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,
2008


OR





 ̈
              TRANSITION
      REPORT PURSUANT 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  ̈ 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  ̈   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
 ̈





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.   ̈




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting
company.  See the definitions of “large accelerated filer”,
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.





Large
      accelerated filer  ̈
              Accelerated
      filer  ̈
              Non-accelerated
      filer x
              Smaller
      reporting company  ̈




Indicate
by check mark whether the Registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act)


Yes   ̈ 
No  x




The
aggregate market value of the common stock held by non-affiliates of the
Registrant on June 30, 2008 was $38 million. The market value calculation
was determined using the closing sale price of the Registrant’s common stock on
June 30, 2008, 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, 2008 there were 6,319,718 shares of the Registrant’s
common stock outstanding.




DOCUMENTS
INCORPORATED BY REFERENCE




Portions
of the Registrant’s Proxy Statement for the 2009 Annual Meeting of Shareholders
(the “2009 Proxy Statement”) are incorporated by reference into Part III of this
Annual Report on Form 10-K to the extent described herein.





TABLE
OF CONTENTS





Item
      No.
                        
                        Page
      No.PART
      I1.
                        Business
                        41A.
                        Risk
      Factors
                        91B.
                        Unresolved
      Staff Comments
                        142.
                        Properties
                        143.
                        Legal
      Proceedings
                        144.
                        Submission
      of Matters to a Vote of Security Holders
                        14PART
      II5.
                        Market for the
      Registrant’s Common Equity, Related Stockholders Matters and Issuer Purchases
      of Equity Securities
                        146.
                        Selected
      Financial Data
                        167.
                        Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                        177A.
                        Quantitative
      and Qualitative Disclosures About Market Risk
                        368.
                        Financial
      Statements and Supplementary Data
                        389.
                        Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                        769A(T).
                        Controls
      and Procedures
                        769B.
                        Other
      Information
                        76PART
      III10.
                        Directors,
      Executive Officers and Corporate Governance
                        7611.
                        Executive
      Compensation
                        7712.
                        Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                        7713.
                        Certain
      Relationships and Related Transactions and Director
      Independence
                        7714.
                        Principal
      Accountant Fees and Services
                        7715.
                        Exhibits
      and Financial Statement Schedules
                        77




2


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 include, without limitation, those specifically
described in Item 1A of Part I of this Annual Report on Form 10-K, as well
as the following:  (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.


3


PART
I





ITEM
1.  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, 2008, 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 LPO,
which is located in Whitfield County, Georgia, expanded the Bank’s presence in
North 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.


4


Employees





As of
December 31, 2008, Cornerstone had 121 full-time equivalent
employees.  The employees are not represented by a collective
bargaining unit.  Cornerstone believes that its relationship with its
employees is good.





Competition





All
phases of the Bank’s banking activities are highly competitive.  The
Bank competes actively with 24 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 $327 million as of December 31,
2008.  The deposit base represents approximately 5.5% of the deposit
base in the Hamilton County Tennessee Metropolitan Statistical
Area.  Three major regional banks represent approximately 74% of the
deposits in the Hamilton County Tennessee 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 Hamilton County
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 $250,000 for each insured
depositor through the BIF.  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.


5


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.





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.




6





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.





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 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.


7


Legislation Affecting Cornerstone and
the Bank





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





FIRREA and
FDICIA





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.





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


8


§
            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.





Gramm-Leach-Bliley
Act





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.





Temporary Liquidity
Guarantee Program





On
November 21, 2008, the Board of Directors of the FDIC adopted a final rule
relating to the Temporary Liquidity Guarantee Program (“TLGP”).  The
TLGP was announced by the FDIC on October 14, 2008, preceded by the
determination of systemic risk by the U.S. Treasury, as an initiative to counter
the system-wide crisis in the nation’s financial sector.  Under the
TLGP, the FDIC will (i) guarantee, through the earlier of maturity or June 30,
2012, certain newly issued senior unsecured debt issued by participating
institutions and (ii) provide unlimited FDIC deposit insurance coverage for
noninterest bearing transaction deposit accounts, Negotiable Order of Withdrawal
Accounts (commonly known as NOW accounts) paying less than 0.5% interest per
annum and Interest on Lawyers Trust Accounts (commonly known as IOLTA) held at
participating FDIC-insured institutions through December 31,
2009.  Coverage under the TLG Program was available for the first 30
days without charge.  The fee assessment for coverage of senior
unsecured debt ranges from 50 basis points to 100 basis points per annum,
depending on the initial maturity of the debt.  The fee assessment for
deposit insurance coverage is 10 basis points per quarter on amounts in covered
accounts exceeding $250,000.  The Bank elected to participate in the
unlimited deposit insurance coverage for noninterest bearing transaction deposit
accounts, but declined to participate in the senior unsecured debt guarantee
coverage.





Future
Legislation





Legislation
is 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.  Such legislation may change banking statutes and the
operating environment of Cornerstone and/or the Bank in substantial and
unpredictable ways and could increase or decrease the cost of doing business,
limit or expand permissible activities or affect the competitive balance,
depending upon whether any of this potential legislation will be enacted and, if
enacted, the effect that it or any implementing regulations would have on the
financial condition or results of operations of Cornerstone and/or the
Bank.  With the recent enactments of the EESA and the ARRA, the nature
and extent of future legislative and regulatory changes affecting financial
institutions is uncertain.  It cannot be predicted whether or what
form any proposed legislation will be adopted or the extent to which the
business of Cornerstone and/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.


9





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 an 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, TN 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.





Impact
of recent negative developments in the financial services industry and U.S. and
global credit markets may adversely impact Cornerstone’s operations and
results.





Recent
developments in the capital markets have resulted in uncertainty in the
financial markets.  It is anticipated that these negative economic
developments will continue into 2009.  Financial institutions across
the U.S. have experienced deteriorating asset quality.  Loan
portfolios include impaired loans to businesses struggling to stay in operation
or achieve adequate cash flow.  Further a decline in collateral values
supporting these loans have also impacted the ability of a business or consumer
to obtain loans or increased financial institutions losses in the event of
foreclosure and liquidation.  At the same time financial institutions
have experienced concerns regarding liquidity.  This concern has
increased the competition for deposits in Cornerstone’s local market as well as
wholesale funding options.  These events have impacted Cornerstone’s,
as well as other bank holding company, stock prices.  The potential
impact of these events may be an expansion of existing or creation of new
federal or state laws and regulations regarding lending and funding practices,
liquidity standards and compliance issues.  Continued negative
developments as well as Cornerstone’s ability to respond to these new operating
and regulatory requirements could negatively impact Cornerstone’s
operations.  The negative consequences could limit our ability to
originate new loans, obtain adequate funding or increase costs associated with
regulatory compliance.   Ultimately, these changes could result
in modifications to Cornerstone’s existing or future strategic plan, capital
requirements, compensation, financial performance and stock
performance.


10


There
can be no assurance that recently enacted legislation will stabilize the U.S.
financial system.





Under the
Temporary Liquidity Guarantee Program (“TLGP”) the FDIC may offer a guarantee of
certain financial institution indebtedness in exchange for an insurance premium
to be paid to the FDIC by issuing financial
institutions.  Participation in the TLGP likely will require the
payment of additional insurance premiums to the FDIC.  We may be
required to pay higher FDIC premiums than those published for 2009 because
market developments have depleted the deposit insurance fund of the FDIC and
reduced the ratio of reserves to insured deposits.  The U.S. Congress
enacted the Emergency Economic Stabilization Act of 2008 (“EESA”) in response to
the impact of the volatility and disruption in the capital and credit markets on
the financial sector.  The U.S. Department of the Treasury (“U.S.
Treasury”) and the federal banking regulators are implementing a number of
programs under this legislation that are intended to address these conditions
and the asset quality, capital and liquidity issues they have caused for certain
financial institutions and to improve the general availability of credit for
consumers and businesses.  In addition, the U.S. Congress recently
enacted the American Recovery and Reinvestment Act of 2009 (“ARRA”) in an effort
to save and create jobs, stimulate the U.S. economy and promote long-term growth
and stability.  There can be no assurance as to the actual impact that
the TLGP, the EESA, the ARRA and their implementing regulations, the FDIC
programs, or any other governmental program will have on the financial
markets.  The failure of the TLGP, the EESA, the ARRA, the FDIC or the
U.S. government to stabilize the financial markets and a continuation or
worsening of current financial market conditions could materially and adversely
affect Cornerstone’s business, financial condition, results of operations,
access to credit and/or the trading price of Cornerstone’s common
stock.





Cornerstone
may require additional capital which may not be able to be
obtained.





Cornerstone
may require capital from sources other than earnings
generation.  These additional sources may include additional equity
investments, trust preferred offerings, borrowed funds or any combination of
these sources of funds.  Cornerstone’s ability to access these
alternative capital sources may be limited due to regulatory restrictions or the
condition of the capital markets.   Therefore, Cornerstone’s
ability to enact a bank acquisition, increase its loan portfolio or expand its
branch network may be impaired.





Cornerstone
is subject to Federal and State regulations that impact its 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, the FDIC and the TDFI. 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.


11





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.




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.  Recent economic events have prompted the Federal Reserve to
reduce its federal funds rate.  Due to the rapid decline in interest
rates, the Bank was unable to recalibrate its liabilities at the same rate at
which loan rates declined.  As a result, the net interest margin was
impacted negatively during 2008 and will continue into 2009.  If the
Federal Reserve’s federal funds rate remains at extremely low levels or does not
increase above the Bank’s interest rate floors, Cornerstone’s funding costs may
increase which will negatively impact the net interest margin and Cornerstone’s
financial performance.




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.


12





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.  Various
factors, such as the general economic environment, interest rates, regulatory
and legislative considerations and competition, may also impede or prohibit
Cornerstone’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 March 2, 2009,directors and executive
officers beneficially owned approximately 16.8% 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.




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 Board 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.




13


ITEM
1B. UNRESOLVED STAFF COMMENTS




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





ITEM
2.  PROPERTIES





As of
December 31, 2008, 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, Tennessee5319
      Highway 153, Hixson, Tennessee2280
      Gunbarrel Road, Chattanooga, Tennessee8966
      Old Lee Highway, Ooltewah, Tennessee835  
      Georgia Avenue, Chattanooga, TennesseeLoan
      Production Offices
                  202  
      West Crawford Street, Dalton, Georgia9724
      Kingston Pike Suite 305B Knoxville,
Tennessee





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. The Bank
also owns a vacant building and lot at 103 S. Campbell Station Road Knoxville,
TN. The Bank intends to renovate the structure into a full service branch
opening in 2010.Cornerstone operates a service center to facilitate all
of its non-customer contact functions located at 6401 Lee Corners, Suite 119,
Chattanooga, Tennessee.





ITEM
3.  LEGAL PROCEEDINGS





As of the
end of 2008, 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 2008 to a vote of security
holders of Cornerstone through a solicitation of proxies or
otherwise.





PART
II





ITEM 5.
              MARKET
      FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER
      PURCHASES OF EQUITY
SECURITIES





On
February 20, 2009, Cornerstone had 6,319,718 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.  There are ten market makers who
provide a market for Cornerstone’s common stock.





There
were approximately 549 holders of record of the common stock as of December 31,
2008.   This number does not include shareholders with shares in
nominee name held by DTC.  As of the end of 2008, there were 3,728,120
shares held in nominee name by DTC.  Cornerstone paid quarterly cash
dividends in 2008 in the amount of $0.07 per share.  Cornerstone
announced, in November 2008, a first quarter 2009 dividend of $0.07, which was
paid on January 5, 2009.  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.


14





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
      paid2009
      Fiscal Year
                    
                    Low
                    
                    
                    High
                    
                    
                    Per
      ShareFirst
      Quarter (through Feb. 24, 2009)
                    
                    $
                    3.76
                    
                    
                    $
                    6.00
                    
                    
                    $
                    .072008
      Fiscal YearFirst
      Quarter
                    
                    $
                    7.99
                    
                    
                    $
                    10.90
                    
                    
                    $
                    0.07Second
      Quarter
                    
                    $
                    5.85
                    
                    
                    $
                    8.95
                    
                    
                    $
                    0.07Third
      Quarter
                    
                    $
                    5.25
                    
                    
                    $
                    7.25
                    
                    
                    $
                    0.07Fourth
      Quarter
                    
                    $
                    4.75
                    
                    
                    $
                    6.00
                    
                    
                    $
                    0.072007
      Fiscal YearFirst
      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





Table 2
presents information regarding the equity compensation plans under which equity
securities of Cornerstone are authorized for issuance.  For further
information relating to Cornerstone’s equity compensation plans, see Item 12 of
this report.





TABLE
2


Equity
      Compensation Plan
                              Year
      Ended December 31, 2008Plan
      category
                            
                            Number
      of securities to
                              be
      issued upon exercise
                              of
      outstanding options
                            
                            
                            Weighted
      average
                              exercise
      price of
                              outstanding
      options
                            
                            
                            Number
      of securitiesremaining availablefor future
issuanceEquity
      compensation plans approved by security holders:
                            
                            
                            837,225
                            
                            
                            $
                            7.03
                            
                            
                            
                            567,525Equity
      compensation plans not approved by security holders:
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            80,000Total
                            
                            
                            837,225
                            
                            
                            $
                            7.03
                            
                            
                            
                            647,525




15





ITEM
6.SELECTED
FINANCIAL DATA





Table 3
presents selected financial data for the periods indicated (amounts in
thousands).





TABLE
3


At and for the Fiscal Years Ended December 31,2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004Total
      interest income
                
                $
                30,680
                
                
                $
                34,784
                
                
                $
                29,158
                
                
                $
                20,672
                
                
                $
                14,058Total
      interest expense
                
                
                12,698
                
                
                
                14,414
                
                
                
                10,306
                
                
                
                6,077
                
                
                
                3,575Net
      interest income
                
                
                17,982
                
                
                
                20,370
                
                
                
                18,852
                
                
                
                14,594
                
                
                
                10,483Provision
      for loan losses
                
                
                3,498
                
                
                
                10,409
                
                
                
                1,106
                
                
                
                1,401
                
                
                
                840Net
      interest income after provision for loan losses
                
                
                14,484
                
                
                
                9,961
                
                
                
                17,746
                
                
                
                13,193
                
                
                
                9,643Noninterest
      income:Investment
      securities gains
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —
                
                
                
                —Other
      income
                
                
                1,892
                
                
                
                1,695
                
                
                
                2,111
                
                
                
                1,904
                
                
                
                1,405Noninterest
      expense
                
                
                12,568
                
                
                
                10,926
                
                
                
                10,718
                
                
                
                8,216
                
                
                
                6,885Income
      before income taxes
                
                
                3,808
                
                
                
                730
                
                
                
                9,139
                
                
                
                6,881
                
                
                
                4,163Income
      tax expense / (benefit)
                
                $
                1,296
                
                
                $
                (141
                )
                
                $
                3,328
                
                
                $
                2,556
                
                
                $
                1,592Net
      income
                
                $
                2,512
                
                
                $
                871
                
                
                $
                5,811
                
                
                $
                4,325
                
                
                $
                2,571Per
      Share Data:Net
      income, basic
                
                $
                0.40
                
                
                $
                0.13
                
                
                $
                0.90
                
                
                $
                0.71
                
                
                $
                0.52Net
      income, assuming dilution
                
                $
                0.39
                
                
                $
                0.13
                
                
                $
                0.85
                
                
                $
                0.66
                
                
                $
                0.46Dividends
      paid
                
                $
                0.28
                
                
                $
                0.20
                
                
                $
                0.12
                
                
                $
                0.09
                
                
                $
                0.03Book
      value
                
                $
                5.78
                
                
                $
                5.70
                
                
                $
                5.86
                
                
                $
                5.07
                
                
                $
                4.32Tangible
      book value(1)
                
                $
                5.33
                
                
                $
                5.24
                
                
                $
                5.40
                
                
                $
                4.54
                
                
                $
                3.88Financial
      Condition Data:Assets
                
                $
                471,803
                
                
                $
                444,421
                
                
                $
                374,942
                
                
                $
                323,611
                
                
                $
                248,614Loans,
      net of unearned interest
                
                $
                378,472
                
                
                $
                369,883
                
                
                $
                305,879
                
                
                $
                262,008
                
                
                $
                202,555Cash
      and investments
                
                $
                57,286
                
                
                $
                51,798
                
                
                $
                51,557
                
                
                $
                46,074
                
                
                $
                34,614Federal
      funds sold
                
                $
                11,025
                
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                —Deposits
                
                $
                326,583
                
                
                $
                313,250
                
                
                $
                275,816
                
                
                $
                252,435
                
                
                $
                187,832FHLB
      advances and line of credit
                
                $
                71,250
                
                
                $
                47,100
                
                
                $
                39,500
                
                
                $
                30,000
                
                
                $
                27,000Subordinated
      debentures
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                —
                
                
                $
                —Federal
      funds purchased and repurchase agreements
                
                $
                35,790
                
                
                $
                41,560
                
                
                $
                19,249
                
                
                $
                4,790
                
                
                $
                7,409Shareholders’
      equity
                
                $
                36,502
                
                
                $
                36,327
                
                
                $
                38,183
                
                
                $
                32,466
                
                
                $
                24,807Tangible
      shareholders’ equity(1)
                
                $
                33,661
                
                
                $
                33,386
                
                
                $
                35,137
                
                
                $
                29,089
                
                
                $
                22,266Selected
      Ratios:Interest
      rate spread
                
                
                3.67
                %
                
                
                4.51
                %
                
                
                5.16
                %
                
                
                4.93
                %
                
                
                4.70
                %Net
      interest margin(2)
                
                
                4.16
                %
                
                
                5.22
                %
                
                
                5.80
                %
                
                
                5.43
                %
                
                
                5.02
                %Return
      on average assets
                
                
                0.55
                %
                
                
                0.21
                %
                
                
                1.69
                %
                
                
                1.51
                %
                
                
                1.15
                %Return
      on average equity
                
                
                6.71
                %
                
                
                2.14
                %
                
                
                16.27
                %
                
                
                14.98
                %
                
                
                13.83
                %Return
      on average tangible equity(1)
                
                
                7.26
                %
                
                
                2.31
                %
                
                
                17.78
                %
                
                
                16.96
                %
                
                
                16.02
                %Average
      equity to average assets
                
                
                8.27
                %
                
                
                9.86
                %
                
                
                10.36
                %
                
                
                10.09
                %
                
                
                8.30
                %Dividend
      payout ratio
                
                
                70.59
                %
                
                
                149.71
                %
                
                
                13.33
                %
                
                
                12.17
                %
                
                
                4.84
                %Ratio
      of nonperforming assets to total assets
                
                
                1.48
                %
                
                
                0.40
                %
                
                
                0.40
                %
                
                
                0.47
                %
                
                
                0.08
                %Ratio
      of allowance for loan losses to nonperforming loans
                
                
                226.23
                %
                
                
                791.16
                %
                
                
                25.90
                %
                
                
                20.70
                %
                
                
                5.33
                %Ratio
      of allowance for loan losses to total average loans, net of unearned
      income
                
                
                2.49
                %
                
                
                3.88
                %
                
                
                1.50
                %
                
                
                1.50
                %
                
                
                1.47
                %




(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.




16


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 31,2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006
                                      
                                      
                                      2005
                                      
                                      
                                      2004Book
      value per share
                                      
                                      $
                                      5.78
                                      
                                      
                                      $
                                      5.70
                                      
                                      
                                      $
                                      5.86
                                      
                                      
                                      $
                                      5.07
                                      
                                      
                                      $
                                      4.32Effect
      of intangible assets per share
                                      
                                      $
                                      0.45
                                      
                                      
                                      $
                                      0.46
                                      
                                      
                                      $
                                      0.47
                                      
                                      
                                      $
                                      0.53
                                      
                                      
                                      $
                                      0.44Tangible
      book value per share
                                      
                                      $
                                      5.33
                                      
                                      
                                      $
                                      5.24
                                      
                                      
                                      $
                                      5.40
                                      
                                      
                                      $
                                      4.54
                                      
                                      
                                      $
                                      3.88Return
      on average equity
                                      
                                      
                                      6.71
                                      %
                                      
                                      
                                      2.14
                                      %
                                      
                                      
                                      16.27
                                      %
                                      
                                      
                                      14.98
                                      %
                                      
                                      
                                      13.83
                                      %Effect
      of intangible assets
                                      
                                      
                                      0.55
                                      %
                                      
                                      
                                      0.17
                                      %
                                      
                                      
                                      1.51
                                      %
                                      
                                      
                                      1.98
                                      %
                                      
                                      
                                      2.19
                                      %Return
      on average tangible equity
                                      
                                      
                                      7.26
                                      %
                                      
                                      
                                      2.31
                                      %
                                      
                                      
                                      17.78
                                      %
                                      
                                      
                                      16.96
                                      %
                                      
                                      
                                      16.02
                                      %




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





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-lookingstatements to reflect
the occurrence of changes or unanticipated events, circumstances, or
results.


17


Management's
Discussion And Analysis of Financial Condition and Results of
Operations





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, 2008 and
December 31, 2007 and our results of operations for each of the three-years
ended December 31, 2008, 2007 and 2006. 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, 2008, Cornerstone had total consolidated assets of approximately
$472 million, total loans of approximately $388 million, total deposits of
approximately $327 million and stockholders’ equity of approximately $37
million.  Cornerstone’s net income increased to $2.5 million for 2008
compared to $871 thousand for 2007 and $5.8 million for 2006.





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, 2008,
Cornerstone recorded net interest income of approximately $17,982,000, which
resulted in a net interest margin of 4.16%.  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%.




