**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-K**





**x**
            **ANNUAL
                REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
                1934****For the fiscal year ended December
              31, 2007**OR**o**
            **TRANSITION REPORT
              PURSANT
              TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
              1934****For transition period from
              __________
              to __________**





**Commission
      file number 000-30497**








(Exact
      Name of Registrant as Specified in its
      Charter)




**Tennessee**
            **62-1173944***(State
                of Incorporation)*
            *(I.R.S.
                Employer Identification No .)*





**835
      Georgia Avenue,**


**Chattanooga,
      TN 37402**


*(Address
      of principal executive offices)(Zip Code)*





**(423)
      385-3000**


*(Registrant’s
      telephone number, including area code)*





**Securities
      registered pursuant to Section 12(b) of the Act: None**





**Securities
      registered pursuant to Section 12(g) of the Act:**


**Common
      Stock, $1.00 Par Value**





Indicate
      by check mark if Registrant is a well known seasoned issuer, as defined in
      Rule
      405 of the of the Securities Act.


Yes
o No
x





Indicate
      by check mark if 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 and 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 (229.405 of this chapter) 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




The
      aggregate market value of the common stock held by non-affiliates of the
      Registrant on June 30, 2007 was $78 million. The market value calculation
      was determined using the closing sale price of the Registrant’s common stock on
      June 30, 2007, as reported on the Over the Counter (“OTC”) Bulletin Board.
      For purposes of this calculation, the term “affiliate” refers to all directors,
      executive officers and 10% shareholders of the Registrant. As of the close
      of
      business on December 31, 2007 there were 6,369,718 shares of the Registrant’s
      common stock outstanding.




**DOCUMENTS
      INCORPORATED BY REFERENCE**




The
      following lists the documents incorporated by reference and the Part of the
      Form 10-K into which the document is incorporated:




1.  Portions
      of Proxy Statement for the 2008 Annual Meeting of Shareholders.
      (Part III)







**TABLE
      OF CONTENTS**


Item
                  No.
              
              
              Page
                  No.**PART
                  I**1.
              Description
                  of Business
              
              11A.
              Risk
                  Factors
              
              61B.
              Unresolved
                  Staff Comments
              
              92.
              Description
                  of Property
              
              93.
              Legal
                  Proceedings
              
              104.
              Submission
                  of Matters to a Vote of Security Holders
              
              10**PART
                  II**5.
              Market
                  for Common Equity, Related Stockholders Matters and Issuer Purchases
                  ofEquity
                  Securities
              
              106.
              Selected
                  Financial Data
              
              117.
              Management's
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              
              138.
              Financial
                  Statements
              
              319.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              
              689A.
              Controls
                  and Procedures
              
              68**PART
                  III**10.
              Directors
                  and Executive Officers of the Registrant
              
              6811.
              Executive
                  Compensation
              
              6912.
              Security
                  Ownership of Certain Beneficial Owners and Management and
                  relatedStockholder
                  Matters
              
              6913.
              Certain
                  Relationships and Related Transactions
              
              6914.
              Principal
                  Accountant Fees and Services
              
              6915.
              Exhibits
                  and Reports on Form 8-K
              
              69


**FORWARD-LOOKING
      STATEMENTS**




Cornerstone
      Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral
      statements, including statements contained in this report which may constitute
      forward-looking statements within the meaning of Section 21E of the
      Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,”
“anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,”
“estimate,” and similar expressions are intended to identify such
      forward-looking statements, but other statements may constitute forward-looking
      statements. These statements should be considered subject to various risks
      and
      uncertainties. Such forward-looking statements are made based upon management’s
      belief as well as assumptions made by, and information currently available
      to,
      management pursuant to “safe harbor” provisions of the Private Securities
      Litigation Reform Act of 1995. Cornerstone’s actual results may differ
      materially from the results anticipated in forward-looking statements due to
      a
      variety of factors. Such factors are described below and in Cornerstone’s Form
      10-K, as updated by Item 1A of part II of this Form 10-Q and include,
      without limitation, (i) unanticipated deterioration in the financial
      condition of borrowers resulting in significant increases in loan losses and
      provisions for those losses, (ii) increased competition with other
      financial institutions, (iii) lack of sustained growth in the economy in
      the Chattanooga, Tennessee area, (iv) rapid fluctuations or unanticipated
      changes in interest rates, (v) the inability of our bank subsidiary,
      Cornerstone Community Bank, to satisfy regulatory requirements for its expansion
      plans, (vi) the inability of Cornerstone to achieve its targeted expansion
      goals in the Knoxville, Tennessee and Dalton, Georgia markets, (vii) the
      inability of Cornerstone to grow its loan portfolio at historic or planned
      rates
      and (viii) changes in the legislative and regulatory environment, including
      compliance with the various provisions of the Sarbanes-Oxley Act of 2002. Many
      of such factors are beyond Cornerstone’s ability to control or predict, and
      readers are cautioned not to put undue reliance on such forward-looking
      statements. Cornerstone does not intend to update or reissue any forward-looking
      statements contained in this report as a result of new information or other
      circumstances that may become known to Cornerstone.








**PART
      I**




**ITEM
      1. DESCRIPTION OF BUSINESS**





**OVERVIEW**





Cornerstone
      was incorporated on September 19, 1983 under the laws of the State of Tennessee
      and is a bank holding company registered under the Bank Holding Company Act
      of
      1956, as amended, and was formerly known as East Ridge Bancshares, Inc. It
      has
      two wholly-owned subsidiaries: Cornerstone Community Bank, a Tennessee banking
      corporation (the “Bank”), resulted from the merger of The Bank of East Ridge and
      Cornerstone Community Bank effective October 15, 1997, and Eagle Financial
      Inc.,
      a Tennessee corporation (“Eagle”), created December 1, 2005 with the assets
      acquired from Eagle Financial, LLC, a Tennessee limited liability company,
      and
      Eagle Funding, LLC, a Nevada limited liability company.





***Cornerstone***





The
      primary activity of Cornerstone currently is, and is expected to remain for
      the
      foreseeable future, the ownership and operation of the Bank. As a bank holding
      company, Cornerstone intends to facilitate the Bank's ability to serve its
      customers' requirements for financial services. The holding company structure
      also provides flexibility for expansion through the possible acquisition of
      other financial institutions and the provision of additional banking-related
      services, as well as certain non-banking services, which a traditional
      commercial bank may not provide under present laws. The holding company
      structure also affords additional flexibility in terms of capital formation
      and
      financing opportunities.





While
      Cornerstone may seek in the future to acquire additional banks or bank holding
      companies or to engage in other activities appropriate for bank holding
      companies under appropriate circumstances as permitted by law, Cornerstone
      currently has no plans, understandings or agreements concerning any other
      activities other than as described below. The results of operations and
      financial condition of Cornerstone for the foreseeable future, therefore, will
      be determined primarily by the results of operations and financial condition
      of
      the Bank.





***The
      Bank***





The
      Bank
      is a Tennessee-chartered commercial bank established in 1985 which has its
      principal executive offices in Chattanooga, Tennessee. The principal business
      of
      the Bank consists of attracting deposits from the general public and investing
      those funds, together with funds generated from operations and from principal
      and interest payments on loans, primarily in commercial loans, commercial and
      residential real estate loans, consumer loans and residential and commercial
      construction loans. Funds not invested in the loan portfolio are invested by
      the
      Bank primarily in obligations of the U.S. Government, U.S. Government agencies,
      various states and their political subdivisions. In addition to deposits,
      sources of funds for the Bank loans and other investments include amortization
      and prepayment of loans, sales of loans or participations in loans, sales of
      its
      investment securities and borrowings from other financial institutions. The
      principal sources of income for the Bank are interest and fees collected on
      loans, fees collected on deposit accounts and interest and dividends collected
      on other investments. The principal expenses of the Bank are interest paid
      on
      deposits, employee compensation and benefits, office expenses and other overhead
      expenses.





At
      December 31, 2007, the Bank had 5 full-service banking offices located in
      Hamilton County, Tennessee.





During
      2007, the Bank established two loan production offices (“LPO”). The first LPO
      opened by the Bank is located in Dalton, Georgia. The new office which is
      located in Whitfield County, Georgia expanded the Bank’s presence in North
      Georgia and represents the Bank’s first effort to service North West Georgia.
      The second LPO is located in Knoxville, Tennessee. The Knoxville LPO offers
      a
      new market for the Bank to compete for loans.





***Eagle***





Eagle’s
      business concentrates on the purchase of account receivables from small
      businesses and commercial loan placement on a conduit basis. The principal
      sources of Eagle’s income are fees derived from the collection of accounts
      receivable and fees generated from the placement of loans with conduit financial
      institutions. Eagle’s principal expenses are interest paid on borrowings,
      employee compensation and benefits, office expenses and other overhead
      expenses





***Employees***





As
      of
      December 31, 2007, Cornerstone had 116 full-time equivalent employees. The
      employees are not represented by a collective bargaining unit. Cornerstone
      believes that its relationships with its employees are good.




1





***Competition***





All
      phases of the Bank’s banking activities are highly competitive. The Bank
      competes actively with twenty-four commercial banks, as well as finance
      companies, credit unions, and other financial institutions located in its
      service area, which includes Hamilton County, Tennessee.





The
      Bank’s deposits totaled approximately $313 million as of December 31, 2007.
      The deposit base represents approximately 4% of the deposit base in the
      Chattanooga, Tennessee-Georgia Metropolitan Statistical Area (“Chattanooga
      MSA”). Three major regional banks represent approximately 58% of the deposits in
      the Chattanooga MSA. These larger financial institutions have greater resources,
      higher lending limits than the Bank, and each of the three institutions has
      over
      20 branches in the Chattanooga MSA. There are also several credit unions located
      in Hamilton County. Credit unions are not subject to the same income tax
      structure as commercial banks. This advantage enables credit unions to offer
      competitive rates to potential customers. The Bank also faces competition in
      certain areas of its business from mortgage banking companies, consumer finance
      companies, insurance companies, money market mutual funds and investment banking
      firms, some of which are not subject to the same degree of regulation as the
      Bank.





The
      Bank
      competes for deposits principally by offering depositors a variety of deposit
      programs with competitive interest rates, quality service and convenient
      locations and hours. The Bank will focus its resources to seek out and attract
      small business relationships and take advantage of the Bank’s ability to provide
      flexible service that meets the needs of this customer class. Management feels
      this market niche is the most promising business area for the future growth
      of
      the Bank.





***Supervision
      and Regulation***





Cornerstone
      is a bank holding company within the meaning of the Bank Holding Company Act
      of
      1956, as amended (the “Act”) and is registered with and regulated by the Board
      of Governors of the Federal Reserve System (the “Board”). Cornerstone is
      required to file with the Board annual reports and such additional information
      as the Board may require pursuant to the Act. The Board may also make
      examinations of Cornerstone and its subsidiaries. Cornerstone is also required
      to comply with the rules and regulations of the Securities and Exchange
      Commission (the “Commission”) under federal securities laws.





The
      Bank
      is a Tennessee-chartered commercial bank and is subject to the supervision
      and
      regulation of the Tennessee Department of Financial Institutions (the “TDFI”).
      In addition, the Bank’s deposit accounts are insured up to applicable limits by
      the Bank Insurance Fund (the “BIF”) of the Federal Deposit Insurance Corporation
      (the “FDIC”) and consequently, the Bank is also subject to regulation and
      supervision by the FDIC. The Bank is not a member of the Federal Reserve
      System.





Federal
      and state banking laws and regulations govern all areas of the operation of
      Cornerstone and the Bank, including reserves, loans, mortgages, capital,
      issuance of securities, payment of dividends and establishment of branches.
      Federal and state banking agencies also have the general authority to limit
      the
      dividends paid by insured banks if such payments should be deemed to constitute
      an unsafe or unsound banking practice. The TDFI, FDIC and Board have the
      authority to impose penalties, initiate civil and administrative actions and
      take other steps intended to prevent banks from engaging in unsafe or unsound
      practices.





***FDIC
      Insurance of Deposit Accounts***





Deposits
      of the Bank are insured by the FDIC to a maximum of $100,000 for each insured
      depositor (higher limits apply to certain retirement plans) through the BIF,
      one
      of the two deposit insurance funds established by federal law. As an insurer,
      the FDIC issues regulations, conducts examinations and generally supervises
      the
      operations of its insured institutions (institutions insured by the FDIC
      hereinafter are referred to as "insured institutions"). Any insured institution
      which does not operate in accordance with or conform to FDIC regulations,
      policies and directives, may be sanctioned for non-compliance. For example,
      proceedings may be instituted against an insured institution if the institution
      or any director, officer or employee thereof engages in unsafe and unsound
      practices, is operating in an unsafe or unsound condition, or has violated
      any
      applicable law, regulation, rule, order or condition imposed by the FDIC. If
      insurance of accounts is terminated by the FDIC, the deposits in the institution
      will continue to be insured by the FDIC for a period of two years following
      the
      date of termination. The FDIC recommends an annual audit by independent
      accountants and also periodically makes its own examinations of the Bank. The
      FDIC may revalue assets of an institution, based upon appraisals, and require
      establishment of specific reserves in amounts equal to the difference between
      such reevaluation and the book value of the assets.





On
      September 15, 1992, the FDIC approved final regulations adopting a risk-related
      deposit insurance system. The risk-related regulations, which became effective
      January 1, 1993, resulted in a significant spread between the highest and lowest
      deposit insurance premiums. Under the risk-related insurance regulations, each
      insured depository institution is assigned to one of three risk classifications:
      "well capitalized," "adequately capitalized," or "under capitalized." Within
      each risk classification, there are three subgroups. Each insured depository
      institution is assigned to one of these subgroups within its risk classification
      based upon supervisory evaluations submitted to the FDIC by the institution’s
      primary federal regulator **.** The
      FDIC
      may terminate its insurance of deposits if it finds that the institution has
      engaged in unsafe and unsound practices, is in an unsafe or unsound condition
      to
      continue operations, or has violated any applicable law, regulation, rule,
      order
      or condition imposed by the FDIC. ****




2





Subsequent
      to the enactment of the Financial Institutions Reform, Recovery and Enforcement
      Act of 1989 (“FIRREA”), the FDIC issued risk-based bank capital guidelines which
      went into effect in stages through 1992. In accordance with the FDIC's
      risk-based standards, an institution's assets and off-balance sheet activities
      are categorized into one of four risk categories, with either a 0%, 20%, 50%,
      or
      100% amount of capital to be held against these assets. In addition, the
      guidelines divide capital instruments into Tier 1 (core) capital and Tier 2
      (supplementary) capital. The risk-based capital adequacy guidelines require
      that
      (i) Tier 1 capital equal or exceed 4% of risk-weighted assets; (ii) Tier 2
      capital may not exceed 100% of Tier 1 capital, although certain Tier 2 capital
      elements are subject to additional limitations; (iii) assets and off-balance
      sheet items must be weighted according to risk; and (iv) the total capital
      to
      risk-weighted assets ratio must be at least 8.0%. The FDIC's current leverage
      capital requirement requires banks receiving the highest regulatory rating
      based
      upon the FDIC's routine examination process, to maintain Tier 1 capital equal
      to
      3.0% of the bank's total assets. Banks receiving lower regulatory ratings are
      required to maintain Tier 1 capital in an amount that is at least 100 to 200
      basis points higher than 3.0% of total assets.





Certain
      provisions of the Federal Reserve Act, made applicable to the Bank by Section
      18(j) of the Federal Deposit Insurance Act (“FDIA”)
      (12 U.S.C. §1828(j)) and administered with respect to the Bank by the
      FDIC, establish standards for the terms of, limit the amount of, and establish
      collateral requirements with respect to any loans or extensions of credit to,
      and investments in, affiliates by the Bank as well as set arms-length criteria
      for such transactions and for certain other transactions (including payment
      by
      the Bank for services) between the Bank and its affiliates. In addition, related
      provisions of the Federal Reserve Act and the Federal Reserve regulations (also
      administered with respect to the Bank by the FDIC) limit the amounts of, and
      establish required procedures and credit standards with respect to, loans and
      other extensions of credit to officers, directors and principal shareholders
      of
      the Bank and to related interests of such persons.





The
      FDIC
      may impose sanctions on any insured bank that does not operate in accordance
      with FDIC regulations, policies and directives. Proceedings may be instituted
      against any insured bank or any director, officer or employee of the bank that
      is believed by the FDIC to be engaged in unsafe or unsound practices, including
      violation of applicable laws and regulations. The FDIC is also empowered to
      assess civil penalties against companies or individuals who violate certain
      federal statutes, orders or regulations. In addition, the FDIC has the authority
      to terminate insurance of accounts, after notice and hearing, upon a finding
      by
      the FDIC that the insured institution is or has engaged in any unsafe or unsound
      practice that has not been corrected, or is in an unsafe or unsound condition
      to
      continue operations or has violated any applicable law, regulation, rule or
      order of, or condition imposed by, the FDIC. Neither Cornerstone nor the Bank
      knows of any past or current practice, condition or violation that might lead
      to
      termination of its deposit insurance.





Although
      the Bank is not a member of the Federal Reserve System, it is subject to Board
      regulations that require it to maintain reserves against its transaction
      accounts (primarily checking accounts). Because reserves generally must be
      maintained in cash or in non-interest bearing accounts, the effect of the
      reserve requirements is to increase the Bank's cost of funds. The Board
      regulations currently require that average daily reserves be maintained against
      transaction accounts in the amount of 3% of the aggregate of such net
      transaction accounts up to $52.6 million, plus 10% of the total in excess of
      $52.6 million.





***State
      of Tennessee Supervision and Regulation***





As
      a
      State of Tennessee-chartered commercial bank, the Bank is subject to various
      state laws and regulations which limit the amount that can be loaned to a single
      borrower, the types of permissible investments, and geographic and new product
      expansion, among other things. The Bank must submit an application to, and
      receive the approval of, the TDFI before opening a new branch office or merging
      with another financial institution. The Commissioner of the TDFI has the
      authority to enforce state laws and regulations by ordering a director, officer
      or employee of the Bank to cease and desist from violating a law or regulation
      or from engaging in unsafe or unsound banking practices.





Tennessee
      law contains limitations on the interest rates that may be charged on various
      types of loans and restrictions on the nature and amount of loans that may
      be
      granted and on the type of investments which may be made. The operations of
      banks are also affected by various consumer laws and regulations, including
      those relating to equal credit opportunity and regulation of consumer lending
      practices. All Tennessee banks, including the Bank, must become and remain
      insured under the FDIA.





State
      banks are subject to regulation by the TDFI with regard to capital requirements
      and the payment of dividends. Tennessee has adopted the provisions of the
      Board’s Regulation O with respect to restrictions on loans and other extensions
      of credit to bank “insiders”. Further, under Tennessee law, state banks are
      prohibited from lending to any one person, firm or corporation amounts more
      than
      fifteen percent (15%) of the Bank equity capital accounts, except (i) in the
      case of certain loans secured by negotiable title documents covering readily
      marketable nonperishable staples, or (ii) with the prior approval of the Bank’s
      board of directors or finance committee (however titled), the Bank may make
      a
      loan to any person, firm or corporation of up to twenty-five percent (25%)
      of
      its equity capital accounts. Tennessee law requires that dividends be paid
      only
      from retained earnings (or undivided profits) except that dividends may be
      paid
      from capital surplus with the prior, written consent of the TDFI. Tennessee
      laws
      regulating banks require certain charges against and transfers from an
      institution’s undivided profits account before undivided profits can be made
      available for the payment of dividends.




3





***Federal
      Supervision and Regulation*** **





Cornerstone
      is regularly examined by the Board, and the Bank is supervised and examined
      by
      the FDIC. Cornerstone is required to file with the Board annual reports and
      other information regarding its business operations and the business operations
      of its subsidiaries. Approval of the Board is required before Cornerstone may
      acquire, directly or indirectly, ownership or control of the voting shares
      of
      any bank, if, after such acquisition, Cornerstone would own or control, directly
      or indirectly, more than 5% of the voting stock of the bank. In addition,
      pursuant to the provisions of the Act and the regulations promulgated
      thereunder, Cornerstone may only engage in, or own or control companies that
      engage in, activities deemed by the Board to be so closely related to banking
      as
      to be a proper incident thereto.





The
      Bank
      and Cornerstone are “affiliated” within the meaning of the Act. Certain
      provisions of the Act establish standards for the terms of, limit the amount
      of,
      and establish collateral requirements with respect to, any loans or extensions
      of credit to, and investments in, affiliates by the Bank, as well as set
      arms-length criteria for such transactions and for certain other transactions
      (including payment by the Bank for services under any contract) between the
      Bank
      and its affiliates. In addition, related provisions of the Act and the
      regulations promulgated under the Act limit the amounts of, and establish
      required procedures and credit standards with respect to, loans and other
      extensions of credit to officers, directors, and principal shareholders of
      the
      Bank, Cornerstone and any other subsidiary of the Cornerstone, and to related
      interests of such persons.





In
      addition to the banking regulations imposed on Cornerstone, the securities
      of
      Cornerstone are not exempt from the federal and state securities laws as are
      the
      securities of the Bank. Accordingly, an offering of Cornerstone’s securities
      must be registered under both the Securities Act of 1933 (the “Securities Act”)
      and state securities laws or qualify for exemptions from registration.





Under
      Section 106(b) of the 1970 Amendments to the Act (12 U.S.C. § 1972), the Bank is
      prohibited from extending credit, selling or leasing property or furnishing
      any
      service to any customer on the condition or requirement that the customer (i)
      obtain any additional property, service or credit from the Company, the Bank
      (other than a loan, discount, deposit, or trust service) or any other subsidiary
      of the Company; (ii) refrain from obtaining any property, credit or service
      from
      any competitor of Cornerstone, the Bank or any subsidiary of Cornerstone; or
      (iii) provide any credit, property or service to Cornerstone, the Bank (other
      than those related to and usually provided in connection with a loan, discount,
      deposit or trust service) or any subsidiary of Cornerstone.





Most
      bank
      holding companies are required to give the Board prior written notice of any
      purchase or redemption of their outstanding equity securities if the gross
      consideration for the purchase or redemption, when combined with the net
      consideration paid for all such purchases or redemptions during the preceding
      12
      months, is equal to 10% or more of the bank holding company's consolidated
      net
      worth. The Board may disapprove such a purchase or redemption if it determines
      that the proposal constitutes an unsafe or unsound practice that would violate
      any law, regulation, Board order or directive or any condition imposed by,
      or
      written agreement with, the Board. The prior notice requirement does not apply
      to certain "well-capitalized" bank holding companies that meet specified
      criteria.





In
      November 1985, the Board adopted its Policy Statement on Cash Dividends Not
      Fully Covered by Earnings. The Policy Statement sets forth various guidelines
      that the Board believes that a bank holding company should follow in
      establishing its dividend policy. In general, the Board stated that bank holding
      companies should not pay dividends except out of current earnings and unless
      the
      prospective rate of earnings retention by the holding company appears consistent
      with its capital needs, asset quality and overall financial
      condition.





***Legislation
      Affecting Cornerstone and the Bank*** **





The
      following information describes certain statutory and regulatory provisions
      and
      is qualified in its entirety by reference to such statutory and regulatory
      provisions.





Far-reaching
      legislation, including FIRREA and the Federal Deposit Insurance Corporation
      Improvement Act of 1991 (“FDICIA”) have for years impacted the business of
      banking. FIRREA primarily affected the regulation of savings institutions rather
      than the regulation of state banks and bank holding companies like the Bank
      and
      Cornerstone, but did include provisions affecting deposit insurance premiums,
      acquisitions of thrifts by banks and bank holding companies, liability of
      commonly controlled depository institutions, receivership and conservatorship
      rights and procedures and substantially increased penalties for violations
      of
      banking statutes, regulations and orders.




4





FDICIA
      resulted in extensive changes to the federal banking laws. The primary purpose
      of FDICIA was to authorize additional borrowings by the FDIC in order to assist
      in the resolution of failed and failing financial institutions. However, the
      law
      also instituted certain changes to the supervisory process and contained various
      provisions affecting the operations of banks and bank holding companies.





The
      additional supervisory powers and regulations mandated by FDICIA, include a
      "prompt corrective action" program based upon five regulatory zones for banks,
      in which all banks are placed largely based on their capital positions.
      Regulators are permitted to take increasingly harsh action as a bank's financial
      condition declines. Regulators are also empowered to place in receivership
      or
      require the sale of a bank to another depository institution when a bank's
      capital leverage ratio reaches two percent. Better capitalized institutions
      are
      generally subject to less onerous regulation and supervision than banks with
      lesser amounts of capital. The FDIC has adopted regulations implementing the
      prompt corrective action provisions of the FDICIA, which place financial
      institutions in the following five categories based upon capitalization ratios:
      (1) a "well capitalized" institution has a total risk-based capital ratio of
      at
      least 10%, a Tier 1 risk-based ratio of at least 6% and a leverage ratio of
      at
      least 5%; (2) an "adequately capitalized" institution has a total risk-based
      ratio of at least 8%, a Tier 1 risk-based ratio of at least 4% and a leverage
      ratio of at least 4%; (3) an "undercapitalized" institution has a total
      risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of
      under
      4% or a leverage ratio of under 4%; (4) a "significantly undercapitalized"
      institution has a total risk-based capital ratio of under 6%, a Tier 1
      risk-based ratio of under 3% or a leverage ratio of under 3%; and (5) a
      "critically undercapitalized" institution has a leverage ratio of 2% or less.
      Institutions in any of the three undercapitalized categories would be prohibited
      from declaring dividends or making capital distributions. The proposed
      regulations also establish procedures for "downgrading" an institution to a
      lower capital category based on supervisory factors other than capital. Various
      other sections of the FDICIA impose substantial audit and reporting requirements
      and increase the role of independent accountants and outside directors. Set
      forth below is a list containing certain significant provisions of the
      FDICIA:





·
            annual
                on-site examinations by regulators (except for smaller, well-capitalized
                banks with high management ratings, which must be examined every
                18
                months);


·
            mandated
                annual independent audits by independent public accountants and an
                independent audit committee of outside directors for institutions
                with
                more than $500,000,000 in assets;


·
            new
                uniform disclosure requirements for interest rates and terms of deposit
                accounts;


·
            a
                requirement that the FDIC establish a risk-based deposit insurance
                assessment system;


·
            authorization
                for the FDIC to impose one or more special assessments on its insured
                banks to recapitalize the BIF;


·
            a
                requirement that each institution submit to its primary regulators
                an
                annual report on its financial condition and management, which report
                will
                be available to the public;


·
            a
                ban on the acceptance of brokered deposits except by well capitalized
                institutions and by adequately capitalized institutions with the
                permission of the FDIC and the regulation of the brokered deposit
                market
                by the FDIC;


·
            restrictions
                on the activities engaged in by state banks and their subsidiaries
                as
                principal, including insurance underwriting, to the same activities
                permissible for national banks and their subsidiaries unless the
                state
                bank is well capitalized and a determination is made by the FDIC
                that the
                activities do not pose a significant risk to the insurance
                fund;


·
            a
                review by each regulatory agency of accounting principles applicable
                to
                reports or statements required to be filed with federal banking agencies
                and a mandate to devise uniform requirements for all such
                filings;


·
            the
                institution by each regulatory agency of noncapital safety and soundness
                standards for each institution it regulates which cover (1) internal
                controls, (2) loan documentation, (3) credit underwriting, (4) interest
                rate exposure, (5) asset growth, (6) compensation, fees and benefits
                paid
                to employees, officers and directors, (7) operational and managerial
                standards, and (8) asset quality, earnings and stock valuation standards
                for preserving a minimum ratio of market value to book value for
                publicly
                traded shares (if feasible);


·
            uniform
                regulations regarding real estate lending;
                and


·
            a
                review by each regulatory agency of the risk-based capital rules
                to ensure
                they take into account adequate interest rate risk, concentration
                of
                credit risk, and the risks of non-traditional
                activities.





The
      activities permissible to Cornerstone and the Bank were substantially expanded
      by the Gramm-Leach-Bliley Act (the “Gramm Act”). The Gramm Act repeals the
      anti-affiliation provisions of the Glass-Steagall Act to permit the common
      ownership of commercial banks, investment banks and insurance companies. The
      Gramm Act amended the Act to permit a financial holding company to engage in
      any
      activity and acquire and retain any company that the Board determines to be
      (i)
      financial in nature or incidental to such financial activity, or (ii)
      complementary to a financial activity and that does not pose a substantial
      risk
      to the safety and soundness of depository institutions or the financial system
      generally. The Gramm Act also modifies current law relating to financial privacy
      and community reinvestment. The new financial privacy provisions generally
      prohibit financial institutions, including the Bank and Cornerstone, from
      disclosing nonpublic personal financial information to third parties unless
      customers have the opportunity to “opt out” of the disclosure.




5





Bills
      are
      regularly introduced in both the United States Congress and the Tennessee
      General Assembly that contain wide-ranging proposals for altering the
      structures, regulations and competitive relationships of the nation’s financial
      institutions. It cannot be predicted whether or what form any proposed
      legislation will be adopted or the extent to which the business of Cornerstone
      or the Bank may be affected thereby.





**ITEM
      1A. RISK FACTORS**





*Investing
      in our common stock involves various risks which are particular to Cornerstone,
      its industry and its market area. Several risk factors regarding investing
      in
      our common stock are discussed below. This listing should not be considered
      as
      all-inclusive. If any of the following risks were to occur, we may not be able
      to conduct our business as currently planned and our financial condition or
      operating results could be negatively impacted. These matters could cause the
      trading price of our common stock to decline in future
      periods.*





***Cornerstone’s
      business strategy includes expansion into new markets and the development of
      new
      products.***





Cornerstone
      intends to continue pursuing a growth strategy for its business through
      acquisitions and de novo branch openings. Cornerstone’s prospects must be
      considered in light of the risks, expenses and difficulties occasionally
      encountered by financial services companies in growth stages, which
      may include the following:


·
            Maintaining
                loan quality;


·
            Maintaining
                adequate management personnel and information systems to oversee
                such
                growth; and


·
            Maintaining
                adequate internal control and compliance functions.





***Cornerstone
      may face risks with respect to future expansion.***





From
      time
      to time Cornerstone may engage in additional de novo branch expansion as
      well as the acquisition of other financial institutions or parts of those
      institutions. Cornerstone may also consider and enter into new lines of
      business or offer new products or services. In addition, Cornerstone
      may receive future inquiries and have discussions regarding acquisition.
      Acquisitions and mergers involve a number of risks, including:


·
            the
                time and costs associated with identifying and evaluating potential
                acquisitions and merger partners;


·
            inaccuracies
                in the estimates and judgments used to evaluate credit, operations,
                management and market risks with respect to the target institution;


·
            the
                time and costs of evaluating new markets, hiring experienced local
                management and opening new offices, and the time lags between these
                activities and the generation of sufficient assets and deposits to
                support
                the costs of the expansion;


·
            Cornerstone’s
                ability to finance an acquisition and possible dilution to its existing
                shareholders;


·
            the
                diversion of Cornerstone’s management’s attention to the negotiation of a
                transaction, and the integration of the operations and personnel
                of the
                combining businesses;


·
            entry
                into new markets where Cornerstone lacks experience;


·
            the
                introduction of new products and services into Cornerstone’s business;


·
            the
                incurrence and possible impairment of goodwill associated with an
                acquisition and possible adverse short-term effects on Cornerstone’s
                results of operations; and


·
            the
                risk of loss of key employees and customers.




Cornerstone
      may incur substantial costs to expand. There can be no assurance that
      integration efforts for any future mergers or acquisitions will be successful.
      Also, Cornerstone may issue equity securities, including common stock and
      securities convertible into shares of Cornerstone’s common stock in connection
      with future acquisitions, which could cause ownership and economic dilution
      to
      Cornerstone’s shareholders. There is no assurance that, following any future
      mergers or acquisitions, Cornerstone’s integration efforts will be successful or
      after giving effect to the acquisition, will achieve profits comparable to
      or
      better than its historical experience.




