its subsidiary depository
institution is well-managed, well-capitalized and has received at least a
satisfactory rating on its last CRA examination. Services that have been
deemed to be financial in nature include securities underwriting, dealing and
market making, sponsoring mutual funds and investment companies, insurance
underwriting and agency activities and merchant banking. The Bank Holding
Company Act requires every financial 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 financial holding companies, the Federal Reserve Board is
required to consider the financial and managerial resources and future
prospects of the financial 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 financial 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
nonbanking 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 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 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 primarily 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 is limited by federal
statutes, regulations and policies. For example, it is the policy of the
Federal Reserve Board that 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 holding
companies should not maintain a level of cash dividends that undermines the
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 financial
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 1 capital). Banking organizations that are subject
to the guidelines are required to maintain a ratio of Tier 1 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 1 capital and Tier 2 capital is total risk-based capital. The Companys
Tier 1 and total risk-based capital ratios as of December 31, 2006 were 10.14%
and 10.97%, respectively.

In addition, the Federal
Reserve Board has established a minimum leverage ratio of Tier 1 capital to
quarterly average assets less goodwill (Tier 1 leverage ratio) of 3.00% for
financial holding companies that meet certain specified criteria, including
that they have the highest regulatory rating. All other financial holding
companies are required to maintain a Tier 1 leverage ratio of 3.00% plus an
additional cushion of at least 100 to 200 basis points. The Companys Tier 1
leverage ratio as of December 31, 2006 was 7.34%, 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) permits, subject to certain conditions, combinations among
banks, securities firms and insurance companies. Under Gramm-Leach, bank
holding companies are permitted to offer their customers virtually any type of
financial service including banking, securities underwriting,

4

insurance (both underwriting
and agency), and merchant banking. In order to engage in these additional
financial activities, a financial holding company must qualify and register
with the Federal Reserve Board, as the Company has, as a financial holding
company by meeting certain higher standards for capital adequacy and
management, with heavy penalties for noncompliance. 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 nonbank 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.

Transactions between the
holding company and its subsidiary bank are subject to Section 23A of the
Federal Reserve Act and to the requirements of Regulation W. 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 and to
the requirements of Regulation W, which generally require 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 statutes.
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 1
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, 2006, 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 Federal Deposit Insurance
Reform Act of 2005 was signed into law on February 8, 2006, and gives the FDIC
increased flexibility in assessing premiums on banks and savings associations,
including the Bank, to pay for deposit insurance and in managing its deposit
insurance reserves. The reform legislation provides a credit to all insured
institutions, based on the amount of their insured deposits at year-end 1996,
to offset the premiums that they may be assessed; combines the BIF and SAIF to
form a single Deposit Insurance Fund; increase deposit insurance to $250,000
for Individual Retirement Accounts; and authorizes inflation-based increases in
deposit insurance on other accounts every 5 years, beginning in 2011. The FDIC
also is directed to conduct studies regarding further deposit insurance reform.

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 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 bank must comply with the applicable provisions of these
consumer protection laws and regulations as part of their ongoing customer
relations. The Check Clearing for the 21st Century Act (Check 21
Act or the Act), which became effective on October 28, 2004, creates a
new negotiable instrument, called a substitute check, which banks are
required to accept as the legal equivalent of a paper check if it meets the
requirements of the Act. The Act is designed to facilitate check truncation, to
foster innovation in the check payment system, and to improve the payment
system by shortening processing times and reducing the volume of paper checks.

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

5

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. Pursuant to Title V
of Gramm-Leach, federal banking regulators adopted rules that limit the ability
of banks and other financial institutions to disclose nonpublic information
about consumers to nonaffiliated third parties. These limitations require
disclosure of privacy policies to consumers and, in some circumstances, allow
consumers to prevent disclosure of certain personal information to a
nonaffiliated third party. Under these rules, financial institutions must
provide: initial notices to customers about their privacy policies, describing
the conditions under which they may disclose nonpublic personal information to
nonaffiliated third parties and affiliates, annual notices of their privacy
policies to current customers, and a reasonable method for customers to opt
out of disclosures to nonaffiliated third parties.

As part of the USA Patriot
Act of 2001, signed into law on October 26, 2001, Congress adopted the
International Money Laundering Abatement and Financial Anti-Terrorism Act of
2001 (IMLAFATA). IMLAFATA authorizes the Secretary of the Treasury, in
consultation with the heads of other government agencies, to adopt special
measures applicable to banks, bank holding companies, or other financial
institutions. Pursuant to this statute, the Department of the Treasury has issued
a number of regulations relating to enhanced recordkeeping and reporting
requirements for certain financial transactions that are of primary money
laundering concern, due diligence requirements concerning the beneficial
ownership of certain types of accounts, and restrictions or prohibitions on
certain types of accounts with foreign financial institutions. Covered
financial institutions also are barred from dealing with foreign shell banks.
In addition, IMLAFATA expands the circumstances under which funds in a bank
account may be forfeited and requires covered financial institutions to respond
under certain circumstances to requests for information from federal banking
agencies within 120 hours. These regulations were also adopted during 2002 to
implement minimum standards to verify customer identity, to encourage
cooperation among financial institutions, federal banking agencies, and law
enforcement authorities regarding possible money laundering or terrorist
activities, to prohibit the anonymous use of concentration accounts, and to
require all covered financial institutions to have in place a Bank Secrecy Act
compliance program. IMLAFATA also amends the Bank Holding Company Act and the
Bank Merger Act to require federal banking agencies to consider the
effectiveness of a financial institutions anti-money laundering activities
when reviewing an application under these acts.

The Bank has in place a Bank
Secrecy Act compliance program, and engages in very few transactions of any
kind with foreign financial institutions or foreign persons.

On July 30, 2002, the
President signed into law the Sarbanes-Oxley Act of 2002 (the Act),
implementing legislative reforms intended to address corporate and accounting
fraud. In addition to the establishment of a new accounting oversight board
that enforces auditing, quality control and independence standards and is
funded by fees from all publicly traded companies, the law restricts provision
of both auditing and consulting services by accounting firms. To ensure auditor
independence, any nonaudit services being provided to an audit client require
preapproval by the issuers audit committee members. In addition, the audit
partners must be rotated. The Act requires chief executive officers and chief
financial officers, or their equivalent, to certify to the accuracy of periodic
reports filed with the SEC, subject to civil and criminal penalties if they
knowingly or willfully violate this certification requirement. In addition,
under the Act, legal counsel is required to report evidence of a material
violation of the securities laws or a breach of fiduciary duty by a company to
its chief executive officer or its chief financial officer, and, if such
officer does not appropriately respond, to report such evidence to the audit
committee or other similar committee of the board of directors or the board
itself.

Longer prison terms and
increased penalties are also applied to corporate executives who violate
federal securities laws, the period during which certain types of suits can be
brought against a company or its officers has been extended, and bonuses issued
to top executives prior to restatement of a companys financial statements are
subject to disgorgement if such restatement was due to corporate misconduct.
Executives are also prohibited from insider trading during retirement plan
blackout periods, and loans to company executives are restricted. The Act
accelerates the time frame for disclosures by public companies, as they must
immediately disclose any material changes in their financial condition or
operations. Directors and executive officers must also provide information for
most changes in ownership in a companys securities within two business days of
the change.

The Act also prohibits any
officer or director of a company or any other person acting under their
direction from taking any action to fraudulently influence, coerce, manipulate
or mislead any independent public or certified accountant engaged in the audit
of the companys financial statements for the purpose of rendering the
financial statements materially misleading. The Act also requires the SEC to
prescribe rules requiring inclusion of an internal control report and
assessment by management in the annual report to stockholders. In addition, the
Act requires that each financial report required to be prepared in accordance
with (or reconciled to) accounting principles generally accepted in the United
States of America and filed with the SEC reflect all material correcting
adjustments that are identified by a registered public accounting firm in
accordance with accounting principles generally accepted in the United States
of America and the rules and regulations of the SEC.

As directed by Section 302(a)
of the Act, the Companys chief executive officer and chief financial officer
are each required to certify that the Companys quarterly and annual reports do
not contain any untrue statement of a material fact. The Act imposes several
requirements, including having these officers certify that: they are responsible
for establishing, maintaining and regularly evaluating the effectiveness of the
Companys internal controls; they have made certain disclosures to the
Companys auditors and the audit committee of the Board of Directors about the
Companys internal controls; and they have included information in the
Companys quarterly and annual reports about their evaluation and whether there
have been significant changes in the Companys internal controls or in other
factors that could significantly affect internal controls during the last
quarter.

In 1970, the U. S. Congress enacted the Fair Credit Reporting Act
(the FCRA) in order to ensure the confidentiality, accuracy, relevancy and
proper utilization of consumer credit report information. Under the framework
of the FCRA, the United States has developed a highly advanced and efficient
credit reporting system. The information contained in that broad system is used
by financial institutions, retailers and other creditors of every size in
making a wide variety of decisions regarding financial transactions. Employers
and law enforcement agencies have also made wide use of the information
collected and maintained in databases made possible by the FCRA. The FCRA
affirmatively preempts state law in a number of areas, including the ability of
entities affiliated by common ownership to share and exchange information
freely, and the requirements on credit bureaus to reinvestigate the contents of
reports in response to consumer complaints, among others. By its terms, the preemption
provisions of the FCRA were to terminate as of December 31, 2003. With the
enactment of the Fair and Accurate Transactions Act (FACT Act) in late 2003,
the preemption provisions of FCRA were extended, although the FACT Act imposes
additional requirements on entities that gather and share consumer credit
information. The FACT Act required the Federal Reserve Board and the Federal
Trade Commission to issue final regulations within nine months of the effective
date of the Act. A series of regulations and announcements have been
promulgated, including a joint FTC/FRB announcement of effective dates for FCRA
amendments, the FTCs Free Credit Report rule, revisions to the FTCs FACT
Act Rules, the FTCs final rules on identity theft and proof of identity, the
FTCs final regulation on consumer information and records disposal, the FTCs
final summaries and notices and a final rule on prescreen notices.

On March 1, 2005 the Federal
Reserve Board issued a final rule that allows the continued inclusion of trust
preferred securities in the Tier 1 capital of bank holding companies. Trust
preferred securities, however, will be subject to stricter quantitative limits.
The rule provides that trust preferred securities, together with other
restricted core capital elements, can be included in a bank holding companys
Tier 1 capital up to 25% of the sum of core capital elements, including
restricted core capital elements, as defined in the rule. At December 31,
2006, the Companys trust preferred securities comprised 23.1% of the sum of
the Companys core capital elements.

6

Item 1A  Risk
Factors

There are risks inherent to
the Companys business. The material risks and uncertainties that management
believes affect the Company are described below. The risks and uncertainties
described below are not the only ones facing the Company. Additional risks and
uncertainties that management is not aware of or focused on or that management
currently deems immaterial may also impair the Companys business operations.
This report is qualified in its entirety by these risk factors. If any of the
following risks actually occur, the Companys financial condition and results
of operations could be materially and adversely affected.

The Company is Subject to Interest
Rate Risk

The Companys earnings and
cash flows are largely dependent upon its net interest income. Net interest
income is the difference between interest income earned on interest-earning
assets such as loans and securities and interest expense paid on interest-bearing
liabilities such as deposits and borrowed funds. Interest rates are highly
sensitive to many factors that are beyond the Companys control, including
general economic conditions and policies of various governmental and regulatory
agencies and, in particular, the Board of Governors of the Federal Reserve
System. Changes in monetary policy, including changes in interest rates, could
influence not only the interest the Company receives on loans and securities
and the amount of interest it pays on deposits and borrowings, but such changes
could also affect (i) the Companys ability to originate loans and obtain
deposits, (ii) the fair value of the Companys financial assets and
liabilities, and (iii) the average duration of the Companys mortgage-backed securities
portfolio. If the interest rates paid on deposits and other borrowings increase
at a faster rate than the interest rates received on loans and other
investments, the Companys net interest income, and therefore earnings, could
be adversely affected. Earnings could also be adversely affected if the
interest rates received on loans and other investments fall more quickly than
the interest rates paid on deposits and other borrowings.

Although management believes
it has implemented effective asset and liability management strategies to
reduce the potential effects of changes in interest rates on the Companys
results of operations, any substantial, unexpected, prolonged change in market
interest rates could have a material adverse effect on the Companys financial
condition and results of operations. See the section captioned Net Interest
Income in Item 7, Managements Discussion and Analysis of Financial Condition
and Results of Operations and Item 7A, Quantitative and Qualitative Disclosure
About Market Risk located elsewhere in this report for further discussion
related to the Companys management of interest rate risk.

The Company is Subject to Lending
Risk

There are inherent risks
associated with the Companys lending activities. These risks include, among
other things, the impact of changes in interest rates and changes in the
economic conditions in the markets where the Company operates as well as the
State of New York and the entire United States. Increases in interest rates
and/or weakening economic conditions could adversely impact the ability of
borrowers to repay outstanding loans or the value of the collateral securing
these loans. The Company is also subject to various laws and regulations that
affect its lending activities. Failure to comply with applicable laws and
regulations could subject the Company to regulatory enforcement action that
could result in the assessment of significant civil money penalties against the
Company.

As of December 31, 2006,
approximately 40.2% of the Companys loan and lease portfolio consisted of
commercial loans and leases net of unearned income. These types of loans are
generally viewed as having more risk of default than residential real estate
loans or consumer loans. Commercial loans are also typically larger than
residential real estate loans and consumer loans. Because the Companys loan
portfolio contains a significant number of commercial loans with relatively
large balances, the deterioration of one or a few of these loans could cause a
significant increase in non-performing loans. An increase in nonperforming
loans could result in a net loss of earnings from these loans, an increase in
the provision for loan losses and an increase in loan charge-offs, all of which
could have a material adverse effect on the Companys financial condition and
results of operations. See the section captioned Loans and Leases in Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operations located elsewhere in this report for further discussion related to
commercial loans and leases.

The Companys Allowance for Loan
and Lease Losses May Be Insufficient

The Company maintains an
allowance for loan and lease losses, which is an allowance established through
a provision for loan and lease losses charged to expense, that represents
managements best estimate of probable losses that may be incurred within the
existing portfolio of loans and leases. The allowance, in the judgment of
management, is necessary to reserve for estimated loan and lease losses and
risks inherent in the loan and lease portfolio. The level of the allowance
reflects managements continuing evaluation of industry concentrations;
specific credit risks; loan loss experience; current loan and lease portfolio
quality; present economic, political and regulatory conditions and unidentified
losses inherent in the current loan portfolio. The determination of the
appropriate level of the allowance for loan and lease losses inherently
involves a high degree of subjectivity and requires the Company to make
significant estimates of current credit risks and future trends, all of which
may undergo material changes. Changes in economic conditions affecting
borrowers, new information regarding existing loans, identification of
additional problem loans and other factors, both within and outside of the
Companys control, may require an increase in the allowance for loan losses. In
addition, bank regulatory agencies periodically review the Companys allowance
for loan losses and may require an increase in the provision for loan losses or
the recognition of further loan charge-offs, based on judgments different than
those of management. In addition, if charge-offs in future periods exceed the
allowance for loan and lease losses, the Company will need additional
provisions to increase the allowance for loan and lease losses. These increases
in the allowance for loan and lease losses will result in a decrease in net
income and, possibly, capital, and may have a material adverse effect on the
Companys financial condition and results of operations. See the section
captioned Loan Quality and the Allowance for Loan and Lease Losses in Item 7.
Managements Discussion and Analysis of Financial Condition and Results of
Operations located elsewhere in this report for further discussion related to
the Companys process for determining the appropriate level of the allowance
for loan and lease losses.

The Companys Profitability
Depends Significantly on Economic Conditions in Upstate New York

The Companys success depends
primarily on the general economic conditions of upstate New York and the
specific local markets in which the Company operates. Unlike larger national or
other regional banks that are more geographically diversified, the Company
provides banking and financial services to customers primarily in the upstate
New York counties of Cortland, Erie, Madison, Oneida, Onondaga and Oswego. The
local economic conditions in these areas have a significant impact on the
demand for the Companys products and services as well as the ability of the
Companys customers to repay loans, the value of the collateral securing loans
and the stability of the Companys deposit funding sources. A significant
decline in general economic conditions, caused by inflation, recession, acts of
terrorism, outbreak of hostilities or other international or domestic
occurrences, unemployment, changes in securities markets or other factors could
impact these local economic conditions and, in turn, have a material adverse
effect on the Companys financial condition and results of operations.

The Company Operates In a Highly
Competitive Industry and Market Area

The Company faces substantial
competition in all areas of its operations from a variety of different
competitors, many of which are larger and may have more financial resources.
Such competitors primarily include national, regional, and community banks
within the various markets where the Company operates. Additionally, various

7

out-of-state banks continue
to enter or have announced plans to enter the market areas in which the Company
currently operates. The Company also faces competition from many other types of
financial institutions, including, without limitation, savings and loans,
credit unions, finance companies, brokerage firms, insurance companies,
factoring companies and other financial intermediaries. The financial services
industry could become even more competitive as a result of legislative,
regulatory and technological changes and continued consolidation. Banks,
securities firms and insurance companies can merge under the umbrella of a
financial holding company, which can offer virtually any type of financial
service, including banking, securities underwriting, insurance (both agency and
underwriting) and merchant banking. Also, technology has lowered barriers to
entry and made it possible for non-banks to offer products and services
traditionally provided by banks, such as automatic transfer and automatic
payment systems. Many of the Companys competitors have fewer regulatory
constraints and may have lower cost structures. Additionally, due to their
size, many competitors may be able to achieve economies of scale and, as a
result, may offer a broader range of products and services as well as better
pricing for those products and services than the Company can. The Companys
ability to compete successfully depends on a number of factors, including,
among other things:


The ability to develop,
  maintain and build upon long-term customer relationships based on top quality
  service, high ethical standards and safe, sound assets.
The ability to expand the
  Companys market position.
The ability to develop and
  maintain relationships with certain leasing intermediaries which provide a
  substantial portion of our leasing business.
The scope, relevance and
  pricing of products and services offered to meet customer needs and demands.
The rate at which the
  Company introduces new products and services relative to its competitors.
Customer satisfaction with
  the Companys level of service.
Industry and general
  economic trends.Failure to perform in any of
these areas could significantly weaken the Companys competitive position,
which could adversely affect the Companys growth and profitability, which, in
turn, could have a material adverse effect on the Companys financial condition
and results of operations.

The Company Is Subject To
Extensive Government Regulation and Supervision

The Company, primarily
through its subsidiary bank, is subject to extensive federal regulation and
supervision. Banking regulations are primarily intended to protect depositors
funds, federal deposit insurance funds and the banking system as a whole, not
shareholders. These regulations affect the Companys lending practices, capital
structure, investment practices, dividend policy and growth, among other
things. Congress and federal regulatory agencies continually review banking
laws, regulations and policies for possible changes. Changes to statutes,
regulations or regulatory policies, including changes in interpretation or
implementation of statutes, regulations or policies, could affect the Company
in substantial and unpredictable ways. Such changes could subject the Company
to additional costs, limit the types of financial services and products the
Company may offer and/or increase the ability of non-banks to offer competing
financial services and products, among other things. Failure to comply with
laws, regulations or policies could result in sanctions by regulatory agencies,
civil money penalties and/or reputation damage, which could have a material
adverse effect on the Companys business, financial condition and results of
operations. While the Company has policies and procedures designed to prevent
any such violations, there can be no assurance that such violations will not
occur. See the section captioned Supervision and Regulation in Item 1.
Business, which is located elsewhere in this report.

The Companys Controls and
Procedures May Fail or Be Circumvented

Management regularly reviews
and updates the Companys internal controls, disclosure controls and
procedures, and corporate governance policies and procedures. Any system of
controls, however well designed and operated, is based in part on certain
assumptions and can provide only reasonable, not absolute, assurances that the
objectives of the system are met. Any failure or circumvention of the Companys
controls and procedures or failure to comply with regulations related to
controls and procedures could have a material adverse effect on the Companys
business, results of operations and financial condition.

New Lines of Business or New
Products and Services May Subject the Company to Additional Risks

From time to time, the
Company may implement new lines of business or offer new products and services
within existing lines of business. There are substantial risks and
uncertainties associated with these efforts, particularly in instances where
the markets are not fully developed. In developing and marketing new lines of
business and/or new products and services the Company may invest significant
time and resources. Initial timetables for the introduction and development of
new lines of business and/or new products or services may not be achieved and
price and profitability targets may not prove feasible. External factors, such
as compliance with regulations, competitive alternatives, and shifting market
preferences, may also impact the successful implementation of a new line of
business or a new product or service. Furthermore, any new line of business
and/or new product or service could have a significant impact on the
effectiveness of the Companys system of internal controls. Failure to
successfully manage these risks in the development and implementation of new
lines of business or new products or services could have a material adverse
effect on the Companys business, results of operations and financial
condition.

The Company Relies on Dividends
from Its Subsidiary for Most of Its Revenue

The Company is a
separate and distinct legal entity from its subsidiaries. It receives
substantially all of its revenue from dividends from its subsidiary bank. These
dividends are the principal source of funds to pay dividends on the Companys
common stock and interest and principal on the Companys debt. Various federal
and/or state laws and regulations limit the amount of dividends that Alliance
Bank may pay to the Company. Also, the Companys right to participate in a
distribution of assets upon a subsidiarys liquidation or reorganization is
subject to the prior claims of the subsidiarys creditors. In the event
Alliance Bank is unable to pay dividends to the Company, the Company may
not be able to service debt, pay obligations or pay dividends on the Companys
common stock.

The inability to receive
dividends from Alliance Bank could have a material adverse effect on the
Companys business, financial condition and results of operations. See the
section captioned Supervision and Regulation in Item 1. Business and Note 19
 Dividends and Restrictions in the notes to consolidated financial statements
included in Item 8. Financial Statements and Supplementary Data, which are
located elsewhere in this report.

The Company May Not Be Able To
Attract and Retain Skilled People

The Companys success
depends, in large part, on its ability to attract and retain key people.
Competition for the best people in most activities engaged in by the Company
can be intense and the Company may not be able to hire people or to retain
them. The unexpected loss of services of one or more of the Companys key
personnel could have a material adverse impact on the Companys business
because of their skills, knowledge of the Companys market, years of industry
experience and the difficulty of promptly finding qualified replacement
personnel.

8

In March 2007, the president
of the Banks leasing subsidiary notified the Company of his intention to
pursue an opportunity with another financial services company. The Companys
ability to replace this individual with the appropriate specialized skills in a
timely manner may have an impact on the rate of growth of the leasing portfolio
in the near-term.

The Companys Information Systems
May Experience an Interruption Or Breach In Security

The Company relies heavily on
communications and information systems to conduct its business. Any failure,
interruption or breach in security of these systems could result in failures or
disruptions in the Companys customer relationship management, general ledger,
deposit, loan and other systems. While the Company has policies and procedures
designed to prevent or limit the effect of the failure, interruption or
security breach of its information systems, there can be no assurance that any
such failures, interruptions or security breaches will not occur or, if they do
occur, that they will be adequately addressed. The occurrence of any failures,
interruptions or security breaches of the Companys information systems could
damage the Companys reputation, result in a loss of customer business, subject
the Company to additional regulatory scrutiny, or expose the Company to civil
litigation and possible financial liability, any of which could have a material
adverse effect on the Companys financial condition and results of operations.

The Company Continually Encounters
Technological Change

The financial services
industry is continually undergoing rapid technological change with frequent
introductions of new technology-driven products and services. The effective use
of technology increases efficiency and enables financial institutions to better
serve customers and to reduce costs. The Companys future success depends, in
part, upon its ability to address the needs of its customers by using
technology to provide products and services that will satisfy customer demands,
as well as to create additional efficiencies in the Companys operations. Many
of the Companys competitors have substantially greater resources to invest in
technological improvements. The Company may not be able to effectively implement
new technology-driven products and services or be successful in marketing these
products and services to its customers. Failure to successfully keep pace with
technological change affecting the financial services industry could have a
material adverse impact on the Companys business and, in turn, the Companys
financial condition and results of operations.