18




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 31,2008
                                        
                                        
                                        2007
                                        
                                        
                                        2006(In
      thousands)
                                          
                                          ASSETS
                                        
                                        Average
                                          Balance
                                        
                                        
                                        Interest
                                          Income/
                                          Expense(1)
                                        
                                        
                                        Yield/
                                          Rate
                                        
                                        
                                        Average
                                          Balance
                                        
                                        
                                        InterestIncome/
                                          Expense(1)
                                        
                                        
                                        Yield/
                                          Rate
                                        
                                        
                                        Average
                                          Balance
                                        
                                        
                                        InterestIncome/
                                          Expense(1)
                                        
                                        
                                        Yield/
                                          RateInterest-earning
      assets:Loans(1)(2)
                                        
                                        $
                                        385,957
                                        
                                        
                                        $
                                        28,661
                                        
                                        
                                        
                                        7.43
                                        %
                                        
                                        $
                                        353,278
                                        
                                        
                                        $
                                        32,981
                                        
                                        
                                        
                                        9.34
                                        %
                                        
                                        $
                                        284,105
                                        
                                        
                                        $
                                        27,317
                                        
                                        
                                        
                                        9.61
                                        %Investment
      securities(3)
                                        
                                        
                                        47,096
                                        
                                        
                                        
                                        1,996
                                        
                                        
                                        
                                        4.36
                                        %
                                        
                                        
                                        37,673
                                        
                                        
                                        
                                        1,750
                                        
                                        
                                        
                                        4.80
                                        %
                                        
                                        
                                        36,218
                                        
                                        
                                        
                                        1,584
                                        
                                        
                                        
                                        4.48
                                        %Federal
      funds sold
                                        
                                        
                                        869
                                        
                                        
                                        
                                        23
                                        
                                        
                                        
                                        2.70
                                        %
                                        
                                        
                                        760
                                        
                                        
                                        
                                        52
                                        
                                        
                                        
                                        6.86
                                        %
                                        
                                        
                                        4,686
                                        
                                        
                                        
                                        258
                                        
                                        
                                        
                                        5.51
                                        %Total
      interest-earning assets
                                        
                                        
                                        433,922
                                        
                                        
                                        
                                        30,680
                                        
                                        
                                        
                                        7.08
                                        %
                                        
                                        
                                        391,711
                                        
                                        
                                        
                                        34,783
                                        
                                        
                                        
                                        8.89
                                        %
                                        
                                        
                                        325,009
                                        
                                        
                                        
                                        29,159
                                        
                                        
                                        
                                        8.98
                                        %Allowance
      for loan losses
                                        
                                        
                                        (8,496
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (5,009
                                        )
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        (4,104
                                        )Cash
      and other assets
                                        
                                        
                                        27,179
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        26,341
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        23,836Total
      assets
                                        
                                        $
                                        452,605
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        413,043
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        344,741TOTAL
      LIABILITIES AND EQUITYInterest-bearing
      liabilities:Deposits:NOW
      accounts
                                        
                                        $
                                        30,106
                                        
                                        
                                        $
                                        211
                                        
                                        
                                        
                                        0.70
                                        %
                                        
                                        $
                                        36,327
                                        
                                        
                                        $
                                        802
                                        
                                        
                                        
                                        2.21
                                        %
                                        
                                        $
                                        34,701
                                        
                                        
                                        $
                                        427
                                        
                                        
                                        
                                        1.23
                                        %Money
      market / Savings
                                        
                                        
                                        51,600
                                        
                                        
                                        
                                        826
                                        
                                        
                                        
                                        1.60
                                        %
                                        
                                        
                                        55,808
                                        
                                        
                                        
                                        2,018
                                        
                                        
                                        
                                        3.61
                                        %
                                        
                                        
                                        58,477
                                        
                                        
                                        
                                        2,225
                                        
                                        
                                        
                                        3.80
                                        %Time
      deposits, $100m andover
                                        
                                        
                                        59,083
                                        
                                        
                                        
                                        2,371
                                        
                                        
                                        
                                        4.01
                                        %
                                        
                                        
                                        61,172
                                        
                                        
                                        
                                        3,134
                                        
                                        
                                        
                                        5.12
                                        %
                                        
                                        
                                        43,692
                                        
                                        
                                        
                                        1,993
                                        
                                        
                                        
                                        4.56
                                        %Time
      deposits, under $100m
                                        
                                        
                                        131,138
                                        
                                        
                                        
                                        5,891
                                        
                                        
                                        
                                        4.49
                                        %
                                        
                                        
                                        107,498
                                        
                                        
                                        
                                        5,387
                                        
                                        
                                        
                                        5.01
                                        %
                                        
                                        
                                        88,773
                                        
                                        
                                        
                                        3,899
                                        
                                        
                                        
                                        4.39
                                        %Total
      interest-bearing deposits
                                        
                                        
                                        271,927
                                        
                                        
                                        
                                        9,299
                                        
                                        
                                        
                                        3.42
                                        %
                                        
                                        
                                        260,805
                                        
                                        
                                        
                                        11,341
                                        
                                        
                                        
                                        4.35
                                        %
                                        
                                        
                                        225,643
                                        
                                        
                                        
                                        8,544
                                        
                                        
                                        
                                        3.78
                                        %Federal
      funds purchased
                                        
                                        
                                        12,952
                                        
                                        
                                        
                                        339
                                        
                                        
                                        
                                        2.62
                                        %
                                        
                                        
                                        11,374
                                        
                                        
                                        
                                        613
                                        
                                        
                                        
                                        5.39
                                        %
                                        
                                        
                                        4,570
                                        
                                        
                                        
                                        232
                                        
                                        
                                        
                                        5.07
                                        %Securities
      sold underagreement to
    repurchase
                                        
                                        
                                        18,580
                                        
                                        
                                        
                                        261
                                        
                                        
                                        
                                        1.41
                                        %
                                        
                                        
                                        8,103
                                        
                                        
                                        
                                        244
                                        
                                        
                                        
                                        3.01
                                        %
                                        
                                        
                                        4,020
                                        
                                        
                                        
                                        116
                                        
                                        
                                        
                                        2.88
                                        %Other
      borrowings
                                        
                                        
                                        68,578
                                        
                                        
                                        
                                        2,799
                                        
                                        
                                        
                                        4.08
                                        %
                                        
                                        
                                        48,282
                                        
                                        
                                        
                                        2,216
                                        
                                        
                                        
                                        4.59
                                        %
                                        
                                        
                                        35,429
                                        
                                        
                                        
                                        1,414
                                        
                                        
                                        
                                        3.98
                                        %Total
      interest-bearingLiabilities
                                        
                                        
                                        372,037
                                        
                                        
                                        
                                        12,698
                                        
                                        
                                        
                                        3.41
                                        %
                                        
                                        
                                        328,564
                                        
                                        
                                        
                                        14,414
                                        
                                        
                                        
                                        4.39
                                        %
                                        
                                        
                                        269,662
                                        
                                        
                                        
                                        10,306
                                        
                                        
                                        
                                        3.82
                                        %Net
      interest spread
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        3.67
                                        %
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        4.51
                                        %
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        5.16
                                        %Other
      liabilities:Demand
      deposits
                                        
                                        
                                        42,915
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        41,503
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        37,056Accrued
      interest payable andother
      liabilities
                                        
                                        
                                        218
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        2,240
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        2,295Stockholders'
      equity
                                        
                                        
                                        37,435
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        40,737
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        35,728Total
      liabilitiesAnd stockholders' equity
                                        
                                        $
                                        452,605
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        413,043
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        344,741Net
      interest margin
                                        
                                        
                                        
                                        
                                        
                                        $
                                        17,982
                                        
                                        
                                        
                                        4.16
                                        %
                                        
                                        
                                        
                                        
                                        
                                        $
                                        20,369
                                        
                                        
                                        
                                        5.22
                                        %
                                        
                                        
                                        
                                        
                                        
                                        $
                                        18,853
                                        
                                        
                                        
                                        5.80
                                        %





(1)  Interest
income on loans includes amortization of deferred loan fees and other discounts
of $227 thousand, $302 thousand, and $288 thousand for the fiscal years ended
December 31, 2008, 2007, and 2006, 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:





Starting
      in September 2007, the Federal Reserve Bank initiated a series of interest
      rate reductions, that as of January 30, 2009, resulted in a Federal Funds
      Target rate of 0.25%.  This 500 basis point reduction has placed
      downward pressure on the banking industry’s net interest
      margins.  Cornerstone was also impacted by this reduction which
      lowered its net interest margin to 4.16% for the year-end 2008 compared to
      5.22% for the year-end 2007.  Currently, the variable portion of
      the Bank’s loan portfolio, indexed to the prime interest rate, has reached
      interest rate floors ranging from 5.00% to 7.00%.  To compensate
      for the reduction in loan yields the Bank lowered its interest bearing
      liabilities from 4.39% in 2007 to 3.41% for 2008.  However,
      uncertainty of liquidity in the national market resulted in certificate of
      deposit rates to remain abnormally elevated throughout
      2008.  This resulted in a disintermediation within the Bank’s
      deposit base as balances migrated from transactional accounts to
      certificate of deposit accounts.  Finally, the Bank expects rate
      pressure on its interest rate loan floors throughout
      2009.  However, the Bank anticipates a return to more
      traditional certificate of deposit interest rates in early
      2009.  The Bank anticipates that its net interest margin will
      remain in the low 4.00% range throughout
2009.


19





As
      of December 31, 2008, the Bank’s investment portfolio resulted in a yield
      of 4.36% compared to 4.80% for the same time period in
      2007.  The Bank’s investment portfolio is used primarily for
      pledging purposes with the State of Tennessee Collateral Pool, Federal
      Reserve Bank discount window and to secure repurchase
      agreements.  As of December 31, 2008, approximately 50% of the
      security portfolio was invested in Agency LIBOR floaters to protect the
      Bank from rapid increases in interest rates.  In the future, the
      Bank intends to purchase longer term securities with artificially high
      spreads in relation to the U.S. Treasury yields to balance the security
      portfolio’s current yield and protect against potential rapid increases in
      interest rates or if inflation concerns materialize.  These
      artificially high spreads to the U.S. Treasuries are a result of perceived
      principal risk to the underlying credit.  However, once the
      economy starts to improve these spreads should reduce to more historic
      yield levels.





During
      2008 the Bank contracted with Promontory Interfinancial Network, LLC to
      offer the Certificate of Deposit Account Registry Service (“CDARS”) to the
      Bank’s existing depository base as well as potential new deposit customers
      in the Chattanooga, TN MSA that had been previously
      unavailable.  The CDARS program allows the Bank to provide FDIC
      insurance coverage for certificates of deposit accounts in excess of
      $100,000.  Effectively, the CDARS program allows the Bank to
      obtain certificate of deposit accounts greater than $100,000 and break the
      large deposit into smaller amounts which are placed with other banks that
      are part of the CDARS network.  This program enables the
      customer to interact with one bank and still receive the same FDIC
      insurance coverage of multiple banking institutions.  The CDARS
      network also gives the Bank further access to brokered deposits, at a
      competitive interest rate, as an additional source of wholesale
      funding.





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 31,2008
      Compared to 2007(In
      Thousands)
                  
                  Volume
                  
                  
                  Rate
                  
                  
                  Mix
                  
                  
                  Net
                    ChangeInterest
      income:Loans
      (1)(2)
                  
                  $
                  2,428
                  
                  
                  $
                  (7,372
                  )
                  
                  $
                  622
                  
                  
                  $
                  (4,320
                  )Investment
      securities
                  
                  
                  411
                  
                  
                  
                  (188
                  )
                  
                  
                  23
                  
                  
                  
                  246Federal
      funds sold
                  
                  
                  3
                  
                  
                  
                  (22
                  )
                  
                  
                  (10
                  )
                  
                  
                  (29
                  )Total
      interest income
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,103
                  )Interest
      expense:NOW
      accounts
                  
                  
                  (44
                  )
                  
                  
                  (455
                  )
                  
                  
                  (92
                  )
                  
                  
                  (591
                  )Money
      market and savings accounts
                  
                  
                  (67
                  )
                  
                  
                  (1,040
                  )
                  
                  
                  (85
                  )
                  
                  
                  (1,192
                  )Time
      deposits, $100,000 and over
                  
                  
                  (93
                  )
                  
                  
                  (402
                  )
                  
                  
                  (268
                  )
                  
                  
                  (763
                  )Time
      deposits, less than $100,000
                  
                  
                  1,017
                  
                  
                  
                  (931
                  )
                  
                  
                  418
                  
                  
                  
                  504Other
      borrowings
                  
                  
                  828
                  
                  
                  
                  (349
                  )
                  
                  
                  104
                  
                  
                  
                  583Federal
      funds purchased
                  
                  
                  41
                  
                  
                  
                  (359
                  )
                  
                  
                  44
                  
                  
                  
                  (274
                  )Securities
      sold under agreement to repurchase
                  
                  
                  148
                  
                  
                  
                  (297
                  )
                  
                  
                  166
                  
                  
                  
                  17Total
      interest expense
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,716
                  )Change
      in net interest income (expense)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  $
                  (2,387
                  )




20





TABLE
7


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
                  )Total
      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





(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 $3.5 million for the
year ended December 31, 2008 compared to $10.4 million for the year ended
December 31, 2007.  Cornerstone’s policies and procedures used to
estimate the allowance for loan losses, as well as the resultant provision for
loan losses, are considered adequate by management and are periodically reviewed
by regulators.  However, there are factors beyond Cornerstone’s
control, such as conditions in the local and national economy which may
negatively impact Cornerstone’s asset quality.  The measurements are
approximations which may require additional provisions to loan losses based upon
changing circumstances or when additional information becomes available or
known.  Other matters relating to the changes in provision for loan
losses are presented below:





Cornerstone’s
      provision for loan losses during 2008 was needed to address multiple
      credits that were not able to maintain operations or cash flow due in
      large part to the economic downturn.  The provision allocation
      differs from the amount charged to earnings in 2007 which was concentrated
      in two large credits.  These large credits contained alleged
      fraud perpetrated by the customer against the Bank.  The Bank
      expects further economic deterioration during 2009.  Therefore,
      the Bank anticipates that the 2009 provision will be equal to or slightly
      larger than the charge to earnings for provision in
  2008.





To
      address the problem credits within the Bank’s loan portfolio a Special
      Asset Committee was created.  This committee has instructed the
      Bank’s loan review department to identify potential problem loans as
      quickly as possible.  This early detection will allow the Bank
      to assist customers with this severe economic environment and potentially
      minimize losses.  Secondly, during 2008 the Bank hired a special
      asset consultant to assist in the disposal of problem assets in an optimal
      manner.





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.


21


Table 8
presents the components of non interest income for the years ended December 31,
2008, 2007 and 2006 (in thousands).





TABLE
8


2008
                
                
                2007
                
                
                2006Customer
      service fees
                
                $
                1,727
                
                
                $
                1,426
                
                
                $
                1,298Other
      noninterest income
                
                
                108
                
                
                
                165
                
                
                
                91Operating
      lease income
                
                
                -
                
                
                
                -
                
                
                
                301Net
      gain from sale of loans & other assets
                
                
                57
                
                
                
                104
                
                
                
                421Total
      noninterest income
                
                $
                1,892
                
                
                $
                1,695
                
                
                $
                2,111





Significant
matters relating to the changes to non interest income are presented
below:





The
      Bank continues to see moderate increases in its customer service
      fees.  While traditional account service fees are included in
      the $1.7 million generated during 2008 the amount also includes fees
      associated with the Bank’s payroll processing services.  Fiscal
      year 2008 marked the first full year the Bank provided processing services
      to payroll processors located across the United States.  The
      payroll processors generate thousands of payroll transactions each week
      while depositing relatively large amounts on a short term
      basis.  These ACH transactions are then forwarded through the
      Federal Reserve Bank to the recipient’s checking
  accounts.





One
      of the major components in other fee income in prior years was the Bank’s
      operating 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, who subsequently purchased the assets.  Currently, the
      Bank has no income from operating lease
  agreements.





Included
      in the net gain from sale of loans and other assets is the Bank’s loss of
      $141 thousand on the sale of assets.  This loss was incurred on
      multiple pieces of other real estate and foreclosed
      assets.  Without these losses, the Bank’s non-interest income
      increased 15.2% over 2007 and should continue to increase during
      2009.





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,
2008, 2007 and 2006 (in thousands).





TABLE
9


2008
                
                
                2007
                
                
                2006Salaries
      and employee benefits
                
                $
                7,140
                
                
                $
                6,609
                
                
                $
                6,018Net
      occupancy and equipment expense
                
                
                1,520
                
                
                
                1,355
                
                
                
                1,075Depreciation
      on leased assets
                
                
                -
                
                
                
                -
                
                
                
                245Other
      operating expenses
                
                
                3,908
                
                
                
                2,962
                
                
                
                3,380Total
      noninterest expense
                
                $
                12,568
                
                
                $
                10,926
                
                
                $
                10,718





Significant
matters relating to the changes to non interest expense are presented
below:





Salary
      expense increased 8.0% over 2007 due primarily to an increase in risk
      management personnel.  Additional employees included in the risk
      management department included one employee added to the compliance
      department, two added to the internal audit department and one consultant
      contracted to assist in Information Technology security.  This
      along with cost of living adjustments represented the majority of the
      Cornerstone’s increase.





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 attracting
      potential new customers.  The Bank also opened two loan
      production offices during 2007; one in Knoxville, Tennessee, and one in
      Dalton, Georgia.




22


Significant
      increases in non interest expense were in the other operating expense
      category which increased 31.9% over 2007.  The majority of the
      increases can be segmented into three areas.  First, the FDIC
      assessment increased $220 thousand; second, other real estate expense
      increased $167 thousand; and third, legal expense increased $160
      thousand.  All three categories are related to the deterioration
      of asset quality and the expense required to properly obtain and
      ultimately dispose of collateral securing problem
  loans.





Income
Tax Expense


The
      difference between Cornerstone’s expected income tax expense, computed by
      multiplying income before income taxes by statutory income tax rates, and
      actual income tax expense, 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,
2007.  Total assets increased approximately $28 million or 6.3% from
$444 million as of December 31, 2007 to $472 million as of December 31,
2008.  During 2008 total loans increased $4 million or 1.2% from
approximately $384 million as of December 31, 2007 to approximately $388 million
as of December 31, 2008.  Finally, stockholders’ equity remained
relatively unchanged during 2008 at approximately $36 million as of December 31,
2008 and December 31, 2007.





Investments-The Bank’s
investment portfolio totaled $46.4 million or 9.8% of total assets as of the
year end 2008 compared to a total of $36.9 million or 8.3% of total assets as of
year end 2007.  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,Securities
      available for sale:
                                                              
                                                              2008
                                                              
                                                              
                                                              2007
                                                              
                                                              
                                                              2006U.S.
      Government and agency obligations
                                                              
                                                              $
                                                              8,252
                                                              
                                                              
                                                              $
                                                              27,414
                                                              
                                                              
                                                              $
                                                              26,470Mortgage-backed
      and other securities
                                                              
                                                              
                                                              31,182
                                                              
                                                              
                                                              
                                                              3,836
                                                              
                                                              
                                                              
                                                              2,634State
      & political subdivisions tax-exempt
                                                              
                                                              
                                                              4,623
                                                              
                                                              
                                                              
                                                              3,503
                                                              
                                                              
                                                              
                                                              3,249Totals
                                                              
                                                              $
                                                              44,057
                                                              
                                                              
                                                              $
                                                              34,753
                                                              
                                                              
                                                              $
                                                              32,353Securities
      held to maturity:Mortgage-backed
      and other securities
                                                              
                                                              $
                                                              169
                                                              
                                                              
                                                              $
                                                              200
                                                              
                                                              
                                                              $
                                                              236Totals
                                                              
                                                              $
                                                              169
                                                              
                                                              
                                                              $
                                                              200
                                                              
                                                              
                                                              $
                                                              236Federal
      Home Loan Bank stock, at cost
                                                              
                                                              
                                                              2,188
                                                              
                                                              
                                                              
                                                              1,912
                                                              
                                                              
                                                              
                                                              1,332Total
      Investments
                                                              
                                                              $
                                                              46,414
                                                              
                                                              
                                                              $
                                                              36,865
                                                              
                                                              
                                                              $
                                                              33,921





During
      2008 the Bank elected to increase the amount of mortgage backed and
      municipal securities.  The mortgage backed securities were
      obtained instead of U.S. Government and agency obligations, as
      traditionally acquired, to provide increased yield while maintaining a 20%
      risk weight classification for capital requirements.  During the
      4th
      quarter of 2008 and continuing into 2009, the Bank has purchased mortgage
      backed securities guaranteed by Government National Mortgage Assocation or
      “Ginnie Mae.”  These securities qualify for 0% risk weight
      allocation thereby improving the Bank’s overall risk weighted capital
      position.   The increase in municipal securities has been
      obtained due to higher yields when compared to alternative investments and
      to provide collateral at the Federal Reserve discount
    window.


23


A
      second objective of the security portfolio is to provide adequate
      collateral to satisfy pledging requirements with the State of Tennessee
      collateral pool, repurchase agreements and the Federal Reserve discount
      window.  During 2008 the Bank increased its Federal Reserve
      discount window borrowing to approximately $4 million by
      year-end.  This increase allowed the Bank to obtain additional
      funding, if needed, in the event the Bank’s daily fed fund lines were
      negatively impacted.





For
December 31, 2008 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, 2007 is presented in tables 13 and 14.