***Cornerstone
      is subject to the success of the local economies where it
      operates.***





With
      the
      exception of the Bank’s loan production office in Knoxville, Tennessee
      substantially all of our loan and deposit customers live, work and bank in
      the
      Chattanooga MSA. Cornerstone’s success depends upon a sound local economy to
      provide opportunities for new business ventures, increased loan demand and
      the
      need for deposit services. Cornerstone’s profit is impacted by these local
      factors as well as general economic conditions and interest rates. For example,
      Cornerstone’s earnings could be impacted by changes in population, income
      levels, deposits and housing starts. Adverse economic conditions in specific
      market areas could reduce Cornerstone’s growth rate and affect the ability of
      its customers to repay their loans. Secondly, adverse market conditions could
      affect the market value of the real estate or other collateral securing
      Cornerstone’s loan portfolio. Sustained periods of increased payment
      delinquencies, foreclosures or losses in the State of Tennessee or the State
      of
      Georgia could adversely affect the value of the collateral and potentially
      affect Cornerstone’s assets, revenues, results of operations and financial
      condition.




6





***Cornerstone
      is subject to Federal and State regulations that impact the company’s operations
      and financial performance.***





Cornerstone
      is subject to examinations and supervision from both federal and state
      regulatory agencies. These agencies require compliance with numerous banking
      regulations. These regulations increase costs and require human and information
      technology resources to comply. Certain activities of Cornerstone such as the
      payment of dividends, investments, acquisitions, and branching are impacted
      by
      these regulations.





The
      laws
      and regulations applicable to the banking industry are subject to change at
      any
      time. Cornerstone cannot predict the events that will result in regulatory
      changes nor their impact on the banking industry and Cornerstone’s
      earnings.





Cornerstone
      operates in a highly regulated industry and is subject to examination,
      supervision, and comprehensive regulation by various federal and state agencies
      including the Board of Governors of the FRB, the FDIC and the Tennessee
      Department of Financial Institutions. Cornerstone’s regulatory compliance is
      costly and restricts and regulates certain of its activities, including payment
      of dividends, mergers and acquisitions, investments, loans and interest rates
      charged, interest rates paid on deposits and locations of offices. Cornerstone
      is also subject to capitalization guidelines established by its regulators,
      which require it to maintain adequate capital to support its growth.




The
      laws
      and regulations applicable to the banking industry could change at any time,
      and
      Cornerstone cannot predict the effects of these changes on its business and
      profitability. Because government regulation greatly affects the business and
      financial results of all commercial banks and bank holding companies,
      Cornerstone’s cost of compliance could adversely affect its ability to operate
      profitably.




The
      Sarbanes-Oxley Act of 2002, and the related rules and regulations
      promulgated by the Securities and Exchange Commission and Nasdaq, have increased
      the scope, complexity and cost of corporate governance, reporting and disclosure
      practices. As a result, Cornerstone has experienced, and may continue to
      experience, greater compliance costs.





***Cornerstone
      could experience declines or losses in earnings if asset quality declines.***





Cornerstone’s
      assets are primarily comprised of loans. If the Bank’s loan customers fail to
      repay their loans in accordance with the terms of the loan agreement, the Bank’s
      earnings would be negatively impacted. To minimize the likelihood of a
      substandard loan portfolio the Bank assesses the credit worthiness of a customer
      as well as performing collateral valuations. An allowance for loan losses is
      also maintained in an attempt to address the various risks involved with
      lending. In determining the amount of the allowance, Cornerstone relies on
      an
      analysis of the loan portfolio based on volume and types of loans, internal
      loan
      classifications, delinquency trends, local and economic conditions and other
      pertinent information. Negative changes in these valuation methods would result
      in a decline in asset quality. Any increase in Cornerstone’s allowance for loan
      losses would have a negative impact on earnings.





***Liquidity
      needs could adversely affect Cornerstone’s results of operations and financial
      condition.***





Cornerstone
      relies on dividends from the Bank as its primary source of funds. The majority
      of the Bank’s funds are comprised of customer deposits and loan repayments.
      While scheduled loan repayments are a relatively stable source of funds, they
      are subject to the ability of borrowers to repay the loans. The repayment of
      loans can be adversely affected by a number of factors, including changes in
      economic conditions, adverse trends or events affecting business industry
      groups, reductions in real estate values or markets, business closings or
      lay-offs, inclement weather, natural disasters and international instability.
      Additionally, deposit levels may be affected by a number of factors,
      including rates paid by competitors, general interest rate levels, returns
      available to customers on alternative investments and general economic
      conditions. Accordingly, Cornerstone may be required from time to time to
      rely on secondary sources of liquidity to meet withdrawal demands or otherwise
      fund operations. Alternative sources include advances from the Federal Home
      Loan
      Bank and federal funds lines of credit from correspondent banks. While
      Cornerstone believes that these sources are currently adequate, there can be
      no
      assurance they will be sufficient to meet future liquidity demands. Cornerstone
      may be required to slow or discontinue loan growth, capital expenditures or
      other investments or liquidate assets if these alternative sources are not
      adequate.




7




***Competition
      from financial institutions and other financial service providers
      may adversely affect Cornerstone’s profitability.***





The
      banking business is highly competitive and Cornerstone experiences competition
      in each of its markets from many other financial institutions. Cornerstone
      competes with other commercial banks, credit unions, savings and loan
      associations, mortgage banking firms, consumer finance companies, securities
      brokerage firms, insurance companies, money market funds, and other mutual
      funds, as well as other community banks and super-regional and national
      financial institutions that operate offices in Cornerstone’s primary market
      areas and elsewhere.





Additionally,
      Cornerstone faces competition from de novo community banks, including those
      with
      senior management who were previously affiliated with other local or regional
      banks or those controlled by investor groups with strong local business and
      community ties. These de novo community banks may offer higher deposit
      rates or lower cost loans in an effort to attract Cornerstone’s customers, and
      may attempt to hire Cornerstone’s management and employees.





Cornerstone
      competes with these other financial institutions both in attracting deposits
      and
      in making loans. In addition, Cornerstone has to attract its customer base
      from
      other existing financial institutions and from new residents. Cornerstone
      expects competition to increase in the future as a result of legislative,
      regulatory and technological changes and the continuing trend of consolidation
      in the financial services industry.




***Changes
      in interest rates could adversely affect Cornerstone’s results of operations and
      financial condition.***





Changes
      in interest rates may affect Cornerstone’s level of interest income, the
      primary component of its gross revenue, as well as the level of its interest
      expense. Interest rates are highly sensitive to many factors that are beyond
      Cornerstone’s control, including general economic conditions and the policies of
      various governmental and regulatory authorities. Accordingly, changes in
      interest rates could decrease Cornerstone’s net interest income. Changes in the
      level of interest rates also may negatively affect Cornerstone’s ability to
      originate real estate loans, the value of its assets and the ability to realize
      gains from the sale of its assets, all of which ultimately affects earnings.




***Cornerstone
      relies heavily on the services of key personnel*** **.**





Cornerstone
      relies on the strategies and management services of Gregory B. Jones, its
      Chairman of the Board and Chief Executive Officer. Although Cornerstone has
      entered into an employment agreement with Mr. Jones, the loss of his services
      could have a material adverse effect on Cornerstone’s business, results of
      operations and financial condition. Cornerstone is also dependent on certain
      other key officers who have important customer relationships or are instrumental
      to its lending and depository operations. Changes in key personnel and their
      responsibilities may be disruptive to operations and could have a material
      adverse effect on Cornerstone’s financial condition and earnings. Cornerstone
      believes that its future results will also depend upon its ability to attract
      and retain highly skilled and qualified personnel, particularly in those areas
      where Cornerstone may open new branches.




***Cornerstone’s
      recent results may not be indicative of its future results.***





Cornerstone
      may not be able to sustain its historical rate of growth or could
      experience very limited or no increase in assets at all. In the future,
      Cornerstone may not have the benefit of several recently favorable factors,
      such as a generally stable economic environment or the ability to find suitable
      expansion opportunities. Various factors, such as interest rate environment,
      regulatory and legislative considerations and competition, may also impede
      or prohibit the Company’s ability to expand its market presence.




***Cornerstone
      is subject to Tennessee’s anti-takeover statutes and certain charter provisions
      which could decrease its chances of being acquired even if the acquisition
      is in
      the best interest of Cornerstone’s shareholders.***




As
      a
      Tennessee corporation, Cornerstone is subject to various legislative acts which
      impose restrictions on and require compliance with procedures designed to
      protect shareholders against unfair or coercive mergers and acquisitions. These
      statutes may delay or prevent offers to acquire Cornerstone and increase
      the difficulty of consummating any such offers, even if the acquisition would
      be
      in its shareholders’ best interests. Cornerstone’s amended and restated charter
      also contains provisions which may make it difficult for another entity to
      acquire it without the approval of a majority of the disinterested directors
      on
      its board of directors. Secondly, the amount of common stock owned by, and
      other
      compensation arrangements with, Cornerstone’s officers and directors
      may make it more difficult to obtain shareholder approval of potential
      takeovers that they oppose. As of February 19, 2008 **,** directors
      and executive officers beneficially owned approximately 17.60% of Cornerstone’s
      common stock. Agreements with Cornerstone’s senior management also provide for
      significant payments under certain circumstances following a change in control.
      These compensation arrangements, together with the common stock and option
      ownership of Cornerstone’s board of directors and management, could make it
      difficult or expensive to obtain majority support for shareholder proposals
      or
      potential acquisition proposals that the board of directors and officers oppose.




8




***The
      success and growth of Cornerstone’s operations will depend on its ability to
      adapt to technological changes.***




The
      banking industry and the ability to deliver financial services is becoming
      more
      dependent on technological advancement, such as the ability to process loan
      applications over the Internet, accept electronic signatures, provide process
      status updates instantly, reliable on-line banking capabilities and other
      customer expected conveniences that are cost efficient to Cornerstone’s business
      processes. As these technologies are improved in the future, Cornerstone may,
      in
      order to remain competitive, be required to make significant capital
      expenditures.




***Even
      though Cornerstone’s common stock is currently traded on the OTC Bulletin Board,
      the trading volume in its common stock has been limited. Secondly, the sale
      of
      substantial amounts of Cornerstone’s common stock in the public market could
      depress the price.***




Cornerstone
      cannot say with any certainty when a more active and liquid trading market
      for
      its common stock will develop or be sustained. Because of this, Cornerstone’s
      shareholders may not be able to sell their shares at the volumes, prices,
      or times that they desire. Cornerstone cannot predict the effect, if any, that
      future sales or the availability of common stock will have on the market price.
      Cornerstone, therefore, can give no assurance that sales of substantial amounts
      of its common stock in the market, or the potential for large amounts of sales
      in the market, would not cause the price of its common stock to decline or
      impair its ability to raise capital through sales of its common stock.




***Cornerstone
      may issue additional common stock or other equity securities in the future
      which could dilute the ownership interest of existing shareholders.***




In
      order
      to maintain capital at desired or required regulatory levels, Cornerstone’s
      board of directors may decide from time to time to issue additional shares
      of common stock, or securities convertible into, exchangeable for or
      representing rights to acquire shares of its common stock. The sale of these
      shares may significantly dilute the book value per share of its common
      stock. New investors in the future may also have rights, preferences and
      privileges senior to its current shareholders which may adversely impact
      its current shareholders.




***Cornerstone’s
      ability to declare and pay dividends is limited by law and it may be unable
      to pay future dividends.***




Cornerstone
      derives the majority of its income from dividends on the shares of common stock
      of the Bank and Eagle. The ability of the Bank and Eagle to declare and pay
      dividends is limited by its obligations to maintain sufficient capital and
      by
      other general restrictions on its dividends that are applicable to banks that
      are regulated by the FDIC and the Department of Financial Institutions. In
      addition, the FRB may impose restrictions on Cornerstone’s ability to pay
      dividends on its common stock. As a result, Cornerstone cannot assure its
      shareholders that it will declare or pay dividends on shares of its common
      stock
      in the future.




**ITEM
      1B. UNRESOLVED STAFF COMMENTS**




There
      are
      no written comments from the Commission staff regarding our periodic or current
      reports under the Act which remain unresolved.





**ITEM
      2. DESCRIPTION OF PROPERTY**





As
      of
      December 31, 2007, the principal offices of Cornerstone are located at 835
      Georgia Avenue, Chattanooga, Tennessee 37402. In addition, the Bank operates
      five full-service branches and two loan production offices that are located
      at:





Branches
            
            4154 Ringgold Road, East Ridge,
              Tennessee
              5319
                Highway 153, Hixson, Tennessee
              2280
                Gunbarrel Road, Chattanooga, Tennessee
              8966
                Old Lee Highway, Ooltewah, Tennessee
              835
                Georgia Avenue, Chattanooga, TennesseeLoan
                Production Offices
            
            202 West Crawford Street, Dalton, Georgia9724 Kingston Pike Suite 305B Knoxville,
              Tennessee




9




The
      Georgia Avenue facility located in downtown Chattanooga, Tennessee serves as
      a
      branch location for the Bank’s customers as well as Cornerstone’s Executive
      offices. The Bank owns the properties located at 2280 Gunbarrel Road, 4154
      Ringgold Road, 5319 Highway 153 and 8966 Old Lee Highway. Cornerstone operates
      a
      service center to facilitate all of its non-customer contact functions located
      at 6401 Lee Corners, Suite B, Chattanooga, Tennessee.





**ITEM
      3. LEGAL PROCEEDINGS**





As
      of the
      end of 2007, neither Cornerstone, the Bank nor Eagle was involved in any
      material litigation. The Bank is periodically involved as a plaintiff or
      defendant in various legal actions in the ordinary course of its business.
      Management believes that any claims pending against Cornerstone or its
      subsidiaries are without merit or that the ultimate liability, if any, resulting
      from them will not materially affect the Bank’s or Eagle’s financial condition
      or Cornerstone’s consolidated financial position.





**ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**





No
      matters were submitted during the fourth quarter of 2007 to a vote of security
      holders of Cornerstone through a solicitation of proxies or
      otherwise.





**PART
      II**





**ITEM
        5.** **MARKET
        FOR THE COMMON EQUITY: RELATED STOCKHOLDER MATTERS AND ISSURER PURCHASES
        OF
        EQUITY SECURITIES**





On
      February 9, 2008, the Company had 6,369,718 shares of common stock outstanding.
      Cornerstone’s common stock is quoted on the OTC Bulletin Board but is not listed
      on a national securities exchange. Morgan Keegan, a subsidiary of Regions Bank,
      is the principal market maker for Cornerstone’s stock. There are nine other
      market makers who assist in providing a market.





There
      were approximately 558 holders of record of the common stock as of December
      31,
      2007. This number does not include shareholders with shares in nominee name
      held
      by DTC. As of the end of 2007, there were 3,607,162 shares held in nominee
      name
      by DTC. Cornerstone paid quarterly cash dividends in 2007 in the amount of
      $0.05
      per share. Cornerstone announced, in December 2007, a first quarter 2008
      dividend of $0.07, which was paid January 4, 2008. Cornerstone’s board of
      directors will continue to evaluate the amount of future dividends, if any,
      after capital needs required for expected growth of assets are reviewed. The
      payment of dividends is solely within the discretion of the board of directors,
      considering Cornerstone’s expenses, the maintenance of reasonable capital and
      risk reserves, and appropriate capitalization requirements for state
      banks.





Table
      1
      presents the high and low closing prices of Cornerstone’s common stock for the
      periods indicated, as reported by published sources. The prices reflect
      inter-dealer prices, without retail mark-up, mark-down or commission and may
      not
      represent actual transactions.




**TABLE
      1**




High
                and Low Common Stock Share Price for the Company
            
            **Dividends
                paid****2008
                Fiscal Year**
            
            **Low**
            
            **High**
            
            **Per
                Share**First
                Quarter (through Feb. 29, 2008)
            
            $
            7.99
            
            $
            10.90
            
            $
            .07**2007
                Fiscal Year**First
                Quarter
            
            $
            14.25
            
            $
            16.50
            
            $
            0.05Second
                Quarter
            
            $
            14.30
            
            $
            15.30
            
            $
            0.05Third
                Quarter
            
            $
            10.95
            
            $
            14.50
            
            $
            0.05Fourth
                Quarter
            
            $
            10.05
            
            $
            12.40
            
            $
            0.05**2006
                Fiscal Year**First
                Quarter
            
            $
            11.63
            
            $
            13.63
            
            $
            0.03Second
                Quarter
            
            $
            11.70
            
            $
            12.88
            
            $
            0.03Third
                Quarter
            
            $
            11.70
            
            $
            13.39
            
            $
            0.03Fourth
                Quarter
            
            $
            13.05
            
            $
            17.00
            
            $
            0.03**2005
                Fiscal Year**First
                Quarter
            
            $
            7.87
            
            $
            9.25
            
            $
            0.05Second
                Quarter
            
            $
            8.38
            
            $
            9.25
            
            $
            0.00Third
                Quarter
            
            $
            8.80
            
            $
            10.25
            
            $
            0.04Fourth
                Quarter
            
            $
            9.75
            
            $
            12.50
            
            $
            0.00





10




Table
      2
      presents the number of shares and average share price for Cornerstone’s Equity
      Compensation Plans.





**TABLE
      2**




Equity
                Compensation PlanYear
                Ended December 31, 2007




Plan
                category
            
            Number
                of securities to be issued upon exercise of outstanding
                options
            
            Weighted
                average exercise price of outstanding options
            
            Number
                of securities remaining available for future issuanceEquity
                compensation plans approved by security holders:
            
            
            784,075
            
            $
            6.92
            
            
            647,675Equity
                compensation plans not approved by security holders:
            
            
            -
            
            
            -
            
            
            80,000Total
            
            
            784,075
            
            $
            6.92
            
            
            727,675




**ITEM
      6.** **** **SELECTED
      FINANCIAL DATA.**





Table
      3
      presents selected financial data for the periods indicated.





**TABLE
      3**




**At and for the Fiscal Years Ended December 31,****2007**
            
            **2006**
            
            **2005**
            
            **2004**
            
            **2003****(Dollars in Thousands)**Total
                interest income
            
            $
            34,784
            
            $
            29,158
            
            $
            20,672
            
            $
            14,058
            
            $
            11,326Total
                interest expense
            
            
            14,414
            
            
            10,306
            
            
            6,077
            
            
            3,575
            
            
            3,210Net
                interest income
            
            
            20,370
            
            
            18,852
            
            
            14,594
            
            
            10,483
            
            
            8,115Provision
                for loan losses
            
            
            10,409
            
            
            1,106
            
            
            1,401
            
            
            840
            
            
            545Net
                interest income after provision for loan losses
            
            
            9,961
            
            
            17,746
            
            
            13,193
            
            
            9,643
            
            
            7,570Noninterest
                income:Investment
                securities gains
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            
            
            —Other
                income
            
            
            1,695
            
            
            2,111
            
            
            1,904
            
            
            1,405
            
            
            1,241Noninterest
                expense
            
            
            10,926
            
            
            10,718
            
            
            8,216
            
            
            6,885
            
            
            5,740Income
                before income taxes
            
            
            730
            
            
            9,139
            
            
            6,881
            
            
            4,163
            
            
            3,071Income
                tax expense / (benefit)
            
            $
            (141
            )
            $
            3,328
            
            $
            2,556
            
            $
            1,592
            
            $
            1,189Net
                income
            
            $
            871
            
            $
            5,811
            
            $
            4,325
            
            $
            2,571
            
            $
            1,881**Per
                Share Data:**Net
                income, basic
            
            $
            0.14
            
            $
            0.90
            
            $
            0.71
            
            $
            0.52
            
            $
            0.38Net
                income, assuming dilution
            
            $
            0.13
            
            $
            0.85
            
            $
            0.66
            
            $
            0.46
            
            $
            0.36Dividends
                paid
            
            $
            0.20
            
            $
            0.12
            
            $
            0.09
            
            $
            0.03
            
            $
            0.00Book
                value
            
            $
            5.70
            
            $
            5.86
            
            $
            5.07
            
            $
            4.32
            
            $
            3.40Tangible
                book value(1)
            
            $
            5.24
            
            $
            5.40
            
            $
            4.54
            
            $
            3.88
            
            $
            2.89**Financial
                Condition Data:**Assets
            
            $
            444,421
            
            $
            374,942
            
            $
            323,611
            
            $
            248,614
            
            $
            200,996Loans,
                net of unearned interest
            
            $
            369,883
            
            $
            305,879
            
            $
            262,008
            
            $
            202,555
            
            $
            155,278Cash
                and investments
            
            $
            51,798
            
            $
            51,557
            
            $
            46,074
            
            $
            34,614
            
            $
            33,118Federal
                funds sold
            
            $
            —
            
            $
            —
            
            
            —
            
            
            —
            
            $
            3,060Deposits
            
            $
            313,250
            
            $
            275,816
            
            $
            252,435
            
            $
            187,832
            
            $
            159,352FHLB
                advances and line of credit
            
            $
            47,100
            
            $
            39,500
            
            $
            30,000
            
            $
            27,000
            
            $
            17,400Subordinated
                debentures
            
            $
            —
            
            $
            —
            
            
            —
            
            
            —
            
            
            —Federal
                funds purchased and repurchase agreements
            
            $
            41,560
            
            $
            19,249
            
            $
            4,790
            
            $
            7,409
            
            $
            6,084Shareholders’
                equity
            
            $
            36,327
            
            $
            38,183
            
            $
            32,466
            
            $
            24,807
            
            $
            16,903Tangible
                shareholders’ equity(1)
            
            $
            33,386
            
            $
            35,137
            
            $
            29,089
            
            $
            22,266
            
            $
            14,362




11




**Selected
                Ratios:**Interest
                rate spread
            
            
            4.51
            %
            
            5.16
            %
            
            4.93
            %
            
            4.70
            %
            
            4.54
            %Net
                interest margin(2)
            
            
            5.22
            %
            
            5.80
            %
            
            5.43
            %
            
            5.02
            %
            
            4.87
            %Return
                on average assets
            
            
            0.21
            %
            
            1.69
            %
            
            1.51
            %
            
            1.15
            %
            
            1.06
            %Return
                on average equity
            
            
            2.14
            %
            
            16.27
            %
            
            14.98
            %
            
            13.83
            %
            
            7.38
            %Return
                on average tangible equity(1)
            
            
            2.31
            %
            
            17.78
            %
            
            16.96
            %
            
            16.02
            %
            
            8.76
            %Average
                equity to average assets
            
            
            9.86
            %
            
            10.36
            %
            
            10.09
            %
            
            8.30
            %
            
            9.04
            %Dividend
                payout ratio
            
            
            149.71
            %
            
            13.33
            %
            
            12.17
            %
            
            4.84
            %
            
            0.00
            %Ratio
                of nonperforming assets to total assets
            
            
            0.40
            %
            
            0.40
            %
            
            0.47
            %
            
            0.08
            %
            
            0.07
            %Ratio
                of allowance for loan losses to nonperforming loans
            
            
            791.16
            %
            
            25.90
            %
            
            20.70
            %
            
            5.33
            %
            
            0.00
            %Ratio
                of allowance for loan losses to total average loans, net of unearned
                income
            
            
            3.88
            %
            
            1.50
            %
            
            1.50
            %
            
            1.47
            %
            
            1.42
            %




(1)
            Tangible
                shareholders’ equity is shareholders’ equity less goodwill and intangible
                assets.


(2)
            Net
                interest margin is the net yield on interest earning assets and is
                the
                difference between the interest yield earned on interest-earning
                assets
                less the interest rate paid on interest bearing
                liabilities.




***GAAP
      Reconciliation and Management Explanation of Non-GAAP Financial
      Measures***




Certain
      financial information included in our summary consolidated financial data is
      determined by methods other than in accordance with U.S. generally accepted
      accounting principles (“GAAP”). These non-GAAP financial measures are “tangible
      book value per share,” “tangible shareholders’ equity,” and “return on average
      tangible equity.” Cornerstone’s management uses these non-GAAP measures in its
      analysis of Cornerstone’s financial performance.




·
            “Tangible
                book value per share” is defined as total equity reduced by recorded
                goodwill and other intangible assets divided by total common shares
                outstanding. This measure is important to investors interested in
                changes
                from period-to-period in book value per share exclusive of changes
                in
                intangible assets. Goodwill, an intangible asset that is recorded
                in a
                purchase business combination, has the effect of increasing total
                book
                value while not increasing the tangible assets of a company. For
                companies
                such as Cornerstone that have engaged in business combinations, purchase
                accounting can result in the recording of significant amounts of
                goodwill
                related to such transactions.





·
            “Tangible
                shareholders’ equity” is shareholders’ equity less goodwill and other
                intangible assets.





·
            “Return
                on average tangible equity” is defined as earnings for the period divided
                by average equity reduced by average goodwill and other intangible
                assets.




These
      disclosures should not be viewed as a substitute for results determined in
      accordance with GAAP, and are not necessarily comparable to non-GAAP performance
      measures which may be presented by other companies. Table 4 presents a
      reconciliation to provide a more detailed analysis of these non-GAAP performance
      measures:




**TABLE
      4**




**At and for the Fiscal Years Ended December 31,****2007**
            
            **2006**
            
            **2005**
            
            **2004**
            
            **2003**Book
                value per share
            
            $
            5.70
            
            $
            5.86
            
            $
            5.07
            
            $
            4.32
            
            $
            3.40Effect
                of intangible assets per share
            
            $
            0.46
            
            $
            0.47
            
            $
            0.53
            
            $
            0.44
            
            $
            0.51Tangible
                book value per share
            
            $
            5.24
            
            $
            5.40
            
            $
            4.54
            
            $
            3.88
            
            $
            2.89Return
                on average equity
            
            
            2.14
            %
            
            16.27
            %
            
            14.98
            %
            
            13.83
            %
            
            7.38
            %Effect
                of intangible assets
            
            
            0.17
            %
            
            1.51
            %
            
            1.98
            %
            
            2.19
            %
            
            1.38
            %Return
                on average tangible equity
            
            
            2.31
            %
            
            17.78
            %
            
            16.96
            %
            
            16.02
            %
            
            8.76
            %




12




**ITEM
      7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
      OF
      OPERATION**





***Forward-Looking
      Statements***





Management’s
      discussion and analysis of Cornerstone’s operations, prospects, and other
      matters, may include forward-looking statements within the meaning of the
      Private Securities Litigation Reform Act of 1995 and other provisions of
      applicable federal and state securities laws. Although Cornerstone believes
      that
      the assumptions underlying such forward-looking statements contained in this
      report are reasonable, any of the assumptions could be inaccurate and,
      accordingly, there can be no assurance that the forward-looking statements
      included herein will prove to be accurate. The use of such words as “expect,”
“anticipate,” “forecast,” and comparable terms should be understood by the
      reader to indicate that the statement is “forward-looking” and thus subject to
      change in a manner that can be unpredictable. Factors that could cause actual
      results to differ from the results anticipated, but not guaranteed, in this
      report, include (without limitation) economic and social conditions, competition
      for loans, mortgages, and other financial services and products, changes in
      interest rates, unforeseen changes in liquidity, results of operations, and
      financial conditions affecting Cornerstone’s customers, and other risks that
      cannot be accurately quantified or completely identified. Many factors affecting
      Cornerstone’s financial condition and profitability, including changes in
      economic conditions, the volatility of interest rates, political events and
      competition from other providers of financial services simply cannot be
      predicted. These factors are unpredictable and beyond Cornerstone’s control.
      Earnings may fluctuate from period to period. The purpose of this type of
      information is to provide readers with information relevant to understanding
      and
      assessing the financial condition and results of operations of the Company,
      and
      not to predict the future or to guarantee results. Cornerstone is unable to
      predict the types of circumstances, conditions and factors that can cause
      anticipated results to change. Cornerstone undertakes no obligation to publish
      revised forward-looking **** statements
      to reflect the occurrence of changes or unanticipated events, circumstances,
      or
      results.




***Management's
      Discussion And Analysis Or Plan Of Operation***





Cornerstone
      Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of
      Cornerstone Community Bank, (the “Bank”) a Tennessee banking corporation, and
      Eagle Financial, Inc., (“Eagle”), an accounts receivable financing company that
      operate primarily in and around Hamilton County, Tennessee. The Bank has also
      established loan production offices in Knoxville, Tennessee and Dalton, Georgia.
      The Bank’s business consists primarily of attracting deposits from the general
      public and, with these and other funds, originating real estate loans, consumer
      loans, business loans, and residential and commercial construction loans. The
      principal sources of income for the Bank are interest and fees collected on
      loans, fees collected on deposit accounts, and interest and dividends collected
      on other investments. The principal expenses of the Bank are interest paid
      on
      deposits, employee compensation and benefits, office expenses, and other
      overhead expenses. Eagle’s principal source of income is revenue received from
      the purchase of receivables. Expenses are related to employee compensation
      and
      benefits, office and overhead expenses.





The
      following is a discussion of our financial condition at December 31, 2007 and
      December 31, 2006 and our results of operations for each of the three-years
      ended December 31, 2007, 2006 and 2005. The purpose of this discussion is to
      focus on information about our financial condition and results of operations
      which is not otherwise apparent from the consolidated financial statements.
      The
      following discussion and analysis should be read along with our consolidated
      financial statements and the related notes included elsewhere
      herein.





***Review
      of Financial Performance***





As
      of
      December 31, 2007 Cornerstone had total consolidated assets of approximately
      $444 million, total loans of approximately $384 million, total deposits of
      approximately $313 million and stockholders equity of approximately $36 million.
      Cornerstone’s net income decreased to $871 thousand for 2007 compared to $5.8
      million 2006 and $4.3 million for 2005.





***Results
      of Operations***





*Net
      Interest Income* -Net
      interest income represents the amount by which interest earned on various
      earning assets exceeds interest paid on deposits and other interest bearing
      liabilities. Net Interest income is also the most significant component of
      our
      earnings. For the year ended December 31, 2007, Cornerstone recorded net
      interest income of approximately $20,370,000, which resulted in a net interest
      margin of 5.22%. For the year ended December 31, 2006, Cornerstone recorded
      net
      interest income of approximately $18,853,000, which resulted in a net interest
      margin of 5.80%. For the year ended December 31, 2005, Cornerstone recorded
      net
      interest income of approximately $14,594,000, which resulted in a net interest
      margin of 5.43%.




13





Table
      5
      presents information with respect to interest income from average
      interest-earning assets, expressed both in dollars and yields, and interest
      expense on average interest-bearing liabilities, expressed both in dollars
      and
      rates, for the periods indicated. The table includes loan yields, which reflect
      the amortization of deferred loan origination and commitment fees. Interest
      income from investment securities includes the accretion of discounts and
      amortization of premiums.





