Securities
      and Exchange Commission


Washington,
      D.C. 20549





**FORM
      10-KSB**





**[X]**  **ANNUAL
      REPORT UNDER SECTION 13 OR 15(d) OF THE** **SECURITIES
      EXCHANGE ACT OF 1934**





For
      the
      fiscal year ended December 31, 2005





**Commission
      file number 000-30497**







*(Name
      of Small Business Issuer in Its Charter)*





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








**5319
      Highway 153**


**Hixson,
      Tennessee 37343**


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





**(423)
      385-3000**


*(Issuer’s
      telephone number)*





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


None





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


Common
      Stock, Par Value $1.00 Per Share





Check
      whether the issuer is required to file reports pursuant to Section 13 or Section
      15(d) of the Securities Exchange Act of 1944.


Yes x No
o





Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or 15(d) of the Exchange Act during the past 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
xNo
o





Check
      if
      disclosure of delinquent filers in response to Item 405 of Regulation S-B is
      not
      contained in this form, and no disclosure will 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-KSB or any amendment
      to
      this Form 10-KSB. o





Check
      whether the issuer is a shell company (as defined in Rule 12b-2 of the
      Securities Exchange Act of 1934). Yes o No x





Revenues
      for the Registrant’s fiscal year ended December 31, 2005, total
      $22,576,802.





The
      aggregate market value of the Registrant's outstanding Common Stock held by
      nonaffiliates of the Registrant on February 15, 2006 was approximately
      $67,607,878. There were 3,208,284 shares of Common Stock outstanding as of
      February 15, 2006.




DOCUMENTS
      INCORPORATED BY REFERENCE





Portions
      of the Registrants definitive 2006 Proxy Statement are incorporated by reference
      in Part III of this Form 10-KSB.










**CORNERSTONE
      BANCSHARES, INC.**


**Annual
      Report on Form 10-KSB**


**For
      the Fiscal Year Ended December 31, 2005**





**Table
      of Contents**




**Item**
              **Number**
            
            **Page**
              **Number****Part I**1.
            Description of Business
            42.
            Description of Property
            103.
            Legal Proceedings
            10**Part
                II**5.
            Market for Common Equity and
              Related Stockholder Matters
            116.
            Management's Discussion and Analysis
              or Plan of Operation
            127.
            Financial Statements
            348.
            Changes in and Disagreements with Accountants
                on
              Accounting and Financial Disclosure
            348A
            Controls and Procedures
            34**Part III**9.
            Directors,
                Executive Officers, Promoters
              and Control Persons; Compliance with
              Section 16(a) of the Exchange Act
            3510.
            Executive Compensation
            3511.
            Security Ownership of Certain Beneficial
              Owners
              and
                Management
            3612.
            Certain Relationships and Related
              Transactions
            3613.
            Exhibits and Reports on Form 8-K
            3614.
            Principal Accountant Fees and
              Services
            37








2








**Forward-Looking
      Statements**




In
      addition to the historical information contained herein, this report contains
      certain forward-looking statements including statements relating to present
      or
      future factors generally affecting the banking industry and specifically
      affecting the operations, markets, and products of Cornerstone Bancshares,
      Inc.
      (the “Company”), Cornerstone Community Bank (the “Bank”) and Eagle Financial,
      Inc. (“Eagle”). Forward-looking statements are based upon estimates and
      assumptions that are subject to significant business, economic and competitive
      uncertainties and contingencies, many of which are beyond the Company’s control,
      and many of which, with respect to future business decisions, are subject to
      change. Without limiting the foregoing, the words “believes,” “anticipates,”
“intends,” “expects,” “are of the opinion that” or similar expressions are
      intended to identify forward-looking statements that involve certain risks
      and
      uncertainties. You should not place undue reliance on these forward-looking
      statements.





Actual
      results could differ materially from those projected for many reasons including,
      without limitation, changing events and trends that have influenced the
      Company’s and the Bank’s assumptions. These trends and events include (i)
      changes in the interest rate environment which may reduce margins, (ii)
      non-achievement of expected growth, (iii) less favorable than anticipated
      changes in national and local business environment and securities markets,
      (iv)
      adverse changes in the regulatory requirements affecting the Company and the
      Bank, (v) greater competitive pressures among financial institutions in the
      Company’s and the Bank’s markets, and (vi) greater than expected loan losses.
      Additional information and other factors that could affect future financial
      results are included in the Company’s filings with the Securities and Exchange
      Commission. We assume no obligation to update any forward-looking statements
      as
      a result of new information, future events or developments, except as required
      by applicable securities laws.





3


**PART
      I**








**ITEM
      1. DESCRIPTION OF BUSINESS**





**Business
      Development**





Cornerstone
      Bancshares, Inc. (“Cornerstone” or the “Company”) 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.





**Business
      of the Company**





***The
      Company***





The
      primary activity of the Company currently is, and is expected to remain for
      the
      foreseeable future, the ownership and operation of the Bank. As a bank holding
      company, the Company 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
      the
      Company 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, the Company
      currently has no plans, understandings or agreements concerning any other
      activities other than as described below. The results of operations and
      financial condition of the Company for the foreseeable future, therefore, will
      be determined primarily by the results of operations and financial condition
      of
      the Bank.





***The
      Bank***





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. 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.





***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
      February 15, 2006, the Company and the Bank collectively had 87 full-time
      equivalent employees of whom 81 are full-time, and 12 are part-time. The
      employees are not represented by a collective bargaining unit. The Company
      and
      the Bank believe that their relationships with their employees are
      good.





***Customers***





It
      is the
      opinion of management that there is no single customer or affiliated group
      of
      customers of the Bank whose deposits, if withdrawn, would have a material
      adverse effect on the business of the Company.





***Competition***





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





Based
      on
      total deposits of approximately $252,436,000 at December 31, 2005, the Bank
      represents 3.52% of the deposit base in the Chattanooga, Tennessee-Georgia
      Metropolitan Statistical Area (“Chattanooga MSA”). Three major regional banks
      represent approximately 60% of the deposits in the Chattanooga MSA. These larger
      financial institutions have greater resources and higher lending limits than
      the
      Bank, and each of the three institutions has over 20 branches in Hamilton
      County. There are several credit unions located in Hamilton County. Since credit
      unions are not subject to income taxes in the way commercial banks are, credit
      unions have an advantage in offering 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***





*General*





The
      Company 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”). The Company 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 the Company and its subsidiaries. The Company 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
      the
      Company 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.





5








*Insurance
      of Deposit Accounts*





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





On
      September 15, 1992, the FDIC approved final regulations adopting a risk-related
      deposit insurance system. The risk-related regulations, which became effective
      January 1, 1993, resulted in a significant spread between the highest and lowest
      deposit insurance premiums. Under the risk-related insurance regulations, each
      insured depository institution is assigned to one of three risk classifications:
      "well capitalized," "adequately capitalized," or "under capitalized." Within
      each risk classification, there are three subgroups. Each insured depository
      institution is assigned to one of these subgroups within its risk classification
      based upon supervisory evaluations submitted to the FDIC by the institution’s
      primary federal regulator **.** Depending
      upon a BIF member’s risk classification and subgroup, applicable regulations
      provide that its deposit insurance premium may be as low as 0.004% of insured
      deposits or as high as .31% of insured deposits. Additionally, because the
      BIF
      has exceeded its designated reserve ratio, the FDIC has now reduced to zero
      the
      assessment rate that is applicable to the most highly rated BIF members. The
      Bank has been notified that, based on its risk classification and supervisory
      subgroup, its BIF assessment rate is 0.004% of insured deposits for the period
      from January 1, to December 31, 2005. This is the most favorable assessment
      rate
      applicable to insured institutions. In addition, the Deposit Insurance Funds
      Act
      of 1998 (DIFA) requires that a Financing Corporation (“FICO”) assessment be paid
      by the Bank. The annual FICO assessment rate for banks is presently 0.0154%
      of
      deposits. The Bank paid $27,579 in assessments during the year ended December
      31, 2005.





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.





At
      December 31, 2005, the Bank had Tier 1 capital of $26.0 million or 9.20% of
      total year to date average assets.







6





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 the Company 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.





*Tennessee
      Supervision and Regulation*





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





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





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





7


*Federal
      Supervision and Regulation*





The
      Company is regularly examined by the Board, and the Bank is supervised and
      examined by the FDIC. The Company 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 the
      Company may acquire, directly or indirectly, ownership or control of the voting
      shares of any bank, if, after such acquisition, the Company 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, the Company 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 the Company 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, the Company and any other subsidiary of the Company, and to related
      interests of such persons.





In
      addition to the banking regulations imposed on the Company, the securities
      of
      the Company are not exempt from the federal and state securities laws as are
      the
      securities of the Bank. Accordingly, an offering of the Company’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 the Company, the Bank or any subsidiary of the Company; or
      (iii) provide any credit, property or service to the Company, the Bank (other
      than those related to and usually provided in connection with a loan, discount,
      deposit or trust service) or any subsidiary of the Company.





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





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





*Legislation
      Affecting the Company and the Bank*





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





Far-reaching
      legislation, including FIRREA and the Federal Deposit Insurance Corporation
      Improvement Act of 1991 (“FDICIA”) have for years impacted the business of
      banking. FIRREA primarily affected the regulation of savings institutions rather
      than the regulation of state banks and bank holding companies like the Bank
      and
      the Company, 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.





8


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





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





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


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


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


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


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


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


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


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


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


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


§
            uniform
                regulations regarding real estate lending;
                and


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





9


The
      activities permissible to the Company 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 the Company, from
      disclosing nonpublic personal financial information to third parties unless
      customers have the opportunity to “opt out” of the disclosure.





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





**ITEM
      2. DESCRIPTION OF PROPERTY**





As
      of
      December 31, 2005, the principal offices of the Company and the Bank are located
      at 5319 Highway 153, Hixson, Tennessee 37343. This property is owned by the
      Company. In addition, the Bank operates four full-service branches in Hamilton
      County, Tennessee that are located at:





4154
      Ringgold Road, East Ridge, Tennessee


610
      Georgia Avenue, Chattanooga, Tennessee


2280
      Gunbarrel Road, Chattanooga, Tennessee


8966
      Old
      Lee Highway, Ooltewah, Tennessee





The
      Georgia Avenue branch contains 1800 square feet and is leased pursuant to a
      lease agreement which provides an initial term of three years with two
      three-year renewal options. Rent is currently $ 29,482 per annum. The Bank
      owns
      the properties located at 2280 Gunbarrel Road, 4154 Ringgold Road, 5319 Highway
      153 and 8966 Old Lee Highway.





The
      Company completed the construction and remodeling of the branch on Ringgold
      Road, East Ridge, Tennessee. The branch was updated to make more efficient
      use
      of the branch’s square footage and to open two additional customer drive-thru
      lanes. The Bank razed a branch operations building located in the back of the
      branch property in the process.





The
      Company operates a service center to house all its non-customer contact
      functions located at 6401 Lee Corners, Suite B, Chattanooga, Tennessee. The
      facility has 15,600 square feet and is leased pursuant to a lease agreement
      which provides for an initial term of five years with one five-year renewal
      option **.** Rent
      is
      currently $ 86,000 per annum.




**ITEM
      3. LEGAL PROCEEDINGS**





As
      of the
      end of 2005, neither the Company, 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 those claims are without merit or that the ultimate
      liability, if any, resulting from them will not materially affect the Bank’s
      financial condition or the Company’s consolidated financial position.








10








**PART
      II**








**ITEM
      5. MARKET FOR THE COMMON EQUITY AND RELATED STOCKHOLDER
      MATTERS**





The
      Company's common stock is quoted on the OTC Bulletin Board but is not listed
      on
      a national securities exchange. Morgan Keegan, a subsidiary of Regions Bank,
      is
      the principal market maker for Cornerstone stock. There are nine other market
      makers who assist in providing a market.





Table
      1
      below sets forth the high and low closing prices of the Company’s common stock
      for the periods indicated, as reported by published sources and as adjusted
      to
      reflect a 100% stock dividend paid on September 16, 2004. The prices reflect
      inter-dealer prices, without retail mark-up, mark-down or commission and may
      not
      represent actual transactions.





There
      were approximately 610 holders of record of the common stock as of December
      31,
      2005. This number does not include shareholders with shares in nominee name
      held
      by DTC. As of the end of 2005, there were 1,557,885 shares held in nominee
      name
      by DTC.





Cornerstone
      paid two cash dividends in 2005. The first dividend was paid on January 18,
      2005
      in the amount of $0.10 per share and the second dividend was paid on July 11,
      2005 in the amount of $0.08 per share. The Company announced quarterly dividends
      of $0.06 each quarter, the first of which was paid January 9, 2006. The
      Company’s board of directors will decide the amount of the next year’s
      dividends, if any, after the capital needs required for expected growth of
      assets are reviewed. The payment of dividends is solely within the discretion
      of
      the Board of Directors, considering Cornerstone’s expenses, the maintenance of
      reasonable capital and risk reserves, and appropriate capitalization
      requirements for state banks.





**TABLE
      1**


High
                and Low Common Stock Share Price for the Company**2006
                Fiscal Year**
            
            **Low**
            
            **High**First
                Quarter (through Feb. 2006)
            
            $23.25
            
            $27.25**2005
                Fiscal Year**First
                Quarter
            
            $15.74
            
            $18.50Second
                Quarter
            
            $16.75
            
            $18.50Third
                Quarter
            
            $17.60
            
            $20.50Fourth
                Quarter
            
            $19.50
            
            $24.99**2004
                Fiscal Year**First
                Quarter
            
            $10.00
            
            $12.50Second
                Quarter
            
            $11.50
            
            $13.90Third
                Quarter
            
            $11.90
            
            $15.00Fourth
                Quarter
            
            $14.00
            
            $17.00**2003
                Fiscal Year**First
                Quarter
            
            $6.25
            
            $7.25Second
                Quarter
            
            $6.05
            
            $8.75Third
                Quarter
            
            $8.25
            
            $9.50Fourth
                Quarter
            
            $8.95
            
            $11.65





On
      October 12, 2004, Cornerstone filed a Form SB-2 with the Securities and Exchange
      Commission to register the issuance of up to 500,000 shares of common stock.
      On
      November 4, 2004, the Securities and Exchange Commission declared the
      registration statement effective and the offering was fully subscribed by the
      end of 2004. Due to administrative issues associated with IRA accounts not
      all
      of the funds were collected until January of 2005. This created a subscription
      receivable in the capital section on the Company’s balance sheet since the funds
      were not collected prior to year end. As of February 5, 2005 all funds from
      the
      subscription were collected and available for use by the Company.





11


Table
      2
      sets forth the number of shares and average share price for the Company’s Equity
      Compensation Plans.





**TABLE
      2**


Equity
                Compensation PlanYear
                Ended December 31, 2005Plan
                category
            Number
                of securities to be issued upon exercise of outstanding
                options
            
            Weighted
                average exercise price of outstanding options
            
            Number
                of securities remaining available for future issuanceEquity
                compensation plans approved by security holders:
            **361,250**
            
            **$
                9.08**
            
            **414,350**Equity
                compensation plans not approved by security holders:
            0
            
            $
                0.00
            
            0Total
            361,250
            
            $
                9.08
            
            414,350





**ITEM
      6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
      OPERATION**





**Forward-Looking
      Statements**





Management’s
      discussion of the Company and management’s analysis of the Company’s operations
      and 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 the Company
      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 the Company’s customers, and other risks that
      cannot be accurately quantified or completely identified. Many factors affecting
      the Company’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. Because these factors are unpredictable and beyond the Company’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. The Company is unable
      to
      predict the types of circumstances, conditions and factors that can cause
      anticipated results to change. The Company undertakes no obligation to publish
      revised forward-looking **** statements
      to reflect the occurrence of changes or unanticipated events, circumstances,
      or
      results.