TABLE
11


Weighted Average
      Yields on the Available For Sale InvestmentsPeriods
      of Maturity from December 31, 2008Less
      than 1 year
                          
                          
                          1 to
      5 years
                          
                          
                          5 to
      10 years
                          
                          
                          Over
      10 yearsSecurities
      available for
      sale:
                          
                          Amount
                          
                          
                          Weighted
                            Avg.
                            Yield
      (1)
                          
                          
                          Amount
                          
                          
                          Weighted
                            Avg.
                            Yield
      (1)
                          
                          
                          Amount
                          
                          
                          Weighted
                            Avg.
                            Yield
      (1)
                          
                          
                          Amount
                          
                          
                          Weighted
                            Avg.
                            Yield
      (1)U.S. Government agencies
                          
                          $
                          6,127
                          
                          
                          
                          4.15
                          %
                          
                          $
                          0
                          
                          
                          
                          0.00
                          %
                          
                          $
                          0
                          
                          
                          
                          0.00
                          %
                          
                          $
                          2,125
                          
                          
                          
                          6.12
                          %Mortgage-backed
      securities (2)
                          
                          
                          0
                          
                          
                          
                          0.00
                          %
                          
                          
                          0
                          
                          
                          
                          0.00
                          %
                          
                          
                          11
                          
                          
                          
                          6.99
                          %
                          
                          
                          31,171
                          
                          
                          
                          2.99
                          %Tax-exempt
      municipal bonds
                          
                          
                          127
                          
                          
                          
                          5.02
                          %
                          
                          
                          925
                          
                          
                          
                          6.38
                          %
                          
                          
                          1,793
                          
                          
                          
                          6.06
                          %
                          
                          
                          1,778
                          
                          
                          
                          6.26
                          %Totals
                          
                          $
                          6,254
                          
                          
                          
                          4.16
                          %
                          
                          $
                          925
                          
                          
                          
                          6.38
                          %
                          
                          $
                          1,804
                          
                          
                          
                          6.07
                          %
                          
                          $
                          35,074
                          
                          
                          
                          3.34
                          %Total
      Securities Available for Sale
                          
                          $
                          44,057
                          
                          
                          
                          3.62
                          %





TABLE
12


Weighted Average
      Yields on the Held to Maturity InvestmentsPeriods
      of Maturity from December 31, 2008Less
      than 1 year
                      
                      
                      1 to
      5 years
                      
                      
                      5 to
      10 years
                      
                      Over
      10 yearsSecurities
      held to maturity:
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield(1)
                      
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield
      (1)
                      
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield
      (1)
                      
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield
      (1)Mortgage-backed
      securities (2)
                      
                      $
                      0
                      
                      
                      
                      0.00
                      %
                      
                      $
                      6
                      
                      
                      
                      6.70
                      %
                      
                      $
                      17
                      
                      
                      
                      3.74
                      %
                      
                      $
                      146
                      
                      
                      
                      5.54
                      %Totals
                      
                      $
                      0
                      
                      
                      
                      0.00
                      %
                      
                      $
                      6
                      
                      
                      
                      6.70
                      %
                      
                      $
                      17
                      
                      
                      
                      3.74
                      %
                      
                      $
                      146
                      
                      
                      
                      5.54
                      %Total
      Securities held to maturity
                      
                      $
                      169
                      
                      
                      
                      5.40
                      %Federal
      Home Loan Bank stock, at cost
                      
                      $
                      2,188
                      
                      
                      
                      5.33
                      %Total
      Investments
                      
                      $
                      46,414
                      
                      
                      
                      3.73
                      %





TABLE
13


Weighted Average
      Yields on the Available For Sale InvestmentsPeriods
      of Maturity from December 31, 2007Less
      than 1 year
                        
                        
                        1 to
      5 years
                        
                        5 to
      10 years
                        
                        
                        Over
      10 yearsSecurities
      available for sale:
                        
                        Amount
                        
                        
                        Weighted
                          Avg.
                          Yield
      (1)
                        
                        
                        Amount
                        
                        
                        Weighted
                          Avg.
                          Yield
      (1)
                        
                        
                        Amount
                        
                        
                        Weighted
                          Avg.
                          Yield
      (1)
                        
                        
                        Amount
                        
                        
                        Weighted
                          Avg.
                          Yield
      (1)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
                        %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
                        %




24





TABLE
14


Weighted Average
      Yields on the Held to Maturity InvestmentsPeriods
      of Maturity from December 31, 2007Less
      than 1 year
                      
                      
                      1 to
      5 years
                      
                      
                      5 to
      10 years
                      
                      Over
      10 yearsSecurities
      held to maturity:
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield(1)
                      
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield(1)
                      
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield
      (1)
                      
                      
                      Amount
                      
                      
                      Weighted
                        Avg.
                        Yield(1)Mortgage-backed
      securities (2)
                      
                      $
                      0
                      
                      
                      
                      0.00
                      %
                      
                      $
                      13
                      
                      
                      
                      6.72
                      %
                      
                      $
                      13
                      
                      
                      
                      5.20
                      %
                      
                      $
                      174
                      
                      
                      
                      6.36
                      %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





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 three 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, 2008 and 2007, Cornerstone’s loan portfolio constituted
approximately 80.2% and 83.2% 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,(In
      thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006
                  
                  
                  2005
                  
                  
                  2004Amount
                  
                  
                  Percent
                  
                  
                  Amount
                  
                  
                  Percent
                  
                  
                  Amount
                  
                  
                  Percent
                  
                  
                  Amount
                  
                  
                  Percent
                  
                  
                  Amount
                  
                  
                  PercentCommercial,
      financial and agricultural
                  
                  $
                  83,140
                  
                  
                  
                  21.42
                  %
                  
                  $
                  98,065
                  
                  
                  
                  25.57
                  %
                  
                  $
                  98,542
                  
                  
                  
                  31.77
                  %
                  
                  $
                  86,039
                  
                  
                  
                  32.40
                  %
                  
                  $
                  61,742
                  
                  
                  
                  30.09
                  %Real
      estate – construction
                  
                  
                  70,456
                  
                  
                  
                  18.15
                  %
                  
                  
                  76,832
                  
                  
                  
                  20.03
                  %
                  
                  
                  57,606
                  
                  
                  
                  18.57
                  %
                  
                  
                  47,071
                  
                  
                  
                  17.72
                  %
                  
                  
                  36,824
                  
                  
                  
                  17.94
                  %Real
      estate – mortgage
                  
                  
                  72,737
                  
                  
                  
                  18.74
                  %
                  
                  
                  64,585
                  
                  
                  
                  16.84
                  %
                  
                  
                  48,700
                  
                  
                  
                  15.70
                  %
                  
                  
                  48,645
                  
                  
                  
                  17.19
                  %
                  
                  
                  38,193
                  
                  
                  
                  18.61
                  %Real
      estate – commercial
                  
                  
                  155,728
                  
                  
                  
                  40.13
                  %
                  
                  
                  138,074
                  
                  
                  
                  35.99
                  %
                  
                  
                  99,197
                  
                  
                  
                  31.98
                  %
                  
                  
                  79,608
                  
                  
                  
                  29.98
                  %
                  
                  
                  61,860
                  
                  
                  
                  30.14
                  %Consumer
      loans
                  
                  
                  6,029
                  
                  
                  
                  1.56
                  %
                  
                  
                  6,037
                  
                  
                  
                  1.57
                  %
                  
                  
                  6,092
                  
                  
                  
                  1.98
                  %
                  
                  
                  7,191
                  
                  
                  
                  2.71
                  %
                  
                  
                  6,602
                  
                  
                  
                  3.22
                  %Total
      loans
                  
                  $
                  388,090
                  
                  
                  
                  100.00
                  %
                  
                  $
                  383,593
                  
                  
                  
                  100.00
                  %
                  
                  $
                  310,137
                  
                  
                  
                  100.00
                  %
                  
                  $
                  265,554
                  
                  
                  
                  100.00
                  %
                  
                  $
                  205,221
                  
                  
                  
                  100.00
                  %





Significant
matters relating to the changes in the loan portfolio composition are presented
below:





Overall
      the Bank’s loan portfolio increased 1.2% during 2008 when compared to 2007
      year-end total.  The Bank continued to place an emphasis on loan
      quality by continuing its credit underwriting process and collateral
      inspection procedures.


25


Table 16
presents the scheduled maturities of the loans in Cornerstone’s loan portfolio
as of December 31, 2008 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, 2008(In thousands)
                
                Less than
                  One Year
                
                
                1 to 5
                  Years
                
                
                Over 5
                  Years
                
                
                TotalCommercial,
      financial and agricultural
                
                $
                64,548
                
                
                $
                14,254
                
                
                $
                4,338
                
                
                $
                83,140Real
      estate – construction
                
                
                52,718
                
                
                
                16,805
                
                
                
                933
                
                
                
                70,456Real
      estate – mortgage
                
                
                22,932
                
                
                
                41,546
                
                
                
                8,259
                
                
                
                72,737Real
      estate – commercial
                
                
                34,947
                
                
                
                106,824
                
                
                
                13,957
                
                
                
                155,728Consumer
                
                
                2,248
                
                
                
                3,716
                
                
                
                65
                
                
                
                6,029Total
      Loans
                
                $
                177,393
                
                
                $
                183,145
                
                
                $
                27,552
                
                
                $
                388,090





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 imbedded in the Bank’s commercial loan portfolio:





The
      terms of the Bank's commercial loans generally range from 90 days to a 15
      year amortization with a five year
balloon.


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.


Loans
      secured by marketable equipment are required to be amortized over a period
      not to exceed 60 months.
 Generally,
      loans secured by current assets such as inventory or accounts receivable
      are structured as revolving lines of credit with annual
      maturities.
 Loans
      secured by chattel, mortgages and accounts receivable may not exceed 85%
      of their market value.
 Loans
      secured by listed stocks, municipal bonds and mutual funds may not exceed
      70% of their market
value.





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.
 Substantially
      all of the Bank's commercial loans are secured and are guaranteed by the
      principals of the borrower.





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.


26


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 qualified by the Federal National
Mortgage Association 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 totaled approximately $67 million as of December 31, 2008
compared to approximately $77 million as of December 31, 2007.  This
number includes all lines of credit that have not been fully drawn and loan
commitments in the same status.


27


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 150 miles of
Chattanooga, Tennessee.  Loans are originated by 18 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 classifiedas 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.




28


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, 2008 is adequate to absorb possible losses from loans
currently in the portfolio.


29


Table 17
presents Cornerstone's allocation of the allowance for loan losses as of
December 31, 2008, 2007, 2006, 2005 and 2004.





TABLE
17


Allowance for Loan LossesYears Ending December 31,2008
                
                
                2007
                
                
                2006(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
                
                $
                4,955
                
                
                
                21.42
                %
                
                $
                9,482
                
                
                
                25.57
                %
                
                $
                1,686
                
                
                
                31.77
                %Real
      estate – construction
                
                
                1,433
                
                
                
                18.15
                %
                
                
                2,447
                
                
                
                20.03
                %
                
                
                1,581
                
                
                
                18.57
                %Real
      estate – mortgage
                
                
                1,532
                
                
                
                18.74
                %
                
                
                101
                
                
                
                16.84
                %
                
                
                77
                
                
                
                15.70
                %Real
      estate – commercial
                
                
                1,376
                
                
                
                40.13
                %
                
                
                1,434
                
                
                
                35.99
                %
                
                
                703
                
                
                
                31.98
                %Consumer
                
                
                322
                
                
                
                1.56
                %
                
                
                246
                
                
                
                1.57
                %
                
                
                211
                
                
                
                1.98
                %Totals
                
                $
                9,618
                
                
                
                100.00
                %
                
                $
                13,710
                
                
                
                100.00
                %
                
                $
                4,258
                
                
                
                100.00
                %





2005
                          
                          
                          2004(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
                          
                          $
                          1,438
                          
                          
                          
                          32.40
                          %
                          
                          $
                          1,002
                          
                          
                          
                          30.09
                          %Real
      estate – construction
                          
                          
                          1,253
                          
                          
                          
                          17.72
                          %
                          
                          
                          962
                          
                          
                          
                          17.94
                          %Real
      estate – mortgage
                          
                          
                          79
                          
                          
                          
                          17.19
                          %
                          
                          
                          122
                          
                          
                          
                          18.61
                          %Real
      estate – commercial
                          
                          
                          535
                          
                          
                          
                          29.98
                          %
                          
                          
                          361
                          
                          
                          
                          30.14
                          %Consumer
                          
                          
                          240
                          
                          
                          
                          2.71
                          %
                          
                          
                          211
                          
                          
                          
                          3.22
                          %Totals
                          
                          $
                          3,545
                          
                          
                          
                          100.00
                          %
                          
                          $
                          2,658
                          
                          
                          
                          100.00
                          %





In
      recent years Cornerstone has refined its loan loss allowance to include
      measurements such as environmental factors for growth, environmental
      factors for real estate values, historical metrics and specific loan
      products with increased levels of risk, such as asset based
      lending.  This process enables Cornerstone to support and
      estimate the necessary allowance needed to protect Cornerstone against
      possible losses.  The allowance as of December 31, 2008 totaled
      $9.6 million compared to $13.7 million as of December 31,
      2007.  The most significant events occurring in the loan loss
      allowance during 2008 were provisions totaling $3.5 million and a
      charge-off $6 million in the 1st
      quarter of 2008.


30


Table 18
presents Cornerstone's delinquent and non-performing assets as of December 31,
2008 and 2007.





TABLE
18


Delinquent
      and Non-performing AssetsActual
      for Years Ending December 31,(In
      thousands)
                  
                  2008
                  
                  
                  2007Accruing
      loans that are contractually past due 90-days or more:Commercial,
      financial and agricultural
                  
                  $
                  0
                  
                  
                  $
                  0Real
      estate – construction
                  
                  
                  0
                  
                  
                  
                  0Real
      estate – mortgage
                  
                  
                  0
                  
                  
                  
                  0Real
      estate- commercial
                  
                  
                  0
                  
                  
                  
                  0Consumer
                  
                  
                  0
                  
                  
                  
                  0Total
      Loans
                  
                  $
                  0
                  
                  
                  $
                  0Non-accruing
      loans 90-days or more:Commercial,
      financial and agricultural
                  
                  $
                  0
                  
                  
                  $
                  124Real
      estate – construction
                  
                  
                  1,180
                  
                  
                  
                  341Real
      estate – mortgage
                  
                  
                  720
                  
                  
                  
                  28Real
      estate – commercial
                  
                  
                  2,352
                  
                  
                  
                  192Consumer
                  
                  
                  0
                  
                  
                  
                  0Total
      Loans
                  
                  $
                  4,252
                  
                  
                  $
                  685Real
      estate acquired through foreclosure
                  
                  $
                  2,459
                  
                  
                  $
                  1,038Property
      acquired through repossession
                  
                  
                  257
                  
                  
                  
                  0Total
      acquired
                  
                  $
                  2,716
                  
                  
                  $
                  1,038Total
      Loans
                  
                  $
                  388,090
                  
                  
                  $
                  383,593Ratio
      of non-performing assets to total loans
                  
                  
                  1.80
                  %
                  
                  
                  0.45
                  %Ratio
      of delinquent (30-days or more) but accruing loans to:Total
      loans
                  
                  
                  2.08
                  %
                  
                  
                  1.12
                  %Total
      assets
                  
                  
                  1.71
                  %
                  
                  
                  0.97
                  %





Recent
      economic developments have negatively impacted the Bank’s loan
      portfolio.  Real estate loans in all three classifications were
      negatively impacted during 2008.  The Bank continues to monitor
      its real estate loan portfolio closely in an attempt to identify potential
      problem loans as soon as possible.  However, as of year end 2008
      the Bank had foreclosed on ten residential properties, six vacant real
      estate lots and two commercial
properties.





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.


31


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





TABLE
19


Loan
      Loss Reserve AnalysisYears
      Ending December 31,(in
      thousands)
                                    
                                    2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006
                                    
                                    
                                    2005
                                    
                                    
                                    2004Average
      loans
                                    
                                    $
                                    385,957
                                    
                                    
                                    $
                                    353,278
                                    
                                    
                                    $
                                    284,105
                                    
                                    
                                    $
                                    236,265
                                    
                                    
                                    $
                                    181,335Allowance
      for possible loan losses, Beginning of the period
                                    
                                    $
                                    13,710
                                    
                                    
                                    $
                                    4,258
                                    
                                    
                                    $
                                    3,545
                                    
                                    
                                    $
                                    2,658
                                    
                                    
                                    $
                                    2,011Charge-offs
      for the period:Commercial,
      financial and agricultural
                                    
                                    
                                    6,991
                                    
                                    
                                    
                                    737
                                    
                                    
                                    
                                    307
                                    
                                    
                                    
                                    275
                                    
                                    
                                    
                                    165Real
      estate – construction
                                    
                                    
                                    434
                                    
                                    
                                    
                                    84
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    48
                                    
                                    
                                    
                                    0Real
      estate – mortgage
                                    
                                    
                                    193
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    104
                                    
                                    
                                    
                                    50
                                    
                                    
                                    
                                    138Real
      estate - commercial
                                    
                                    
                                    210
                                    
                                    
                                    
                                    180
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    78
                                    
                                    
                                    
                                    0Consumer
                                    
                                    
                                    151
                                    
                                    
                                    
                                    74
                                    
                                    
                                    
                                    70
                                    
                                    
                                    
                                    111
                                    
                                    
                                    
                                    69Total
      charge-offs
                                    
                                    
                                    7,979
                                    
                                    
                                    
                                    1,075
                                    
                                    
                                    
                                    481
                                    
                                    
                                    
                                    562
                                    
                                    
                                    
                                    372Recoveries
      for the period:Commercial,
      financial and agricultural
                                    
                                    
                                    362
                                    
                                    
                                    
                                    114
                                    
                                    
                                    
                                    66
                                    
                                    
                                    
                                    12
                                    
                                    
                                    
                                    149Real
      estate – construction
                                    
                                    
                                    14
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    1
                                    
                                    
                                    
                                    0Real
      estate – mortgage
                                    
                                    
                                    1
                                    
                                    
                                    
                                    4
                                    
                                    
                                    
                                    7
                                    
                                    
                                    
                                    6
                                    
                                    
                                    
                                    7Real
      estate – commercial
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0Consumer
                                    
                                    
                                    12
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    15
                                    
                                    
                                    
                                    28
                                    
                                    
                                    
                                    23Total
      recoveries
                                    
                                    
                                    389
                                    
                                    
                                    
                                    118
                                    
                                    
                                    
                                    88
                                    
                                    
                                    
                                    47
                                    
                                    
                                    
                                    179Net
      charge-offs for the period
                                    
                                    
                                    7,590
                                    
                                    
                                    
                                    957
                                    
                                    
                                    
                                    393
                                    
                                    
                                    
                                    515
                                    
                                    
                                    
                                    193Provision
      for loan losses
                                    
                                    
                                    3,498
                                    
                                    
                                    
                                    10,409
                                    
                                    
                                    
                                    1,106
                                    
                                    
                                    
                                    1,402
                                    
                                    
                                    
                                    840Adjustments
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0
                                    
                                    
                                    
                                    0Allowance
      for possible loan losses, end of period
                                    
                                    $
                                    9,618
                                    
                                    
                                    $
                                    13,710
                                    
                                    
                                    $
                                    4,258
                                    
                                    
                                    $
                                    3,545
                                    
                                    
                                    $
                                    2,658Ratio
      of allowance for loan losses to total average loans
      outstanding
                                    
                                    
                                    2.49
                                    %
                                    
                                    
                                    3.88
                                    %
                                    
                                    
                                    1.50
                                    %
                                    
                                    
                                    1.50
                                    %
                                    
                                    
                                    1.47
                                    %Ratio
      of net charge-offs during the period to average loans outstanding during
      the period
                                    
                                    
                                    1.97
                                    %
                                    
                                    
                                    0.27
                                    %
                                    
                                    
                                    0.14
                                    %
                                    
                                    
                                    0.22
                                    %
                                    
                                    
                                    0.10
                                    %





Intangibles-During 2002,
Cornerstone 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 2008, 2007 or 2006. Also, in December, 2005, Cornerstone
completed the purchase of Eagle Financial, Inc. and recorded an intangible asset
of $848,916. Amortization expense relating to this intangible for 2008, 2007 and
2006 was $108,000, $108,000 and $345,388, 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.


32





Part of
the banking industries lexicon is core and non-core
funding.   Core funding includes all deposits except time
deposits issued in denominations of $100,000 or greater.  All other
funding is classified as non-core funding.  The Bank attempts to
minimize its reliance on non-core funding by attracting local deposit
accounts.   However, local market competition or advantageous
interest rate positions can influence the Bank to select non-core
funding.





Table 20
presents the Bank’s, core vs. non-core funding as of December 31, 2008 and 2007
(in thousands).





TABLE
20





Core
      vs. Non-Core FundingDecember
      31, 2008
                      
                      
                      December
      31, 2007Amount
                      
                      
                      Percent
                      
                      
                      Amount
                      
                      
                      PercentCore
      funding:Noninterest
      bearing demand deposits
                      
                      $
                      40,078
                      
                      
                      
                      9.3
                      %
                      
                      $
                      45,285
                      
                      
                      
                      11.3
                      %Interest-bearing
      demand deposits
                      
                      
                      26,909
                      
                      
                      
                      6.3
                      %
                      
                      
                      31,985
                      
                      
                      
                      8.0
                      %Savings
      & money market accounts
                      
                      
                      35,848
                      
                      
                      
                      8.3
                      %
                      
                      
                      49,970
                      
                      
                      
                      12.4
                      %Time
      deposits under $100,000
                      
                      
                      147,928
                      
                      
                      
                      34.5
                      %
                      
                      
                      114,505
                      
                      
                      
                      28.5
                      %Total
      core funding
                      
                      
                      250,763
                      
                      
                      
                      58.4
                      %
                      
                      
                      241,745
                      
                      
                      
                      60.2
                      %Non-core
      funding:Brokered
      deposits
                      
                      
                      16,763
                      
                      
                      
                      3.9
                      %
                      
                      
                      13,255
                      
                      
                      
                      3.3
                      %Time
      deposits greater than $100,000
                      
                      
                      59,057
                      
                      
                      
                      13.8
                      %
                      
                      
                      58,250
                      
                      
                      
                      14.5
                      %Federal
      funds purchased
                      
                      
                      0
                      
                      
                      
                      0.0
                      %
                      
                      
                      28,450
                      
                      
                      
                      7.1
                      %Securities
      sold under agreements to repurchase
                      
                      
                      35,790
                      
                      
                      
                      8.3
                      %
                      
                      
                      13,110
                      
                      
                      
                      3.3
                      %Federal
      Home Loan Bank advances
                      
                      
                      67,000
                      
                      
                      
                      15.6
                      %
                      
                      
                      47,000
                      
                      
                      
                      11.6
                      %Total
      non-core funding
                      
                      
                      178,610
                      
                      
                      
                      41.6
                      %
                      
                      
                      160,065
                      
                      
                      
                      39.8
                      %Total
                      
                      $
                      429,373
                      
                      
                      
                      100.0
                      %
                      
                      $
                      401,810
                      
                      
                      
                      100.0
                      %




During
      2008 Cornerstone continued to see an erosion of its non-interest bearing
      demand deposits, interest bearing demand deposits, savings and money
      market accounts.  The primary reason for the decline in deposit
      balances can be attributed to increased competition and Cornerstone’s
      attempt to reprice interest sensitive deposits to compensate for the
      decline in the Bank’s loan yields.  To compensate for the
      decline in these accounts Cornerstone offered local market certificate of
      deposit specials and obtained additional Federal Home Loan Bank
      advances.