**TABLE
      5**




Yields
                Earned on Average Earning Assets and
              Rates
                Paid on Average Interest Bearing LiabilitiesYears
                Ended December 31,




2007
            
            2006
            
            2005(In
                thousands)
            
            Average
              Balance
            
            Interest
                Income/
              Expense(1)
            
            Yield/Rate
            
            Average
              Balance
            
            Interest
                Income/
              Expense(1)
            
            Yield/Rate
            
            AverageBalance
            
            Interest
                Income/
              Expense(1)
            
            Yield/Rate**ASSETS**Interest-earning
                assets:Loans(1)(2)
            
            $
            353,278
            
            $
            32,981
            
            
            9.34
            %
            $
            284,105
            
            $
            27,317
            
            
            9.61
            %
            $
            236,265
            
            $
            19,354
            
            
            8.19
            %Investment
                securities(3)
            
            
            37,673
            
            
            1,750
            
            
            4.80
            %
            
            36,218
            
            
            1,584
            
            
            4.48
            %
            
            29,705
            
            
            1,217
            
            
            4.24
            %Federal
                funds sold
            
            
            760
            
            
            52
            
            
            6.86
            %
            
            4,686
            
            
            258
            
            
            5.51
            %
            
            2,976
            
            
            101
            
            
            3.39
            %Total
                interest-earning assets
            
            
            391,711
            
            
            34,783
            
            
            8.89
            %
            
            325,009
            
            
            29,159
            
            
            8.98
            %
            
            268,946
            
            
            20,672
            
            
            7.68
            %Allowance
                for loan losses
            
            
            (5,009
            )
            
            
            
            
            
            
            
            (4,104
            )
            
            
            
            
            
            
            
            (3,025
            )Cash
                and other assets
            
            
            26,341
            
            
            
            
            
            
            
            
            23,836
            
            
            
            
            
            
            
            
            20,288Total
                assets
            
            $
            413,043
            
            
            
            
            
            
            
            $
            344,741
            
            
            
            
            
            
            
            $
            286,209**TOTAL
                LIABILITIES AND EQUITY**Interest-bearing
                liabilities:Deposits:NOW
                accounts
            
            $
            36,327
            
            
            802
            
            
            2.21
            %
            $
            34,701
            
            
            427
            
            
            1.23
            %
            $
            33,943
            
            
            329
            
            
            0.97
            %Money
                market / Savings
            
            
            55,808
            
            
            2,018
            
            
            3.61
            %
            
            58,477
            
            
            2,225
            
            
            3.80
            %
            
            45,232
            
            
            1,107
            
            
            2.45
            %Time
                deposits, $100m andOver
            
            
            61,172
            
            
            3,134
            
            
            5.12
            %
            
            43,692
            
            
            1,993
            
            
            4.56
            %
            
            32,611
            
            
            1,145
            
            
            3.51
            %Time
                deposits, under $100m
            
            
            107,498
            
            
            5,387
            
            
            5.01
            %
            
            88,773
            
            
            3,899
            
            
            4.39
            %
            
            70,167
            
            
            2,240
            
            
            3.19
            %Total
                interest-bearing deposits
            
            
            260,805
            
            
            11,341
            
            
            4.35
            %
            
            225,643
            
            
            8,544
            
            
            3.78
            %
            
            181,953
            
            
            4,821
            
            
            2.65
            %Federal
                funds purchased
            
            
            11,374
            
            
            613
            
            
            5.39
            %
            
            4,570
            
            
            232
            
            
            5.07
            %
            
            4,269
            
            
            143
            
            
            3.35
            %Securities
                  sold under agreement to repurchase
            
            
            8,103
            
            
            244
            
            
            3.01
            %
            
            4,020
            
            
            116
            
            
            2.88
            %
            
            3,501
            
            
            60
            
            
            1.71
            %Other
                borrowings
            
            
            48,282
            
            
            2,216
            
            
            4.59
            %
            
            35,429
            
            
            1,414
            
            
            3.98
            %
            
            30,973
            
            
            1054
            
            
            3.40
            %Total
                interest-bearingLiabilities
            
            
            328,564
            
            
            14,414
            
            
            4.39
            %
            
            269,662
            
            
            10,306
            
            
            3.82
            %
            
            220,696
            
            
            6,078
            
            
            2.75
            %Net
                interest spread
            
            
            
            
            
            
            
            
            4.51
            %
            
            
            
            
            
            
            
            5.16
            %
            
            
            
            
            
            
            
            4.93
            %Other
                liabilities:Demand
                deposits
            
            
            41,503
            
            
            
            
            
            
            
            
            37,056
            
            
            
            
            
            
            
            
            34,730Accrued
                    interest payable and other liabilities
            
            
            2,240
            
            
            
            
            
            
            
            
            2,295
            
            
            
            
            
            
            
            
            1,909Stockholders'
                equity
            
            
            40,737
            
            
            
            
            
            
            
            
            35,728
            
            
            
            
            
            
            
            
            28,874Total
                liabilitiesAnd
                stockholders' equity
            
            $
            413,043
            
            
            
            
            
            
            
            $
            344,741
            
            
            
            
            
            
            
            $
            286,209Net
                interest margin
            
            
            
            
            $
            20,369
            
            
            5.22
            %
            
            
            
            $
            18,853
            
            
            5.80
            %
            
            
            
            $
            14,594
            
            
            5.43
            %




(1)
      Interest income on loans includes amortization of deferred loan fees and other
      discounts of $302 thousand, $288 thousand, and $262 thousand for the fiscal
      years ended December 31, 2007, 2006, and 2005, respectively.




(2)
      Nonperforming loans are included in the computation of average loan balances,
      and interest income on such loans is recognized on a cash basis.




(3)
      Yields on securities are calculated on a fully tax equivalent
      basis.




Other
      matters related to the changes in net interest income, net interest yields
      and
      rates, and net interest margin are presented below:


logo
              During
                  2007 the Bank continued to increase its loan portfolio with an
                  emphasis in
                  commercial loans. During 2007 the Bank hired 5 additional relationship
                  managers to attract new loan and deposit customers.
  14
  logo
                  As
                      of December 31, 2007, the Bank’s investment portfolio resulted in a yield
                      of 4.80% compared to 4.48% for the same time period in 2006.
                      The Bank’s
                      investment portfolio is used primarily for pledging purposes
                      with the
                      State of Tennessee Collateral Pool, Federal Reserve discount
                      window and to
                      secure repurchase agreements.
 
 logo
              The
                  Bank expects continued pressure on the net interest margin due
                  to market
                  conditions such as increased competition in Cornerstone’s primary deposit
                  market. Therefore, the Bank has elected to grow its funding base
                  with a
                  variety of solutions including local market CD specials, brokered
                  deposits
                  and borrowings from the Federal Home Loan Bank (the “FHLB”). As of
                  December 31, 2007 borrowings from the FHLB totaled $47 million
                  with an
                  interest cost of 4.37%.
 
 logo
              During
                  2007 the Bank offered several certificate of deposit (“CD”) promotions to
                  attract deposits from customers in the Chattanooga Tennessee MSA.
                  The Bank
                  also obtained approximately $13 million in brokered CDs to provide
                  additional funding. Management believes that the brokered CD market
                  provides a convenient source of funds and will continue to obtain
                  brokered
                  CDs to offset higher interest rates demanded by other funding sources.
 
 logo
              During
                  the fourth quarter the Bank settled an interest contract dispute
                  in the
                  amount of $316 thousand. The additional expense reduced the net
                  interest
                  margin by 30 basis points for the quarter and 8 basis points for
                  2007.
                  Without this one time charge the net interest margin would have
                  been 4.94%
                  for the quarter and 5.30% year to date. This expense reduced the
                  4th
                  quarter and annual earnings by approximately $200 thousand after
                  taxes.
 
 logo
              Starting
                  in September 2007 the Federal Reserve Bank initiated a series of
                  interest
                  rate cuts that as of January 30, 2008 resulted in the Federal Funds
                  Target
                  rate of 3.00%. This 225 basis point reduction has placed downward
                  pressure
                  on the banking industry’s net interest margins. Cornerstone also
                  experienced a reduction in its net interest margin to 4.64%for
                  the
                  4thquarter 2007.
 
 Tables
        6
        and 7 present the changes in interest income and interest expense that are
        attributable to three factors:
 
 (i)  A
        change
        in volume or amount of an asset or liability.
  (ii)  A
        change
        in interest rates.
  (iii)  A
        change
        caused by the combination of changes in asset or deposit mix.
 
 The
        tables describes the extent to which changes in interest rates and changes
        in
        volume of interest-earning assets and interest-bearing liabilities have affected
        Cornerstone’s interest income and expense during the periods indicated. For each
        category of interest-earning assets and interest-bearing liabilities,
        information is provided as to changes attributable to change in volume (change
        in volume multiplied by current rate) and change in rates (change in rate
        multiplied by current volume). The remaining difference has been allocated
        to
        mix.
 **TABLE
          6**
  INTEREST
                    INCOME AND EXPENSE ANALYSISYear
                    Ended December 31,2007
                    Compared to 2006(In
                    Thousands)
                
                Volume
                
                Rate
                
                Mix
                
                Net
                  ChangeInterest
                    income:Loans
                    (1)(2)
                
                $
                6,461
                
                
                ($954
                )
                $
                157
                
                $
                5,664Investment
                    securities
                
                
                69
                
                
                105
                
                
                (8
                )
                
                166Federal
                    funds sold
                
                
                (204
                )
                
                (8
                )
                
                6
                
                
                (206
                )Other
                    earning assets
                
                
                0
                
                
                0
                
                
                0
                
                
                0Total
                    interest income
                
                
                
                
                
                
                
                
                
                
                
                5,624Interest
                    expense:NOW
                    accounts
                
                
                36
                
                
                356
                
                
                (16
                )
                
                376Money
                    market and savings accounts
                
                
                (96
                )
                
                (103
                )
                
                (8
                )
                
                (207
                )Time
                    deposits, $100,000 and over
                
                
                895
                
                
                343
                
                
                (98
                )
                
                1,140Time
                    deposits, less than $100,000
                
                
                938
                
                
                666
                
                
                (116
                )
                
                1,488Other
                    borrowings
                
                
                590
                
                
                294
                
                
                (82
                )
                
                802Federal
                    funds purchased
                
                
                367
                
                
                36
                
                
                (22
                )
                
                381Securities
                    sold under agreement to repurchase
                
                
                123
                
                
                11
                
                
                (7
                )
                
                127Total
                    interest expense
                
                
                
                
                
                
                
                
                
                
                
                4,107Change
                    in net interest income (expense)
                
                
                
                
                
                
                
                
                
                
                $
                1,517




15




**TABLE
        7**
  INTEREST
                  INCOME AND EXPENSE ANALYSISYear
                  Ended December 31,2006
                  Compared to 2005(In
                  Thousands)
              
              Volume
              
              Rate
              
              Mix
              
              Net
                ChangeInterest
                  income:Loans
                  (1)(2)
              
              $
              4,597
              
              $
              4,034
              
              
              ($668
              )
              $
              7,963Investment
                  securities
              
              
              292
              
              
              87
              
              
              (12
              )
              
              367Federal
                  funds sold
              
              
              106
              
              
              113
              
              
              (62
              )
              
              157Other
                  earning assets
              
              
              0
              
              
              0
              
              
              0
              
              
              0Total
                  interest income
              
              
              
              
              
              
              
              
              
              
              
              8,487Interest
                  expense:NOW
                  accounts
              
              
              9
              
              
              90
              
              
              (1
              )
              
              98Money
                  market and savings accounts
              
              
              503
              
              
              789
              
              
              (174
              )
              
              1,118Time
                  deposits, $100,000 and over
              
              
              596
              
              
              459
              
              
              (207
              )
              
              848Time
                  deposits, less than $100,000
              
              
              817
              
              
              1,065
              
              
              (223
              )
              
              1,659Other
                  borrowings
              
              
              177
              
              
              209
              
              
              (23
              )
              
              363Federal
                  funds purchased
              
              
              15
              
              
              74
              
              
              (3
              )
              
              86Securities
                  sold under agreement to repurchase
              
              
              15
              
              
              51
              
              
              (10
              )
              
              56Total
                  interest expense
              
              
              
              
              
              
              
              
              
              
              
              4,228Change
                  in net interest income (expense)
              
              
              
              
              
              
              
              
              
              
              $
              4,259
  (1)
        Loan
        amounts include non-accruing loans.
  (2)
        Interest income includes the portion of loan fees recognized in the respective
        periods.
 
 *Provision
        for Loan Losses* -The
        provision for loan losses represents a charge to earnings necessary to establish
        an allowance for loan losses that, in management’s evaluation, should be
        adequate to provide coverage for the inherent losses on outstanding loans.
        The
        provision for loan losses amounted to $10.4 million for the year ended December
        31, 2007. Other matters relating to the changes in provision for loan losses
        are
        presented below:
  logo
              During
                  the second quarter of 2007, the Bank identified a customer relationship
                  in
                  its asset based lending program totaling $5.5 million in which
                  management
                  detected a suspected customer fraud.  The company responsible for
                  this problem loan is still operating under a forbearance agreement
                  with
                  the bank and is current on all credit obligations.  The problem arose
                  out of a suspected fraud and the company’s operations are still considered
                  a source of repayment and if properly managed may be able to satisfy
                  the
                  debt obligations.  During 2007 in accordance with FAS 114, management
                  assigned $2.8 million to the loan loss allowance for this specific
                  credit
                  and anticipates that the amount will adequately provide for any
                  probable
                  shortfalls of collateral if the company were to discontinue
                  operations.
 
 logo
              On
                  February 13, 2008 Cornerstone revised its previously announced
                  fiscal
                  year-ended 2007 financial results due to an apparent customer fraud.
                  The
                  apparent fraud was discovered as a result of additional risk controls
                  being implemented as a result of the above mentioned credit. This
                  customer
                  was determined to have submitted apparently fraudulent financial
                  statements that were reviewed by a certified public accountant
                  during
                  2007. The customer’s relationship with the Bank totaled approximately $7.6
                  million which included a $6 million commercial line of credit secured
                  by
                  accounts receivable, inventory and all other business assets and
                  $1.6
                  million secured by commercial real estate. The company has ceased
                  operations and moved to a liquidation status. The Bank provided
                  $6.5
                  million to the loan loss allowance for the credit and charged off
                  $6
                  million during the month of March 2008. Management has determined
                  that the
                  remaining $1.1 million is adequately secured and does not expect
                  a
                  shortfall during liquidation.
 
 *Non
        Interest Income-* Items
        reported as non interest income include service charges on checking accounts,
        insufficient funds charges, automated clearing house (“ACH”) processing fees and
        the Bank’s secondary mortgage department earnings. Increases in income derived
        from service charges and ACH fees are primarily a function of the Bank’s growth
        while fees from the origination of mortgage loans will often reflect market
        conditions and fluctuate from period to period.
  16
  Table
        8
        presents the components of non interest income for the years ended December
        31,
        2007, 2006 and 2005 (in thousands).
 
 **TABLE
        8**
  2007
              
              2006
              
              2005Customer
                  service fees
              
              $
              1,426
              
              $
              1,298
              
              $
              984Other
                  noninterest income
              
              
              165
              
              
              91
              
              
              68Operating
                  lease income
              
              
              -
              
              
              301
              
              
              540Net
                  gain from sale of loans & other assets
              
              
              104
              
              
              421
              
              
              313Total
                  noninterest income
              
              $
              1,695
              
              $
              2,111
              
              $
              1,905
 
 Significant
        matters relating to the changes to non interest income are presented
        below:
 
 logo
              Service
                  charges on deposits primarily increased as a result of the growth
                  in
                  demand deposits and interest demand
                  deposits.
 
 logo
              The
                  Bank created a new line of business in 2007. A major service provider
                  for
                  the payroll processor industry recently terminated most of its
                  processors
                  in order to pursue its core bank lines of business. Cornerstone
                  recognized
                  this as an opportunity and has built the program and infrastructure
                  to
                  service this sector of ACH processing. Currently, the Bank has
                  seven
                  payroll processors processing ACH transactions and expects to add
                  approximately five to ten additional payroll processors in 2008.
                  This line
                  of business has the ability to produce a material amount of non-interest
                  income with a relatively low amount of credit and transaction risk.
 
 logo
              One
                  of the major components in other fee income in prior years was
                  the Bank’s
                  lease income. The Bank had entered into an operating lease agreement
                  with
                  one of its customers that resulted in monthly lease income to the
                  Bank.
                  The lease has been terminated with the customer, which has purchased
                  the
                  assets. Currently, the Bank has no income from operating lease
                  agreements.
 
 *Non
        Interest Expense* -Items
        reported as non interest expense include salaries and employee benefits,
        occupancy and equipment expense and other operating expense.
 
 Table
        9
        presents the components of non interest expense for the years ended December
        31,
        2007, 2006 and 2005 (in thousands).
 
 **TABLE
        9**
  2007
              
              2006
              
              2005Salaries
                  and employee benefits
              
              $
              6,609
              
              $
              6,018
              
              $
              4,503Net
                  occupancy and equipment expense
              
              
              1,355
              
              
              1,075
              
              
              859Depreciation
                  on leased assets
              
              
              -
              
              
              245
              
              
              379Other
                  operating expenses
              
              
              2,962
              
              
              3,380
              
              
              2,475Total
                  noninterest income
              
              $
              10,926
              
              $
              10,718
              
              $
              8,216
 
 Significant
        matters relating to the changes to non interest expense are presented
        below:
 
 logo
              As
                  of December 2006 Cornerstone had 98 full time equivalent employees.
                  By
                  December 2007, the number of full time equivalent employees had
                  increased
                  to 116. The positions filled by these employees included 5 additional
                  relationship managers and two additional employees in the Bank’s ACH
                  processing department. The addition of these employees as well
                  as the
                  additional staff hired should have a positive impact on the Bank’s growth
                  and performance during 2008.
 
 logo
              Occupancy
                  and equipment expense has increased from prior periods in part
                  due to the
                  relocation of the Bank’s downtown branch and Cornerstone’s corporate
                  headquarters. While the relocation has increased expenses, the
                  Bank’s
                  presence in downtown Chattanooga, Tennessee, provides existing
                  bank
                  customers with greater access to the Bank’s services as well as potential
                  new customers. The Bank also opened two loan production offices
                  during
                  2007; one in Knoxville, Tennessee, and one in Dalton, Georgia.
 
 17
  *Income
        Tax Expense*
 
 logo
              The
                  difference between Cornerstone’s expected income tax expense, computed by
                  multiplying income before income taxes by statutory income tax
                  rates, is
                  primarily attributable to new market tax credits for federal and
                  state
                  purposes, tax exempt loans and tax exempt
                  securities.
 
 ***Financial
        Condition***
 
 *Overview* -Cornerstone’s
        consolidated balance sheet reflects significant growth since December 31,
        2006.
        Total assets increased approximately $69 million or 18.5% from $375 million
        as
        of December 31, 2006 to $444 million as of December 31, 2007. The primary
        component of the growth continues to be the Bank’s loan portfolio. Total loans
        increased $73 million or 23.7% from approximately $310 million as of December
        31, 2006 to approximately $384 million as of December 31, 2007.
  *Investments* -The
        Bank’s investment portfolio totaled $36.9 million or 8.3% of total assets as of
        the year end 2007 compared to a total of $33.9 million or 9.0% of total assets
        as of year end 2006. The portfolio is accounted for in two classifications:
        “Held to Maturity” and “Available for Sale”. The Bank also has an investment in
        Federal Home Loan Bank Stock. The objective of the Bank’s investment policy is
        to invest funds not otherwise needed to meet the loan demand of the Bank’s
        market area and to meet the following five objectives: Gap Management,
        Liquidity, Pledging, Return, and Local Community Support. In doing so, the
        Bank
        uses the portfolio to provide structure and liquidity that the loan portfolio
        cannot. The management investment committee balances the market and credit
        risks
        against the potential investment return, ensures investments are compatible
        with
        the pledge requirements of the Bank’s deposit of public funds, maintains
        compliance with regulatory investment requirements, and assists various public
        entities with their financing needs. The management investment committee
        is
        authorized to execute security transactions for the investment portfolio
        based
        on the decisions of the Board of Directors Asset Liability Committee (“ALCO”).
        All the investment transactions occurring since the previous ALCO meeting
        are
        reviewed by the ALCO at its next monthly meeting, in addition to the entire
        portfolio. The investment policy allows portfolio holdings to include short-term
        securities purchased to provide the Bank’s needed liquidity and longer-term
        securities purchased to generate stable income for the Bank during periods
        of
        interest rate fluctuations.
 
 Table
        10 presents
        the carrying value of the Bank's investments at the dates indicated. Available
        for sale securities are carried at fair market value and securities held
        to
        maturity are held at their book value (amounts in thousands).
 
 **TABLE
        10**
  Investment
                    PortfolioYears
                  Ending December 31,
  2007
              
              2006
              
              2005Securities
                  available for sale:U.S.
                  Government and agency obligations
              
              $
              27,414
              
              $
              26,470
              
              $
              22,349Mortgage-backed
                  and other securities
              
              
              3,836
              
              
              2,634
              
              
              4,000State
                  & political subdivisions tax-exempt
              
              
              3,503
              
              
              3,249
              
              
              3,285Corporate
                  debt
              
              
              0
              
              
              0
              
              
              494Totals
              
              $
              34,753
              
              $
              32,353
              
              $
              30,128Securities
                  held to maturity:U.S.
                  Government and agency obligations
              
              $
              0
              
              $
              0
              
              $
              0Mortgage-backed
                  and other securities
              
              
              200
              
              
              236
              
              
              322State
                  & political subdivisions tax-exempt
              
              
              0
              
              
              0
              
              
              0Corporate
                  debt
              
              
              0
              
              
              0
              
              
              0Totals
              
              $
              200
              
              $
              236
              
              $
              322Federal
                  Home Loan Bank stock, at cost
              
              
              1,912
              
              
              1,332
              
              
              1,034Total
                  Investments
              
              $
              36,865
              
              $
              33,921
              
              $
              31,484
  For
        December 31, 2007 tables 11 and 12 present the book value of the Bank's
        investments, the weighted average yields on the Bank's investments and the
        periods to maturity of the Bank's investments for the “Securities Available for
        Sale” and the “Securities Held to Maturity,” respectively. Available for Sale
        and Held to Maturity information relating to December 31, 2006 is presented
        in
        tables 13 and 14.
  18
  **TABLE
        11**
  Weighted
                  Average Yields on the Available For Sale Investments
                  Periods
                    of Maturity from December 31,
                    2007
  Less
                  than 1 year
              
              1
                  to 5 years
              
              5
                  to 10 years
              
              Over
                  10 yearsAmount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)Securities
                  available for sale:U.S.
                  Treasuries
              
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %U.S.
                  Government agencies
              
              
              8,491
              
              
              4.43
              %
              
              16,848
              
              
              4.57
              %
              
              0
              
              
              0.00
              %
              
              2,075
              
              
              6.12
              %Mortgage-backed
                  securities (2)
              
              
              0
              
              
              0.00
              %
              
              2
              
              
              6.30
              %
              
              13
              
              
              7.01
              %
              
              3,821
              
              
              5.17
              %Tax-exempt
                  municipal bonds
              
              
              126
              
              
              5.14
              %
              
              739
              
              
              4.29
              %
              
              1,233
              
              
              4.28
              %
              
              1,405
              
              
              4.09
              %Other
                  bonds, notes, debentures and securities
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Totals
              
              $
              8,617
              
              
              4.44
              %
              $
              17,589
              
              
              4.56
              %
              $
              1,246
              
              
              4.31
              %
              $
              7,301
              
              
              5.32
              %Total
                  Securities Available for Sale
              
              $
              34,753
              
              
              4.76
              %
  **TABLE
        12**
  Weighted
                  Average Yields on the Held To Maturity Investments
                Periods
                  of Maturity from December 31, 2007
  Less
                  than 1 year
              
              1
                  to 5 years
              
              5
                  to 10 years
              
              Over
                  10 yearsAmount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)Securities
                available for sale:U.S.
                  Treasuries
              
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %U.S.
                  Government agencies
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Mortgage-backed
                  securities (2)
              
              
              0
              
              
              0.00
              %
              
              13
              
              
              6.72
              %
              
              13
              
              
              5.20
              %
              
              174
              
              
              6.36
              %Tax-exempt
                  municipal bonds
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Other
                  bonds, notes, debentures and securities
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Totals
              
              $
              0
              
              
              0.00
              %
              $
              13
              
              
              6.72
              %
              $
              13
              
              
              5.20
              %
              $
              174
              
              
              6.36
              %Total
                  Securities held to maturity
              
              $
              200
              
              
              6.31
              %Federal
                  Home Loan Bank stock, at cost
              
              $
              1,912
              
              
              5.52
              %Total
                  Investments
              
              $
              36,865
              
              
              4.80
              %
  (1)
        The
        weighted average yields on tax-exempt securities have been computed on a
        tax-equivalent basis.
  (2)
        Mortgages are allocated by maturity and not amortized
  **TABLE
        13**
  Weighted
                  Average Yields on the Available For Sale Investments
                  Periods
                    of Maturity from December 31,
                    2006
  Less
                  than 1 year
              
              1
                  to 5 years
              
              5
                  to 10 years
              
              Over
                  10 yearsAmount
              
              
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)Securities
                  available for sale:U.S.
                  Treasuries
              
              $
              0
              
              
              
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %U.S.
                  Government agencies
              
              
              7,610
              
              
              
              
              
              4.21
              %
              
              16,801
              
              
              4.46
              %
              
              0
              
              
              0.00
              %
              
              2,059
              
              
              5.76
              %Mortgage-backed
                  securities (2)
              
              
              1
              
              
              
              
              
              7.49
              %
              
              3
              
              
              5.43
              %
              
              14
              
              
              6.75
              %
              
              2,616
              
              
              5.57
              %Tax-exempt
                  municipal bonds
              
              
              0
              
              
              
              
              
              0.00
              %
              
              558
              
              
              4.71
              %
              
              1,167
              
              
              4.43
              %
              
              1,525
              
              
              5.34
              %Other
                  bonds, notes, debentures and securities
              
              
              0
              
              
              
              
              
              %
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Totals
              
              $
              7,611
              
              
              
              
              
              4.21
              %
              $
              17,362
              
              
              4.47
              %
              $
              1,181
              
              
              4.46
              %
              $
              6,199
              
              
              5.58
              %Total
                  Securities Available for Sale
              
              $
              32,353
              
              
              
              
              
              4.62
              %
  19
  **TABLE
        14**
  Weighted
                  Average Yields on the Held To Maturity Investments
                  Periods
                    of Maturity from December 31,
                    2006
  Less
                  than 1 year
              
              1
                  to 5 years
              
              5
                  to 10 years
              
              Over
                  10 yearsAmount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)
              
              Amount
              
              Weighted
                Avg.
                  Yield (1)Securities
                  available for sale:U.S.
                  Treasuries
              
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %U.S.
                  Government agencies
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Mortgage-backed
                  securities (2)
              
              
              0
              
              
              0.00
              %
              
              19
              
              
              7.50
              %
              
              0
              
              
              0.00
              %
              
              217
              
              
              5.59
              %Tax-exempt
                  municipal bonds
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Other
                  bonds, notes, debentures and securities
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Totals
              
              $
              0
              
              
              0.00
              %
              $
              19
              
              
              7.50
              %
              $
              0
              
              
              0.00
              %
              $
              217
              
              
              5.59
              %Total
                  Securities held to maturity
              
              $
              236
              
              
              5.75
              %Federal
                  Home Loan Bank stock, at cost
              
              $
              1,332
              
              
              5.82
              %Total
                  Investments
              
              $
              33,921
              
              
              4.66
              %
  (1)
        The
        weighted average yields on tax-exempt securities have been computed on a
        tax-equivalent basis.
  (2)
        Mortgages are allocated by maturity and not amortized
 
 *Lending* -All
        lending activities of the Bank are under the direct supervision and control
        of
        the Directors Loan Committee, which consists of the Chief Executive Officer,
        President, Senior Loan Administrator, and five outside directors. Also present
        at meetings of the committee are the loan review officer and other lending
        officers as required. All lending activities of Eagle are under the direct
        supervision and control of its Board of Directors which consist of the Chief
        Executive Officer, President, Treasurer, Secretary, Bank’s Senior Loan
        Administrator and four outside directors. These loan committees enforce loan
        authorizations for each officer, make lending decisions on loans exceeding
        such
        limits, review and oversee problem credits, and determine the allocation
        of
        funds for each lending category.
 
 At
        December 31, 2007 and 2006, Cornerstone’s loan portfolio constituted
        approximately 83.2% and 81.6% of Cornerstone’s total assets, respectively.
 
 Table
        15
        presents the composition of the Cornerstone’s loan portfolio at the indicated
        dates.
 
 **TABLE
        15**
  Loan
                  Portfolio CompositionYears
                  Ending December 31,2007
              
              2006
              
              2005
              
              2004
              
              2003(In
                  thousands)
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              Percent
              
              Amount
              
              PercentCommercial,
                  financial and agricultural
              
              $
              98,065
              
              
              25.57
              %
              $
              98,542
              
              
              31.77
              %
              $
              86,039
              
              
              32.40
              %
              $
              61,742
              
              
              30.09
              %
              $
              42,420
              
              
              26.97
              %Real
                  estate - construction
              
              
              76,832
              
              
              20.03
              %
              
              57,606
              
              
              18.57
              %
              
              47,071
              
              
              17.72
              %
              
              36,824
              
              
              17.94
              %
              
              24,081
              
              
              15.31
              %Real
                  estate - mortgage
              
              
              64,585
              
              
              16.84
              %
              
              48,700
              
              
              15.70
              %
              
              48,645
              
              
              17.19
              %
              
              38,193
              
              
              18.61
              %
              
              28,185
              
              
              17.92
              %Real
                  estate - commercial
              
              
              138,074
              
              
              35.99
              %
              
              99,197
              
              
              31.98
              %
              
              79,608
              
              
              29.98
              %
              
              61,860
              
              
              30.14
              %
              
              56,527
              
              
              35.94
              %Consumer
                  loans
              
              
              6,037
              
              
              1.57
              %
              
              6,092
              
              
              1.98
              %
              
              7,191
              
              
              2.71
              %
              
              6,602
              
              
              3.22
              %
              
              6,077
              
              
              3.86
              %Total
                  loans
              
              $
              383,593
              
              
              100.00
              %
              $
              310,137
              
              
              100.00
              %
              $
              265,554
              
              
              100.00
              %
              $
              205,221
              
              
              100.00
              %
              $
              157,290
              
              
              100.00
              %
 
 Significant
        matters relating to the changes in the loan portfolio composition are presented
        below:
 
 logo
              During
                  2007 the Bank increased its loan portfolio in commercial real estate
                  loans
                  from $99 million to $138 million by the end of the year. The primary
                  reason for this growth was an increase in the number of Relationship
                  Managers (RM) and the creation of two new loan production offices
                  (LPO)
                  during 2007. The LPO’s were opened in Knoxville, TN and Dalton, GA and
                  were responsible for approximately $30 million in loan growth across
                  multiple classifications. In the Chattanooga market the Bank hired
                  four
                  RM’s. The increased man power and expanded markets were the result
                  of
                  Cornerstone’s strategic plan to grow loans at a rapid pace to offset the
                  expected contraction of the Bank’s net interest margin.
  20
 
 Table
        16
        presents the scheduled maturities of the loans in Cornerstone’s loan portfolio
        as of December 31, 2007 based on their contractual terms to maturity. Overdrafts
        are reported as due in less than one year. Loans unpaid at maturity are
        renegotiated based on current market rates and terms.
 