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





***General***





The
      following should be read in conjunction with the information and tables that
      follow. For a discussion of liquidity and the impact of inflation, see “Capital
      Resources/Liquidity” below.








12





***Summary***





Net
      income for 2005 was $4,324,519 which represents a 68.2% increase from the
      Company’s net income of $2,571,083 in 2004. Net income per common share of $1.42
      for 2005 was 37.9% higher than 2004 net income per common share of $1.03. Pretax
      income of $6,881,135 for 2005 increased $2,717,552 from 2004 pretax income
      of
      $4,163,583.





The
      increase in net income per common share from 2004 to 2005 comes directly from
      the dramatic growth of the Company’s earning assets, especially average loans,
      which grew 30.3%. This growth coupled with repetitive loan and security
      repricing as the Federal Reserve increased the target Federal Funds rate
      throughout 2005 helped the Company realize a 39.2% increase in net interest
      income to $14,594,290. Also contributing to improved net income was a 35.5%
      increase in non-interest income. Most of the increase was due to operating
      lease
      income, a new product line the Bank introduced in 2004, and the sale of
      commercial loans to conduit lenders. Asset quality remained at its better than
      industry standard level during 2005. Dramatic loan growth required the Bank
      to
      increase the loan loss provision to $1,401,600 during 2005. Non-interest expense
      increased 19.3% in 2005 due mostly to an increase in salaries and benefits
      of
      15.4% and the addition of depreciation expense associated with leased assets.





***Business
      of the Company***





The
      Company's earnings depend primarily on the Bank’s and Eagle’s "net interest
      income," which is the difference between the interest income it receives from
      its assets (primarily its loans and investment securities) and the interest
      expense (or "cost of funds") which it pays on its liabilities (primarily its
      deposits). Net interest income is a function of (i) the difference between
      rates of interest earned on interest-earning assets and rates of interest paid
      on interest-bearing liabilities (the "interest rate spread" or "net interest
      spread") and (ii) the relative amounts of its interest-earning assets and
      interest-bearing liabilities. When interest-earning assets approximate or exceed
      interest-bearing liabilities, any positive interest rate spread will generate
      net interest income. The Company adheres to an asset and liability management
      strategy, which is intended to control the impact of interest rate fluctuations
      upon the Company's earnings and to make the yields on the Bank’s loan portfolio
      and investment securities and Eagle’s receivable financing more responsive to
      its cost of funds. This is accomplished by more closely matching the maturities
      of its interest-earning assets and its interest-bearing liabilities, while
      still
      maximizing net interest income. Nevertheless, the Company is and will continue
      to be affected by changes in the levels of interest rates and other factors
      beyond its control.





Unless
      specifically noted below, the following information is presented on a
      consolidated basis reflecting the Company’s performance as a whole. The
      Company's results of operations are dependent primarily upon the results of
      operations of the Bank.





For
      the
      fiscal years ended December 31, 2005 and 2004, the Company's weighted
      average rate earned on all interest-earning assets was 7.68% and 6.73%,
      respectively, and the Company's weighted average rate paid on all
      interest-bearing liabilities for the same years was 2.75% and 2.03%,
      respectively. The Company's interest rate spread for the years ended
      December 31, 2005 and 2004 therefore was 4.93% and 4.70%, respectively, and
      its net interest income for such years was $14,594,290 and $10,483,424
      respectively. For fiscal 2005, the Company recorded net income of $4,324,519
      or
      $1.42 basic earnings per common share as compared with net income of $2,571,083
      or $1.03 basic earnings per common share for fiscal 2004. The increase in net
      income was due to a 39.2% increase in the Bank’s net interest income and a 35.5%
      increase in non-interest income, while non-interest expense increased only
      19.3%.





Table
      3
      below sets forth certain additional measures of the Company’s performance for
      the periods indicated. Average balances in the table, as well as all average
      balances presented elsewhere in this report, were derived based on daily
      balances whenever possible. However, some average balances, which require data
      from the Company, as opposed to the Bank, were derived based on month-end
      balances since the data processing systems for those entities do not provide
      daily average balance information. The use of month-end averages does not
      materially alter any information given, and all averages are still
      representative of the operations of the Company.





13








**TABLE
      3**


Performance
                MeasuresYears
                Ended December 31,2005
            
            2004
            
            2003Net
                Interest Margin(Net
                interest income divided by average interest-earning
                assets)
            5.43%
            
            5.02%
            
            4.87%Return
                on Average Assets(Net
                income divided by average total assets)
            1.51%
            
            1.15%
            
            1.06%Return
                on Average Equity(Net
                income divided by average equity)
            14.98%
            
            13.83%
            
            11.68%Equity
                to Assets(Average
                equity divided by average total assets)
            10.09%
            
            8.30%
            
            9.04%Loans
                to Deposits(Average
                loans divided by average deposits)
            109.04%
            
            104.73%
            
            101.21%Dividend
                Payout Ratio(Dividends
                paid by the Company divided by net income)
            12.17%
            
            4.84%
            
            0.00%








***Results
      of Operations***





Year
      ended December 31, 2005 compared to year ended December 31, 2004:





*Net
      Interest Income.* Net
      interest income is the principal component of a financial institution’s income
      stream and represents the spread between interest and fee income generated
      from
      earning assets and the interest expense paid on liabilities. The following
      discussion is on a fully taxable equivalent basis.





Net
      interest income before loan loss provision for 2005 increased by $4,110,866
      or
      39.2% over 2004. The increase in net interest income from 2004 to 2005 is due
      to
      material growth of the balance sheet and interest rate sensitivity of the Bank’s
      assets compared to its liabilities. Interest income grew 47.0% as the Federal
      Reserve increased the target Federal Funds rate 200 basis points during 2005.
      The Bank was in a favorable position to take advantage of the rapid and
      predictable increases due to its loan and security portfolios being mostly
      variable rate instruments. Loan origination fees remained strong as the Bank
      became more proficient at Small Business Administration (SBA) lending and asset
      based lending. The Bank anticipates loan growth to continue along with loan
      origination fees. Interest expense increased 70.0% in 2005. Cornerstone funded
      the rapid asset growth primarily with certificates of deposit and money market
      deposits which are typically more expensive for new deposits while retaining
      existing deposits. This allowed the cost of the funds to only go up 72 basis
      points while the raw cost of the funds increased 70%.





Interest
      income increased $6,613,367 or 47.0% in 2005 from 2004. Interest income produced
      by the loan portfolio increased $6,323,768 or 48.5% from 2004 to 2005. Interest
      income on investment securities and Federal Funds sold increased slightly at
      $289,599 or 28.2% from 2004 to 2005. The increase in loan interest income was
      due to a large increase in the volume and rate of loans as the portfolio grew,
      and was increased further by loan origination fees and servicing fees generated
      by the origination of SBA loans. The Bank attributes the strong loan growth
      to
      an increase in the number of relationship managers and their level of expertise.
      The small securities income increase was due to the generally higher interest
      rate environment, which presented few opportunities to invest without material
      interest rate risk exposure. Total interest expense increased $2,502,501 or
      70.0% in 2005 from 2004.





One
      of
      the most useful tools for measuring the ability of a community bank to make
      money is its ability to maximize its net interest margin and its interest rate
      spread. The net interest margin, or the net yield on earning assets, is computed
      by dividing fully taxable equivalent net interest income by average-earning
      assets. This ratio represents the difference between the average yield on
      average-earning assets and the average rate paid for all funds used to support
      those earning assets. The Companies ended 2005 with a net interest margin of
      5.43%. The net interest spread, defined as the rate of interest income minus
      the
      rate of interest expense, increased 23 basis points from 4.70% in 2004 to 4.93%
      in 2005. The yield on earning assets increased 95 basis points to 7.68% in
      2005
      from 6.73% in 2004.





14


*Allowance
      for Loan Loss.* The
      allowance for possible loan loss represents management’s assessment of the risks
      associated with extending credit and its evaluation of the quality of the loan
      portfolio. Management analyzes the loan portfolio to determine the adequacy
      of
      the allowance for possible loan losses and the appropriate provisions required
      to maintain a level considered adequate to absorb anticipated loan losses.
      Management believes that the allowance for possible loan losses balance of
      $3,545,042 as of December 31, 2005, is sufficient to absorb known credit risks
      in the portfolio. No assurance can be given, however, that adverse economic
      circumstances will not result in increased losses in the loan portfolio and
      require greater provisions for possible loan losses in the future.





*Non-performing
      Assets.* Non-performing assets include non-performing loans and foreclosed real estate
      held for sale. Non-performing loans include loans classified as non-accrual
      or
      renegotiated. Cornerstone’s policy is to place a loan on non-accrual status when
      it is contractually past due 90 days or more as to payment of principal or
      interest. At the time a loan is placed on non-accrual status, interest
      previously accrued but not collected may be reversed and charged against current
      earnings. Recognition of any interest after a loan has been placed on
      non-accrual status is accounted for on a cash basis. As of December 31, 2005,
      the Company had $1,731,383 of non-performing assets.





*Non-interest
      Income.* Non-interest income consists of revenues generated from a broad range of
      financial services and activities including fee-based services and profits
      and
      commissions earned through credit life insurance sales and other activities.
      In
      addition, gains or losses realized from the sale of investment securities are
      included in non-interest income. Total non-interest income increased by $498,844
      or 35.5% from 2004 to 2005. Fee income from service charges on deposit accounts
      increased $84,872 or 9.4% in 2005. The Bank had no security gain in 2005. Fees
      generated from the sale of loans sold to the secondary market increased $116,581
      in 2005 due to an increase in SBA loan origination. Operating lease income
      increased $292,505 or 118.3% during 2005. This service is offered on a very
      selective basis and the Bank does not expect to see significant growth in this
      area in 2006.





*Non-interest
      Expense.* Non-interest expense for 2005 increased by $1,330,558 or 19.3% from 2004.
      Salaries and employee benefits increased by $602,405 or 15.4% from $3,900,505
      in
      2004 to $4,502,910 in 2005. Hiring of additional personnel to cover the growth
      of the Bank, accounted for the majority of the increase for 2005. Occupancy
      expense increased 12.0% as the Bank continued to operate five full service
      branches and update equipment. Other non-interest expense increased $443,055
      or
      21.8% in 2005. This increase was related to data processing and other expenses
      incurred due to the Bank’s growth. Lastly depreciation expense associated with
      the Bank’s operating leases increased $193,246 or 104.0% due to increased number
      of leases outstanding.





***Financial
      Condition***





*Earning
      Assets.* Average
      earning assets in 2005 increased $62,408 million or 27.89% over 2004 due to
      material loan growth in 2005. This loan growth led the expansion of the balance
      sheet and the Bank funded the loan growth with a combination of FHLB borrowings,
      money market deposits and certificates of deposit. The average security
      portfolio grew $2.6 million or 9.6% to maintain an appropriate amount of
      securities for pledging purposes and liquidity.





*Loan
      Portfolio.* The
      Bank’s average loans for 2005 were $236.3 million, an increase of 30.3% over
      $181.3 million in average loans for 2004. The actual balance, before the loan
      loss allowance, at the end of 2005 was $265.6 million, representing an increase
      of $60.3 million from 2004. Loan growth for 2005, was evenly weighted throughout
      the year with several large, high quality loans greatly increasing the Bank’s
      outstanding balances. The growth was concentrated in commercial and commercial
      real estate. The Bank hired additional relationship mangers during 2005 in
      an
      effort to continue the Bank’s growth. The Bank feels strongly that the key to
      success in lending, as well as for the Bank as a whole, is to hire talented
      employees to provide outstanding customer service in a safe and sound manner.





15


*Investment
      Securities* .
      Cornerstone’s average investment securities portfolio increased $2.6 million
      from 2004 to 2005, while Federal Funds increased $1.8 million during the same
      period. The average investment portfolio and average federal funds sold for
      2005
      was $32.7 million. Cornerstone maintains an investment strategy of seeking
      portfolio yields within acceptable risk levels as well as providing liquidity,
      pledging requirements and GAP management. To accomplish these strategies, the
      Bank positioned the Investment Portfolio on the assumption that there was a
      higher probability of rates continuing to rise, and as a result took a cautious
      interest rate stance and invested appropriately. The majority of the purchases
      during 2005 were in US Agency callable notes structured with an interest rate
      cushion to protect the Bank if interest rates continue to rise. The Bank allowed
      its US Agency LIBOR floaters to be called as rates increased during 2005 without
      replacing them, as the agency U.S. Agency **** callable
      securities represented a better value due to the compressed spreads on the
      LIBOR
      floaters and scarcity of the security. Cornerstone maintains two classifications
      of investment securities: “Held to Maturity” and “Available for Sale.” The
“Available for Sale” securities are carried at fair market value, whereas “Held
      to Maturity” securities are carried at book value. At year-end 2005, unrealized
      losses in the “Available for Sale” portfolio amounted to $341,466.





*Intangibles.* During
      2002, the Company adopted the provisions of Statement of Financial Statement
      No.
      142 Goodwill and other Intangible Assets concerning the $2,541,476 goodwill
      created by the merger with the Bank of East Ridge. Goodwill and 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 2005,
      2004 or 2003. Also, in December, 2005, the Company completed the purchase of
      Eagle Financial, Inc. and recorded an intangible asset of 848,916. Amortization
      expense of $13,500 was recognized on this amortizable intangible.




*Deposits.* Cornerstone’s
      average deposits increased $43.5 million or 25.2% from 2004 to 2005. From
      year-end 2004 to year-end 2005, total actual deposits increased $64.6 million
      or
      34.4%. The Bank’s deposit strategy continues to be focused on attracting
      transaction deposits from business customers while filling funding gaps with
      certificate of deposit specials to attract incremental funds while not driving
      up the cost of certificates already on the books. The Bank saw extraordinary
      success during 2005 in attracting business and public deposits to the Bank.
      Average interest bearing transaction accounts increased 25.3% while average
      demand deposits increased 24.4%. This success partially funded the Bank’s loan
      growth and allowed the Bank to maintain its net interest margin at an above
      peer
      bank level. The Bank expects to continue its focus on attracting deposits from
      businesses, especially transaction accounts, which are less expensive and tie
      the customer base closely to the Bank.





*Capital
      Resources.* Stockholders
      average equity increased $10.3 million or 55.4%. The Company had net income
      of
      $4,324,519 in 2005, and the value of the investment security portfolio’s
      unrealized gains or losses, net of tax, decreased from a gain of $116.0 thousand
      to a loss of $165.9 thousand. The actual balance of stockholder’s equity
      increased $7.7 million or 30.9% from $24.8 million as of the end of 2004 to
      $32.5 million. During 2005, the Company completed the 500,000 shares initial
      offering that begun at the end of 2004 represented approximately $7 million
      in
      additional capital. Also during 2005, several directors exercised non-qualified
      options adding an additional $2.2 million to the Company’s
      capital.





***Net
      Interest Income***





Table
      4
      below sets forth 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.