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.


33


Table 21
presents the composition of deposits for the Bank, excluding accrued interest
payable, by type for the years ended December 31, 2008, 2007 and 2006 (in
thousands).





TABLE
21


Deposit
      CompositionYears
      Ending December 31,(In
      thousands)
                  
                  2008
                  
                  
                  2007
                  
                  
                  2006Demand
      deposits
                  
                  $
                  40,078
                  
                  
                  $
                  45,285
                  
                  
                  $
                  41,723NOW
      deposits
                  
                  
                  26,909
                  
                  
                  
                  31,985
                  
                  
                  
                  38,160Savings
      & money market deposits
                  
                  
                  35,848
                  
                  
                  
                  49,970
                  
                  
                  
                  56,913Time
      deposits $100,000 and over
                  
                  
                  59,057
                  
                  
                  
                  58,250
                  
                  
                  
                  44,544Time
      deposits under $100,000
                  
                  
                  164,692
                  
                  
                  
                  127,760
                  
                  
                  
                  94,476Total
      Deposits
                  
                  $
                  326,584
                  
                  
                  $
                  313,250
                  
                  
                  $
                  275,816





On
      October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”)
      became law.  The EESA enabled the FDIC to temporarily increase
      the amount of FDIC deposit insurance coverage from $100,000 to $250,000
      per qualified depositor through December 31, 2009.  Also during
      the fourth quarter of 2008, the FDIC’s Temporary Liquidity Guarantee
      Program extended unlimited deposit insurance coverage for non-interest
      bearing transaction accounts at participating FDIC insured
      banks.  Finally, the FDIC offered coverage regarding debt
      obligation coverage.  These services were offered by the FDIC
      with a fee structure for each product.  The Bank chose to accept
      the unlimited transaction account coverage but refused the debt obligation
      coverage.




The
      Bank’s deposit liabilities were impacted due to uncertainty of liquidity
      in the national markets causing certificate of deposit rates to stay
      unnaturally high throughout 2008.  This resulted in a
      disintermediation within the Bank’s deposit base as balances migrated from
      transactional accounts to certificate of deposit
      accounts.  Accounts contained within the classification of “Time
      deposits under $100,000” increased due to local market certificate of
      deposit specials and additional funds obtained from the traditional
      brokered certificate of deposit market and additional funds obtained
      through the CDARS program.





Table 22
presents a breakdown by category of the average amount of deposits and the
average rate paid on deposits for the periods indicated:





TABLE
22


Average
      Amount and Average Rate Paid on DepositsYears
      Ending December 31,(In
      thousands)
                          
                          2008
                          
                          
                          2007
                          
                          
                          2006Amount
                          
                          
                          Rate
                          
                          
                          Amount
                          
                          
                          Rate
                          
                          
                          Amount
                          
                          
                          RateDemand
      deposits
                          
                          $
                          42,915
                          
                          
                          
                          
                          
                          $
                          41,503
                          
                          
                          
                          
                          
                          $
                          37,056NOW
      deposits
                          
                          
                          30,106
                          
                          
                          
                          0.70
                          %
                          
                          
                          36,327
                          
                          
                          
                          2.21
                          %
                          
                          
                          34,701
                          
                          
                          
                          1.23
                          %Savings
      & money market deposits
                          
                          
                          51,600
                          
                          
                          
                          1.60
                          %
                          
                          
                          55,808
                          
                          
                          
                          3.61
                          %
                          
                          
                          58,477
                          
                          
                          
                          3.80
                          %Time
      deposits $100,000 and over
                          
                          
                          59,083
                          
                          
                          
                          4.01
                          %
                          
                          
                          61,172
                          
                          
                          
                          5.12
                          %
                          
                          
                          43,692
                          
                          
                          
                          4.56
                          %Time
      deposits under $100,000
                          
                          
                          131,138
                          
                          
                          
                          4.49
                          %
                          
                          
                          107,498
                          
                          
                          
                          5.01
                          %
                          
                          
                          88,773
                          
                          
                          
                          4.39
                          %Total
      Deposits
                          
                          $
                          314,842
                          
                          
                          
                          3.42
                          %
                          
                          $
                          302,308
                          
                          
                          
                          4.35
                          %
                          
                          $
                          262,699
                          
                          
                          
                          3.78
                          %





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 $67 million outstanding
with the FHLB.  The FHLB offers
multiple products to assist banks in their funding needs.  The
advances from the FHLB as of December 31, 2008 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, 2008, the interest rates on these loans ranged from 3.52% to
5.00%.  The Bank has several Federal Funds lines of credit available
with correspondent banks with a total availability of $40 million as of the end
of 2008.  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, 2008, 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, 2008, there was $4.3
million borrowed on the line of credit and Cornerstone has the remaining balance
available to inject capital into the Bank or fund other
investments.


34


Capital





Capital
Resources-Stockholder’s average equity for 2008 and 2007 totaled $37.4
million and $40.7 million, respectively.  As of December 31, 2008,
Cornerstone’s actual stockholder equity totaled $36.5 million compared to $36.3
million as of December 31, 2007.  The number of common shares
outstanding decreased to 6,319,718 as of year end 2008 from 6,369,718 as of year
end 2007.  Changes in the number of common shares outstanding resulted
from Cornerstone repurchasing 72,000 shares of treasury stock during 2008 and
subsequently issuing 22,000 shares prior to the 2008 year-end.





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 23 lists the five categories of capital
and each of the minimum requirements for the three risk-based
ratios.





TABLE
23


Minimum Requirements for Risk-Based Capital RatiosTotal 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, 2008, the Bank exceeded the regulatory minimums and
      qualified as a well-capitalized institution under the
      regulations.  The Bank had Tier 1 capital of $36.3 or 7.9% of
      average assets as of December 31, 2008 compared to Tier 1 capital of $31.6
      or 7.4% of average assets as of December 31, 2007.  The Bank had
      total capital of $41.4 or 10.3% of risk weighted assets as of December 31,
      2008 compared to total capital of $36.6 or 9.3% of risk weighted assets as
      of December 31, 2007.





Liquidity-Ofprimary 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 2008 was 10.4% compared to 4.8% at year end
2007.  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.


35


In
December 2008, Cornerstone applied for $12 million under the U.S. Treasury’s
Capital Purchase Program, instituted as part of the Troubled Asset Relief
Program established under the EESA.  At present, this application has
not been approved, and Cornerstone has not received any assurances that it will
be approved.  Management does not know of any other trends, demands,
commitments, events or uncertainties that will result in or are reasonably
likely to result in liquidity increasing or decreasing in any material
manner.





Table 24
presents the average loan to deposit ratios, a liquidity measure, for periods
indicated:





TABLE
24


December 31, 2008
                  
                  
                  December 31, 2007Average
      loans to average deposits
                  
                  
                  122.59
                  %
                  
                  
                  116.86
                  %





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 Cornerstone’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.




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 25
presents the re-pricing of the Bank’s interest earning assets and
interest-bearing liabilities as of December 31, 2008.  This interest
sensitivity gap table is designed to monitor the Bank’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.  The Bank’s interest rate management policy is to attempt
to maintain a relatively stable net interest margin in periods of interest rate
fluctuations.   The Bank’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 25 excludes the
interest sensitive assets and liabilities of Eagle and the Bank’s holding
company, Cornerstone Bancshares, Inc.  The exclusion for Eagle is an
interest sensitive asset, consisting of accounts receivable, totaling $1.2
million.  The exclusion for the holding company is an interest
sensitive liability, which is a line of credit with $4.3 million
outstanding.  Both the interest sensitive asset of Eagle and the
interest sensitive liability of the holding company would be accounted for in
the less than one year analysis.


36


TABLE
25


Re-pricing of Interest Sensitive Assets and Liabilities
                  Year-end balance as of December 31, 2008(In thousands)
                  Interest Sensitive Assets:
                
                Less than
                  One
                  Year
                
                
                1 to 5
                  Years (3)
                
                
                Over 5
                  Years (3)
                
                
                TotalFederal
      funds sold
                
                $
                11,025
                
                
                $
                0
                
                
                $
                0
                
                
                $
                11,025Investment
      securitiesTaxable
      (1)
                
                
                34,945
                
                
                
                32
                
                
                
                7,512
                
                
                
                42,489Tax-exempt
      (1)
                
                
                125
                
                
                
                900
                
                
                
                2,899
                
                
                
                3,924Loans
      (2)Fixed
      rate and adjustable rate 1-4 family mortgage
                
                
                18,294
                
                
                
                32,010
                
                
                
                7,686
                
                
                
                57,990Scheduled
      payments
                
                
                172,602
                
                
                
                146,947
                
                
                
                9,395
                
                
                
                328,944Other
                
                
                3,078
                
                
                
                0
                
                
                
                0
                
                
                
                3,078Total
      Interest Sensitive Assets
                
                $
                240,069
                
                
                $
                179,889
                
                
                $
                27,492
                
                
                $
                447,450Interest
      Sensitive Liabilities:NOW
      accounts
                
                $
                10,766
                
                
                $
                16,143
                
                
                $
                0
                
                
                $
                26,909Money
      market and savings accounts
                
                
                17,122
                
                
                
                18,726
                
                
                
                0
                
                
                
                35,848Time
      deposits
                
                
                192,694
                
                
                
                31,055
                
                
                
                0
                
                
                
                223,749Other
      interest bearing liabilities
                
                
                72,790
                
                
                
                30,000
                
                
                
                0
                
                
                
                102,790Total
      Interest Sensitive Liabilities
                
                $
                293,372
                
                
                $
                95,924
                
                
                $
                0
                
                
                $
                389,296Interest
      Sensitive Gap
                
                
                (53,303
                )
                
                
                83,965
                
                
                
                27,492
                
                
                
                58,154Cumulative
      Interest Sensitive Gap
                
                
                (53,303
                )
                
                
                30,662
                
                
                
                58,154Ratio
      of cumulative gap to total Interest Sensitive Assets
                
                
                (11.91
                )%
                
                
                6.85
                %
                
                
                13.00
                %


(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.





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.


37


ITEM
8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





CORNERSTONE
BANCSHARES, INC. AND SUBSIDIARIES





Consolidated
Financial Statements and Footnotes





Table
of Contents





Page
      No.Management’s
      Report on Internal Control over Financial Reporting
                39Report
      of Independent Registered Public Accounting Firm – Financial
      Statements
                40Consolidated
      Financial StatementsConsolidated
      balance sheets
                41Consolidated
      statements of income
                42Consolidated
      statements of changes in stockholders’ equity
                43Consolidated
      statements of cash flows
                45Notes
      to consolidated financial statements
                46


38


MANAGEMENT’S
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, 2008. 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, 2008, Cornerstone’s
internal control over financial reporting is effective based on those
criteria.


39


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
(Company) as of December 31, 2008 and 2007, 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,
2008.  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, 2008 and 2007, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2008, in
conformity with U.S. generally accepted accounting principles.
 
 We were not engaged to examine
management’s assessment of the effectiveness of the Company’s internal control
over financial reporting as of December 31, 2008, included in Management’s Report on Internal
Control Over Financial Reporting found in Item 9A(T) of Form 10-K for the
year ended December 31, 2008, and, accordingly, we do not express an
opinion thereon.
 
 /s/
HAZLETT, LEWIS & BIETER, PLLC
 
 Chattanooga,
Tennessee
 March 18,
2009
  40




CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
  CONSOLIDATED  BALANCE  SHEETS
 December
31, 2008 and 2007
 
 2008
                  
                  
                  2007ASSETSCash
      and due from banks
                  
                  $
                  10,872,390
                  
                  
                  $
                  14,933,349Federal
      funds sold
                  
                  
                  11,025,000
                  
                  
                  
                  -Cash
      and cash equivalents
                  
                  
                  21,897,390
                  
                  
                  
                  14,933,349Securities
      available for sale
                  
                  
                  44,056,559
                  
                  
                  
                  34,751,985Securities
      held to maturity (fair value approximates $169,759 at 2008 and $199,678 at
      2007)
                  
                  
                  169,284
                  
                  
                  
                  200,037Federal
      Home Loan Bank stock, at cost
                  
                  
                  2,187,500
                  
                  
                  
                  1,911,600Loans,
      net of allowance for loan losses of $9,618,265 in 2008 and $13,710,109 in
      2007
                  
                  
                  378,471,619
                  
                  
                  
                  369,883,009Bank
      premises and equipment, net
                  
                  
                  8,471,955
                  
                  
                  
                  6,470,893Accrued
      interest receivable
                  
                  
                  1,771,091
                  
                  
                  
                  2,407,977Goodwill
      and amortizable intangibles
                  
                  
                  2,840,773
                  
                  
                  
                  2,941,798Other
      assets
                  
                  
                  11,937,004
                  
                  
                  
                  10,920,605Total
      assets
                  
                  $
                  471,803,175
                  
                  
                  $
                  444,421,253LIABILITIES
      AND STOCKHOLDERS' EQUITYDeposits:Noninterest-bearing
      demand deposits
                  
                  $
                  40,077,977
                  
                  
                  $
                  45,284,518Interest-bearing
      demand deposits
                  
                  
                  26,908,572
                  
                  
                  
                  31,984,590Savings
      deposits and money market accounts
                  
                  
                  35,847,667
                  
                  
                  
                  49,970,489Time
      deposits of $100,000 or more
                  
                  
                  59,056,590
                  
                  
                  
                  58,250,272Time
      deposits under $100,000
                  
                  
                  164,692,417
                  
                  
                  
                  127,759,856Total
      deposits
                  
                  
                  326,583,223
                  
                  
                  
                  313,249,725Accrued
      interest payable
                  
                  
                  469,586
                  
                  
                  
                  216,086Federal
      funds purchased and securities sold under agreements to
      repurchase
                  
                  
                  35,790,246
                  
                  
                  
                  41,560,355Federal
      Home Loan Bank advances and line of credit
                  
                  
                  71,250,000
                  
                  
                  
                  47,100,000Other
      liabilities
                  
                  
                  1,208,611
                  
                  
                  
                  5,967,737Total
      liabilities
                  
                  
                  435,301,666
                  
                  
                  
                  408,093,903Stockholders'
      equity:Preferred
      stock - no par value; 2,000,000 shares authorized; no shares
      issued
                  
                  
                  -
                  
                  
                  
                  -Common
      stock - $1.00 par value; 10,000,000 shares authorized;6,522,718
      shares issued in 2008 and 2007;6,319,718
      and 6,369,718 outstanding in 2008 and 2007
                  
                  
                  6,319,718
                  
                  
                  
                  6,369,718Additional
      paid-in capital
                  
                  
                  20,311,638
                  
                  
                  
                  20,532,787Retained
      earnings
                  
                  
                  10,056,680
                  
                  
                  
                  9,317,878Accumulated
      other comprehensive income
                  
                  
                  (186,527
                  )
                  
                  
                  106,967Total
      stockholders' equity
                  
                  
                  36,501,509
                  
                  
                  
                  36,327,350Total
      liabilities and stockholders' equity
                  
                  $
                  471,803,175
                  
                  
                  $
                  444,421,253
 
 The Notes
to Consolidated Financial Statements are an integral part of these
statements.
  41
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 CONSOLIDATED  STATEMENTS  OF  INCOME
 Years
Ended December 31, 2008, 2007 and 2006
 
 2008
                      
                      
                      2007
                      
                      
                      2006INTEREST
      INCOMELoans,
      including fees
                      
                      $
                      28,660,491
                      
                      
                      $
                      32,981,334
                      
                      
                      $
                      27,317,002Securities
      and interest-bearing deposits in other banks
                      
                      
                      1,996,228
                      
                      
                      
                      1,750,023
                      
                      
                      
                      1,583,984Federal
      funds sold
                      
                      
                      23,455
                      
                      
                      
                      52,161
                      
                      
                      
                      257,820Total
      interest income
                      
                      
                      30,680,174
                      
                      
                      
                      34,783,518
                      
                      
                      
                      29,158,806INTEREST
      EXPENSETime
      deposits of $100,000 or more
                      
                      
                      2,370,873
                      
                      
                      
                      3,134,084
                      
                      
                      
                      1,993,796Other
      deposits
                      
                      
                      6,928,475
                      
                      
                      
                      8,206,843
                      
                      
                      
                      6,550,906Federal
      funds purchased and securities sold under agreements to
      repurchase
                      
                      
                      600,163
                      
                      
                      
                      857,161
                      
                      
                      
                      347,861Federal
      Home Loan Bank advances and line of credit
                      
                      
                      2,798,563
                      
                      
                      
                      2,215,517
                      
                      
                      
                      1,413,546Total
      interest expense
                      
                      
                      12,698,074
                      
                      
                      
                      14,413,605
                      
                      
                      
                      10,306,109Net
      interest income before provision for loan losses
                      
                      
                      17,982,100
                      
                      
                      
                      20,369,913
                      
                      
                      
                      18,852,697Provision
      for loan losses
                      
                      
                      3,498,000
                      
                      
                      
                      10,409,365
                      
                      
                      
                      1,106,600Net
      interest income after provision for loan losses
                      
                      
                      14,484,100
                      
                      
                      
                      9,960,548
                      
                      
                      
                      17,746,097NONINTEREST
      INCOMECustomer
      service fees
                      
                      
                      1,726,681
                      
                      
                      
                      1,425,822
                      
                      
                      
                      1,298,041Other
      noninterest income
                      
                      
                      107,522
                      
                      
                      
                      165,495
                      
                      
                      
                      91,047Operating
      lease income
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      300,932Net
      gains from sale of loans and other assets
                      
                      
                      57,828
                      
                      
                      
                      103,773
                      
                      
                      
                      421,236Total
      noninterest income
                      
                      
                      1,892,031
                      
                      
                      
                      1,695,090
                      
                      
                      
                      2,111,256NONINTEREST
      EXPENSESSalaries
      and employee benefits
                      
                      
                      7,139,594
                      
                      
                      
                      6,608,808
                      
                      
                      
                      6,018,619Net
      occupancy and equipment expense
                      
                      
                      1,520,378
                      
                      
                      
                      1,354,642
                      
                      
                      
                      1,075,081Depreciation
      on leased assets
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      244,580Other
      operating expenses
                      
                      
                      3,907,793
                      
                      
                      
                      2,962,151
                      
                      
                      
                      3,379,950Total
      noninterest expenses
                      
                      
                      12,567,765
                      
                      
                      
                      10,925,601
                      
                      
                      
                      10,718,230Income
      before income tax expense
                      
                      
                      3,808,366
                      
                      
                      
                      730,037
                      
                      
                      
                      9,139,123Income
      tax expense (benefit)
                      
                      
                      1,296,542
                      
                      
                      
                      (141,115
                      )
                      
                      
                      3,327,523Net
      income
                      
                      $
                      2,511,824
                      
                      
                      $
                      871,152
                      
                      
                      $
                      5,811,600EARNINGS
      PER COMMON SHAREBasic
                      
                      $
                      .40
                      
                      
                      $
                      .13
                      
                      
                      $
                      .90Diluted
                      
                      
                      .39
                      
                      
                      
                      .13
                      
                      
                      
                      .85
 
 The Notes
to Consolidated Financial Statements are an integral part of these
statements.
  42
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 CONSOLIDATED  STATEMENTS  OF  CHANGES  IN  STOCKHOLDERS'  EQUITY
 Years
Ended December 31, 2008, 2007 and 2006
 
 AccumulatedAdditional
                  
                  
                  
                  
                  
                  Other
                  
                  
                  TotalComprehensive
                  
                  
                  Common
                  
                  
                  Paid-in
                  
                  
                  Retained
                  
                  
                  Comprehensive
                  
                  
                  Stockholders'Income
                  
                  
                  Stock
                  
                  
                  Capital
                  
                  
                  Earnings
                  
                  
                  Income
                  
                  
                  EquityBALANCE,
      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
                  )
                  
                  
                  38,183,265Issuance
      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
 
 (continued
on next page)
  43
 
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 CONSOLIDATED  STATEMENTS  OF  CHANGES  IN  STOCKHOLDERS'  EQUITY
 Years
Ended December 31, 2008, 2007 and 2006
 
 (continued
from previous page)
 
 AccumulatedAdditional
                  
                  
                  
                  
                  
                  Other
                  
                  
                  TotalComprehensive
                  
                  
                  Common
                  
                  
                  Paid-in
                  
                  
                  Retained
                  
                  
                  Comprehensive
                  
                  
                  Stockholders'Income
                  
                  
                  Stock
                  
                  
                  Capital
                  
                  
                  Earnings
                  
                  
                  Income
                  
                  
                  EquityBALANCE,
      December 31, 2007
                  
                  
                  
                  
                  $
                  6,369,718
                  
                  
                  $
                  20,532,787
                  
                  
                  $
                  9,317,878
                  
                  
                  $
                  106,967
                  
                  
                  $
                  36,327,350Issuance
      of common stock
                  
                  
                  
                  
                  
                  22,000
                  
                  
                  
                  60,500
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  82,500Stock
      compensation expense
                  
                  
                  
                  
                  
                  -
                  
                  
                  
                  279,400
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  279,400Dividends
      - $.28 per share
                  
                  
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1,773,022
                  )
                  
                  
                  -
                  
                  
                  
                  (1,773,022
                  )Repurchase
      of common stock
                  
                  
                  
                  
                  
                  (72,000
                  )
                  
                  
                  (561,049
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (633,049
                  )Comprehensive
      income:Net
      income
                  
                  $
                  2,511,824
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2,511,824
                  