 **TABLE
        16**
  Loans
                  Maturing
                Year-end
                  balance as of December 31, 2007(In
                  thousands)
              
              Less
                  than One Year
              
              1
                  to 5 Years
              
              Over
                  5 Years
              
              TotalCommercial,
                  financial and agricultural
              
              $
              84,288
              
              $
              13,354
              
              $
              423
              
              $
              98,065Real
                  estate - construction
              
              
              68,632
              
              
              7,845
              
              
              355
              
              
              76,832Real
                  estate - mortgage
              
              
              30,688
              
              
              29,389
              
              
              4,508
              
              
              64,585Real
                  estate - commercial
              
              
              62,088
              
              
              74,696
              
              
              1,290
              
              
              138,074Consumer
              
              
              3,164
              
              
              2,831
              
              
              42
              
              
              6,037Total
                  Loans
              
              $
              248,860
              
              $
              128,115
              
              $
              6,618
              
              $
              383,593
  ***Types
        of Loans***
 
 *Commercial
        Loans-* The
        Bank’s commercial loan portfolio is comprised of commercial, industrial, and
        non-farm non-residential loans, hereinafter referred to as commercial loans
        (excluding commercial construction loans). These installment loans and lines
        of
        credit are extended to individuals, partnerships and corporations for a variety
        of business purposes, such as accounts receivable and inventory financing,
        equipment financing, business expansion and working capital. The following
        is a
        list of terms impeded in the Bank’s commercial loan portfolio:
 logo
                The
                    terms of the Bank's commercial loans generally range from 90
                    days to a 15
                    year amortization with a five year balloon.
  logo
                Commercial
                    loans are generally tied to the prime index and adjust according
                    with
                    changes in the prime rate. The
                    Bank also extends fixed interest rate loans when appropriate
                    to match the
                    borrower’s needs.
  logo
                Loans
                    secured by marketable equipment are required to be amortized
                    over a period
                    not to exceed 60 months.
  logo
                Generally,
                    loans secured by current assets such as inventory or accounts
                    receivable
                    are structured as revolving lines of credit with annual maturities.
  logo
                Loans
                    secured by chattel, mortgages and accounts receivable may not
                    exceed 85%
                    of their market value.
  logo
                Loans
                    secured by listed stocks, municipal bonds and mutual funds may
                    not exceed
                    70% of their market value.
  logo
                Unsecured
                    short-term loans and lines of credit must meet criteria set by
                    the Bank’s
                    Loan Committee. Current financial statements support all commercial
                    loans,
                    and such financial statements are updated annually.
  logo
                Substantially all of the Bank's commercial
                    loans are
                    secured and are guaranteed by the principals of the
                    borrower.
  Most
          of
          the Bank’s commercial loans are made with the intention of establishing a
          long-term relationship that fulfills the customer’s loan as well as deposit
          needs. This is the fastest growing area of the loan portfolio and is being
          staffed to continue this trend. The Bank believes this area has the best
          potential for future growth and has the highest barriers of entry to our
          competitors.
 
 *Real
          Estate: Construction Loans-* The
          Bank
          makes residential construction loans to owner-occupants and to persons
          building
          residential properties for resale. The Bank has two main areas of construction
          loans: one is to residential real estate developers for speculative or
          custom
          single-family residential properties, and the other is to custom commercial
          construction projects with guaranteed takeout provisions. Construction
          loans are
          usually variable rate loans made for terms of one year or less, but extensions
          are permitted if construction has continued satisfactorily, the loan is
          current
          and other circumstances warrant the extension. Construction loans are limited
          to
          80% of the appraised value of the lot and the completed value of the proposed
          structure.
 
 Construction
          financing generally is considered to involve a higher degree of credit
          risk than
          permanent mortgage financing of residential properties, and this additional
          risk
          usually is reflected in higher interest rates. The higher risk of loss
          on
          construction loans is attributable in large part to the fact that loan
          funds are
          estimated and advanced upon the security of the project under construction,
          which is of uncertain value prior to the completion of construction. Moreover,
          because of the uncertainties inherent in estimating construction costs,
          delays
          arising from labor problems, material shortages and other unpredictable
          contingencies, it is relatively difficult to accurately evaluate the total
          loan
          funds required to complete a project and to accurately evaluate the related
          loan-to-value ratios. If the estimates of construction costs and the saleability
          of the property upon completion of the project prove to be inaccurate,
          the Bank
          may be required to advance funds beyond the amount originally committed
          to
          permit completion of the project. If the estimate of value proves to be
          inaccurate, the Bank may be confronted, at or prior to the maturity of
          the loan,
          with a project with a value that is insufficient to assure full
          repayment.
  21
 
 The
          Bank's underwriting criteria are designed to evaluate and minimize the
          risk of
          each construction loan. Among other items, the Bank considers evidence
          of the
          availability of permanent financing or a take-out commitment to the borrower,
          the financial strength and reputation of the borrower, an independent appraisal
          and review of cost estimates, market conditions, and, if applicable, the
          amount
          of the borrower's equity in the project, pre-construction sale or leasing
          information and cash flow projections of the borrower.
 
 *Real
          Estate: Mortgage Loans-* Real
          estate mortgage loans include all one to four family residential loans
          secured
          by real estate for purposes other than construction or acquisition and
          development. All real estate loans are held in the Bank’s loan portfolio except
          for loans that are designated as loans held for sale. The loans held for
          sale
          are FHLB or FNMA qualified and have been pre-approved by an underwriting
          specialist prior to closing. The remainder of the Bank’s mortgage loans are home
          equity loans and are made at fixed interest rates for terms of one to three
          years with balloon payment provisions and amortized over a 10 to 15 year
          period.
          The Bank's experience indicates that real estate loans normally remain
          outstanding for much shorter periods (seven years on average) than their
          stated
          maturity because the borrowers repay the loans in full either upon the
          sale of
          the secured property or upon the refinancing of the original loan.
 
 In
          the
          case of owner occupied single-family residences, real estate loans are
          made for
          up to 95% of the value of the property securing the loan, based upon an
          appraisal if the loan amount is over $100,000. When the loan is secured
          by real
          estate containing a non-owner occupied dwelling of one to four family units,
          loans generally are made for up to 80% of the value, based upon an appraisal
          if
          the loan amount is over $100,000. The Bank also requires title insurance
          to
          insure the priority of the property lien on its real estate loans over
          $50,000
          and requires fire and casualty insurance on all of its loans.
 
 The
          real
          estate loans originated by the Bank contain a "due-on-sale" clause, which
          provides that the Bank may declare the unpaid balance of the loan immediately
          due and payable upon the sale of the mortgaged property. Such clauses are
          an
          important means of reducing the average loan life and increasing the yield
          on
          existing fixed-rate real estate loans, and it is the Bank's policy to enforce
          due-on-sale clauses.
 
 *Real
          Estate: Commercial-* Commercial
          real estate mortgage loans include all one to four family residential loans
          secured by real estate for purposes other than construction or acquisition
          and
          development. All real estate loans are held in the Bank’s loan portfolio except
          for loans that have been participated to correspondent banks. The Bank
          will sell
          these participations if a loan exceeds the Bank’s legal lending limit or as is
          deemed appropriate by the Director’s Loan Committee. Commercial real estate
          mortgage loans are a combination of properties that are leased out or used
          for a
          primary place of a business the Bank has a relationship with. Most of the
          commercial real estate loans have fixed interest rates for terms of one
          to three
          years with balloon payment provisions and are amortized over a 10 to 15
          year
          period, but whenever possible the Bank will seek a variable rate loan which
          would be tied to the New York prime rate and adjusted monthly. The Bank's
          experience indicates that real estate loans normally remain outstanding
          for much
          shorter periods (seven years on average) than their stated maturity because
          the
          borrowers repay the loans in full either upon the sale of the secured property
          or upon the refinancing of the original loan.
 
 Commercial
          real estate loans are made for up to 85% of the value of the property securing
          the loan, based upon an appraisal if the loan amount is over $100,000.
          The Bank
          also requires title insurance to insure the priority of the property lien
          on its
          real estate loans over $50,000 and requires fire and casualty insurance
          on all
          of its loans.
 
 *Consumer
          Loans-* These
          loans consist of consumer installment loans and consumer credit card balances.
          The Bank makes both secured and unsecured consumer loans for a variety
          of
          personal and household purposes. Most of the Bank's consumer loans are
          automobile loans, boat loans, property improvement loans and loans to depositors
          on the security of their certificates of deposit. These loans are generally
          made
          for terms of up to five years at fixed interest rates. The Bank considers
          consumer loans to involve a relatively high credit risk compared to real
          estate
          loans. Consumer loans, therefore, generally yield a relatively high return
          to
          the Bank and provide a relatively short maturity. The Bank believes that
          the
          generally higher yields and the shorter terms available on various types
          of
          consumer loans tend to offset the relatively higher risk associated with
          such
          loans, and contribute to a profitable spread between the Bank's average
          yield on
          earning assets and the Bank's cost of funds.
 
 *Lending
          Commitments-* Commitments
          under standby letters of credit and undisbursed loan commitments increased
          from
          $68 million in 2006 to $77 million in 2007. This number includes all lines
          of
          credit that have not been fully drawn and loan commitments in the same
          status.
  22





***Origination,
      Purchase and Sale of Loans***





The
      Bank
      originates the majority of its loans in Hamilton County, Tennessee. However,
      the
      Bank also originates loans in Marion, Sequatchie, Knox and Bradley Counties
      in
      Tennessee, and Dade, Walker, Whitfield and Catoosa Counties in Georgia, each
      of
      which is within 50 miles of Chattanooga, Tennessee. Loans are originated by
      20
      relationship managers who operate from the Bank's offices in Chattanooga,
      Tennessee and from the loan production offices in Dalton, Georgia and Knoxville,
      Tennessee. These relationship managers actively solicit loan applications from
      existing customers, local manufacturers and retailers, builders, real estate
      developers, real estate agents and others. The Bank also receives numerous
      loan
      applications as a result of customer referrals and walk-ins to its
      offices.





Upon
      receipt of a loan application and all required supporting information from
      a
      prospective borrower, the Bank obtains a credit report and verifies specific
      information relating to the loan applicant's employment, income and
      creditworthiness. For significant extensions of credit in which real estate
      will
      secure the proposed loan, a certified appraisal of the real estate is undertaken
      by an independent appraiser approved by the Bank. The Bank's relationship
      managers then analyze the credit worthiness of the borrower and the value of
      any
      collateral involved.





The
      Bank’s loan approval process is intended to be conservative but also responsive
      to customer needs. Loans are approved in accordance with the Bank's written
      loan
      policy, which provides for several tiers of approval authority, based on a
      borrower's aggregate debt with the Bank. The Bank’s legal lending limit is 25%
      of the Bank’s qualifying equity for secured loans and 15% for unsecured
      loans.





The
      Bank
      has in the past purchased and sold commercial loan participations with
      correspondent banks and will continue the practice when management feels the
      action would be in the best interest of shareholders. The purchase of loan
      participations allows the Bank to expand its loan portfolio and increase
      profitability while still maintaining the high credit standards, which are
      applied to all extensions of credit made by the Bank. The sale of loan
      participations allows the Bank to make larger loans and retain a servicing
      fee
      for its labor, which it otherwise would be unable to make due to capital or
      other funding considerations.





***Loan
      Fee Income***





In
      addition to interest earned on loans, the Bank receives origination fees for
      making loans, commitment fees for making certain loans, and other fees for
      miscellaneous loan-related services. Such fee income varies with the volume
      of
      loans made, prepaid or sold, and the rates of fees vary from time to time
      depending on the supply of funds and competitive conditions.





Commitment
      fees are charged by the Bank to the borrower for certain loans and are
      calculated as a percentage of the principal amount of the loan. These fees
      normally are deducted from the proceeds of the loan and generally range from
      1/2% to 2% of the principal amount, depending on the type and volume of loans
      made and market conditions such as the demand for loans, the availability of
      money and general economic conditions. The Bank complies with FASB 91 and
      amortizes all significant loan fees over the life of the loan. The Bank also
      receives miscellaneous fee income from late payment charges, overdraft fees,
      property inspection fees, and miscellaneous services related to its existing
      loans.





***Problem
      Loans and Allowance for Loan Losses***





*Problem
      Loans-* In
      originating loans, Cornerstone recognizes that it will experience credit losses
      and that the risk of loss will vary with, among other things, the type of loan
      being made, the creditworthiness of the borrower over the term of the loan
      and,
      in the case of a secured loan, the quality of the security for the loan.
      Cornerstone has instituted measures at the Bank and Eagle which are designed
      to
      reduce the risk of, and monitor exposure to, credit losses.





The
      Bank’s loan portfolio is systematically reviewed by the Bank's management,
      internal auditors, external auditors, and State and Federal regulators to ensure
      that the Bank’s larger loan relationships are being maintained within the loan
      policy guidelines, and remain properly underwritten. Input from all the above
      sources is used by the Bank to take corrective actions as necessary. As
      discussed below, each of the Bank's loans is assigned a rating in accordance
      with the Bank's internal loan rating system. All past due loans are reviewed
      by
      the Bank's senior lending officers and all past due loans over $25,000 are
      reviewed monthly by the Director’s Loan Committee. All loans
      classified **** as
      substandard or doubtful, as well as any "special mention" loans (defined in
      the
      following paragraph), are placed on the Bank’s watch list and reviewed at least
      monthly by the Director’s Loan Committee. In addition, all loans to a particular
      borrower are reviewed, regardless of classification, each time such borrower
      requests a renewal or extension of any loan or requests an additional loan.
      All
      lines of credit are reviewed annually prior to renewal. Such reviews include,
      but are not limited to, the ability of the borrower to repay the loan, a
      re-assessment of the borrower’s financial condition, the value of any collateral
      and the estimated potential loss to the Bank, if any.




23




The
      Bank's internal problem loan rating system establishes three classifications
      for
      problem assets: substandard, doubtful and loss. Additionally, in connection
      with
      regulatory examinations of the Bank, Federal and State examiners have authority
      to identify problem assets and, if appropriate, require the Bank to classify
      them. Substandard assets have one or more defined weaknesses and are
      characterized by the distinct possibility that the Bank will sustain some loss
      if the deficiencies are not corrected. Doubtful assets have the weaknesses
      of
      substandard assets with the additional characteristic that the weaknesses make
      collection or liquidation in full, on the basis of currently existing facts,
      conditions and values, highly questionable and improbable. An asset classified
      as loss is considered uncollectible and of such little value that continuance
      as
      an asset of the Bank is not warranted. Consequently, such assets are charged-off
      in the month they are classified as loss. Federal regulations also designate
      a
      "special mention" category, described as assets which do not currently expose
      the Bank to a sufficient degree of risk to warrant classification but do possess
      credit deficiencies or potential weaknesses deserving management's close
      attention.





Assets
      classified as substandard or doubtful require the Bank to establish general
      allowances for loan losses. If an asset or portion thereof is classified as
      loss, the Bank must either establish specific allowances for loan losses in
      the
      amount of 100% of the portion of the asset classified as loss or charge off
      such
      amount. General loss allowances established to cover possible losses related
      to
      assets classified as substandard or doubtful may be included, up to certain
      limits, in determining the Bank's regulatory capital, while specific valuation
      allowances for loan losses do not qualify as regulatory capital.





The
      Bank's collection procedures provide that when a loan becomes between fifteen
      days and thirty days delinquent, the borrower is contacted by mail and payment
      is requested. If the delinquency continues, subsequent efforts are made to
      contact and request payment from the delinquent borrower. Most loan
      delinquencies are cured within 60 days and no legal action is required. In
      certain circumstances, the Bank, for a fee, may modify the loan, grant a limited
      moratorium on loan payments or revise the payment schedule to enable the
      borrower to restructure his or her financial affairs **.** Generally,
      the Bank stops accruing interest and any accrued non collected interest will
      be
      reversed in accordance with GAAP on delinquent loans when payment is in arrears
      for 90 days or when collection otherwise becomes doubtful. If the delinquency
      exceeds 120 days and is not cured through the Bank's normal collection
      procedures or through a restructuring, the Bank will institute measures to
      enforce its remedies resulting from the default, including commencing a
      foreclosure, repossession or collection action. In certain cases, the Bank
      will
      consider accepting a voluntary conveyance of collateral in lieu of foreclosure
      or repossession. Real property acquired by the Bank as a result of foreclosure
      or by deed in lieu of foreclosure is classified as "real estate owned" until
      it
      is sold and is carried at the lower of cost or fair value less estimated costs
      to dispose. Accounting standards define fair value as the amount that is
      expected to be received in a current sale between a willing buyer and seller
      other than in a forced or liquidation sale. Fair values at foreclosure are
      based
      on appraisals. Losses arising from the acquisition of foreclosed properties
      are
      charged against the allowance for loan losses. Subsequent write-downs are
      provided by a charge to income through losses on other real estate in the period
      in which the need arises.





*Allowance
      for Loan Losses-* The
      allowance or reserve for possible loan losses is a means of absorbing future
      losses, which could be incurred from the current loan portfolio. The Bank
      maintains an allowance for possible loan losses, and management adjusts the
      general allowances monthly by charges to income in response to changes to
      outstanding loan balances.





The
      allowance for loan losses is evaluated on a regular basis by management and
      is
      based upon management’s periodic review of the collectability of loans in light
      of historical experience, the nature and volume of the loan portfolio, adverse
      situations that may affect the borrower’s ability to repay, estimated value of
      any underlying collateral and prevailing economic conditions. This evaluation
      is
      inherently subjective as it requires estimates that are susceptible to
      significant revision as more information becomes available. A loan or portion
      thereof is charged off against the general allowance when management has
      determined that losses on such loans are probable. Recoveries on any loans
      charged-off in prior fiscal periods are credited to the allowance. It is the
      opinion of the Bank's management that the balance in the general allowance
      for
      loan losses as of December 31, 2007 is adequate to absorb possible losses
      from loans currently in the portfolio.




24




Table
      17
      presents Cornerstone's allocation of the allowance for loan losses as of
      December 31, 2007, 2006, 2005, 2004 and 2003.




TABLE
      17


Allowance
                  for Loan Losses Years Ending December 31,2007
              
              2006
              
              2005(In
                  thousands)
                Balance
                  at end of period applicable to
              
              Amount
              
              Percent
                  of loans by category to total loans
              
              Amount
              
              Percent
                  of loans by category to total loans
              
              Amount
              
              Percent
                  of loans by category to total loansCommercial,
                  financial and agricultural
              
              $
              9,482
              
              
              25.57
              %
              $
              1,686
              
              
              31.77
              %
              $
              1,438
              
              
              32.40
              %Real
                  estate - construction
              
              
              2,447
              
              
              20.03
              %
              
              1,581
              
              
              18.57
              %
              
              1,253
              
              
              17.72
              %Real
                  estate - mortgage
              
              
              101
              
              
              16.84
              %
              
              77
              
              
              15.70
              %
              
              79
              
              
              17.19
              %Real
                  estate - commercial
              
              
              1,434
              
              
              35.99
              %
              
              703
              
              
              31.98
              %
              
              535
              
              
              29.98
              %Consumer
              
              
              246
              
              
              1.57
              %
              
              211
              
              
              1.98
              %
              
              240
              
              
              2.71
              %Totals
              
              $
              13,710
              
              
              100.00
              %
              $
              4,258
              
              
              100.00
              %
              $
              3,545
              
              
              100.00
              %


2004
              
              2003(In
                  thousands) Balance at end of period applicable to
              
              Amount
              
              Percent
                  of loans by category to total loans
              
              Amount
              
              Percent
                  of loans by category to total loansCommercial,
                  financial and agricultural
              
              $
              1,002
              
              
              30.09
              %
              $
              840
              
              
              26.97
              %Real
                  estate - construction
              
              
              962
              
              
              17.94
              %
              
              539
              
              
              15.31
              %Real
                  estate - mortgage
              
              
              122
              
              
              18.61
              %
              
              139
              
              
              17.92
              %Real
                  estate - commercial
              
              
              361
              
              
              30.14
              %
              
              352
              
              
              35.94
              %Consumer
              
              
              211
              
              
              3.22
              %
              
              141
              
              
              3.86
              %Totals
              
              $
              2,658
              
              
              100.00
              %
              $
              2,011
              
              
              100.00
              %





Table
      18
      presents Cornerstone's delinquent and non-performing assets as of December
      31, 2007 and 2006.





**TABLE
      18**




Delinquent
                and Non-performing AssetsActual
                for Years Ending December 31,(In
                thousands)
            
            2007
            
            2006Accruing
                loans that are contractuallypast
                due 90-days or more:Commercial,
                financial and agricultural
            
            $
            0
            
            $
            0Real
                estate - construction
            
            
            0
            
            
            0Real
                estate - mortgage
            
            
            0
            
            
            0Consumer
            
            
            0
            
            
            0Total
                Loans
            
            $
            0
            
            $
            0Non-accruing
                loans 90-days or more:Commercial,
                financial and agricultural
            
            $
            124
            
            $
            127Real
                estate - construction
            
            
            341
            
            
            186Real
                estate - mortgage
            
            
            220
            
            
            789Consumer
            
            
            0
            
            
            0Total
                Loans
            
            $
            685
            
            $
            1,102




25




Real
                estate acquired through foreclosure
            
            $
            1,038
            
            $
            380Property
                acquired through repossession
            
            
            0
            
            
            0Total
                acquired
            
            
            1,038
            
            
            380Total
                Loans
            
            $
            383,593
            
            $
            310,137Ratio
                of non-performing assets to total loans
            
            
            0.45
            %
            
            0.48
            %Ratio
                of delinquent (30-days or more) but accruing loans to:Total
                loans
            
            
            1.12
            %
            
            0.77
            %Total
                assets
            
            
            0.97
            %
            
            0.63
            %





In
      addition to the Bank's loan rating system for problem assets described above
      (see “Problem Loans,” above), the Bank has established a loan rating system for
      all categories of loans which assists management and the Board of Directors
      in
      determining the adequacy of the Bank's allowance for loan losses. Each loan
      in
      the Bank's portfolio is assigned a rating which is reviewed by management
      periodically to ensure its continued suitability. An exception is made in the
      case of (i) monthly installment loans which are grouped together by delinquency
      status such as over 10, 30, 60, or 90 days past due and (ii) problem assets
      which are rated as substandard, doubtful, or loss as discussed above. All other
      loans are assigned a rating of excellent, good, or average. The total amount
      of
      loans in each of these loan rating categories is weighted by a factor that
      management believes reasonably reflects losses that can be anticipated with
      respect to loans in each of these categories. Based on these weightings, the
      Bank’s management establishes an allowance for loan losses that is reviewed by
      its Board of Directors each month.





Table
      19
      presents Cornerstone’s loan loss experience for the periods
      indicated.





**TABLE
      19**


Loan
                  Loss Reserve AnalysisYears
                  Ending December 31,(in
                  thousands)
              
              2007
              
              2006
              
              2005
              
              2004
              
              2003Average
                  loans
              
              $
              353,278
              
              $
              284,105
              
              $
              236,265
              
              $
              181,335
              
              $
              141,586Allowance
                  for possible loan losses,Beginning
                  of the period
              
              $
              4,258
              
              $
              3,545
              
              $
              2,658
              
              $
              2,011
              
              $
              1,591Charge-offs
                  for the period:Commercial,
                  financial and agricultural
              
              
              737
              
              
              307
              
              
              275
              
              
              165
              
              
              223Real
                  estate - construction
              
              
              84
              
              
              0
              
              
              48
              
              
              0
              
              
              0Real
                  estate - mortgage
              
              
              180
              
              
              104
              
              
              128
              
              
              138
              
              
              6Consumer
              
              
              74
              
              
              70
              
              
              111
              
              
              69
              
              
              106Total
                  charge-offs
              
              
              1,075
              
              
              481
              
              
              562
              
              
              372
              
              
              335Recoveries
                  for the period:Commercial,
                  financial and agricultural
              
              
              114
              
              
              66
              
              
              12
              
              
              149
              
              
              183Real
                  estate - construction
              
              
              0
              
              
              0
              
              
              1
              
              
              0
              
              
              3Real
                  estate - mortgage
              
              
              4
              
              
              7
              
              
              6
              
              
              7
              
              
              0Consumer
              
              
              0
              
              
              15
              
              
              28
              
              
              23
              
              
              24Total
                  recoveries
              
              
              118
              
              
              88
              
              
              47
              
              
              179
              
              
              210Net
                  charge-offs for the period
              
              
              957
              
              
              393
              
              
              515
              
              
              193
              
              
              125Provision
                  for loan losses
              
              
              10,409
              
              
              1,106
              
              
              1,402
              
              
              840
              
              
              545Adjustments
              
              
              0
              
              
              0
              
              
              0
              
              
              0
              
              
              0Allowance
                  for possible loan losses, end of period
              
              $
              13,710
              
              $
              4,258
              
              $
              3,545
              
              $
              2,658
              
              $
              2,011Ratio
                  of allowance for loan losses to total average loans
                  outstanding
              
              
              3.88
              %
              
              1.50
              %
              
              1.50
              %
              
              1.47
              %
              
              1.42
              %Ratio
                  of net charge-offs during the period to average loans outstanding
                  during
                  the period
              
              
              0.27
              %
              
              0.14
              %
              
              0.22
              %
              
              0.10
              %
              
              0.09
              %
  26





*Intangibles-* During
      2002, the Company adopted the provisions of Statement of Financial Statement
      No.
      142 Goodwill and other Intangible Assets concerning the $2,541,476 goodwill
      created by the merger with the Bank of East Ridge. Goodwill is tested annually
      for impairment. If the carrying value of goodwill exceeds the fair value, a
      write-down is recorded. No impairment loss was recognized during 2007, 2006
      or
      2005. Also, in December, 2005, the Company completed the purchase of Eagle
      Financial, Inc. and recorded an intangible asset of $848,916. Amortization
      expense relating to this intangible for 2007, 2006 and 2005 was $108,000,
      $345,388 and $13,500, respectively.




***Sources
      of Funds***





*Overview* -Time,
      money market, savings and demand deposits are the major source of Cornerstone’s
      funds for lending and other investment purposes. All deposits are held by the
      Bank. In addition, Cornerstone obtains funds from loan principal repayments
      and
      proceeds from sales of loan participations and investment securities. Loan
      repayments are a relatively stable source of funds, while deposit inflows and
      outflows and sales of loan participations and investment securities are
      significantly influenced by prevailing interest rates, economic conditions
      and
      the Company's asset and liability management strategies. Borrowings are used
      on
      either a short-term basis to compensate for reductions in the availability
      of
      other sources of funds or on a longer-term basis to reduce interest rate
      risk.





*Deposits* -The
      Bank
      offers several types of deposit accounts, with the principal differences
      relating to the minimum balances required, the time period the funds must remain
      on deposit and the interest rate. Deposits are obtained primarily from the
      Bank's Chattanooga Metropolitan Statistical Area (MSA). The Bank does advertise
      for deposits outside of this area and has had moderate success attracting
      deposits from credit unions around the United States. The Bank does not rely
      upon any single person or group of related persons for a material portion of
      its
      deposits. However, the Bank has a large depositor related to its ACH business
      line that leaves a large amount of money for the Bank to use as it passes
      through the Bank to its final destination. A principal source of deposits for
      the Bank consists of short-term money market and other accounts, which are
      highly responsive to changes in market interest rates. Accordingly, the Bank,
      like all financial institutions, is subject to short-term fluctuations in
      deposits in response to customer actions due to changing short-term market
      interest rates. The ability of the Bank to attract and maintain deposits and
      the
      Bank's cost of funds has been and will continue to be significantly affected
      by
      money market conditions.




Table
      20
      presents the composition of deposits for the Bank, excluding accrued interest
      payable, by type for the years ended December 31, 2007, 2006 and 2005 (in
      thousands).





**TABLE
      20**


****Deposit
                    CompositionYears
                    Ending December 31,
 (In
                    thousands)
                
                2007
                
                2006
                
                2005Demand
                    deposits
                
                $
                45,285
                
                $
                41,723
                
                $
                42,118NOW
                    deposits
                
                
                31,985
                
                
                38,160
                
                
                33,080Savings
                    & money market deposits
                
                
                49,970
                
                
                56,913
                
                
                55,411Time
                    deposits $100,000 and over
                
                
                71,505
                
                
                44,544
                
                
                38,707Time
                    deposits under $100,000
                
                
                114,505
                
                
                94,476
                
                
                83,119Total
                    Deposits
                
                $
                313,250
                
                $
                275,816
                
                $
                252,435





Table
      21
      presents a breakdown by category of the average amount of deposits and the
      average rate paid on deposits for the periods indicated:





**TABLE
      21**




Average
        Amount and Average Rate Paid on Deposits Years
          Ending December 31,




2007
            
            
            2006
            
            
            2005Amount
            
            
            Rate
            
            
            Amount
            
            
            Rate
            
            
            Amount
            
            
            RateDemand
                deposits
            
            $
            41,503
            
            
            
            
            $
            37,056
            
            
            
            
            $
            34,730NOW
                deposits
            
            
            36,327
            
            
            2.21
            %
            
            34,701
            
            
            1.23
            %
            
            33,943
            
            
            0.97
            %Savings
                & money market deposits
            
            
            55,808
            
            
            3.61
            %
            
            58,477
            
            
            3.80
            %
            
            45,232
            
            
            2.45
            %Time
                deposits $100,000 and over
            
            
            61,172
            
            
            5.12
            %
            
            43,692
            
            
            4.56
            %
            
            32,611
            
            
            3.51
            %Time
                deposits under $100,000
            
            
            107,498
            
            
            5.01
            %
            
            88,773
            
            
            4.39
            %
            
            70,167
            
            
            3.19
            %Total
                Deposits
            
            $
            302,308
            
            
            4.35
            %
            $
            262,699
            
            
            3.78
            %
            $
            216,683
            
            
            2.65
            %




27




*Borrowings-* The
      Bank
      joined the Federal Home Loan Bank of Cincinnati in October of 2000. The Federal
      Home Loan Bank (the “FHLB”) allows the Bank to borrow funds on a contractual
      basis many times at rates lower than the costs of local certificates of deposit.
      In addition, the FHLB has the ability to provide structured advances that best
      reduce or leverage the interest rate risk of the Bank. The Bank as of the end
      of
      the year had $47 million outstanding with the FHLB **.** The FHLB
      offers multiple products to assist banks in their funding needs. During 2007
      the
      Bank obtained funding by obtaining a daily revolving credit advance and fixed
      rate loans. **** The
      revolving credit advance has a minimum advance requirement of $15 million and
      is
      priced at a variable rate. As of December 31, 2007 the Bank had converted
      borrowings under the revolving credit advance to fixed rate loans with stated
      maturities ranging from two years to ten years. FHLB loans totaling $47 million
      as of December 31, 2007 are structured as an obligation with a fixed rate with
      the majority of loans incorporating an optional conversion to a floating rate
      after a stated period of time. The loans have maturities ranging from May 2010
      to January 2017. As of December 31, 2007 the interest rates on these loans
      ranged from 3.87% to 5.00%. The Bank has several Federal Funds lines of credit
      available with correspondent banks with a total availability of $44 million
      as
      of the end of 2007. In addition, the Bank has the right to borrow from the
      Federal Reserve Bank if necessary to supplement its supply of funds available
      for lending and to meet deposit withdrawal requirements. As of December 31,
      2007, Cornerstone had established a line of credit of $8.5 million priced at
      New
      York Prime Rate minus 150 basis points. The loan was established to insert
      capital infusions to the Bank to fund growth or retire treasury stock, if any,
      as needed. This line allows Cornerstone to act as a source of strength for
      the
      Bank without the expense or dilution of additional common stock. As of December
      31, 2007, there was $100,000 borrowed on the line of credit and Cornerstone
      has
      the remaining balance available to inject capital into the Bank or fund other
      investments.





***Capital***





*Capital
      Resources-* Stockholder’s
      average equity for 2007 and 2006 totaled $40.7 million and $35.7 million,
      respectively. As of December 31, 2007, Cornerstone’s actual stockholder equity
      had decreased from $38.2 million in 2006 to $36.3. The decrease is primarily
      attributable to the increase in the Bank’s allowance for loan losses that was
      recognized in December 2007. The number of common shares outstanding decreased
      to 6,369,718 as of year end 2007 from 6,511,848 as of year end 2006. Changes
      in
      the number of common shares outstanding are the result of two transactions.
      The
      first transaction resulted in an increase in the number of shares outstanding
      by
      10,870 as employees and a member of the board of directors exercised stock
      options during 2007. The second transaction resulted in the reduction of the
      number of shares outstanding by 153,000. The number of shares outstanding
      decreased primarily during the 3 rd and
      4 th quarters
      of 2007 as a result of Cornerstone’s initiation of a stock repurchase program
      totaling 150,000 shares as announced in Cornerstone’s Form 8-K filing on October
      19, 2007.





*Capital
      Adequacy* -Capital
      adequacy refers to the level of capital required to sustain asset growth and
      to
      absorb losses. The objective of Cornerstone’s management is to maintain a level
      of capitalization that is sufficient to take advantage of profitable growth
      opportunities while meeting regulatory requirements. This is achieved by
      improving profitability by effectively allocating resources to more profitable
      business, improving asset quality, strengthening service quality, and
      streamlining costs. The primary measures used by management to monitor the
      results of these efforts are the ratios of actual equity to average assets
      and
      actual equity to risk-adjusted assets.