16





**TABLE
      4**


Yields
                Earned on Average Earning Assets and
              Rates
                Paid on Average Interest Bearing LiabilitiesYears
                Ended December 31,2005
            
            2004
            
            2003(In
                thousands)
              
              **ASSETS**
            
            Average
              Balance
            
            Interest
                Income/
              Expense(1)
            
            Yield/Rate
            
            Average
              Balance
            
            Interest
                Income/
              Expense(1)
            
            Yield/Rate
            
            AverageBalance
            
            Interest
                Income/
              Expense(1)
            
            Yield/RateInterest-earning
                assets:Loans(1)(2)
            
            $
            236,265
            
            $
            19,354
            
            
            8.19
            %
            $
            181,335
            
            $
            13,030
            
            
            7.19
            %
            $
            141,586
            
            $
            10,326
            
            
            7.29
            %Investment
                securities(3)
            
            
            29,705
            
            
            1,217
            
            
            4.24
            %
            
            27,115
            
            
            1,006
            
            
            3.87
            %
            
            24,118
            
            
            980
            
            
            4.16
            %Federal
                funds sold
            
            
            2,976
            
            
            101
            
            
            3.39
            %
            
            1,218
            
            
            23
            
            
            1.89
            %
            
            1,550
            
            
            20
            
            
            1.29
            %Other
                earning assets
            
            
            0
            
            
            0
            
            
            0.00
            %
            
            0
            
            
            0
            
            
            0.00
            %
            
            0
            
            
            0
            
            
            0.00
            %Total
                interest-earning assets
            
            
            268,946
            
            
            20,672
            
            
            7.68
            %
            
            209,668
            
            
            14,059
            
            
            6.73
            %
            
            167,254
            
            
            11,326
            
            
            6.79
            %Allowance
                for loan losses
            
            
            (3,025
            )
            
            
            
            
            
            
            
            (2,293
            )
            
            
            
            
            
            
            
            (1,843
            )Cash
                and other assets
            
            
            20,288
            
            
            
            
            
            
            
            
            16,426
            
            
            
            
            
            
            
            
            12,791Total
                assets
            
            $
            286,209
            
            
            
            
            
            
            
            $
            223,801
            
            
            
            
            
            
            
            $
            178,202**TOTAL
                LIABILITIES**
              **AND
                EQUITY**Interest-bearing
                liabilities:Deposits:NOW
                accounts
            
            $
            33,943
            
            
            329
            
            
            0.97
            %
            $
            28,843
            
            
            138
            
            
            0.48
            %
            $
            22,299
            
            
            66
            
            
            0.30
            %Money
                market / Savings
            
            
            45,232
            
            
            1,107
            
            
            2.45
            %
            
            32,282
            
            
            429
            
            
            1.33
            %
            
            25,467
            
            
            339
            
            
            1.33
            %Time
                deposits, $100m andOver
            
            
            32,611
            
            
            1,145
            
            
            3.51
            %
            
            25,734
            
            
            649
            
            
            2.52
            %
            
            19,430
            
            
            606
            
            
            3.12
            %Time
                deposits, under $100 m
            
            
            70,167
            
            
            2,240
            
            
            3.19
            %
            
            58,367
            
            
            1,457
            
            
            2.50
            %
            
            54,679
            
            
            1,577
            
            
            2.88
            %Total
                interest-bearing deposits
            
            
            181,953
            
            
            4,821
            
            
            2.65
            %
            
            145,226
            
            
            2,673
            
            
            1.84
            %
            
            121,872
            
            
            2,588
            
            
            2.12
            %Federal
                funds purchased
            
            
            4,269
            
            
            143
            
            
            3.35
            %
            
            2,140
            
            
            33
            
            
            1.54
            %
            
            2,248
            
            
            33
            
            
            1.47
            %Securities
                sold underagreement
                to repurchase
            
            
            3,501
            
            
            60
            
            
            1.71
            %
            
            2,575
            
            
            23
            
            
            0.89
            %
            
            2,602
            
            
            22
            
            
            0.85
            %Other
                borrowings
            
            
            30,973
            
            
            1054
            
            
            3.40
            %
            
            25,942
            
            
            846
            
            
            3.26
            %
            
            16,123
            
            
            568
            
            
            3.52
            %Total
                interest-bearingLiabilities
            
            
            220,696
            
            
            6,078
            
            
            2.75
            %
            
            175,889
            
            
            3,575
            
            
            2.03
            %
            
            142,848
            
            
            3,211
            
            
            2.25
            %Net
                interest spread
            
            
            
            
            
            
            
            
            4.93
            %
            
            
            
            
            
            
            
            4.70
            %
            
            
            
            
            
            
            
            4.54
            %Other
                liabilities:Demand
                deposits
            
            
            34,730
            
            
            
            
            
            
            
            
            27,918
            
            
            
            
            
            
            
            
            18,017Accrued
                interest payable andother
                liabilities
            
            
            1,909
            
            
            
            
            
            
            
            
            1,408
            
            
            
            
            
            
            
            
            1,224Stockholders'
                equity
            
            
            28,874
            
            
            
            
            
            
            
            
            18,586
            
            
            
            
            
            
            
            
            16,113Total
                liabilitiesAnd
                stockholders' equity
            
            $
            286,209
            
            
            
            
            
            
            
            $
            223,801
            
            
            
            
            
            
            
            $
            178,202Net
                interest margin
            
            
            
            
            $
            14,594
            
            
            5.43
            %
            
            
            
            $
            10,484
            
            
            5.02
            %
            
            
            
            $
            8,116
            
            
            4.87
            %


(1)
      Interest income on loans includes amortization of deferred loan fees and other
      discounts of $262 million, $229 million, and $115 million for the fiscal years
      ended December 31, 2005, 2004, and 2003, 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.





T able
      5
      below sets forth information regarding the weighted average contractual yields
      earned on the Company's interest-earning assets and the weighted average
      interest rates paid on the Company's interest-bearing liabilities outstanding
      at
      December 31, 2005. Investment securities available for sale (“AFS”) are
      held at market value and held to maturity (“HTM”) are shown at amortized
      costs.








17





**TABLE
      5**


Weighted
                Average of Interest Earning Assets and Interest Bearing
                LiabilitiesActual
                Year End Balance for December 31,
                2005


(In
                thousands)
            
            Amount
            
            Average
              Yield/RateInterest-earning
                assets:Loans
            
            $
            236,265
            
            
            8.19
            %Investment
                securities
            
            
            29,705
            
            
            4.10
            %Federal
                funds sold
            
            
            2,976
            
            
            3.39
            %Total
                interest-earning assets
            
            $
            268,946
            
            
            7.68
            %Interest
                bearing liabilities:NOW
                account deposits
            
            $
            33,943
            
            
            0.97
            %Savings
                and money market deposits
            
            
            45,232
            
            
            2.45
            %Time
                deposits under $100,000
            
            
            70,167
            
            
            3.19
            %Time
                deposits of $100,000 or more
            
            
            32,611
            
            
            3.51
            %Federal
                funds purchased
            
            
            4,269
            
            
            3.35
            %Securities
                sold under agreements to repurchase
            
            
            3,501
            
            
            1.71
            %Long-term
                debt
            
            
            30,973
            
            
            3.40
            %Total
                interest bearing liabilities
            
            $
            220,696
            
            
            2.75
            %





Table
      6
      sets forth 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; or (iii) a change
      caused by the combination of changes in asset or deposit mix. The following
      table describes the extent to which changes in interest rates and changes in
      volume of interest-earning assets and interest-bearing liabilities have affected
      the Company'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
      7
      sets forth the re-pricing of the Company's interest earning assets and
      interest-bearing liabilities as of December 31, 2005. This interest sensitivity
      gap table is designed to monitor the Company'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 Company's
      interest rate management policy is to attempt to maintain a relatively stable
      net interest margin in periods of interest rate fluctuations. The Company'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. Presently, the Bank is in a positive one-year cumulative GAP
      position of 22.3% and is confident that it is positioned properly for the
      Federal Reserve’s FOMC anticipated actions during 2006. Due to the Federal
      Reserve’s announcement that the Federal Funds rates are approaching a neutral
      position, the Bank has begun the process of moving the Bank’s interest
      sensitivity to a more neutral position. This will be accomplished by purchasing
      longer term securities with call protection and increasing the number of fixed
      rate loans. The Bank to date has not participated in any derivative products
      to
      address this issue and does not foresee the need to do so in the immediate
      future. Below is a table, which reflects the Company's interest-earning assets
      and interest-bearing liabilities. 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.





18





**TABLE
**6****




INTEREST
                INCOME AND EXPENSE ANALYSIS






Year
                Ended December 31,
              2005
                Compared to 2004(In
                Thousands)
            
            Volume
            
            Rate
            
            Mix
            
            Net
              ChangeInterest
                income:Loans
                (1)(2)
            
            $
            4,499
            
            $
            2,363
            
            
            ($541
            )
            $
            6,321Investment
                securities
            
            
            110
            
            
            110
            
            
            (9
            )
            
            211Federal
                funds sold
            
            
            54
            
            
            36
            
            
            (12
            )
            
            78Other
                earning assets
            
            
            0
            
            
            0
            
            
            0
            
            
            0Total
                interest income
            
            
            
            
            
            
            
            
            
            
            
            6,610Interest
                expense:NOW
                accounts
            
            
            49
            
            
            166
            
            
            (25
            )
            
            190Money
                market and savings accounts
            
            
            317
            
            
            507
            
            
            (146
            )
            
            678Time
                deposits, $100,000 and over
            
            
            171
            
            
            303
            
            
            22
            
            
            496Time
                deposits, less than $100,000
            
            
            376
            
            
            484
            
            
            (78
            )
            
            782Other
                borrowings
            
            
            171
            
            
            40
            
            
            (9
            )
            
            202Federal
                funds purchased
            
            
            73
            
            
            82
            
            
            (41
            )
            
            114Securities
                sold under agreement to repurchase
            
            
            15
            
            
            24
            
            
            (2
            )
            
            37Total
                interest expense
            
            
            
            
            
            
            
            
            
            
            
            2,499Change
                in net interest income (expense)
            
            
            
            
            
            
            
            
            
            
            $
            4,111








INTEREST
                INCOME AND EXPENSE ANALYSIS






Year
                Ended December 31,
              2004
                Compared to 2003(In
                Thousands)
            
            Volume
            
            Rate
            
            Mix
            
            Net
              ChangeInterest
                income:Loans
                (1)(2)
            
            $
            2,858
            
            $
            (181
            )
            $
            27
            
            $
            2,704Investment
                securities
            
            
            116
            
            
            (52
            )
            
            (38
            )
            
            26Federal
                funds sold
            
            
            (6
            )
            
            7
            
            
            2
            
            
            3Other
                earning assets
            
            
            0
            
            
            0
            
            
            0
            
            
            0Total
                interest income
            
            
            
            
            
            
            
            
            
            
            
            2,733Interest
                expense:NOW
                accounts
            
            
            31
            
            
            345
            
            
            (304
            )
            
            72Money
                market and savings accounts
            
            
            91
            
            
            0
            
            
            (1
            )
            
            90Time
                deposits, $100,000 and over
            
            
            159
            
            
            0
            
            
            (116
            )
            
            43Time
                deposits, less than $100,000
            
            
            92
            
            
            (5
            )
            
            (207
            )
            
            (120
            )Other
                borrowings
            
            
            320
            
            
            0
            
            
            (42
            )
            
            278Federal
                funds purchased
            
            
            (2
            )
            
            0
            
            
            1
            
            
            (1
            )Securities
                sold under agreement to repurchase
            
            
            0
            
            
            149
            
            
            (147
            )
            
            2Total
                interest expense
            
            
            
            
            
            
            
            
            
            
            
            364Change
                in net interest income (expense)
            
            
            
            
            
            
            
            
            
            
            $
            2,369


(1)
      Loan
      amounts include non-accruing loans.


(2)
      Interest income includes the portion of loan fees recognized in the respective
      periods.







19





**TABLE
      7**


Re-pricing
                of Interest Sensitive Assets and Liabilities
              Year-end
                balance as of December 31, 2005


(In
                thousands)
              Interest
                Sensitive Assets:
            
            Less
                than One Year
            
            1
                to 5 Years (3)
            
            Over
                5 Years (3)
            
            TotalFederal
                funds sold
            
            $
            0
            
            $
            0
            
            $
            0
            
            $
            0Investment
                securitiesTaxable
                (1)
            
            
            5,581
            
            
            22,427
            
            
            187
            
            
            28,195Tax-exempt
                (1)
            
            
            0
            
            
            565
            
            
            2,724
            
            
            3,289Loans
                (2)Fixed
                rate and adjustable rate 1-4 family mortgage
            
            
            27,265
            
            
            8,378
            
            
            631
            
            
            36,274Scheduled
                payments
            
            
            192,219
            
            
            36,142
            
            
            919
            
            
            229,280Total
                Interest Sensitive Assets
            
            $
            225,065
            
            $
            67,512
            
            $
            4,461
            
            $
            297,038Interest
                Sensitive Liabilities:NOW
                accounts
            
            $
            17,401
            
            $
            26,100
            
            $
            0
            
            $
            43,501Money
                market and savings accounts
            
            
            35,533
            
            
            11,844
            
            
            0
            
            
            47,377Time
                deposits
            
            
            92,401
            
            
            29,425
            
            
            0
            
            
            121,826Other
                interest bearing liabilities
            
            
            13,430
            
            
            17,000
            
            
            2,000
            
            
            32,430Total
                Interest Sensitive Liabilities
            
            $
            158,765
            
            $
            84,369
            
            $
            2,000
            
            $
            245,134Interest
                Sensitive Gap
            
            $
            66,300
            
            
            ($16,857
            )
            $
            2,461
            
            $
            51,904Cumulative
                Interest Sensitive Gap
            
            $
            66,300
            
            $
            49,443
            
            $
            51,904Ratio
                of cumulative gap to total Interest Sensitive Assets
            
            
            22.32
            %
            
            16.65
            %
            
            17.47
            %


(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.





***Lending
      Activities***





*Loan
      Policy*





All
      lending activities of the Bank are under the direct supervision and control
      of
      the Directors Loan Committee, which consists of the Chief Executive Officer,
      President, Senior Loan Administrator, and five outside directors. Also present
      at meetings of the committee are the loan review officer and other lending
      officers as required. All lending activities of Eagle are under the direct
      supervision and control of its Board of Directors which consist of the Chief
      Executive Officer, President, Treasurer, Secretary, Bank’s Senior Loan
      Administrator and four outside directors. These loan committees enforce loan
      authorizations for each officer, makes lending decisions on loans exceeding
      such
      limits, services all requests for officer credits to the extent allowable under
      current laws and regulations, administers all problem credits, and determines
      the allocation of funds for each lending category. The Bank’s established
      maximum loan volume to assets is 85%. The loan portfolio consists primarily
      of
      real estate, commercial and installment loans.





*General*


At
      December 31, 2005, the Company's loan portfolio constituted approximately
      81.0% of the Company's total assets, approximately 82.9% for the Bank, and
      76.7%
      for Eagle. Table 8 sets forth the composition of the Company's loan portfolio
      at
      the indicated dates.