                  
                  
                  -
                  
                  
                  
                  2,511,824Other
      comprehensive income, net of tax:Unrealized
      holding gains (losses) on securities available for sale, net of
      reclassification adjustment
                  
                  
                  (293,494
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (293,494
                  )
                  
                  
                  (293,494
                  )Total
      comprehensive income
                  
                  $
                  2,218,330BALANCE,
      December 31, 2008
                  
                  
                  
                  
                  
                  $
                  6,319,718
                  
                  
                  $
                  20,311,638
                  
                  
                  $
                  10,056,680
                  
                  
                  $
                  (186,527
                  )
                  
                  $
                  36,501,509
 
 The Notes
to Consolidated Financial Statements are an integral part of these
statements.
  44
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 CONSOLIDATED  STATEMENTS  OF  CASH  FLOWS
 Years
Ended December 31, 2008, 2007 and 2006
 
 2008
                  
                  
                  2007
                  
                  
                  2006CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
                  
                  $
                  2,511,824
                  
                  
                  $
                  871,152
                  
                  
                  $
                  5,811,600Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                  
                  
                  694,499
                  
                  
                  
                  605,062
                  
                  
                  
                  990,052Provision
      for loan losses
                  
                  
                  3,498,000
                  
                  
                  
                  10,409,365
                  
                  
                  
                  1,106,600Stock
      compensation expense
                  
                  
                  279,400
                  
                  
                  
                  220,016
                  
                  
                  
                  147,925Gain
      on sales of loans and other assets
                  
                  
                  (57,828
                  )
                  
                  
                  (103,773
                  )
                  
                  
                  (421,236
                  )Deferred
      income taxes
                  
                  
                  3,302,186
                  
                  
                  
                  (3,478,707
                  )
                  
                  
                  (481,466
                  )Changes
      in other operating assets and liabilities:Net
      change in loans held for sale
                  
                  
                  (112,000
                  )
                  
                  
                  484,900
                  
                  
                  
                  (97,752
                  )Accrued
      interest receivable
                  
                  
                  636,886
                  
                  
                  
                  (287,199
                  )
                  
                  
                  (381,318
                  )Accrued
      interest payable
                  
                  
                  253,500
                  
                  
                  
                  (92,306
                  )
                  
                  
                  65,528Other
      assets and liabilities
                  
                  
                  (7,509,166
                  )
                  
                  
                  3,154,062
                  
                  
                  
                  (1,438,845
                  )Net
      cash provided by operating activities
                  
                  
                  3,497,301
                  
                  
                  
                  11,782,572
                  
                  
                  
                  5,301,088CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from security transactions:Securities
      available for sale
                  
                  
                  23,596,577
                  
                  
                  
                  13,008,453
                  
                  
                  
                  1,865,807Securities
      held to maturity
                  
                  
                  30,594
                  
                  
                  
                  36,467
                  
                  
                  
                  85,400Purchase
      of securities available for sale
                  
                  
                  (33,350,455
                  )
                  
                  
                  (15,037,296
                  )
                  
                  
                  (3,975,324
                  )Purchase
      of Federal Home Loan Bank stock
                  
                  
                  (275,900
                  )
                  
                  
                  (559,400
                  )
                  
                  
                  (247,700
                  )Loan
      originations and principal collections, net
                  
                  
                  (14,691,368
                  )
                  
                  
                  (76,239,255
                  )
                  
                  
                  (43,432,372
                  )Purchase
      of bank premises and equipment
                  
                  
                  (2,589,553
                  )
                  
                  
                  (840,644
                  )
                  
                  
                  (1,278,809
                  )Purchase
      of equity investment
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (3,000,000
                  )Proceeds
      from sale of other real estate and other assets
                  
                  
                  1,357,027
                  
                  
                  
                  784,592
                  
                  
                  
                  806,406Net
      cash used in investing activities
                  
                  
                  (25,923,078
                  )
                  
                  
                  (78,847,083
                  )
                  
                  
                  (49,176,592
                  )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase in deposits
                  
                  
                  13,333,498
                  
                  
                  
                  37,433,192
                  
                  
                  
                  23,380,643(Decrease)
      increase in federal funds purchased and securities sold under agreements
      to repurchase
                  
                  
                  (5,770,109
                  )
                  
                  
                  22,310,654
                  
                  
                  
                  14,458,964Proceeds
      from Federal Home Loan Bank advances
                  
                  
                  20,000,000
                  
                  
                  
                  35,000,000
                  
                  
                  
                  20,000,000Repayment
      of Federal Home Loan Bank advances
                  
                  
                  -
                  
                  
                  
                  (27,000,000
                  )
                  
                  
                  (11,000,000
                  )Net
      borrowings (repayments) under line of credit
                  
                  
                  4,150,000
                  
                  
                  
                  (400,000
                  )
                  
                  
                  500,000Purchase
      of common stock
                  
                  
                  (633,049
                  )
                  
                  
                  (1,751,291
                  )
                  
                  
                  (206,807
                  )Payment
      of dividends
                  
                  
                  (1,773,022
                  )
                  
                  
                  (1,303,577
                  )
                  
                  
                  (775,138
                  )Issuance
      of common stock
                  
                  
                  82,500
                  
                  
                  
                  72,926
                  
                  
                  
                  563,299Net
      cash provided by financing activities
                  
                  
                  29,389,818
                  
                  
                  
                  64,361,904
                  
                  
                  
                  46,920,961NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                  
                  
                  6,964,041
                  
                  
                  
                  (2,702,607
                  )
                  
                  
                  3,045,457CASH
      AND CASH EQUIVALENTS, beginning of year
                  
                  
                  14,933,349
                  
                  
                  
                  17,635,956
                  
                  
                  
                  14,590,499CASH
      AND CASH EQUIVALENTS, end of year
                  
                  $
                  21,897,390
                  
                  
                  $
                  14,933,349
                  
                  
                  $
                  17,635,956SUPPLEMENTAL
      DISCLOSURES OF CASH FLOW INFORMATIONCash
      paid during the period for interest
                  
                  $
                  12,444,574
                  
                  
                  $
                  14,505,911
                  
                  
                  $
                  10,240,581Cash
      paid during the period for taxes
                  
                  
                  738,886
                  
                  
                  
                  4,092,910
                  
                  
                  
                  3,259,073NONCASH
      INVESTING AND FINANCING ACTIVITIESAcquisition
      of real estate through foreclosure
                  
                  $
                  2,915,414
                  
                  
                  $
                  1,518,329
                  
                  
                  $
                  493,588Loan
      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.
  45




CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 Note
      1.
              Summary
      of Significant Accounting Policies
 
 The
accounting and reporting policies of Cornerstone Bancshares, Inc. and
subsidiaries (Cornerstone) 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:
 
 Cornerstone
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 Cornerstone, the Bank
and Eagle.  All material intercompany accounts and transactions have
been eliminated in consolidation.
 
 Goodwill:
 
 Goodwill
represents the excess of the cost of Cornerstone’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.  Cornerstone 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, 2008, 2007 or
2006.
 
 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 Cornerstone
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.
  46
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
  Note
      1.
              Summary
      of Significant Accounting Policies
(continued)
 
 Loans:
 
 Cornerstone
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 Cornerstone’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.
  47
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
 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 Cornerstone 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, Cornerstone 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:
 
 Cornerstone’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.
 
 Cornerstone
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, Cornerstone’s
ownership interest in the partnership’s capital is reported as an investment on
its consolidated balance sheets and Cornerstone’s allocable share of the income
or loss from the partnership is reported in noninterest income or expense in the
consolidated statements of income.  Cornerstone 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 Cornerstone.  After Cornerstone’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 Cornerstone’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.
  48
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
 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 Cornerstone, (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) Cornerstone
does not maintain effective control over the transferred assets through an
agreement to repurchase them before their maturity.
 
 Advertising
costs:
 
 Cornerstone
expenses all advertising costs as incurred.  Advertising expense was
$92,252, $83,632, and $84,233, for the years ended December 31, 2008, 2007 and
2006, respectively.
 
 Cash and
cash equivalents:
 
 Cornerstone
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, 2008, Cornerstone had two stock-based compensation
plans.  Effective January 1, 2006, Cornerstone 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.
 
 Cornerstone
adopted SFAS 123R using the modified prospective application as permitted
under SFAS 123R. Accordingly, prior period amounts have not been restated.
Under this application, Cornerstone 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, Cornerstone 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  Cornerstone’s common stock on the date of
grant.
  49
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
  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 distinct 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 Cornerstone’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 2008, 2007 and 2006 were
not significant for separate disclosure.  Accordingly, Cornerstone’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 Cornerstone
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)” (FIN 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 FIN 46-R, a VIE must be consolidated by Cornerstone 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.  Cornerstone has an investment in
Appalachian Fund for Growth II Partnership 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, Cornerstone 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.
  50
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
 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, 2008 and 2007,
these reserve balances were approximately $2,321,000 and $2,826,000,
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, 2008 and 2007, is as follows:
 
 December 31, 2008Gross
                                  
                                  
                                  GrossAmortized
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Unrealized
                                  
                                  
                                  MarketCost
                                  
                                  
                                  Gains
                                  
                                  
                                  Losses
                                  
                                  
                                  ValueSecurities
      available for sale:U.S.
      Government securities
                                  
                                  $
                                  7,976,040
                                  
                                  
                                  $
                                  275,731
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  8,251,771State
      and municipal securities
                                  
                                  
                                  4,609,632
                                  
                                  
                                  
                                  82,013
                                  
                                  
                                  
                                  (68,830
                                  )
                                  
                                  
                                  4,622,815Mortgage-backed
      securities
                                  
                                  
                                  31,753,504
                                  
                                  
                                  
                                  160,387
                                  
                                  
                                  
                                  (731,918
                                  )
                                  
                                  
                                  31,181,973$
                                  44,339,176
                                  
                                  
                                  $
                                  518,131
                                  
                                  
                                  $
                                  (800,748
                                  )
                                  
                                  $
                                  44,056,559Securities
      held to maturity:Mortgage-backed
      securities
                                  
                                  $
                                  169,284
                                  
                                  
                                  $
                                  1,158
                                  
                                  
                                  $
                                  (683
                                  )
                                  
                                  $
                                  169,759
 
 December 31, 2007Gross
                              
                              
                              GrossAmortized
                              
                              
                              Unrealized
                              
                              
                              Unrealized
                              
                              
                              MarketCost
                              
                              
                              Gains
                              
                              
                              Losses
                              
                              
                              ValueSecurities
      available for sale:U.S.
      Government securities
                              
                              $
                              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
  51
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
 Note
      3.
              Securities
      (continued)
 
 At
December 31, 2008 and 2007, securities with a carrying value of
approximately $11,262,000 and $11,255,000, respectively, were pledged to secure
public deposits and for other purposes required or permitted by
law.
 
 At
December 31, 2008 and 2007, the carrying amount of securities pledged to
secure repurchase agreements was approximately $32,516,000 and $18,270,000,
respectively.
 
 The
amortized cost and estimated market value of securities at December 31, 2008, 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
                                      
                                      $
                                      6,121,575
                                      
                                      
                                      $
                                      6,253,467
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      -Due
      from one year to five years
                                      
                                      
                                      900,112
                                      
                                      
                                      
                                      925,194
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Due
      from five years to ten years
                                      
                                      
                                      1,752,383
                                      
                                      
                                      
                                      1,792,728
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Due
      after ten years
                                      
                                      
                                      3,811,602
                                      
                                      
                                      
                                      3,903,197
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -12,585,672
                                      
                                      
                                      
                                      12,874,586
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Mortgage-backed
      securities
                                      
                                      
                                      31,753,504
                                      
                                      
                                      
                                      31,181,973
                                      
                                      
                                      
                                      169,284
                                      
                                      
                                      
                                      169,759$
                                      44,339,176
                                      
                                      
                                      $
                                      44,056,559
                                      
                                      
                                      $
                                      169,284
                                      
                                      
                                      $
                                      169,759
 
 For the
years ended December 31, 2008, 2007 and 2006, there were no sales of securities
available for sale.
 
 The
following tables present gross unrealized losses and market value, aggregated by
investment category and length of time that individual securities available for
sale have been in a continuous unrealized loss position, at December 31,
2008 and 2007:
 
 As of December 31, 2008Less than 12 Months
                              
                              
                              12 Months or Greater
                              
                              
                              TotalGross
                              
                              
                              
                              
                              
                              Gross
                              
                              
                              
                              
                              
                              GrossMarket
                              
                              
                              Unrealized
                              
                              
                              Market
                              
                              
                              Unrealized
                              
                              
                              Market
                              
                              
                              UnrealizedValue
                              
                              
                              Losses
                              
                              
                              Value
                              
                              
                              Losses
                              
                              
                              Value
                              
                              
                              LossesSecurities
      available for sale:State
      and municipal securities
                              
                              $
                              1,125,144
                              
                              
                              $
                              (48,772
                              )
                              
                              $
                              206,650
                              
                              
                              $
                              (20,058
                              )
                              
                              $
                              1,331,794
                              
                              
                              $
                              (68,830
                              )Mortgage-backed
      securities
                              
                              
                              19,234,621
                              
                              
                              
                              (719,051
                              )
                              
                              
                              642,457
                              
                              
                              
                              (12,867
                              )
                              
                              
                              19,877,078
                              
                              
                              
                              (731,918
                              )$
                              20,359,765
                              
                              
                              $
                              (767,823
                              )
                              
                              $
                              849,107
                              
                              
                              $
                              (32,925
                              )
                              
                              $
                              21,208,872
                              
                              
                              $
                              (800,748
                              )Securities
      held to maturity:Mortgage-backed  securities
                              
                              $
                              26,405
                              
                              
                              $
                              (289
                              )
                              
                              $
                              30,897
                              
                              
                              $
                              (394
                              )
                              
                              $
                              57,302
                              
                              
                              $
                              (683
                              )
  52
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 Note
      3.
              Securities
      (continued)
 
 As of December 31, 2007Less than 12 Months
                                  
                                  
                                  12 Months or Greater
                                  
                                  
                                  TotalGross
                                  
                                  
                                  
                                  
                                  
                                  Gross
                                  
                                  
                                  
                                  
                                  
                                  GrossMarket
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Market
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Market
                                  
                                  
                                  UnrealizedValue
                                  
                                  
                                  Losses
                                  
                                  
                                  Value
                                  
                                  
                                  Losses
                                  
                                  
                                  Value
                                  
                                  
                                  LossesSecurities
      available for sale:U.S.
      Government securities
                                  
                                  $
                                  873,281
                                  
                                  
                                  $
                                  (29
                                  )
                                  
                                  $
                                  12,951,003
                                  
                                  
                                  $
                                  (38,913
                                  )
                                  
                                  $
                                  13,824,284
                                  
                                  
                                  $
                                  (38,942
                                  )State
      and municipal  securities
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  229,139
                                  
                                  
                                  
                                  (3
                                  )
                                  
                                  
                                  229,139
                                  
                                  
                                  
                                  (3
                                  )Mortgage-backed  securities
                                  
                                  
                                  851,190
                                  
                                  
                                  
                                  (2,403
                                  )
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  851,190
                                  
                                  
                                  
                                  (2,403
                                  )$
                                  1,724,471
                                  
                                  
                                  $
                                  (2,432
                                  )
                                  
                                  $
                                  13,180,142
                                  
                                  
                                  $
                                  (38,916
                                  )
                                  
                                  $
                                  14,904,613
                                  
                                  
                                  $
                                  (41,348
                                  )Securities
      held to maturity:Mortgage-backed  securities
                                  
                                  $
                                  31,603
                                  
                                  
                                  $
                                  (34
                                  )
                                  
                                  $
                                  111,525
                                  
                                  
                                  $
                                  (749
                                  )
                                  
                                  $
                                  143,128
                                  
                                  
                                  $
                                  (783
                                  )
 
 Although
there have been declines in the market value and credit quality of some of
Cornerstone’s investment securities during 2008, management believes it is
probable that Cornerstone will be able to collect all amounts due according to
the contractual terms of securities considered to be impaired at year
end.  Management believes the impairment relates primarily to the
current interest rate environment and an overall temporary decline in values in
the financial markets.  Since management has the ability to hold its
debt securities until maturity, or for the foreseeable future for its securities
available for sale, no declines in fair value are deemed to be other than
temporary in nature.
 
 Note
      4.
              Loans
      and Allowance for Loan Losses
 
 At
December 31, 2008 and 2007, the Bank's loans consist of the following (in
thousands):
 2008
                                                                
                                                                
                                                                2007Mortgage
      loans on real estate:Residential
      1-4 family
                                                                
                                                                $
                                                                42,136
                                                                
                                                                
                                                                $
                                                                35,309Residential
      multifamily (5 or more)
                                                                
                                                                
                                                                14,747
                                                                
                                                                
                                                                
                                                                16,573Held
      for sale
                                                                
                                                                
                                                                104
                                                                
                                                                
                                                                
                                                                216Commercial
                                                                
                                                                
                                                                155,728
                                                                
                                                                
                                                                
                                                                138,074Construction
                                                                
                                                                
                                                                70,456
                                                                
                                                                
                                                                
                                                                76,832Second
      mortgages
                                                                
                                                                
                                                                3,030
                                                                
                                                                
                                                                
                                                                2,270Equity
      lines of credit
                                                                
                                                                
                                                                12,720
                                                                
                                                                
                                                                
                                                                10,214298,921
                                                                
                                                                
                                                                
                                                                279,488Commercial
      loans
                                                                
                                                                
                                                                83,140
                                                                
                                                                
                                                                
                                                                97,896Consumer
      installment loans:Personal
                                                                
                                                                
                                                                5,486
                                                                
                                                                
                                                                
                                                                5,652Credit
      cards
                                                                
                                                                
                                                                543
                                                                
                                                                
                                                                
                                                                5576,029
                                                                
                                                                
                                                                
                                                                6,209Total
      loans
                                                                
                                                                
                                                                388,090
                                                                
                                                                
                                                                
                                                                383,593Less:  Allowance
      for loan losses
                                                                
                                                                
                                                                (9,618
                                                                )
                                                                
                                                                
                                                                (13,710
                                                                )Loans,
      net
                                                                
                                                                $
                                                                378,472
                                                                
                                                                
                                                                $
                                                                369,883
  53
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 Note
      4.
              Loans
      and Allowance for Loan Losses
(continued)
 
 2008
                      
                      
                      2007
                      
                      
                      2006An
      analysis of the allowance for loan losses follows:Balance,
      beginning of year
                      
                      $
                      13,710,109
                      
                      
                      $
                      4,258,352
                      
                      
                      $
                      3,545,042Provision
      charged to operations
                      
                      
                      3,498,000
                      
                      
                      
                      10,409,365
                      
                      
                      
                      1,106,600Charge-offs
                      
                      
                      (7,978,767
                      )
                      
                      
                      (1,075,670
                      )
                      
                      
                      (470,367
                      )Recoveries
                      
                      
                      388,923
                      
                      
                      
                      118,062
                      
                      
                      
                      77,077Balance,
      end of year
                      
                      $
                      9,618,265
                      
                      
                      $
                      13,710,109
                      
                      
                      $
                      4,258,352
 
 The
Bank's only significant concentration of credit at December 31, 2008, occurred
in real estate loans which totaled approximately $299 million.  While
real estate loans accounted for 77 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 31,2008
                        
                        
                        2007Impaired
      loans without a valuation allowance
                        
                        $
                        2,543,320
                        
                        
                        $
                        17,075Impaired
      loans with a valuation allowance
                        
                        
                        17,375,043
                        
                        
                        
                        13,176,547Total
      impaired loans
                        
                        $
                        19,918,363
                        
                        
                        $
                        13,193,622Valuation
      allowance related to impaired loans
                        
                        $
                        5,872,373
                        
                        
                        $
                        9,789,748Total
      non-accrual loans
                        
                        $
                        4,252,791
                        
                        
                        $
                        684,903Total
      loans past-due ninety days or more and still accruing
                        
                        $
                        -
                        
                        
                        $
                        -
 
 Years Ended December 31,2008
                    
                    
                    2007
                    
                    
                    2006Average
      investment in impaired loans
                    
                    $
                    10,891,357
                    
                    
                    $
                    3,348,873
                    
                    
                    $
                    1,754,906Interest
      income recognized on impaired loans
                    
                    $
                    966,011
                    
                    
                    $
                    1,182,407
                    
                    
                    $
                    121,987Interest
      income recognized on a cash basis on impaired loans
                    
                    $
                    -
                    
                    
                    $
                    28,900
                    
                    
                    $
                    78,391
 
 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:
 
 2008
                    
                    
                    2007Beginning
      balance
                    
                    $
                    772,942
                    
                    
                    $
                    751,496New
      loans
                    
                    
                    65,177
                    
                    
                    
                    521,678Repayments
                    
                    
                    (648,446
                    )
                    
                    
                    (500,232
                    )Ending
      balance
                    
                    $
                    189,673
                    
                    
                    $
                    772,942
  54
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
 Note
      5.
              Bank
      Premises and Equipment
 
 A summary
of bank premises and equipment at December 31, 2008 and 2007, is as
follows:
  2008
                        
                        
                        2007Land
                        
                        $
                        3,338,413
                        
                        
                        $
                        1,658,625Buildings
      and improvements
                        
                        
                        4,537,349
                        
                        
                        
                        4,131,932Furniture,
      fixtures and equipment
                        
                        
                        4,255,237
                        
                        
                        
                        3,849,46212,130,999
                        
                        
                        
                        9,640,019Accumulated
      depreciation
                        
                        
                        (3,659,044
                        )
                        
                        
                        (3,169,126
                        )$
                        8,471,955
                        
                        
                        $
                        6,470,893
 
 Depreciation
expense for the years ended December 31, 2008, 2007 and 2006, amounted to
$588,490, $500,573, and $644,664, respectively.
 
 Certain
      bank facilities and equipment are leased under various operating
      leases.  Total rent expense on these leases for the years ended
      December 31, 2008, 2007 and 2006, was $386,714, $384,004, and $235,455,
      respectively.
 