The
      FDIC
      has adopted capital guidelines governing the activities of banks. These
      guidelines require the maintenance of an amount of capital based on
      risk-adjusted assets so that categories of assets with potentially higher credit
      risk will require more capital backing than assets with lower risk. In addition,
      banks are required to maintain capital to support, on a risk-adjusted basis,
      certain off-balance sheet activities such as loan commitments. The capital
      guidelines classify capital into two tiers, referred to as Tier I and Tier
      II.
      Under risk-based capital requirements, total capital consists of Tier I capital,
      which is generally common shareholder’s equity less goodwill, and Tier II, which
      is primarily Tier I capital plus a portion of the loan loss allowance. In
      determining risk-based capital requirements, assets are assigned risk-weights
      of
      0% to 100%, depending primarily on the regulatory assigned levels of credit
      risk
      associated with such assets. Off-balance sheet items are considered in the
      calculation of risk-adjusted assets through conversion factors established
      by
      regulators. The framework for calculating risk-based capital requires banks
      to
      meet the regulatory minimums of 4% Tier I and 8% total risk based capital.
      In
      1990 regulators added a leverage computation to the capital requirements,
      comparing Tier I capital to total average assets less goodwill.




The
      Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”)
      established five capital categories for banks. Under the regulation defining
      these five capital categories, each bank is classified into one of the five
      categories based on its level of risk-based capital as measured by Tier I
      capital, total risk-based capital, and Tier I leverage ratios and its
      supervisory ratings. Table 22 lists the five categories of capital and each
      of
      the minimum requirements for the three risk-based ratios.





28




**TABLE
      22**


Minimum
        Requirements for Risk-Based Capital Ratios


Total
                Risk-Based
              Capital
                Ratio
            
            Tier
                I Risk-Based
              Capital
                Ratio
            
            Leverage
                RatioWell
                capitalized
            
            
            10%
                or above
            
            
            6%
                or above
            
            
            5%
                or aboveAdequately
                capitalized
            
            
            8%
                or above
            
            
            4%
                or above
            
            
            4%
                or aboveUnder
                Capitalized
            
            
            Less
                than 8
            %
            
            Less
                than 4
            %
            
            Less
                than 4
            %Significantly
                undercapitalized
            
            
            Less
                than 6
            %
            
            Less
                than 3
            %
            
            Less
                than 3
            %Critically
                undercapitalized
            
            
            
            
            
            
            
            
            2%
                or less





As
      of
      December 31, 2007, Cornerstone exceeded the regulatory minimums and qualified
      as
      an adequately-capitalized institution under the regulations. The Bank had Tier
      1
      capital of $31.6 or 7.4% of average assets as of December 31, 2007 compared
      to
      Tier 1 capital of $31.7 or 9.4% of average assets as of December 31, 2006.
      The
      Bank had total capital of $36.6 or 9.3% of risk weighted assets as of December
      31, 2007 compared to total capital of $35.8 or 10.9% of risk weighted assets
      as
      of December 31, 2006. The Bank fell from a well capitalized capital position
      during 2006 to an adequately capitalized position in 2007 due to the $6.5
      million loan loss provision provided to the Bank’s loan loss allowance after the
      actual close of 2007. This treatment was in accordance with Generally Accepted
      Accounting Principles as this loss pertained to 2007 and was identified before
      issuance of the financial statements.




*Liquidity-* of
      a ** primary
      importance to depositors, creditors and regulators is the ability to have
      readily available funds sufficient to repay fully maturing liabilities.
      Cornerstone’s liquidity, represented by cash and cash from banks, is a result of
      its operating, investing and financing activities. In order to ensure funds
      are
      available at all times, Cornerstone devotes resources to projecting on a monthly
      basis the amount of funds accessible. Liquidity requirements can also be met
      through short-term borrowing or the disposition of short-term assets, which
      are
      generally matched to correspond to the maturity of liabilities.





Cornerstone’s
      liquidity target is measured by adding the Bank’s net cash, short term and
      marketable securities not pledged and dividing this number by total deposits
      and
      short-term liabilities not secured by assets pledged. The Bank’s liquidity ratio
      at year end 2007 was 4.8% compared to 8.4% at year end 2006. Cornerstone is
      not
      subject to any specific liquidity requirements imposed by regulatory orders.
      Cornerstone is subject however, to general FDIC guidelines, which do not require
      a minimum level of liquidity. Management believes its liquidity ratios meet
      or
      exceed these guidelines. Management does not know of any trends or demands,
      which are reasonably likely to result in liquidity increasing or decreasing
      in
      any material manner.





Table
      23
      presents the average loan to deposit ratios, a liquidity measure, for periods
      indicated:





**TABLE
      23**




December
                31, 2007
            
            December
                31, 2006Average
                loans to average deposits
            
            
            116.86
            %
            
            108.15
            %




**ITEM
      7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
      RISK**





Cornerstone’s
      Asset/Liability Committee (“ALCO”) actively measures and manages interest rate
      risk using a process developed by the Bank. The ALCO is also responsible for
      approving Cornerstone’s asset/liability management policies, overseeing the
      formulation and implementation of strategies to improve balance sheet
      positioning and earnings, and reviewing Cornerstones’s interest rate sensitivity
      position.




The
      primary tool that management uses to measure short-term interest rate risk
      is a
      net interest income simulation model prepared by an independent national
      consulting firm and reviewed by another separate and independent national
      consulting firm. These simulations estimate the impact that various changes
      in
      the overall level of interest rates over one- and two-year time horizons would
      have on net interest income. The results help Cornerstone develop strategies
      for
      managing exposure to interest rate risk.




29




Like
      any
      forecasting technique, interest rate simulation modeling is based on a large
      number of assumptions. In this case, the assumptions relate primarily to loan
      and deposit growth, asset and liability prepayments, interest rates and balance
      sheet management strategies. Management believes that both individually and
      in
      the aggregate the assumptions are reasonable. Nevertheless, the simulation
      modeling process produces only a sophisticated estimate, not a precise
      calculation of exposure.




Table
      24
      presents the re-pricing of Cornerstone’s interest earning assets and
      interest-bearing liabilities as of December 31, 2007. This interest sensitivity
      gap table is designed to monitor Cornerstone’s interest rate risk exposure
      within the designated time period. In order to control interest rate risk,
      management regularly monitors the volume of interest sensitive assets relative
      to interest sensitive liabilities over specific time intervals. Cornerstone’s
      interest rate management policy is to attempt to maintain a relatively stable
      net interest margin in periods of interest rate fluctuations. Cornerstone’s
      policy is to attempt to maintain a ratio of cumulative gap to total interest
      sensitive assets of negative 15.00% to positive 15.00% in the time period of
      one
      year or less. The information set forth below is based on the following
      assumptions of management: (i) savings and money market and NOW accounts will
      be
      less interest rate sensitive and the re-pricing on these accounts will be spread
      out over a five-year period; and (ii) securities other than mortgage-backed
      securities have been scheduled by maturity date while mortgages have been
      amortized over the life of the mortgage.





**TABLE
      24**




Re-pricing
                of Interest Sensitive Assets and Liabilities
              Year-end
                balance as of December 31, 2007(In
                thousands)
            
            Less
                than One Year
            
            1
                to 5 Years (3)
            
            Over
                5 Years (3)
            
            TotalInterest
              Sensitive Assets:Federal
                funds sold
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0Investment
                securitiesTaxable
                (1)
            
            
            8,491
            
            
            16,863
            
            
            6,096
            
            
            31,450Tax-exempt
                (1)
            
            
            126
            
            
            739
            
            
            2,638
            
            
            3,503Loans
                (2)Fixed
                rate and adjustable rate 1-4 family mortgage
            
            
            30,688
            
            
            29,389
            
            
            4,508
            
            
            64,585Scheduled
                payments
            
            
            218,172
            
            
            98,726
            
            
            2,110
            
            
            319,008Total
                Interest Sensitive Assets
            
            $
            257,477
            
            $
            145,717
            
            $
            15,352
            
            $
            418,546Interest
                Sensitive Liabilities:NOW
                accounts
            
            $
            12,797
            
            $
            19,195
            
            $
            0
            
            $
            31,992Money
                market and savings accounts
            
            
            24,203
            
            
            25,760
            
            
            0
            
            
            49,963Time
                deposits
            
            
            167,423
            
            
            18,588
            
            
            0
            
            
            186,011Other
                interest bearing liabilities
            
            
            88,660
            
            
            0
            
            
            0
            
            
            88,660Total
                Interest Sensitive Liabilities
            
            $
            293,083
            
            $
            63,543
            
            $
            0
            
            $
            356,626Interest
                Sensitive Gap
            
            
            (35,606
            )
            
            82,174
            
            
            15,352
            
            
            61,920Cumulative
                Interest Sensitive Gap
            
            
            (35,606
            )
            
            46,568
            
            
            61,920Ratio
                of cumulative gap to total Interest Sensitive Assets
            
            
            (8.51
            )%
            
            11.13
            %
            
            14.79
            %




(1)
      All
      AFS securities are shown at the market value and HTM are shown at book
      value.




(2)
      Non-performing loans are included as interest-earning assets.




(3)
      All
      assets and liabilities in these categories are fixed rates.





Symbol logo
            During
                2007 management made an effort to reduce the Bank’s sensitivity to
                interest sensitive assets by lengthening the maturities of its securities
                and loans while reducing the average maturities of its interest sensitive
                liabilities. This was undertaken due to the uncertainty in the economy
                and
                growing probability that interest rates would
                decline.





30


*Impact
      of Inflation and Changing Price-* The
      financial statements and related financial data presented herein have been
      prepared in accordance with U.S. generally accepted accounting principles,
      which
      require the measurement of the financial position and operating results in
      terms
      of historical dollars without considering the changes in the relative purchasing
      power of money over time and due to inflation. Management is primarily concerned
      with two inflationary factors; The first and the most common is the general
      impact of inflation on operations of Cornerstone and is reflected in increased
      operating costs. The other and more material to the Bank’s profitability are
      interest rate adjustments by the Federal Reserve and the general fixed income
      market in reaction to inflation. In other words, interest rate risk, unlike
      most
      industrial companies, substantially impacts Cornerstone because virtually all
      of
      the assets and liabilities of Cornerstone are monetary in nature. As a result,
      interest rates may have a more significant impact on Cornerstone’s performance
      than the effects of general levels of inflation. Interest rates do not
      necessarily move in the same direction or in the same magnitude as the price
      of
      goods and services and each issue must be dealt with
      independently.


**ITEM
      8. FINANCIAL STATEMENTS**





**CORNERSTONE
      BANCSHARES, INC. AND SUBSIDIARIES**





**Consolidated
      Financial Statements and Footnotes**





**Table
                of
                Contents**Page
                No.Management
                Report on Internal Control over Financial Reporting
            32Report
                of Independent Registered Public Accounting Firm - Internal Control
                over
                Financial Reporting
            33Report
                of Independent Registered Public Accounting Firm - Financial
                Statements
            35Consolidated
                Financial StatementsConsolidated
                balance sheets
            36Consolidated
                statements of income
            37Consolidated
                statements of changes in stockholders’ equity
            38Consolidated
                statements of cash flows
            40Notes
                to consolidated financial statements
            41




31




**MANAGEMENT
      REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**





The
      management of Cornerstone is responsible for establishing and maintaining
      adequate internal control over financial reporting. Cornerstone’s internal
      control system was designed to provide reasonable assurance to Cornerstone’s
      management and board of directors regarding the preparation and fair
      presentation of published financial statements. All internal control systems,
      no
      matter how well designed, have inherent limitations. Therefore, even those
      systems determined to be effective can provide only reasonable assurance with
      respect to financial statement preparation and presentation.





Cornerstone’s
      management has assessed the effectiveness of internal controls over financial
      reporting as of December 31, 2007. In making this assessment, it used the
      criteria set forth by the Committee of Sponsoring Organizations of the Treadway
      Commission (COSO) in Internal Control-Integrated Framework.





Based
      on
      our assessment we believe that, as of December 31, 2007, Cornerstone’s
      internal control over financial reporting is effective based on those criteria.





Cornerstone’s
      independent registered public accounting firm has issued an audit report on
      Cornerstone’s internal control over financial reporting. This report appears in
      Item No. 8 of this Annual Report on Form 10-K.




32


Report
        of Independent Registered Public Accounting Firm
  To
        the
        Stockholders and
 Board
        of
        Directors
 Cornerstone
        Bancshares, Inc.
 Chattanooga,
        Tennessee
 
 We
        have
        audited the internal control over financial reporting of Cornerstone Bancshares,
        Inc. and subsidiaries (the Company) as of December 31, 2007, based on criteria
        established in “Internal Control— Integrated Framework” issued by the Committee
        of Sponsoring Organizations of the Treadway Commission (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, included in the accompanying Management
        Report
        on Internal Control over Financial Reporting. Our responsibility is to express
        an opinion on the Company's internal control over financial reporting based
        on
        our audit.
 
 We
        conducted our audit 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. Our audit included obtaining an understanding of internal control
        over
        financial reporting, assessing the risk that a material weakness exists,
        testing
        and evaluating the design and operating effectiveness of internal control
        based
        on the assessed risk and performing such other procedures as we considered
        necessary in the circumstances. We believe that our audit provides a reasonable
        basis for our opinion.
 
 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 (1) pertain
        to
        the maintenance of records that, in reasonable detail, accurately and fairly
        reflect the transactions and dispositions of the assets of the company; (2)
        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 (3) 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.
  33
 
 In
        our
        opinion, the Company maintained, in all material respects, effective internal
        control over financial reporting as of December 31, 2007, based on criteria
        established in “Internal Control—Integrated Framework” issued by the Committee
        of Sponsoring Organizations of the Treadway Commission (COSO).
 
 We
        have
        also audited, in accordance with the standards of the Public Company Accounting
        Oversight Board (United States), the financial statements as of and for the
        year
        ended December 31, 2007, of the Company and our report dated March 12,
        2008, expressed an unqualified opinion on those financial
        statements.
  /s/ HAZLETT,
                LEWIS & BIETER, PLLCChattanooga,
                  Tennessee
                March
                  12, 2008
  34
  Report
        of Independent Registered Public Accounting Firm
  To
        the
        Stockholders and
 Board
        of
        Directors
 Cornerstone
        Bancshares, Inc.
 Chattanooga,
        Tennessee
 
 We
        have
        audited the accompanying consolidated balance sheets of Cornerstone Bancshares,
        Inc. and subsidiaries (the Company) as of December 31, 2007 and 2006, and
        the
        related consolidated statements of income, changes in stockholders’ equity,
        and cash flows for each of the three years in the period ended December 31,
        2007. 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 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 includes examining,
        on a
        test basis, evidence supporting the amounts and disclosures in the financial
        statements. An audit also includes assessing the accounting principles used
        and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audits provide a
        reasonable basis for our opinion.
 
 In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the financial position of Cornerstone Bancshares,
        Inc.
        and subsidiaries as of December 31, 2007 and 2006, and the results of their
        operations and their cash flows for each of the three years in the period
        ended
        December 31, 2007, in conformity with accounting principles generally accepted
        in the United States of America.
 
 We
        have
        also audited, in accordance with the standards of the Public Company Accounting
        Oversight Board (United States), the effectiveness of the Company’s internal
        control over financial reporting as of December 31, 2007, based on the
        criteria established in “Internal Control - Integrated Framework” issued by the
        Committee of Sponsoring Organizations of the Treadway Commission and our
        report
        dated March 12, 2008, expressed an unqualified opinion on the Company’s internal
        control over financial reporting.
 
 /s/
        HAZLETT, LEWIS & BIETER, PLLC
 
 Chattanooga,
        Tennessee
 March
        12,
        2008
  35
 CORNERSTONE
                  BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                  BALANCE SHEETSDecember
                  31, 2007 and 2006
  2007
              
              2006ASSETSCash
                  and due from banks
              
              $
              14,933,349
              
              $
              17,635,956Securities
                  available for sale
              
              
              34,751,985
              
              
              32,353,380Securities
                  held to maturity (fair value approximates$199,678
                  at 2007 and $236,189 at 2006)
              
              
              200,037
              
              
              236,169Federal
                  Home Loan Bank stock, at cost
              
              
              1,911,600
              
              
              1,332,100Loans,
                  net of allowance for loan losses of$13,710,109
                  in 2007 and $4,258,352 in 2006
              
              
              369,883,009
              
              
              305,879,013Bank
                  premises and equipment, net
              
              
              6,470,893
              
              
              6,134,009Accrued
                  interest receivable
              
              
              2,407,977
              
              
              2,120,778Goodwill
                  and amortizable intangibles
              
              
              2,941,798
              
              
              3,046,287Other
                  assets
              
              
              10,920,605
              
              
              6,204,541Total
                  assets
              
              $
              444,421,253
              
              $
              374,942,233LIABILITIES
                  AND STOCKHOLDERS' EQUITYDeposits:Noninterest-bearing
                  demand deposits
              
              $
              45,284,518
              
              $
              41,722,570Interest-bearing
                  demand deposits
              
              
              31,984,590
              
              
              38,159,718Savings
                  deposits and money market accounts
              
              
              49,970,489
              
              
              56,913,225Time
                  deposits of $100,000 or more
              
              
              71,505,272
              
              
              44,544,335Time
                  deposits under $100,000
              
              
              114,504,856
              
              
              94,476,685Total
                  deposits
              
              
              313,249,725
              
              
              275,816,533Accrued
                  interest payable
              
              
              216,086
              
              
              308,392Federal
                  funds purchased and securities sold underagreements
                  to repurchase
              
              
              41,560,355
              
              
              19,249,701Federal
                  Home Loan Bank advances and line of credit
              
              
              47,100,000
              
              
              39,500,000Other
                  liabilities
              
              
              5,967,737
              
              
              1,884,342Total
                  liabilities
              
              
              408,093,903
              
              
              336,758,968Stockholders'
                  equity:Preferred
                  stock - no par value; 2,000,000 sharesauthorized;
                  no shares issued
              
              
              -
              
              
              -Common
                  stock - $1.00 par value; 10,000,000 shares authorized;6,522,718
                  and 6,511,848 shares issued in 2007 and 2006;6,369,718
                  and 6,511,848 outstanding in 2007 and 2006
              
              
              6,369,718
              
              
              6,511,848Additional
                  paid-in capital
              
              
              20,532,787
              
              
              21,849,006Retained
                  earnings
              
              
              9,317,878
              
              
              9,881,029Accumulated
                  other comprehensive income (expense)
              
              
              106,967
              
              
              (58,618
              )Total
                  stockholders' equity
              
              
              36,327,350
              
              
              38,183,265Total
                  liabilities and stockholders' equity
              
              $
              444,421,253
              
              $
              374,942,233
  The
                  Notes to Consolidated Financial Statements are an integral part
                  of these
                  statements.
  36
  CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF INCOMEYears
                    Ended December 31, 2007, 2006 and
                    2005
  2007
                
                2006
                
                2005INTEREST
                    INCOMELoans,
                    including fees
                
                $
                32,981,334
                
                $
                27,317,002
                
                $
                19,353,740Securities
                    and interest-bearing deposits in other banks
                
                
                1,750,023
                
                
                1,583,984
                
                
                1,217,405Federal
                    funds sold
                
                
                52,161
                
                
                257,820
                
                
                100,937Total
                    interest income
                
                
                34,783,518
                
                
                29,158,806
                
                
                20,672,082INTEREST
                    EXPENSETime
                    deposits of $100,000 or more
                
                
                3,134,084
                
                
                1,993,796
                
                
                1,144,939Other
                    deposits
                
                
                8,206,843
                
                
                6,550,906
                
                
                3,675,702Federal
                    funds purchased and securitiessold
                    under agreements to repurchase
                
                
                857,161
                
                
                347,861
                
                
                203,476Federal
                    Home Loan Bank advances and line of credit
                
                
                2,215,517
                
                
                1,413,546
                
                
                1,053,675Total
                    interest expense
                
                
                14,413,605
                
                
                10,306,109
                
                
                6,077,792Net
                    interest income before provision for loan losses
                
                
                20,369,913
                
                
                18,852,697
                
                
                14,594,290Provision
                    for loan losses
                
                
                10,409,365
                
                
                1,106,600
                
                
                1,401,600Net
                    interest income after provision for loan losses
                
                
                9,960,548
                
                
                17,746,097
                
                
                13,192,690NONINTEREST
                    INCOMECustomer
                    service fees
                
                
                1,425,822
                
                
                1,298,041
                
                
                984,085Other
                    noninterest income
                
                
                165,495
                
                
                91,047
                
                
                67,956Operating
                    lease income
                
                
                -
                
                
                300,932
                
                
                539,756Net
                    gains from sale of loans and other assets
                
                
                103,773
                
                
                421,236
                
                
                312,923Total
                    noninterest income
                
                
                1,695,090
                
                
                2,111,256
                
                
                1,904,720NONINTEREST
                    EXPENSESSalaries
                    and employee benefits
                
                
                6,608,808
                
                
                6,018,619
                
                
                4,502,910Net
                    occupancy and equipment expense
                
                
                1,354,642
                
                
                1,075,081
                
                
                859,313Depreciation
                    on leased assets
                
                
                -
                
                
                244,580
                
                
                379,053Other
                    operating expenses
                
                
                2,962,151
                
                
                3,379,950
                
                
                2,474,999Total
                    noninterest expenses
                
                
                10,925,601
                
                
                10,718,230
                
                
                8,216,275Income
                    before income tax expense
                
                
                730,037
                
                
                9,139,123
                
                
                6,881,135Income
                    tax (benefit) expense
                
                
                (141,115
                )
                
                3,327,523
                
                
                2,556,616Net
                    income
                
                $
                871,152
                
                $
                5,811,600
                
                $
                4,324,519EARNINGS
                    PER COMMON SHAREBasic
                
                $
                .14
                
                $
                .90
                
                $
                .71Diluted
                
                
                .13
                
                
                .85
                
                
                .66
  The
                    Notes to Consolidated Financial Statements are an integral part
                    of these
                    statements.
  37
  CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITYYears
                    Ended December 31, 2007, 2006 and
                    2005
  Comprehensive
                    Income
                
                Common
                    Stock
                
                Common
                      Stock
                      Subscribed
                
                Additional
                      Paid-in
                      Capital
                
                Retained
                    Earnings
                
                Accumulated
                        Other
                        Comprehensive
                        Income
                
                Stock
                      Subscriptions
                      Receivable
                
                Total
                      Stockholders'
                      EquityBALANCE,
                    December 31, 2004
                
                
                
                
                $
                2,868,823
                
                $
                119,961
                
                $
                19,160,936
                
                $
                4,340,981
                
                $
                116,034
                
                $
                (1,799,415
                )
                $
                24,807,320Issuance
                    of common stock
                
                
                
                
                
                7,079
                
                
                -
                
                
                98,172
                
                
                -
                
                
                -
                
                
                -
                
                
                105,251Issuance
                    of common stock under Director's stock option plan
                
                
                
                
                
                209,000
                
                
                -
                
                
                836,000
                
                
                -
                
                
                -
                
                
                -
                
                
                1,045,000Tax
                    benefit received from Director's stock option exercise
                
                
                
                
                
                -
                
                
                -
                
                
                1,185,315
                
                
                -
                
                
                -
                
                
                -
                
                
                1,185,315Dividends
                    - $.07 per share
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                (435,948
                )
                
                -
                
                
                -
                
                
                (435,948
                )Stock
                    subscriptions settled
                
                
                
                
                
                119,961
                
                
                (119,961
                )
                
                -
                
                
                -
                
                
                -
                
                
                1,799,415
                
                
                1,799,415Repurchase
                    of common stock
                
                
                
                
                
                (4,000
                )
                
                -
                
                
                (78,520
                )
                
                -
                
                
                -
                
                
                -
                
                
                (82,520
                )Comprehensive
                    income:Net
                    income
                
                $
                4,324,519
                
                
                -
                
                
                -
                
                
                -
                
                
                4,324,519
                
                
                -
                
                
                -
                
                
                4,324,519Other
                    comprehensive income, net of tax:Unrealized
                        holding gains (losses) on securities available for sale, net of
                        reclassification adjustment
                
                
                (281,989
                )
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                (281,989
                )
                
                -
                
                
                (281,989
                )Total
                    comprehensive income
                
                $
                4,042,530BALANCE,
                    December 31, 2005
                
                
                
                
                
                3,200,863
                
                
                -
                
                
                21,201,903
                
                
                8,229,552
                
                
                (165,955
                )
                
                -
                
                
                32,466,363Issuance
                    of common stock
                
                
                
                
                
                15,526
                
                
                -
                
                
                246,333
                
                
                -
                
                
                -
                
                
                -
                
                
                261,859Issuance
                    of common stock under Director's stock option plan
                
                
                
                
                
                51,500
                
                
                -
                
                
                249,940
                
                
                -
                
                
                -
                
                
                -
                
                
                301,440Tax
                    benefit received from Director's stock option exercise
                
                
                
                
                
                -
                
                
                -
                
                
                202,012
                
                
                -
                
                
                -
                
                
                -
                
                
                202,012Stock
                    compensation expense
                
                
                
                
                
                -
                
                
                -
                
                
                147,925
                
                
                -
                
                
                -
                
                
                -
                
                
                147,925Dividends
                    - $.14 per share
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                (908,464
                )
                
                -
                
                
                -
                
                
                (908,464
                )Split-up
                    effected in the form of a dividend
                
                
                
                
                
                3,251,659
                
                
                -
                
                
                -
                
                
                (3,251,659
                )
                
                -
                
                
                -
                
                
                -Repurchase
                    of common stock
                
                
                
                
                
                (7,700
                )
                
                -
                
                
                (199,107
                )
                
                -
                
                
                -
                
                
                -
                
                
                (206,807
                )Comprehensive
                    income:Net
                    income
                
                $
                5,811,600
                
                
                -
                
                
                -
                
                
                -
                
                
                5,811,600
                
                
                -
                
                
                -
                
                
                5,811,600Other
                    comprehensive income, net of tax:Unrealized
                        holding gains (losses) on securities available for sale, net of
                        reclassification adjustment
                
                
                107,337
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                107,337
                
                
                -
                
                
                107,337Total
                    comprehensive income
                
                $
                5,918,937BALANCE,
                    December 31, 2006
                
                
                
                
                $
                6,511,848
                
                $
                -
                
                $
                21,849,006
                
                $
                9,881,029
                
                $
                (58,618
                )
                $
                -
                
                $
                38,183,265
  (continued
                    on next page)
  38
  CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITYYears
                    Ended December 31, 2007, 2006 and 2005
  (continued
                    from previous page)
  Comprehensive
                    Income
                
                
                Common
                    Stock
                
                
                Common
                      Stock
                      Subscribed
                
                
                Additional
                      Paid-in
                      Capital
                
                
                Retained
                    Earnings
                
                
                Accumulated
                        Other
                        Comprehensive
                        Income
                
                
                Stock
                      Subscriptions
                      Receivable
                
                
                Total
                      Stockholders'
                      EquityBALANCE,
                    December 31, 2006
                
                
                
                
                $
                6,511,848
                
                $
                -
                
                $
                21,849,006
                
                $
                9,881,029
                
                $
                (58,618
                )
                $
                -
                
                $
                38,183,265Issuance
                    of common stock
                
                
                
                
                
                5,870
                
                
                -
                
                
                20,446
                
                
                -
                
                
                -
                
                
                -
                
                
                26,316Issuance
                    of common stock under Director's stock option plan
                
                
                
                
                
                5,000
                
                
                -
                
                
                41,610
                
                
                -
                
                
                -
                
                
                -
                
                
                46,610Stock
                    compensation expense
                
                
                
                
                
                -
                
                
                -
                
                
                220,016
                
                
                -
                
                
                -
                
                
                -
                
                
                220,016Dividends
                    - $.22 per share
                
                
                
                
                
                -
                
                
                -
                
                
                -
                
                
                (1,434,303
                )
                
                -
                
                
                -
                
                
                (1,434,303
                )Repurchase
                    of common stock
                
                
                
                
                
                (153,000
                )
                
                -
                
                
                (1,598,291
                )
                
                -
                
                
                -
                
                
                -
                
                
                (1,751,291
                )Comprehensive
                    income:Net
                    income
                
                $
                871,152
                
                
                -
                
                
                -
                
                
                -
                
                
                871,152
                
                
                -
                
                
                -
                
                
                871,152Other
                    comprehensive income, net of tax:Unrealized
                        holding gains (losses) on securities available for sale, net of
                        reclassification adjustment
                
                
                165,585
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                165,585
                
                
                -
                
                
                165,585Total
                    comprehensive income
                
                $
                1,036,737BALANCE,
                    December 31, 2007
                
                
                
                
                $
                6,369,718
                
                $
                -
                
                $
                20,532,787
                
                $
                9,317,878
                
                $
                106,967
                
                $
                -
                
                $
                36,327,350
  The
                    Notes to Consolidated Financial Statements are an integral part
                    of these
                    statements.
  39
  CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF CASH FLOWSYears
                    Ended December 31, 2007, 2006 and 2005
  2007
                
                2006
                
                2005CASH
                    FLOWS FROM OPERATING ACTIVITIESNet
                    income
                
                $
                871,152
                
                $
                5,811,600
                
                $
                4,324,519Adjustments
                    to reconcile net income to net cashprovided
                    by operating activities:Depreciation
                    and amortization
                
                
                605,062
                
                
                990,052
                
                
                764,127Provision
                    for loan losses
                
                
                10,409,365
                
                
                1,106,600
                
                
                1,401,600Stock
                    compensation expense
                
                
                220,016
                
                
                147,925
                
                
                -Gains
                    on sales of loans and other assets
                
                
                (103,773
                )
                
                (421,236
                )
                
                (312,923
                )Deferred
                    income taxes
                
                
                (3,478,707
                )
                
                (481,466
                )
                
                (460,452
                )Changes
                    in other operating assets and liabilities:Net
                    change in loans held for sale
                
                
                484,900
                
                
                (97,752
                )
                
                (257,148
                )Accrued
                    interest receivable
                
                
                (287,199
                )
                
                (381,318
                )
                
                (554,982
                )Accrued
                    interest payable
                
                
                (92,306
                )
                
                65,528
                
                
                151,269Other
                    assets and liabilities
                
                
                3,154,062
                
                
                (1,438,845
                )
                
                1,629,962Net
                    cash provided by operating activities
                
                
                11,782,572
                
                
                5,301,088
                
                
                6,685,972CASH
                    FLOWS FROM INVESTING ACTIVITIESProceeds
                    from security transactions:Securities
                    available for sale
                
                
                13,008,453
                
                
                1,865,807
                
                
                11,818,836Securities
                    held to maturity
                
                
                36,467
                
                
                85,400
                
                
                69,067Purchase
                    of securities available for sale
                
                
                (15,037,296
                )
                
                (3,975,324
                )
                
                (15,901,889
                )Purchase
                    of Federal Home Loan Bank stock
                
                
                (559,400
                )
                
                (247,700
                )
                
                (136,000
                )Loan
                    originations and principal collections, net
                
                
                (76,239,255
                )
                
                (43,432,372
                )
                
                (59,112,700
                )Purchase
                    of bank premises and equipment
                
                
                (840,644
                )
                
                (1,278,809
                )
                
                (1,978,538
                )Acquisition
                    of business
                
                
                -
                
                
                -
                
                
                (1,380,000
                )Purchase
                    of equity investment
                
                
                -
                
                
                (3,000,000
                )
                
                -Proceeds
                    from sale of other real estate and other assets
                
                
                784,592
                
                
                806,406
                
                
                300,464Net
                    cash used in investing activities
                
                
                (78,847,083
                )
                
                (49,176,592
                )
                
                (66,320,760
                )CASH
                    FLOWS FROM FINANCING ACTIVITIESNet
                    increase in deposits
                
                
                37,433,192
                
                
                23,380,643
                
                
                64,602,988Increase
                    (decrease) in federal funds purchased andsecurities
                    sold under agreements to repurchase
                
                
                22,310,654
                
                
                14,458,964
                
                
                (2,618,425
                )Proceeds
                    from Federal Home Loan Bank advances
                
                
                35,000,000
                
                
                20,000,000
                
                
                5,000,000Repayment
                    of Federal Home Loan Bank advances
                
                
                (27,000,000
                )
                
                (11,000,000
                )
                
                (2,000,000
                )Net
                    borrowings (repayments) under line of credit
                
                
                (400,000
                )
                
                500,000
                
                
                -Purchase
                    of common stock
                
                
                (1,751,291
                )
                
                (206,807
                )
                
                (82,520
                )Payment
                    of dividends
                
                
                (1,303,577
                )
                
                (775,138
                )
                
                (526,476
                )Issuance
                    of common stock
                
                
                72,926
                
                
                563,299
                
                
                2,949,666Net
                    cash provided by financing activities
                
                
                64,361,904
                
                
                46,920,961
                
                
                67,325,233NET
                    (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS
                
                
                (2,702,607
                )
                
                3,045,457
                
                
                7,690,445CASH
                    AND CASH EQUIVALENTS, beginning of year
                
                
                17,635,956
                
                
                14,590,499
                
                
                6,900,054CASH
                    AND CASH EQUIVALENTS, end of year
                
                $
                14,933,349
                
                $
                17,635,956
                
                $
                14,590,499SUPPLEMENTAL
                    DISCLOSURES OF CASH FLOW INFORMATIONCash
                    paid during the period for interest
                
                $
                14,505,911
                
                $
                10,240,581
                
                $
                5,926,523Cash
                    paid during the period for taxes
                
                
                4,092,910
                
                
                3,259,073
                
                
                1,910,850NONCASH
                    INVESTING AND FINANCING ACTIVITIESAcquisition
                    of real estate through foreclosure
                
                $
                1,518,329
                
                $
                493,588
                
                $
                1,010,555Loan
                    extended in lieu of cash for sale of leased assets
                
                
                -
                
                
                1,950,435
                
                
                -
  The
                    Notes to Consolidated Financial Statements are an integral part
                    of these
                    statements.
  40
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        1. Summary
        of Significant Accounting Policies
 
 The
        accounting and reporting policies of Cornerstone Bancshares, Inc. and
        subsidiaries (the Company) conform with accounting principles generally accepted
        in the United States of America and accepted accounting and reporting practices
        within the banking industry. The significant accounting policies are summarized
        as follows:
 
 Nature
        of
        operations and geographic concentration:
 
 The
        Company is a bank-holding company which owns all of the outstanding common
        stock
        of Cornerstone Community Bank (the Bank) and Eagle Financial, Inc. (Eagle).
        The
        Bank provides a variety of financial services through five full service branch
        locations in Chattanooga, Tennessee a loan production office in Knoxville,
        Tennessee, and a loan production office in Dalton, Georgia. The Bank's primary
        deposit products are demand deposits, savings accounts, and certificates
        of
        deposit. Its primary lending products are commercial loans, real estate loans,
        and installment loans. Eagle is a finance and factoring company located in
        Chattanooga, Tennessee.
 