Severe Weather, Natural Disasters,
Acts of War or Terrorism and Other External Events Could Significantly Impact
the Companys Business

Severe weather, natural
disasters, acts of war or terrorism and other adverse external events could
have a significant impact on the Companys ability to conduct business. Such
events could affect the stability of the Companys deposit base, impair the
ability of borrowers to repay outstanding loans, impair the value of collateral
securing loans, cause significant property damage, result in loss of revenue
and/or cause the Company to incur additional expenses. Although management has
established disaster recovery policies and procedures, the occurrence of any
such event could have a material adverse effect on the Companys business,
which, in turn, could have a material adverse effect on the Companys financial
condition and results of operations.

The Companys Articles of
Incorporation, By-Laws and Shareholder Rights Plan As Well As Certain Banking
Laws May Have an Anti-Takeover Effect

Provisions of the Companys
articles of incorporation and by-laws, federal banking laws, including
regulatory approval requirements, and the Companys stock purchase rights plan
could make it more difficult for a third party to acquire the Company, even if
doing so would be perceived to be beneficial to the Companys stockholders. The
combination of these provisions effectively inhibits a non-negotiated merger or
other business combination, which, in turn, could adversely affect the market
price of the Companys common stock.

Item 1B.
 Unresolved Staff Comments

Not applicable.

Item 2  Properties

The Company conducts business in upstate New York
State through 29 banking offices and two administration centers. The Company
leases its corporate administrative center, located in Syracuse, NY. Eleven banking offices and one of the
administrative centers are subject to leases and/or land leases. The
other banking offices and administrative center are owned. The administrative
center that we own was acquired from Bridge Street and is currently unoccupied.
This property is classified with assets held for sale at December 31, 2006.

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 the Northern District of 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. Management believes that, ultimately, the State of New York will be
held responsible for these claims and that this matter will be settled without
adversely impacting the Company, although to date efforts to settle this
litigation have been unsuccessful.

The Company and its
subsidiaries are subject to various claims, legal proceedings and matters that
arise in the ordinary course of business. 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, 2006.

9

PART II

Item 5  Market for the Registrants Common Equity, Related
Stockholder Matters and Issuer Purchases of Equity Securities

Common
Stock Data

The common stock of the
Company is listed on the NASDAQ Global Market under the symbol ALNC. Market
makers for the stock include Ryan, Beck & Company (800-342-2325), Sandler
ONeill & Partners, L.P. (800-635-6851), and McConnell Budd & Romano
(800-538-6957). There were 1,030 shareholders of record as of December 31,
2006. The following table presents stock prices for the Company for 2006 and
2005. Stock prices below are based on daily high and low closing prices for the
quarter, as reported on the NASDAQ Global Market.

2006

High

Low

Dividend
  Declared1st Quarter

$
32.75

$
30.26


$
0.222nd Quarter

$
31.00

$
27.29


$
0.223rd Quarter

$
32.97

$
29.51


$
0.224th Quarter

$
32.54

$
29.85


$
0.222005

High

Low

Dividend
  Declared1st Quarter

$
32.00

$
29.50


$
0.212nd Quarter

$
31.84

$
29.55


$
0.213rd Quarter

$
32.14

$
29.01


$
0.214th Quarter

$
32.35

$
29.81


$
0.21Registrar
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 American Stock Transfer and Trust Company,
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 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.

10

On September 28, 2005, the
Company announced that its Board of Directors had authorized the repurchase of
up to 5% of the Companys outstanding common stock, or approximately 180,000
shares, over a 12-month period commencing on October 1, 2005. On October 5,
2006, the Companys Board of Directors approved a six month extension of the
repurchase program through March 2007. The following table provides information
with respect to repurchases of the Companys common stock in accordance with
the repurchase plan during the fourth quarter ended December 31, 2006.

Period

Total
  Number of Shares Purchased

Average
  Price PaidPer Share

Total
  Number ofShares Purchased asPart of PubliclyAnnounced Plan

Maximum
  Number ofShares that may yet bePurchased under thePlan126,31210/1/06  10/31/06











126,31211/1/06  11/30/06


90,182

$
30.76


90,182


36,13012/1/06  12/31/06


4,300

$
30.77


4,300


31,830Total


94,482

$
30.76


94,48211

Stock Performance Graph



The graph below matches Alliance Financial Corporation's cumulative 5-year total shareholder return on common stock with the cumulative total returns of the S & P 500 index, the Russell 3000 index and the NASDAQ Bank index. The graph tracks the performance of a $100 investment in our common stock and in each of the indexes (with the reinvestment of all dividends) from 12/31/2001 to 12/31/2006.








Period EndingIndex
        12/31/01
        12/31/02
        12/31/03
        12/31/04
        12/31/05
        12/31/06Alliance Financial Corporation
        100.00
        116.96
        141.56
        139.10
        150.41
        153.73S&P 500
        100.00
        77.90
        100.24
        111.15
        116.61
        135.03Russell 3000
        100.00
        78.46
        102.83
        115.11
        122.16
        141.35SNL NASDAQ Bank
        100.00
        59.14
        89.11
        103.85
        130.57
        166.05



The stock price performance included in this graph is not necessarily indicative of future stock price performance.




12

Item 6  Selected Financial
Data

Five-Year
Comparative Summary

December 31,2006

2005

2004

2003

2002(In thousands)Selected Financial Condition DataTotal Assets

$
1,272,967

$
983,256

$
893,934

$
826,255

$
774,950Loans &
  leases


882,566


654,086


526,100


479,055


419,388Allowance
  for loan and lease losses


7,029


4,960


5,267


6,069


5,019Investment
  securities


263,987


267,494


319,758


299,031


308,806Goodwill


33,456











Intangible
  assets, net


14,912


9,671








Deposits


935,596


739,118


623,121


561,400


546,653Borrowings


179,650


150,429


181,854


178,483


154,667Junior
  subordinated obligations


25,774


10,310


10,310


10,310


Shareholders
  equity

$
109,506

$
69,571

$
68,896

$
66,153

$
62,953Trust assets under management
(Market
  value, not included in Total Assets)

$
927,674

$
862,504

$
282,281

$
252,621

$
213,131Year ended December 31,2006

2005

2004

2003

2002(In thousands, except share and per share data)Selected Operating DataInterest
  income

$
57,773

$
46,425

$
41,002

$
40,158

$
42,841Interest
  expense


29,951


19,336


12,684


12,827


15,944Net interest
  income


27,822


27,089


28,318


27,331


26,897Provision
  for loan and lease losses


2,477


144


984


2,349


1,895Net interest income after
provision for
  loan and lease losses


25,345


26,945


27,334


24,982


25,002Non-interest
  income


17,718


14,156


9,006


9,689


6,796Total
  Operating income


43,063


41,101


36,340


34,671


31,798Non-interest
  expense


33,990


31,440


27,159


23,868


22,536Income
  before taxes


9,073


9,661


9,181


10,803


9,262Income tax
  expense


1,762


2,154


1,926


2,792


2,351Net Income

$
7,311

$
7,507

$
7,255

$
8,011

$
6,911Stock and Per Share DataBasic
  earnings per share

$
1.92

$
2.09

$
2.03

$
2.28

$
2.00Diluted
  earnings per share

$
1.88

$
2.05

$
2.00

$
2.23

$
1.98Basic
  weighted average shares outstanding


3,804,711


3,593,864


3,565,226


3,510,074


3,448,431Diluted
  weighted average shares outstanding


3,874,484


3,664,684


3,631,806


3,584,930


3,482,809Cash
  dividends declared

$
0.88

$
0.84

$
0.84

$
0.94

$
0.79Dividend
  payout ratio (1)


46.8
%

41.0
%

42.0
%

42.2
%

39.9
%Book value

$
22.81

$
19.52

$
19.29

$
18.72

$
18.23Tangible
  book value

$
12.74

$
16.80

$
19.29

$
18.72

$
18.23(1)
Cash
  dividends declared per share divided by diluted earnings per share.13

Year ended
  December 31,Selected Financial and Other Data (1)

2006

2005

2004

2003

2002Performance Ratios:Return on
  average assets


0.69
%

0.80
%

0.84
%

1.01
%

0.93
%Return on
average
  equity


9.40
%

10.75
%

10.75
%

12.34
%

11.96
%Non-interest
  income to total income(2)


38.91
%

34.35
%

22.64
%

23.82
%

18.25
%Efficiency
Ratio


74.63
%

76.19
%

74.19
%

66.53
%

68.49
%Rate/Yield Information:Yield on
earning
  assets


6.05
%

5.47
%

5.26
%

5.65
%

6.35
%Cost of
funds


3.46
%

2.48
%

1.77
%

1.95
%

2.56
%Net interest
  rate spread


2.59
%

2.99
%

3.49
%

3.70
%

3.79
%Net interest
  margin (tax equivalent)(3)


3.02
%

3.28
%

3.69
%

3.91
%

4.05
%(1)
Averages presented are
  daily averages(2)
Non-interest income (net of
  realized gains and losses on securities) divided by the sum of net interest
  income and non-interest income (net of realized gains and losses on
  securities(3)
Tax equivalent net interest
  income divided by average earning assetsAt or for the Year ended December 31,2006

2005

2004

2003

2002Asset Quality RatiosNon-performing
  loans and leases to total loans and leases


0.30
%

0.25
%

0.53
%

0.98
%

0.38
%Non-performing
  assets to total assets


0.21
%

0.17
%

0.31
%

0.57
%

0.21
%Allowance for
  loan and lease losses to non-performing loans and leases


266.35
%

304.67
%

191.46
%

130.43
%

360.56
%Allowance for
  loan and lease losses to total loans and leases


0.80
%

0.76
%

1.00
%

1.27
%

1.20
%Net charge-offs
  to average loans and leases


0.23
%

0.08
%

0.36
%

0.29
%

0.33
%Equity
  RatiosAverage total
  shareholders equity to average total assets


7.37
%

7.43
%

7.82
%

8.21
%

7.79
%Tier 1 (core)
  capital


7.53
%

7.42
%

8.70
%

8.92
%

7.41
%Tier 1
  risk-based capital


10.42
%

10.93
%

14.34
%

14.70
%

12.94
%Total risk-based
  capital


11.26
%

11.72
%

15.34
%

15.93
%

14.09
%14

Summarized quarterly financial information for the
years ended December 31, 2006 and 2005 is as follows:

Three months ended12/31/06

9/30/06

6/30/06

3/31/06

12/31/05

9/30/05

6/30/05

3/31/05(Dollars
  in thousands, except share and per share data)Total interest income

$
17,433

$
14,066

$
13,565

$
12,709

$
12,584

$
11,997

$
11,228

$
10,616Total interest
expense


9,248


7,604


6,925


6.174


5,743


5,265


4,515


3,813Net interest income


8,185


6,462


6,640


6,535


6,841


6,732


6,713


6,803Provision for loan
losses


510


550


417


1,000


178


125


385


(544
)Non-interest income


5,476


4,170


4,041


4,031


3,899


3,724


3,583


2,949Operating expense


10,756


7,688


7,723


7,823


8,457


7,734


7,633


7,615Income before income
taxes


2,395


2,394


2,541


1,743


2,105


2,597


2,278


2,681Provision for income
taxes


315


575


569


303


342


615


530


667Net Income

$
2,080

$
1,819

$
1,972

$
1,440

$
1,763

$
1,982

$
1,748

$
2,014Basic earnings per
share

$
0.44

$
0.52

$
0.56

$
0.40

$
0.49

$
0.55

$
0.49

$
0.56Diluted earnings per
share

$
0.43

$
0.51

$
0.54

$
0.40

$
0.48

$
0.54

$
0.48

$
0.55Basic weighted average shares
outstanding


4,720,384


3,503,851


3,487,279


3,566,228


3,592,579


3,597,758


3,597,397


3,587,627Diluted weighted average shares
outstanding


4,801,544


3,585,204


3,638,442


3,639,637


3,664,305


3,669,419


3,668,813


3,663,242Cash dividends declared per
share

$
0.22

$
0.22

$
0.22

$
0.22

$
0.21

$
0.21

$
0.21

$
0.21Net interest margin (tax
equivalent)


3.08
%

2.91
%

3.05
%

3.04
%

3.19
%

3.16
%

3.32
%

3.47
%Return on average
assets


0.67
%

0.72
%

0.80
%

0.59
%

0.72
%

0.82
%

0.76
%

0.91
%Return on average
equity


8.31
%

10.27
%

11.30
%

8.18
%

9.97
%

11.23
%

10.14
%

11.66
%Efficiency ratio


78.74
%

72.31
%

72.31
%

74.04
%

78.74
%

73.97
%

74.14
%

78.09
%Item 7 
Managements Discussion and Analysis of Financial Condition and Results of
Operations

Introduction

Alliance Financial
Corporation (the Company) is a financial holding company which owns and
operates Alliance Bank, N.A., Alliance Financial Capital Trust I, Alliance
Financial Capital Trust II (collectively the Capital Trusts) and Ladds
Agency, Inc., a multi-line insurance agency. The Company provides financial
services through its Bank subsidiary from 29 customer service facilities in the
New York counties of Cortland, Madison, Oneida, Onondaga, Oswego, and from a
Trust Administration Center in Buffalo, NY, in Erie County. Primary services
include commercial, retail and municipal banking, consumer finance, mortgage
financing and servicing, and trust and investment management services. The
Capital Trusts were formed for the purpose of issuing corporation-obligated
mandatorily redeemable capital securities to third-party investors and investing
the proceeds from the sale of such capital securities solely in junior
subordinated debt securities of the Company. The Bank has a substantially
wholly-owned subsidiary, Alliance Preferred Funding Corp., which is engaged in
residential real estate activity, and a wholly-owned subsidiary, Alliance
Leasing, Inc., which is engaged in commercial leasing activity in over 30
states.

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. Application of these principles
requires management to make estimates, assumptions, and judgments that affect
the amounts reported in the financial statements and accompanying notes. These
estimates, assumptions, and judgments 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
judgments. Certain policies inherently have a greater reliance on the use of
estimates, assumptions, and judgments 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 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,
accrued income taxes, pensions and post-retirement obligations and the fair
value analysis of goodwill and intangible assets 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. Actual
results could differ from those estimates.

15

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, 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 14 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.

The Company
utilizes significant estimates and assumptions in determining the fair value of
its intangible asset for purposes of impairment testing. The valuation requires
the use of assumptions, including, among others, discount rates, rates of
return on assets, account attrition rates and costs of servicing.

Comparison of Operating Results for
the Year Ended December 31, 2006, 2005 and 2004

Earnings Summary and
Executive Overview

Net income for
2006 was $7.3 million, a decrease of $196,000, or 2.6%, compared to net income
of $7.5 million in 2005. Diluted earnings per share was $1.88 in 2006, down
8.3%, or $0.17 per share, compared to $2.05 per share in 2005. The decline in
diluted earnings per share resulted primarily from the issuance of 1,292,000
shares of common stock in connection with the acquisition combined with
incremental earnings from the acquisition being substantially offset by
integration and closing costs.

A 12.1% increase in average interest earning assets offset a 26 basis
point decrease in our net interest margin compared with 2005 caused largely by
the flat yield curve throughout 2006, resulting in a modest 2.7% increase in
net interest income. Non-interest income increased $3.6 million compared with
2005, resulting largely from our expanded trust business and higher service
charges, while operating expenses increased $2.6 million due in large part to
the acquisition of Bridge Street and the associated one-time and ongoing
expenses. The provision for loan and lease losses increased $2.3 million in
2006 compared with 2005 due to the growth and changing mix of our loan and
lease portfolio and to a higher level of charge-offs in 2006, including two
relationships totaling $951,000 which were charged off in the first half of
2006.

Net income for
2005 was $7.5 million, an increase of $252,000, or 3.5%, compared to net income
of $7.3 million in 2004. Diluted earnings per share for 2005 increased 2.5% to
$2.05 per share, compared to $2.00 per share in 2004. Strong growth in the
Banks earning assets in 2005, with average loans and leases up 17.5%, was funded
by average deposit growth of 12.5%. The growth was achieved with a focus on
building business and personal account balances across the Banks expanding
branch network. The Banks strategic initiative to target branch expansion in
Onondaga County, continued in 2005 with the fourth quarter opening of a de-novo
branch and the relocation of another branch to a new facility in an improved
location. Although growth in loans and deposits was strong in 2005, the
continued rise in short-term market interest rates combined with a flattening
yield curve compressed the Companys net interest margin. As a result, the net
interest margin declined to 3.28% in 2005 from 3.69% in 2004.

In February
2005, Alliance acquired a portfolio of personal trust accounts and related
assets under management from HSBC, USA, N.A. and assumed the successor trustee
role from HSBC on approximately 1,800 personal trust accounts and further
assumed approximately $560 million in assets under management. The acquisition
generated fee income in excess of $6 million in 2005 and increased non-interest
income.

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 by which interest and fees on loans and leases, investments, and
other earning assets exceed the cost of deposits and other interest-bearing
liabilities. Net interest income
totaled $27.8 million in 2006, compared to $27.1 million in 2005, reflecting the
favorable impact of the increase in average earning assets, which offset the
effect of a lower net interest margin in 2006. Average earning assets increased
$107.1 million in 2006, due largely to organic growth in our leasing and
indirect loan portfolios, which increased $54.2 million and $32.6 million,
respectively. The rest of our earning asset growth resulted from a combination
of new loan originations and from assets acquired from Bridge Street in October
2006.

Net interest
income declined $1.2 million or 4.3% in 2005 compared with 2004 due to a
decrease in the Companys net interest margin which offset average earning
asset growth of $73.0 million or 9.0% in 2006. The Companys 2005 tax
equivalent net interest margin of 3.28% was down 41 basis points compared to
3.69% in 2004. The net
interest margin compression in 2006 and 2005 was primarily the result of rising
short-term market interest rates that increased the Banks cost of funds on a
large percentage of its interest-bearing liabilities with short-term maturity
or variable interest rate characteristics. The flattening of the yield curve
provided less benefit to the yields on a significant percentage of the
Companys interest earning assets that have a pricing correlation with
intermediate and longer-term market interest rates, and that rose less than
short-term rates during the year.

Higher short-term interest rates and the persistently flat yield curve
and periods of yield curve inversions over the past year, along with highly
competitive deposit pricing and customer preference for higher yielding time
deposits over savings and money market accounts continued to negatively impact
our net interest margin in 2006. An increase in our earning asset yield of 58
basis points in 2006 compared with 2005 was offset by an increase in our cost
of funds of 98 basis points over the same period. The net interest margin on a
tax-equivalent basis was 3.02% in 2006, compared with 3.28% in 2005.

The average
balance of our investment securities portfolio decreased $29.4 million in 2006
and $14.5 million in 2005 as we reinvested some of the cash flows from the
portfolio in loans and leases with yields higher than those available in the
types of securities we typically hold in our portfolio. As a result, investment
securities comprised 26.3% of total average earning assets in 2006, down from
32.8% in 2005 and 37.6% in 2004.

Average loans
and leases (net of unearned income) increased to 73.4% of average earning
assets in 2006, from 66.7% in 2005 and 61.9% in 2004. The mix of our loan and
lease portfolio also changed somewhat as a result of the strong growth in our
leasing and indirect lending portfolios. Leases accounted for 9.1% of average
loans and leases in 2006, compared with 4.1% in 2005 and 0.7% in 2004. Indirect
loans were 18.2% of total loans and leases in 2006, up from 16.7% in 2005 and
13.6% in 2004.

16

Average loans
and leases (net of unearned income) increased $138.1 million in 2006, with
leases and indirect loans comprising 39.2% and 23.6%, respectively, of the
increase. A large part of the growth in our leasing portfolio occurred during
the second half of 2006, reflecting the success of our efforts to expand this
business line. We originate leases through reputable, well-established middle
market leasing companies, and through vendor and direct customer relationships,
with an emphasis on the medical, education and municipal sectors. The leases
are underwritten using our typical commercial credit standards, and the
collateral securing the leases is generally readily marketable. The president
of the Banks leasing subsidiary notified the Company in March 2007 of his
intention to pursue an opportunity with another financial services company. The
Companys ability to replace this individual with the appropriate specialized
skills in a timely manner may have an impact on the rate of growth of the
leasing portfolio in the near-term.

The rate of
growth in our indirect loan portfolio slowed in the second half of 2006 as we
increased our indirect loan rates in an effort to slow the rate of growth in
these loans, as highly competitive pricing and higher funding costs have
negatively impacted the profitability of indirect lending. As a result, we
anticipate the rate of growth in this portfolio in 2007 will be less than that
of 2006.

Increases in
average residential loans, which accounted for 19.5% of the increase in average
loans and leases, and commercial loans (12.2% of the increase in average loans
and leases) resulted from a combination of new loan originations and assets
acquired from Bridge Street. Highly competitive lending conditions and ample
availability of commercial financing in our market area has contributed to
slower growth in our commercial loan portfolio in recent quarters. We expect
this highly competitive lending environment will continue for the foreseeable
future. Commercial lending continues to be an important part of our growth
strategy, and we have realigned our commercial lending division and implemented
a more focused business development strategy in an effort to increase the rate
of growth in this portfolio in coming quarters.

Average loans
and leases increased $87.5 million in 2005 compared with 2004 with leases and
indirect auto loans accounting for 35.4% and 42.2%, respectively, of the total
growth in average loans and leases. The growth in our lease portfolio reflects
our efforts to expand this portion of our portfolio, as noted above. Average
indirect auto loans in 2005 increased 33.4%, or $36.9 million, however the
yield on this portfolio decreased 2 basis points in spite of a rising interest
rate environment due largely to the highly competitive market for indirect auto
loans in our market. Average commercial loans in 2005 increased $9.8 million,
or 6.5%, when compared with the prior year. We experienced smaller rates of
growth in our residential mortgage and commercial loan portfolios due to highly
competitive market conditions. Average consumer loans increased 8.2% or $5.0
million in 2005 due largely to growth in home equity lines of credit.

Average
deposits increased $105.1 million in 2006 and $77.7 million in 2005 due in
large part to the expansion of our franchise through a de-novo branch strategy
and the acquisition of Bridge Street in October 2006, and also from our
business development activities which emphasizes obtaining the operating
accounts of our commercial loan customers. Average deposits represented 83.5%
of our total funding sources in 2006, up from 81.5% in 2005 and 79.3% in 2004.
We have experienced significant growth in average demand deposits, which
increased $27.3 million and $9.0 million in 2006 and 2005, respectively, and
represented 23.4% of deposits in 2006, compared with 23.0% in 2005 and 24.4% in
2004. The increase in short-term interest rates and competition for deposits
caused an increase in the rates we pay on short-term time accounts in 2005 and
2006. As a result, we began to see a movement of funds out of savings and money
market accounts and into higher yielding short-term time accounts. Time
accounts represented 46.9% of average total deposits in 2006, up from 42.4% in
2005 and 39.4% in 2004. Savings and money market accounts were 7.7% and 21.9%
of average deposits in 2006, respectively, compared with 8.5% and 26.1%,
respectively in 2005 and 10.4% and 25.8%, respectively, in 2004.

We expect that the highly competitive deposit pricing in our markets,
along with the migration of savings and money market deposits to higher rate
short-term time accounts, will continue for the foreseeable future. These
conditions, along with the current inverted yield curve, are likely to continue
to pressure our net interest margin in 2007.

17

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.