20




**TABLE
      8**


Loan
                Portfolio CompositionYears
                Ending December 31,


2005
            
            2004
            
            2003
            
            2002
            
            2001Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            Percent
            
            Amount
            
            PercentCommercial,
                financial and agricultural
            
            $
            86,039
            
            
            32.40
            %
            $
            61,742
            
            
            30.09
            %
            $
            42,420
            
            
            26.97
            %
            $
            28,034
            
            
            22.48
            %
            $
            20,424
            
            
            19.42
            %Real
                estate - construction
            
            
            47,071
            
            
            17.72
            %
            
            36,824
            
            
            17.94
            %
            
            24,081
            
            
            15.31
            %
            
            20,517
            
            
            16.46
            %
            
            13,190
            
            
            12.54
            %Real
                estate - mortgage
            
            
            45,645
            
            
            17.19
            %
            
            38,193
            
            
            18.61
            %
            
            28,185
            
            
            17.92
            %
            
            28,331
            
            
            22.72
            %
            
            30,828
            
            
            29.32
            %Real
                estate - commercial
            
            
            79,608
            
            
            29.98
            %
            
            61,860
            
            
            30.14
            %
            
            56,527
            
            
            35.94
            %
            
            41,926
            
            
            33.62
            %
            
            34,541
            
            
            32.85
            %Consumer
                loans
            
            
            7,191
            
            
            2.71
            %
            
            6,602
            
            
            3.22
            %
            
            6,077
            
            
            3.86
            %
            
            5,880
            
            
            4.72
            %
            
            6,170
            
            
            5.87
            %Total
                loans
            
            $
            265,554
            
            
            100.00
            %
            $
            205,221
            
            
            100.00
            %
            $
            157,290
            
            
            100.00
            %
            $
            124,688
            
            
            100.00
            %
            $
            105,154
            
            
            100.00
            %








Table
      9
      sets forth the scheduled maturities of the loans in the Company's loan portfolio
      as of December 31, 2005 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
      9**


Loans
                Maturing
              Year-end
                balance as of December 31, 2005


(In
                thousands)
            
            Less
                than One Year
            
            1
                to 5 Years
            
            Over
                5 Years
            
            TotalCommercial,
                financial and agricultural
            
            $
            77,239
            
            $
            8,795
            
            $
            5
            
            $
            86,039Real
                estate - construction
            
            
            46,229
            
            
            842
            
            
            0
            
            
            47,071Real
                estate - mortgage
            
            
            36,636
            
            
            8,378
            
            
            631
            
            
            45,645Real
                estate - commercial
            
            
            55,815
            
            
            22,991
            
            
            802
            
            
            79,608Consumer
            
            
            3,565
            
            
            3,514
            
            
            112
            
            
            7,191Total
                Loans
            
            $
            219,484
            
            $
            44,520
            
            $
            1,550
            
            $
            265,554





***Types
      of Loans***





*Commercial
      Loans*





Commercial,
      industrial, and non-farm non-residential loans, hereinafter referred to as
      commercial loans (excluding commercial construction loans) totaled $86.0 million
      or 32.4% of the Company’s loan portfolio at December 31, 2005. Commercial
      loans consist of loans and lines of credit 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 terms of the Bank's commercial loans generally range from 90 days
      to a 15 year amortization with a five year balloon. The loans generally carry
      interest rates, which adjust in accordance with changes in the prime rate,
      but
      when appropriate will be fixed to match the borrower’s needs. Substantially all
      of the Bank's commercial loans are secured and are guaranteed by the principals
      of the borrower. This is the fastest growing area of the loan portfolio and
      is
      being staffed to continue this trend. The Bank believes this area has the best
      potential for future growth and has the highest barriers of entry to our
      competitors.





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. Commercial loans,
      which are considered small business loans, are the core business of the Bank.
      Most loans are made with a long-term relationship intended and the Bank also
      seeks to obtain the borrower’s business and personal depository accounts.





21





*Real
      Estate - Construction Loans*





As
      of
      December 31, 2005, Cornerstone had $47.1 million in construction and development
      loans outstanding, which represented 17.7% of the loan portfolio. All
      construction and development loans are held in the Bank’s loan portfolio. 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
      and if 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.





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*





At
      December 31, 2005, real estate mortgage loans totaled $45.6 million or
      17.2% of the Company's loan portfolio. Real estate mortgage loans include all
      one to four family residential loans secured by real estate for purposes other
      than construction or acquisition and development. All real estate loans are
      held
      in the Bank’s loan portfolio except for loans that are designated as loans held
      for sale. The loans held for sale are FHLB or FNMA qualified and have been
      pre-approved by an underwriting specialist prior to closing. As of December
      31,
      2005, the Bank held $603 thousand of these secondary market mortgages. 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.





22


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*





At
      December 31, 2005, commercial real estate mortgage loans totaled $ 79.6
      million or 30.0% of the Company's loan portfolio. 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 once a loan exceeds the Bank’s legal lending limit or 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 10-15 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*





At
      December 31, 2005, consumer loans totaled $7.2 million or 2.7% of the
      Company's loan portfolio. These loans consist of consumer installment loans
      and
      consumer credit card balances. As of December 31, 2005, the Bank had $951
      thousand credit card balances outstanding





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*





As
      of
      December 31, 2005, commitments under standby letters of credit and undisbursed
      loan commitments aggregated approximately $63,972,000. This number includes
      all
      lines that have not been fully drawn and loan commitments in the same status.





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





The
      Bank
      originates loans primarily in Hamilton County, Tennessee. The Bank also
      originates loans in Marion, Sequatchie, and Bradley Counties in Tennessee,
      and
      Dade, Walker and Catoosa Counties in Georgia, each of which is contiguous to
      Hamilton County. Loans are originated by thirteen loan officers who operate
      from
      the Bank's offices in Chattanooga. These loan officers 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.




23


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 loan officers
      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. Certain loan officers have the
      authority to approve loans of up to $ 500,000. All other loan officers have
      the
      authority to approve secured loans of up to at least $ 25,000. There is an
      Officers Loan Committee comprised of the senior officers of the Bank which
      must
      approve any loan that increases the borrower’s aggregate indebtedness above an
      individual officer’s limit, but that is not more than $ 2,000,000. The Directors
      Loan Committee must approve all loans over $ 2,000,000 up to $ 4,500,000. All
      loans above $4,500,000 up to the Bank’s legal lending limit must be approved by
      the Board of Directors of 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. As of the end December 31, 2005, the Bank had
      participations purchased totaling $4.5 million and participations sold of $20.8
      million.




***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. For the year ended December 31, 2005, the Bank recognized
      origination, commitment and other loan fees totaling $1,631,844, which equaled
      8.4% of the Company’s total loan interest income for the year.





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





*Problem
      Loans*





In
      originating loans, the Company 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. The
      Company has instituted measures at the Bank which are designed to reduce the
      risk of, and monitor exposure to, credit losses.





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





24


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 15 days and 30
      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.





The
      Bank
      attempts to sell real estate owned promptly after foreclosure, and sold $224,696
      of its real estate owned due to loan foreclosures during the year ended December
      31, 2005. The book value of real estate owned that was sold by the Bank during
      the year ended December 31, 2005 totaled $244,916. As of December 31, 2005,
      the Bank had $776,136 in value of real estate owned as a result of
      foreclosure.





Table
      10
      sets forth information regarding the Company's delinquent and non-performing
      assets as of the dates indicated.





25





*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
      Bank
      maintains a general allowance equal to approximately 1.30% of the total
      principal amount of loans outstanding and management adjusts the general
      allowance monthly by charges or credits to income in response to changes in
      the
      outstanding loan balance. Management also may establish specific loan loss
      allowances for specific loans after considering such factors as past
      delinquencies on the loan, the value of the underlying collateral and the size
      of the loan. 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, 2005 is adequate to
      absorb possible losses from loans currently in the portfolio.





**TABLE
      10**


Delinquent
                and Non-performing AssetsActual
                for Years Ending December 31,


(In
                thousands)
            
            2005
            
            2004Accruing
                loans that are contractuallypast
                due 90-days or more:Commercial,
                financial and agricultural
            
            $
            216
            
            $
            0Real
                estate - construction
            
            
            0
            
            
            0Real
                estate - mortgage
            
            
            0
            
            
            0Consumer
            
            
            0
            
            
            0Total
                Loans
            
            $
            216
            
            $
            0Non-accruing
                loans 90-days or more:Commercial,
                financial and agricultural
            
            $
            0
            
            $
            0Real
                estate - construction
            
            
            52
            
            
            102Real
                estate - mortgage
            
            
            670
            
            
            39Consumer
            
            
            12
            
            
            1Total
                Loans
            
            $
            734
            
            $
            142Real
                estate acquired through foreclosure
            
            $
            776
            
            $
            98Property
                acquired through repossession
            
            
            5
            
            
            20Total
                acquired
            
            $
            781
            
            $
            118Total
                Loans
            
            $
            265,554
            
            $
            205,221Ratio
                of non-performing assets to total loans
            
            
            0.66
            %
            
            0.10
            %Ratio
                of delinquent (30-days or more) but accruing loans to:Total
                loans
            
            
            0.82
            %
            
            0.34
            %Total
                assets
            
            
            0.67
            %
            
            0.28
            %





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.


26








Table
      11
      summarizes the Company's loan loss experience for the periods
      indicated.








**TABLE
      11**


Loan
                Loss Reserve AnalysisYears
                Ending December 31,


(in
                thousands)
            
            
            2005
            
            
            2004
            
            
            2003
            
            
            2002
            
            
            2001Average
                loans
            
            $
            236,265
            
            $
            181,335
            
            $
            141,586
            
            $
            107,676
            
            $
            90,860Allowance
                for possible loan losses,Beginning
                of the period
            
            $
            2,658
            
            $
            2,011
            
            $
            1,591
            
            $
            1,322
            
            $
            1,142Charge-offs
                for the period:Commercial,
                financial and agricultural
            
            
            275
            
            
            165
            
            
            223
            
            
            423
            
            
            129Real
                estate - construction
            
            
            48
            
            
            0
            
            
            0
            
            
            0
            
            
            0Real
                estate - mortgage
            
            
            128
            
            
            138
            
            
            6
            
            
            12
            
            
            69Consumer
            
            
            111
            
            
            69
            
            
            106
            
            
            2
            
            
            60Total
                charge-offs
            
            
            562
            
            
            372
            
            
            335
            
            
            497
            
            
            403Recoveries
                for the period:Commercial,
                financial and agricultural
            
            
            12
            
            
            149
            
            
            183
            
            
            75
            
            
            108Real
                estate - construction
            
            
            1
            
            
            0
            
            
            3
            
            
            0
            
            
            1Real
                estate - mortgage
            
            
            6
            
            
            7
            
            
            0
            
            
            7
            
            
            3Consumer
            
            
            28
            
            
            23
            
            
            24
            
            
            27
            
            
            36Total
                recoveries
            
            
            47
            
            
            179
            
            
            210
            
            
            109
            
            
            148Net
                charge-offs for the period
            
            
            515
            
            
            186
            
            
            125
            
            
            388
            
            
            255Provision
                for loan losses
            
            
            1402
            
            
            840
            
            
            545
            
            
            683
            
            
            435Adjustments
            
            
            0
            
            
            0
            
            
            0
            
            
            (26
            )
            
            0Allowance
                for possible loan losses, end of period
            
            $
            3,545
            
            $
            2,658
            
            $
            2,011
            
            $
            1,591
            
            $
            1,322Ratio
                of allowance for loan losses to total average loans
                outstanding
            
            
            1.50
            %
            
            1.47
            %
            
            1.42
            %
            
            1.48
            %
            
            1.46
            %Ratio
                of net charge-offs during the period to average loans outstanding
                during
                the period
            
            
            0.22
            %
            
            0.10
            %
            
            0.09
            %
            
            0.36
            %
            
            0.28
            %







27





Table
      12
      below sets forth the Company's allocation of the allowance for loan losses
      as of
      December 31, 2005, 2004 and 2003.





**TABLE
      12**


Allowance
                for Loan LossesYears
                Ending December 31,


2005
              
              
              2004
              
              
              2003(In
                  thousands)
                Balance
                  at end of period applicable to
              
              
              Amount
              
              Percent
                  of loans by category to total loans
              
              
              Amount
              
              Percent
                  of loans by category to total loans
              
              
              Amount
              
              
              Percent
                  of loans by category to total loansCommercial,
                  financial and agricultural
              
              $
              1,438
              
              
              32.40
              %
              $
              1,002
              
              
              30.09
              %
              $
              840
              
              
              26.97
              %Real
                  estate - construction
              
              
              1,253
              
              
              17.72
              %
              
              962
              
              
              17.94
              %
              
              539
              
              
              15.31
              %Real
                  estate - commercial
              
              
              535
              
              
              29.98
              %
              
              361
              
              
              30.14
              %
              
              352
              
              
              35.94
              %Real
                  estate - mortgage
              
              
              79
              
              
              17.19
              %
              
              122
              
              
              18.61
              %
              
              139
              
              
              17.92
              %Consumer
              
              
              240
              
              
              2.71
              %
              
              211
              
              
              3.22
              %
              
              141
              
              
              3.86
              %Totals
              
              $
              3,545
              
              
              100.00
              %
              $
              2,658
              
              
              100.00
              %
              $
              2,011
              
              
              100.00
              %
 2002
              
              2001(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
              
              $
              537
              
              
              22.48
              %
              $
              388
              
              
              19.42
              %Real
                  estate - construction
              
              
              524
              
              
              16.46
              %
              
              332
              
              
              12.54
              %Real
                  estate - commercial
              
              
              245
              
              
              22.71
              %
              
              251
              
              
              32.85
              %Real
                  estate - mortgage
              
              
              138
              
              
              33.62
              %
              
              200
              
              
              29.32
              %Consumer
              
              
              147
              
              
              4.72
              %
              
              151
              
              
              5.87
              %Totals
              
              $
              1,591
              
              
              100.00
              %
              $
              1,322
              
              
              100.00
              %






***Investment
      Activities***





*Investment
      Policy*





The
      objective of the Company’s investment policy is to invest funds not otherwise
      needed to meet the loan demand of the Company’s market area and to meet the
      following five objectives: Gap Management, Liquidity, Pledging, Return, and
      Local Community Support. In doing so, Cornerstone uses the portfolio to provide
      structure and liquidity that the loan portfolio cannot. The management
      investment committee balances the market risk and credit risks against the
      potential investment return, make investments compatible with the pledge
      requirements of the Company’s deposit of public funds,


maintain
      compliance with regulatory investment requirements, and assists the 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.





28


The
      Bank’s investment portfolio totaled $ 31.5 million or 9.7% of total assets at
      December 31, 2005.








T able
      13
      sets forth the carrying value of the Bank's investments at the dates indicated.
      Securities are held in both available for sale and held to maturity categories.
      Securities available for sale are carried at fair market value and securities
      held to maturity are held at their book value.