 Principles
        of consolidation:
 
 The
        consolidated financial statements include the accounts of the Company, the
        Bank
        and Eagle. All material intercompany accounts and transactions have been
        eliminated in consolidation.
 
 Goodwill:
 
 Goodwill
        represents the excess of the cost of the Company’s 1997 purchase of the net
        assets of the Bank of East Ridge over the underlying fair value of such net
        assets at the date of acquisition. The Company applies the provisions of
        Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and
        Other Intangible Assets,” which requires that goodwill and other intangible
        assets deemed to have an indefinite life not be amortized. Goodwill is tested
        annually for impairment. If the carrying value of goodwill exceeds the fair
        value, a write-down is recorded. There was no impairment in any of the years
        ending December 31, 2007, 2006 or 2005.
 
 Use
        of
        estimates:
 
 In
        preparing financial statements in conformity with accounting principles
        generally accepted in the United States of America, management is required
        to
        make estimates and assumptions that affect the reported amounts of assets
        and
        liabilities as of the date of the balance sheet and reported amounts of revenues
        and expenses during the reporting period. Actual results could differ from
        those
        estimates. Material estimates that are particularly susceptible to significant
        change in the near term relate to the determination of the allowance for
        loan
        losses.
 
 Securities:
 
 Debt
        securities are classified as held to maturity when the Bank has the intent
        and
        ability to hold the securities to maturity. Securities held to maturity are
        carried at amortized cost. The amortization of premiums and accretion of
        discounts are recognized in interest income using methods approximating the
        interest method over the period to maturity.
 
 Debt
        securities not classified as held to maturity are classified as available
        for
        sale. Securities available for sale are carried at market value with unrealized
        gains and losses reported in other comprehensive income. Realized gains and
        losses on securities available for sale are included in other income and,
        when
        applicable, are reported as a reclassification adjustment, net of tax, in
        other
        comprehensive income.
 
 Declines
        in the market value of held to maturity and available for sale securities
        below
        their cost that are deemed to be other than temporary are reflected in earnings
        as realized losses. In estimating other than temporary impairment losses,
        management considers (1) the length of time and the extent to which the
        market value has been less than cost, (2) the financial condition and
        near-term prospects of the issuer, and (3) the intent and ability of the
        Company
        to retain its investment in the issuer for a period of time sufficient to
        allow
        for any anticipated recovery in market value. Gains and losses on the sale
        of
        securities are recorded on the trade date and are determined using the specific
        identification method.
  41
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        1.  Summary
        of Significant Accounting Policies (continued)
 
 Loans:
 
 The
        Company grants mortgage, commercial and consumer loans to customers. A
        substantial portion of the loan portfolio is represented by mortgage loans
        throughout Chattanooga, Tennessee and surrounding areas. The ability of the
        Company’s customers to pay their loans is dependent upon both real estate and
        general economic conditions in this concentrated area.
 
 Loans
        that management has the intent and ability to hold for the foreseeable future
        or
        until maturity or pay-off generally are reported at their outstanding unpaid
        principal balances adjusted for the allowance for loan losses, if any, and
        any
        deferred fees or costs on originated loans. Mortgage loans originated and
        intended for sale in the secondary market are carried at the lower of cost
        or
        estimated market value in the aggregate. Interest income is accrued on the
        unpaid principal balance. Loan origination fees, net of certain direct
        origination costs, are deferred and recognized as an adjustment to the related
        loan yield using the interest method.
 
 The
        accrual of interest on mortgage and commercial loans is discontinued at the
        time
        the loan is 90 days past due unless the credit is well-secured and in process
        of
        collection. Credit card loans and other personal loans are typically charged
        off
        no later than 120 days past due. Past due status is based on contractual
        terms of the loan. In all cases, loans are placed on non-accrual or charged-off
        at an earlier date if collection of principal or interest is considered
        doubtful.
 
 All
        interest accrued but not collected for loans that are placed on non-accrual
        or
        charged off is reversed against interest income. The interest on these loans
        is
        accounted for on the cash-basis or cost-recovery method, until qualifying
        for
        return to accrual. Loans are returned to accrual status when all the principal
        and interest amounts contractually due are brought current and future payments
        are reasonably assured.
 
 Allowance
        for loan losses:
 
 The
        allowance for loan losses is established as losses are estimated to have
        occurred through a provision for loan losses charged to earnings. Loan losses
        are charged against the allowance when management believes the uncollectibility
        of a loan balance is confirmed. Subsequent recoveries, if any, are credited
        to
        the allowance.
 
 The
        allowance for loan losses is evaluated on a regular basis by management and
        is
        based upon management’s periodic review of the collectibility of the loans in
        light of historical experience, the nature and volume of the loan portfolio,
        adverse situations that may affect the borrower’s ability to repay, estimated
        value of any underlying collateral and prevailing economic conditions. This
        evaluation is inherently subjective as it requires estimates that are
        susceptible to significant revision as more information becomes
        available.
 
 The
        allowance consists of specific, general and unallocated components. The specific
        component relates to loans that are classified as either doubtful, substandard
        or special mention. For such loans that are also classified as impaired,
        an
        allowance is established when the discounted cash flows (or collateral value
        or
        observable market price) of the impaired loan is lower than the carrying
        value
        of that loan. The general component covers non-classified loans and is based
        on
        historical loss experience adjusted for qualitative factors. An unallocated
        component is maintained to cover uncertainties that could affect management’s
        estimate of probable losses. The unallocated component of the allowance reflects
        the margin of imprecision inherent in the underlying assumptions used in
        the
        methodologies for estimating specific and general losses in the
        portfolio.
  42
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        1.  Summary
        of Significant Accounting Policies (continued)
 
 Allowance
        for loan losses: (continued)
 
 A
        loan is
        considered impaired when, based on current information and events, 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
        agreement. Factors considered by management in determining impairment include
        payment status, collateral value, and the probability of collecting scheduled
        principal and interest payments when due. Loans that experience insignificant
        payment delays and payment shortfalls generally are not classified as impaired.
        Management determines the significance of payment delays and payment shortfalls
        on a case-by-case basis, taking into consideration all of the circumstances
        surrounding the loan and the borrower, including the length of the delay,
        the
        reasons for the delay, the borrower’s prior payment record, and the amount of
        the shortfall in relation to the principal and interest owed. Impairment
        is
        measured on a loan by loan basis for commercial and construction loans by
        either
        the present value of expected future cash flows discounted at the loan’s
        effective interest rate, the loan’s obtainable market price, or the fair value
        of the collateral if the loan is collateral dependent.
 
 Large
        groups of smaller balance homogeneous loans are collectively evaluated for
        impairment. Accordingly, the Company does not separately identify individual
        consumer and residential loans for impairment disclosures, unless such loans
        are
        the subject of a restructuring agreement.
 
 Premises
        and equipment:
 
 Land
        is
        carried at cost.  Other premises and equipment are carried at cost net
        of accumulated depreciation.  Depreciation is computed using the
        straight-line method based on the estimated useful lives of the assets.
        Maintenance and repairs are expensed as incurred while major additions and
        improvements are capitalized. Gains and losses on dispositions, if any, are
        reported in current operations.
 
 Investment
        in partnership:
 
 The
        Company’s investment in a partnership consists of an equity interest in a
        lending partnership for the purposes of investing in the New Market Tax Credit
        Program. This program permits taxpayers to claim a credit against federal
        income
        taxes for Qualified Equity Investments made to acquire stock or a capital
        interest in designated Community Development Entities (CDEs).  These
        designated CDEs must use substantially all (defined as 85 percent) of these
        proceeds to make qualified low-income community investments.
 
 The
        Company uses the equity method when it owns an interest in a partnership
        and can
        exert significant influence over the partnership’s operations but cannot control
        the partnership’s operations. Under the equity method, the Company’s ownership
        interest in the partnership’s capital is reported as an investment on its
        consolidated balance sheets and the Company’s allocable share of the income or
        loss from the partnership is reported in noninterest income or expense in
        the
        consolidated statements of income. The Company ceases recording losses on
        an
        investment in partnership when the cumulative losses and distributions from
        the
        partnership exceed the carrying amount of the investment and any advances
        made
        by the Company. After the Company’s investment in such partnership reaches zero,
        cash distributions received from these investments are recorded as
        income.
 
 Other
        real estate owned:
 
 Real
        estate properties acquired through or in lieu of loan foreclosure are initially
        recorded at the lower of the Company’s carrying amount or fair value less
        estimated selling cost at the date of foreclosure. Any write-downs based
        on the
        asset’s fair value at the date of acquisition are charged to the allowance for
        loan losses. After foreclosure, these assets are carried at the lower of
        their
        new cost basis or fair value less cost to sell. Costs of significant property
        improvements are capitalized, whereas costs relating to holding property
        are
        expensed. The portion of interest costs relating to development of real estate
        is capitalized. Valuations are periodically performed by management, and
        any
        subsequent write-downs are recorded as a charge to operations, if necessary,
        to
        reduce the carrying value of a property to the lower of its cost or fair
        value
        less cost to sell.
  43
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        1.  Summary
        of Significant Accounting Policies (continued)
 
 Income
        taxes:
 
 Deferred
        tax assets and liabilities are recognized for the estimated future tax
        consequences attributable to differences between the tax bases of assets
        and
        liabilities and their carrying amounts for financial reporting purposes.
        Deferred tax assets and liabilities are measured using enacted tax rates
        in
        effect for the year in which the temporary differences are expected to be
        recovered or settled.
 
 Transfers
        of financial assets:
 
 Transfers
        of financial assets are accounted for as sales, when control over the assets
        has
        been surrendered. Control over assets is deemed to be surrendered when (1)
        the
        assets have been isolated from the Company, (2) the transferee obtains the
        right
        (free of conditions that constrain it from taking advantage of that right)
        to
        pledge or exchange the transferred assets, and (3) the Company does not maintain
        effective control over the transferred assets through an agreement to repurchase
        them before their maturity.
 
 Advertising
        costs:
 
 The
        Company expenses all advertising costs as incurred. Advertising expense was
        $83,632, $84,233, and $84,564, for the years ended December 31, 2007, 2006
        and
        2005, respectively.
 
 Cash
        and
        cash equivalents:
 
 The
        Company considers all cash and amounts due from depository institutions,
        interest-bearing deposits in other banks, and federal funds sold to be cash
        equivalents for purposes of the statements of cash flows.
 
 Stock-based
        compensation:
 
 At
        December 31, 2007, the Company had two stock-based compensation plans, which
        are
        described in Note 15. Effective January 1, 2006, the Company adopted
        Statement of Financial Accounting Standards No. 123 (revised 2004),
“Share-Based Payment” (SFAS 123R) which was issued by the FASB in
        December 2004.  SFAS 123R revises SFAS 123 “Accounting
        for Stock Based Compensation”, and supersedes APB 25, “Accounting for Stock
        Issued to Employees” (APB 25) and its related interpretations.
        SFAS 123R requires recognition of the cost of employee services received in
        exchange for an award of equity instruments in the financial statements over
        the
        period the employee is required to perform the services in exchange for the
        award (presumptively the vesting period). SFAS 123R also requires
        measurement of the cost of employee services received in exchange for an
        award
        based on the grant date fair value of the award. SFAS 123R also amends
        SFAS 95 Statement of Cash Flows, to require that excess tax benefits be
        reported as financing cash inflows, rather than as a reduction of taxes paid,
        which is included within operating cash flows.
 
 The
        Company adopted SFAS 123R using the modified prospective application as
        permitted under SFAS 123R. Accordingly, prior period amounts have not been
        restated. Under this application, the Company is required to record compensation
        expense for all awards granted after the date of adoption and for the unvested
        portion of previously granted awards that remain outstanding at the date
        of
        adoption. Prior to the adoption of SFAS 123R, the Company used the
        intrinsic value method as prescribed by APB 25 and thus recognized no
        compensation expense for options granted with exercise prices equal to the
        fair
        market value of the Company’s common stock on the date of grant.
  44
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        1.  Summary
        of Significant Accounting Policies (continued)
 
 Segment
        reporting:
 
 Statement
        of Financial Accounting Standards No. 131, “Disclosures about Segments of an
        Enterprise and Related Information” (SFAS 131) provides for the
        identification of reportable segments on the basis of discreet business units
        and their financial information to the extent such units are reviewed by
        an
        entity’s chief decision maker (which can be an individual or group of management
        persons). SFAS 131 permits aggregation or combination of segments that have
        similar characteristics. In the Company’s operations, each bank branch is viewed
        by management as being a separately identifiable business or segment from
        the
        perspective of monitoring performance and allocation of financial resources.
        Although the branches operate independently and are managed and monitored
        separately, each is substantially similar in terms of business focus, type
        of
        customers, products and services. Further, the results of Eagle for 2007,
        2006
        and 2005 were not significant for separate disclosure. Accordingly, the
        Company’s consolidated financial statements reflect the presentation of segment
        information on an aggregated basis in one reportable segment.
 
 Earnings
        per share:
 
 Basic
        earnings per share represents income available to common stockholders divided
        by
        the weighted-average number of common shares outstanding during the period.
        Diluted earnings per share reflects additional common shares that would have
        been outstanding if dilutive potential common shares had been issued, as
        well as
        any adjustment to income that would result from the assumed issuance. Potential
        common shares that may be issued by the Corporation relate solely to outstanding
        stock options, and are determined using the treasury stock method.
 
 Variable
        interest entities:
 
 An
        entity
        is referred to as a variable interest entity (VIE) if it meets the criteria
        outlined in FASB Interpretation No. 46-R, “Consolidation of Variable Interest
        Entities (revised December 2003)” (FASBI 46-R), which are: (1) the entity
        has equity that is insufficient to permit the entity to finance its activities
        without additional subordinated financial support from other parties, or
        (2) the
        entity has equity investors that cannot make significant decisions about
        the
        entity’s operations or that do not absorb the expected losses or receive the
        expected returns of the entity.
 
 In
        addition, as specified in FASBI 46-R, a VIE must be consolidated by the Company
        if it is deemed to be the primary beneficiary of the VIE, which is the party
        involved with the VIE that has a majority of the expected losses, expected
        residual returns, or both. The Company has an investment in Appalachian Fund
        for
        Growth II Partnership, as more fully described in Note 22, that qualifies
        as an
        unconsolidated VIE.
 
 Reclassification:
 
 Certain
        amounts in the prior consolidated financial statements have been reclassified
        to
        conform to the current year presentation. The reclassifications had no effect
        on
        net income or stockholders’ equity as previously reported.
 
 Off-balance
        sheet credit related financial instruments:
 
 In
        the
        ordinary course of business, the Corporation has entered into commitments
        to
        extend credit, including commitments under credit card arrangements, commercial
        letters of credit, and standby letters of credit. Such financial instruments
        are
        recorded when they are funded.
  45
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        2.  Restrictions
        on Cash and Due From Banks
 
 The
        Bank
        is required to maintain balances on hand or with the Federal Reserve Bank
        based
        on a percentage of deposits. At December 31, 2007 and 2006, these reserve
        balances were approximately $2,826,000 and $2,617,000,
        respectively.
 
 Note
        3.  Securities
 
 Securities
        have been classified on the balance sheet, according to management’s intent, as
        either securities held to maturity or securities available for sale. The
        amortized cost and approximate market value of securities at December 31,
        2007
        and 2006, is as follows:
 
 2007Gross
              
              GrossAmortized
              
              Unrealized
              
              Unrealized
              
              MarketCost
              
              Gains
              
              Losses
              
              ValueSecurities
                  available for sale:U.S.
                  Government agencies
              
              $
              27,335,992
              
              $
              116,624
              
              $
              (38,942
              )
              $
              27,413,674State
                  and municipal securities
              
              
              3,436,399
              
              
              66,369
              
              
              (3
              )
              
              3,502,765Mortgage-backed
                  securities
              
              
              3,817,522
              
              
              20,427
              
              
              (2,403
              )
              
              3,835,546$
              34,589,913
              
              $
              203,420
              
              $
              (41,348
              )
              $
              34,751,985Securities
                  held to maturity:Mortgage-backed
                  securities
              
              $
              200,037
              
              $
              424
              
              $
              (783
              )
              $
              199,678
 2006Gross
                
                GrossAmortized
                
                Unrealized
                
                Unrealized
                
                MarketCost
                
                Gains
                
                Losses
                
                ValueSecurities
                    available for sale:U.S.
                    Government agencies
                
                $
                26,631,431
                
                $
                81,949
                
                $
                (243,160
                )
                $
                26,470,220State
                    and municipal securities
                
                
                3,209,905
                
                
                51,952
                
                
                (12,479
                )
                
                3,249,378Mortgage-backed
                    securities
                
                
                2,600,860
                
                
                32,922
                
                
                -
                
                
                2,633,782$
                32,442,196
                
                $
                166,823
                
                $
                (255,639
                )
                $
                32,353,380Securities
                    held to maturity:Mortgage-backed
                    securities
                
                $
                236,169
                
                $
                475
                
                $
                (455
                )
                $
                236,189
  At
        December 31, 2007 and 2006, securities with a carrying value of
        approximately $11,255,000 and $11,476,000, respectively, were pledged to
        secure
        public deposits and for other purposes required or permitted by
        law.
 
 At
        December 31, 2007 and 2006, the carrying amount of securities pledged to
        secure repurchase agreements was approximately $18,270,000 and $9,936,000,
        respectively.
  46
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        3.  Securities
        (continued)
 
 The
        amortized cost and estimated market value of securities at December 31, 2007,
        by
        contractual maturity, are shown below. 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.
 Securities
                    Available for Sale
                
                Securities
                    Held to MaturityAmortized
                
                Market
                
                Amortized
                
                MarketCost
                
                Value
                
                Cost
                
                ValueDue
                    in one year or less
                
                $
                8,631,193
                
                $
                8,617,325
                
                $
                -
                
                $
                -Due
                    from one year to five years
                
                
                17,578,544
                
                
                17,586,816
                
                
                -
                
                
                -Due
                    from five years to ten years
                
                
                1,181,260
                
                
                1,232,270
                
                
                -
                
                
                -Due
                    after ten years
                
                
                3,381,394
                
                
                3,480,028
                
                
                -
                
                
                -30,772,391
                
                
                30,916,439
                
                
                -
                
                
                -Mortgage-backed
                    securities
                
                
                3,817,522
                
                
                3,835,546
                
                
                200,037
                
                
                199,678$
                34,589,913
                
                $
                34,751,985
                
                $
                200,037
                
                $
                199,678
 
 For
        the
        years ended December 31, 2007, 2006 and 2005, there were no sales of securities
        available for sale. At December 31, 2007 and 2006, gross unrealized losses
        on investments were not significant in relation to the Company’s investment
        portfolio.
 
 Note
        4.  Loans
        and
        Allowance for Loan Losses
 
 At
        December 31, 2007 and 2006, the Bank's loans consist of the following (in
        thousands):
 2007
                
                2006Mortgage
                    loans on real estate:Residential
                    1-4 family
                
                $
                35,309
                
                $
                23,681Residential
                    multifamily (5 or more)
                
                
                16,573
                
                
                14,421Held
                    for sale
                
                
                216
                
                
                701Commercial
                
                
                138,074
                
                
                98,904Construction
                
                
                76,832
                
                
                57,606Second
                    mortgages
                
                
                2,270
                
                
                2,564Equity
                    lines of credit
                
                
                10,214
                
                
                7,333279,488
                
                
                205,210Commercial
                    loans
                
                
                97,896
                
                
                97,933Consumer
                    installment loans:Personal
                
                
                5,652
                
                
                6,490Credit
                    cards
                
                
                557
                
                
                5046,209
                
                
                6,994Total
                    loans
                
                
                383,593
                
                
                310,137Less:
                    Allowance for loan losses
                
                
                (13,710
                )
                
                (4,258
                )Loans,
                    net
                
                $
                369,883
                
                $
                305,879
  47
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        4.  Loans
        and
        Allowance for Loan Losses (continued)
 An
                    analysis of the allowance for loan losses follows:2007
                
                2006
                
                2005Balance,
                    beginning of year
                
                
                
                
                $
                4,258,352
                
                $
                3,545,042
                
                $
                2,665,464Provision
                    charged to operations
                
                
                
                
                
                10,409,365
                
                
                1,106,600
                
                
                1,401,600Charge-offs
                
                
                
                
                
                (1,075,670
                )
                
                (470,367
                )
                
                (557,227
                )Recoveries
                
                
                
                
                
                118,062
                
                
                77,077
                
                
                35,205Balance,
                    end of year
                
                
                
                
                $
                13,710,109
                
                $
                4,258,352
                
                $
                3,545,042
  The
        Bank's only significant concentration of credit at December 31, 2007, occurred
        in real estate loans which totaled approximately $279 million. While real
        estate
        loans accounted for 73 percent of total loans, these loans were primarily
        residential development and construction loans, residential mortgage loans,
        and
        commercial loans secured by commercial properties. Substantially all real
        estate
        loans are secured by properties located in Tennessee.
  The
        following is a summary of information pertaining to impaired and non-accrual
        loans:
 December
                    31,2007
                
                2006Impaired
                    loans without a valuation allowance
                
                $
                17,075
                
                $
                3,545Impaired
                    loans with a valuation allowance
                
                
                13,176,547
                
                
                1,711,053Total
                    impaired loans
                
                $
                13,193,623
                
                $
                1,714,598Valuation
                    allowance related to impaired loans
                
                $
                9,789,748
                
                $
                216,948Total
                    non-accrual loans
                
                $
                684,903
                
                $
                1,102,833Total
                    loans past-due ninety days or more and still accruing
                
                $
                -
                
                $
                -
 Years
                    Ended December 31,.
                
                2007
                
                2006
                
                2005Average
                    investment in impaired loans
                
                $
                776,095
                
                $
                171,460
                
                $
                167,635Interest
                    income recognized on impaired loans
                
                $
                1,182,407
                
                $
                121,987
                
                $
                42,465Interest
                    income recognized on a cash basis on impaired loans
                
                $
                28,900
                
                $
                78,391
                
                $
                42,465
  In
        the
        ordinary course of business, the Bank has granted loans to principal officers
        and directors and their affiliates. Annual activity of these related party
        loans
        were as follows:
 2007
                
                2006Beginning
                    balance
                
                $
                751,496
                
                $
                771,270New
                    loans
                
                
                521,678
                
                
                95,936Repayments
                
                
                (500,232
                )
                
                (115,710
                )Ending
                    balance
                
                $
                772,942
                
                $
                751,496
  48
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        5.  Bank
        Premises and Equipment
 
 A
        summary
        of bank premises and equipment at December 31, 2007 and 2006, is as follows:
 2007
                
                2006Land
                
                $
                1,658,625
                
                $
                1,625,567Buildings
                    and improvements
                
                
                4,131,932
                
                
                4,060,313Furniture,
                    fixtures and equipment
                
                
                3,849,462
                
                
                3,123,9299,640,019
                
                
                8,809,809Accumulated
                    depreciation
                
                
                (3,169,126
                )
                
                (2,675,800
                )$
                6,470,893
                
                $
                6,134,009
 
 Depreciation
        expense for the years ended December 31, 2007, 2006 and 2005, amounted to
        $500,573, $644,664 and $736,731, respectively.
 
 Certain
        bank facilities and equipment are leased under various operating leases.
        Total
        rent expense on these leases for the years ended December 31, 2007, 2006
        and
        2005, was $384,004, $235,455 and $160,626, respectively.
 
 Future
        minimum rental commitments under non-cancelable leases are as
        follows:
 2008
                
                $
                342,0062009
                
                
                355,1032010
                
                
                340,3432011
                
                
                343,2122012
                
                
                341,003Thereafter
                
                
                1,040,543Total
                
                $
                2,762,210
 
 Note
        6.  Time
        and
        Related-Party Deposits
 
 At
        December 31, 2007, the scheduled maturities of time deposits are as
        follows:
 2008
                
                $
                167,422,5932009
                
                
                16,182,0292010
                
                
                2,203,1102011
                
                
                169,7152012
                
                
                32,681Total
                
                $
                186,010,128
 
 Deposits
        from related parties held by the Bank at December 31, 2007 and 2006, amounted
        to
        approximately $692,000 and $829,000, respectively.
 
 Note
        7.  Concentrations
        in Deposits
 
 At
        December 31, 2006, the Company had a concentration in the money market account
        of one customer totaling approximately $15,000,000. This balance accounted
        for
        approximately 5 percent of total deposits at December 31, 2006. At December
        31, 2007 the Company did not have a significant concentration with any one
        customer.
  49
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
  Note
        8.  Income
        Taxes
 
 The
        Company files consolidated income tax returns with its subsidiaries. Under
        the
        terms of a tax-sharing agreement, the subsidiaries’ allocated portion of the
        consolidated tax liability is computed as if they were reporting income and
        expenses to the Internal Revenue Service as a separate entity.
 
 Income
        tax expense in the statements of income for the years ended December 31,
        2007, 2006 and 2005, consists of the following:
 2007
                
                2006
                
                2005Current
                    tax expense
                
                $
                3,337,592
                
                $
                3,808,989
                
                $
                3,017,068Deferred
                    tax expense (benefit) related to:Allowance
                    for loan losses
                
                
                (3,623,934
                )
                
                (356,910
                )
                
                (361,227
                )Other
                
                
                145,227
                
                
                (124,556
                )
                
                (99,225
                )Income
                    tax expense (benefit)
                
                $
                (141,115
                )
                $
                3,327,523
                
                $
                2,556,616
 The
        income tax expense is different from the expected tax expense computed by
        multiplying income before income tax expense by the statutory federal income
        tax
        rates. These differences are reconciled as follows:
 2007
                
                2006
                
                2005Expected
                    tax at statutory rates
                
                $
                248,213
                
                $
                3,107,302
                
                $
                2,339,586Increase
                    (decrease) resulting from tax effect of:State
                    income taxes, net of federal tax benefit
                
                
                31,318
                
                
                392,068
                
                
                295,201New
                    market tax credits
                
                
                (300,000
                )
                
                (150,000
                )
                
                -Other
                
                
                (120,646
                )
                
                (21,847
                )
                
                (78,171
                )Income
                    tax expense (benefit)
                
                $
                (141,115
                )
                $
                3,327,523
                
                $
                2,556,616
 The
        components of the net deferred tax asset, included in other assets, are as
        follows:
 2007
                
                2006Deferred
                    tax assets:Deferred
                    compensation
                
                $
                133,011
                
                $
                140,954Deferred
                    loan fees
                
                
                103,112
                
                
                128,605Allowance
                    for loan losses
                
                
                5,094,791
                
                
                1,470,857Net
                    unrealized loss on securities available for sale
                
                
                -
                
                
                30,197Other
                
                
                68,351
                
                
                177,1705,399,265
                
                
                1,947,783Deferred
                    tax liabilities:Depreciation
                
                
                96,972
                
                
                78,656Life
                    insurance
                
                
                173,427
                
                
                166,918Net
                    unrealized gain in securities available for sale
                
                
                85,303
                
                
                -Other
                
                
                13,545
                
                
                35,398369,247
                
                
                280,972Net
                    deferred tax asset
                
                $
                5,030,018
                
                $
                1,666,811
  50
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        9.  Federal
        Funds Purchased and Securities Sold Under Agreements to Repurchase
 
 Federal
                  funds purchased and securities sold under agreements to repurchase
                  amounted to $41,560,355 and $19,249,701 at December 31, 2007 and
                  2006,
                  respectively. These agreements generally mature within one to four
                  days
                  from the transaction date.
 
 Note
        10.  Federal
        Home Loan Bank Advances and Line of Credit
 
 The
        Bank
        has agreements with the Federal Home Loan Bank of Cincinnati (FHLB) that
        can
        provide convertible fixed rate advances to the Bank in an amount up to
        approximately $68,000,000. All of the Bank’s loans secured by first mortgages on
        1-4 family residential, multi-family properties, and commercial properties
        are
        pledged as collateral for these advances.
 