Years
  ended December 31,2006

2005

2004Avg.
  Balance

Amt. of
  Interest

Avg.
  Yield/
  Rate

Avg.
  Balance

Amt. of
  Interest

Avg.
  Yield/
  Rate

Avg.
  Balance

Amt. of
  Interest

Avg.
  Yield/
  Rate(Dollars
  in thousands)Assets:Interest-earning
assets:Federal funds
sold

$
2,450

$
149


6.08
%
$
4,094

$
128


3.13
%
$
4,165

$
45


1.08
%Taxable
investment securities


185,234


7,744


4.18
%

217,166


8,304


3.82
%

236,917


9,313


3.93
%Nontaxable
investment securities


75,410


4,683


6.21
%

72,868


4,594


6.30
%

67,578


4,410


6.53
%Residential
real estate loans


205,527


12,438


6.05
%

178,669


10,802


6.05
%

173,829


10,793


6.21
%Commercial
loans


170,870


13,459


7.88
%

154,030


10,564


6.86
%

145,101


8,691


5.99
%Non-taxable
commercial loans


6,998


476


6.80
%

7,036


417


5.92
%

6,189


332


5.36
%Taxable leases
(net of unearned income)


72,597


5,091


7.01
%

27,375


1,834


6.70
%

5,116


472


9.23
%Nontaxable
leases (net of unearned income)


17,907


1,038


5.80
%

8,894


518


5.83
%

163


9


5.52
%Indirect auto
loans


179,994


9,123


5.07
%

147,364


6,909


4.69
%

110,464


5,208


4.71
%Consumer
loans


73,355


5,680


7.74
%

65,744


4,235


6.44
%

60,745


3,344


5.50
%Total
interest-earning assets

$
990,342

$
59,881


6.05
%
$
883,240

$
48,305


5.47
%
$
810,267

$
42,617


5.26
%Non-interest-earning
assets:Other
assets


73,276








62,338








54,840Less:
Allowance for loan and lease losses


(5,518
)







(5,212
)







(6,033
)Net unrealized (losses) gains
on available-for-sale securities


(3,227
)







(2
)







3,707Total

$
1,054,873







$
940,364







$
862,781Liabilities
  and Shareholders Equity:Interest-bearing
liabilities:Demand
deposits

$
87,221

$
519


0.60
%
$
80,463

$
250


0.31
%
$
83,235

$
230


0.28
%Savings
deposits


62,412


339


0.54
%

59,876


307


0.51
%

64,793


322


0.50
%MMDA
deposits


176,811


5,141


2.91
%

182,905


3,955


2.16
%

160,612


1.868


1.16
%Time
deposits


378,402


16,161


4.27
%

297,040


8,988


3.03
%

245,747


6,257


2.55
%Borrowings(1)


145,140


6,647


4.58
%

149,289


5,192


3.48
%

152,839


3,548


2.32
%Junior
subordinated obligations issued to unconsolidated subsidiary
  trusts


14,606


1,144


7.83
%

10,310


644


6.25
%

10,310


459


4.45
%Total
interest-bearing liabilities

$
864,592

$
29,951


3.46
%
$
779,883

$
19,336


2.48
%
$
717,536

$
12,684


1.77
%Non-interest-bearing
liabilities:Demand
deposits


101,266








80,757








68,949Other
liabilities


11,239








9,880








8,799Shareholders equity


77,776








69,844








67,497Total

$
1,054,873







$
940,364







$
862,781Net interest income (tax
equivalent)




$
29,930







$
28,969







$
29,933Net interest margin (tax
equivalent)








3.02
%







3.28
%







3.69
%Net interest rate
spread








2.59
%







2.99
%







3.49
%Federal tax exemption on
nontaxable investment securities, loans and
  leases included in interest income




$
2,108







$
1,880







$
1,614(1)
Includes
  mortgagors escrow funds.18

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. Volume changes are computed by multiplying the volume
difference by the prior years rate. Rate changes are computed by multiplying
the rate difference by the prior years balance. The change in interest due to
both rate and volume has been allocated equally between the volume and rate
variances.

2006
  Compared to 2005

2005
  Compared to 2004Increase
  (decrease due to)

Increase
  (decrease due to)Volume

Rate

Net
  Change

Volume

Rate

Net
  Change(In thousands)Federal
funds
  sold

$
(75
)
$
94

$
19

$
(2
)
$
86

$
84Taxable
  investment securities


(1,278
)

718


(560
)

(766
)

(243
)

(1,009
)Non-taxable
  investment securities


160


(69
)

91


339


(156
)

183Real estate
  loans


1,624


12


1,636


297


(288
)

9Commercial
loans


1,240


1,655


2,895


574


1,300


1,874Non-taxable
  commercial loans


(2
)

61


59


47


38


85Taxable
leases,
  net of unearned discount


3,100


157


3,257


1,773


(410
)

1,363Non-taxable
  leases, net of unearned discount


524


(4
)

520


495


13


508Indirect
loans


1,592


622


2,214


1,735


(34
)

1,701Consumer
loans


539


906


1,445


298


593


891Total
  interest-earning assets

$
7,424

$
4,152

$
11,576

$
4,790

$
899

$
5,689Interest-bearing
  demand deposits


30


239


269


(9
)

29


20Savings
deposits


13


19


32


(24
)

9


(15
)MMDA
deposits


(154
)

1,340


1,186


370


1,717


2,087Time
deposits


2,968


4,205


7,173


1,429


1,302


2,731Borrowings


(165
)

1,620


1,455


(105
)

1,749


1,644Junior
  subordinated obligations issued to unconsolidated subsidiary trusts


302


198


500





186


186Total
  interest-bearing liabilities

$
2,994

$
7,621

$
10,615

$
1,661

$
4,992

$
6,653Net interest
  income (tax equivalent)

$
4,430

$
(3,469
)
$
961

$
3,129

$
(4,093
)
$
(964
)Non-interest
Income

The Companys non-interest 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 noncore components that primarily consist of net gains or losses from
sales of investment securities.

The following table sets forth certain information on
non-interest income for the years indicated:

Years
  ended December 31,2006

2005

2004(In
  thousands)Service charges on deposit accounts

$
4,316

$
2,957

$
3,056Trust and brokerage income


8,895


7,864


1,778Bank-owned life insurance


455


402


810Card-related fees


1,291


926


776Insurance agency income


615





Rental income from operating leases


797


1,186


783Gain on sale of loans


126


163


197(Losses) gains on sale of securities
  available-for-sale


(2
)

(19
)

717Other operating income


1,225


677


889Total non-interest income

$
17,718

$
14,156

$
9,006Non-interest income was $17.7 million in 2006, which
was an increase of $3.6 million or 25.2% compared with $14.2 million in 2005.
Service charges on deposit accounts increased $1.4 million or 46.0% due
primarily to the impact of changes we made to certain transaction fees in the
fourth quarter of 2005, and also to fees earned on accounts acquired from
Bridge Street. Trust and brokerage income increased $1.0 million or 13.1%
compared with 2005 due to the timing of the acquisition of approximately $560
million of trust assets under management from HSBC, USA N.A., which closed in
February 2005, and also to higher trust fees resulting from the positive
returns on assets in 2006. Card related fees increased $365,000 in the year
ended December 31, 2006 compared with the year ago period due primarily to
higher customer debit card utilization and fees earned on former Bridge Street
accounts. Insurance agency income totaling $615,000 represents revenue from the
insurance subsidiary acquired in the Bridge Street transaction. Rental income
from leases decreased $389,000 or 32.8% compared with 2005 due to the declining
balance in our operating lease portfolio. We ceased originating operating
leases in early 2004, and as a result, rental income declined steadily during
2006 and will cease in early 2007 (along with related depreciation expense on
the leased assets). Other non-interest income increased $548,000 in 2006
compared with 2005, with approximately $168,000 resulting from non-recurring
items. The balance of the increase in other non-interest income resulted
primarily from increases in mortgage servicing fees and miscellaneous customer
fees. Non-interest income (excluding loss on sales of securities) comprised
38.9% of revenue in 2006 up from 34.4% in 2005.

19

Non-interest income in 2005 increased $5.2 million, or
57.2% compared to 2004 due primarily to a $6.1 million increase in trust and
brokerage income which resulted from the February 2005 acquisition of the trust
assets from HSBC. Primarily as a result of the acquisition, the total market
value of trust assets under management increased to more than $862 million at
December 31, 2005 from approximately $282 million at the end of 2004. Income on
bank-owned life insurance decreased in 2005 due to a higher level of death
benefits received in 2004, and card-related fees increased 19.3% due to higher
customer debit card utilization.

The following table sets forth certain information on
operating expenses for the years indicated:

Years
  ended December 31,2006

2005

2004(In
  thousands)Salaries, wages, and employee benefits

$
16,607

$
17,150

$
14,919Building, occupancy, and equipment


6,460


5,746


5,295Communication expense


744


603


614Stationery and supplies expense


645


514


520Marketing expense


1,128


921


603Professional fees


3,239


2,385


1,676Amortization of intangible assets


797


418


Directors fees


573


342


310Postage expense


434


349


357Other operating expense


3,363


3,012


2,865Total operating expenses

$
33,990

$
31,440

$
27,159Non-interest expense was $34.0 million in the year
ended December 31, 2006, up $2.6 million or 8.1% compared with $31.4 million in
2005. The increase in non-interest expense was due in large part to the
acquisition of Bridge Street, except as noted below. Non-recurring merger and
conversion expenses totaled approximately $1.0 million in the fourth quarter of
2006, and were primarily in professional fees, salaries and benefits,
communications expense, stationery and supplies and marketing expense.

Salaries and benefits decreased $543,000 or 3.2% in
2006 compared with 2005 due primarily to efficiencies gained through the
implementation of a new staffing model in the first quarter of 2006 being
partially offset by salaries and benefits for employees of Bridge Street in the
fourth quarter of 2006.

Occupancy and equipment expense increased $714,000 or
12.4% in 2006, due to a write-down of $174,000 on bank-owned property
reclassified to assets held for sale in the fourth quarter and to expenses
associated with properties acquired from Bridge Street. Also contributing to
the increase were occupancy costs relating to additional branches in operation
during the period.

Increases in communication expense, stationery and
supplies, marketing and professional fees resulted largely from acquisition and
conversion related activities. Also included in professional fees in 2006 was
approximately $228,000 in consulting fees paid in the first quarter related to
the personnel staffing model project.

Amortization of intangible assets increased $379,000
in 2006 compared with 2005 as a result of amortization of intangible assets
established in connection with the Bridge Street acquisition.

Director fees increased $231,000 or 67.5% for the year
due to an increase in the number of meetings in 2006 primarily related to the
acquisition of Bridge Street and corporate governance matters, and an increase
in the amount of earnings on directors deferred compensation which is tied to
the book value of Alliance common stock.

Other operating expenses increased $351,000 or 11.7%
due primarily to higher loan origination costs and ATM processing fees
resulting primarily from increases in customer account and transaction volumes
from organic growth and customers acquired from Bridge Street.

Non-interest expense increased $4.3 million, or 15.8%,
in 2005 compared with 2004. In 2005, operating expenses included approximately
$2.5 million related to servicing the trust portfolio acquired from HSBC, and
approximately $700,000 in non-recurring severance costs and contract fees paid
in connection with the personnel staffing project. The project was designed to
revise work flows, streamline processes, and improve efficiency while at the
same time reducing staff.

Salaries and associated benefit expenses in 2005 were
up $2.2 million, or 15.0%, and represented 52.1% of the 2005 increase in total
operating expense. The increase in salary and benefits expense related in large
part to employees that were hired from HSBC in connection with the trust
acquisition, an increase in staff supporting growth in the commercial leasing
business, and employee severance costs incurred during the fourth quarter of
the year. The total number of Company employees (full time equivalent) declined
from 293 at the end of 2004 to 265 at the end of 2005, with the decline
reflecting the results of the personnel staffing project.

The Companys occupancy and equipment expense
increased $451,000, or 8.5%, in 2005 compared with 2004, due largely to higher
building lease expense from an increase in the number of customer service
facilities and an increase in depreciation and amortization expense of capital
assets supporting the expansion and growth of the Companys business.

Marketing expense increased $318,000, or 52.7% in 2005
compared with the prior year due primarily to an expanded marketing program in
support of our de-novo branching strategy and to the inception of an agreement
with Onondaga County for naming rights to the countys sports stadium designed
to increase the Companys name recognition in Central New York.

As a result of the HSBC trust acquisition, the Company
expensed $418,000 in 2005 relating to the amortization of the intangible asset
created in connection with the acquisition. The Company had no amortization
expense related to intangible assets prior to 2005.

20

Provision
for Income Tax

The Companys effective tax rate for 2006, 2005 and
2004 was 19.4%, 22.3% and 21.0%, respectively. The decrease in the effective
tax rate in 2006 compared with 2005 is primarily attributable to increased
non-taxable interest and life insurance income relative to total pre-tax
income. This increase resulted from the level of non-taxable investments
obtained in the Bridge Street acquisition. The increase in the effective tax
rate in 2005 compared with 2004 primarily reflects a decline in the percentage
of non-taxable insurance income to pre-tax income. A reconciliation of the
effective tax rate to the statutory tax rate is included in Note 14 to the
consolidated financial statements.

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. Our
mortgage-backed securities portfolio is comprised of pass-through securities
guaranteed by either Fannie Mae, Freddie Mac or Ginnie Mae. 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 amortized cost of our investment portfolio was
$265.7 million at December 31, 2006, down from $270.2 million at December 31,
2005 and $317.3 million at December 31, 2004. As discussed previously in this
Form 10-K, a portion of the cash flows from our investment portfolio was used
to fund loan growth.

The following table sets forth the amortized cost and
market value for the Companys available-for-sale securities portfolio:

Years
  ended December 31,2006

2005

2004Amortized
  Cost

Fair
  Value

Amortized
  Cost

Fair
  Value

Amortized
  Cost

Fair
  Value(In thousands)U.S.
Treasury
  obligations

$
6,839

$
6,420

$
6,574

$
6,105

$
9,855

$
9,283U.S.
government-sponsored
  corporations


62,178


61,452


66,456


65,302


88,342


88,289Mortgage-backed
  securities


97,908


96,163


111,968


109,477


135,431


135,089Obligations
of
  states and political subdivisions


86,299


87,388


73,610


74,908


70,688


74,076Federal Home
  Loan Bank and Federal Reserve Bank stock


7,985


7,985


6,508


6,508


8,037


8,037Other equity
  securities


4,442


4,579


5,132


5,194


4,948


4,984Total

$
265,651

$
263,987

$
270,248

$
267,494

$
317,301

$
319,758Net
unrealized
  (losses) gains on available-for-sale securities


(1,664
)




(2,754
)




2,457Total
carrying
  value

$
263,987




$
267,494




$
319,758The following table sets forth as of December 31,
2006, the maturities of investment securities and the weighted-average yields
of such securities, which have been calculated on the basis of the cost,
weighted for scheduled maturity of each security, and adjusted to a fully
tax-equivalent basis:

At December 31, 2006Amount
  Maturing
  Within
  One Year
  or Less

Amount
  Maturing After
  One Year but
  Within Five Years

Amount
  Maturing After
  Five Years but
  Within Ten Years

Amount
  Maturing After
  Ten Years

Total Cost(In thousands)U.S.
Treasury
  obligations

$
100




$
6,739




$
6,839U.S.
  government-sponsored corporations


17,419


34,978


9,781





62,178Mortgage-backed
  securities


22,916


57,157


12,265


5,570


97,908Obligations
of
  states and political subdivisions


922


27,961


51,062


6,354


86,299Total
  available-for-sale portfolio value

$
41,357

$
120,096

$
79,847

$
11,924

$
253,224Weighted
average
  yield at year end1


4.15
%

4.23
%

4.34
%

4.58
%

4.27
%(1)
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.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 through its
branch network, its commercial department and its leasing subsidiary.
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 to borrowers outside of the primary service area. Loans are
internally generated and the majority of the lending activity takes place in
the New York State counties of Cortland, Madison, Onondaga, Oneida, and Oswego.
In addition, the Bank originates indirect auto loans in the western counties of
New York State. The Banks leasing subsidiary originates the majority of its
leases through reputable, well-established middle market leasing companies, and
through vendor and direct customer relationships, with an emphasis on the
medical and education sectors. The leases are underwritten using our typical
commercial credit standards, and the collateral securing the leases is
generally readily marketable. The business is conducted in over 30 states.

21

Total loans and leases, net of unearned income,
increased $228.5 million in 2006. The acquisition of Bridge Street added gross
loans totaling $142.3 million or 62.3% of the increase in loans and leases in
2006.

Commercial loans increased $61.2 million in 2006 and
were $223.5 million at December 31, 2006 or 25.3% of total loans and leases,
compared with $162.4 million (24.8% of total loans and leases) at December 31,
2005. The increase resulted from loans acquired from Bridge Street totaling
$64.7 million (net of $2.4 million of loans sold in December), which offset a
slight decrease in our commercial portfolio in 2006, due to highly competitive
commercial lending conditions in our market.

The Companys commercial lease portfolio (net of
unearned income) increased $66.2 million in 2006 as a result of our continuing
focus on developing this business line. Net leases totaled $131.3 million at
the end of 2006, which represents 14.9% of total loans and leases, compared
with $65.2 million (10.0% of total loans and leases) at December 31, 2005. The
president of the Banks leasing subsidiary notified the Company in March 2007
of his intention to pursue an opportunity with another financial services
company. The Companys ability to replace this individual with the appropriate
specialized skills in a timely manner may have an impact on the rate of growth
of the leasing portfolio in the near-term.

Residential mortgages increased $67.3 million in 2006,
and were $253.8 million or 28.8% of total loans and leases at December 31,
2006, compared with $186.6 million (28.5% of total loans and leases) at
December 31, 2005. Residential mortgages totaling $57.9 million, or 86.0% of
the increase in 2006, were acquired from Bridge Street. We do not offer
non-traditional mortgages, such as interest-only or negative amortizing loans,
due to the higher credit risk of these types of loans.

Indirect auto loans were $182.5 million, or 20.7% of
total loans and leases at December 31, 2006, compared with $172.1 or 26.3% of
total loans and leases at December 31, 2005. During the second quarter of 2006
we increased our indirect loan rates in an effort to slow the rate of growth in
these loans, as highly competitive pricing and higher funding costs have
negatively impacted the profitability of indirect lending. As a result, we
anticipate the rate of growth in this portfolio will slow in coming quarters.

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


|                                    |  |                            |         |         |  |        |   |         |         |        |  |         |   |        |         |         |       |        |   |         |   |       |   |   |         |   |       |  
|----------------------------------- |  | -------------------------- | ------- | ------- |  | ------ | - | ------- | ------- | ------ |  | ------- | - | ------ | ------- | ------- | ----- | ------ | - | ------- | - | ----- | - | - | ------- | - | ----- | -
|                                    |  | Years
  ended December 31, |        
|                                    |  |                            |        
|                                    |  | 2006                       |         | 2005    |  | 2004   |   | 2003    |         | 2002   | 
|                                    |  |                            |         |         |  |        |   |         |         |        | 
|                                    |  | Amount                     |         | Percent |  | Amount |   | Percent |         | Amount |  | Percent |   | Amount |         | Percent |       | Amount |   | Percent |  
|                                    |  |                            |         |         |  |        |   |         |         |        |  |         |   |        |         |         |       |        |   |         |  
|                                    |  | (Dollars
  in thousands)   |        
|Commercial
loans                    |  | $                          | 223,527 |         |  | 25.3   | % | $       | 162,351 |        |  | 24.8    | % | $      | 154,188 |         | 29.3  | %      | $ | 147,647 |   | 30.8  | % | $ | 139,555 |   | 33.3  | %
|Leases, net
of unearned income      |  |                            | 131,338 |         |  | 14.9   | % |         | 65,172  |        |  | 10.0    | % |        | 13,762  |         | 2.6   | %      |   | 1,478   |   | 0.3   | % |   | 141     |   | 0.0   | %
|Residential
real estate             |  |                            | 253,825 |         |  | 28.8   | % |         | 186,550 |        |  | 28.5    | % |        | 176,666 |         | 33.6  | %      |   | 173,963 |   | 36.3  | % |   | 153,148 |   | 36.5  | %
|Indirect
auto                       |  |                            | 182,528 |         |  | 20.7   | % |         | 172,113 |        |  | 26.3    | % |        | 117,623 |         | 22.4  | %      |   | 97,163  |   | 20.3  | % |   | 68,811  |   | 16.4  | %
|Consumer                            |  |                            | 91,348  |         |  | 10.3   | % |         | 67,900  |        |  | 10.4    | % |        | 63,861  |         | 12.1  | %      |   | 58,804  |   | 12.3  | % |   | 57,733  |   | 13.8  | %
|                                    |  |                            |         |         |  |        |   |         |         |        |  |         |   |        |         |         |       |        |   |         |   |       |   |   |         |   |       |  
|Total loans
and leases              |  | $                          | 882,566 |         |  | 100.0  | % | $       | 654,086 |        |  | 100.0   | % | $      | 526,100 |         | 100.0 | %      | $ | 479,055 |   | 100.0 | % | $ | 419,388 |   | 100.0 | %
|                                    |  |                            |         |         |  |        |   |         |         |        |  |         |   |        |         |         |       |        |   |         |   |       |   |   |         |   |       |  
|Less:                               |  |                            |         |         |  |        |   |         |         |        |  |         |   |        |         |         |       |        |   |         |   |       |   |   |         |   |       |  
|Allowance
for loan and lease losses |  |                            | (7,029  | )       |  |        |   |         | (4,960  | )      |  |         |   |        | (5,267  | )       |       |        |   | (6,069  | ) |       |   |   | (5,019  | ) |       |  
|                                    |  |                            |         |         |  |        |   |         |         |        |  |         |   |        |         |         |       |        |   |         |   |       |   |   |         |   |       |  
|Net Loans
and Leases                |  | $                          | 875,537 |         |  |        |   | $       | 649,126 |        |  |         |   | $      | 520,833 |         |       |        | $ | 472,986 |   |       |   | $ | 414,369 |   |       |  
|                                    |  |                            |         |         |  |        |   |         |         |        |  |         |   |        |         |         |       |        |   |         |   |       |   |   |         |   |       |  

The following table shows the amount of loans and
leases outstanding as of December 31, 2006, which, based on remaining scheduled
payments of principal, are due in the periods indicated: Maturing
  within
  one year or less

Maturing
  after one but
  within five years

Maturing
  after
  five butwithin ten years

Maturing
  after
  ten years

Total(In
  thousands)Commercial

$
69,023

$
73,158

$
43,824

$
37,522

$
223,527Leases, net of unearned income


36,481


88,427


6,430





131,338Residential real estate


22,392


83,068


92,554


55,811


253,825Indirect auto


54,106


127,279


1,143





182,528Consumer


10,205


31,004


42,423


7,716


91,348Total loans & leases, net of unearned income

$
192,207

$
402,936

$
186,374

$
101,049

$
882,566 The following table sets forth the sensitivity of the
loan amounts due after one year to changes in inter­est rates, as of December
31, 2006: Fixed Rate

Variable
  Rate(In
  thousands)Due after one year, but within five years

$
335,433

$
67,503Due after five years


186,352


101,071 22   Loan Quality and the Allowance for Loan and
Lease Losses

The following table
represents information concerning the aggregate amount of non-performing
assets:

December
  31,2006

2005

2004

2003

2002(In thousands)Non-accrual
  loans and leases:Commercial

$
1,248

$
1,103

$
2,116

$
3,987

$
755Leases


99











Residential
real estate


298


12


168





Indirect
auto


63


74


90


97


60Consumer


141


169


60


93


38Total
  non-accrual loans and leases

$
1,849

$
1,358

$
2,434

$
4,177

$
853Accruing
  loans and leases past due 90 days or more


790


270


317


476


539Total
  non-performing loans

$
2,639

$
1,628

$
2,751

$
4,653

$
1,392Other real
  estate owned and other repossessed assets





6


53


24


198Total
  non-performing assets

$
2,639

$
1,634

$
2,804

$
4,677

$
1,590Total
  non-performing loans and leases to total loans and leases


0.30
%

0.25
%

0.53
%

0.98
%

0.38
%Total
  non-performing assets to total assets


0.21
%

0.17
%

0.31
%

0.57
%

0.21
%Allowance
  for loan and lease losses to non-performing loans and leases


266.35
%

304.67
%

191.46
%

130.43
%

360.56
%Allowance
  for loan and lease losses to total loans and leases


0.80
%

0.76
%

1.00
%

1.27
%

1.20
%Non-performing assets, defined as nonaccruing loans and leases plus
loans and leases 90 days or more past due, along with other real estate owned
and other repossessed assets as of December 31, 2006 were $2.6 million, up $1.0
million, or 61.5%, compared to December 31, 2005. The increase in nonperforming
loans resulted entirely
from non-performing assets acquired from Bridge Street. The largest
non-performing loan at year-end was an $855,000 commercial line of credit that
we acquired from Bridge Street. Payments are being made in accordance with the
contractual terms of the agreement, however, the facility, which is secured by
a first-lien on accounts receivable, has been placed on non-accrual status
while the terms of an extension of the facility are negotiated. A number of
small relationships make up the remaining balance of nonperforming loans, the
largest of which is a $119,000 commercial loan.

