My house is located in the Buffalo area of NY. It is a brick cape built in 1927. I recently discovered that the cold air returns are on the outside walls and the heat registers are on the inside walls of the house. Is this the way it is supposed to be?

If it ain't broke, don't fix it. Some modern systems have the supply registers under the windows, and the return grilles centrally located, but if your house has worked well for over 80 years, don't mess with it.

Yes and no.
Many years ago the theory was to put the return ducts on the exteior wall with the thought being draw the cold air from the outside walls before it gets into the rest of the room.
Well with new understandings of how the heat moves within a room, that theory changed late 60's early 70's Now we put the returns in the middle of home with supplys on outside walls.

If you next question would be can I change them around? Again Yes and no.
You cannot change them by leaving the ducts the way they are. You would need to remove them right up to the point where they enter the wall. Then re-duct them with proper supply and return duct sizes.
Not worth the effort unless your doing a complete home re-build.

consult a local hvac installer. It may be as simple as changing the intake and outake at the furnace, just make sure the supply and returns are sized the same. consult a local hvac company.

I must disagree. Its not that simple as switching the duct around at the heating system. The ducts have been sized to deliver the air properly. The ducts have been sized for air flow only in one direction. It will not work properly if you did so. It would end up costing you more in heat bills and you would have less efficency.
Quite frankly there is no reaon to switch the ducts around. The cost of doing so would never be paid back by savings and comfort.