 At
        December 31, 2007 and 2006, FHLB advances consist of the following:
 2007
                
                2006Long-term
                    advance dated December 27, 2000, requiring monthly interest payments,
                    fixed at 5.00% until conversion option is exercised, principal
                    due in
                    December 2010
                
                $
                2,000,000
                
                $
                2,000,000Long-term
                    advance dated September 13, 2002, requiring monthly interest
                    payments,
                    fixed at 3.51%, convertible on September 2007, principal due
                    in September
                    2012
                
                
                -
                
                
                2,000,000Long-term
                    advance dated January 23, 2004, requiring monthly interest payments,
                    fixed
                    at 2.50%, convertible on January 2007, principal due in January
                    2014
                
                
                -
                
                
                5,000,000Long-term
                    advance dated May 27, 2004, requiring monthly interest payments,
                    fixed at
                    3.46%, convertible on May 2007, principal due in May 2014
                
                
                -
                
                
                5,000,000Long-term
                    advance dated February 9, 2005, requiring monthly interest payments,
                    fixed
                    at 3.86%, convertible on February 2010, principal due in February
                    2015
                
                
                5,000,000
                
                
                5,000,000Long-term
                    advance dated May 14, 2007, requiring monthly interest payments,
                    fixed at
                    4.78%, with a put option exercisable in November 2007 and then
                    quarterly
                    thereafter, principal due in May 2010
                
                
                5,000,000
                
                
                -Long-term
                    advance dated December 6, 2007, requiring monthly interest payments,
                    fixed
                    at 3.87%, until maturity, principal due in December 2010
                
                
                5,000,000
                
                
                -Long-term
                    advance dated May 11, 2007, requiring monthly interest payments,
                    fixed at
                    4.66%, with a put option exercisable in February 2008 and then
                    quarterly
                    thereafter, principal due in May 2011
                
                
                5,000,000
                
                
                -Long-term
                    advance dated May 15, 2007, requiring monthly interest payments,
                    fixed at
                    4.58%, with a put option exercisable in May 2008 and then quarterly
                    thereafter, principal due in May 2012
                
                
                5,000,000
                
                
                -
  51
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        10.  Federal
        Home Loan Bank Advances and Line of Credit (continued)
 2007
                
                2006Long-term
                    advance dated July 31, 2007, requiring monthly interest payments,
                    fixed at
                    4.50%, with a put option exercisable in July 2008 and then quarterly
                    thereafter, principal due in July 2013
                
                $
                5,000,000
                
                $
                -Long-term
                    advance dated August 7, 2007, requiring monthly interest payments,
                    fixed
                    at 4.43%, with a put option exercisable in February 2009 and
                    then
                    quarterly thereafter, principal due in August 2014
                
                
                5,000,000
                
                
                -Long-term
                    advance dated January 20, 2006, requiring monthly interest payments,
                    fixed
                    at 4.18%, with a put option exercisable in January 2009 and then
                    quarterly
                    thereafter, principal due in January 2016
                
                
                5,000,000
                
                
                5,000,000Long-term
                    advance dated January 10, 2007, requiring monthly interest payments,
                    fixed
                    at 4.25%, with a put option exercisable in January 2008 and then
                    quarterly
                    thereafter, principal due in January 2017
                
                
                5,000,000
                
                
                -Daily
                    revolving credit advances under agreement dated May 18, 2006,
                    rates are
                    variable based on three-month LIBOR rate, requires monthly interest
                    payments
                
                
                -
                
                
                15,000,000$
                47,000,000
                
                $
                39,000,000
 
 Scheduled
        maturities of the Federal Home Loan Bank advances are as follows:
 2008
                
                $
                -2009
                
                
                -2010
                
                
                12,000,0002011
                
                
                5,000,0002012
                
                
                5,000,000Thereafter
                
                
                25,000,000Total
                
                $
                47,000,000
 
 During
        the fixed rate term, the advances may be prepaid subject to a prepayment
        penalty
        as defined in the agreements. On convertible agreements, the FHLB has the
        right
        to convert the fixed rate on the above advances at the end of the initial
        fixed
        rate period and on a quarterly basis thereafter. If the conversion option
        is
        exercised, the advances will bear interest at the three-month London Interbank
        Offered Rate (LIBOR) adjusted quarterly at a spread of zero basis points
        to the
        LIBOR index. Subsequent to any conversion, the Bank has the option to prepay
        the
        advances, in full or in part, without penalty on the conversion date or any
        subsequent quarterly repricing date. On agreements with put options, the
        FHLB
        has the right, at its discretion, to terminate only the entire advance prior
        to
        the stated maturity date. The termination option may only be exercised on
        the
        expiration date of the predetermined lockout period and on a quarterly basis
        thereafter.
 
 The
        Company has an $8,500,000 line of credit with another bank that is secured
        by
        100% of the Bank’s common stock and bears interest at Prime minus 1.50%, due
        quarterly. Outstanding principal and accrued interest will be due at the
        maturity date of July 19, 2008. Borrowings outstanding under the agreements
        were
        $100,000 and $500,000 at December 31, 2007 and 2006, respectively.
  52
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        11.  Employee
        Benefit Plans
 
 401(k)
        plan:
 
 The
        Bank
        has a 401(k) employee benefit plan covering substantially all employees that
        have completed at least 30 days of service and met minimum age requirements.
        The
        Bank’s contribution to the plan is discretionary and was $230,732 for 2007,
        $195,445 for 2006 and $142,719 for 2005.
 
 Employee
        Stock Ownership Plan:
 
 The
        Company has a non-leveraged employee stock ownership plan (ESOP) to which
        the
        Company makes 100% of the contributions for purchasing the Company’s common
        stock, and allocates the contributions among the participants based on
        regulatory guidelines. The Company’s contribution is discretionary, as
        determined by the Compensation Committee. Employer contributions are available
        to all employees after 1,000 hours of service. There are certain age and
        years-of-service requirements before contributions can be made for the benefit
        of the employee. The ESOP plan also provides for a three year 100% vesting
        requirement; therefore employees terminating employment before their third
        anniversary date will forfeit their accrued benefit under the ESOP. The
        forfeiture will be re-allocated among the remaining ESOP participants. The
        Company made no contribution to the ESOP in 2007 and $248,261 in
        2006.
 
 Note
        12.  Financial
        Instruments With Off-Balance-Sheet Risk
 
 In
        the
        normal course of business, the Bank has outstanding commitments and contingent
        liabilities, such as commitments to extend credit and standby letters of
        credit,
        which are not included in the accompanying financial statements. The Bank’s
        exposure to credit loss in the event of nonperformance by the other party
        to the
        financial instruments for commitments to extend credit and standby letters
        of
        credit is represented by the contractual or notional amount of those
        instruments. The Bank uses the same credit policies in making such commitments
        as it does for instruments that are included in the balance sheet. At
        December 31, 2007 and 2006, undisbursed loan commitments aggregated
        $71,690,000 and $65,682,000, respectively. In addition, there were outstanding
        standby letters of credit totaling $4,996,000 and $2,341,000,
        respectively.
 
 Commitments
        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
        payment
        of a fee. Since many of the commitments are expected to expire without being
        drawn upon, the total commitment amounts do not necessarily represent future
        cash requirements. The Bank evaluates each customer’s creditworthiness on a
        case-by-case basis. The amount of collateral obtained, if deemed necessary
        by
        the Bank upon extension of credit, is based on management’s credit evaluation.
        Collateral held varies but may include accounts receivable, inventory, property
        and equipment, and income-producing commercial properties.
 
 Standby
        letters of credit are conditional commitments issued by the Bank to guarantee
        the performance of a customer to a third party. Standby letters of credit
        generally have fixed expiration dates or other termination clauses and may
        require payment of a fee. The credit risk involved in issuing letters of
        credit
        is essentially the same as that involved in extending loan facilities to
        customers. The Bank’s policy for obtaining collateral, and the nature of such
        collateral, is essentially the same as that involved in making commitments
        to
        extend credit.
 
 The
        Bank
        incurred insignificant losses on its commitments during 2007, 2006 and 2005.
  53
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        13.  Fair
        Value of Financial Instruments
 
 Fair
        value estimates are made at a specific point in time, based on relevant market
        information about the financial instrument. These estimates do not reflect
        any
        premium or discount that could result from offering for sale at one time
        the
        Company's entire holdings of a particular financial instrument. Because no
        market exists for a significant portion of the Company's financial instruments,
        fair value estimates are based on judgments regarding future expected loss
        experience, current economic conditions, risk characteristics of various
        financial instruments, and other factors. These estimates are subjective
        in
        nature; involve uncertainties and matters of judgment; and, therefore, cannot
        be
        determined with precision. Changes in assumptions could significantly affect
        the
        estimates.
 
 Fair
        value estimates are based on existing financial instruments without attempting
        to estimate the value of anticipated future business and the value of assets
        and
        liabilities that are not considered financial instruments. The following
        methods
        and assumptions were used to estimate the fair value of each class of financial
        instruments:
 
 Cash
        and
        due from banks:
 
 For
        cash
        and due from banks, the carrying amount is a reasonable estimate of fair
        value.
 
 Securities:
 
 The
        fair
        value of securities is estimated based on bid prices published in financial
        newspapers or bid quotations received from securities dealers.
 
 Federal
        Home Loan Bank stock:
 
 The
        carrying amount of Federal Home Loan Bank stock approximates fair value based
        on
        the stock redemption provisions of the Federal Home Loan Bank.
 
 Loans,
        net:
 
 The
        fair
        value of loans is calculated by discounting scheduled cash flows through
        the
        estimated maturity using estimated market discount rates, adjusted for credit
        risk and servicing costs. The estimate of maturity is based on historical
        experience with repayments for each loan classification, modified, as required,
        by an estimate of the effect of current economic and lending
        conditions.
 
 Deposits:
 
 The
        fair
        value of deposits with no stated maturity, such as demand deposits, money
        market
        accounts, and savings deposits, is equal to the amount payable on demand.
        The
        fair value of time deposits is based on the discounted value of contractual
        cash
        flows. The discount rate is estimated using the rates currently offered for
        deposits of similar remaining maturities.
 
 Federal
        funds purchased and securities sold under agreements to repurchase:
 
 The
        estimated value of these liabilities, which are extremely short term,
        approximates their carrying value.
 
 Federal
        Home Loan Bank advances and line of credit:
 
 The
        carrying amounts of the FHLB advances and the line of credit approximate
        their
        fair value.
  54
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
 
 Note
        13.  Fair
        Value of Financial Instruments (continued)
 
 Commitments
        to extend credit:
 
 The
        fair
        value of commitments is estimated using the fees currently charged to enter
        into
        similar agreements, taking into account the remaining terms of the agreements
        and the present creditworthiness of the counterparties. For fixed-rate loan
        commitments, fair value also considers the difference between current levels
        of
        interest rates and the committed rates.
 
 The
        carrying amount and estimated fair value of the Company's financial instruments
        at December 31, 2007 and 2006, are as follows (in
        thousands):
 2007
                
                2006Carrying
                
                Estimated
                
                Carrying
                
                EstimatedAmount
                
                Fair
                    Value
                
                Amount
                
                Fair
                    ValueAssets:Cash
                    and due from banks
                
                $
                14,933
                
                $
                14,933
                
                $
                17,636
                
                $
                17,636Securities
                
                
                34,952
                
                
                34,952
                
                
                32,590
                
                
                32,590Federal
                    Home Loan Bank stock
                
                
                1,912
                
                
                1,912
                
                
                1,332
                
                
                1,332Loans,
                    net
                
                
                369,883
                
                
                373,116
                
                
                305,879
                
                
                305,248Liabilities:Noninterest-bearing
                    demand deposits
                
                $
                45,285
                
                $
                45,285
                
                $
                41,723
                
                $
                41,723Interest-bearing
                    demand deposits
                
                
                31,985
                
                
                31,985
                
                
                38,160
                
                
                38,160Savings
                    deposits and money market accounts
                
                
                49,970
                
                
                49,970
                
                
                56,913
                
                
                56,913Time
                    deposits
                
                
                186,010
                
                
                189,106
                
                
                139,021
                
                
                140,713Federal
                    funds purchased and securitiessold
                    under agreements to repurchase
                
                
                41,560
                
                
                41,560
                
                
                19,250
                
                
                19,250Federal
                    Home Loan Bank advancesand
                    line of credit
                
                
                47,100
                
                
                47,100
                
                
                39,500
                
                
                39,500Unrecognized
                    financial instruments(net
                    of contract amount):Commitments
                    to extend credit
                
                
                -
                
                
                -
                
                
                -
                
                
                -
  Note
        14.  Contingencies
 
 The
        Bank
        is involved in certain claims arising from normal business activities.
        Management believes that the impact of those claims are without merit and
        that
        the ultimate liability, if any, resulting from them will not materially affect
        the Bank’s financial condition or the Company’s consolidated financial position,
        results of operations or cash flows.
 
 Note
        15.  Stock
        Option Plans
 
 The
        Company has stock option plans which are more fully described below. For
        the
        years ended December 31, 2007 and 2006, the Company recognized $220,016 and
        $147,925, respectively, in compensation expense for all stock
        options.
  55
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2007, 2006 and 2005
 
 Note
        15.  Stock
        Option Plans (continued)
 
 The
        following table illustrates the effect on the Company’s reported net income and
        earnings per share if the Company had applied the fair value recognition
        provision of SFAS 123 to stock-based employee compensation prior to the adoption
        date:
 
 Stock-based
        compensation:
 2005Net
                    income, as reported
                
                $
                4,324,519Deduct:
                    Total stock-based employee compensation expensedetermined
                    under fair value method for all awards,net
                    of the related tax effects
                
                
                (61,402
                )Pro
                    forma net income
                
                $
                4,263,117Earnings
                    per share:Basic
                    - as reported
                
                $
                0.71Basic
                    - pro forma
                
                $
                0.70Diluted
                    - as reported
                
                $
                0.66Diluted
                    - pro forma
                
                $
                0.65
  The
        fair
        value of each option grant is estimated on the date of grant using the
        Black-Scholes option-pricing model with the following assumptions:
 Years
                    Ended December 31,2007
                
                2006
                
                2005Dividend
                    yield
                
                
                1.33%
                
                
                
                0.98%
                
                
                
                0.98%Expected
                    life
                
                
                7.0
                    years
                
                
                
                6.6
                    years
                
                
                
                6.9
                    yearsExpected
                    volatility
                
                
                12.22%
                
                
                
                11.80%
                
                
                
                11.80%Risk-free
                    interest rate
                
                
                4.51%
                
                
                
                5.11%
                
                
                
                4.19%
 
 The
        expected volatility is based upon historical volatility. The risk-free interest
        rates for periods within the contractual life of the awards are based on
        the
        U.S. Treasury yield curve in effect at the time of the grant. The expected
        life
        is based on historical exercise experience. The dividend yield assumption
        is
        based on the Company’s history and expectation of dividend payouts. During 2006
        the Company’s stock options were subject to a 2-for-1 stock dividend. The impact
        of the dividend was to double the total number of options available under
        each
        of the stock option plans and reduce the existing option price in half. The
        information shown below retroactively reflects the impact of this dividend.
        Below is a more detailed description of the stock option plans.
  56
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
 
 Note
        15.  Stock
        Option Plans (continued)
 
 Board
        of
        Directors plan:
 
 The
        Company has a stock option plan under which members of the Board of Directors,
        at the formation of the Bank, were granted options to purchase a total of
        up to
        600,000 shares of the Bank's common stock. On October 15, 1997, the Bank
        stock options were converted to Company stock options. Only non-qualified
        stock
        options may be granted under the Plan. The exercise price of each option
        equals
        the market price of the Corporation’s stock on the date of grant and the
        option’s maximum term is ten years, at which point they expire. Vesting for
        options granted during 2005, 2006 and 2007, are 50% on each of the first
        and
        second anniversary of the grant date with full vesting occurring at the second
        anniversary date. At December 31, 2007, the total remaining compensation
        cost to be recognized on non-vested options is approximately $91,000. An
        analysis of this stock option plan is presented in the following
        table:
 Years
                    Ended December 31,2007
                
                2006
                
                2005Average
                
                Aggregate
                
                
                
                Average
                
                AverageExercise
                
                Intrinsic
                
                
                
                Exercise
                
                ExerciseShares
                
                Price
                
                Value(1)
                
                Shares
                
                Price
                
                Shares
                
                PriceOutstanding
                    at beginning of year
                
                
                67,000
                
                $
                10.61
                
                
                
                
                
                90,000
                
                $
                3.80
                
                
                500,000
                
                $
                2.62Granted
                
                
                9,000
                
                
                15.25
                
                
                
                
                
                40,000
                
                
                13.25
                
                
                10,000
                
                
                9.23Exercised
                
                
                (5,000
                )
                
                9.32
                
                
                
                
                
                (63,000
                )
                
                2.55
                
                
                (418,000
                )
                
                2.50Forfeited
                
                
                (2,000
                )
                
                13.25
                
                
                
                
                
                -
                
                
                -
                
                
                (2,000
                )
                
                7.33Outstanding
                    at end of year
                
                
                69,000
                
                $
                11.23
                
                $
                164,214
                
                
                67,000
                
                $
                10.61
                
                
                90,000
                
                $
                3.80Options
                    exercisable at year-end
                
                
                42,000
                
                $
                9.51
                
                $
                157,914
                
                
                22,500
                
                $
                6.20
                
                
                72,000
                
                $
                2.91Weighted-average
                    fair value ofoptions
                    granted during the year
                
                $
                3.33
                
                
                
                
                
                
                
                $
                3.24
                
                
                
                
                $
                2.05
 (1)
                  The
                      aggregate intrinsic value of a stock option in the table above
                      represents
                      the total pre-tax intrinsic value (the amount by which the
                      current market
                      value of the underlying stock exceeds the exercise price of
                      the option)
                      that would have been received by the option holders had all
                      option holders
                      exercised their options on December 31, 2007. This amount changes
                      based on
                      changes in the market value of the Company's stock. The total
                      intrinsic
                      value of options exercised during 2007 was approximately $21,000.
                      The fair
                      value (present value of the estimated future benefit to the
                      option holder)
                      of each option grant is estimated on the date of grant using
                      the
                      Black-Scholes option pricing
                      model.
 
 Information
        pertaining to options outstanding at December 31, 2007, is as
        follows:
 Options
                    Outstanding
                
                Options
                    ExercisableWeighted
                
                Weighted
                
                
                
                WeightedAverage
                
                Average
                
                
                
                AverageExercise
                
                Number
                
                Remaining
                
                Exercise
                
                Number
                
                ExercisePrices
                
                Outstanding
                
                Life
                
                Price
                
                Exercisable
                
                Price$
                    5.44
                
                
                16,000
                
                
                6.2
                    Years
                
                $
                5.44
                
                
                16,000
                
                $
                5.449.23
                
                
                8,000
                
                
                7.2
                    Years
                
                
                9.23
                
                
                8,000
                
                
                9.2313.25
                
                
                36,000
                
                
                8.2
                    Years
                
                
                13.25
                
                
                18,000
                
                
                13.2515.25
                
                
                9,000
                
                
                9.2
                    Years
                
                
                15.25
                
                
                -
                
                
                -Outstanding
                    at end of year
                
                
                69,000
                
                
                7.7
                    Years
                
                
                11.23
                
                
                42,000
                
                
                9.51
  57
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
 
 Note
        15.  Stock
        Option Plans (continued)
 
 Information
        pertaining to non-vested options for the year ended December 31, 2007, is
        as
        follows:
 Weighted
                    AverageNumber
                
                Grant
                    Dateof
                    Shares
                
                Fair
                    ValueNon-vested
                    options, December 31, 2006
                
                
                44,500
                
                $
                12.84Granted
                
                
                9,000
                
                
                15.25Vested
                
                
                (24,500
                )
                
                12.51Forfeited/expired
                
                
                (2,000
                )
                
                13.25Non-vested
                    options, December 31, 2007
                
                
                27,000
                
                
                13.93
  The
        total
        fair value of shares vested during 2007 was approximately $332,900.
 
 Officer
        and Employee Plans:
 
 The
        Company has two stock option plans under which officers and employees can
        be
        granted incentive stock options or non-qualified stock options to purchase
        a
        total of up to 1,420,000 shares of the Company’s common stock. The option price
        for incentive stock options shall be not less than 100 percent of the fair
        market value of the common stock on the date of the grant. The non-qualified
        stock options may be equal to or more or less than the fair market value
        of the
        common stock on the date of the grant. The stock options vest at 30 percent
        on the second and third anniversaries of the grant date and 40 percent on
        the fourth anniversary of the grant date. These options expire ten years
        from
        the grant date. At December 31, 2007, the total remaining compensation cost
        to
        be recognized on non-vested options is approximately $625,000. An analysis
        of
        the activity for each of the years ending December 31, 2007, 2006 and 2005,
        for
        this stock option plan follows:
 Years
                        Ended December 31,2007
                    
                    2006
                    
                    2005Average
                    
                    Aggregate
                    
                    
                    
                    Average
                    
                    AverageExercise
                    
                    Intrinsic
                    
                    
                    
                    Exercise
                    
                    ExerciseShares
                    
                    Price
                    
                    Value(1)
                    
                    Shares
                    
                    Price
                    
                    Shares
                    
                    PriceOutstanding
                        at beginning of year
                    
                    
                    669,120
                    
                    $
                    5.79
                    
                    
                    
                    
                    
                    632,500
                    
                    $
                    4.64
                    
                    
                    564,400
                    
                    $
                    3.97Granted
                    
                    
                    53,800
                    
                    
                    15.25
                    
                    
                    
                    
                    
                    82,800
                    
                    
                    13.25
                    
                    
                    80,300
                    
                    
                    9.23Exercised
                    
                    
                    (5,870
                    )
                    
                    4.48
                    
                    
                    
                    
                    
                    (46,180
                    )
                    
                    3.54
                    
                    
                    (5,100
                    )
                    
                    4.47Forfeited
                    
                    
                    (1,975
                    )
                    
                    14.03
                    
                    
                    
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (7,100
                    )
                    
                    3.27Outstanding
                        at end of year
                    
                    
                    715,075
                    
                    $
                    6.52
                    
                    $
                    5,177,118
                    
                    
                    669,120
                    
                    $
                    5.79
                    
                    
                    632,500
                    
                    $
                    4.64Options
                        exercisable at year-end
                    
                    
                    470,990
                    
                    $
                    4.06
                    
                    $
                    4,473,950
                    
                    
                    367,120
                    
                    $
                    3.71
                    
                    
                    300,900
                    
                    $
                    3.47Weighted-average
                        fair value ofoptions
                        granted during the year
                    
                    $
                    3.33
                    
                    
                    
                    
                    
                    
                    
                    $
                    3.24
                    
                    
                    
                    
                    $
                    2.05
  (1)
                  The
                      aggregate intrinsic value of a stock option in the table above
                      represents
                      the total pre-tax intrinsic value (the amount by which the
                      current market
                      value of the underlying stock exceeds the exercise price of
                      the option)
                      that would have been received by the option holders had all
                      option holders
                      exercised their options on December 31, 2007. This amount changes
                      based on
                      changes in the market value of the Company's stock. The total
                      intrinsic
                      value of options exercised during 2007 was approximately $53,000.
                      The fair
                      value (present value of the estimated future benefit to the
                      option holder)
                      of each option grant is estimated on the date of grant using
                      the
                      Black-Scholes option pricing
                      model.
  58
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
 
 Note
        15.  Stock
        Option Plans (continued)
 
 Information
        pertaining to options outstanding at December 31, 2007, is as
        follows:
 Options
                    Outstanding
                
                Options
                    ExercisableWeighted
                
                Weighted
                
                
                
                WeightedAverage
                
                Average
                
                
                
                AverageExercise
                
                Number
                
                Remaining
                
                Exercise
                
                Number
                
                ExercisePrices
                
                Outstanding
                
                Life
                
                Price
                
                Exercisable
                
                Price$3.25
                    - $3.75
                
                
                368,600
                
                
                3.7
                    Years
                
                $
                3.51
                
                
                368,600
                
                $
                3.515.44
                
                
                132,440
                
                
                6.2
                    Years
                
                
                5.44
                
                
                78,840
                
                
                5.449.23
                
                
                79,410
                
                
                7.2
                    Years
                
                
                9.23
                
                
                23,550
                
                
                9.2313.25
                
                
                81,600
                
                
                8.2
                    Years
                
                
                13.25
                
                
                -
                
                
                -15.25
                
                
                50,275
                
                
                9.2
                    Years
                
                
                15.25
                
                
                -
                
                
                -15.20
                
                
                2,750
                
                
                9.3
                    Years
                
                
                15.20
                
                
                -
                
                
                -Outstanding
                    at end of year
                
                
                715,075
                
                
                5.5
                    Years
                
                
                6.52
                
                
                470,990
                
                
                4.12
 
 Information
        pertaining to non-vested options for the year ended December 31, 2007, is
        as
        follows:
 Weighted
                    AverageNumber
                
                Grant
                    Dateof
                    Shares
                
                Fair
                    ValueNon-vested
                    options, December 31, 2006
                
                
                302,000
                
                $
                8.32Granted
                
                
                53,800
                
                
                15.25Vested
                
                
                (109,740
                )
                
                5.49Forfeited/expired
                
                
                (1,975
                )
                
                14.03Non-vested
                    options, December 31, 2007
                
                
                244,085
                
                
                11.08
 The
          total
          fair value of shares vested during 2007 was approximately
          $1,491,100.
  Note
        16.  Liquidity
        and Capital Resources
 
 The
        Company’s primary source of funds with which to pay its future obligations is
        the receipt of dividends from its subsidiary bank. Banking regulations provide
        that the Bank must maintain capital sufficient to enable it to operate as
        a
        viable institution and, as a result, may limit the amount of dividends the
        Bank
        may pay without prior approval. It is management’s intention to limit the amount
        of dividends paid in order to maintain compliance with capital guidelines
        and to
        maintain an appropriate capital position in the Bank.
 
 Note
        17.  Regulatory
        Matters
 
 The
        Company (on a consolidated basis) and the Bank are subject to various regulatory
        capital requirements administered by the Tennessee Department of Financial
        Institutions and the federal banking agencies. Failure to meet minimum capital
        requirements can initiate certain mandatory and possibly additional
        discretionary actions by regulators that, if undertaken, could have a direct
        material effect on the Company’s and the Bank's financial statements. Under
        capital adequacy guidelines and the regulatory framework for prompt corrective
        action, the Company and the Bank must meet specific capital guidelines that
        involve quantitative measures of the Company’s and the Bank's assets,
        liabilities, and certain off-balance-sheet items as calculated under regulatory
        accounting practices. The Company’s and the Bank's capital amounts and
        classification 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 the Bank to maintain minimum amounts and ratios (set forth in
        the
        table below) of total and Tier I capital (as defined in the regulations) to
        risk-weighted assets (as defined), and of Tier I capital (as defined) to
        average assets (as defined). Management believes, as of December 31, 2007
        and 2006, that the Company and the Bank meet all capital adequacy requirements
        to which they are subject.
  59
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
 
 Note
        17.  Regulatory
        Matters (continued)
 
 As
        of
        December 31, 2007, the most recent notification from the Federal Deposit
        Insurance Corporation categorized the Bank as adequately capitalized under
        the
        regulatory framework for prompt corrective action. To be categorized as
        adequately capitalized, an institution must maintain minimum total risk-based,
        Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following
        tables. There are no conditions or events since that notification that
        management believes have changed the Bank's prompt corrective action category
        for bank capital.
 
 The
        Company’s and the Bank's actual capital amounts and ratios are also presented in
        the table. Dollar amounts are presented in thousands.
 For
                      CapitalActual
                  
                  Adequacy
                      PurposesAmount
                  
                  Ratio
                  
                  Amount
                  
                  RatioAs
                      of December 31, 2007:Total
                      capital to risk-weighted assets:Consolidated
                  
                  $
                  38,353
                  
                  
                  9.7
                  %
                  $
                  31,660
                  
                  
                  8.0
                  %Cornerstone
                      Community Bank
                  
                  
                  36,651
                  
                  
                  9.3
                  %
                  
                  31,409
                  
                  
                  8.0
                  %Tier
                      I capital to risk-weighted assets:Consolidated
                  
                  
                  33,297
                  
                  
                  8.4
                  %
                  
                  15,830
                  
                  
                  4.0
                  %Cornerstone
                      Community Bank
                  
                  
                  31,635
                  
                  
                  8.1
                  %
                  
                  15,704
                  
                  
                  4.0
                  %Tier
                      I capital to average assets:Consolidated
                  
                  
                  33,297
                  
                  
                  7.7
                  %
                  
                  17,282
                  
                  
                  4.0
                  %Cornerstone
                      Community Bank
                  
                  
                  31,635
                  
                  
                  7.4
                  %
                  
                  17,187
                  
                  
                  4.0
                  %As
                      of December 31, 2006:Total
                      capital to risk-weighted assets:Consolidated
                  
                  $
                  39,311
                  
                  
                  12.0
                  %
                  $
                  26,243
                  
                  
                  8.0
                  %Cornerstone
                      Community Bank
                  
                  
                  35,770
                  
                  
                  10.9
                  %
                  
                  26,164
                  
                  
                  8.0
                  %Tier
                      I capital to risk-weighted assets:Consolidated
                  
                  
                  35,210
                  
                  
                  10.7
                  %
                  
                  13,121
                  
                  
                  4.0
                  %Cornerstone
                      Community Bank
                  
                  
                  31,681
                  
                  
                  9.7
                  %
                  
                  13,082
                  
                  
                  4.0
                  %Tier
                      I capital to average assets:Consolidated
                  
                  
                  35,210
                  
                  
                  10.2
                  %
                  
                  13,790
                  
                  
                  4.0
                  %Cornerstone
                      Community Bank
                  
                  
                  31,681
                  
                  
                  9.4
                  %
                  
                  13,541
                  
                  
                  4.0
                  %
  Note
        18.  Other
        Comprehensive Income
 
 Other
        comprehensive income consists of unrealized holding gains and losses on
        securities available for sale. A summary of other comprehensive income and
        the
        related tax effects for the years ended December 31, 2007, 2006 and 2005,
        is as follows:
 TaxBefore-Tax
                
                (Expense)
                
                Net-of-TaxAmount
                
                Benefit
                
                AmountYear
                    ended December 31, 2007:Unrealized
                    holding gains and lossesarising
                    during the period
                
                $
                250,886
                
                $
                (85,301
                )
                $
                165,585Less
                    reclassification adjustment forgains
                    realized in net income
                
                
                -
                
                
                -
                
                
                -$
                250,886
                
                $
                (85,301
                )
                $
                165,585
  60
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
 
 Note
        18.  Other
        Comprehensive Income (continued)
 TaxBefore-Tax
                
                (Expense)
                
                Net-of-TaxAmount
                
                Benefit
                
                AmountYear
                    ended December 31, 2006:Unrealized
                    holding gains and lossesarising
                    during the period
                
                $
                162,632
                
                $
                (55,295
                )
                $
                107,337Less
                    reclassification adjustment forgains
                    realized in net income
                
                
                -
                
                
                -
                
                
                -$
                162,632
                
                $
                (55,295
                )
                $
                107,337Year
                    ended December 31, 2005:Unrealized
                    holding gains and lossesarising
                    during the period
                
                $
                (427,257
                )
                $
                145,268
                
                $
                (281,989
                )Less
                    reclassification adjustment forgains
                    realized in net income
                
                
                -
                
                
                -
                
                
                -$
                (427,257
                )
                $
                145,268
                
                $
                (281,989
                )
  Note
        19.  Earnings
        Per Common Share
 
 Basic
        earnings per share represents income available to common stockholders divided
        by
        the weighted-average number of common shares outstanding during the period.
        Diluted earnings per share reflects additional common shares that would have
        been outstanding if dilutive potential common shares had been issued, as
        well as
        any adjustment to income that would result from the assumed issuance.
 
 Potential
        common shares that may be issued by the Company relate to outstanding stock
        options, determined using the treasury stock method.
 