The
allowance to non-performing loans and leases ratio declined 266.4% at December
31, 2006, compared with 304.7% at December 31, 2005. Total delinquencies,
defined as loans and leases 30 days or more past due and nonaccruing, were
1.84% of total loans and leases outstanding as of December 31, 2006, compared
to 1.32% at the end of 2005.

The
Bank has a loan and lease review program that it believes takes a conservative
approach to evaluating nonperforming loans and leases and the loan and lease
portfolio in general­. The loan and lease review program continually audits the
loan and lease portfolio to confirm managements loan and lease risk rating
system, and tracks problem loans and leases to ensure compliance with loan and
lease policy underwriting guidelines, and to evaluate the adequacy of the allowance
for loan and lease losses.

The
Banks policy is to place a loan or lease on non­accrual status and recognize
income on a cash basis when a loan or lease is more than 90 days past due,
unless in the opinion of management, the loan or lease is well secured­ and in
the process of collection. The impact of interest not recognized on
non­accrual loans and leases was $40,000 in 2006, $75,000 in 2005, and $267,000
in 2004. The Bank considers a loan or lease impaired when, based on current
information and events, it is probable that the Bank will be unable to collect
the scheduled payments of principal and interest when due accord­ing to the
contractual terms of the loan or lease agreement. The measurement of impaired
loans and leases is generally based upon the present value of future cash flows
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. As of December 31, 2006 and 2005, there were no
impaired loans or leases for which specific valuation allowances had been
recorded.

The
allowance for loan and lease losses represents manage­ments best estimate of
probable loan and lease losses in the Banks loan and lease 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 Bank uses a general
allocation methodology for all residential and consumer loan pools. This
methodology estimates a reserve­ for each pool based on the most recent
three-year loss rate, adjusted to reflect the expected impact that current
trends regarding loan growth, delinquency, losses, economic conditions, loan
concentrations, policy changes and current interest rates are likely to have.
For commercial loan and lease pools, the Bank establishes a specific reserve
allocation for all loans and leases in excess of $150,000 which have been risk
rated under the Banks risk rating system, as substandard or doubtful. The
specific allocation is based on the most recent valuation of the loan or lease
collateral­. For all other commercial loans and leases, the Bank 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 qualitative 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 Banks loan and lease
portfolio. Loans and leases are charged against the allowance for loan and
lease losses, in accordance with the Banks loan and lease policy, when they
are deter­mined by management to be uncollectible. Recoveries on loans and
leases previously charged off are credited to the allowance for loan and lease
losses when they are received. When management determines that the allowance
for loan and lease losses is less than adequate to provide for potential
losses, a direct charge is made to operating income.

23

The
following table summarizes loan and lease balances at the end of each period
indicated and the daily average­ amount of loans and leases. Also summarized
are changes in the allowance for loan and lease losses arising from loans and
leases charged off, recoveries on loans and leases previously charged off and
additions to the allowance, which have been charged to expense.

Years
  ended December 31,2006

2005

2004

2003

2002(In
thousands)Balance at
  beginning of year

$
4,960

$
5,267

$
6,069

$
5,019

$
4,478Loans and
  leases charged-off:Commercial
loans


689


393


1,271


487


367Leases


560











Residential
real estate


33


39


123


62


63Indirect
auto


195


296


531


787


1,061Consumer


913


360


265


333


303Total loans
and leases charged off


2,390


1,088


2,190


1,669


1,794Recoveries
  of loans and leases previously charged off:Commercial
loans


59


209


52


53


82Residential
real estate


1


45


10





9Indirect
auto


213


191


218


193


235Consumer


412


192


124


124


114Total
recoveries


685


637


404


370


440Net loans
  and leases charged off


1,705


451


1,786


1,299


1,354Provision
  for loan and lease losses


2,477


144


984


2,349


1,895Allowance
  acquired from Bridge Street Financial Inc.


1,297











Balance at
  end of year

$
7,029

$
4,960

$
5,267

$
6,069

$
5,019The
allowance for loan and lease losses at December 31, 2006 was $7.0 million, or
0.80% of loans and leases outstanding compared to $5.0 million or 0.77% of
loans and leases outstanding at December 31, 2005. The provision for loan and
lease losses was $2.5 million in 2006, compared with $144,000 in 2005. Net
charge-offs were $1.7 million in 2006, compared with $451,000 in 2005. The
increased level of provisions in 2006 is a reflection of the growth and changing
mix of our loan and lease portfolio and higher charge-offs. Two commercial
relationships comprised approximately 40% of total charge-offs in 2006., The
allowance for loan losses was also increased in 2006 by the $1.3 million of
loan loss allowances that was acquired in the acquisition of Bridge Street in
the fourth quarter of 2006. Net charge offs in 2005 declined 74.7% compared
with 2004, to $451,000 from $1.8 million, and the ratio of net charge-offs to
average loans and leases fell to 0.08% from 0.36% for the comparable periods.
The decline in the 2005 loss rate reflected a reduction of $1.0 million in net
commercial loan losses, and a $208,000, reduction in indirect auto loan losses
compared with 2004. Net charge-offs in 2004 were significantly impacted by the
charge-off of $1.2 million taken on a single commercial loan. The decline in
the indirect auto loan loss rate over the past five years reflects a tightening
of the Banks loan underwriting guidelines in 2001 combined with an effective
collection program over the period.

The
allowance for loan and lease losses has been allocated within the following
categories of loans and leases at the dates indicated (Dollars in thousands):

December
  31,2006

2005

2004

2003

2002Amount
  of
  Allowance

Percent

Amount
  of
  Allowance

Percent

Amount
  of
  Allowance

Percent

Amount
of
  Allowance

Percent

Amount
of
  Allowance

PercentCommercial

$
3,143


44.71
%
$
2,521


50.83
%
$
2,714


51.53
%
$
3,091


50.93
%
$
2,575


51.31
%Leases


1,468


20.88
%

385


7.76
%

51


0.97
%










Residential real
estate


969


13.79
%

653


13.17
%

689


13.08
%

608


10.01
%

361


7.19
%Indirect auto


785


11.17
%

1,099


22.16
%

1,447


27.47
%

1,879


30.96
%

1,551


30.90
%Consumer


664


9.45
%

302


6.08
%

366


6.95
%

491


8.10
%

532


10.60
%Total

$
7,029


100.0
%
$
4,960


100.00
%
$
5,267


100.00
%
$
6,069


100.00
%
$
5,019


100.00
%The
allowance for loan and lease losses is allocated according to the amount deemed
to be reasonably necessary to provide for the probable losses within each
category of loans and leases. Increases in the amount allocated to the
commercial and lease portfolios reflect the higher outstanding balances of
these portfolios coupled with the higher inherent risk of these portfolios
compared with residential and consumer lending. During 2006, strong credit
quality the indirect auto loan portfolio, as evidenced by net recoveries of
$18,000 in 2006, resulted in a reduction in the allocation of the allowance to
the indirect portfolio, in spite of 6.1% growth in the portfolio during the
year.

Deposits and Other Borrowings

The
Companys deposits are acquired through the Bank and represent its primary
source of funds. The deposit base is comprised of demand deposit, savings and
money market accounts, and time deposits that are primarily provided by
individuals, businesses, and local governments within the communities served.
The Bank continuously monitors market pricing, competitors rates, and internal
interest rate spreads to maintain and promote growth and profitability.

24

The following table sets
forth the composition of the Companys deposits by business line at year-end:

December 31, 2006

December 31, 2005Retail

Commercial

Municipal

Total

Percent

Retail

Commercial

Municipal

Total

PercentNon-interest
  checking

$
34,236

$
90,667

$
4,672

$
129,575


13.9
%
$
18,217

$
68,674

$
4,992

$
91,883


12.5
%Interest checking


69,642


9,083


15,094


93,819


10.0
%

60,150


8,661


11,725


80,536


10.9
%Total checking


103,878


99,750


19,766


223,394


23.9
%

78,367


77,335


16,717


172,419


23.4
%Savings


77,751


6,436


1,701


85,888


9.2
%

49,501


3,979


1,734


55,214


7.5
%Money market


76,771


39,709


72,662


189,142


20.2
%

80,870


29,809


66,215


176,894


23.9
%Time deposits


367,751


27,876


41,545


437,172


46.7
%

260,247


22,462


51,882


334,591


45.2
%Total deposits

$
626,151

$
173,771

$
135,674

$
935,596


100.0
%
$
468,985

$
133,585

$
136,548

$
739,118


100.0
%Total
deposits were $935.6 million at December 31, 2006, an increase of $196.5
million from December 31, 2005. Checking accounts increased $51.0 million in
the year ended December 31, 2006, of which $39.6 million was attributable to
accounts acquired from Bridge Street. In addition, increases in commercial and
retail checking deposits in 2006 resulted in large part to the success of our
ongoing business development efforts and our expanded branch network. Savings
and money market accounts increased $42.9 million in 2006, after giving effect
to the $79.2 million of accounts acquired form Bridge Street. Time accounts
increased $102.6 million, including $49.6 million acquired form Bridge Street,
in 2006. The increase in time accounts is a trend over the past two years that
mirrors a decreasing trend in savings and money market accounts (exclusive of
the accounts acquired from Bridge Street) as customers have favored higher
rate, short-term time accounts over lower rate savings and money market
accounts. We expect the intense competition for deposits in our market area
will continue for the foreseeable future, which, along with the significant
difference between higher yielding short term-time account rates and savings
and money market rates, may result in a continuing migration of savings and
money market accounts to time accounts.

Time
deposits in excess of $100,000, which are more volatile and sensitive to
interest rates, totaled $127.4 million at December 31, 2006, representing 29.1%
of total time deposits and 13.6% of total deposits. These deposits totaled
$113.8 million, representing 34% of total time deposits and 15.4% of total
deposits at year-end 2005.

The
following table indicates the amount of the Companys time deposits of $100,000
or more by time remaining until maturity as of December 31, 2006 (in
thousands):

Less than
  three months

$
38,286Three months
  to six months


33,198Six months
  to one year


34,449Over one
  year


21,501Total

$
127,434The
Bank offers retail repurchase agreements primarily to its larger business
customers. Under the terms of the agreements, the Bank sells invest­ment
portfolio securities to the customer and agrees to repurchase the securities on
the next business day. The Bank uses this arrangement as a deposit alternative
for its business customers. As of December 31, 2006, retail repurchase
agreement balances amounted to $42.0 million compared to balances of $32.9
million at December 31, 2005. During 2006, the Bank utilized collateralized
repurchase agreements with various brokers and advances from the Federal Home
Loan Bank of New York (FHLB) as alternative sources of funding and as a
liability management tool. At December 31, 2006, the combination of repurchase
agreements and FHLB advances were $136.5 million, compared to $117.5 million at
December 31, 2005. Detailed information regarding the Companys borrowings is
included in Note 9 in the consolidated financial statements section of this
report.

In
December 2003, the Company formed Alliance Financial Capital Trust I, a wholly
owned subsidiary of the Company. The trust was formed for the purpose of
issuing $10.0 million of Company-obligated mandatorily redeemable capital
securities (the capital securities) to third-party investors and investing the
proceeds from the sale of such capital securities solely in junior subordinated
debt securities of the Company. The debentures held by the trust are the sole
assets of that trust. Distributions on the capital securities issued by the
trust are payable quarterly at a rate per annum equal to the interest rate
being earned by the trust on the debentures held by the trust. The capital
securities have a variable annual coupon rate that resets quarterly based upon
three-month LIBOR plus 285 basis points (8.23%). The capital securities have a
30-year maturity and are redeemable at par in January 2009 and any time
thereafter.

In
September 2006, the Company formed Alliance Financial Capital Trust II, a
wholly-owned subsidiary of the Company. The trust was formed for the purpose of
issuing $15.0 million of Company-obligated mandatorily redeemable capital
securities (the capital securities) to third-party investors and investing the
proceeds from the sale of such capital securities solely in junior subordinated
debt securities of the Company. The debentures held by the trust are the sole
assets of that trust. Distributions on the capital securities issued by the
trust are payable quarterly at a rate per annum equal to the interest rate
being earned by the trust on the debentures held by the trust. The capital
securities have a variable annual coupon rate that resets quarterly based upon
three-month LIBOR plus 165 basis points (7.01%). The capital securities have a
30-year maturity and are redeemable at par in September 2011 and any time
thereafter.

Capital

Shareholders
equity was $109.5 million at December 31, 2006, compared with $69.6 million at
December 31, 2005. Shareholders equity was increased by $38.1 million from the
issuance of common stock (862,856 new shares and 428,956 shares from treasury)
in connection with the acquisition of Bridge Street, and by net income for 2006
of $7.3 million. Shareholders equity was reduced by dividends declared in 2006
totaling $3.4 million, and by the repurchase of 94,482 shares of Alliance
common stock in the fourth quarter at a total cost of $2.9 million. There
remains 31,830 shares available for repurchase as of December 31, 2006 under
the previously announced program. Shareholders equity was further reduced by
$994,000 (net of deferred taxes) upon the adoption by the Company of Statement
of Financial Accounting Standards No. 158 Employers Accounting for Defined
Benefit Pension and Other Postretirement Plans  an amendment of FASB
Statements No. 87, 88, 106, and 132(R) as of December 31, 2006. The adoption
of this statement had no effect on our regulatory capital ratios.

The
Companys goal is to maintain a strong capital position, consistent with the
risk profile of the Bank, that supports­ growth and expansion activities while
at the same time exceeding regulatory standards. Capital adequacy in the
banking industry is evaluated primarily by the use of ratios which measure
capital against total assets, as well as against total assets­ that are
weighted based on defined risk characteris­tics. At December 31, 2006, the
Company exceeded all regulatory required minimum capital ratios and met the
regulatory definition of a well-capitalized institution. A more com­prehensive
analysis of regulatory capital requirements, including ratios for the Company,
is included in Note 22 in the consolidated financial statements.

25

Liquidity

The
Companys liquidity is primarily measured by the Banks ability to provide
funds to meet loan and lease requests, to accommodate possible outflows of
deposits, and to take advantage of market interest rate opportunities. Funding
of loan and lease requests, providing for liability outflows, and management 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 Management 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 December 31, 2006, 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 FHLB, and
securities sold under repurchase agreements. During the 12 months ended
December 31, 2006, cash and cash equivalents increased by $4..5 million as net
cash provided by operating activities and deposit and financing activities of
$63.6 million exceeded the net cash used in lending and investing activities of
$59.1 million. Net cash provided by deposit and financing activities reflects a
net increase in deposits of $24.0 million, an increase in subordinated
obligations of $15.5 million and a net increase in borrowings of $5.5 million.
Net cash used in lending and investing activities reflects a net increase in
loans of $87.6 million, a net reduction in investment securities of $43.6
million, a net increase in premises and equipment of $2.0 million, and $13.2
million used for the acquisition of Bridge Street.

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 December 31, 2006, the
Banks credit limit with the FHLB was $195.9 million, with outstanding borrowings
in the amount of $136.5 million.

Contractual Obligations, Commitments, and
Off-Balance Sheet Arrangements

The
Company has various financial obligations, including contractual obligations
and commitments that may require future cash payments. The following table
presents as of December 31, 2006, significant fixed and determinable
contractual obligations to third parties by payment date. Further discussion of
the nature of each obligation is included in the referenced note to the
consolidated financial statements.

Payments Due InContractual obligation

Note
  Reference

One Year
  or Less

One to
  Three Years

Three to
  Five Years

Over Five
  Years

Total(Dollars in thousands)Time deposits*


10

$
360,638

$
70,080

$
6,454

$


$
437,172Federal funds purchased and
  agreements to repurchase securities*


11


56,473











56,473Short-term borrowings*


11


25,000











25,000Junior subordinated
  obligations issued to unconsolidated subsidiaries*


12











25,774


25,774Long-term borrowings*


11


15,700


32,477


10,000


40,000


98,177Operating leases


19


900


1,693


1,595


3,926


8,114Purchase obligations


19


140


344


344


2,052


2,880Total




$
457,776

$
124,594

$
18,394

$
52,827

$
653,591*
Excludes interestThe
Company also has obligations under its postretirement plan as described in Note
16 to the consolidated financial statements. The postretirement benefit
payments represent actuarially determined future benefit payments to eligible
plan participants.

Commitments and Off-Balance Sheet
Arrangements

In the normal course of business, to meet the financing needs of its
customers and to reduce its exposure to fluctuations in interest rates, the
Bank is party to financial instruments with off-balance sheet risk, held for
purposes other than trading. The financial instruments involve, to varying
degrees, elements of credit and interest rate risk in excess of the amount
recognized in the consolidated balance sheets. The Banks exposure to credit
loss in the event of nonperformance by the other party to the financial
instrument, for loan commitments and standby letters of credit, is represented
by the contractual amount of those instruments, assuming that the amounts are
fully advanced and that collateral or other security is of no value. The Bank uses the same credit policies in making
commitments and conditional obligations as it does for on-balance sheet
loans. The amount of collateral obtained, if deemed necessary by the Bank upon
extension of credit, is based on managements credit evaluation of the
borrower. Collateral held varies, but may include accounts receivable,
inventory, property, plant and equipment, and income-producing commercial
properties. Commitments to originate loans, unused lines of credit, and
un-advanced portions of construction loans are agreements to lend to a customer
provided there is no violation of any condition established in the contract.
Commitments generally have fixed expiration dates or other termination clauses
and may require payment of a fee. Many of the commitments are expected to
expire without being drawn upon. Therefore, the amounts presented below do not
necessarily represent future cash requirements. Standby letters of credit are
conditional commitments issued by the Bank to guarantee the performance by a
customer to a third party. These guarantees are issued primarily to support
public and private borrowing arrangements, bond financing, and similar
transactions. The credit risk involved in issuing letters of credit is
essentially the same as that involved in extending loan commitments to
customers.

26

The following table details the amounts and expected
maturities of significant commitments and off-balance sheet arrangements as of
December 31, 2006. Further discussion of these commitments and off-balance
sheet arrangements is included in Note 19 to the consolidated financial
statements.

Commitments
to extend credit:

One Year
  or Less

One to
  Three Years

Three to
  Five Years

Over 
  Five Years

Total(Dollars in thousands)Commercial loans and leases

$
52,067

$
10,467

$
1,431

$
7,447

$
71,412Residential real estate


7,587











7,587Revolving home equity lines


1,
  356


6,904


11,461


26,729


46,450Consumer revolving credit


9,728











9,728Standby letters of credit


2,663











2,663New Accounting Pronouncements

In February 2007, the FASB issued SFAS No. 159, The Fair
Value Option for Financial Assets and Financial Liabilities -
Including an Amendment of FASB Statement No. 115. This standard permits an
entity to choose to measure many financial instruments and certain other items
at fair value. This option is available to all entities, including
not-for-profit organizations. Most of the provisions in Statement 159 are
elective; however, the amendment to FASB Statement No. 115, Accounting for
Certain Investments in Debt and Equity Securities, applies to all entities with
available-for-sale and trading securities. Some requirements apply differently
to entities that do not report net income. The FASB's stated objective in
issuing this standard is as follows: to improve financial reporting by providing
entities with the opportunity to mitigate volatility in reported earnings
caused by measuring related assets and liabilities differently without having
to apply complex hedge accounting provisions.

The fair value option established by Statement 159
permits all entities to choose to measure eligible items at fair value at
specified election dates. A business entity will report unrealized gains and
losses on items for which the fair value option has been elected in earnings
(or another performance indicator if the business entity does not report
earnings) at each subsequent reporting date. A not-for-profit organization will
report unrealized gains and losses in its statement of activities or similar
statement. The fair value option: (a) may be applied instrument by instrument,
with a few exceptions, such as investments otherwise accounted for by the
equity method; (b) is irrevocable (unless a new election date occurs); and (c)
is applied only to entire instruments and not to portions of instruments.

This Statement is effective for the Company as of
January 1, 2008. The Company is currently analyzing the effects of this
statement and the impact on the Companys financial conditions or results of
operations has not yet been determined.

In September 2006, the FASB issued SFAS No. 157, Fair
Value Measurements. This Statement applies under other accounting
pronouncements that require or permit fair value measurements. This Statement
defines fair value, establishes methods for measuring fair value and expands
disclosures about fair value measurements. While this Statement does not
require any new fair value measurements, it is intended to increase consistency
and comparability in fair value measurements, and expand disclosures about fair
value measurements among companies. This Statement is effective for the Company
beginning January 1, 2008. The Company is currently evaluating the impact this
will have on the Companys current practice of measuring fair value and any
additional disclosures required in our financial statements.

In June 2006, the FASB issued Interpretation No. 48, Accounting for
Uncertainty in Income Taxesan
interpretation of FASB Statement No. 109. This Interpretation
clarifies the accounting for uncertainty in income taxes recognized in an
enterprises financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. This
Interpretation prescribes a recognition threshold and measurement attribute for
the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. This Interpretation also provides
guidance on derecognition, classification, interest and penalties, accounting
in interim periods, disclosure, and transition.

This Interpretation is effective for the Company as of
January 1, 2007. The Company is currently analyzing the effects of this
interpretation and the impact on the Companys financial conditions or results
of operations  has not yet been
determined.

In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing
of Financial Assetsan
amendment of FASB Statement No. 140. This Statement amends FASB
Statement No. 140, Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities, with respect to the accounting for
separately recognized servicing assets and servicing liabilities. This
Statement requires an entity to recognize a servicing asset or servicing
liability each time it undertakes an obligation to service a financial asset by
entering into a servicing contract in any of the following situations: i) a
transfer of the servicers financial assets that meets the requirements for
sale accounting; ii) a transfer of the servicers financial assets to a
qualifying special-purpose entity in a guaranteed mortgage securitization in
which the transferor retains all of the resulting securities and classifies
them as either available-for-sale securities or trading securities in
accordance with FASB Statement No. 115, Accounting for Certain Investments in
Debt and Equity Securities; and iii) an acquisition or assumption of an
obligation to service a financial asset that does not relate to financial
assets of the servicer or its consolidated affiliates. This statement requires
all separately recognized servicing assets and servicing liabilities to be
initially measured at fair value, if practicable. Subsequent measurement for
each class of separately recognized servicing assets and servicing liabilities
shall be based on either the Amortization Method or Fair Value Measurement
Method, as defined by this statement.

This Statement is effective for the Company as of
January 1, 2007, and the requirements for recognition and initial measurement
of servicing assets and servicing liabilities will be applied prospectively to
all transactions after the effective date of this Statement. The impact on the
Companys financial conditions or results of operations is not expected to be
significant.

Item 7A  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 Banks Asset Liability Management 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.

27

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, taken together
they represent a reasonably comprehensive view of the magnitude of interest
rate risk, the distribution of risk along 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 balance sheet is likely to evolve though 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 loans. Noncontractual 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 12 months would adversely affect
net interest income over the same period by more than 15% when compared to the
stable rate scenario. At December 31, 2006, based on the results of our
simulation model and assuming that management does not take action to alter the
outcome, the Bank would expect net interest income to decline 9.9% if
short-term interest rates increase by 2%, and increase 9.1% if short-term
interest rates decline by 2%. By comparison, at December 31, 2005, based on the
results of our simulation model, and assuming that management did not take
action to alter the outcome, the Bank expected net interest income to decrease
10.7% if short-term interest rates increase by 2%, and increase 9.7% if
short-term interest rates decline by 2%.