**TABLE
      13**


Securities
                PortfolioYears
                Ending December 31,


Securities
                available for sale:
            
            2005
            
            2004
            
            2003U.S.
                Government and agency obligations
            
            $
            22,349
            
            $
            10,977
            
            $
            11,088Mortgage-backed
                and other securities
            
            
            4,000
            
            
            11,326
            
            
            11,208State
                & political subdivisions tax-exempt
            
            
            3,285
            
            
            3,140
            
            
            1,453Corporate
                debt
            
            
            494
            
            
            1,027
            
            
            1,659Totals
            
            $
            30,128
            
            $
            26,470
            
            $
            24,408Securities
                held to maturity:U.S.
                Government and agency obligations
            
            $
            0
            
            $
            0
            
            $
            0Mortgage-backed
                and other securities
            
            
            322
            
            
            391
            
            
            641State
                & political subdivisions tax-exempt
            
            
            0
            
            
            0
            
            
            0Corporate
                debt
            
            
            0
            
            
            0
            
            
            0Totals
            
            $
            322
            
            $
            391
            
            $
            641Federal
                Home Loan Bank stock, at cost
            
            
            1,034
            
            
            854
            
            
            582Total
                Securities
            
            $
            31,484
            
            $
            27,715
            
            $
            26,049







For
      December 31, 2005 tables 14 and 15 set forth 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.








**TABLE
      14**


Weighted
                Average Yields on the Available For Sale InvestmentsPeriods
                of Maturity from December 31, 2005


Less
                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.
                Treasuries
            
            $
            0
            
            
            0.00
            %
            $
            0
            
            
            0.00
            %
            $
            0
            
            
            0.00
            %
            $
            0
            
            
            0.00
            %U.S.
                Government agencies
            
            
            0
            
            
            0.00
            %
            
            22,350
            
            
            4.36
            %
            
            0
            
            
            0.00
            %
            
            739
            
            
            5.71
            %Mortgage-backed
                securities (2)
            
            
            0
            
            
            0.00
            %
            
            10
            
            
            6.67
            %
            
            20
            
            
            6.68
            %
            
            3,230
            
            
            4.42
            %Tax-exempt
                municipal bonds
            
            
            0
            
            
            0.00
            %
            
            565
            
            
            4.71
            %
            
            619
            
            
            4.16
            %
            
            2,101
            
            
            5.22
            %Other
                bonds, notes, debentures and securities
            
            
            494
            
            
            7.02
            %
            
            0
            
            
            0.00
            %
            
            0
            
            
            0.00
            %
            
            0
            
            
            0.00
            %Totals
            
            $
            494
            
            
            7.02
            %
            $
            22,925
            
            
            4.37
            %
            $
            639
            
            
            4.24
            %
            $
            6,070
            
            
            4.86
            %Total
                Securities Available for Sale
            
            $
            30,128
            
            
            4.51
            %







29







**TABLE
      15**


Weighted
                Average Yields on the Held To Maturity InvestmentsPeriods
                of Maturity from December 31, 2005


Less
                  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)U.S.
                  Treasuries
              
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %
              $
              0
              
              
              0.00
              %U.S.
                  Government agencies
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Mortgage-backed
                  securities (2)
              
              
              0
              
              
              0.00
              %
              
              29
              
              
              7.50
              %
              
              37
              
              
              6.68
              %
              
              256
              
              
              5.87
              %Tax-exempt
                  municipal bonds
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Other
                  bonds, notes, debentures and securities
              
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %
              
              0
              
              
              0.00
              %Totals
              
              $
              0
              
              
              0.00
              %
              $
              29
              
              
              7.50
              %
              $
              37
              
              
              6.68
              %
              $
              256
              
              
              5.87
              %
 Total
                  Securities held to maturity
              
              $
              322
              
              
              6.02
              %Federal
                  Home Loan Bank stock, at cost
              
              $
              1,034
              
              
              4.87
              %Total
                  Securities
              
              $
              31,484
              
              
              4.54
              %




(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





***Sources
      of Funds***





*General*





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





*Deposits*





The
      Bank
      offers several types of deposit accounts, with the principal differences
      relating to the minimum balances required, the time period the funds must remain
      on deposit and the interest rate. Deposits are obtained primarily from the
      Bank's Chattanooga Metropolitan Statistical Area (MSA). The Bank does advertise
      for deposits outside of this area and has had moderate success attracting
      deposits from credit unions around the United States. The Bank does not solicit
      funds from brokers. 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.




30





Table
      16
      sets forth the composition of deposits for the Company, excluding accrued
      interest payable, by type for the years ended December 31, 2005, December 31,
      2004 and December 31, 2003.








**TABLE
      16**


Deposit
                CompositionYears
                Ending December 31,


(In
                thousands)
            
            2005
            
            2004
            
            2003Demand
                deposits
            
            $
            42,118
            
            $
            34,024
            
            $
            22,327NOW
                deposits
            
            
            33,080
            
            
            32,855
            
            
            28,514Savings
                & money market deposits
            
            
            55,411
            
            
            31,211
            
            
            27,712Time
                deposits under $100,000
            
            
            83,119
            
            
            59,653
            
            
            58,535Time
                deposits $100,000 and over
            
            
            38,707
            
            
            30,089
            
            
            22,264Total
                Deposits
            
            $
            252,435
            
            $
            187,832
            
            $
            159,352





Table
      17
      presents a breakdown by category of the average amount of deposits and the
      average rate paid on deposits for the periods indicated:





**TABLE
      17**


Average
                Amount and Average Rate Paid on DepositsYears
                Ending December 31,


(Inthousands)
            
            2005
            
            2004
            
            2003Amount
            
            Rate
            
            Amount
            
            Rate
            
            Amount
            
            RateDemand
                deposits
            
            $
            34,730
            
            
            
            
            $
            27,918
            
            
            
            
            $
            18,017NOW
                deposits
            
            
            33,943
            
            
            0.97
            %
            
            28,843
            
            
            0.48
            %
            
            22,299
            
            
            0.30
            %Savings
                & money market deposits
            
            
            45,232
            
            
            2.45
            %
            
            32,282
            
            
            1.33
            %
            
            25,467
            
            
            1.33
            %Time
                deposits under $100,000
            
            
            70,167
            
            
            3.19
            %
            
            58,367
            
            
            2.50
            %
            
            54,679
            
            
            2.88
            %Time
                deposits $100,000 and over
            
            
            32,611
            
            
            3.51
            %
            
            25,734
            
            
            2.52
            %
            
            19,430
            
            
            3.12
            %Total
                Deposits
            
            $
            216,683
            
            
            2.65
            %
            $
            173,144
            
            
            1.55
            %
            $
            139,892
            
            
            1.85
            %





*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 $30 million outstanding with the FHLB. All the loans are from
      $2 to
      $5 million in size and are structured as ten year obligations with an optional
      conversion to a floating rate after a stated period of time. The loans have
      maturities ranging from December 2010 to February 2015 and have conversion
      dates
      ranging from immediate to February 2010. Interest rates range from 2.4% to
      5.0%.
      The Bank has several Federal Funds lines of credit available with correspondent
      banks with a total availability of $33 million as of the end of 2005. 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, 2005, the Company had
      established a line of credit of $5.0 million priced at 1 month LIBOR plus 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
      the
      Company to act as a source of strength for the Bank without the expense or
      dilution of additional common stock. As of December 31, 2005, there were no
      borrowings on the line of credit and the Company has the entire amount available
      to inject capital into the Bank or fund other investments. ****





***Balance
      Sheet Management***





*Liquidity
      Management.* Liquidity
      is the ability of a company to convert assets into cash without significant
      loss
      and to raise funds by increasing liabilities. Liquidity management involves
      having the ability to meet day-to-day cash flow requirements of its customers,
      whether they are depositors wishing to withdraw funds or borrowers requiring
      funds to meet their credit needs.





31


The
      primary function of asset / liability management is not only to assure adequate
      liquidity in order for the Company to meet the needs of its customer base,
      but
      also to maintain an appropriate balance between interest-sensitive assets and
      interest-sensitive liabilities so that the Company can profitably deploy its
      assets and therefore optimize earnings. Both assets and liabilities are
      considered sources of liquidity funding and both are, therefore, monitored
      on a
      daily basis.





The
      asset
      portion of the balance sheet provides liquidity primarily through loan repayment
      and maturity of investment securities. Additional sources of liquidity are
      the
      investment in Federal Funds sold and prepayments from the mortgage backed
      securities from the investment portfolio.





The
      liability portion of the balance sheet provides liquidity through various
      interest bearing and non-interest bearing deposit accounts. Other short-term
      liabilities, which do not qualify as a deposit, are Federal Funds purchased
      and
      securities under agreement to repurchase (REPO’s). Both are temporary solutions
      for liquidity as Federal Funds must be paid off at least once every 30 days
      and
      REPO’s must be collateralized by investment securities. At year-end December 31,
      2005, the Company had $2.4 million Federal Funds purchased and $2.4 million
      in
      REPO’s. Longer-term liabilities are limited to FHLB advances, which would be
      used to reduce interest rate risk, and Company loans used to repurchase common
      stock or finance any acquisition in the future.





***Capital
      Resources / Liquidity***





*Liquidity.* Of
      primary importance to depositors, creditors and regulators is the ability to
      have readily available funds sufficient to repay fully maturing liabilities.
      The
      Company’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, the Company 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.





The
      Company’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 approved liquidity
      policy is targeted at 10% and currently the Bank’s liquidity ratio is 7.9%. The
      Company is not subject to any specific liquidity requirements imposed by
      regulatory orders. The Company is subject to general FDIC guidelines, which
      do
      not require a minimum level of liquidity. Management believes its liquidity
      ratios meet or exceed these guidelines. Management does not know of any trends
      or demands, which are reasonably likely to result in liquidity increasing or
      decreasing in any material manner.





Table
      18
      sets forth the average loan to deposit ratios, a liquidity measure, for periods
      indicated:




**TABLE
              18**December
                31, 2005
            
            December
                31, 2004Average
                loans to average deposits
            
            
            109.04
            %
            
            104.73
            %





*Impact
      of Inflation and Changing Prices.* 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 concerned with
      two
      inflationary factors; the first and the most common is the general impact of
      inflation on operations of the Company 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 the Company because virtually all
      of
      the assets and liabilities of the Company are monetary in nature. As a result,
      interest rates may have a more significant impact on the Company’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.





32


***Capital
      Adequacy***





Capital
      adequacy refers to the level of capital required to sustain asset growth and
      to
      absorb losses. The objective of the Company’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.





Table
      19
      sets forth the composition of the Bank's capital at December 31, 2005 and
      2004.





**TABLE
      19**


Bank
                CapitalYears
                Ending December 31,


(In
                thousands)
            
            December
                31, 2005
            
            December
                31, 2004Capital:Tier
                I Capital:Stockholders’
                equity
            
            $
            25,816
            
            $
            19,989Less
                gain on AFS securities
            
            
            0
            
            
            (116
            )Plus
                loss on AFS securities
            
            
            166
            
            
            0Less
                disallowed intangibles
            
            
            (1
            )
            
            0Total
                Tier I Capital
            
            
            25,981
            
            
            19,873Tier
                II Capital:Qualifying
                debt
            
            
            0
            
            
            0Reserve
                for non-core Bank activities
            
            
            310
            
            
            263Qualifying
                allowance for loan losses
            
            
            3,422
            
            
            2,665Less
                disallowed intangibles
            
            
            (224
            )
            
            (289
            )Total
                Tier II Capital
            
            
            3,508
            
            
            2,639Total
                Capital
            
            $
            29,489
            
            $
            22,512Risk-adjusted
                Assets
            
            $
            280,439
            
            $
            218,199Average
                Assets
            
            $
            283,394
            
            $
            221,073Ratios:Tier
                I capital to risk-adjusted assets
            
            
            9.26
            %
            
            9.11
            %Tier
                II capital to risk-adjusted assets
            
            
            10.52
            %
            
            10.32
            %Leverage
                ratio (Tier I capital to average assets
              Less
                disallowed intangibles)
            
            
            9.17
            %
            
            8.99
            %





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











33





**TABLE
      20**


Minimum
                Requirements for Risk-Based Capital
                Ratios


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





On
      December 31, 2005, the Company exceeded the regulatory minimums and qualified
      as
      a well-capitalized institution under the regulations. The Bank will adopt
      Statement of Financial Accounting Standard number 123R in 2006. There are no
      critical accounting policies applied that have alternative applications which
      would likely change the results of operations in a material amount. Management
      of the Bank believes it has made the proper judgements about its selection
      of
      accounting policies. ****





**ITEM
      7. FINANCIAL STATEMENTS**





The
      consolidated financial statements of the Company and its subsidiary, together
      with the Report of Independent Certified Public Accountants thereon, are
      included on pages F-1 through F-28 **** of
      this
      Annual Report on Form 10-KSB.




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





Neither
      the Company nor the Bank has had any change in accountants or disagreements
      with
      accountants on accounting and financial disclosure during the two most recent
      fiscal years or subsequently.





**ITEM
      8A. CONTROLS AND PROCEDURES**





Our
      principal executive officer and principal financial officer have evaluated
      the
      effectiveness of our disclosure controls and procedures (as defined in Rules
      13(a)-15(e) and 15(d)-15(e)) under the Securities Exchange Act of 1934, as
      amended (the “Exchange Act”) as of December 31, 2005 (the “Evaluation Date”).
      Based upon such evaluation, such officers have concluded that, as of the
      Evaluation Date, our disclosure controls and procedures are effective in
      alerting them on a timely basis to material information relating to us
      (including our consolidated subsidiaries) required to be included in our
      periodic filings under the Exchange Act.




Since
      the
      Evaluation Date, there have not been any significant changes in our disclosure
      controls and procedures or in other factors that could significantly affect
      such
      controls. There were no significant deficiencies or material weaknesses, and
      therefore there were no corrective actions taken.





It
      should
      be noted that any system of controls, however well designed and operated, can
      provide only reasonable, and not absolute, assurance that the objectives of
      the
      system are met. In addition, the design of any control system is based in part
      upon certain assumptions about the likelihood of future events. Because of
      these
      and other inherent limitations of control systems, there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions, regardless of how remote.





34




**PART
      III**





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


Information
        relating to the directors and executive officers of the Company is set forth
        under the caption “Proposals - Election of Directors” in the Company’s 2006
        Proxy Statement. Such information is incorporated into this report by reference.
        Information relating to audit committee financial experts is set forth under
        the
        caption “Audit Committee Report - Identification of Members and Functions of
        Committee” in the Company’s 2006 Proxy Statement. Such information is
        incorporated into this report by reference.
 
 Section
        16(a) Beneficial Ownership Reporting Compliance
 
 Under
        Section 16(a) of the Securities Exchange Act of 1934, as amended, the directors
        and officers of the Company and any person who owns 10% or more of the Company’s
        Common Stock are required to report to the Securities and Exchange Commission
        (the “SEC”), within specified due dates, their initial beneficial ownership of
        the Company’s Common Stock and all subsequent changes to their beneficial
        ownership. Officers, directors, and greater than 10% shareholders are required
        by SEC regulations to furnish the Company with copies of all forms they file
        in
        accordance with Section 16(a). Based solely on the Company’s review of these
        reports or on representations or information provided to the Company by the
        persons required to make such filings, the Company believes that all Section
        16(a) filing requirements were complied with during the last fiscal year,
        with
        the exception of the following late filings: (a) each of Kenneth B. Driver,
        Karl Fillauer, James H. Large, Russell W. Lloyd, Doyce G. Payne M.D.,
        Turner Smith, Billy O. Wiggins and Marsha Yessick filed one late report on
        a
        Form 4 on May 4, 2005 (with the exception of Mr. Driver, who filed
        such report on May 3, 2005), in which each reported one late transaction
        related to the grant on March 1, 2005 of stock options to acquire
        500 shares of the Company’s Common Stock; (b) Lawrence D. Levine filed
        four late reports on Form 4s, which were filed (i) on May 4,
        2005, reporting one late transaction related to the grant on March 1, 2005
        of stock options to acquire 500 shares of the Company’s Common Stock,
        (ii) on August 10, 2005, reporting one late transaction related to the
        disposition on August 5, 2005 of 230 shares of the Company’s Common
        Stock, (iii) on October 12, 2005, reporting one late transaction
        related to the exercise on October 5, 2005 of stock options to acquire
        20,000 shares of the Company’s Common Stock and (iv) on
        November 10, 2005, reporting one late transaction related to the
        disposition on November 2, 2005 of 5,500 shares of the Company’s
        Common Stock; and (c) Earl A. Marler, Jr. filed three late reports on
        Form 4s, which were filed (i) on May 4, 2005, reporting one late
        transaction related to the grant on March 1, 2005 of stock options to
        acquire 500 shares of the Company’s Common Stock, (ii) on
        June 13, 2005, reporting one late transaction related to the exercise on
        June 2, 2005 of stock options to acquire 10,000 shares of the
        Company’s Common Stock and (iii) on December 14, 2005, reporting one
        late transaction related to the disposition on November 2, 2005 of
        10,000 shares of the Company’s Common Stock.