 Future
minimum rental commitments under non-cancelable leases are as
follows:
 
 2009
                    
                    $
                    362,5072010
                    
                    
                    344,6622011
                    
                    
                    343,2122012
                    
                    
                    341,0032013
                    
                    
                    341,003Thereafter
                    
                    
                    699,540Total
                    
                    $
                    2,431,927
 
 Note
      6.
              Time
      and Related-Party Deposits
 
 At
December 31, 2008, the scheduled maturities of time deposits are as
follows:
 
 2009
                    
                    $
                    192,6932010
                    
                    
                    27,4162011
                    
                    
                    2,6622012
                    
                    
                    502013
                    
                    
                    928Total
                    
                    $
                    223,749
 
 Deposits
from related parties held by the Bank at December 31, 2008 and 2007, amounted to
approximately and $1,007,000 and $692,000, respectively.
  55
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
  Note
      7.
              Income
      Taxes
 
 Cornerstone
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,
2008, 2007 and 2006, consists of the following:
 
 2008
                            
                            
                            2007
                            
                            
                            2006Current
      tax expense
                            
                            $
                            (2,005,644
                            )
                            
                            $
                            3,337,592
                            
                            
                            $
                            3,808,989Deferred
      tax expense (benefit) related to:Allowance
      for loan losses
                            
                            
                            3,158,858
                            
                            
                            
                            (3,623,934
                            )
                            
                            
                            (356,910
                            )Other
                            
                            
                            143,328
                            
                            
                            
                            145,227
                            
                            
                            
                            (124,556
                            )Income
      tax expense (benefit)
                            
                            $
                            1,296,542
                            
                            
                            $
                            (141,115
                            )
                            
                            $
                            3,327,523
 
 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:
 
 2008
                                    
                                    
                                    2007
                                    
                                    
                                    2006Expected
      tax at statutory rates
                                    
                                    $
                                    1,294,844
                                    
                                    
                                    $
                                    248,213
                                    
                                    
                                    $
                                    3,107,302Increase
      (decrease) resulting from tax effect of:State
      income taxes, net of federal tax benefit
                                    
                                    
                                    163,379
                                    
                                    
                                    
                                    31,318
                                    
                                    
                                    
                                    392,068New
      market tax credits
                                    
                                    
                                    (150,000
                                    )
                                    
                                    
                                    (300,000
                                    )
                                    
                                    
                                    (150,000
                                    )Other
                                    
                                    
                                    (11,681
                                    )
                                    
                                    
                                    (120,646
                                    )
                                    
                                    
                                    (21,847
                                    )Income
      tax expense (benefit)
                                    
                                    $
                                    1,296,542
                                    
                                    
                                    $
                                    (141,115
                                    )
                                    
                                    $
                                    3,327,523
 
 The
components of the net deferred tax asset, included in other assets, are as
follows:
 
 2008
                                  
                                  
                                  2007Deferred
      tax assets:Deferred
      compensation
                                  
                                  $
                                  124,583
                                  
                                  
                                  $
                                  133,011Deferred
      loan fees
                                  
                                  
                                  52,150
                                  
                                  
                                  
                                  103,112Allowance
      for loan losses
                                  
                                  
                                  1,935,933
                                  
                                  
                                  
                                  5,094,791Net
      unrealized loss on securities available for sale
                                  
                                  
                                  151,194
                                  
                                  
                                  
                                  -Other
                                  
                                  
                                  28,334
                                  
                                  
                                  
                                  68,3512,292,194
                                  
                                  
                                  
                                  5,399,265Deferred
      tax liabilities:Depreciation
                                  
                                  
                                  126,979
                                  
                                  
                                  
                                  96,972Life
      insurance
                                  
                                  
                                  186,721
                                  
                                  
                                  
                                  173,427Net
      unrealized gain in securities available for sale
                                  
                                  
                                  -
                                  
                                  
                                  
                                  85,303Other
                                  
                                  
                                  14,165
                                  
                                  
                                  
                                  13,545327,865
                                  
                                  
                                  
                                  369,247Net
      deferred tax asset
                                  
                                  $
                                  1,964,329
                                  
                                  
                                  $
                                  5,030,018
  56
 
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
  Note
      7.
              Income
      Taxes (continued)
 
 In July
2006, 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 Cornerstone 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 Cornerstone’s 2007
fiscal year.  The adoption of this interpretation did not have a
material impact on Cornerstone’s consolidated financial
statements.  Further, Cornerstone recognized no interest and penalties
assessed by taxing authorities on any underpayment of income tax for 2008, 2007
or 2006.
 
 Note
      8.
              Federal
      Funds Purchased and Securities Sold Under Agreements to
      Repurchase
 
 Federal
      funds purchased and securities sold under agreements to repurchase
      amounted to $35,790,246 and $41,560,355 at December 31, 2008 and 2007,
      respectively.  These agreements generally mature within one to
      four days from the transaction
date.
 
 Note
      9.
              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 advances to the Bank in an amount up to approximately
$76,000,000.  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, 2008 and 2007, FHLB advances consist of the following:
 
 2008
                            
                            
                            2007Long-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 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
                            
                            
                            
                            5,000,000Long-term
      advance dated December 6, 2007, requiring
                              monthly
      interest payments, fixed at 3.87%, until
                              maturity,
      principal due in December 2010
                            
                            
                            5,000,000
                            
                            
                            
                            5,000,000Long-term
      advance dated June 26, 2008, requiring
                              monthly
      interest payments, fixed at 3.64%, until
                              maturity,
      principal due in July 2010
                            
                            
                            5,000,000
                            
                            
                            
                            -Long-term
      advance dated July 2, 2008, requiring
                              monthly
      interest payments, fixed at 3.85%, until
                              maturity,
      principal due in July 2011
                            
                            
                            5,000,000
                            
                            
                            
                            -Long-term
      advance dated January 18, 2008, requiring
                              monthly
      interest payments, fixed at 3.59%, until
                              maturity,
      principal due in January 2013
                            
                            
                            5,000,000
                            
                            
                            
                            -
  57
  
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 Note 9.
Federal Home Loan Bank Advances and Line of Credit (continued)
 
 2008
                                                                                  
                                                                                  
                                                                                  2007Long-term
      advance dated May 11, 2007, requiringmonthly
      interest payments, fixed at 4.66%, with aput
      option exercisable in February 2008 and thenquarterly
      thereafter, principal due in May 2011
                                                                                  
                                                                                  $
                                                                                  5,000,000
                                                                                  
                                                                                  
                                                                                  $
                                                                                  5,000,000Long-term
      advance dated May 15, 2007, requiringmonthly
      interest payments, fixed at 4.58%, with aput
      option exercisable in May 2008 and thenquarterly
      thereafter, principal due in May 2012
                                                                                  
                                                                                  
                                                                                  5,000,000
                                                                                  
                                                                                  
                                                                                  
                                                                                  5,000,000Long-term
      advance dated July 31, 2007, requiringmonthly
      interest payments, fixed at 4.50%, with aput
      option exercisable in July 2008 and thenquarterly
      thereafter, principal due in July 2013
                                                                                  
                                                                                  
                                                                                  5,000,000
                                                                                  
                                                                                  
                                                                                  
                                                                                  5,000,000Long-term
      advance dated August 7, 2007, requiringmonthly
      interest payments, fixed at 4.43%, with aput
      option exercisable in February 2009 and thenquarterly
      thereafter, principal due in August 2014
                                                                                  
                                                                                  
                                                                                  5,000,000
                                                                                  
                                                                                  
                                                                                  
                                                                                  5,000,000Long-term
      advance dated January 2, 2008, requiringmonthly
      interest payments, fixed at 3.52% with aput
      option exercisable in January 2011 and thequarterly
      thereafter, principal due in January 2015
                                                                                  
                                                                                  
                                                                                  5,000,000
                                                                                  
                                                                                  
                                                                                  
                                                                                  -Long-term
      advance dated January 20, 2006, requiringmonthly
      interest payments, fixed at 4.18%, with aput
      option exercisable in January 2009 and thenquarterly
      thereafter, principal due in January 2016
                                                                                  
                                                                                  
                                                                                  5,000,000
                                                                                  
                                                                                  
                                                                                  
                                                                                  5,000,000Long-term
      advance dated January 10, 2007, requiringmonthly
      interest payments, fixed at 4.25%, with aput
      option exercisable in January 2008 and thenquarterly
      thereafter, principal due in January 2017
                                                                                  
                                                                                  
                                                                                  5,000,000
                                                                                  
                                                                                  
                                                                                  
                                                                                  5,000,000$
                                                                                  67,000,000
                                                                                  
                                                                                  
                                                                                  $
                                                                                  47,000,000
 
 Scheduled
maturities of the Federal Home Loan Bank advances are as follows:
 
 2009
                    
                    $
                    -2010
                    
                    
                    17,000,0002011
                    
                    
                    10,000,0002012
                    
                    
                    5,000,0002013
                    
                    
                    10,000,000Thereafter
                    
                    
                    25,000,000Total
                    
                    $
                    67,000,000
  58
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 Note
      9.
              Federal
      Home Loan Bank Advances and Line of Credit
  (continued)
 
 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.
 
 Cornerstone
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 are due in
March 2009.  Borrowings outstanding under the agreements were
$4,250,000 and $100,000 at December 31, 2008 and 2007,
respectively.
 
 Note
      10.
              Employee
      Benefit Plans
 
 401(k)
plan:
 
 Cornerstone
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.  Cornerstone’s contribution to the plan is discretionary
and was $87,408 for 2008, $230,732 for 2007 and $195,445 for 2006.
 
 Employee
Stock Ownership Plan:
 
 Cornerstone
has a non-leveraged employee stock ownership plan (ESOP) to which Cornerstone
makes 100% of the contributions for purchasing Cornerstone’s common stock, and
allocates the contributions among the participants based on regulatory
guidelines.  Cornerstone’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.  Cornerstone made a contribution of $166,347 in 2008, no
contribution to the ESOP in 2007 and a contribution of $248,261 in
2006.
 
 Note
      11.
              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, 2008 and 2007, undisbursed loan
commitments aggregated $63,426,000 and $71,690,000, respectively.  In
addition, there were outstanding standby letters of credit totaling $3,983,000
and $4,996,000, 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.
  59
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 Note
      11.
              Financial
      Instruments With Off-Balance-Sheet Risk
  (continued)
 
 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 2008, 2007 and
2006.
 
 Note
      12.
              Fair
      Value Disclosures
 
 Fair
value measurements:
 
 On
January 1, 2008, Cornerstone adopted Statement of Financial Accounting Standards
No. 157, “Fair Value Measurements,” (SFAS 157), whichdefines fair value as
the exchange price that would be received for an asset or paid to transfer a
liability (an exit price) in the principal or most advantageous market for the
asset or liability in an orderly transaction between market participants on the
measurement date. SFAS 157also establishes a fair
value hierarchy which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value.
The standard describes three levels of inputs that may be used to measure fair
value.
 
 Level 1:
Quoted prices (unadjusted) or identical assets or liabilities in active markets
that the entity has the ability to access as of the measurement
date.
 
 Level 2:
Significant other observable inputs other than Level 1 prices, such as quoted
prices for similar assets or liabilities, quoted prices in markets that are not
active, and other inputs that are observable or can be corroborated by
observable market data.
 
 Level 3:
Significant unobservable inputs that reflect a company’s own assumptions about
the assumptions that market participants would use in pricing an asset or
liability.
 
 Cornerstone
utilizes fair value measurements to record fair value adjustments to certain
assets and determine fair value disclosures.  Accordingly, securities
available for sale are recorded at fair value on a recurring basis.
Additionally, from time to time, Cornerstone may be required to record other
assets at fair value on a nonrecurring basis, such as loans held for sale, and
impaired loans.  These nonrecurring fair value adjustments typically
involve application of lower of cost or market accounting or write-downs of
individual assets.
 
 Following
is a description of valuation methodologies used for assets and liabilities
recorded at fair value.
 
 Securities
available for sale-Investment securities available for sale are recorded at fair
value on a recurring basis. Fair value measurement is based upon quoted prices,
if available. If quoted prices are not available, fair values are measured using
independent pricing models or other model-based valuation techniques such as the
present value of future cash flows, adjusted for the security’s credit rating,
prepayment assumptions and other factors such as credit loss assumptions. Level
1 securities include those traded on an active exchange, such as the New York
Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers
in active over-the-counter markets and money market funds. Level 2 securities
include mortgage-backed securities, U.S. Government securities and municipal
bonds.
  60
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 Note
      12.
              Fair
      Value Disclosures (continued)
 
 Fair
      value measurements (continued):
 
 Impaired
loans-Cornerstone does not record loans at fair value on a recurring basis.
However, from time to time, a loan is considered impaired and an allowance for
loan losses is established. Loans for which it is probable that payment of
interest and principal will not be made in accordance with the contractual terms
of the loan agreement are considered impaired. Once a loan is identified as
individually impaired, management measures impairment in accordance with SFAS
114, “Accounting by Creditors for Impairment of a Loan,” (SFAS 114). The fair
value of impaired loans is estimated using one of several methods, including
collateral value, liquidation value and discounted cash flows. Those impaired
loans not requiring an allowance represent loans for which the fair value of the
expected repayments or collateral exceed the recorded investments in such loans.
In accordance with SFAS 157,impaired loans where an
allowance is established based on the fair value of collateral require
classification in the fair value hierarchy. When the fair value of the
collateral is based on an observable market price or a current appraised value,
we record the impaired loan as nonrecurring Level 2. When an appraised value is
not available or management determines the fair value of the collateral is
further impaired below the appraised value and there is no observable market
price, we record the impaired loan as nonrecurring Level 3.
 
 Assets
and liabilities recorded at fair value on a recurring basis are as follows
(amounts in thousands).
 
 Quoted
      PricesIn
      Active
                            
                            
                            SignificantMarkets
      for
                            
                            
                            Other
                            
                            
                            SignificantBalance
      as of
                            
                            
                            Identical
                            
                            
                            Observable
                            
                            
                            UnobservableDecember
      31,
                            
                            
                            Assets
                            
                            
                            Inputs
                            
                            
                            Inputs2008
                            
                            
                            (Level 1)
                            
                            
                            (Level 2)
                            
                            
                            (Level 3)Securities
      available for sale
                            
                            $
                            44,057
                            
                            
                            $
                            -
                            
                            
                            $
                            44,057
                            
                            
                            $
                            -
  Cornerstone
has no assets or liabilities whose fair values are measured on a recurring basis
using Level 3 inputs.
 
 Assets
measured at fair value on a nonrecurring basis are included in the table below
(amounts in thousands).
 
 Quoted
      PricesIn
      Active
                            
                            
                            SignificantMarkets
      for
                            
                            
                            Other
                            
                            
                            SignificantBalance
      as of
                            
                            
                            Identical
                            
                            
                            Observable
                            
                            
                            UnobservableDecember
      31,
                            
                            
                            Assets
                            
                            
                            Inputs
                            
                            
                            Inputs2008
                            
                            
                            (Level 1)
                            
                            
                            (Level 2)
                            
                            
                            (Level 3)Impaired
      loans
                            
                            $
                            11,503
                            
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            11,503
 
 Impaired
loans, which are measured for impairment using the fair value of the collateral
for collateral-dependent loans, had a carrying amount of approximately
$17,375,000, with a valuation allowance of approximately $5,872,000 at December
31, 2008.  Losses derived from Level 3 inputs were calculated
primarily by models utilizing estimated collateral value or the discounted
present value of expected cash flows.
  61
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 Note
      12.
              Fair
      Value Disclosures (continued)
 
 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 Cornerstone's entire holdings of a particular financial
instrument.  Because no market exists for a significant portion of
Cornerstone’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
cash equivalents:
 
 For cash
and cash equivalents, 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.
  62
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 Note
      12.
              Fair
      Value Disclosures (continued)
 
 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 Cornerstone's financial instruments
at December 31, 2008 and 2007, are as follows (in thousands):
 
 2008
                        
                        
                        2007Carrying
                        
                        
                        Estimated
                        
                        
                        Carrying
                        
                        
                        EstimatedAmount
                        
                        
                        Fair Value
                        
                        
                        Amount
                        
                        
                        Fair ValueAssets:Cash
      and cash equivalents
                        
                        $
                        21,897
                        
                        
                        $
                        21,897
                        
                        
                        $
                        14,933
                        
                        
                        $
                        14,933Securities
                        
                        
                        44,226
                        
                        
                        
                        44,226
                        
                        
                        
                        34,952
                        
                        
                        
                        34,952Federal
      Home Loan Bank stock
                        
                        
                        2,188
                        
                        
                        
                        2,188
                        
                        
                        
                        1,912
                        
                        
                        
                        1,912Loans,
      net
                        
                        
                        378,472
                        
                        
                        
                        380,394
                        
                        
                        
                        369,883
                        
                        
                        
                        373,116Liabilities:Noninterest-bearing
      demand deposits
                        
                        
                        40,078
                        
                        
                        
                        40,078
                        
                        
                        
                        45,285
                        
                        
                        
                        45,285Interest-bearing
      demand deposits
                        
                        
                        26,909
                        
                        
                        
                        26,909
                        
                        
                        
                        31,985
                        
                        
                        
                        31,985Savings
      deposits and money market accounts
                        
                        
                        35,848
                        
                        
                        
                        35,848
                        
                        
                        
                        49,970
                        
                        
                        
                        49,970Time
      deposits
                        
                        
                        223,749
                        
                        
                        
                        225,882
                        
                        
                        
                        186,010
                        
                        
                        
                        189,106Federal
      funds purchased and securities sold under agreements to
      repurchase
                        
                        
                        35,790
                        
                        
                        
                        35,790
                        
                        
                        
                        41,560
                        
                        
                        
                        41,560Federal
      Home Loan Bank advances and line of credit
                        
                        
                        71,250
                        
                        
                        
                        71,250
                        
                        
                        
                        47,100
                        
                        
                        
                        47,100Unrecognized
      financial instruments (net of contract amount):Commitments
      to extend credit
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
 
 Note
      13.
              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 Cornerstone’s
consolidated financial position, results of operations or cash
flows.
  63
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 Note
      14.
              Stock
      Option Plans
 
 Cornerstone
has stock option plans which are more fully described below.  For the
years ended December 31, 2008, 2007 and 2006 Cornerstone recognized
$279,400, $220,016 and $147,925 respectively, in compensation expense for all
stock options.
 
 The fair
value of each option granted is estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions:
  Years Ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006Dividend
      yield
                          
                          
                          1.47
                          %
                          
                          
                          1.33
                          %
                          
                          
                          0.98
                          %Expected
      life
                          
                          8.0
                          years
                          
                          7.0
                          years
                          
                          6.6
                          yearsExpected
      volatility
                          
                          
                          20.27
                          %
                          
                          
                          12.22
                          %
                          
                          
                          11.80
                          %Risk-free
      interest rate
                          
                          
                          4.22
                          %
                          
                          
                          4.51
                          %
                          
                          
                          5.11
                          %
 
 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
Cornerstone’s history and expectation of dividend payouts.  During
2006 Cornerstone’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.
 