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 Company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 December 31,
2006 NPV analysis, a 2% instantaneous increase in interest rates was estimated
to increase NPV by 5.6%. NPV was estimated to decrease 10.09% if rates
immediately declined by 2%. The Companys policy guidelines limit the amount of
the estimated decline/increase to 25% in a 2% rate change scenario. By
comparison, the December 31, 2005 NPV analysis estimated a 2% instantaneous
increase in interest rates would decrease NPV by 7.7%. NPV was estimated to
increase 1.9% if rates immediately declined by 2%.

28

Item 8  Financial Statements and Supplementary
Data

Alliance
  Financial Corporation and Subsidiaries 
  Consolidated Balance Sheets
  December 31, 2006 and 20052006


2005(Dollars
  in thousands)AssetsCash and due
  from banks

$
27,398

$
17,972Federal funds
  sold





4,906Securities
  available for sale


256,752


261,368Federal Home
  Loan Bank of NY (FHLB) Stock


7,235


6,126Total loans and
  leases, net of unearned income


882,566


654,086Less allowance
  for loan and lease losses


7,029


4,960Net loans and
  leases


875,537


649,126Premises and
  equipment, net


20,125


13,032Accrued interest
  receivable


4,605


3,915Bank-owned life
  insurance


16,449


9,565Assets held for
  sale


2,367


Goodwill


33,456


Intangible
  assets, net


14,912


9,671Other assets


14,131


7,575Total assets

$
1,272,967

$
983,256Liabilities and
shareholders
  equityLiabilitiesDepositsNon-interest
  bearing


129,575


91,883Interest
bearing


806,021


647,235Total deposits


935,596


739,118Borrowings


179,650


150,429Accrued interest
  payable


2,651


2,261Other
  liabilities


19,790


11,567Junior
  subordinated obligations issued to unconsolidated subsidiary trusts


25,774


10,310Total
  liabilities


1,163,461


913,685Shareholders
  equity:Preferred stock
   par value $25.00 a share; 1,000,000 shares authorized, none issued; Common
  stock  par value $1.00 a share; 10,000,000 shares authorized, 4,894,994 and 3,978,601
  shares issued, and 4,800,512 and 3,565,012 shares outstanding for 2006 and
  2005, respectively


4,895


3,979Surplus


38,986


11,185Unamortized
  value of restricted stock





(1,453
)Undivided
  profits


70,658


66,740Accumulated
  other comprehensive loss


(2,122
)

(1,700
)Treasury stock,
  at cost; 94,482 and 413,589 shares, respectively


(2,911
)

(9,180
)Total Shareholders
Equity


109,506


69,571Total Liabilities and
Shareholders
  Equity

$
1,272,967

$
983,256The
accompanying notes are an integral part of the consolidated financial
statements.

29

Alliance Financial Corporation and SubsidiariesConsolidated Statements of IncomeYears Ended December 31, 2006, 2005 and 2004December
  31,2006

2005

2004(In
  thousands, except per share data)Interest IncomeInterest and
  fees on loans and leases

$
46,790

$
34,960

$
28,514Federal
  funds sold and interest bearing deposits


148


129


45Securities


10,835


11,336


12,443Total
Interest Income


57,773


46,425


41,002Interest
  ExpenseDeposits:Savings
accounts


339


307


322Money market
accounts


5,141


3,955


1,868Time
accounts


16,161


8,988


6,257NOW
  accounts


519


250


230Total


22,160


13,500


8,677Borrowings:Repurchase
agreements


2,596


2,297


1,948FHLB
advances


4,052


2,895


1,600Mortgagors escrow funds


4





Junior subordinated
obligations


1,139


644


459Total interest
expense


29,951


19,336


12,684Net interest income


27,822


27,089


28,318Provision for loan and lease
losses


2,477


144


984Net interest income after
provision for
  loan and lease losses


25,345


26,945


27,334Non-interest
  income:Trust and
brokerage income


8,895


7,864


1,778Insurance
agency income


615





Service
charges on deposit accounts


4,316


2,957


3,056(Loss) gain
on sale of securities available for sale


(2
)

(19
)

717Gain on the
sale of loans


126


163


197Income from
bank-owned life insurance


455


402


810Card-related
fees


1,291


926


776Rental income
from leases


797


1,186


783Other
non-interest income


1,225


677


818Total
non-interest income


17,718


14,156


9,006Non-interest
expense:Salaries and
employee benefits


16,607


17,150


14,919Occupancy and
equipment expense


6,460


5,746


5,295Communication
expense


744


603


614Stationery
and supplies expense


645


514


520Marketing
expense


1,128


921


794Amortization
of intangible assets


797


418


Professional
fees


3,239


2,385


1,676Other
operating expense


4,370


3,703


3,341Total
non-interest expense


33,990


31,440


27,159Income before
income tax expense


9,073


9,661


9,181Income tax
expense


1,762


2,154


1,926Net
  income

$
7,311

$
7,507

$
7,255Net income Per Common
ShareBasic

$
1.92

$
2.09

$
2.03Diluted

$
1.88

$
2.05

$
2.00The accompanying notes are an integral part
of the consolidated financial statements.

30

Alliance
  Financial Corporation and SubsidiariesConsolidated
  Statements of Changes in Shareholders EquityYears
  Ended December 31, 2006, 2005 and 2004Issued and 
  OutstandingCommonShares

CommonStock

Surplus

UnamortizedValue ofRestrictedStock

UndividedProfits

AccumulatedOtherComprehensiveIncome

TreasuryStock

Total(In
  thousands, except share and per share data)Balance at December 31, 2003


3,534,761

$
3,910

$
9,268

$
(563
)
$
57,976

$
3,517

$
(7,955
)
$
66,153Comprehensive income:Net
income














7,255








7,255Other
comprehensive income, net of taxes

















(2,099
)




(2,099
)Total
comprehensive income























5,156Issuance of
restricted stock


20,000


20


641


(661
)







Amortization
of restricted stock











177











177Stock options
exercised


17,111


17


389














406Cash
dividends, $.84 per share














(2,996
)







(2,996
)Balance
  at December 31, 2004


3,571,872


3,947


10,298


(1,047
)

62,235


1,418


(7,955
)

68,896Comprehensive income:Net
income














7,507








7,507Other
comprehensive income, net of taxes

















(3,118
)




(3,118
)Total
comprehensive income























4,389Issuance of
restricted stock


24,500


24


754


(778
)










Forfeiture of
restricted
  stock


(3,582
)

(3
)

(108
)

98











(13
)Amortization
of restricted
  stock











274











274Tax benefit
of restricted
  stock plan














16








16Stock options
exercised


10,543


11


241














252Tax benefit
of stock-based
  compensation























Cash
dividend, $.84 per share














(3,018
)







(3,018
)Treasury
stock purchased


(38,321
)
















(1,225
)

(1,225
)Balance at December 31,
2005


3,565,012


3,979


11,185


(1,453
)

66,740


(1,700
)

(9,180
)

69,571Comprehensive income:Net
income














7,311








7,311Other
comprehensive income,
  net of taxes

















572





572Total
comprehensive income























7,883Cumulative effect of change in
accounting for adoption of SFAS No.
  158

















(994
)




(994
)Shares issued in purchase of
Bridge Street Financial Inc.


1,291,812


863


27,518











9,676


38,057Issuance of restricted
stock


26,500


27


789


(816
)










Forfeiture of restricted
stock


(19,995
)

(21
)

(594
)

503











(112
)Amortization of restricted
stock











332











332Tax benefit of restricted stock
plan














22








22Stock options
exercised


47,032


47


1,080














1,127Tax benefit of stock-based
compensation








442














442Cash dividends, $.88 per
share














(3,415
)







(3,415
)Treasury stock
purchased


(109,849
)
















(3,407
)

(3,407
)Reclassification of unearned
restricted stock awards to surplus in
  accordance with SFAS No. 123R (67,375 shares)








(1,434
)

1,434











Balance at December 31,
2006


4,800,512

$
4,895

$
38,986

$


$
70,658

$
(2,122
)
$
(2,911
)
$
109,506The accompanying notes are an integral part
of the consolidated financial statements.

31

Alliance Financial Corporation and SubsidiariesConsolidated Statements of Comprehensive IncomeYears Ended December 31, 2006, 2005 and 20042006

2005

2004(In
  thousands)Net income

$
7,311

$
7,507

$
7,255Other comprehensive income
(loss) net of tax:Net unrealized (losses) gains
for the period, net of tax expense
  (benefit) of $455 in 2006, $(2,099) in 2005 and $(1,361) in 2004


645


(3,129
)

(1,613
)Reclassification adjustment for
losses (gains) included in net income,
  net of tax (benefit)  expense of $(1) in 2006, $(8) in 2005 and
  $287 in 2004


1


11


(430
)Change in minimum pension
liability


(74
)




(56
)Total other comprehensive
income (loss)


572


(3,118
)

(2,099
)Comprehensive income

$
7,883

$
4,389

$
5,156The accompanying notes are an integral part
of the consolidated financial statements.

32

Alliance
  Financial Corporation and SubsidiariesConsolidated
  Statements of Cash FlowsYears
  Ended December 31, 2006, 2005 and 20042006

2005

2004(In
  thousands)Operating
Activities:Net income

$
7,311

$
7,507

$
7,255Adjustments to reconcile net
income to net
  cash provided by operating activities:Provision for
loan and lease losses


2,477


144


984Depreciation
expense


2,837


2,762


1,639Decrease
(increase) in surrender value of
  life insurance


(455
)

(402
)

132Provision
(benefit) for deferred income
  taxes


(1,353
)

(272
)

2,429Accretion of
investment security discounts
  and premiums, net


(195
)

(105
)

(280
)Net loss
(gain) on sale of securities
  available-for-sale


2


19


(717
)Net loss
(gain) on sale of premises and
  equipment


22


124


(71
)Impairment
write-down on premises


174





Proceeds from
the sale of mortgage loans


7,824


10,647


10,848Origination of
loans held-for-sale


(7,763
)

(10,584
)

(10,754
)Gain on sale
of loans


(61
)

(63
)

(94
)Amortization
of capitalized servicing
  rights


104


88


74Amortization
of intangible assets


797


418


Restricted
stock expense


220


274


177Change in
other assets and liabilities


11,728


3,314


(910
)Net Cash Provided by Operating
Activities


23,669


13,871


10,712Lending
  and Investing Activities:Proceeds from maturities,
redemptions,
  calls and principal repayments of investment securities, available-for-sale


60,725


73,969


59,721Proceeds from sales of
investment
  securities available-for-sale


9,718


16,100


31,468Purchase of investment
securities
  available-for-sale


(27,128
)

(43,212
)

(112,618
)Purchase of FHLB
stock


(14,579
)

(12,873
)

(7,055
)Redemption of FHLB
stock


14,845


13,155


5,350Net increase in loans and
leases


(87,558
)

(128,437
)

(46,808
)Purchases of premises and
equipment


(1,994
)

(1,967
)

(3,663
)Proceeds from the sale of
premises and
  equipment


16


503


170Acquisitions


(13,171
)

(10,089
)

Net Cash Used in Lending and
Investing
  Activities


(59,126
)

(92,851
)

(73,435
)Deposit
  and Financing Activities:Net (decrease) increase in
demand deposits,
  NOW, money market and savings accounts


(20,530
)

41,352


17,519Net increase in time
deposits


44,456


74,645


44,202Net increase (decrease) in
short-term
  borrowings


27,264


(51,425
)

33,371Payments on long-term
borrowings


(46,750
)

(20,000
)

(40,000
)Proceeds from long-term
borrowings


25,000


40,000


10,000Net increase in junior
subordinated
  obligations


15,464





Proceeds from the exercise of
stock options


1,127


252


406Treasury stock
purchased


(3,407
)

(1,225
)

Tax benefit of stock-based
compensation


464


16


Cash dividends


(3,111
)

(3,015
)

(3,341
)Net Cash Provided by Deposit
and Financing
  Activities


39,977


80,600


62,157Net Increase (decrease) in Cash
and Cash
  Equivalents


4,520


1,620


(566
)Cash and cash equivalents at
beginning of
  year


22,878


21,258


21,824Cash and Cash Equivalents at
End of Year

$
27,398

$
22,878

$
21,258Supplemental Disclosures of
Cash Flow
  Information:Interest
received during the year

$
57,083

$
46,515

$
41,188Interest paid
during the year


29,561


18,526


12,477Income
taxes


2,455


1,800


1,280Non-cash investing
activities:Change in
unrealized loss on available for
  sale securities


1,090


5,211


3,404Fair value of assets acquired in
  acquisition


252,182





Fair value of liabilities
assumed in
  acquisition


200,954





Transfer of premises and
equipment to
  assets held for sale


118





Non-cash financing activities:Dividend
declared and unpaid


1,057


753


750Common stock issued in
acquisition

$
38,057

$


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

33

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsNature of Operations

Alliance Financial
Corporation (the Company) is a financial holding company which owns and
operates Alliance Bank, N.A., Alliance Financial Capital Trust I, Alliance
Financial Capital Trust II (collectively the Capital Trusts) and Ladds
Agency, Inc., a multi-line insurance agency. The Company provides financial
services through its Bank subsidiary from 29 customer service facilities in the
New York counties of Cortland, Madison, Oneida, Onondaga, Oswego, and from a
Trust Administration Center in Buffalo, NY, in Erie County. Primary services
include commercial, retail and municipal banking, consumer finance, mortgage
financing and servicing, and trust and investment management services. The
Capital Trusts were formed for the purpose of issuing corporation-obligated
mandatorily redeemable capital securities to third-party investors and
investing the proceeds from the sale of such capital securities solely in
junior subordinated debt securities of the Company. The Bank has a
substantially wholly-owned subsidiary, Alliance Preferred Funding Corp., which
is engaged in residential real estate activity, and a wholly-owned subsidiary,
Alliance Leasing, Inc., which is engaged in commercial leasing activity in over
thirty states.

1.Basis of Presentation
and Significant Accounting Policies

Principles of Consolidation

The consolidated financial
statements include the accounts of the Company and its wholly-owned
subsidiaries, Alliance Bank, N.A. and Ladds Agency, Inc., after elimination of
intercompany accounts and transactions. The Companys wholly-owned
subsidiaries, Alliance Financial Capital Trust I and II, qualify as variable
interest entities under FASB Interpretation No. 46 (FIN 46), Consolidation
of Variable Interest Entities. However, the Company is not the primary
beneficiary and therefore has not consolidated the accounts of Alliance
Financial Capital Trust I and II in its consolidated financial statements.

Critical Accounting Estimates and Policies

The preparation of financial
statements in conformity with accounting principles generally accepted in the
United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Management has identified the allowance for loan and lease losses, accrued
income taxes, and the carrying value of goodwill and intangible assets 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. Actual results could differ from those estimates.

Risk and Uncertainties

In the normal course of its
business, the Company encounters economic and regulatory risks. There are three
main components of economic risk: interest rate risk, credit risk and market
risk. The Company is subject to interest rate risk to the degree that its
interest-bearing liabilities mature or reprice at different speeds, or on
different bases, from its interest-earning assets. The Companys primary credit
risk is the risk of default on the Companys loan portfolio that results from
the borrowers inability or unwillingness to make contractually required
payments. Market risk reflects potential changes in the value of collateral
underlying loans, the fair value of investment securities, and loans held for
sale.

The Company is subject to
regulations of various governmental agencies. These regulations can and do
change significantly from period to period. The Company also undergoes periodic
examinations by the regulatory agencies, which may subject it to further
changes with respect to asset valuations, amounts of required loan and lease
loss allowances, and operating restrictions resulting from the regulators
judgments based on information available to them at the time of their
examinations.

Cash and Cash Equivalents

For purposes of reporting
cash flows, cash and cash equivalents include cash on hand, amounts due from
banks and highly liquid investments with original maturities less than ninety
days.

Investment Securities

The Company classifies
investment securities as held-to-maturity or available-for-sale.
Held-to-maturity securities are those that the Company has the positive intent
and ability to hold to maturity, and are reported at cost, adjusted for amortization
of premiums and accretion of discounts. Investment securities not classified as
held-to-maturity are classified as available-for-sale and are reported at fair
value, with net unrealized holding gains and losses reflected as a separate
component of shareholders equity, net of the applicable income tax effect.
None of the Companys investment securities have been classified as trading
securities.

Gains and losses on the sale
of investment securities are based on the specific identification method.
Premiums and discounts on securities are amortized and accreted into income
using the interest method over the life of the security. Investment securities
are reviewed regularly for other than temporary impairment. Where there is
other than temporary impairment, the impairment loss is recognized in the
consolidated statements of income. Purchases and sales of securities are
recognized on a settlement-date basis.

Federal Home Loan Bank of New York Stock

As a member of the Federal
Home Loan Bank of New York (FHLB), the Company is required to hold stock in
the FHLB. FHLB stock is carried at cost since there is no readily available
market value. The stock cannot be sold, but can be redeemed by the FHLB at
cost.

Securities Sold under Agreements to Repurchase

Repurchase agreements are
accounted for as collateralized borrowings, and the obligations to repurchase
securities sold are reflected as a liability in the statement of financial
condition, since the Company maintains effective control over the transferred
securities. The securities underlying the agreements remain in the investment

34

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial Statementsaccount. The fair value of
the collateral provided to a third party is continually monitored, and
additional collateral is provided to the third party, or surplus collateral is
returned to the Company as deemed appropriate.

Loans and Leases

Loans and leases are stated
at unpaid principal balances less the allowance for loan and lease losses,
unearned interest income and net deferred loan origination fees and costs.
Interest on loans is based upon the principal amount outstanding. Interest on
loans is accrued except when in managements opinion the collectibility of
interest is doubtful, at which time the accrual of interest on the loan is
discontinued. Loan and lease origination fees and certain direct origination
costs are deferred and the net amount is amortized as a yield adjustment over
the life of the loan or lease.

Operating leases are stated
at cost of the equipment less depreciation. Equipment on operating leases is
depreciated on a straight-line basis to its estimated residual value over the
lease term. Operating lease income is recognized on a straight-line basis over the
term of the lease. Income attributable to all other leases is initially
recorded as unearned income and subsequently recognized as finance income at
level rates of return over the term of the leases. The recorded residual values
of the Companys leased assets are estimated at the inception of the lease to
be the expected fair market value of the assets at the end of the lease term.
On a quarterly basis, the Company reassesses the realizable value of its lease
residual values. In accordance with generally accepted accounting principles,
anticipated increases in specific future residual values are not recognized
before realization. Anticipated decreases in specific future residual values
that are considered to be other than temporary are recognized immediately.

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 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 most recent three-year loss rate, adjusted to
reflect the expected impact that current trends regarding loan and lease
growth, delinquency, losses, economic conditions, loan concentration, policy
changes, 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, 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 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 or leases is generally discounted­
at the historical effective interest rate, except­­ that all
collateral-dependent loans or leases are measured­ for impairment based on fair
value of the collateral.

Loans will be charged off
when they are considered a loss regardless of the delinquency status. From a
delinquency standpoint, the policy of this bank is to charge off loans when
they are 120 days past due unless extenuating circumstances are documented that
attest to the ability to collect the loan. Special circumstances to include
fraudulent loans and loans in bankruptcy will be charged off no later than 90
days of discovery or within 120 days delinquent, whichever is shorter. In lieu
of charging off the entire loan balance, loans with collateral may be written
down to the value of the collateral, less cost to sell, if foreclosure of
repossession of collateral is assured and in process.

Income Recognition on Impaired and Nonaccrual
Loans and Leases

Loans and leases, including
impaired loans or leases, are generally classified as nonaccrual if they are
past due as to maturity of payment of principal or interest for a period of
more than 90 days unless they are well secured and are in the process of
collection. While a loan or lease is classified as nonaccrual and the future
collectibility of the recorded loan or lease balance is doubtful, collections
of interest and principal are generally applied as a reduction to principal
outstanding.

Goodwill and Intangible Assets

Goodwill represents the
excess of the purchase price over the fair value of net assets acquired for
transactions accounted for under the purchase method of accounting for business
combinations. Goodwill is not being amortized, but is evaluated at least
annually for impairment. Intangible assets resulting from the acquisition of
Bridge Street Financial, Inc. in 2006 include core deposit intangibles,
customer relationship intangibles and a covenant to not compete. The core
deposit intangible and customer list intangible are being amortized over 10
years using an accelerated method. The non-compete covenant is being amortized
on a straight-line basis over a period of 3 years based on the agreement. The
trust relationship intangible related to the purchase of trust accounts and
related assets under management from HSBC, USA, N.A. in 2005 is amortized on a
straight-line basis over a 20-year life. These intangibles are tested for
impairment whenever events or changes in circumstances indicate that the
carrying amounts may not be recoverable.

Mortgage Servicing Rights

Originated mortgage servicing
rights are recorded at their fair value at the time of transfer and amortized
in proportion to and over the period of estimated net servicing income or loss.
The Company uses a valuation service provider that calculates the present value
of future cash flows to determine the fair value of the servicing rights. In
using this valuation method, the Company integrated assumptions that market
participants would use in estimating future net servicing income, which
included estimates of the cost of servicing per loan, the discount rate, and
prepayment speeds. The carrying value of the originated mortgage servicing
asset is periodically evaluated for impairment using similar market
assumptions.

35

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsBank Premises, Furniture, and Equipment

Bank premises, furniture, and
equipment are stated at cost less accumulated depreciation and amortization.
Depreciation and amortization are calculated using the straight-line method
over the estimated useful lives of the assets. Useful lives range from one year
to 10 years for furniture, fixtures and equipment; three to five years for
software, hardware, and data handling equipment; and 10 to 39 years for
buildings and building improvements. Leasehold improvements are amortized over
the term of the respective lease.
Maintenance and repairs are charged to operating expenses as incurred. The
asset cost and accumulated depreciation are removed from the accounts for
assets sold or retired and any resulting gain or loss is included in the
determination of the income.

Stock-Based Compensation

Effective January 1, 2006,
the Company adopted provisions of Financial Accounting Standards Board (FASB)
Statement No. 123R Share-Based Payment, (FAS 123R) for its share-based
compensation plans. The Company previously accounted for these plans under the
recognition and measurement principles of Accounting Principles Board (APB) No.
25, Accounting for Stock Issued to Employees, (APB 25) and related
interpretations and disclosure requirements established by FAS 123, Accounting
for Stock-Based Compensation. Under APB 25, because the exercise price of the
Companys employee stock options equaled the market price of the underlying
stock on the date of the grant, no compensation expense was recorded. The pro
forma effects on income for stock options were instead disclosed in a footnote
to the financial statements. Expense was recorded in the income statement for
restricted stock units.

Under FAS 123R, all
share-based compensation cost is measured at the grant date, based on the fair
value of the award, and is recognized as an expense in the income statement
over the vesting period. The Company adopted FAS 123R using the modified
prospective method. Under this transition method, compensation cost recognized
in 2006 includes the cost for all share-based payments granted prior to, but
not yet vested as of January 1, 2006. This cost was based on grant-date fair
value estimated in accordance with the original provisions of FAS 123. The cost
for all share-based awards granted subsequent to January 1, 2006 represented
the grant-date fair value that was estimated in accordance with the provisions
of FAS 123R. Results for prior periods have not been restated. The effect of
adopting the provisions of FAS123R decreased net income $28,000, net of a tax
benefit of $18,000, and reduced basic and diluted earnings per share by $.01.

The following table
illustrates the effect on net income and earnings per share in 2005 and 2004 if
the Company had applied the fair value recognition provisions of SFAS 123, Accounting
for Stock-Based Compensation,to stock option awards granted on
Alliance Financial Corporation common stock.