The
      Company 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.





**ITEM
      10. EXECUTIVE COMPENSATION**





Information
      relating to director compensation is set forth under the caption “Information
      About the Board of Directors and its Committees - Compensation of Directors” in
      the Company’s 2006 Proxy Statement, and information relating to executive
      compensation is set forth under the caption “Executive Compensation” in the
      Company’s 2006 Proxy Statement. Such information is incorporated into this
      report by reference.


35


**ITEM
      11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT**





Information
      relating to ownership of the Company’s common stock by certain persons is set
      forth under the caption “Security Ownership of Certain Beneficial Owners and
      Management” in the Company’s 2006 Proxy Statement. Such information is
      incorporated into this report by reference. Information relating to equity
      compensation plans is set forth under the caption “Executive Compensation -
      Equity Compensation Plan Information as of December 31, 2005 in the Company’s
      2006 Proxy Statement. Such information is incorporated into this report by
      reference.





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





Information
      relating to certain transactions between the Company, and its affiliates and
      certain other persons is set forth under the caption “Certain Relationships and
      Related Transactions” in the Company’s 2006 Proxy Statement. Such information is
      incorporated into this report by reference.





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


(a)  Exhibits





(1)  The
      following consolidated financial statements of the Company and its subsidiary,
      together with the Report of Independent Certified Public Accountants thereon,
      are included on pages F-1 through F-28 **** of
      this
      Annual Report on Form 10-KSB:





Report
      of
      Independent Registered Public Accounting Firm





Consolidated
      Balance Sheets as of December 31, 2005 and 2004





Consolidated
      Statements of Income for the years ended


December 31,
      2005, 2004 and 2003





Consolidated
      Statements of Changes in Stockholders’ Equity


for
      the
      years ended December 31, 2005, 2004 and 2003





Consolidated
      Statements of Cash Flows for the years ended


December
      31, 2005, 2004 and 2003





Notes
      to
      Consolidated Financial Statements





All
      other
      financial statement schedules not listed are omitted because either they are
      not
      applicable, not required or the required information is included in the
      consolidated financial statements or the notes thereto.





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





Exhibit No.
            
            Description3.1
            
            Amended and Restated Charters of Cornerstone
              Bancshares, Inc. (1)3.2
            
            First Amendment to Amended and Restated
              Charter of Cornerstone Bancshares, Inc. (2)3.3
            
            Amended and Restated Bylaws of Cornerstone
              Bancshares, Inc. (3)4
            
            The right of securities holders are
              defined
              in the Charter and Bylaws provided in exhibits 3.1, 3.2 and 3.3
              respectively.




36






10.1
            
            Cornerstone Community Bank Employee
              Stock
              Ownership Plan14
            
            Code of Ethics. (5)21
            
            Subsidiaries of the registrant.31
            
            Certifications of chief executive officer
              and
              chief financial officer32
            
            Section
              906 certifications of chief executive officer and chief financial
              officer.





_______________________





(1)
            
            Incorporated
                by reference from Exhibit 3.1 of the registrant’s Form 10-KSB filed on
                March 21, 2005 (File No. 000-30497).


(2)
            
            Incorporated
                by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on May
                16, 2005 (File No. 000-30497).


(3)
              
              Incorporated
                    by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on
                    August 15, 2005 (File No.
                    000-30497).
 (4)
              
              Incorporated
                    by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on
                    November 10, 2005 (File No.
                    000-30497)
 (5)
              
              Incorporated
                  by reference from Exhibit 10.1 of the registrant’s Form 8-K filed on
                  August 18, 2005,as
                  amended (File No. 333).
 (6)
              
              Incorporated
                  by reference from Exhibit 14 of the registrant’s Form 10-KSB on March 24,
                  2004 (File No. 000-30497)




(b)  The
      following reports on Form 8-K were filed with the Securities and Exchange
      Commission during 2005:





(1)
            
            Form
                8-K filed on January 18, 2005 reporting earnings results for the
                fiscal
                quarter ended December 31, 2005.


(2)
            
            Form
                8-K filed on April 18, 2005 reporting earnings results for the fiscal
                quarter ended March 31, 2005.


(3)
            
            Form
                8-K filed on May 20, 2005 reporting the declaration of a cash
                dividend.


(4)
            
            Form
                8-K filed on June 3, 2005 reporting the resignation of Russell Lloyd
                as
                director.


(5)
            
            Form
                8-K filed on July 19, 2005 reporting earnings results for the fiscal
                quarter ended June 30, 2005.


(6)
            
            Form
                8-K filed on September 26, 2005 reporting the appointment of Miller
                Welborn and Frank McDonald as directors and a new earnings
                guidance.


(7)
            
            Form
                8-K filed on October 17, 2005 reporting earnings results for the
                fiscal
                quarter ended September 30, 2005.


(8)
            
            Form
                8-K filed on November 28, 2005 reporting the declaration of a cash
                dividend.







**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 the Company’s 2006 Proxy
      Statement. Such information is incorporated into this report by
      reference.








37




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 as of December 31, 2005 and 2004, 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,
        2005. These consolidated 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, 2005 and 2004, and the results of their
        operations and their cash flows for each of the three years in the period
        ended
        December 31, 2005, in conformity with U.S. generally accepted accounting
        principles.
 
 **/S/
        HAZLETT, LEWIS & BIETER, PLLC**
 
 Chattanooga,
        Tennessee
 February
        17, 2006






F-1




CORNERSTONE
                  BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                  BALANCE SHEETSDecember
                  31, 2005 and 2004
  2005
              
              2004ASSETSCash
                  and due from banks
              
              $
              14,590,499
              
              $
              6,900,054Securities
                  available for sale
              
              
              30,127,486
              
              
              26,470,691Securities
                  held to maturity (fair value of$321,408
                  in 2005 and $393,097 in 2004)
              
              
              322,180
              
              
              390,599Federal
                  Home Loan Bank stock, at cost
              
              
              1,033,900
              
              
              854,200Loans,
                  net of allowance for loan losses of$3,545,042
                  in 2005 and $2,665,464 in 2004
              
              
              262,008,632
              
              
              202,555,862Bank
                  premises and equipment, net
              
              
              7,207,146
              
              
              5,967,735Accrued
                  interest receivable
              
              
              1,739,460
              
              
              1,184,478Goodwill
                  and amortizable intangibles
              
              
              3,376,892
              
              
              2,541,476Other
                  assets
              
              
              3,205,706
              
              
              1,749,539Total
                  assets
              
              $
              323,611,901
              
              $
              248,614,634LIABILITIES
                  AND STOCKHOLDERS' EQUITYDeposits:Noninterest-bearing
                  demand deposits
              
              $
              42,118,351
              
              $
              34,024,241Interest-bearing
                  demand deposits
              
              
              33,080,446
              
              
              32,855,396Savings
                  deposits and money market accounts
              
              
              55,410,928
              
              
              31,211,457Time
                  deposits of $100,000 or more
              
              
              38,707,366
              
              
              30,089,057Time
                  deposits under $100,000
              
              
              83,118,799
              
              
              59,652,751Total
                  deposits
              
              
              252,435,890
              
              
              187,832,902Accrued
                  interest payable
              
              
              242,864
              
              
              91,595Federal
                  funds purchased and securities sold underagreements
                  to repurchase
              
              
              4,790,737
              
              
              7,409,162Federal
                  Home Loan Bank advances
              
              
              30,000,000
              
              
              27,000,000Other
                  liabilities
              
              
              3,676,047
              
              
              1,473,655Total
                  liabilities
              
              
              291,145,538
              
              
              223,807,314Stockholders'
                  equity:Preferred
                  stock - no par value; 2,000,000 sharesauthorized;
                  no shares issued
              
              
              —
              
              
              —Common
                  stock - $1.00 par value; 10,000,000 shares authorizedin
                  2005 and 2004; shares issued and outstanding -
                  3,201,334in
                  2005 and 2,868,823 in 2004
              
              
              3,201,334
              
              
              2,868,823Common
                  stock subscribed; 119,961 shares in 2004
              
              
              —
              
              
              119,961Additional
                  paid-in capital
              
              
              21,211,135
              
              
              19,160,936Retained
                  earnings
              
              
              8,229,552
              
              
              4,340,981Accumulated
                  other comprehensive income
              
              
              (165,955
              )
              
              116,03432,476,066
              
              
              26,606,735Treasury
                  stock, 471 shares in 2005, at cost
              
              
              (9,703
              )
              
              —Stock
                  subscriptions receivable
              
              
              —
              
              
              (1,799,415
              )Total
                  stockholders' equity
              
              
              32,466,363
              
              
              24,807,320Total
                  liabilities and stockholders' equity
              
              $
              323,611,901
              
              $
              248,614,634The
                  Notes to Consolidated Financial Statements are an integral part
                  of these
                  statements.
  F-2
 
 CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF INCOMEYears
                    Ended December 31, 2005, 2004 and 2003
  2005
                
                2004
                
                2003INTEREST
                    INCOMELoans,
                    including fees
                
                $
                19,353,740
                
                $
                13,029,972
                
                $
                10,326,391Securities
                    and interest-bearing deposits in other banks
                
                
                1,217,405
                
                
                1,006,068
                
                
                980,062Federal
                    funds sold
                
                
                100,937
                
                
                22,675
                
                
                19,965Total
                    interest income
                
                
                20,672,082
                
                
                14,058,715
                
                
                11,326,418INTEREST
                    EXPENSETime
                    deposits of $100,000 or more
                
                
                1,144,939
                
                
                648,651
                
                
                606,162Other
                    deposits
                
                
                3,675,702
                
                
                2,024,596
                
                
                1,981,634Federal
                    funds purchased and securitiessold
                    under agreements to repurchase
                
                
                203,476
                
                
                56,269
                
                
                54,947Federal
                    Home Loan Bank advances and note payable
                
                
                1,053,675
                
                
                845,775
                
                
                568,056Total
                    interest expense
                
                
                6,077,792
                
                
                3,575,291
                
                
                3,210,799Net
                    interest income before provision for loan losses
                
                
                14,594,290
                
                
                10,483,424
                
                
                8,115,619Provision
                    for loan losses
                
                
                1,401,600
                
                
                840,000
                
                
                545,000Net
                    interest income after provision for loan losses
                
                
                13,192,690
                
                
                9,643,424
                
                
                7,570,619NONINTEREST
                    INCOMEService
                    charges
                
                
                984,085
                
                
                899,213
                
                
                888,805Other
                    noninterest income
                
                
                67,956
                
                
                63,070
                
                
                59,615Operating
                    lease income
                
                
                539,756
                
                
                247,251
                
                
                —Net
                    gains from sale of loans and other assets
                
                
                312,923
                
                
                196,342
                
                
                293,453Total
                    noninterest income
                
                
                1,904,720
                
                
                1,405,876
                
                
                1,241,873NONINTEREST
                    EXPENSESSalaries
                    and employee benefits
                
                
                4,502,910
                
                
                3,900,505
                
                
                3,325,470Net
                    occupancy and equipment expense
                
                
                859,313
                
                
                767,461
                
                
                683,811Depreciation
                    on leased assets
                
                
                379,053
                
                
                185,807
                
                
                —Other
                    operating expenses
                
                
                2,474,999
                
                
                2,031,944
                
                
                1,731,552Total
                    noninterest expenses
                
                
                8,216,275
                
                
                6,885,717
                
                
                5,740,833Income
                    before income tax expense
                
                
                6,881,135
                
                
                4,163,583
                
                
                3,071,659Income
                    tax expense
                
                
                2,556,616
                
                
                1,592,500
                
                
                1,189,800Net
                    income
                
                $
                4,324,519
                
                $
                2,571,083
                
                $
                1,881,859EARNINGS
                    PER COMMON SHAREBasic
                
                $
                1.42
                
                $
                1.03
                
                $
                .76Diluted
                
                
                1.32
                
                
                .92
                
                
                .71The
                    Notes to Consolidated Financial Statements are an integral part
                    of these
                    statements.
   F-3
  CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITYYears
                    Ended December 31, 2005, 2004 and 2003
  AccumulatedCommon
                
                Additional
                
                
                
                Other
                
                
                
                Stock
                
                TotalComprehensive
                
                Common
                
                Stock
                
                Paid-in
                
                Retained
                
                Comprehensive
                
                Treasury
                
                Subscriptions
                
                Stockholders'Income
                
                Stock
                
                Subscribed
                
                Capital
                
                Earnings
                
                Income
                
                Stock
                
                Receivable
                
                EquityBALANCE,
                    December 31, 2002
                
                
                
                
                $
                1,233,167
                
                $
                —
                
                $
                12,093,868
                
                $
                1,538,341
                
                $
                281,374
                
                $
                —
                
                $
                —
                
                $
                15,146,750Issuance
                    of common stock
                
                
                
                
                
                10,000
                
                
                —
                
                
                90,000
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                100,000Dividends
                    - $.10 per share
                
                
                
                
                
                —
                
                
                —
                
                
                —
                
                
                (124,316
                )
                
                —
                
                
                —
                
                
                —
                
                
                (124,316
                )Comprehensive
                    income:Net
                    income
                
                $
                1,881,859
                
                
                —
                
                
                —
                
                
                —
                
                
                1,881,859
                
                
                —
                
                
                —
                
                
                —
                
                
                1,881,859Other
                    comprehensive income, net of tax:Unrealized
                    holding
                  gains
                    (losses) onsecurities
                    available
                  for
                    sale, net ofreclassification
                  adjustments
                
                
                (100,792
                )
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                (100,792
                )
                
                —
                
                
                —
                
                
                (100,792
                )Total
                    comprehensive income
                
                $
                1,781,067BALANCE,
                    December 31, 2003
                
                
                
                
                
                1,243,167
                
                
                —
                
                
                12,183,868
                
                
                3,295,884
                
                
                180,582
                
                
                —
                
                
                —
                
                
                16,903,501Issuance
                    of common stock
                
                
                
                
                
                382,039
                
                
                —
                
                
                5,297,614
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                5,679,653Dividends
                    - $.10 per share
                
                
                
                
                
                —
                
                
                —
                
                
                —
                
                
                (282,369
                )
                