 Board of
Directors plan:
 
 Cornerstone
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 common stock.  Only non-qualified stock options may be
granted under the Plan.  In addition, members of the Board of
Directors can be issued options under the Cornerstone 2002 Long-Term Incentive
Plan to purchase up to 1,200,000 shares of Cornerstone stock.  The
options available for issuance to Board members under the 2002 Long-Term
Incentive Plan are shared with officers and employees of
Cornerstone.  The exercise price of each option equals the market
price of Cornerstone’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 2006, 2007 and 2008, 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, 2008, the total remaining compensation
cost to be recognized on non-vested options is approximately
$44,000.  An analysis of this stock option plan is presented in the
following table:
 
 Years Ended December 31,2008
                                                                                            
                                                                                            
                                                                                            2007
                                                                                            
                                                                                            
                                                                                            2006Average
                                                                                            
                                                                                            
                                                                                            Aggregate
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            Average
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            AverageExercise
                                                                                            
                                                                                            
                                                                                            Intrinsic
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            Exercise
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            ExerciseShares
                                                                                            
                                                                                            
                                                                                            Price
                                                                                            
                                                                                            
                                                                                            Value(1)
                                                                                            
                                                                                            
                                                                                            Shares
                                                                                            
                                                                                            
                                                                                            Price
                                                                                            
                                                                                            
                                                                                            Share
                                                                                            
                                                                                            
                                                                                            PriceOutstanding
      at beginning of year
                                                                                            
                                                                                            
                                                                                            69,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            11.23
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            67,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            10.61
                                                                                            
                                                                                            
                                                                                            
                                                                                            90,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            3.80Granted
                                                                                            
                                                                                            
                                                                                            12,800
                                                                                            
                                                                                            
                                                                                            
                                                                                            7.99
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            9,000
                                                                                            
                                                                                            
                                                                                            
                                                                                            15.25
                                                                                            
                                                                                            
                                                                                            
                                                                                            40,000
                                                                                            
                                                                                            
                                                                                            
                                                                                            13.25Exercised
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            (5,000
                                                                                            )
                                                                                            
                                                                                            
                                                                                            9.32
                                                                                            
                                                                                            
                                                                                            
                                                                                            (63,000
                                                                                            )
                                                                                            
                                                                                            
                                                                                            2.55Forfeited
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            (2,000
                                                                                            )
                                                                                            
                                                                                            
                                                                                            13.25
                                                                                            
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            -Outstanding
      at end of year
                                                                                            
                                                                                            
                                                                                            81,800
                                                                                            
                                                                                            
                                                                                            $
                                                                                            10.73
                                                                                            
                                                                                            
                                                                                            $
                                                                                            29,608
                                                                                            
                                                                                            
                                                                                            
                                                                                            69,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            11.23
                                                                                            
                                                                                            
                                                                                            
                                                                                            67,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            10.61Options
      exercisable at year-end
                                                                                            
                                                                                            
                                                                                            64,500
                                                                                            
                                                                                            
                                                                                            $
                                                                                            10.95
                                                                                            
                                                                                            
                                                                                            $
                                                                                            29,608
                                                                                            
                                                                                            
                                                                                            
                                                                                            42,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            9.51
                                                                                            
                                                                                            
                                                                                            
                                                                                            22,500
                                                                                            
                                                                                            
                                                                                            $
                                                                                            6.20Weighted-average
      fair value of options granted during the year
                                                                                            
                                                                                            $
                                                                                            2.23
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            $
                                                                                            3.33
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            
                                                                                            $
                                                                                            3.24
  64
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
 Note 14.
Stock Option Plans (continued)
 
 (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, 2008. This amount changes based on
      changes in the market value of the Cornerstone's stock. 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, 2008, 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
                                                                                                                        
                                                                                                                        5.2
      Years
                                                                                                                        
                                                                                                                        $
                                                                                                                        5.44
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        16,000
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        5.449.23
                                                                                                                        
                                                                                                                        
                                                                                                                        8,000
                                                                                                                        
                                                                                                                        6.2
      Years
                                                                                                                        
                                                                                                                        
                                                                                                                        9.23
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        8,000
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        9.2313.25
                                                                                                                        
                                                                                                                        
                                                                                                                        36,000
                                                                                                                        
                                                                                                                        7.2
      Years
                                                                                                                        
                                                                                                                        
                                                                                                                        13.25
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        36,000
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        13.2515.25
                                                                                                                        
                                                                                                                        
                                                                                                                        9,000
                                                                                                                        
                                                                                                                        8.2
      Years
                                                                                                                        
                                                                                                                        
                                                                                                                        15.25
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        4,500
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        15.257.99
                                                                                                                        
                                                                                                                        
                                                                                                                        12,800
                                                                                                                        
                                                                                                                        9.2
      Years
                                                                                                                        
                                                                                                                        
                                                                                                                        7.99
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -Outstanding
      at end of year
                                                                                                                        
                                                                                                                        
                                                                                                                        81,800
                                                                                                                        
                                                                                                                        7.9
      Years
                                                                                                                        
                                                                                                                        
                                                                                                                        10.73
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        64,500
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        10.95
 
 Information
pertaining to non-vested options for the year ended December 31, 2008, is as
follows:
 
 Weighted AverageNumber
                                                                                  
                                                                                  
                                                                                  Grant Dateof Shares
                                                                                  
                                                                                  
                                                                                  Fair ValueNon-vested
      options, December 31, 2007
                                                                                  
                                                                                  
                                                                                  27,000
                                                                                  
                                                                                  
                                                                                  $
                                                                                  13.93Granted
                                                                                  
                                                                                  
                                                                                  12,800
                                                                                  
                                                                                  
                                                                                  
                                                                                  7.99Vested
                                                                                  
                                                                                  
                                                                                  (22,500
                                                                                  )
                                                                                  
                                                                                  
                                                                                  13.65Forfeited/expired
                                                                                  
                                                                                  
                                                                                  -
                                                                                  
                                                                                  
                                                                                  
                                                                                  -Non-vested
      options, December 31, 2008
                                                                                  
                                                                                  
                                                                                  17,300
                                                                                  
                                                                                  
                                                                                  
                                                                                  9.88The
      total fair value of shares vested during 2008 was
      approximately
                                                                                  
                                                                                  $
                                                                                  171,000.
 
 Officer
and Employee Plans:
 
 Cornerstone
has two stock option plans, the 1996 Cornerstone Statutory and Non-statutory
Option Plan and the Cornerstone 2002 Long-Term Incentive Plan, under which
officers and employees can be granted incentive stock options or non-qualified
stock options to purchase a total of up to 220,000 and 1,200,000 shares,
respectively, of Cornerstone’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, 2008, the total remaining compensation cost to
be recognized on non-vested options is approximately $573,000.  An
analysis of the activity for each of the years ending December 31, 2008, 2007
and 2006, for this stock option plan follows:
  65
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
  
 
 Note
      14.
              Stock
      Option Plans (continued)
 
 Years Ended December 31,2008
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            2007
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            2006Average
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Aggregate
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Average
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            AverageExercise
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Intrinsic
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Exercise
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            ExerciseShares
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Price
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Value(1)
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Shares
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Price
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            Shares
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            PriceOutstanding
      at beginning of year
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            715,075
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            6.52
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            669,120
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            5.79
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            632,500
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            4.64Granted
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            71,500
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            7.99
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            53,800
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            15.25
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            82,800
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            13.25Exercised
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            (22,000
                                                                                                                                                                                            )
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            3.75
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            (5,870
                                                                                                                                                                                            )
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            4.48
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            (46,180
                                                                                                                                                                                            )
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            3.54Forfeited
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            (9,150
                                                                                                                                                                                            )
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            13.34
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            (1,975
                                                                                                                                                                                            )
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            14.03
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            -
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            -Outstanding
      at end of year
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            755,425
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            6.63
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            1,634,022
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            715,075
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            6.52
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            669,120
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            5.79Options
      exercisable at year-end
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            549,516
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            4.87
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            1,634,022
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            470,990
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            4.06
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            367,120
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            3.71Weighted-average
      fair value of options granted during the year
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            2.23
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            3.33
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            
                                                                                                                                                                                            $
                                                                                                                                                                                            3.24
 
 (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, 2008.  This amount
      changes based on changes in the market value of the Cornerstone's stock.
      The total intrinsic value of options exercised during 2008 was
      approximately $78,000.  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, 2008, 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
                                                                                              
                                                                                              
                                                                                              346,600
                                                                                              
                                                                                              2.8
      Years
                                                                                              
                                                                                              $
                                                                                              3.50
                                                                                              
                                                                                              
                                                                                              
                                                                                              346,600
                                                                                              
                                                                                              
                                                                                              $
                                                                                              3.505.44
                                                                                              
                                                                                              
                                                                                              132,440
                                                                                              
                                                                                              5.2
      Years
                                                                                              
                                                                                              
                                                                                              5.44
                                                                                              
                                                                                              
                                                                                              
                                                                                              132,440
                                                                                              
                                                                                              
                                                                                              
                                                                                              5.449.23
                                                                                              
                                                                                              
                                                                                              78,910
                                                                                              
                                                                                              6.2
      Years
                                                                                              
                                                                                              
                                                                                              9.23
                                                                                              
                                                                                              
                                                                                              
                                                                                              47,346
                                                                                              
                                                                                              
                                                                                              
                                                                                              9.2313.25
                                                                                              
                                                                                              
                                                                                              77,100
                                                                                              
                                                                                              7.2
      Years
                                                                                              
                                                                                              
                                                                                              13.25
                                                                                              
                                                                                              
                                                                                              
                                                                                              23,130
                                                                                              
                                                                                              
                                                                                              
                                                                                              13.2515.25
                                                                                              
                                                                                              
                                                                                              46,875
                                                                                              
                                                                                              8.2
      Years
                                                                                              
                                                                                              
                                                                                              15.25
                                                                                              
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              -15.20
                                                                                              
                                                                                              
                                                                                              2,750
                                                                                              
                                                                                              8.3
      Years
                                                                                              
                                                                                              
                                                                                              15.20
                                                                                              
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              -7.99
                                                                                              
                                                                                              
                                                                                              70,750
                                                                                              
                                                                                              9.2
      Years
                                                                                              
                                                                                              
                                                                                              7.99
                                                                                              
                                                                                              
                                                                                              
                                                                                              -
                                                                                              
                                                                                              
                                                                                              
                                                                                              -Outstanding
      at end of year
                                                                                              
                                                                                              
                                                                                              755,425
                                                                                              
                                                                                              5.0
      Years
                                                                                              
                                                                                              
                                                                                              6.63
                                                                                              
                                                                                              
                                                                                              
                                                                                              549,516
                                                                                              
                                                                                              
                                                                                              
                                                                                              4.87
  66
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note
      14.
              Stock
      Option Plans (continued)
 
 Information
pertaining to non-vested options for the year ended December 31, 2008, is as
follows:
 
 Weighted AverageNumber
                                                        
                                                        
                                                        Grant Dateof Shares
                                                        
                                                        
                                                        Fair ValueNon-vested
      options, December 31, 2007
                                                        
                                                        
                                                        244,085
                                                        
                                                        
                                                        $
                                                        11.08Granted
                                                        
                                                        
                                                        71,500
                                                        
                                                        
                                                        
                                                        7.99Vested
                                                        
                                                        
                                                        (100,526
                                                        )
                                                        
                                                        
                                                        8.15Forfeited/expired
                                                        
                                                        
                                                        (9,150
                                                        )
                                                        
                                                        
                                                        13.34Non-vested
      options, December 31, 2008
                                                        
                                                        
                                                        205,909
                                                        
                                                        
                                                        
                                                        11.31
 
 The total
fair value of shares vested during 2008 was approximately $693,000.
 
 Note
      15.
              Liquidity
      and Capital Resources
 
 Cornerstone’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
      16.
              Regulatory
      Matters
 
 Cornerstone
(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 Cornerstone’s and the Bank's financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, Cornerstone and the Bank must meet
specific capital guidelines that involve quantitative measures of Cornerstone’s
and the Bank's assets, liabilities, and certain off-balance-sheet items as
calculated under regulatory accounting practices.  Cornerstone’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.  Prompt corrective action provisions are not applicable to
bank holding companies.
 
 Quantitative
measures established by regulation to ensure capital adequacy require
Cornerstone 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, 2008 and 2007, that Cornerstone and the Bank meet all
capital adequacy requirements to which they are subject.
 
 As of
December 31, 2008, the most recent notification from the Federal Deposit
Insurance Corporation categorized the Bank as well capitalized under the
regulatory framework for prompt corrective action.  To be categorized
as well 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.
  67
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note
      16.
              Regulatory
      Matters (continued)
 
 Cornerstone’s
and the Bank's actual capital amounts and ratios are also presented in the
table.  Dollar amounts are presented in thousands.
 
 MinimumCapital
                                                                              
                                                                              
                                                                              Minimum To BeActual
                                                                              
                                                                              
                                                                              Requirements
                                                                              
                                                                              
                                                                              Well CapitalizedAmount
                                                                              
                                                                              
                                                                              Ratio
                                                                              
                                                                              
                                                                              Amount
                                                                              
                                                                              
                                                                              Ratio
                                                                              
                                                                              
                                                                              Amount
                                                                              
                                                                              
                                                                              RatioAs
      of December 31, 2008:Total
      capital to risk-weighted assets:Consolidated
                                                                              
                                                                              $
                                                                              38,974
                                                                              
                                                                              
                                                                              
                                                                              9.7
                                                                              %
                                                                              
                                                                              $
                                                                              32,282
                                                                              
                                                                              
                                                                              
                                                                              8.0
                                                                              %
                                                                              
                                                                              
                                                                              N/A
                                                                              
                                                                              
                                                                              
                                                                              N/ACornerstone
      Community Bank
                                                                              
                                                                              
                                                                              41,410
                                                                              
                                                                              
                                                                              
                                                                              10.3
                                                                              %
                                                                              
                                                                              
                                                                              32,130
                                                                              
                                                                              
                                                                              
                                                                              8.0
                                                                              %
                                                                              
                                                                              $
                                                                              40,163
                                                                              
                                                                              
                                                                              
                                                                              10.0
                                                                              %Tier
      1 capital to risk-weighted assets:Consolidated
                                                                              
                                                                              
                                                                              33,873
                                                                              
                                                                              
                                                                              
                                                                              8.4
                                                                              %
                                                                              
                                                                              
                                                                              16,141
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              N/A
                                                                              
                                                                              
                                                                              
                                                                              N/ACornerstone
      Community Bank
                                                                              
                                                                              
                                                                              36,336
                                                                              
                                                                              
                                                                              
                                                                              9.1
                                                                              %
                                                                              
                                                                              
                                                                              16,065
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              24,098
                                                                              
                                                                              
                                                                              
                                                                              6.0
                                                                              %Tier
      1 capital to average assets:Consolidated
                                                                              
                                                                              
                                                                              33,873
                                                                              
                                                                              
                                                                              
                                                                              7.4
                                                                              %
                                                                              
                                                                              
                                                                              18,390
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              N/A
                                                                              
                                                                              
                                                                              
                                                                              N/ACornerstone
      Community Bank
                                                                              
                                                                              
                                                                              36,336
                                                                              
                                                                              
                                                                              
                                                                              7.9
                                                                              %
                                                                              
                                                                              
                                                                              18,339
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              22,924
                                                                              
                                                                              
                                                                              
                                                                              5.0
                                                                              %As
      of December 31, 2007:Total
      capital to risk-weighted assets:Consolidated
                                                                              
                                                                              $
                                                                              38,353
                                                                              
                                                                              
                                                                              
                                                                              9.7
                                                                              %
                                                                              
                                                                              $
                                                                              31,660
                                                                              
                                                                              
                                                                              
                                                                              8.0
                                                                              %
                                                                              
                                                                              
                                                                              N/A
                                                                              
                                                                              
                                                                              
                                                                              N/ACornerstone
      Community Bank
                                                                              
                                                                              
                                                                              36,651
                                                                              
                                                                              
                                                                              
                                                                              9.3
                                                                              %
                                                                              
                                                                              
                                                                              31,409
                                                                              
                                                                              
                                                                              
                                                                              8.0
                                                                              %
                                                                              
                                                                              $
                                                                              39,261
                                                                              
                                                                              
                                                                              
                                                                              10.0
                                                                              %Tier
      1 capital to risk-weighted assets:Consolidated
                                                                              
                                                                              
                                                                              33,297
                                                                              
                                                                              
                                                                              
                                                                              8.4
                                                                              %
                                                                              
                                                                              
                                                                              15,830
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              N/A
                                                                              
                                                                              
                                                                              
                                                                              N/ACornerstone
      Community Bank
                                                                              
                                                                              
                                                                              31,635
                                                                              
                                                                              
                                                                              
                                                                              8.1
                                                                              %
                                                                              
                                                                              
                                                                              15,704
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              23,556
                                                                              
                                                                              
                                                                              
                                                                              6.0
                                                                              %Tier
      1 capital to average assets:Consolidated
                                                                              
                                                                              
                                                                              33,297
                                                                              
                                                                              
                                                                              
                                                                              7.7
                                                                              %
                                                                              
                                                                              
                                                                              17,282
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              N/A
                                                                              
                                                                              
                                                                              
                                                                              N/ACornerstone
      Community Bank
                                                                              
                                                                              
                                                                              31,635
                                                                              
                                                                              
                                                                              
                                                                              7.4
                                                                              %
                                                                              
                                                                              
                                                                              17,187
                                                                              
                                                                              
                                                                              
                                                                              4.0
                                                                              %
                                                                              
                                                                              
                                                                              21,484
                                                                              
                                                                              
                                                                              
                                                                              5.0
                                                                              %
  68
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note
      17.
              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, 2008,
2007 and 2006, is as follows:
 
 TaxBefore-Tax
                                                                                                                        
                                                                                                                        
                                                                                                                        (Expense)
                                                                                                                        
                                                                                                                        
                                                                                                                        Net-of-TaxAmount
                                                                                                                        
                                                                                                                        
                                                                                                                        Benefit
                                                                                                                        
                                                                                                                        
                                                                                                                        AmountYear
      ended December 31, 2008:Unrealized
      holding gains and losses arising during the period
                                                                                                                        
                                                                                                                        $
                                                                                                                        (444,690
                                                                                                                        )
                                                                                                                        
                                                                                                                        $
                                                                                                                        151,196
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        (293,494
                                                                                                                        )Less
      reclassification adjustment for gains realized in net
    income
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -$
                                                                                                                        (444,690
                                                                                                                        )
                                                                                                                        
                                                                                                                        $
                                                                                                                        151,196
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        (293,494
                                                                                                                        )Year
      ended December 31, 2007:Unrealized
      holding gains and losses arising during the period
                                                                                                                        
                                                                                                                        $
                                                                                                                        250,886
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        (85,301
                                                                                                                        )
                                                                                                                        
                                                                                                                        $
                                                                                                                        165,585Less
      reclassification adjustment for gains realized in net
    income
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -$
                                                                                                                        250,886
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        (85,301
                                                                                                                        )
                                                                                                                        
                                                                                                                        $
                                                                                                                        165,585Year
      ended December 31, 2006:Unrealized
      holding gains and losses arising during the period
                                                                                                                        
                                                                                                                        $
                                                                                                                        162,632
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        (55,295
                                                                                                                        )
                                                                                                                        
                                                                                                                        $
                                                                                                                        107,337Less
      reclassification adjustment for gains realized in net
    income
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -
                                                                                                                        
                                                                                                                        
                                                                                                                        
                                                                                                                        -$
                                                                                                                        162,632
                                                                                                                        
                                                                                                                        
                                                                                                                        $
                                                                                                                        (55,295
                                                                                                                        )
                                                                                                                        
                                                                                                                        $
                                                                                                                        107,337
 
 Note
      18.
              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 Cornerstone relate to outstanding stock
options, determined using the treasury stock method.
  69
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note 18.
              Earnings
      Per Common Share (continued)
 
 Earnings
per common share have been computed based on the following:
 
 2008
                                                                      
                                                                      
                                                                      2007
                                                                      
                                                                      
                                                                      2006Net
      income
                                                                      
                                                                      $
                                                                      2,511,824
                                                                      
                                                                      
                                                                      $
                                                                      871,152
                                                                      
                                                                      
                                                                      $
                                                                      5,811,600Less:  Preferred
      stock dividends
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      -Net
      income applicable to common stock
                                                                      
                                                                      $
                                                                      2,511,824
                                                                      
                                                                      
                                                                      $
                                                                      871,152
                                                                      
                                                                      
                                                                      $
                                                                      5,811,600Average
      number of common shares outstanding
                                                                      
                                                                      
                                                                      6,322,150
                                                                      
                                                                      
                                                                      
                                                                      6,498,794
                                                                      
                                                                      
                                                                      
                                                                      6,481,568Effect
      of dilutive stock options
                                                                      
                                                                      
                                                                      136,826
                                                                      
                                                                      
                                                                      
                                                                      339,346
                                                                      
                                                                      
                                                                      
                                                                      352,630Average
      number of common shares outstanding used to calculate diluted earnings per
      common share
                                                                      
                                                                      
                                                                      6,458,976
                                                                      
                                                                      
                                                                      
                                                                      6,838,140
                                                                      
                                                                      
                                                                      
                                                                      6,834,198
 
 The
effects of outstanding antidilutive stock options are excluded from the
computation of diluted earnings per share.  There were 329,526 and
62,150 antidilutive stock options for 2008 and 2007,
respectively.  There were no antidilutive stock options during
2006.  During 2006, Cornerstone enacted a 2-for-1 split in the form of
stock dividend.
 
 Note
      19.
              Recent
      Accounting Pronouncements
 
 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. Cornerstone adopted the guidance of SFAS 157 beginning
January 1, 2008, and the adoption did not have a material impact on
Cornerstone’s consolidated financial statements.
 
 On
October 10, 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of
a Financial Asset When the Market for That Asset Is Not Active” (FSP FAS 157-3).
FSP FAS 157-3 clarifies the application of SFAS 157 in a market that is not
active and provides an example to illustrate key considerations in determining
the fair value of a financial asset when the market for that financial asset is
not active.  FSP FAS 157-3 is effective upon issuance,
including prior periods for when financial statements have not been
issued.  Cornerstone adopted FSP FAS 157-3 for the period ended
December 31, 2008, and the adoption did not have any significant impact on
Cornerstone’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. Cornerstone 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
Cornerstone’s consolidated financial statements.
  70
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note
      19.
              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. Cornerstone 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. Cornerstone is currently evaluating the impact of adopting the
statement, which is effective for fiscal years beginning on or after December
15, 2008.
 
 During
March 2008, the FASB issued Statement of Financial Accounting Standards No. 161,
“Disclosures about Derivative Instruments and Hedging Activities – An Amendment
of FASB Statement No. 133” (SFAS 161).  SFAS 161 amends and
expands the disclosure requirements of SFAS No. 133 “Accounting for Derivative
Instruments and Hedging Activities” (SFAS 133) with the intent to provide users
of financial statements with an enhanced understanding of: (a) how and why an
entity uses derivative instruments; (b) how derivative instruments and related
hedged items are accounted for under SFAS 133 and its related interpretations;
and (c) how derivative instruments and related hedged items affect an entity’s
financial position, financial performance, and cash flows.  To meet
those objectives, SFAS 161 requires qualitative disclosures about objectives and
strategies for using derivatives, quantitative disclosures about fair value
amounts of and gains and losses on derivative instruments, and disclosures about
credit-risk-related contingent features in derivative
agreements.  SFAS 161 is effective for financial statements issued for
fiscal years and interim periods beginning after November 15,
2008.  The adoption is not expected to have a material effect on the
consolidated financial statements.
 
 During
May 2008, the FASB issued Statement of Financial Accounting Standards No. 162,
“The Hierarchy of Generally Accepted Accounting Principles” (SFAS
162).  This Statement identifies the sources of accounting principles
and the framework for selecting the principles to be used in the preparation of
financial statements of nongovernmental entities that are presented in
conformity with generally accepted accounting principles (GAAP) in the United
States.  This Statement is effective 60 days following the SEC
approval of the Public Company Accounting Oversight Board amendments to AU
Section 411, “The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles.”  Adoption of SFAS 162 will not be a
change in Cornerstone’s current accounting practices; therefore, it will not
have a material impact on Cornerstone’s consolidated financial condition or
results of operations.
 
 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”. Cornerstone adopted EITF 06-4
effective as of January 1, 2008, and the adoption did not have a material
impact on Cornerstone’s consolidated financial statements.
  71
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note
      19.
              Recent
      Accounting Pronouncements
(continued)
 
 During
June 2008, the FASB issued FASB Staff Position EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions are Participating
Securities” (EITF 03-6-1).  EITF 03-6-1 clarifies whether
instruments, such as restricted stock, granted in share-based payments are
participating securities prior to vesting.  Such participating
securities must be included in the computation of earnings per share under the
two-class method as described in SFAS No. 128, “Earnings per
Share.”  EITF 03-6-1 requires companies to treat unvested share-based
payment awards that have non-forfeitable rights to dividend or dividend
equivalents as a separate class of securities in calculating earnings per
share.  EITF 03-6-1 is effective for financial statements issued for
fiscal years and interim periods beginning after December 15, 2008, and
requires a company to retrospectively adjust its earnings per share
data.  Early adoption is not permitted.  It is not expected
that the adoption of EITF 03-6-1 will have a material effect on consolidated
results of operations or earnings per share.
 