 Earnings
        per common share have been computed based on the following:
 2007
                
                2006
                
                2005Net
                    income
                
                $
                871,152
                
                $
                5,811,600
                
                $
                4,324,519Less:
                    Preferred stock dividends
                
                
                -
                
                
                -
                
                
                -Net
                    income applicable to common stock
                
                $
                871,152
                
                $
                5,811,600
                
                $
                4,324,519Average
                    number of common shares outstanding
                
                
                6,439,942
                
                
                6,481,568
                
                
                6,091,250Effect
                    of dilutive stock options
                
                
                339,346
                
                
                352,630
                
                
                440,470Average
                    number of common shares outstanding usedto
                    calculate diluted earnings per common share
                
                
                6,779,288
                
                
                6,834,198
                
                
                6,531,720
 The
        effects of outstanding antidilutive stock options are excluded from the
        computation of diluted earnings per share. There were 62,150 antidilutive
        stock
        options for 2007. There were no antidilutive stock options during 2006 or
        2005.
        During 2006, the Company enacted a 2-for-1 split in the form of stock dividend.
        The average number of common shares outstanding and the effect of dilutive
        stock
        options for 2005 have been retroactively adjusted to reflect these
        transactions.
  61
 
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
  Note
        20.  Stock
        Subscriptions Receivable
 
 Effective
        October 8, 2004, the Company filed an offering with the Securities and Exchange
        Commission to sell up to 500,000 shares of newly issued Company common stock.
        At
        December 31, 2004, the Company had sold the entire 500,000 shares for an
        issue
        price of $15 per share. However, of this amount, there were 119,961 shares
        of
        common stock subscribed for which the Company had not yet received funds
        and
        issued common stock certificates. The Company recognized stock subscriptions
        receivable of $1,799,415 as of December 31, 2004, related to this
        transaction. As shown in the consolidated statements of changes in stockholders’
equity, the stock subscriptions receivable were fully settled and the related
        common stock certificates were issued during 2005.
 
 Note
        21.  Recent
        Accounting Pronouncements
 
 In
        March
        2006, the FASB issued Statement of Financial Accounting Standards No. 156,
        “Accounting for Servicing of Financial Assets - An Amendment of FASB Statement
        No. 140” (SFAS 156). This standard requires an entity to recognize a
        servicing asset or servicing liability each time it undertakes a contractual
        obligation to service a financial asset in certain circumstances. All separately
        recognized servicing assets and servicing liabilities are required to be
        initially measured at fair value. Subsequent measurement methods include
        the
        amortization method, whereby servicing assets or servicing liabilities are
        amortized in proportion to and over the period of estimated net servicing
        income
        or net servicing loss, or the fair value method, whereby servicing assets
        or
        servicing liabilities are measured at fair value at each reporting date and
        changes in fair value are reported in earnings in the period in which they
        occur. If the amortization method is used, an entity must assess servicing
        assets or servicing liabilities for impairment or increased obligation based
        on
        the fair value at each reporting date. SFAS 156 is effective for fiscal
        years beginning after September 15, 2006. The adoption of this statement
        did not have a material impact on the Company’s consolidated financial
        statements.
 
 In
        September 2006, the FASB issued Statement of Financial Accounting Standards
        No.
        157, “Fair Value Measurements” (SFAS 157). This standard defines fair value,
        establishes a framework for measuring fair value in generally accepted
        accounting principles and expands disclosures about fair value measurements.
        SFAS 157 applies only to fair-value measurements that are already required
        or permitted by other accounting standards and is expected to increase the
        consistency of those measurements. The definition of fair value focuses on
        the
        exit price, i.e., the price that would be received to sell an asset or paid
        to
        transfer a liability in an orderly transaction between market participants
        at
        the measurement date, not the entry price, i.e., the price that would be
        paid to
        acquire the asset or received to assume the liability at the measurement
        date.
        The statement emphasizes that fair value is a market-based measurement; not
        an
        entity-specific measurement. Therefore, the fair value measurement should
        be
        determined based on the assumptions that market participants would use in
        pricing the asset or liability. The effective date for SFAS 157 is for
        fiscal years beginning after November 15, 2007, and interim periods within
        those fiscal years. The Company adopted the guidance of SFAS 157 beginning
        January 1, 2008, and the adoption did not have a material impact on the
        Company’s consolidated financial statements.
 
 In
        February 2007, the FASB issued Statement of Financial Accounting Standards
        No.
        159, “The Fair Value Option for Financial Assets and Financial Liabilities —
Including an Amendment of FASB Statement No. 115” (SFAS 159). 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. Most
        of the
        provisions in SFAS 159 are elective; however, the amendment to SFAS No. 115,
        “Accounting for Certain Investments in Debt and Equity Securities”, applies to
        all entities with available-for-sale and trading securities. SFAS 159 is
        effective as of the beginning of an entity’s first fiscal year that begins after
        November 15, 2007. The Company did not elect the fair value option as of
        January
        1, 2008, for any of its financial assets or financial liabilities and,
        accordingly, the adoption of the statement did not have a material impact
        on the
        Company’s consolidated financial statements.
  62
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
  Note
        21.  Recent
        Accounting Pronouncements (continued)
 
 In
        December 2007, the FASB issued Statement of Financial Accounting Standards
        No.
        160, “Non-controlling Interests in Consolidated Financial Statements — An
        Amendment of ARB No. 51” (SFAS 160), which, among other things, provides
        guidance and establishes amended accounting and reporting standards for a
        parent
        company’s non-controlling interest in a subsidiary. The Company is currently
        evaluating the impact of adopting SFAS 160, which is effective for fiscal
        years
        beginning on or after December 15, 2008.
 
 In
        December 2007, the FASB issued Statement of Financial Accounting Standards
        No.
        141(R), “Business Combinations” (SFAS 141R), which replaces SFAS No. 141,
“Business Combinations”. SFAS 141(R), among other things, establishes principles
        and requirements for how an acquirer entity recognizes and measures in its
        financial statements the identifiable assets acquired, the liabilities assumed
        (including intangibles) and any non-controlling interests in the acquired
        entity. The Company is currently evaluating the impact of adopting the
        statement, which is effective for fiscal years beginning on or after December
        15, 2008.
 
 In
        July
        2006, the FASB issued Financial Interpretation No. 48, “Accounting for
        Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109”
(FIN 48), which clarifies the accounting for uncertainty in tax positions.
        This
        Interpretation requires that the Company recognize in its financial statements,
        the impact of a tax position, if that position is more likely than not of
        being
        sustained on audit, based on the technical merits of the position. The
        provisions of FIN 48 were effective as of the beginning of the Company’s 2007
        fiscal year. The adoption of this interpretation did not have a material
        impact
        on the Company’s consolidated financial statements.
 
 In
        September 2006, the FASB ratified the consensus reached by the Emerging Issues
        Task Force (EITF) on Issue No. 06-4, “Accounting for Deferred Compensation and
        Postretirement Benefit Aspects of Endorsement Split Dollar Life Insurance
        Arrangements” (EITF 06-4). EITF 06-4 requires the recognition of a liability and
        related compensation expense for endorsement split-dollar life insurance
        policies that provide a benefit to an employee that extends to post-retirement
        periods. Under EITF 06-4, life insurance policies purchased for the purpose
        of
        providing such benefits do not effectively settle an entity’s obligation to the
        employee. Accordingly, the entity must recognize a liability and related
        compensation expense during the employee’s active service period based on the
        future cost of insurance to be incurred during the employee’s retirement. If the
        entity has agreed to provide the employee with a death benefit, then the
        liability for the future death benefit should be recognized by following
        the
        guidance in SFAS No. 106, “Employer’s Accounting for Postretirement Benefits
        Other Than Pensions”. The Company adopted EITF 06-4 effective as of
        January 1, 2008, and the adoption did not have a material impact on the
        Company’s consolidated financial statements.
 
 In
        September 2006, the Securities and Exchange Commission (SEC) issued Staff
        Accounting Bulletin No. 108, “Considering the Effects of Prior Year
        Misstatements when Quantifying Misstatements in Current Year Financial
        Statements” (SAB 108). SAB 108 provides interpretive guidance on how the
        effects of the carryover or reversal of prior year misstatements should be
        considered in quantifying a current year misstatement. The SEC staff believes
        that registrants should quantify errors using both the balance sheet and
        income
        statement approach when quantifying a misstatement that, when all relevant
        quantitative and qualitative factors are considered, is material. SAB 108
        was
        effective for the Company’s fiscal year ending December 31, 2006.
        SAB 108 did not have a material impact on the Company’s consolidated
        financial statements.
 
 In
        November 2007, the Securities and Exchange Commission issued Staff Accounting
        Bulletin No. 109, “Written Loan Commitments Recorded at Fair Value through
        Earnings” (SAB 109). SAB 109 supersedes guidance provided by SAB No. 105,
“Loan Commitments Accounted for as Derivative Instruments” (SAB 105) and
        provides guidance on written loan commitments accounted for at fair value
        through earnings. Specifically, SAB 109 addresses the inclusion of expected
        net
        future cash flows related to the associated servicing of a loan in the
        measurement of all written loan commitments accounted for at fair value through
        earnings. In addition, SAB 109 retains the SEC’s position on the exclusion of
        internally-developed intangible assets as part of the fair value of a derivative
        loan commitment originally established in SAB 105. The Company adopted SAB
        109
        as of January 1, 2008, and the adoption of SAB 109 did not have a material
        impact on the Company’s consolidated financial statements.
 
 The
        Company has determined that all other recently issued accounting pronouncements
        will not have a material impact on its consolidated financial statements
        or do
        not apply to its operations.
  63
  CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
  Note
        22.  Acquisition
 
 On
        December 1, 2005, the Company acquired certain assets and assumed liabilities
        of
        Eagle for a purchase price of $1,380,000 in cash plus assumption of
        approximately $1,609,000 in liabilities. Assets acquired, primarily accounts
        receivable, amounted to approximately $2,140,000. The excess of purchase
        price
        over the fair value of the assets acquired of $848,916 was recorded as an
        intangible asset separable from goodwill, as it pertained to customer
        relationships, active customer contracts and brand recognition, and met the
        separability criteria of Statement of Financial Accounting Standards
        No. 141, “Business Combinations” (SFAS 141). The Company is amortizing the
        intangible assets over their benefit periods which range from 1 to 7 years.
        The
        Company recognized amortization expense of $108,000, $345,388 and $13,500
        for
        the periods ended December 31, 2007, 2006 and 2005, respectively. Amortization
        expense for each of the following five years is estimated as follows: 2008
        -
        $107,691; 2009 - $107,691; 2010 - $107,691; 2011 - $36,382; and 2012 -
        $22,573.
 
 The
        Eagle
        acquisition was accounted for under the provisions of SFAS 141 and the results
        of operations have been included in the accompanying consolidated financial
        statements since the date of acquisition. Pro-forma disclosures of the
        acquisition have not been included, as the overall impact of the acquisition
        was
        not significant in relation to the Company’s operating results.
 
 Note
        23.  Equity
        Investment
 
 During
        2006, the Company invested $3,000,000 for a 25% share of the Appalachian
        Fund
        for Growth II Partnership (AFG), which is managed by the Southeast Local
        Development Corporation (General Partner). AFG is targeting high job creation
        and retention businesses and businesses providing important community services.
        The funds are being deployed to help: 1) attract new businesses to under-served
        service areas by offering creative financing; 2) supply creative financing
        for
        businesses to rehabilitate existing distressed properties to facilitate
        community development; and 3) leverage other private investment into its
        targeted communities. In return for its investment in AFG, the Company and
        other
        investors will receive new market tax credits. For 2007 and 2006 the Company
        received approximately $300,000 and $150,000, respectively, in new market
        tax
        credits.
 
 AFG
        meets
        the criteria of a VIE outlined in FASBI 46-R. AFG has not been consolidated
        by the Company as the Company is not the primary beneficiary.
  64
  CORNERSTONE
                      BANCSHARES, INC. AND SUBSIDIARIESNOTES
                      TO CONSOLIDATED FINANCIAL STATEMENTSDecember
                      31, 2007, 2006 and 2005
  Note
                      24. Quarterly Data (unaudited)
  Years
                      Ended December 31,2007
                  
                  2006Fourth
                      Quarter
                  
                  Third
                      Quarter
                  
                  Second
                      Quarter
                  
                  First
                      Quarter
                  
                  Fourth
                      Quarter
                  
                  Third
                      Quarter
                  
                  Second
                      Quarter
                  
                  First
                      QuarterInterest
                      income
                  
                  $
                  8,857,394
                  
                  $
                  9,109,824
                  
                  $
                  8,743,087
                  
                  $
                  8,073,213
                  
                  $
                  7,931,542
                  
                  $
                  7,533,801
                  
                  $
                  7,184,095
                  
                  $
                  6,509,368Interest
                      expense
                  
                  
                  3,970,038
                  
                  
                  3,785,203
                  
                  
                  3,469,307
                  
                  
                  3,189,057
                  
                  
                  2,932,985
                  
                  
                  2,781,355
                  
                  
                  2,437,644
                  
                  
                  2,154,125Net
                      interest income, beforeprovision
                      for loan losses
                  
                  
                  4,887,356
                  
                  
                  5,324,621
                  
                  
                  5,273,780
                  
                  
                  4,884,156
                  
                  
                  4,998,557
                  
                  
                  4,752,446
                  
                  
                  4,746,451
                  
                  
                  4,355,243Provision
                      for loan losses
                  
                  
                  7,208,865
                  
                  
                  2,963,500
                  
                  
                  235,000
                  
                  
                  2,000
                  
                  
                  48,800
                  
                  
                  204,800
                  
                  
                  475,000
                  
                  
                  378,000Net
                      interest (loss) income, after provisionfor
                      loan losses
                  
                  
                  (2,321,509
                  )
                  
                  2,361,121
                  
                  
                  5,038,780
                  
                  
                  4,882,156
                  
                  
                  4,949,757
                  
                  
                  4,547,646
                  
                  
                  4,271,451
                  
                  
                  3,977,243Noninterest
                      income
                  
                  
                  471,459
                  
                  
                  380,233
                  
                  
                  439,404
                  
                  
                  403,994
                  
                  
                  591,689
                  
                  
                  418,102
                  
                  
                  668,453
                  
                  
                  433,012Noninterest
                      expenses
                  
                  
                  2,856,953
                  
                  
                  2,370,989
                  
                  
                  3,011,708
                  
                  
                  2,685,951
                  
                  
                  3,512,381
                  
                  
                  2,422,234
                  
                  
                  2,541,394
                  
                  
                  2,242,221(Loss)
                      income before income taxes
                  
                  
                  (4,707,003
                  )
                  
                  370,365
                  
                  
                  2,466,476
                  
                  
                  2,600,199
                  
                  
                  2,029,065
                  
                  
                  2,543,514
                  
                  
                  2,398,510
                  
                  
                  2,168,034Income
                      tax (benefit) expense
                  
                  
                  (1,802,855
                  )
                  
                  (188,971
                  )
                  
                  902,289
                  
                  
                  948,422
                  
                  
                  582,200
                  
                  
                  997,065
                  
                  
                  935,298
                  
                  
                  812,960Net
                      (loss) income
                  
                  $
                  (2,904,148
                  )
                  $
                  559,336
                  
                  $
                  1,564,187
                  
                  $
                  1,651,777
                  
                  $
                  1,446,865
                  
                  $
                  1,546,449
                  
                  $
                  1,463,212
                  
                  $
                  1,355,074Earnings
                      (loss) per common share:Basic
                      (1)
                  
                  $
                  (0.44
                  )
                  $
                  0.09
                  
                  $
                  0.24
                  
                  $
                  0.25
                  
                  $
                  0.22
                  
                  $
                  0.24
                  
                  $
                  0.23
                  
                  $
                  0.21Diluted
                      (1)
                  
                  $
                  (0.42
                  )
                  $
                  0.08
                  
                  $
                  0.23
                  
                  $
                  0.24
                  
                  $
                  0.20
                  
                  $
                  0.23
                  
                  $
                  0.22
                  
                  $
                  0.20
 (1)
                    During
                        2006, the Company enacted a 2-for-1-split-up effected in
                        the form of a
                        stock dividend. Therefore, previously reported EPS amounts
                        disbursed
                        herein have been retroactively adjusted to reflect this
                        transaction.
  65
  CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
 
 Note
        25.  Condensed
        Parent Information
 BALANCE
                        SHEETS
                    
                    2007
                    
                    2006ASSETSCash
                    
                    $
                    387,064
                    
                    $
                    311,073Investment
                        in subsidiaries
                    
                    
                    33,257,674
                    
                    
                    33,320,259Loan
                        to subsidiary
                    
                    
                    750,000
                    
                    
                    2,869,500Goodwill
                    
                    
                    2,541,476
                    
                    
                    2,541,476Other
                        assets
                    
                    
                    201,448
                    
                    
                    158,524Total
                        assets
                    
                    $
                    37,137,662
                    
                    $
                    39,200,832LIABILITIES
                        AND STOCKHOLDERS’ EQUITYOther
                        liabilities
                    
                    $
                    710,312
                    
                    $
                    517,567Line
                        of credit
                    
                    
                    100,000
                    
                    
                    500,000Total
                        liabilities
                    
                    
                    810,312
                    
                    
                    1,017,567Stockholders’
                        equity
                    
                    
                    36,327,350
                    
                    
                    38,183,265Total
                        liabilities and stockholders’ equity
                    
                    $
                    37,137,662
                    
                    $
                    39,200,832
  STATEMENTS
                        OF INCOME
                    
                    2007
                    
                    2006
                    
                    2005INCOMEDividends
                    
                    $
                    1,280,260
                    
                    $
                    590,130
                    
                    $
                    200,000Interest
                        income
                    
                    
                    158,039
                    
                    
                    139,935
                    
                    
                    10,0001,438,299
                    
                    
                    730,065
                    
                    
                    210,000EXPENSESInterest
                        expense
                    
                    
                    24,882
                    
                    
                    1,632
                    
                    
                    -Other
                        operating expenses
                    
                    
                    623,405
                    
                    
                    914,786
                    
                    
                    263,824Income
                        (loss) before equity in undistributed earnings
                    
                    
                    790,012
                    
                    
                    (186,353
                    )
                    
                    (53,824
                    )Equity
                        in undistributed earnings (loss) of subsidiary
                    
                    
                    (228,170
                    )
                    
                    5,700,951
                    
                    
                    4,261,344Income
                        tax benefit
                    
                    
                    309,310
                    
                    
                    297,002
                    
                    
                    116,999Net
                        income
                    
                    $
                    871,152
                    
                    $
                    5,811,600
                    
                    $
                    4,324,519
 66
  CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2007, 2006 and 2005
  Note
            25.  Condensed
            Parent Information (continued)
 STATEMENTS
                        OF CASH FLOWS
                    
                    2007
                    
                    2006
                    
                    2005CASH
                        FLOWS FROM OPERATING ACTIVITIESNet
                        income
                    
                    $
                    871,152
                    
                    $
                    5,811,600
                    
                    $
                    4,324,519Adjustments
                        to reconcile net income to net cashprovided
                        by operating activities:Stock
                        compensation expense
                    
                    
                    220,016
                    
                    
                    147,925
                    
                    
                    -Equity
                        in undistributed income of subsidiary
                    
                    
                    228,170
                    
                    
                    (5,700,951
                    )
                    
                    (4,261,344
                    )Other
                    
                    
                    19,095
                    
                    
                    895,292
                    
                    
                    20,818Net
                        cash provided by operating activities
                    
                    
                    1,338,433
                    
                    
                    1,153,866
                    
                    
                    83,993CASH
                        FLOWS FROM INVESTING ACTIVITIESAcquisition
                        of business
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,380,000
                    )Repayment
                        from (loan to) subsidiary
                    
                    
                    2,119,500
                    
                    
                    (1,440,706
                    )
                    
                    (1,428,794
                    )Capital
                        contribution to subsidiary
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,775,000
                    )Net
                        cash provided by (used in) investing activities
                    
                    
                    2,119,500
                    
                    
                    (1,440,706
                    )
                    
                    (4,583,794
                    )CASH
                        FLOWS FROM FINANCING ACTIVITIESNet
                        borrowings (repayments) under line of credit
                    
                    
                    (400,000
                    )
                    
                    500,000
                    
                    
                    -Purchase
                        of common stock
                    
                    
                    (1,751,291
                    )
                    
                    (206,807
                    )
                    
                    (82,520
                    )Payment
                        of dividends
                    
                    
                    (1,303,577
                    )
                    
                    (775,138
                    )
                    
                    (526,476
                    )Issuance
                        of common stock
                    
                    
                    72,926
                    
                    
                    563,299
                    
                    
                    2,949,666Net
                        cash (used in) provided by financing activities
                    
                    
                    (3,381,942
                    )
                    
                    81,354
                    
                    
                    2,340,670NET
                        INCREASE (DECREASE) IN CASH AND CASHEQUIVALENTS
                    
                    
                    75,991
                    
                    
                    (205,486
                    )
                    
                    (2,159,131
                    )CASH
                        AND CASH EQUIVALENTS, beginning of year
                    
                    
                    311,073
                    
                    
                    516,559
                    
                    
                    2,675,690CASH
                        AND CASH EQUIVALENTS, end of year
                    
                    $
                    387,064
                    
                    $
                    311,073
                    
                    $
                    516,559SUPPLEMENTAL
                        DISCLOSURES OF CASH FLOWINFORMATIONCash
                        paid during the year for:Interest
                    
                    $
                    24,882
                    
                    $
                    1,632
                    
                    $
                    -Income
                        taxes
                    
                    
                    3,592,300
                    
                    
                    2,944,000
                    
                    
                    1,190,850
 
 67




**ITEM
      9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





Cornerstone
      has not had any change in accountants or disagreements with accountants on
      accounting and financial disclosure during the two most recent fiscal years
      or
      subsequently.





**ITEM
      9A. CONTROLS AND PROCEDURES**





**Disclosure
      Controls and Procedures**





Cornerstone
      maintains disclosure controls and procedures, as defined in Rule 13a-15(e)
      promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”), that
      are designed to ensure that information required to be disclosed by it in the
      reports that it files or submits under the Exchange Act is recorded, processed,
      summarized and reported within the time periods specified in the SEC’s rules and
      forms and that such information is accumulated and communicated to Cornerstone’s
      management, including its Chief Executive Officer and Chief Financial Officer,
      as appropriate, to allow timely decisions regarding required disclosure.
      Cornerstone carried out an evaluation, under the supervision and with the
      participation of its management, including its Chief Executive Officer and
      Chief
      Financial Officer, of the effectiveness of the design and operation of its
      disclosure controls and procedures as of the end of the period covered by this
      report. Based on the evaluation of these disclosure controls and procedures,
      the
      Chief Executive Officer and Chief Financial Officer concluded that Cornerstone’s
      disclosure controls and procedures were effective.





**Management
      Report on Internal Control over Financial Reporting**




The
      report of Cornerstone’s management on internal control over financial reporting
      is set forth in Item No. 8 of this Annual Report on Form 10-K. The report of
      Cornerstone’s independent registered public accounting firm on Cornerstone’s
      internal control over financial reporting is set forth in Item No. 8 of this
      Annual Report on Form 10-K.





**Changes
      in Internal Controls**





There
      were no changes in Cornerstone’s internal control over financial reporting
      during Cornerstone’s fiscal quarter ended December 31, 2007 that have
      materially affected, or are reasonably likely to materially affect,
      Cornerstone’s internal control over financial reporting.





**PART
      III**





**ITEM
      10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**





Information
      relating to the directors and executive officers of Cornerstone is set forth
      under the caption “Proposals - Election of Directors” in Cornerstone’s 2008
      Proxy Statement. Such information is incorporated into this report by reference.
      Information relating to audit committee financial experts is set forth under
      the
      caption “Audit Committee Report - Identification of Members and Functions of
      Committee” in Cornerstone’s Proxy Statement. Such information is incorporated
      into this report by reference.





Cornerstone
      has adopted a code of business conduct and ethics that applies to its directors,
      officers and employees, including its principal executive officers, principal
      financial officer, principal accounting officer, controller or persons
      performing similar functions.




68





**ITEM
      11. EXECUTIVE COMPENSATION**





Information
      relating to executive compensation is set forth under the caption “Executive
      Compensation” in Cornerstone’s 2008 Proxy Statement. Such information is
      incorporated into this report by reference.





**ITEM
      12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS**





Information
      relating to ownership of Cornerstone’s common stock by certain persons is set
      forth under the caption “Security Ownership of Certain Beneficial Owners and
      Management” in Cornerstone’s 2008 Proxy Statement. Such information is
      incorporated into this report by reference. Information relating to equity
      compensation plans is set forth under the caption “Executive Compensation
      Information” and “The Company’s Long-Term Equity and Qualified Retirements
      Plans” in Cornerstone’s 2008 Proxy Statement. Such information is incorporated
      into this report by reference. Information relating to compliance with the
      reporting requirements of Section 16(a) of the Exchange Act by Cornerstone’s
      executive officers and directors, persons who own more than ten percent of
      Cornerstone’s common stock and their affiliates who are required to comply with
      such reporting requirements is set forth under the caption “Section 16(a)
      Beneficial Ownership Reporting Compliance” in Cornerstone’s 2008 Proxy
      Statement. Such information is incorporate into this report by reference.





**ITEM
      13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**





Information
      relating to certain transactions between Cornerstone, and its affiliates and
      certain other persons is set forth under the caption “Certain Relationships and
      Related Transactions” in Cornerstone’s 2008 Proxy Statement. Such information is
      incorporated into this report by reference.





**ITEM
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**





Information
      relating to principal accountant fees and services is set forth under the
      caption “Audit Committee Report - Audit Fees” in Cornerstone’s 2008 Proxy
      Statement. Such information is incorporated into this report by
      reference.





**ITEM
      15. EXHIBITS AND REPORTS ON FORM 8-K**




(a)
      Exhibits




(1)
      The
      following documents are filed or incorporated herein by reference as exhibits
      to
      this report:


Exhibit
                  No.
              
              Description3.1
              
              Amended
                  and Restated Charters of Cornerstone Bancshares, Inc.
                  (1)3.2
              
              First
                  Amendment to Amended and Restated Charter of Cornerstone Bancshares,
                  Inc.
                  (2)3.3
              
              Amended
                  and Restated Bylaws of Cornerstone Bancshares, Inc. (3)4
              
              The
                  right of securities holders are defined in the Charter and Bylaws
                  provided
                  in exhibits 3.1, 3.2and
                  3.3 respectively.10.1
              
              Cornerstone
                  Community Bank Employee Stock Ownership Plan (4)14
              
              Code
                  of Ethics. (5)21
              
              Subsidiaries
                  of the registrant.31
              
              Certifications
                  of chief executive officer and chief financial officer.32
              
              Section
                  906 certifications of chief executive officer and chief financial
                  officer.





(1)
              
              Incorporated
                  by reference from Exhibit 3.1 of the registrant’s Form 10-KSB filed on
                  March 24, 2004(File
                  No. 000-30497).(2)
              
              Incorporated
                  by reference from Exhibit 3 of the registrant’s Form 10-QSB filed
                  onMay
                  14, 2004 (File No. 000-30497).(3)
              
              Incorporated
                  by reference from Exhibit 3.2 of the registrant’s Form 10-KSB filed on
                  March 24, 2004(File
                  No. 000-30497).(4)
              
              Incorporated
                  by reference from Exhibit 10.1 of the registrant’s Form 8-K filed on July
                  19, 2005(File
                  No. 000-30497)(5)
              
              Incorporated
                  by reference from Exhibit 14 of the registrant’s Form 10-KSB filed on
                  March 24,2004
                  (File No. 000-30497).


69





(b)  The
      following reports on Form 8-K were filed with the Securities and Exchange
      Commission during 2007:


(1)
              
              Form
                  8-K filed on January 17, 2007 reporting earnings results for the
                  fiscal
                  quarter ended December 31, 2006.(2)
              
              Form
                  8-K filed on March 1, 2007 reporting the declaration of a cash
                  dividend.(3)
              
              Form
                  8-K filed on April 16, 2007 reporting earnings results for the
                  fiscal
                  quarter ended March 31, 2007.(4)
              
              Form
                  8-K filed on May 29, 2007 reporting the declaration of a cash
                  dividend.(5)
              
              Form
                  8-K filed on July 19, 2007 reporting earnings results for the fiscal
                  quarter ended June 30, 2007.(6)
              
              Form
                  8-K filed on August 24, 2007 reporting the declaration of a cash
                  dividend.(7)
              
              Form
                  8-K filed on October 19, 2007 reporting earnings results for the
                  fiscal
                  quarter ended September 30, 2007.(8)
              
              Form
                  8-K filed on October 19, 2007 reporting the registrants stock repurchase
                  program of 150,000 shares.(9)
              
              Form
                  8-K filed on November 26, 2007 reporting the declaration of a cash
                  dividend.




70




**SIGNATURES**





In
      accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
      the
      Registrant has caused this report to be signed on its behalf by the undersigned,
      thereunto duly authorized.


CORNERSTONE
                BANCSHARES, INC.Date:
              March
              13, 2008
            By:
            /s/
              Gregory B. JonesGregory
                B. Jones
              Chairman
                and Chief Executive Officer
              (principal
                executive officer) By:
            /s/
              Nathaniel F. HughesNathaniel
                F. Hughes
              President
                and Treasurer
              (principal
                financial officer and accounting
                officer)


71


In
      accordance with 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
      indicated on March 13, 2008.




Signature
              
              Title/s/
                  Gregory B. Jones
                  Gregory
                    B. Jones
              
              Chairman
                  of the Board and Chief Executive Officer
                  and
                    Director (principal executive officer)/s/
                  B. Kenneth Driver
                  B.
                    Kenneth Driver
              
              Director/s/
                  Karl Fillauer
                  Karl
                    Fillauer
              
              Director/s/
                  Nathaniel F. Hughes
                  Nathaniel
                    F. Hughes
              
              President
                  and Treasurer
                (principal
                    financial officer and accounting officer) and
                  Director/s/
                  Jerry D. Lee
                  Jerry
                    D. Lee
              
              Executive
                  Vice President and Senior Lender
                and
                    Director/s/
                  Lawrence D. Levine
                  Lawrence
                    D. Levine
              
              Director/s/
                  Frank S. McDonald
                  Frank
                    S. McDonald
              
              Director/s/
                  Doyce G. Payne
                  Doyce
                    G. Payne
              
              Director/s/
                  W. Miller Welborn
                  W.
                    Miller Welborn
              
              Director/s/
                  Billy O. Wiggins
                  Billy
                    O. Wiggins
              
              Director/s/
                  Marsha Yessick
                  Marsha
                    Yessick
              
              Director
  72




**INDEX
      OF EXHIBITS**


Exhibit
                  No.
              
              Description3.1
              
              Amended
                  and Restated Charters of Cornerstone Bancshares, Inc.
                  (1)3.2
              
              First
                  Amendment to Amended and Restated Charter of Cornerstone Bancshares,
                  Inc.
                  (2)3.3
              
              Amended
                  and Restated Bylaws of Cornerstone Bancshares, Inc. (3)4
              
              The
                  right of securities holders are defined in the Charter and Bylaws
                  provided
                  in exhibits 3.1, 3.2and
                  3.3 respectively.10.1
              
              Cornerstone
                  Community Bank Employee Stock Ownership Plan (4)14
              
              Code
                  of Ethics. (5)21
              
              Subsidiaries
                  of the registrant.31
              
              Certifications
                  of chief executive officer and chief financial officer.32
              
              Section
                  906 certifications of chief executive officer and chief financial
                  officer.





(1)
              
              Incorporated
                  by reference from Exhibit 3.1 of the registrant’s Form 10-KSB filed on
                  March 24, 2004(File
                  No. 000-30497).(2)
              
              Incorporated
                  by reference from Exhibit 3 of the registrant’s Form 10-QSB filed
                  onMay
                  14, 2004 (File No. 000-30497).(3)
              
              Incorporated
                  by reference from Exhibit 3.2 of the registrant’s Form 10-KSB filed on
                  March 24, 2004(File
                  No. 000-30497).(4)
              
              Incorporated
                  by reference from Exhibit 10.1 of the registrant’s Form 8-K filed on July
                  19, 2005(File
                  No. 000-30497)(5)
              
              Incorporated
                  by reference from Exhibit 14 of the registrant’s Form 10-KSB filed on
                  March 24,2004
                  (File No. 000-30497).




73