                —
                
                
                —
                
                
                —
                
                
                (282,369
                )Split-up
                    effected in the
                  form
                    of a dividend
                
                
                
                
                
                1,243,617
                
                
                —
                
                
                —
                
                
                (1,243,617
                )
                
                —
                
                
                —
                
                
                —
                
                
                —Stock
                    subscriptions subscribed
                
                
                
                
                
                —
                
                
                119,961
                
                
                1,679,454
                
                
                —
                
                
                —
                
                
                —
                
                
                (1,799,415
                )
                
                —Comprehensive
                    income:Net
                    income
                
                $
                2,571,083
                
                
                —
                
                
                —
                
                
                —
                
                
                2,571,083
                
                
                —
                
                
                —
                
                
                —
                
                
                2,571,083Other
                    comprehensive income, net of tax:Unrealized
                    holding
                  gains
                    (losses) onsecurities
                    available
                  for
                    sale, net ofreclassification
                  adjustment
                
                
                (64,548
                )
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                (64,548
                )
                
                —
                
                
                —
                
                
                (64,548
                )Total
                    comprehensive income
                
                $
                2,506,535BALANCE,
                    December 31, 2004
                
                
                
                
                $
                2,868,823
                
                $
                119,961
                
                $
                19,160,936
                
                $
                4,340,981
                
                $
                116,034
                
                $
                —
                
                $
                (1,799,415
                )
                $
                24,807,320(continued
                    on page F-5)
   F-4
  CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITYYears
                    Ended December 31, 2005, 2004 and 2003
 (continued
            from page F-4)
 AccumulatedCommon
                
                Additional
                
                
                
                Other
                
                
                
                Stock
                
                TotalComprehensive
                
                Common
                
                Stock
                
                Paid-in
                
                Retained
                
                Comprehensive
                
                Treasury
                
                Subscriptions
                
                Stockholders'Income
                
                Stock
                
                Subscribed
                
                Capital
                
                Earnings
                
                Income
                
                Stock
                
                Receivable
                
                EquityBALANCE,
                    December 31, 2004
                
                
                
                
                $
                2,868,823
                
                $
                119,961
                
                $
                19,160,936
                
                $
                4,340,981
                
                $
                116,034
                
                $
                —
                
                $
                (1,799,415
                )
                $
                24,807,320Issuance
                    of common stock
                
                
                
                
                
                3,550
                
                
                —
                
                
                19,638
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                23,188Issuance
                    of common stockunder
                    Director's stock option
                  plan
                
                
                
                
                
                209,000
                
                
                —
                
                
                836,000
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                1,045,000Tax
                    benefit received fromDirector's
                    stock option
                  exercise
                
                
                
                
                
                —
                
                
                —
                
                
                1,185,315
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                1,185,315Dividends -
                    $.14 per share
                
                
                
                
                
                —
                
                
                —
                
                
                —
                
                
                (435,948
                )
                
                —
                
                
                —
                
                
                —
                
                
                (435,948
                )Stock
                    subscriptions settled
                
                
                
                
                
                119,961
                
                
                (119,961
                )
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                1,799,415
                
                
                1,799,415Purchase
                    of treasury stock
                
                
                
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                (82,506
                )
                
                —
                
                
                (82,506
                )Reissuance
                    of treasury stock
                
                
                
                
                
                —
                
                
                —
                
                
                9,246
                
                
                —
                
                
                —
                
                
                72,803
                
                
                —
                
                
                82,049Comprehensive
                    income:Net
                    income
                
                $
                4,324,519
                
                
                —
                
                
                —
                
                
                —
                
                
                4,324,519
                
                
                —
                
                
                —
                
                
                —
                
                
                4,324,519Other
                    comprehensive income, net of tax:Unrealized
                    holding
                  gains
                    (losses) onsecurities
                    available
                  for
                    sale, net ofreclassification
                  adjustment
                
                
                (281,989
                )
                
                —
                
                
                —
                
                
                —
                
                
                —
                
                
                (281,989
                )
                
                —
                
                
                —
                
                
                (281,989
                )Total
                    comprehensive income
                
                $
                4,042,530BALANCE,
                    December 31, 2005
                
                
                
                
                $
                3,201,334
                
                $
                —
                
                $
                21,211,135
                
                $
                8,229,552
                
                $
                (165,955
                )
                $
                (9,703
                )
                $
                —
                
                $
                32,466,363The
                    Notes to Consolidated Financial Statements are an integral part
                    of these
                    statements.
   F-5
  CORNERSTONE
                    BANCSHARES, INC. AND SUBSIDIARIESCONSOLIDATED
                    STATEMENTS OF CASH FLOWSYears
                    Ended December 31, 2005, 2004 and 2003
  2005
                
                2004
                
                2003CASH
                    FLOWS FROM OPERATING ACTIVITIESNet
                    income
                
                $
                4,324,519
                
                $
                2,571,083
                
                $
                1,881,859Adjustments
                    to reconcile net income to net cashprovided
                    by operating activities:Depreciation
                    and amortization
                
                
                764,127
                
                
                710,686
                
                
                390,383Provision
                    for loan losses
                
                
                1,401,600
                
                
                840,000
                
                
                545,000Gains
                    on sales of loans and other assets
                
                
                (312,923
                )
                
                (196,342
                )
                
                (293,453
                )Deferred
                    income taxes
                
                
                (460,452
                )
                
                (120,176
                )
                
                (272,751
                )Changes
                    in other operating assets and liabilities:Net
                    change in loans held for sale
                
                
                (257,148
                )
                
                808,978
                
                
                2,486,457Accrued
                    interest receivable
                
                
                (554,982
                )
                
                (245,715
                )
                
                (259,165
                )Accrued
                    interest payable
                
                
                151,269
                
                
                (10,568
                )
                
                (19,107
                )Other
                    assets and liabilities
                
                
                1,629,962
                
                
                192,752
                
                
                235,048Net
                    cash provided by operating activities
                
                
                6,685,972
                
                
                4,550,698
                
                
                4,694,271CASH
                    FLOWS FROM INVESTING ACTIVITIESProceeds
                    from security transactions:Securities
                    available for sale
                
                
                11,818,836
                
                
                20,441,782
                
                
                20,475,056Securities
                    held to maturity
                
                
                69,067
                
                
                251,816
                
                
                386,892Purchase
                    of securities available for sale
                
                
                (16,037,889
                )
                
                (22,564,473
                )
                
                (24,394,458
                )Loan
                    originations and principal collections, net
                
                
                (59,112,700
                )
                
                (48,784,301
                )
                
                (35,029,960
                )Purchase
                    of bank premises and equipment
                
                
                (1,978,538
                )
                
                (2,424,228
                )
                
                (630,746
                )Acquisition
                    of business
                
                
                (1,380,000
                )
                
                —
                
                
                —Proceeds
                    from sale of other real estate and other assets
                
                
                300,464
                
                
                336,637
                
                
                255,050Net
                    cash used in investing activities
                
                
                (66,320,760
                )
                
                (52,742,767
                )
                
                (38,938,166
                )CASH
                    FLOWS FROM FINANCING ACTIVITIESNet
                    increase in deposits
                
                
                64,602,988
                
                
                28,480,627
                
                
                28,905,951Increase
                    (decrease) in federal funds purchased andsecurities
                    sold under agreements to repurchase
                
                
                (2,618,425
                )
                
                1,325,084
                
                
                2,580,939Proceeds
                    from Federal Home Loan Bank advances
                
                
                5,000,000
                
                
                10,000,000
                
                
                7,000,000Proceeds
                    from note payable
                
                
                —
                
                
                2,500,000
                
                
                400,000Repayment
                    of Federal Home Loan Bank advances and note payable
                
                
                (2,000,000
                )
                
                (2,900,000
                )
                
                —Purchase
                    of treasury stock
                
                
                (82,506
                )
                
                —
                
                
                —Proceeds
                    from re—issuance of treasury stock
                
                
                82,049
                
                
                —
                
                
                —Payment
                    of dividends
                
                
                (526,476
                )
                
                (124,316
                )
                
                —Issuance
                    of common stock
                
                
                2,867,603
                
                
                5,679,653
                
                
                100,000Net
                    cash provided by financing activities
                
                
                67,325,233
                
                
                44,961,048
                
                
                38,986,890NET
                    INCREASE (DECREASE) IN CASHAND
                    CASH EQUIVALENTS
                
                
                7,690,445
                
                
                (3,231,021
                )
                
                4,742,995CASH
                    AND CASH EQUIVALENTS, beginning of year
                
                
                6,900,054
                
                
                10,131,075
                
                
                5,388,080CASH
                    AND CASH EQUIVALENTS, end of year
                
                $
                14,590,499
                
                $
                6,900,054
                
                $
                10,131,075SUPPLEMENTAL
                    DISCLOSURES OF CASHFLOW
                    INFORMATIONCash
                    paid during the period for interest
                
                $
                5,926,523
                
                $
                3,585,859
                
                $
                3,229,906Cash
                    paid during the period for taxes
                
                
                1,910,850
                
                
                1,988,062
                
                
                1,316,985NONCASH
                    INVESTING AND FINANCING ACTIVITIESAcquisition
                    of real estate through foreclosure
                
                $
                1,010,555
                
                $
                53,111
                
                $
                104,261The
                    Notes to Consolidated Financial Statements are an integral part
                    of these
                    statements.
   F-6
 
 CORNERSTONE
            BANCSHARES, INC. AND SUBSIDIARIES
  NOTES
            TO
            CONSOLIDATED FINANCIAL STATEMENTS
 December
              31, 2005, 2004 and 2003
 Note
            1. Summary
            of Significant Accounting Policies
 
 The
            accounting and reporting policies of Cornerstone Bancshares, Inc. and
            subsidiaries (Company) conform with generally accepted accounting principles
            and
            practices within the banking industry. The policies that materially affect
            financial position and results of operations are summarized as
            follows:
 
 Nature
            of
            operations and geographic concentration:
 
 The
            Company is a bank-holding company which owns all of the outstanding common
            stock
            of Cornerstone Community Bank (Bank) and Eagle Financial, Inc. (Eagle).
            The Bank
            provides a variety of financial services through five locations in Chattanooga,
            Tennessee and surrounding areas. The Bank's primary deposit products
            are demand
            deposits, savings accounts, and certificates of deposit. Its primary
            lending
            products are commercial loans, real estate loans, and installment loans.
            Eagle
            is a finance and factoring company located in Chattanooga,
            Tennessee.
 
 Principles
            of consolidation:
 
 The
            consolidated financial statements include the accounts of the Company,
            the Bank
            and Eagle. All material intercompany accounts and transactions have been
            eliminated in consolidation.
 
 Goodwill:
 
 Goodwill
            represents the excess of the cost of the Company’s 1997 purchase of the net
            assets of the Bank of East Ridge over the underlying fair value of such
            net
            assets at the date of acquisition. The Company has adopted the provisions
            of
            Statement of Financial Accounting Standards 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. No impairment loss was recognized during 2005,
            2004 or
            2003.
 
 Use
            of
            estimates:
 
 In
            preparing consolidated financial statements in conformity with generally
            accepted accounting principles, 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 positive
            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
            (losses)
            on securities available for sale are included in other income (expense)
            and,
            when applicable, are reported as a reclassification adjustment, net of
            tax, in
            other comprehensive income.
 
 Declines
            in the market value of held to maturity and available for sale securities
            below
            their cost that are deemed to be other than temporary are reflected in
            earnings
            as realized losses. In estimating other than temporary impairment losses,
            management considers (1) the length of time and the extent to which the
            market value has been less than cost, (2) the financial condition and
            near-term prospects of the issuer, and (3) the intent and ability of
            the Company
            to retain its investment in the issuer for a period of time sufficient
            to allow
            for any anticipated recovery in market value. Gains and losses on the
            sale of
            securities are recorded on the trade date and are determined using the
            specific
            identification method.
   F-7
 CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
  NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS


December
        31, 2005, 2004 and 2003
 
 
 Note
        1. Summary
        of Significant Accounting Policies (continued)
 
 Loans:
 
 The
        Company grants mortgage, commercial and consumer loans to customers. A
        substantial portion of the loan portfolio is represented by mortgage loans
        throughout Chattanooga, Tennessee and surrounding areas. The ability of the
        Company’s debtors to honor their contracts is dependent upon the real estate and
        general economic conditions in this 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 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 of 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.
  F-8
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        1. Summary
        of Significant Accounting Policies (continued)
 
 Allowance
        for loan losses: (continued)
 
 A
        loan is
        considered impaired when, based on current information and events, it is
        probable that the Company will be unable to collect the scheduled payments
        of
        principal or interest when due according to the contractual terms of the
        loan
        agreement. Factors considered by management in determining impairment include
        payment status, collateral value, and the probability of collecting scheduled
        principal and interest payments when due. Loans that experience insignificant
        payment delays and payment shortfalls generally are not classified as impaired.
        Management determines the significance of payment delays and payment shortfalls
        on a case-by-case basis, taking into consideration all of the circumstances
        surrounding the loan and the borrower, including the length of the delay,
        the
        reasons for the delay, the borrower’s prior payment record, and the amount of
        the shortfall in relation to the principal and interest owed. Impairment
        is
        measured on a loan by loan basis for commercial and construction loans by
        either
        the present value of expected future cash flows discounted at the loan’s
        effective interest rate, the loan’s obtainable market price, or the fair value
        of the collateral if the loan is collateral dependent.
 
 Large
        groups of smaller balance homogeneous loans are collectively evaluated for
        impairment. Accordingly, the Company does not separately identify individual
        consumer and residential loans for impairment disclosures, unless such loans
        are
        the subject of a restructuring agreement.
 
 Premises
        and equipment:
 
 Land
        is
        carried at cost.  Other premises and equipment are carried at cost net
        of accumulated depreciation.  Depreciation is computed using the
        straight-line method based principally 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 are included
        in current operations.
 
 Other
        real estate owned:
 
 Real
        estate properties acquired through or in lieu of loan foreclosure are initially
        recorded at the lower of the Company’s carrying amount or fair value less
        estimated selling cost at the date of foreclosure. Any write-downs based
        on the
        asset’s fair value at the date of acquisition are charged to the allowance for
        loan losses. After foreclosure, these assets are carried at the lower of
        their
        new cost basis or fair value less cost to sell. Costs of significant property
        improvements are capitalized, whereas costs relating to holding property
        are
        expensed. The portion of interest costs relating to development of real estate
        is capitalized. Valuations are periodically performed by management, and
        any
        subsequent write-downs are recorded as a charge to operations, if necessary,
        to
        reduce the carrying value of a property to the lower of its cost or fair
        value
        less cost to sell.
 
 Income
        taxes:
 
 Income
        taxes are provided for the tax effects of the transactions reported in the
        financial statements and consist of taxes currently due plus deferred income
        taxes related primarily to differences between the tax basis and the financial
        statement carrying amounts of the allowance for loan losses and accumulated
        depreciation. The deferred tax assets and liabilities represent the future
        tax
        return consequences of those differences, which will either be taxable or
        deductible when the assets and liabilities are recovered or settled. Deferred
        tax assets and liabilities are reflected at income tax rates applicable to
        the
        period in which the deferred tax assets or liabilities are expected to be
        realized or settled. As changes in tax laws or rates are enacted, deferred
        tax
        assets and liabilities are adjusted through the provision for income
        taxes.
 