 In
December 2008, the FASB issued FASB Staff Position No. FAS 140-4 and FIN
46(R)-8, “Disclosures about Transfers of Financial Assets and Interests in
Variable Interest Entities” (FSP 140-4 and 46(R)-8). This FSP requires
additional disclosures by public entities with continuing involvement in
transfers of financial assets to special purpose entities and with variable
interests in VIEs, including sponsors that have a variable interest in a VIE.
Additionally, this FSP requires certain disclosures to be provided by a public
entity that is (1) a sponsor of a qualifying special-purpose entity (SPE)
that holds a variable interest in the qualifying SPE but was not the transferor
(nontransferor) of financial assets to the qualifying SPE, and (2) a
servicer of a qualifying SPE that holds a significant variable interest in the
qualifying SPE but was not the transferor (nontransferor) of financial assets to
the qualifying SPE. This FSP is effective for the first reporting period
(interim or annual) that ends after December 15, 2008. Cornerstone adopted
FSP 140-4 and 46(R)-8 as of December 31, 2008, and its adoption did not
have a significant impact on the consolidated financial statements.
 
 Cornerstone
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.
 
 Note
      20.
              Equity
      Investment
 
 During
2006, Cornerstone 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, Cornerstone and
other investors will receive new market tax credits.  For 2008, 2007
and 2006 Cornerstone received approximately $150,000, $300,000 and $150,000,
respectively, in new market tax credits.
 
 AFG meets
the criteria of a VIE outlined in FIN 46-R.  AFG has not been
consolidated by Cornerstone as Cornerstone is not the primary
beneficiary.
  72
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note
      21.
              Condensed
      Parent Information
 
 BALANCE SHEETSDecember 31,
                                                                    
                                                                    
                                                                    December 31,2008
                                                                    
                                                                    
                                                                    2007ASSETSCash
                                                                    
                                                                    $
                                                                    439,440
                                                                    
                                                                    
                                                                    $
                                                                    387,064Investment
      in subsidiaries
                                                                    
                                                                    
                                                                    37,295,042
                                                                    
                                                                    
                                                                    
                                                                    33,257,674Loan
      to subsidiary
                                                                    
                                                                    
                                                                    450,000
                                                                    
                                                                    
                                                                    
                                                                    750,000Goodwill
                                                                    
                                                                    
                                                                    2,541,476
                                                                    
                                                                    
                                                                    
                                                                    2,541,476Other
      assets
                                                                    
                                                                    
                                                                    513,738
                                                                    
                                                                    
                                                                    
                                                                    201,448Total
      assets
                                                                    
                                                                    $
                                                                    41,239,696
                                                                    
                                                                    
                                                                    $
                                                                    37,137,662LIABILITIES
      AND STOCKHOLDERS’ EQUITYOther
      liabilities
                                                                    
                                                                    $
                                                                    488,187
                                                                    
                                                                    
                                                                    $
                                                                    710,312Line
      of credit
                                                                    
                                                                    
                                                                    4,250,000
                                                                    
                                                                    
                                                                    
                                                                    100,000Total
      liabilities
                                                                    
                                                                    
                                                                    4,738,187
                                                                    
                                                                    
                                                                    
                                                                    810,312Stockholders’
      equity
                                                                    
                                                                    
                                                                    36,501,509
                                                                    
                                                                    
                                                                    
                                                                    36,327,350Total
      liabilities and stockholders’ equity
                                                                    
                                                                    $
                                                                    41,239,696
                                                                    
                                                                    
                                                                    $
                                                                    37,137,662
 
 STATEMENTS OF INCOMEYears Ended December 31,2008
                                                                  
                                                                  
                                                                  2007
                                                                  
                                                                  
                                                                  2006INCOMEDividends
                                                                  
                                                                  $
                                                                  1,475,325
                                                                  
                                                                  
                                                                  $
                                                                  1,280,260
                                                                  
                                                                  
                                                                  $
                                                                  590,130Interest
      income
                                                                  
                                                                  
                                                                  33,336
                                                                  
                                                                  
                                                                  
                                                                  158,039
                                                                  
                                                                  
                                                                  
                                                                  139,9351,508,661
                                                                  
                                                                  
                                                                  
                                                                  1,438,299
                                                                  
                                                                  
                                                                  
                                                                  730,065EXPENSESInterest
      expense
                                                                  
                                                                  
                                                                  137,421
                                                                  
                                                                  
                                                                  
                                                                  24,882
                                                                  
                                                                  
                                                                  
                                                                  1,632Other
      operating expenses
                                                                  
                                                                  
                                                                  1,225,402
                                                                  
                                                                  
                                                                  
                                                                  623,405
                                                                  
                                                                  
                                                                  
                                                                  914,786Income
      (loss) before equity in undistributed earnings
                                                                  
                                                                  
                                                                  145,838
                                                                  
                                                                  
                                                                  
                                                                  790,012
                                                                  
                                                                  
                                                                  
                                                                  (186,353
                                                                  )Equity
      in undistributed earnings (loss) of subsidiary
                                                                  
                                                                  
                                                                  1,830,862
                                                                  
                                                                  
                                                                  
                                                                  (228,170
                                                                  )
                                                                  
                                                                  
                                                                  5,700,951Income
      tax benefit
                                                                  
                                                                  
                                                                  535,124
                                                                  
                                                                  
                                                                  
                                                                  309,310
                                                                  
                                                                  
                                                                  
                                                                  297,002Net
      income
                                                                  
                                                                  $
                                                                  2,511,824
                                                                  
                                                                  
                                                                  $
                                                                  871,152
                                                                  
                                                                  
                                                                  $
                                                                  5,811,600
  73
  CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 
 Note
      21.
              Condensed
      Parent Information (continued)
 
 2008
                                                                                                            
                                                                                                            
                                                                                                            2007
                                                                                                            
                                                                                                            
                                                                                                            2006STATEMENTS OF CASH FLOWSCASH
      FLOWS FROM OPERATING ACTIVITIESNet
      income
                                                                                                            
                                                                                                            $
                                                                                                            2,511,824
                                                                                                            
                                                                                                            
                                                                                                            $
                                                                                                            871,152
                                                                                                            
                                                                                                            
                                                                                                            $
                                                                                                            5,811,600Adjustments
      to reconcile net income to net cash provided by operating
      activities:Stock
      compensation expense
                                                                                                            
                                                                                                            
                                                                                                            279,400
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            220,016
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            147,925Equity
      in undistributed income of subsidiary
                                                                                                            
                                                                                                            
                                                                                                            (1,830,862
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            228,170
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            (5,700,951
                                                                                                            )Other
                                                                                                            
                                                                                                            
                                                                                                            (534,415
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            19,095
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            895,292Net
      cash provided by operating activities
                                                                                                            
                                                                                                            
                                                                                                            425,947
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            1,338,433
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            1,153,866CASH
      FLOWS FROM INVESTING ACTIVITIESRepayment
      from (loan to) subsidiary
                                                                                                            
                                                                                                            
                                                                                                            300,000
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            2,119,500
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            (1,440,706
                                                                                                            )Capital
      contribution to subsidiary
                                                                                                            
                                                                                                            
                                                                                                            (2,500,000
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            -
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            -Net
      cash (used in) provided by investing activities
                                                                                                            
                                                                                                            
                                                                                                            (2,200,000
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            2,119,500
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            (1,440,706
                                                                                                            )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      borrowings (repayments) under line of credit
                                                                                                            
                                                                                                            
                                                                                                            4,150,000
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            (400,000
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            500,000Purchase
      of common stock
                                                                                                            
                                                                                                            
                                                                                                            (633,049
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            (1,751,291
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            (206,807
                                                                                                            )Payment
      of dividends
                                                                                                            
                                                                                                            
                                                                                                            (1,773,022
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            (1,303,577
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            (775,138
                                                                                                            )Issuance
      of common stock
                                                                                                            
                                                                                                            
                                                                                                            82,500
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            72,926
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            563,299Net
      cash provided by (used in) financing activities
                                                                                                            
                                                                                                            
                                                                                                            1,826,429
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            (3,381,942
                                                                                                            )
                                                                                                            
                                                                                                            
                                                                                                            81,354NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
                                                                                                            
                                                                                                            
                                                                                                            52,376
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            75,991
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            (205,486
                                                                                                            )CASH
      AND CASH EQUIVALENTS, beginning of year
                                                                                                            
                                                                                                            
                                                                                                            387,064
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            311,073
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            516,559CASH
      AND CASH EQUIVALENTS, end of year
                                                                                                            
                                                                                                            $
                                                                                                            439,440
                                                                                                            
                                                                                                            
                                                                                                            $
                                                                                                            387,064
                                                                                                            
                                                                                                            
                                                                                                            $
                                                                                                            311,073SUPPLEMENTAL
      DISCLOSURES OF CASH FLOWINFORMATIONCash
      paid during the year for:Interest
                                                                                                            
                                                                                                            $
                                                                                                            137,421
                                                                                                            
                                                                                                            
                                                                                                            $
                                                                                                            24,882
                                                                                                            
                                                                                                            
                                                                                                            $
                                                                                                            1,632Income
      taxes
                                                                                                            
                                                                                                            
                                                                                                            -
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            3,592,300
                                                                                                            
                                                                                                            
                                                                                                            
                                                                                                            2,944,000
  74


CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARIES
 
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2008, 2007 and 2006
 
 
 Note
22.  Quarterly Data (unaudited)
 
 Years
      Ended December 31,2008
                  
                  
                  2007Fourth
                  
                  
                  Third
                  
                  
                  Second
                  
                  
                  First
                  
                  
                  Fourth
                  
                  
                  Third
                  
                  
                  Second
                  
                  
                  FirstQuarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  Quarter
                  
                  
                  QuarterInterest
      income
                  
                  $
                  7,400,732
                  
                  
                  $
                  7,462,473
                  
                  
                  $
                  7,756,905
                  
                  
                  $
                  8,060,064
                  
                  
                  $
                  8,857,394
                  
                  
                  $
                  9,109,824
                  
                  
                  $
                  8,743,087
                  
                  
                  $
                  8,073,213Interest
      expense
                  
                  
                  2,977,990
                  
                  
                  
                  3,026,759
                  
                  
                  
                  3,223,449
                  
                  
                  
                  3,469,876
                  
                  
                  
                  3,970,038
                  
                  
                  
                  3,785,203
                  
                  
                  
                  3,469,307
                  
                  
                  
                  3,189,057Net
      interest income, before provision for loan losses
                  
                  
                  4,422,742
                  
                  
                  
                  4,435,714
                  
                  
                  
                  4,533,456
                  
                  
                  
                  4,590,188
                  
                  
                  
                  4,887,356
                  
                  
                  
                  5,324,621
                  
                  
                  
                  5,273,780
                  
                  
                  
                  4,884,156Provision
      for loan losses
                  
                  
                  2,571,000
                  
                  
                  
                  440,000
                  
                  
                  
                  170,000
                  
                  
                  
                  317,000
                  
                  
                  
                  7,208,865
                  
                  
                  
                  2,963,500
                  
                  
                  
                  235,000
                  
                  
                  
                  2,000Net
      interest (loss) income, after provision for loan losses
                  
                  
                  1,851,742
                  
                  
                  
                  3,995,714
                  
                  
                  
                  4,363,456
                  
                  
                  
                  4,273,188
                  
                  
                  
                  (2,321,509
                  )
                  
                  
                  2,361,121
                  
                  
                  
                  5,038,780
                  
                  
                  
                  4,882,156Noninterest
      income
                  
                  
                  496,420
                  
                  
                  
                  476,733
                  
                  
                  
                  524,572
                  
                  
                  
                  394,306
                  
                  
                  
                  471,459
                  
                  
                  
                  380,233
                  
                  
                  
                  439,404
                  
                  
                  
                  403,994Noninterest
      expenses
                  
                  
                  3,104,109
                  
                  
                  
                  3,151,037
                  
                  
                  
                  3,215,991
                  
                  
                  
                  3,096,628
                  
                  
                  
                  2,856,953
                  
                  
                  
                  2,370,989
                  
                  
                  
                  3,011,708
                  
                  
                  
                  2,685,951(Loss)
      income before income taxes
                  
                  
                  (755,947
                  )
                  
                  
                  1,321,410
                  
                  
                  
                  1,672,037
                  
                  
                  
                  1,570,866
                  
                  
                  
                  (4,707,003
                  )
                  
                  
                  370,365
                  
                  
                  
                  2,466,476
                  
                  
                  
                  2,600,199Income
      tax (benefit) expense
                  
                  
                  (319,640
                  )
                  
                  
                  461,194
                  
                  
                  
                  598,981
                  
                  
                  
                  556,007
                  
                  
                  
                  (1,802,855
                  )
                  
                  
                  (188,971
                  )
                  
                  
                  902,289
                  
                  
                  
                  948,422Net
      (loss) income
                  
                  $
                  (436,307
                  )
                  
                  $
                  860,216
                  
                  
                  $
                  1,073,056
                  
                  
                  $
                  1,014,859
                  
                  
                  $
                  (2,904,148
                  )
                  
                  $
                  559,336
                  
                  
                  $
                  1,564,187
                  
                  
                  $
                  1,651,777Earnings
      (loss) per common share:Basic
                  
                  $
                  (0.07
                  )
                  
                  $
                  0.14
                  
                  
                  $
                  0.17
                  
                  
                  $
                  0.16
                  
                  
                  $
                  (0.45
                  )
                  
                  $
                  0.09
                  
                  
                  $
                  0.24
                  
                  
                  $
                  0.25Diluted
                  
                  $
                  (0.06
                  )
                  
                  $
                  0.13
                  
                  
                  $
                  0.17
                  
                  
                  $
                  0.15
                  
                  
                  $
                  (0.42
                  )
                  
                  $
                  0.08
                  
                  
                  $
                  0.23
                  
                  
                  $
                  0.24
  75




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(T).  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’s Report on Internal
Control over Financial Reporting


The
report of Cornerstone’s management on internal control over financial reporting
is set forth in Item 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, 2008 that have
materially affected, or are reasonably likely to materially affect,
Cornerstone’s internal control over financial reporting.





ITEM
9B. OTHER INFORMATION





There is
no other information that should be disclosed or included in this Item
9B.





PART
III





ITEM
10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE





Information
relating to the directors and executive officers of Cornerstone is set forth
under the caption “Proposals - Election of Directors” in Cornerstone’s 2009
Proxy Statement. Such information is incorporated into this report by
reference.  Such information is incorporated into this report by
reference.





Information
relating to Cornerstone’s audit committee and audit committee financial experts
is set forth under the caption “Corporate Governance and the Board of
Directors—Audit Committee” in Cornerstone’s 2009 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
beneficially 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 “Other Matters—Section 16(a) Beneficial Ownership
Reporting Compliance” in Cornerstone’s 2009 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.


76


ITEM
11.  EXECUTIVE COMPENSATION





Information
relating to executive compensation and the compensation committee report is set
forth under the captions “Compensation Discussion and Analysis” and “Executive
Compensation” in Cornerstone’s 2009 Proxy Statement.  Such information
is incorporated into this report by reference.





Information
relating to compensation committee interlocks and insider participation is set
forth under the caption “Human Resource/Compensation Committee—Compensation
Committee Interlocks and Insider Participation” in Cornerstone’s 2009 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 beneficial 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 2009 Proxy Statement.  Such
information is incorporated into this report by reference.




Information
relating to Cornerstone’s equity compensation plans is set forth under the
caption “The Company’s Long-Term Equity and Qualified Retirements Plans” in
Cornerstone’s 2009 Proxy Statement.  Such information is incorporated
into this report by reference.





ITEM
      13.
            CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS, AND
      DIRECTOR  INDEPENDENCE





Information
relating to certain transactions between Cornerstone and its affiliates and
certain other persons and to Cornerstone’s policies and procedures for approval
of such transactions is set forth under the captions “Certain Relationships and
Related Transactions” and “Corporate Governance and the Board of
Directors—Policies and Procedures for Approval of Related Person Transactions”
in Cornerstone’s 2009 Proxy Statement.  Such information is
incorporated into this report by reference.





Information
relating to director independence is set forth under the caption “Corporate
Governance and the Board of Directors—Board Composition and Director
Independence” in Cornerstone’s 2009 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 2009 Proxy
Statement.  Such information is incorporated into this report by
reference.





ITEM
15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES







(a)
              The
      following documents are filed as part of this report:(1)
              Financial
      StatementsThe
      following report and consolidated financial statements of Cornerstone and
      Subsidiaries are included in Item 8:Report
      of Independent Registered Public Accounting FirmConsolidated
      Balance Sheets as of December 31, 2008 and 2007Consolidated
      Statements of Income for the years ended December 31, 2008, 2007 and
      2006Consolidated
      Statement of Changes in Stockholders’ Equity for the years ended December
      31, 2008, 2007 and 2006Consolidated
      Statements of Cash Flows for the years ended December 31, 2008, 2007 and
      2006Notes
      to Consolidated Financial Statements(2)
              Financial
      Statement Schedules:Schedule
      II: Valuation and Qualifying AccountsAll
      other schedules for which provision is made in the applicable accounting
      regulation of the Securities and Exchange Commission are not required
      under the related instructions or are inapplicable and therefore have been
      omitted.(3)
              The
      following documents are filed or incorporated by reference as exhibits to
      this report:




77




Exhibit No.
              
              Description3.1
              
              Amended
      and Restated Charter 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, 3.2 and 3.3 respectively.10.1*
              
              Cornerstone
      Community Bank Employee Stock Ownership Plan (4)14
              
              Code
      of Ethics. (5)21
              
              Subsidiaries
      of the registrant.31.1
              
              Certification
      of principal executive officer.31.2
              
              Certification
      of principal financial officer.32
              
              Section
      906 certifications of chief executive officer and chief financial
      officer.





*
            This
      item is a management contract or compensatory plan or arrangement required
      to be filed as an exhibit to this Form 10-K pursuant to Item 15(b) of this
      report.





(1)
            Incorporated
      by reference to Exhibit 3.1 of the registrant’s Form 10-KSB filed on March
      24, 2004 (File No. 000-30497).


(2)
            Incorporated
      by reference to Exhibit 3 of the registrant’s Form 10-Q filed on May
      14, 2004 (File No.
000-30497).





(3)
            Incorporated
      by reference to Exhibit 3.2 of the registrant’s Form 10-KSB filed on March
      24, 2004 (File No. 000-30497).


(4)
            Incorporated
      by reference to Exhibit 10.1 of the registrant’s Form 8-K filed on July
      19, 2005 (File No. 000-30497).


(5)
            Incorporated
      by reference to Exhibit 14 of the registrant’s Form 10-KSB filed on March
      24, 2004 (File No. 000-30497).


78


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 19,
    2009
              By:
              /s/  Gregory B.
    JonesGregory
      B. JonesChairman
      and Chief Executive Officer(principal
      executive officer)By:
              /s/  Nathaniel F.
      HughesNathaniel
      F. HughesPresident
      and Treasurer(principal
      financial officer and accounting
officer)


79


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 19, 2009.








Signature
                    
                    Title/s/  Gregory B.
    Jones
                    
                    Chairman of the Board and Chief Executive
      OfficerGregory
      B. Jones
                    
                    and  Director
      (principal executive officer)/s/  B. Kenneth
      Driver
                    
                    DirectorB.
      Kenneth Driver/s/  Karl
Fillauer
                    
                    DirectorKarl
      Fillauer/s/  Nathaniel F.
      Hughes
                    
                    President
      and TreasurerNathaniel
      F. Hughes
                    
                    (principal
      financial officer and accounting officer) and Director/s/  Jerry D. Lee
                    
                    Executive Vice President and Senior
      LenderJerry
      D. Lee
                    
                    and
      Director/s/  Lawrence D.
      Levine
                    
                    DirectorLawrence
      D. Levine/s/ Frank S. McDonald
                    
                    DirectorFrank
      S. McDonald/s/  Doyce G.
    Payne
                    
                    DirectorDoyce
      G. Payne/s/  W. Miller
      Welborn
                    
                    DirectorW.
      Miller Welborn/s/  Billy O.
    Wiggins
                    
                    DirectorBilly
      O. Wiggins/s/  Marsha
    Yessick
                    
                    DirectorMarsha
      Yessick


80


INDEX OF
EXHIBITS





Exhibit
      No.
              
              Description3.1
              
              Amended
      and Restated Charter 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, 3.2 and 3.3 respectively.10.1*
              
              Cornerstone
      Community Bank Employee Stock Ownership Plan (4)14
              
              Code
      of Ethics. (5)21
              
              Subsidiaries
      of the registrant.31.1
              
              Certification
      of principal executive officer.31.2
              
              Certification
      of principal financial officer.32
              
              Section
      906 certifications of chief executive officer and chief financial
      officer.





*
            This
      item is a management contract or compensatory plan or arrangement required
      to be filed as an exhibit to this Form 10-K pursuant to Item 15(b) of this
      report.





(1)
            Incorporated
      by reference to Exhibit 3.1 of the registrant’s Form 10-KSB filed on March
      24, 2004 (File No. 000-30497).


(2)
            Incorporated
      by reference to Exhibit 3 of the registrant’s Form 10-Q filed on May
      14, 2004 (File No.
000-30497).





(5)
            Incorporated
      by reference to Exhibit 3.2 of the registrant’s Form 10-KSB filed on March
      24, 2004 (File No. 000-30497).


(6)
            Incorporated
      by reference to Exhibit 10.1 of the registrant’s Form 8-K filed on July
      19, 2005 (File No. 000-30497).


(5)
            Incorporated
      by reference to Exhibit 14 of the registrant’s Form 10-KSB filed on March
      24, 2004 (File No. 000-30497).




81