2005

2004(Dollars
  in thousands, except per share data)Net Income:As
reported

$
7,507

$
7,255Less pro forma
expense related to options
  granted, net of related tax effects


(35
)

(43
)Pro forma net income

$
7,472

$
7,212Pro forma net income per
share:Basic 
as reported

$
2.09

$
2.03Basic 
pro forma

$
2.08

$
2.02Diluted 
as reported

$
2.05

$
2.00Diluted 
pro forma

$
2.04

$
1.99The fair value of stock
options granted prior to 2003 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. There were no stock options granted by the
Company in 2003 and 2005. The fair value of the 2,000 options granted by the
Company in 2004 was estimated by the Company.

The majority of the stock
options that have been granted by the Company vest upon the attainment of
certain stock price targets. The expected life for options vesting upon the
attainment of certain stock price targets is two years after the performance
target is attained and the option is vested, or nine years if the targets are
not met. Increased volatility of the Companys stock price in 2003 accelerated
the expected vesting of options previously granted, and was reflected in the
pro-forma expense in 2003. Additional information regarding the Companys Stock
Option Plan is detailed in Footnote 18.

Segment Reporting

The Company
operates as one segment. Its operations are solely in the financial services
industry and include providing to its customers traditional banking, equipment
leasing and other financial services. The Company operates primarily in the
geographical regions of Cortland, Madison, Oneida, Onondaga, and Oswego
counties of New York State, and from a Trust Administration Center in Buffalo,
NY, in Erie County. In addition, Alliance Leasing conducts business in over
thirty states. Management makes operating decisions and assesses performance
based on an ongoing review of the Companys consolidated financial results.
Therefore, the Company has a single operating segment for financial reporting
purposes.

Reclassification

Reclassifications
are made to prior years consolidated financial statements, when necessary, to
conform to the current years presentation. These reclassifications have no
effect on net income as previously reported.

Income Taxes

Provision for income taxes is
based on taxes currently payable or refundable and deferred income taxes on
temporary differences between the tax basis of assets and liabilities and their
reported amount in the financial statements. Deferred tax assets and
liabilities are reported in the financial statements at currently enacted income
tax rates applicable to the period in which the deferred tax assets and
liabilities are expected to be realized or settled.

36

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsTrust Assets Under Management

Assets held in fiduciary or
agency capacities for customers are not included in the accompanying
consolidated statements of condition, since such items are not assets of the
Company. Fees associated with providing trust management services are recorded
on a cash basis of income recognition and are included in Other Income.

2. Acquisitions

On October 6, 2006, the
Company acquired Bridge Street Financial, Inc. (Bridge Street), the financial
holding company of Oswego County National Bank, which operated eight branches
in Oswego and Onondaga counties of New York, and an insurance agency
subsidiary, Ladds Insurance Agency, Inc. The Company expects the merger to
enhance its banking franchise and competitive market position in Central New
York. The merger also increases the Companys operating and marketing scale and
its customer base. The Company issued 1,292,000 shares of stock valued at $38.1
million using a price of $29.46 per Bridge Street share (average of two days
before and two days after merger announcement on April 24, 2006) and paid cash
of $13.2 million to the former Bridge Street shareholders for total merger
consideration of $51.3 million.

The acquisition of Bridge
Street was accounted for using the purchase method of accounting and, accordingly,
operations acquired from Bridge Street have been included in the Companys
financial results since the acquisition date. The assets acquired and
liabilities assumed from Bridge Street were recorded at their estimated fair
values. In connection with the acquisition, the Company recorded approximately
$33.5 million of nondeductible goodwill, $4.2 million of core deposit
intangible, $942,000 of customer list intangible and $894,000 of covenant to
not compete intangible. The goodwill is not being amortized, but is evaluated
at least annually for impairment. No impairment of goodwill was recognized in
2006. The core deposit intangible and customer list intangible are being
amortized over 10 years using an accelerated method. The non-compete covenant
is being amortized over a period of 3 years based on the agreement.

The following table
summarized the estimated fair value of the assets acquired and liabilities
assumed at the date of the Bridge Street acquisition (in thousands):

At October 6, 2006Assets:Cash

$
8,820Investment
  securities


38,791Loans
  (gross)


142,627Allowance
  for loan losses


(1,297
)Premises and
  equipment


8,266Assets held
  for sale


2,249Bank-owned
  life insurance


6,429Goodwill


33,456Intangible
  assets


6,038Other assets


6,803Total assets
acquired

$
252,182Liabilities:Interest-bearing
  deposits

$
137,545Non-interest
  bearing deposits


35,007Borrowings


23,707Other
  liabilities


4,695Total
liabilities assumed

$
200,954Presented below is certain
unaudited pro forma information for the years ended December 31, 2006 and 2005,
as if Bridge Street had been acquired on January 1 of the respective years.
These results combine the historical results of Bridge Street into the
Companys consolidated statements of income. While certain adjustments were
made for the estimated impact of the purchase accounting adjustments and other
acquisition-related activity, they are not necessarily indicative of what would
have occurred had the acquisition actually taken place at that time. In
particular, the Company expects to achieve operating cost savings as a result
of the acquisition, which are not reflected in the pro forma amounts presented.

For the Years Ended December 31,2006

2005(in thousands, except per share data)Net interest
  income

$
33,162

$
33,747Provision
  for loan and lease losses


(3,537
)

(641
)Non-interest
  income


21,490


19,213Operating
  expenses


(41,943
)

(42,880
)Provision
  for income taxes


(1,254
)

(1,715
)Net income

$
7,918

$
7,724Basic
  earnings per share

$
1.65

$
1.58Diluted
  earnings per share

$
1.63

$
1.5637

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsOn February 18, 2005, the
Bank acquired, and assumed the successor trustee role from HSBC Bank, USA,
N.A., for approximately 1,800 personal trust accounts with approximately $560
million in assets under management. In connection with the acquisition, the
Bank recorded, at cost, an intangible asset in an amount of $10.1 million. The
asset is being amortized over 20 years on a straight line method.

3. Investment Securities

The amortized
cost and approximate fair value of investment securities at December 31 are as
follows (in thousands):

December 31, 2006Amortized Cost

Gross
  Unrealized
  Gains

Gross
  Unrealized
  Losses

Estimated
  Fair ValueDebt
Securities:U.S. Treasury
obligations

$
6,839

$


$
419

$
6,420Obligations of U.S. government
-sponsored
  corporations


62,178


5


731


61,452Obligations of states and
political
  subdivisions


86,299


1,457


368


87,388Mortgage-backed
securities


97,908


163


1,908


96,163Total debt securities


253,224


1,625


3,426


251,423Stock Investments:Federal Home
Loan Bank and Federal Reserve
  Bank stock


7,985








7,985Other equity
securities


3,942


166





4,108Mutual
Funds


500





29


471Total stock
investments


12,427


166


29


12,564Total
available-for-sale

$
265,651

$
1,791

$
3,455

$
263,987December 31, 2005Amortized Cost

Gross
  UnrealizedGains

Gross
  UnrealizedLosses

Estimated
  Fair ValueDebt
Securities:U.S. Treasury
obligations

$
6,574

$


$
469

$
6,105Obligations of U.S.
government-sponsored
  corporations


66,456


31


1,185


65,302Obligations of states and
political
  subdivisions


73,610


1,730


432


74,908Mortgage-backed
securities


111,968


97


2,588


109,477Total debt securities


258,608


1,858


4,674


255,792Stock Investments:Federal Home
Loan Bank and Federal Reserve
  Bank stock


6,508








6,508Other equity
securities


4,632


88





4,720Mutual
Funds


500





26


474Total stock
investments


11,640


88


26


11,702Total
available-for-sale

$
270,248

$
1,946

$
4,700

$
267,494The carrying value and
estimated market value of debt securities at December 31, 2006, by contractual
maturity, are shown below (in thousands). The maturities of mortgage-backed
securities are based on average life of the security. All other expected
maturities will differ from contractual maturities because borrowers may have
the right to call or prepay obligations with or without call or prepayment
penalties.

Amortized
  Cost

Estimated
  Fair ValueDue in one year or less

$
41,357

$
40,951Due after
  one year through five years


120,096


118,538Due after
  five years through ten years


79,847


80,009Due after
  ten years


11,924


11,925Total debt
  securities

$
253,224

$
251,423At December
31, 2006 and 2005, investment securities with a carrying value of $228.1
million and $251.6 million, respectively, were pledged as collateral for
certain deposits and other purposes as required or permitted by law.

The Company recognized gross gains of
$8,000,
$3,000, and $717,000, for 2006, 2005, and 2004, respectively, and gross losses
of $10,000, $22,000, and $0, for 2006, 2005, and 2004, respectively.

38

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial Statements

The following
table shows the Companys investments gross unrealized losses and fair value,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at the dates indicated (in thousands):

December
  31, 2006Less than
  12 Months

12 Months
  or Longer

TotalType of
Security

Fair Value

Unrealized
  Loss

Fair Value

Unrealized
  Loss

Fair Value

Unrealized
  LossU.S. Treasury
obligations

$


$


$
6,320

$
419

$
6,320

$
419U.S. government-sponsored
corporations


11,697


28


45,694


703


57,391


731Obligations of states and
political
  subdivisions


2,046


8


22,074


360


24,120


368Mortgage-backed
securities


3,526


15


70,285


1,893


73,811


1,908Subtotal, debt
securities


17,269


51


144,373


3,375


161,642


3,426Mutual Funds








471


29


471


29Total temporarily impaired
securities

$
17,269

$
51

$
144,844

$
3,404

$
162,113

$
3,455December
  31, 2005Less than
  12 Months

12 Months
  or Longer

TotalType of
Security

Fair Value

Unrealized
  Loss

Fair Value

Unrealized
  Loss

Fair Value

Unrealized
  LossU.S. Treasury
obligations

$
99

$


$
6,006

$
469

$
6,105

$
469U.S. government-sponsored
corporation


19,865


390


38,211


795


58,076


1,185Obligations of states and
political
  subdivisions


22,008


286


4,272


146


26,280


432Mortgage-backed
securities


41,619


694


57,833


1,894


99,452


2,588Subtotal, debt
securities


83,591


1,370


106,322


3,304


189,913


4,674Mutual Funds








474


26


474


26Total temporarily impaired
securities

$
83,591

$
1,370

$
106,796

$
3,330

$
190,387

$
4,700Management
does not believe any individual unrealized loss as of December 31, 2006
represents an other-than-temporary impairment.
A total of 29 available for sale securities were in a continuous
unrealized loss position for less than 12 months and 203 securities for 12
months or longer.  The unrealized losses
relate primarily to securities issued by the U.S. Treasury, FNMA, GNMA, FHLMC,
FHLB, the State of New York, and various political subdivisions within the
State of New York. These unrealized losses are primarily attributable to
changes in interest rates and individually were 7.9% or less of their
respective amortized cost basis. The Company has both the intent and ability to
hold the securities contained in the previous table for a time necessary to
recover the amortized cost.

4. Loans and Leases

Major
classifications of loans and leases at December 31 are as follows (in
thousands):

2006

2005Commercial
  loans

$
223,527

$
162,351Leases


153,827


76,040Residential
  Real Estate


253,825


186,550Indirect
  Auto Loans


182,528


172,113Other
  Consumer Loans


91,348


67,900Total


905,055


664,954Less:
  Unearned income


22,489


10,868Less:
  Allowance for loan & lease losses


7,029


4,960Net loans
  & leases

$
875,537

$
649,126Mortgage loans
serviced for others are not included in the accompanying consolidated
statements of financial condition. The unpaid balances of mortgage loans
serviced for others were $146.2 million, $51.0 million, and $46.7 million, at
December 31, 2006, 2005, and 2004, respectively. The carrying value of mortgage
servicing rights was $1.2 million, $304,000, and $292,000 at December 31, 2006,
2005, and 2004, respectively.

39

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsNonperforming
loans and leases at December 31 are as follows (in thousands):

2006

2005

2004Loans 90
  days past due and still accruing

$
790

$
270

$
317Non-accrual
  loans


1,849


1,358


2,434Total
  nonperforming loans

$
2,639

$
1,628

$
2,7515. Allowance for Loan
and lease Losses

Changes in the
allowance for loan and lease losses for the years ended December 31 are
summarized as follows (in thousands):

2006

2005

2004Balance at
  January 1

$
4,960

$
5,267

$
6,069Provision
  for loan and lease losses


2,477


144


984Allowance
  acquired from Bridge Street Financial, Inc.


1,297





Recoveries


685


637


404Loans and
  leases charged off


(2,390
)

(1,088
)

(2,190
)Balance at
  December 31

$
7,029

$
4,960

$
5,2676. Related Party Transactions

Directors and
executive officers of the Company and their affiliated companies were customers
of, and had other transactions with, the Company in the ordinary course of
business during 2006. Loan transactions with related parties are summarized as
follows (in thousands):

2006

2005Balance at
  beginning of year

$
9,324

$
8,893New loans
  and advances


2,556


903Loan
  payments


(1,966
)

(472
)Balance at
  end of year

$
9,914

$
9,3247. Bank Premises,
Furniture, and Equipment

Bank premises,
furniture, and equipment at December 31 consist of the following (in
thousands):

2006

2005Land

$
2,399

$
1,101Bank
  premises


17,608


11,423Furniture
  and equipment


23,106


20,946Total cost

$
43,113

$
33,470Less:
  Accumulated depreciation


22,988


20,438$
20,125

$
13,0328. Assets Held for
Sale

Assets held
for sale at December 31, 2006 include the former administrative and operations
center of Bridge Street. The carrying value of the building at December 31,
2006 is $1.6 million, which was the estimated fair value at the date of
acquisition.

The Company
also acquired a vacant parcel of land from Bridge Street which is included in
assets held for sale.  The carrying
value of the land at December 31, 2006 is $465,000, which was the estimated
fair value at the date of acquisition.

Another
property classified as held for sale is a building that formerly housed certain
back-office operations of the Company.
The property was transferred from premises and equipment in December
2006 at its estimated fair value of $118,000.
An impairment write-down of $174,000 was recorded in connection with the
transfer and is included in occupancy and equipment expense.  The Company ceased depreciating the building
at the time of transfer.

Two commercial loans acquired
from Bridge Street with an estimated fair value of $184,000 are included in
assets held for sale at December 31, 2006.
The loans were recorded at their estimated fair value at the time of
acquisition.

40

Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements9. Other Intangible Assets

The following
table summarizes the companys intangible assets that are subject to
amortization (in thousands):

December
  31, 2006Gross
  Carrying Amount

Accumulated
  Amortization

Net
  Carrying AmountIntangible
AssetsCore deposit
intangible


$
4,202



$
191



$
4,011Non-compete
covenant



894




75




819Trust business
intangible



10,089




922




9,167Insurance
agency customer intangible



942




27




915Total


$
16,127



$
1,215



$
14,912December
  31, 2005Gross
  Carrying Amount

Accumulated
  Amortization

Net
  Carrying AmountTrust business
intangible


$
10,089



$
418



$
9,671Amortization
expense for intangible assets for the next five years is estimated as follows (in thousands):

Core Deposit

Non-compete

Trust Business

Insurance AgencyIntangible

Covenant

Intangible

Customer Intangible

Total2007


$
745



$
298



$
504



$
167



$
1,7142008



668




298




504




150




1,6202009



592




223




504




133




1,4522010



516









504




116




1,1362011



439









504




99




1,042Thereafter



1,051









6,647




250




7,94810. Deposits

Deposits consisted of the
following at December 31 (in thousands):

2006

2005Non-interest-bearing
  checking

$
129,575

$
91,883Interest-bearing
  checking


93,819


80,536Savings
  accounts


85,888


55,214Money market
  accounts


189,142


176,894Time
  deposits


437,172


334,591Total
  deposits

$
935,596

$
739,118The following table indicates
the maturities of the Companys time deposits at December 31 (in thousands):

2006

2005Due in one
  year

$
360,638

$
227,073Due in two
  years


61,951


88,255Due in three
  years


8,128


12,106Due in four
  years


4,109


4,764Due in five
  years or more


2,346


2,393Total time
  deposits

$
437,172

$
334,591Total time deposits in excess
of $100,000 as of December 31, 2006, 2005 and 2004 were $127.4 million, $113.8
million and $69.2 million, respectively.

41

Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial Statements11. Borrowings

The following is a summary of
borrowings outstanding at December 31 (in thousands):

2006

2005Short-term:Federal Home
Loan Bank overnight advances


$
25,000



$
Federal funds
purchased



13,300




Repurchase
agreements



43,173




50,429Total
short-term borrowings



81,473




50,429Long-term:Federal Home
Loan Bank term advances



73,400




80,000Repurchase
agreements



24,777




20,000Total
long-term borrowings



98,177




100,000Total borrowings


$
179,650



$
150,429The following table sets
forth certain information with respect to the overnight lines of credit and
federal funds purchased and short term repurchase agreements (Dollars in
thousands):

2006

2005

2004Federal
  Home Loan Bank (FHLB) overnight advances and federal funds purchased:Maximum month-end balance


$
38,300



$
18,000



$
19,500Balance at end of year



38,300









13,600Average balance during the
  year



11,040




4,421




5,207Weighted average interest rate
at end of year



5.44
%








2.61
%Weighted average interest rate
during the year



5.46
%



3.69
%



1.71
%Repurchase agreements:Maximum month-end balance


$
46,152



$
90,355



$
88,254Balance at end of year



43,173




50,429




88,254Average balance during the
  year



38,898




63,057




46,892Weighted average interest rate
at end of year



3.95
%



4.07
%



2.15
%Weighted average interest rate
during the year



4.47
%



3.16
%



1.46
%Repurchase agreements
outstanding at December 31, 2006 are at a rate of 3.95% and were at interest
rates ranging from 4.00% to 4.23% at December 31, 2005. As of the dates indicated,
the contractual amounts of FHLB term advances mature as follows (in thousands):

December 31, 2006

December 31, 2005Maturing

Amount

Weighted
  Average Rate

Amount

Weighted
  Average Rate2006


$









$
25,000




4.43
%2007



15,700




3.55
%



14,000




3.58
%2008



16,700




5.20
%








2009



11,000




5.26
%



11,000




5.26
%2010



10,000




6.11
%



10,000




6.11
%Thereafter



20,000




3.75
%



20,000




3.75
%Total FHLB Term Advances


$
73,400




4.59
%


$
80,000




4.44
%42

Alliance Financial Corporation and Subsidiaries
Notes to Consolidated Financial StatementsAs of the dates indicated,
the contractual amounts of long-term repurchase agreements mature as follows
(in thousands):

December 31, 2006

December 31, 2005Maturing

Amount

Weighted
  Average Rate

Amount

Weighted
  Average Rate2008


$
2,000




3.80
%


$




$
2009



2,777




3.99
%








Thereafter



20,000




4.01
%


$
20,000




4.01
%Total repurchase agreements


$
24,777




3.99
%


$
20,000




4.01
%Three of the Companys fixed
rate FHLB advances totaling $10.0 million at a weighted average rate of 6.11%
callable in 2007 and $20.0 million with a rate of 3.75% callable in 2008. If
called, the Company has the option to reprice the advance at the then-current
FHLB rates or repay the advance.

At December 31, 2006 and
2005, the Company had available $35.5 million and $17.5 million, respectively,
of Federal Funds lines of credit with other financial institutions, of which $0
was in use at December 31, 2006 and 2005, respectively.

The Company offers retail
repurchase agreements primarily to its larger business customers. Under the
terms of the agreement, the Company sells investment portfolio securities to
the customer agreeing to repurchase the securities on the next business day.
The Company views the borrowing as a deposit alternative for its business
customers. On December 31, 2006, the Company had securities with a market value
of $50.7 million pledged as collateral for these agreements. The Company also
has agreements with the Federal Home Loan Bank of New York (FHLB), and Bank
approved brokers to sell securities under agreements to repurchase. At December
31, 2006, investment securities with market value of $25.3 million were pledged
against repurchase agreements in the amount of $24.8 million. All of these
repurchase agreements at December 31, 2006 were with the FHLB.

The Company also has access
to various credit facilities through the FHLB, including an overnight line of
credit, a one-month line of credit, and a Term Advance Program, under which it
can borrow at various terms and interest rates. All of the credit facilities
are subject to meeting the collateral requirements of the FHLB. In addition to
pledging investment securities, the Company has also pledged, under a blanket
collateral agreement, certain residential mortgage loans with balances at
December 31, 2006 of $170.6 million. At December 31, 2006, the Company had
borrowed $111.7 million against the pledged mortgages. At December 31, 2006, the
Company had $59.4 million available under its various credit facilities with
the FHLB.

12.Junior Subordinated Obligations

On September
21, 2006, the Company formed a wholly-owned subsidiary, Alliance Financial
Capital Trust II, a Delaware business trust. The Trust issued $15.0 million of
30-year floating rate Company-obligated pooled capital securities. The Company
borrowed the proceeds of the capital securities from its subsidiary by issuing
floating rate junior subordinated deferrable interest debentures having
substantially similar terms. The capital securities mature in 2036, but may be
redeemed at the Companys option on predetermined dates with the first
redemption date at par in five years. The capital securities of the trust are a
pooled trust preferred fund of Preferred Term Securities XXIV, Ltd., and
interest rates on the securities adjust quarterly based on the 3-month LIBOR
plus 1.65% (7.01% at December 31, 2006). The Company guarantees all of the
securities.

On December
19, 2003, the Company formed a wholly owned subsidiary, Alliance Financial
Capital Trust I, a Delaware business trust. The Trust issued $10.0 million of
30-year floating rate Company-obligated pooled capital securities. The Company
borrowed the proceeds of the capital securities from its subsidiary by issuing
floating rate junior subordinated deferrable interest debentures having
substantially similar terms. The capital securities mature in 2033, but may be
redeemed at the Companys option on predetermined dates with the first
redemption date at par in five years. The capital securities of the trust are a
pooled trust preferred fund of ALESCO Preferred Funding II, Ltd., and interest
rates on the securities adjust quarterly based on the 3-month LIBOR plus 2.85%
(8.23% at December 31, 2006). The Company guarantees all of the securities.

The Company had a $310,000
investment in Trust I at December 31, 2006 and 2005 and a $464,000 investment
in Trust II at December 31, 2006.

The trusts are variable
interest entities (VIEs) as defined by FASB Interpretation No. 46 (FIN 46
R). The Company is not the primary beneficiary of the VIEs and as such they
are not consolidated in the Companys financial statements in accordance with
FIN 46R. Liabilities owed to the trusts, totaling $25.8 million and $10.3
million, were reflected as liabilities in the consolidated balance sheets at
December 31, 2006 and 2005, respectively.

43

Alliance Financial Corporation and SubsidiariesNotes to Consolidated Financial Statements13. Net Income Per Common Share

Basic and
diluted net income per common share calculations for the years ended December
31 are as follows (in thousands, except share and per share amounts):

2006

2005

2004BasicNet income

$
7,311

$
7,507

$
7,255Average
  common shares outstanding


3,804,711


3,593,864


3,565,226Net income
  per common share  basic

$
1.92

$
2.09

$
2.03DilutedNet income

$
7,311

$
7,507

$
7,255Average
  common shares outstanding


3,804,711


3,593,864


3,565,226Incremental
  shares from assumed conversion of stock options and restricted stock


69,773


70,820


66,580Average
  common shares outstanding  diluted


3,874,484


3,664,684


3,631,806Net income
  per common share  diluted

$
1.88

$
2.05

$
2.00Basic earnings
per share are computed by dividing net income by the weighted average number of
common shares outstanding throughout each year. 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.

14. INCOME TAXES

The provision
for income taxes for the years ended December 31 is summarized as follows (in
thousands):

2006

2005

2004Current tax expense
  (benefit)

$
1,028

$
2,426

$
(503
)Deferred tax
  provision (benefit)


734


(272
)

2,429Total
  provision for income taxes

$
1,762

$
2,154

$
1,926The provision
for income taxes includes the following (in thousands):

2006

2005

2004Federal
  income tax

$
1,468

$
1,982

$
1,785New York
  State franchise tax


294


172


141Total

$
1,762

$
2,154

$
1,926A
reconciliation between the statutory federal income tax rate and the effective
income tax rate for the years indicated is as follows:

2006

2005

2004Statutory
  federal income tax rate


34.0
%

34.0
%

34.0
%State
  franchise tax, net of federal tax benefit


2.1
%

1.4
%

1.2
%Tax exempt
  interest income


(13.2
%)

(11.5
%)

(10.8
%)Tax exempt
  insurance income


(1.7
%)

(1.4
%)

(3.0
%)Other, net


(1.8
%)

(0.2
%)

(0.4
%)Total


19.4
%

22.3
%

21.0
%44

Alliance Financial Corporation and SubsidiariesNotes to Consolidated Financial StatementsThe components
of deferred income taxes, included in other assets, at December 31, are as
follows (in thousands):

2006

2005Assets:Loans

$
826

$
Allowance for loan and lease
losses


2,676


1,932Assets held for sale


505


Postretirement
benefits


1,454


1,422Deferred compensation


2,263


1,240Pension costs


663


Tax attribute
carry-forwards


1,894


Incentive compensation
plans


257


195Net unrealized loss on
available-for-sale
  securities


665


1,136Other


351


62Total
  deferred tax assets


11,554


5,987Liabilities:Investment
  securities


503


344Loans


535


Depreciation
  and leasing


3,664


3,304Deferred
  fees


855


288Intangible
  assets


2,237


Other


175


11Total
  deferred tax liabilities


7,969


3,947Net deferred
  tax asset at year-end


3,585


2,040Realization of deferred tax assets is dependent upon the generation of
future taxable income or the existence of sufficient taxable income or the
existence of sufficient taxable income within the carry-back period. A
valuation allowance is provided when it is more likely than not that some
portion of the deferred tax assets will not be realized. In assessing the need
for a valuation allowance, management considers the scheduled reversal of the
deferred tax liabilities, the level of historical taxable income, and the
projected future taxable income over the periods in which the temporary
differences comprising the deferred tax assets will be deductible. Based on its
assessment, management determined that no valuation allowance is necessary.

The Company acquired $1.6 million in tax attribute carry-forwards in
the Bridge Street acquisition. The Company has a capital loss carry-forward of
$2,000 which expires in 2010. The Company also has a Federal Net Operating Loss
carry-forward of $2.7 million which will expire in 2025 and an AMT Credit
carry-forward of $943,000, which can be carried forward indefinitely. Lastly,
the Company has a New York State Net Operating Loss carry-forward of $310,000
which will expire in 2025 and a State Tax Credit carry-forward of $8,000 which
is not subject to expiration. The utilization of the net operating losses,
$680,000 of the AMT credit carry-forward and the state tax credit carry-forward
is subject to annual limitations imposed by the Internal Revenue Code. The
Company believes these limitations will not prevent the carry-forward benefits
from being utilized.

45

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial Statements15. Other Comprehensive Income

A summary of activity in accumulated other
comprehensive income follows (in thousands):

2006

2005

2004Effect from Unrealized Gains
  (Losses) on Securities Available for SaleAccumulated
  unrealized (losses) gains on securities available for sale at January 1, net
  of tax


$
(1,644
)


$
1,474



$
3,517Net unrealized gains (losses)
for the
  period, net of tax (benefit) expense of $445 in 2006, $(2,099) in 2005 and
  $(1,361) in 2004



645




(3,129
)



(1,613
)Reclassification adjustment
for losses
  (gains) included in net income, net of tax (benefit) expense of $(1) in 2006,
  $(8) in 2005 and $287 in 2004



1




11




(430
)Effect on other
  comprehensive income for the period



646




(3,118
)



(2,043
)Accumulated
  unrealized (losses) gains on securities available for sale at December 31,
  net of tax


$
(998
)


$
(1,644
)


$
1,474Effect from Pension and
  Post-Retirement PlansAccumulated
  unrealized losses for pension obligations at January 1, net of tax


$
(56
)


$
(56
)


$
Change in
  minimum pension liability



(74
)








(56
)Effect on other
  comprehensive income for the period



(74
)








(56
)Prior service
  costs, net of tax expense of $126 in 2006



(190
)








Net loss, net of
  tax benefit of $536 in 2006



(804
)








Cumulative
  effect of change in accounting for adoption of SFAS No. 158



(994
)








Accumulated
  unrealized losses for pension obligations at December 31, net of tax


$
(1,124
)


$
(56
)


$
(56
)Accumulated
  other comprehensive (loss) income at January 1, net of tax


$
(1,700
)


$
1,418



$
3,517Other
  comprehensive loss, net of tax



572




(3,118
)



(2,099
)Cumulative
  effect of change in accounting for adoption of SFAS No. 158



(994
)








Accumulated
  other comprehensive (loss) income at December 31, net of tax


$
(2,122
)


$
(1,700
)


$
1,41816. RETIREMENT PLANS AND POST-RETIREMENT BENEFITS

The Company provides
retirement benefits through a defined contribution 401(k) plan that covers
substantially all of its employees and former employees of Bridge Street. The
Bridge Street defined contribution 401(k) plan was terminated on October 6,
2006 and all plan assets were transferred to the Companys plan. Former Bridge
Street employees service with Bridge Street at the time of the acquisition is
deemed to be service with the Company for eligibility and vesting purposes
only, but not for purposes of benefit accrual or the allocation of employer
contributions. Contributions to the Companys 401(k) plan are determined by the
Board of Directors and are based on percentages of compensation for eligible
employees. Contributions are funded following the end of the plan (calendar)
year. Company contributions to the plan were $522,000, $656,000, and $594,000
in 2006, 2005, and 2004, respectively.

The Company has a
noncontributory defined benefit pension plan which it assumed from Bridge
Street. The plan covers substantially all former Bridge Street full-time
employees who met eligibility requirements on October 6, 2006, at which time
all benefits were frozen. Under the plan, retirement benefits are primarily a
function of both the years of service and the level of compensation. The amount
contributed to the plan is determined annually on the basis of (a) the maximum
amount that can be deducted for federal income tax purposes, or (b) the amount
certified by an actuary as necessary to avoid an accumulated funding deficiency
as defined by the Employee Retirement Income Security Act of 1974.

As of October 1, 2006 (the
measurement date of the plan) the fair value of plan assets was $4.5 million,
and the projected benefit obligation was $4.1 million. The $374,000 excess of
the fair value of plan assets over the projected benefit obligation is recorded
as a prepaid expense at December 31, 2006.

The discount rate used to
determine benefit obligations for the plan as of October 1, 2006 was 5.90%, and
was based upon the Citibank pension liability index on September 30, 2006. The
Citibank pension liability index was determined to appropriately reflect the
rate at which our pension liabilities could be effectively settled, based upon
the expected duration of the plan.

The rate of compensation
increase is not applicable since the Company froze the plan upon acquisition.

46

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsThe following benefit payments,
which reflect expected future service, as appropriate, are expected to be paid
(in thousands):

Year
  ending December 31:2007

$
1862008


1902009


1952010


2192011


246Years 2012-2016

$
1,408Plan assets are invested in
six diversified investment funds of the RSI Retirement Trust (the Trust), a
no load series open-ended mutual fund. The investment funds include four equity
mutual funds and two bond mutual funds, each with its own investment
objectives, investment strategies and risks, as detailed in the Trusts
prospectus. The Trust has been given discretion by the Plan Sponsor to
determine the appropriate strategic asset allocation versus plan liabilities,
as governed by the Trusts Statement of Investment Objectives and Guidelines (the
Guidelines).

The long-term investment
objective is to be invested 65% in equity securities (equity mutual funds) and
35% in debt securities (bond mutual funds). If the plan is underfunded under
the Guidelines, the bond fund portion will be temporarily increased to 50% in
order to lessen asset value volatility. When the plan is no longer underfunded,
the bond fund portion will be decreased back to 35%. Asset rebalancing is
performed at least annually, with interim adjustments made when the investment
mix varies more than 10% from the target.

The investment goal is to
achieve investment results that will contribute to the proper funding of the
pension plan by exceeding the rate of inflation over the long-term. In
addition, investment managers for the Trust are expected to provide above
average performance when compared to their peer managers. Performance
volatility is also monitored. Risk/volatility is further managed by the
distinct investment objectives of each of the Trust funds and the diversification
within each fund.

The plans weighted-average
asset allocations at October 1, 2006, by asset category is as follows:

Asset Category

Plan assets at 
  October 1, 2006Equity securities


73
%Debt Securities (Bond Mutual Funds)


27
%Total


100
%The long-term
rate-of-return-on-assets assumption was set based on historical returns earned
by equities and fixed income securities, adjusted to reflect expectations of
future returns as applied to the plans target allocation of asset classes. Equities
and fixed income securities were assumed to earn real rates of return in the
ranges of 5-9% and 2-6%, respectively. The long-term inflation rate was
estimated to be 3%. When these overall return expectations are applied to the
plans target allocation, the result is an expected rate of return of 7% to
11%.

The Company does not expect to make any
contribution to its pension plan in 2007.

The Company also provides post-retirement medical and life insurance
benefits to qualifying employees. Benefits are available to full-time employees
who have worked 15 years and attained age 55. Subsequent to the acquisition of
Bridge Street, benefits for the Bridge Street active participants were converted
to those under the Companys plan. 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.

47

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsThe following
tables set forth the changes in the post-retirement plans and accrued benefit
cost for the years ended December 31 (in thousands):

2006

2005Change in benefit
obligation:Benefit obligation at beginning
of year

$
5,340

$
5,214Service cost


121


136Interest cost


284


292Actuarial gain


(126
)

(1
)Benefits paid


(314
)

(301
)Benefit obligation for former
Bridge Street
  employees


755Benefit obligation at end of
year

$
6,060

$
5,340Components of prepaid/accrued
benefit cost:Unfunded status

$
(6,060
)
$
(5,340
)Unrecognized prior service
cost


N/A


210Unrecognized actuarial net
loss


N/A


1,479Accrued benefit obligation at
end of year

$
(6,060
)
$
(3,651
)At December
31, 2006, there were $186,000 and $1.3 million in unamortized prior service
cost and unamortized actuarial net loss, respectively, recorded as components
of accumulated other comprehensive income.

The discount
rates used in determining the benefit obligation as of December 31, 2006, 2005
and 2004 were 5.90%, 5.50% and 5.75%, respectively and were based upon the
Citibank pension liability index. The Citibank pension liability index was
determined to appropriately reflect the rate at which our post-retirement
liabilities could be effectively settled, based upon the expected duration of
the plan.

For
measurement purposes, with respect to the postretirement benefit plans, a 10.0%
annual rate of increase in the per capita cost of covered health care benefits
is assumed for 2007. The rate is assumed to decrease gradually to 4.5% by the
year 2015 and remain at that level thereafter.

The
composition of the plans net periodic cost for the years ended December 31 is
as follows (in thousands):

2006

2005

2004Service cost

$
121

$
188

$
145Interest cost


284


292


306Amortization of unrecognized
prior service
  cost


79


86


99Net periodic cost

$
484

$
566

$
550Assumed health
care cost trend rates have a significant effect on the amounts reported for
health care plans. A one percentage point change in assumed health care cost
trend rates would have the following effects (in thousands):

One
  percentage
  point increase

One
  percentage
  point decreaseEffect on total of service and
interest
  cost

$
31

$
(26
)Effect on postretirement benefit
  obligations


406


(349
)48

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsThe following
post-retirement healthcare benefits are expected to be paid over the next 10
years (in thousands):

Benefits paid for the year:2007

$
3992008


3702009


3622010


3812011


40020122016

$
2,098The above
benefit payments include expected life insurance claims, rather than the
premiums that the Company is paying to provide the life insurance.

The Company
assumed a supplemental retirement plan for directors from Bridge Street,
providing for extended compensation after retirement. The plan was funded with
life insurance policies on the participants, with the Company as owner and
beneficiary of the policies. Cash surrender value of these policies
approximated $6.5 million at December 31, 2006. At December 31, 2006 other
liabilities include approximately $761,000 accrued under the supplemental
retirement plan.

The Company
has supplemental executive retirement plans for certain current and former
employees. Included in other assets, the Company has segregated assets of
$841,000, $602,000 and $705,000 at December 31, 2006, 2005 and 2004,
respectively, to fund the estimated benefit obligation associated with certain
plans. At December 31, 2006 and 2005, other liabilities included approximately
$4.5 million and $1.4 million accrued under these plans. Benefits paid under
these plans were $226,000 in 2006, $206,000 in 2005 and $203,000 in 2004. The
benefit obligation, service cost, and actuarial gain/(loss) were $3.5 million,
and ($43,000) respectively at December 31, 2006, $1.7 million, $186,000 and
($256,000), respectively, at December 31, 2005, and $1.6 million, $209,000, and
($148,000), respectively, at December 31, 2004. Compensation expense includes
approximately $480,000, $166,000, and $171,000 relating to these plans at
December 31, 2006, 2005, and 2004, respectively.

The discount
rate used in determining the benefit obligation as of December 31, 2006 and
2005 was 5.80% and 5.50%, respectively. The discount rate used to determine
benefit obligations for the plans was based upon the Citibank pension liability
index on September 30, 2006. The Citibank pension liability index, less an
adjustment of 10 basis points, was determined to appropriately reflect the rate
at which our pension liabilities could be effectively settled, based upon the
expected duration of the plans. For measurement purposes in 2007, with respect
to the supplemental executive retirement plans, an 8.50% annual rate was
assumed as the investment return on account balances, and salaries were assumed
to increase at an annual rate of 4.00%.

The Company
amortizes unrecognized gain or losses and prior service costs on a straight
line basis over the future working lifetime of the participant expected to
receive benefits under the plan. In the year of a participants retirement, any
unrecognized gains or losses and prior service costs are fully recognized.
Future unrecognized gains or losses arising after retirement are amortized over
the participants remaining life expectancy. The compensation expense resulting
from the full recognition of unrecognized losses and prior service costs
totaled $328,000 in 2006. There was no such expense in 2005 and 2004.

The following
supplemental retirement benefits are expected to be paid over the next 10 years
(in thousands):

Benefits paid for the year:2007

$
3952008


3882009


2592010


2582011


24820122016

$
1,439The Company
recognized $112,000 and $78,000 in prior service costs and $778,000 and $26,000
in net losses in accumulated other comprehensive loss, net of tax as of
December 31, 2006 for the post-retirement plan and the supplemental retirement
plan, respectively. As of December 31, 2005 $56,000 was recognized as a
decrease to other comprehensive income for the supplemental retirement plan.

In 2007,
$62,000 and $10,000 are the estimated costs that will be amortized from
accumulated other comprehensive loss into the net periodic cost for the post
retirement plan and supplemental retirement plan, respectively.

The incremental
effect of applying SFAS 158 on individual line items in the statement of
condition at December 31, 2006 was a $994,000 increase, net of taxes, in other
liabilities and accumulated other comprehensive loss.

The Company
assumed the former Bridge Street Employee Stock Ownership Plan (ESOP), which
was maintained for former employees of Bridge Street and its wholly-owned
subsidiary Oswego County National Bank. Bridge Street terminated the ESOP
effective October 6, 2006. In connection with the Companys acquisition of
Bridge Street, and pursuant to the terms of the ESOP, the ESOP repaid the
remaining balance of the loan from Bridge Street and all surplus assets in the
ESOP were allocated to the participants. The dissolution of the ESOP and
distribution of its assets to the participants is pending receipt of a
favorable determination letter from the Internal Revenue Service.

17. Deferred
Compensation

The Company
maintains an optional deferred compen­sation plan for its directors, whereby
fees normally received are deferred and paid by the Company upon the retirement
of the director. At December 31, 2006 and 2005, other liabilities included
approx­i­mately $2.2 million and $1.7 million, respectively, relating to
deferred

49

Alliance Financial Corporation and
  Subsidiaries
  Notes to Consolidated Financial Statementscompensation.
Deferred compensation expense resulting from the earnings on deferred
balances for the years ended December 31, 2006, 2005, and 2004 approximated
$319, 000, $270, 000, and $237,000, respectively.

The Company assumed a nonqualified deferred
compensation plan for former directors of Bridge Street, under which
participants were eligible to elect to defer all or part of their annual
director fees. The plan provides that deferred fees are to be invested in
mutual funds, as selected by the individual directors. The plan was
discontinued effective with the acquisition of Bridge Street.  At December 31, 2006, deferred director fees
included in other liabilities, and the corresponding assets included in other
assets, aggregated approximately $1.1 million.

18. Stock Options and Awards

The Company has a long-term incentive compensation
plan that has been approved by the shareholders authorizing the use of 550,000
shares of authorized but unissued common stock of the Company. Under the plan,
the Board of Directors may grant incentive stock options, nonqualified stock
options, and restricted stock awards to officers, employees, and certain other
individuals.

The stock options issued by the Company are as
follows:

Of the 195,128 options outstanding at December 31,
2006, 179,128 of the options were issued with a 10-year term, vesting one year
after the issue date, and exercisable based on the Company achieving specified
stock prices. 15,000 of the options were issued with a 10-year term and vest
and become exercisable ratably over a three-year period. 1,000 of the options
were issued with a five-year term and vested on issuance.

During 2006, compensation expense recognized for stock
options was $28,000 net of a tax benefit of $18,000.  As of December 31, 2006, there was $49,000 of unrecognized
compensation cost related to non-vested stock option awards.  This cost is expected to be recognized over
a weighted average period of approximately 1 year.  The company generally uses authorized but unissued shares to
satisfy stock option exercises.

Stock option activity in the plan for the years ended
December 31 was as follows:

Options
  Outstanding

Range of 
  Option Price
  Per Share

Weighted
  Average 
  Option Price
  Per Share

Shares
  Exercisable2006Granted











Exercised


47,032

$
17.75  $24.75

$
23.00


Forfeited


10,889

$
24.75

$
24.75


Ending balance


195,128

$
17.75  $28.65

$
21.85


166,7182005Granted











Exercised


10,543

$
18.25  $24.75

$
23.84


Forfeited


4,818

$
24.75

$
24.75


Ending balance


253,049

$
17.75  $28.65

$
22.19


216,3682004Granted


2,000

$
26.93  $28.65

$
27.79


Exercised


17,111

$
18.25  $26.93

$
23.76


Forfeited


977

$
24.75  $26.93

$
25.31


Ending balance


268,410

$
17.75  $28.65

$
22.30


226,911The stock options outstanding at December 31, 2006 are
as follows:

Shares
  Outstanding

Weighted
  Average 
  Exercise Price

Weighted
  Average Remaining 
  Contractual Life
  (in years)

Shares
  Exercisable

Weighted
  Average 
  Exercise Price30,000

$
17.75


3.0


30,000

$
17.7540,000


18.50


3.0


40,000


18.508,000


19.00


4.0


8,000


19.005,000


21.75


2.2


5,000


21.7538,800


23.50


5.0


38,800


23.5072,328


24.75


3.0


43,918


24.751,000


28.65


2.5


1,000


28.65Total


195,128

$
21.85


3.4


166,718

$
21.3650

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsThe total
intrinsic value of options exercised during 2006, 2005 and 2004 was $408,000,
$66,000, and $120,000, respectively.
The aggregate intrinsic value of shares outstanding and exercisable at
December 31, 2006 was $2.0 million and $1.8 million, respectively.

Restricted
stock awards are recorded as deferred compensation, a component of
stockholders equity, at fair value at the date of the grant and amortized to
compensation expense over the specified vesting periods. These shares become
vested over a 7-year period. Furthermore, 50% of the shares awarded, to all
grantees  except the Companys Chief
Executive Officer, become vested on the date, at least three years after the
award date, that the Companys stock price has closed at a price that is at
least 160% of the award price for 15 consecutive days. Compensation expense to
record the amortization of the cost of all restricted shares issued for the
years ended December 31, 2006, 2005 and 2004 was $213,000, $268,000, and
$177,000, respectively.

Restricted
stock activity in the plan for the years ended December 31 was as follows:

Shares

Weighted
  
  Average
  grant price2006Granted


26,500



$
30.81Vested


1,905



$
30.21Forfeited


19,995



$
30.67Ending
  balance


67,375



$
31.062005Granted


24,500



$
31.75Vested


643



$
29.40Forfeited


3,582



$
30.88Ending
  balance


62,775



$
31.002004Granted


20,000



$
33.05Vested







Forfeited







Ending
  balance


42,500



$
30.5619. Commitments and Contingent Liabilities

The Company is
a party to financial instruments with off-balance-sheet risk in the normal
course of business to meet the financing needs of its customers. These
financial instruments consist primarily of commitments to extend credit and
letters of credit which involve, to varying degrees, elements of credit risk in
excess of amounts recognized in the consolidated statements of condition. The
contract amount of those commitments and letters of credit reflects the extent
of involvement the Company has in those particular classes of financial
instruments. The Companys exposure to credit loss in the event of
nonperformance by the counterparty to the financial instrument for commitments
to extend credit and letters of credit is represented by the contractual amount
of the instruments. The Company uses the same credit policies in making
commitments and letters of credit as it does for on-balance-sheet instruments.

Financial
instruments whose contract amounts represent credit risk (in thousands):

Contract
  Amount2006

2005

2004Commitments
  to extend credit

$
135,177

$
96,411

$
87,346Standby
  letters of credit


2,663


3,279


5,105Commitments to
extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require
payments of a fee. Since some of the commitment amounts are expected to expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements. Standby letters of credit written are
conditional commitments issued by the Company to guarantee the performance of a
customer to a third party. Those guarantees are primarily issued to support
public and private borrowing arrangements, including bond financing and similar
transactions. The credit risk involved in issuing standby letters of credit is
essentially the same as that involved in extending loan facilities to
customers. Since the letters of credit are expected to expire without being
drawn upon, the total commitment amounts do not necessarily represent future
cash requirements. For both commitments to extend credit and standby letters of
credit, the amount of collateral obtained, if deemed necessary by the Company
upon the extension of credit, is based on managements credit evaluation of the
counterparty. Collateral held varies, but includes residential and commercial
real estate.

The Company leases office space
and certain branches under noncancelable operating lease agreements having
initial terms which expire at various dates through 2019. Total rental expenses
were approximately $982,000 in 2006, $845,000 in 2005, and $669,000 in 2004.

51

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsMinimum rental payments under
the initial terms of these leases are summarized as follows (in thousands):

Year ending December 31:2007

$
9002008


8722009


8212010


7912011


804Thereafter


3,926Total
  minimum lease payments

$
8,114The Bank
entered into an agreement in 2005 with Onondaga County whereby the Bank
obtained the naming rights to a sports stadium in Syracuse, NY. for a 20-year
term. Under the agreement, the Bank paid $25,000 in 2005, $75,000 in 2006, and
will pay $120,000 in 2007, and $152,000 from 2008 through 2024.

The Company is
required to maintain a reserve balance as established by the Federal Reserve
Bank of New York. The required average total reserve for the 14-day maintenance
period ended December 31, 2006 was $2.3 million.

FASB
Interpretation No. 47 (FIN 47) issued in March 2005 clarified that the term conditional
retirement obligation as used in FASB Statement No. 143 (FAS 143), Accounting
for Asset Retirement Obligations,refers to a legal obligation to
perform an asset retirement activity in which the timing and (or) method of
settlement are conditional on a future event that may or may not be within the
control of the Company. The Company is required to recognize a liability for
the fair value of a conditional asset retirement obligation when it is
incurred, generally upon acquisition, construction, or development and (or)
through the normal operation of the asset, and if the fair value of the
liability can be reasonably estimated. FAS 143 acknowledges that in some cases
sufficient information may not be available to reasonably estimate the fair
value of an asset retirement obligation. The Company acknowledges that some of
its facilities were constructed years ago when asbestos was used for insulation
and other construction purposes. Regulations are now in place that require the
Company to handle and dispose of asbestos in a special manner if major
renovations or demolition of a facility are to be completed. The Company does
not believe that it has sufficient information to estimate the fair value of
the obligation at this time since any major renovations or demolition of any of
its facilities have not been planned and would occur at an unknown future date.
Accordingly, the Company has not recognized a liability or a contingent
liability in connection with potential future costs to remove and dispose of
asbestos from its facilities.

20. Dividends and
restrictions

The primary
source of cash to pay dividends to the Companys shareholders is through
dividends from its banking subsidiary. The Federal Reserve Board and the Office
of the Comptroller of the Currency are authorized to determine certain
circumstances that the payment of dividends would be an unsafe or unsound
practice and to prohibit payment of such dividends. The payment of dividends
that deplete a banks capital base could be deemed to constitute such an unsafe
or unsound practice. Banking organizations may generally only pay dividends
from the combined current year and prior two years net income less any
dividends previously paid during that period. At December 31, 2006, approxi­mately
$20.5 million was available for the declaration of dividends by the Bank. There
were no loans or advances from the subsidiary Bank to the Company at December
31, 2006.

21. Fair Value of
Financial Instruments

Statement of
Financial Accounting Standards No. 107, Disclosures about Fair Value of
Financial Instruments, requires disclosure of fair value information of
financial instruments, whether or not recognized in the statement of condition,
for which it is practicable to estimate that value. In cases where quoted
market prices are not available, fair values are based on estimates using
present value or other valuation techniques. Those techniques are significantly
affected by the assumptions used, including the discount rate and estimates of
future cash flows. In that regard, the derived fair value estimates cannot be
substantiated by comparison to independent markets and, in many cases, could
not be realized in immediate settlement of the instrument. Accordingly, the
aggregate fair value amounts presented do not represent the underlying value of
the Company.

The carrying amounts and
estimated fair values of financial instruments at December 31 are as follows
(in thousands):

2006

2005Carrying Amount

Fair Value

Carrying Amount

Fair ValueFinancial Assets:Cash and
  cash equivalents

$
27,398

$
27,398

$
22,878

$
22,878Investment
  securities


263,987


263,987


267,494


267,494Loans and
  leases


905,055


893,303


664,955


657,193Total Financial
  Assets

$
1,196,440

$
1,184,688

$
955,327

$
947,565Financial Liabilities:Deposits

$
935,596

$
935,997

$
739,118

$
738,369Borrowings


205,424


203,333


160,739


159,897Total
  Financial Liabilities

$
1,141,020

$
1,139,330

$
899,857

$
898,266The fair value
of commitments to extend credit and standby letters of credit is not
significant.

52

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsThe following
methods and assumptions were used by the Company in estimating its fair value
disclosures for financial instruments:

Cash and Cash Equivalents:

The carrying
amounts reported in the consolidated statements of condition for cash and
short-term instruments approximate those assets fair value.

Investment Securities:

Fair values
for investment securities are based on quoted market prices or dealer quotes.

Loans and Leases:

Fair values for
loans and leases are estimated using discounted cash flow analysis, based on
interest rates approximating those currently being offered for loans with
similar terms and credit quality. The fair value of accrued interest
approximates carrying value.

Deposits:

The fair
values disclosed for non-interest-bearing accounts and accounts with no stated
maturity are, by definition, equal to the amount payable on demand at the
reporting date. The fair value of time deposits was estimated by discounting
expected monthly maturities at interest rates approximating those currently
being offered on time deposits of similar terms. The fair value of accrued
interest approximates carrying value.

Borrowings:

The fair value
of borrowings are estimated using discounted cash flow analysis, based on
interest rates approximating those currently being offered for borrowings with
similar terms.

Off-balance-sheet Instruments:

Off-balance-sheet
financial instruments consist of commitments to extend credit and standby
letters of credit, with fair value based on fees currently charged to enter
into agreements with similar terms and credit quality.

22. Regulatory
Matters

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 table below) of total risk-based capital and Tier 1
capital (as defined in the regulations) to risk-weighted assets (as defined).
The leverage ratio (as defined in the regulations) reflects Tier 1 capital
divided by the average total assets for the period. Average assets used in the
calculation exclude the Companys intangible assets.

The capital
levels at the Companys subsidiary bank are maintained at or above the
well-capitalized minimums of 10%, 6% and 5% for the total risk-based, Tier 1
capital, and leverage ratio, respectively. As of December 31, 2005, 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. There are no conditions or events since that notification
that management believes have changed the institutions category.

On December
19, 2003, the Company formed a wholly-owned subsidiary, Alliance Financial
Capital Trust I (Trust I), a Delaware business trust. Trust I issued $10.0
million of 30-year floating rate Company-obligated pooled capital securities
(trust preferred securities). On September 21, 2006, the Company formed a
wholly-owned subsidiary, Alliance Financial Capital Trust II (Trust II), a
Delaware business trust. Trust II issued $15.0 million of 30 year floating rate
trust preferred securities. Trust preferred securities 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 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
treat trust preferred securities as Tier 1 capital up to a 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.

53

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsThe Companys regulatory
capital measures are presented in the following table (dollars in thousands):

Actual

For Capital
  Adequacy Purposes

To Be Well Capitalized Under
  Prompt Corrective
  Action ProvisionsAmount

Ratio

Amount

Ratio

Amount

RatioAs of December 31, 2006Total
  risk-based capital

$
95,510


10.97
%
$
69,631


38.00
%
$
87,039


310.00
%Tier 1
  capital


88,215


10.14
%

34,816


34.00
%

52,223


36.00
%Leverage


88,215


7. 34
%

48,083


34.00
%

60,103


35.00
%As of December 31, 2005Total
  risk-based capital

$
76,766


11.72
%
$
52,407


38.00
%
$
65,509


310.00
%Tier 1
  capital


71,604


10.93
%

26,204


34.00
%

39,305


36.00
%Leverage


71,604


7.42
%

38,597


34.00
%

48,247


35.00
%23. Parent Company
Financial Information

Condensed
financial statement information of Alliance Financial Corporation for the years
ended December 31 is as follows (in thousands):

Condensed Balance Sheets

2006

2005Assets:Investment
  in subsidiaries

$
130,095

$
73,087Cash


2,327


3,344Investment
  securities


3,690


4,009Other Assets


514


369Total Assets


136,626


80,809Liabilities:Junior
  subordinated debentures


25,774


10,310Dividends
  payable


1,057


753Other
  liabilities


289


175Total
Liabilities


27,120


11,238Shareholders Equity:Common stock


4,895


3,979Surplus


38,986


11,185Unamortized
  value of restricted stock





(1,453
)Undivided
  profits


70,658


66,740Accumulated
  other comprehensive loss


(2,122
)

(1,700
)Treasury
  stock


(2,911
)

(9,180
)Total Shareholders Equity


109,506


69,571Total Liabilities and Shareholders Equity

$
136,626

$
80,809Condensed
  Statements of Income


2006

2005

2004Dividend
  income from subsidiary Bank

$


$
2,500

$
Interest and
  dividends on securities


158


206


175Gain on the
  sale of securities





3


269Interest
  expense on junior subordinated debentures


(1,139
)

(644
)

(459
)Operating
  expenses


(87
)

(14
)

(97
)(1,068
)

2,051


(112
)Equity in
  undistributed income of subsidiaries


8,379


5,456


7,367Net Income

$
7,311

$
7,507

$
7,25554

Alliance Financial Corporation and Subsidiaries
  Notes to Consolidated Financial StatementsCondensed
Statements of Cash Flows2006

2005

2004Operating Activities:Net Income

$
7,311

$
7,507

$
7,255Adjustments to
reconcile net income to net
  cash provided by (used in) operating activities:Equity in
undistributed net income of
  subsidiary


(8,379
)

(5,456
)

(7,367
)Gains on sale
of securities available for
  sale





(3
)

(269
)Depreciation
expense


24





Net change in
other assets and liabilities


3,590


314


274Net Cash
  Provided by (Used in) Operating Activities


2,546


2,362


(107
)Investing Activities:Purchase of investment
securities,
  available-for-sale


(464
)

(198
)

(1,739
)Proceeds from sales of
investment
  securities, available-for-sale





17


507Acquisition


(13,171
)




Net Cash Used in Investing
Activities


(13,635
)

(181
)

(1,232
)Financing Activities:Proceeds from issuing
subordinated
  debentures


15,464





Treasury stock
purchased


(3,407
)

(1,225
)

Proceeds from the exercise of
stock options


1,127


252


406Cash dividends paid


(3,111
)

(3,015
)

(3,341
)Net Cash Provided by (Used in)
Financing
  Activities


10,073


(3,988
)

(2,935
)Decrease in Cash and Cash
Equivalents


(1,016
)

(1,807
)

(4,274
)Cash and Cash Equivalents at
Beginning of
  Year


3,343


5,150


9,424Cash and Cash Equivalents at
End of Year

$
2,327

$
3,343

$
5,150Supplemental Disclosures of
Cash Flow
  Information:Non-cash financing activities:Dividend
declared and unpaid

$
1,057

$
753

$
750On September 28, 2005, the
Company announced that its Board of Directors had authorized the repurchase of
up to 5% of the Companys outstanding common stock, or approximately180,000
shares, over a 12-month period commencing on October 1, 2005.  On October 5, 2006, the Companys Board of
Directors approved a six month extension of the repurchase program through
March 2007.  At December 31, 2006,
31,830 shares remain available for repurchase under the program.

On October 26, 2001 the
Companys Board of Directors adopted a shareholders rights plan. Under the
plan, Series A Junior Participating Preferred Stock Purchase Rights were
distributed at the close of business on October 29, 2001 to shareholders of
record as of that date. The Rights trade with the Common Stock, and are
exercisable and trade separately from the Common Stock only if a person or
group acquires or announces a tender or exchange offer that would result in
such person or group owning 20% or more of the Common Stock of the Company. In
the event the person or group acquires a 20% Common Stock position, the Rights
allow other holders to purchase stock of the Company at a discount to market
value. The Company is generally entitled to redeem the Rights at $.001 per
Right at any time prior to the 10th day after a person or group has acquired a
20% Common Stock position. The Rights will expire on October 29, 2011 unless
the plan is extended or the Rights are earlier redeemed or exchanged.

55

Item 9  Changes in and Disagreements with
Accountants on Accounting and Financial Disclosure

Not
applicable

Item 9A  Controls and
Procedures

REPORT OF MANAGEMENTS RESPONSIBILITY

Management is
responsible for preparation of the consolidated financial statements and
related financial information contained in all sections of this Annual Report
on Form 10-K, including the determination of amounts that must necessarily be
based on judgments and estimates. It is the belief of management that effective
internal controls over financial reporting have been designed to produce
reliable financial statements that have been prepared in conformity, in all
material respects, with generally accepted accounting principles appropriate in
the circumstances, and that the financial information appearing throughout this
annual report is consistent, in all material respects, with the consolidated
financial statements.

The Audit
Committee of the Board of Directors, composed solely of independent directors,
meets periodically with the Companys management, internal auditors and
independent registered public accounting firm, PricewaterhouseCoopers LLP, to
review matters relating to the quality of financial reporting, internal
accounting control, and the nature, extent, and results of audit efforts. The
internal auditors and independent public accounting firm have unlimited access
to the Audit Committee to discuss all such matters.

/s/ Jack H. Webb

/s/ J. Daniel
MohrChairman,
  President & CEO

Chief
  Financial Officer & TreasurerSyracuse, New
York
March 13, 2007

MANAGEMENTS
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

The Companys
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Rules 13a-15(f)
and 15d-15(f) of the Securities Exchange Act of 1934, as amended.  Because of its inherent limitations,
internal control over financial reporting may not prevent or detect
misstatements.  Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with policies or procedures may deteriorate.  The Companys internal control over
financial reporting is a process designed under the supervision of the
Companys principal executive officer and principal financial officer to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of the Companys financial statements for external
reporting purposes in accordance with Unites States generally accepted
accounting principles.

Under the
supervision and with the participation of management, including the Companys
principal executive officer and principal financial officer, the Company
conducted and evaluation of the effectiveness of its internal control over
financial reporting based on the framework in Internal Control  Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission.  Based on its evaluation
under that framework, management concluded that the Companys internal control
over financial reporting was effective as of December 31, 2006.  In addition, based on our assessment,
management has determined that there were no material weaknesses in the
Companys internal controls over financial reporting.

Managements
assessment of the effectiveness of the Companys internal control over
financial reporting as of December 31, 2006 has been audited by Pricewaterhouse
Coopers LLP, an independent registered public accounting firm, as stated in
their report appearing herein, which expresses unqualified opinions on
managements assessment and on the effectiveness of the Companys internal
control over financial reporting as of December 31, 2006.

MANAGEMENTS REPORT ON CHANGES IN INTERNAL
CONTROLS

Additionally,
there were no changes in the Corporations internal control over financial
reporting that occurred during the quarter ended December 31, 2006 that have
materially affected, or are reasonably likely to materially affect, the
Corporations internal control over financial reporting.

EVALUATION OF DISCLOSURE CONTROLS AND
PROCEDURES

The Companys
principal executive officer and principal financial officer evaluated, as of
December 31, 2006, the effectiveness of the Companys disclosure controls and
procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended).
Based on that evaluation, the Companys principal executive officer and
principal financial officer concluded that the Companys disclosure controls
and procedures as of December 31, 2006 were effective.

/s/ Jack H.
Webb
/s/ J.
Daniel MohrChairman,
  President & CEO
Chief
  Financial Officer & TreasurerSyracuse, New
York March 13, 2007
56

REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board
of Directors and Shareholders of Alliance Financial Corporation:

We have
completed integrated audits of Alliance Financial Corporations
consolidated financial statements and of its internal control over financial
reporting as of December 31, 2006 in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Our opinions, based on our audits,
are presented below.

Consolidated financial statements

In our
opinion, the accompanying Consolidated Balance Sheets and related Consolidated Statements of Income, Consolidated Statements of Changes in Shareholders Equity, Consolidated Statements of Comprehensive Income and Consolidated Statements of Cash Flows
index present fairly, in all material respects, the financial
position of Alliance Financial Corporation and its subsidiaries at December 31,
2006 and 2005, and the results of their operations and their cash flows for each of
the three years in the period ended December 31, 2006 in conformity with
accounting principles generally accepted in the United States of America. These
financial statements are the responsibility of the Companys management. Our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these statements in accordance with the
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit of financial statements includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.

Internal control over financial reporting

Also, in our
opinion, managements assessment, included in Managements Report on Internal
Control over Financial Reporting appearing under Item 9A, that the Company
maintained effective internal control over financial reporting as of December
31, 2006, based on criteria established in Internal Control  Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO), is fairly stated, in all material respects, based on those criteria.
Furthermore, in our opinion, the Company maintained, in all material respects,
effective internal control over financial reporting as of December 31, 2006,
based on criteria established in Internal Control  Integrated Framework
issued by the COSO. The Companys management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express opinions on managements assessment and on
the effectiveness of the Companys internal control over financial reporting
based on our audit. We conducted our audit of internal control over financial
reporting in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material respects.
An audit of internal control over financial reporting includes obtaining an
understanding of internal control over financial reporting, evaluating
managements assessment, testing and evaluating the design and operating
effectiveness of internal control, and performing such other procedures as we
consider necessary in the circumstances. We believe that our audit provides a
reasonable basis for our opinions.

A companys
internal control over financial reporting is a process designed to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A companys internal control over
financial reporting includes those policies and procedures that
(i) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets
of the company; (ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and
(iii) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the companys
assets that could have a material effect on the financial statements.

Because of its
inherent limitations, internal control over financial reporting may not prevent
or detect misstatements. Also, projections of any evaluation of effectiveness
to future periods are subject to the risk that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.

/s/
PricewaterhouseCoopers LLP
Syracuse, New York 
March 13, 2007

57

Item 9B  Other Information

Not applicable

PART III

Item 10  Directors and Executive Officers of
the Registrant and Corporate Governance

The information required by
this Item 10 is incorporated herein by reference to the sections entitled
Information Concerning Nominees for Directors, Directors Continuing in Office
and Executive Officers, Audit Committee Report, and Section 16 (a)
Beneficial Ownership Reporting Compliance in the Companys Proxy Statement.
The Company has adopted a Code of Ethics applicable to its Chief Executive
Officer, Chief Financial Officer, Controller and senior financial management.
The Companys Code of Ethics for Senior Officers is available at the Companys
website at www.alliancebankna.com.

Item 11  Executive
Compensation

The information required by
this Item 11 is incorporated herein by reference to the section entitled
Executive Compensation in the Companys Proxy Statement issued in connection
with its 2007 Annual Meeting of Shareholders (Proxy Statement).

Item 12  Security Ownership of Certain
Beneficial Owners and Management and Related Stockholder Matters

The information required by
this item 12 is incorporated herein by reference to the section entitled
Information Concerning Nominees For Directors, Directors Continuing In Office
And Executive Officers and Security Ownership of Certain Beneficial Owners
in the Companys Proxy Statement.

Item 13  Certain Relationships, Related
Transactions and Director Independence

The information required by
this Item 13 is incorporated herein by reference to the section entitled
Certain Transactions in the Companys Proxy Statement.

Item 14  Principal Accountant Fees and
Services

The information required by
this Item 14 is incorporated herein by reference to the section entitled
Independent Public Accountants in the Companys Proxy Statement.

58

PART IV

Item 15  Exhibits
and Financial Statement Schedules

The financial
statement schedules and exhibits filed as part of this form 10-K are as
follows:

(a) (1)
The
  following consolidated financial statements are included in Part II, Item 8
  hereof:Consolidated
  Balance Sheets at December 31, 2006 and 2005.Consolidated
  Statements of Income for the years ended December 31, 2006, 2005 and 2004.Consolidated
  Statements of Comprehensive Income for the years ended December 31, 2006,
  2005 and 2004.Consolidated
  Statements of Shareholders Equity for each of the years ended December 31,
  2006, 2005 and 2004.Consolidated
  Statements of Cash Flows for the years ended December 31, 2006, 2005 and
  2004.Notes to
  Consolidated Financial Statements.(a) (2)
Financial
  statement schedules are omitted from this Form 10-K since the required
  information is not applicable to the Company.(a) (3)
Exhibits:The following
documents are filed as Exhibits to this Form 10-K or are incorporated by
reference to the prior filings of the Company with the Securities and Exchange
Commission (the Commission).

Exhibit
Number

Exhibit3.1

Amended and
  Restated Certificate of Incorporation of the Company (incorporated herein by
  reference to exhibit 3.1 to the Companys Registration Statement on Form S-4
  (Registration No. 333-62623) filed with the Commission on August 31, 1998, as
  amended3.2

Amended and
  Restated Bylaws of the Company (incorporated herein by reference to exhibit
  number 3.2 to the Companys Current Report on Form 8-K (File No. 0-15366)
  filed with the Commission on September 3, 2004)4.1

Rights
  Agreement dated October 19, 2001 between Alliance Financial Corporation and
  American Stock Transfer & Trust Company, including the Certificate of
  Amendment to the companys Certificate of Incorporation, the form of Rights
  Certificate and the Summary of Rights attached thereto as Exhibits A, B, and
  C, respectively (incorporated herein by reference to exhibit 4.1 to the
  Companys Form 8-A12G filed with the Commission on October 25, 2001)10.1

Alliance
  Financial Corporation 1998 Long Term Incentive Compensation Plan
  (incorporated herein by reference to exhibit 10.1 to the Companys
  Registration Statement on Form S-4, Registration No. 333-62623, filed with
  the Commission on August 31, 1998, as amended)10.2

Employment
  Agreement dated July 6, 2006 by and between the Company and Jack H. Webb
  (incorporated herein by reference to exhibit 10.1 of the Companys Current
  Report on Form 8-K filed with the Commission on July 7, 2006)10.3

Change of
  Control Agreement, dated as of February 16, 1999, by and among the Company,
  First National Bank of Cortland, Oneida Valley National Bank, and James W.
  Getman (incorporated herein by reference to exhibit 10.2 to the Companys
  Quarterly Report on Form 10-Q filed with the Commission on May 17, 1999)10.4

Directors
  Compensation Deferral Plan of the Company (incorporated herein by reference
  to exhibit 10.1 to the Companys Quarterly Report on Form 10-Q filed with the
  Commission on August 13, 1999)10.5

Supplemental
  Retirement Agreement, dated as of May 1, 2000, by and among the Company,
  Alliance Bank, N.A. and Jack H. Webb (incorporated herein by reference to
  exhibit 10.2 to the Companys Quarterly Report on Form 10-Q filed with the
  Commission on August 14, 2000)10.6

First
  National Bank of Cortland Excess Benefit Plan for David R. Alvord, dated
  December 31, 1991, and all amendments thereto (incorporated herein by reference
  to exhibit 10.13 to the Companys Annual Report on Form 10-K filed with the
  Commission on March 30, 2001)10.7

Oneida
  Valley National Bank Supplemental Retirement Income Plan for John C. Mott,
  dated September 1, 1997, and all amendments thereto (incorporated herein by
  reference to exhibit 10.14 to the Companys Annual Report on Form 10-K filed
  with the Commission on March 29, 2002)10.8

Change of
  Control Agreement, dated May 3, 2006 by and between the Company and J. Daniel
  Mohr (incorporated by reference to exhibit 10.2 to the Companys Current
  Report on Form 8-K filed with the Commission on May 4, 2006)10.9

Employment Agreement dated October 6, 2005 by and among
the Company
  and John H. Watt Jr. (incorporated herein by reference to exhibit number 10.1
  to the Companys Quarterly Report on Form 10-Q filed with the Commission on
  November 3, 2005)10.10

Director Supplemental Retirement Benefit Plan of Oswego
County
  Savings Bank, dated as of March 15, 200010.11

Oswego County National Bank Voluntary Deferred
Compensation Plan for
  Directors, Amended and Restated effective January 1, 200510.12

Agreement and Plan of Merger by and between Alliance
Financial
  Corporation and Bridge Street Financial, Inc. (incorporated herein by
  reference to Appendix A to the Companys Regisration Statement on Form S-4/A
  (Registration No. 333-135141) filed with the Commission on July 25, 2006)21

List of the
  Companys Subsidiaries59

23

Consent of PricewaterhouseCoopers LLP31.1

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 200231.2

Certification of J. Daniel Mohr, Treasurer and Chief
Financial
  Officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act
  of 200232.1

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 200232.2

Certification of J. Daniel Mohr, 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(b)

See Item
  15(a)(3) above.(c)

See Item
  15(a)(2) above.60

SIGNATURES



Pursuant to the requirements of Section 13 or 15(d) 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(Registrant)DateMarch 13, 2007
        
        By/s/ Jack H. WebbJack H. Webb, Chairman, President & CEO(Principal Executive Officer)DateMarch 13, 2007
        
        By/s/J. Daniel MohrJ. Daniel Mohr, Treasurer & CFO(Principal Financial and Accounting Officer)  Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant, and in the capacities and on the dates indicated.  /s/ Mary Pat Adams
        DateMarch 15, 2007Mary Pat Adams, Director/s/ Donald S. Ames
        DateMarch 15, 2007Donald S. Ames, Director/s/Donald H. Dew
        DateMarch 15, 2007Donald H. Dew, Director__________________________________
        Date___________________________Peter M. Dunn, Director/s/ John M. Endries
        DateMarch 15, 2007John M. Endries, Director/s/ Samuel J. Lanzafame
        DateMarch 15, 2007Samuel J. Lanzafame, Director/s/ Margaret G. Ogden
        DateMarch 15, 2007Margaret G. Ogden, Director/s/ Lowell A. Seifter
        DateMarch 15, 2007Lowell A. Seifter, Director__________________________________
        Date___________________________Charles E. Shafer, Director__________________________________
        Date___________________________Charles H. Spaulding, Director__________________________________
        Date___________________________Paul M. Solomon, Director/s/Deborah F. Stanley
        DateMarch 15, 2007Deborah F. Stanley, Director/s/ Jack H. Webb
        DateMarch 15, 2007Jack H. Webb, Chairman, President& CEO and Director(Principal Executive Officer) 61