 Transfers
        of financial assets:
 
 Transfers
        of financial assets are accounted for as sales, when control over the assets
        has
        been surrendered. Control over assets is deemed to be surrendered when (1)
        the
        assets have been isolated from the Company, (2) the transferee obtains the
        right
        (free of conditions that constrain it from taking advantage of that right)
        to
        pledge or exchange the transferred assets, and (3) the Company does not maintain
        effective control over the transferred assets through an agreement to repurchase
        them before their maturity.
  F-9
  CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        1. Summary
        of Significant Accounting Policies (continued)
 
 Advertising
        costs:
 
 The
        Company expenses all advertising costs as incurred. Advertising expense was
        $84,564, $85,564, and $33,146 for the years ended December 31, 2005, 2004
        and
        2003, respectively.
 
 Cash
        and
        cash equivalents:
 
 The
        Bank
        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, 2005, the Company has two stock-based compensation plans, which
        are
        described fully in Note 13. The Company applies the recognition and
        measurement principles of APB Opinion No. 25, “Accounting for Stock Issued
        to Employees,” and related interpretations in accounting for those plans. No
        stock-based employee compensation is reflected in net income as all options
        granted under these plans had an exercise price equal to or above the market
        value of the underlying common stock on the date of the grant. The following
        table illustrates the effect on net income and earnings per share if the
        company
        had applied the fair value recognition provisions of FASB Statement
        No. 123, “Accounting for Stock-Based Compensation,” to stock-based
        compensation.
 
 Stock-based
        compensation:
 
 2005
              
              2004
              
              2003Net
                  income, as reported
              
              $
              4,324,519
              
              $
              2,571,083
              
              $
              1,881,859Deduct:
                  Total stock-based employeecompensation
                  expense determinedunder
                  fair value method for all awards,net
                  of the related tax effects
              
              
              (61,402
              )
              
              (49,469
              )
              
              (36,962
              )Pro
                  forma net income
              
              $
              4,263,117
              
              $
              2,521,614
              
              $
              1,844,897Earnings
                  per share:Basic-as
                  reported
              
              $
              1.42
              
              $
              1.03
              
              $
              0.76Basic-pro
                  forma
              
              $
              1.40
              
              $
              1.01
              
              $
              0.74Diluted-as
                  reported
              
              $
              1.32
              
              $
              0.92
              
              $
              0.71Diluted-pro
                  forma
              
              $
              0.90
              
              $
              0.69
              
              $
              1.30
 
 Segment
        reporting:
  Statement
        of Financial Accounting Standards No. 131, “Disclosures about Segments of an
        Enterprise and Related Information” provides for the identification of
        reportable segments on the basis of discreet business units and their financial
        information to the extent such units are reviewed by an entity’s chief decision
        maker (which can be an individual or group of management persons). The Statement
        permits aggregation or combination of segments that have similar
        characteristics. In the Company’s operations, each bank branch is viewed by
        management as being a separately identifiable business or segment from the
        perspective of monitoring performance and allocation of financial resources.
        Although the branches operate independently and are managed and monitored
        separately, each is substantially similar in terms of business focus, type
        of
        customers, products and services. Further, the results of Eagle for 2005
        were
        not significant for separate disclosure due to the proximity of the acquisition
        to December 31, 2005. Accordingly, the Company’s consolidated financial
        statements reflect the presentation of segment information on an aggregated
        basis in one reportable segment.
  F-10
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        1. Summary
        of Significant Accounting Policies (continued)
 
 Off-balance
        sheet credit related financial instruments:
 
 In
        the
        ordinary course of business, the Corporation has entered into commitments
        to
        extend credit, including commitments under credit card arrangements, commercial
        letters of credit, and standby letters of credit. Such financial statements
        are
        recorded when they are funded.
 
 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, 2005 and 2004, these reserve
        balances were approximately $2,635,000 and $1,668,000,
        respectively.
 
 Note
        3.  Securities
 
 Securities
        have been classified in 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,
        2005
        and 2004, is as follows:
 
 2005Gross
              
              GrossAmortized
              
              Unrealized
              
              Unrealized
              
              MarketCost
              
              Gains
              
              Losses
              
              ValueSecurities
                  available for sale:U.S.
                  Government agencies
              
              $
              22,652,365
              
              $
              —
              
              $
              (303,023
              )
              $
              22,349,342State
                  and municipal securities
              
              
              3,261,104
              
              
              54,620
              
              
              (30,855
              )
              
              3,284,869Mortgage-backed
                  securities
              
              
              3,964,527
              
              
              35,399
              
              
              (401
              )
              
              3,999,526Corporate
                  debt securities
              
              
              500,937
              
              
              —
              
              
              (7,187
              )
              
              493,750$
              30,378,933
              
              $
              90,019
              
              $
              (341,466
              )
              $
              30,127,486Securities
                  held to maturity:Mortgage-backed
                  securities
              
              $
              322,180
              
              $
              985
              
              $
              (1,757
              )
              $
              321,4082004Gross
              
              
              GrossAmortized
              
              
              Unrealized
              
              
              Unrealized
              
              
              MarketCost
              
              
              Gains
              
              
              Losses
              
              
              ValueSecurities
                  available for sale:U.S.
                  Government agencies
              
              $
              10,980,741
              
              $
              14,936
              
              $
              (18,565
              )
              $
              10,977,112State
                  and municipal securities
              
              
              3,075,221
              
              
              83,549
              
              
              (18,484
              )
              
              3,140,286Mortgage-backed
                  securities
              
              
              11,224,993
              
              
              102,076
              
              
              (137
              )
              
              11,326,932Corporate
                  debt securities
              
              
              1,013,926
              
              
              12,435
              
              
              —
              
              
              1,026,361$
              26,294,881
              
              $
              212,996
              
              $
              (37,186
              )
              $
              26,470,691Securities
                  held to maturity:Mortgage-backed
                  securities
              
              $
              390,599
              
              $
              3,578
              
              $
              (1,080
              )
              $
              393,097
 
  F-11
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        3. Securities
        (continued)
 
 At
        December 31, 2005 and 2004, securities with a carrying value of
        approximately $12,424,000 and $8,628,000, respectively, were pledged to secure
        public deposits and for other purposes required or permitted by
        law.
 
 At
        December 31, 2005 and 2004, the carrying amount of securities pledged to
        secure repurchase agreements was approximately $6,936,000 and $7,005,000,
        respectively.
 
 The
        amortized cost and estimated market value of securities at December 31, 2005,
        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
              
              $
              500,937
              
              $
              493,750
              
              $
              —
              
              $
              —Due
                  from one year to five years
              
              
              23,218,578
              
              
              22,914,417
              
              
              —
              
              
              —Due
                  from five years to ten years
              
              
              598,171
              
              
              618,663
              
              
              —
              
              
              —Due
                  after ten years
              
              
              2,096,720
              
              
              2,101,130
              
              
              —
              
              
              —26,414,406
              
              
              26,127,960
              
              
              —
              
              
              —Mortgage-backed
                  securities
              
              
              3,964,527
              
              
              3,999,526
              
              
              322,180
              
              
              321,408$
              30,378,933
              
              $
              30,127,486
              
              $
              322,180
              
              $
              321,408
  For
        the
        years ended December 31, 2005, 2004 and 2003, there were no sales of securities
        available for sale. At December 31, 2005, virtually all unrealized losses
        have arisen during the past twelve months.
 
 Note
        4. Loans
        and
        Allowance for Loan Losses
 
 At
        December 31, 2005 and 2004, the Bank's loans consist of the following (in
        thousands):
  2005
              
              2004Mortgage
                  loans on real estate:Residential
                  1-4 family
              
              $
              26,118
              
              $
              23,521Residential
                  multifamily (5 or more)
              
              
              9,374
              
              
              6,153Held
                  for sale
              
              
              603
              
              
              346Commercial
              
              
              79,608
              
              
              61,860Construction
              
              
              47,071
              
              
              36,824Second
                  mortgages
              
              
              3,216
              
              
              2,032Equity
                  lines of credit
              
              
              6,334
              
              
              6,141172,324
              
              
              136,877Commercial
                  loans
              
              
              86,039
              
              
              61,742Consumer
                  installment loans:Personal
              
              
              6,240
              
              
              6,273Credit
                  cards
              
              
              951
              
              
              3296,602
              
              
              7,191Total
                  loans
              
              
              265,554
              
              
              205,221Less:
                  Allowance for loan losses
              
              
              (3,545
              )
              
              (2,665
              )Loans,
                  net
              
              $
              262,009
              
              $
              202,556
   F-12
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 
 Note
        4. Loans
        and
        Allowance for Loan Losses (continued)
 
 A
        summary
        of transactions in the allowance for loan losses for the years ended
        December 31, 2005, 2004 and 2003, is as follows:
  2005
              
              2004
              
              2003Balance,
                  beginning of year
              
              $
              2,665,464
              
              $
              2,011,329
              
              $
              1,591,152Provision
                  for loan losses
              
              
              1,401,600
              
              
              840,000
              
              
              545,000Loans
                  charged-off
              
              
              (557,227
              )
              
              (364,657
              )
              
              (334,884
              )Recoveries
                  of loans previously charged-off
              
              
              35,205
              
              
              178,792
              
              
              210,061Balance,
                  end of year
              
              $
              3,545,042
              
              $
              2,665,464
              
              $
              2,011,329
 
 The
        Bank's only significant concentration of credit at December 31, 2005, occurred
        in real estate loans which totaled approximately $172 million. While real
        estate
        loans accounted for 65 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.
  In
        the
        normal course of business, the Bank makes loans to executive officers, principal
        shareholders, and directors and their affiliates of the Bank on substantially
        the same terms, including interest rates and collateral, as those prevailing
        at
        the time for comparable transactions with other borrowers. Loans to executive
        officers, principal shareholders, and directors and their affiliates were
        approximately $1,730,000 and $1,189,000 at December 31, 2005 and 2004,
        respectively.
 
 Loans
        classified as impaired were insignificant in relation to the Bank’s loan
        portfolio at December 31, 2005 and 2004.
 
 Interest
        income recognized on impaired loans was insignificant to total interest income
        on loans for each of the years ending December 31, 2005, 2004 and
        2003.
 
 Note
        5. Bank
        Premises and Equipment
 
 A
        summary
        of bank premises and equipment at December 31, 2005 and 2004, is as follows:
  2005
              
              2004Land
              
              $
              1,625,567
              
              $
              1,625,567Buildings
                  and improvements
              
              
              3,388,834
              
              
              3,076,321Furniture,
                  fixtures and equipment
              
              
              5,113,021
              
              
              3,248,71410,127,422
              
              
              7,950,602Accumulated
                  depreciation
              
              
              (2,920,276
              )
              
              (1,982,867
              )$
              7,207,146
              
              $
              5,967,735
 
 Depreciation
        expense for the years ended December 31, 2005, 2004 and 2003, amounted to
        $736,731, $527,167, and $288,637, respectively.
  F-13
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        5. Bank
        Premises and Equipment (continued)
  Certain
        bank facilities and equipment are leased under various operating leases.
        Total
        rent expense for the years ended December 31, 2005, 2004 and 2003, was $160,626,
        $147,451and $166,318, respectively.
 
 Future
        minimum rental commitments under non-cancelable leases are as
        follows:
 
 2006
              
              $
              152,0002007
              
              
              156,2582008
              
              
              130,5182009
              
              
              134,3252010
              
              
              137,700Thereafter
              
              
              626,805Total
              
              $
              1,337,606
  Note
        6. Time
        Deposits
 
 At
        December 31, 2005, the scheduled maturities of time deposits are as
        follows:
 
 2006
              
              $
              92,418,6482007
              
              
              21,847,3892008
              
              
              4,359,2722009
              
              
              1,124,0362010
              
              
              2,074,786Thereafter
              
              
              2,034Total
              
              $
              121,826,165
  Note
        7. Concentrations
        in Deposits
 
 At
        December 31, 2005, the Company had a concentration in the money market account
        of one customer totaling approximately $20,500,000. This balance accounted
        for
        approximately 8 percent of total deposits. There were no concentrations at
        December 31, 2004.
 
 Note
        8. Income
        Taxes
 
 The
        Company files consolidated income tax returns with its subsidiaries. Under
        the
        terms of a tax-sharing agreement, the subsidiaries’ allocated portion of the
        consolidated tax liability is computed as if they were reporting income and
        expenses to the Internal Revenue Service as a separate entity.
 
 Income
        tax expense in the statements of income for the years ended December 31,
        2005, 2004 and 2003, consists of the following:
 
 2005
              
              2004
              
              2003Current
                  tax expense
              
              $
              3,017,068
              
              $
              1,712,676
              
              $
              1,462,551Deferred
                  tax expense (benefit) related to:Allowance
                  for loan losses
              
              
              (361,227
              )
              
              (236,309
              )
              
              (133,011
              )Other
              
              
              (99,225
              )
              
              116,133
              
              
              (139,740
              )Income
                  tax expense
              
              $
              2,556,616
              
              $
              1,592,500
              
              $
              1,189,800
 
 
 
 F-14
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        8. Income
        Taxes (continued)
 
 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. The reasons for this difference are as follows:
 
 2005
              
              2004
              
              2003Expected
                  tax at statutory rates
              
              $
              2,339,586
              
              $
              1,415,618
              
              $
              1,044,364Increase
                  (decrease) resulting from tax effect of:State
                  income taxes, net of federal tax benefit
              
              
              295,201
              
              
              178,618
              
              
              131,774Other
              
              
              (78,171
              )
              
              (1,736
              )
              
              13,662Income
                  tax expense
              
              $
              2,556,616
              
              $
              1,592,500
              
              $
              1,189,800
 
 
 The
        components of the net deferred tax asset, included in other assets, are as
        follows:
 2005
              
              2004Deferred
                  tax assets:Deferred
                  compensation
              
              $
              140,716
              
              $
              141,864Deferred
                  loan fees
              
              
              213,710
              
              
              236,316Allowance
                  for loan losses
              
              
              1,113,947
              
              
              752,720Deferred
                  gains
              
              
              —
              
              
              56,344Net
                  unrealized loss on securities available for sale
              
              
              85,492
              
              
              —Other
              
              
              108,612
              
              
              24,4321,662,477
              
              
              1,211,676Deferred
                  tax liabilities:Net
                  unrealized gain on securities available for sale
              
              
              —
              
              
              59,775Depreciation
              
              
              260,174
              
              
              364,975Life
                  insurance
              
              
              156,443
              
              
              148,632Other
              
              
              5,220
              
              
              3,373421,837
              
              
              576,755Net
                  deferred tax asset
              
              $
              1,240,640
              
              $
              634,921
 
 
 Note
        9. Federal
        Home Loan Bank Advances and Note Payable
 
 The
        Bank
        has agreements with the Federal Home Loan Bank of Cincinnati (FHLB) that
        can
        provide convertible fixed rate advances to the Bank in an amount up to
        approximately $42,300,000. 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.
  F-15
 
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        9. Federal
        Home Loan Bank Advances and Note Payable (continued)
 
 At
        December 31, 2005 and 2004, FHLB advances consist of the following:
 
 2005
              
              2004Long-term
                  advance dated December 27, 2000,requiring
                  monthly interest payments, fixedat
                  5.00% until conversion option is
                  exercised,principal
                  due in December 2010
              
              $
              2,000,000
              
              $
              2,000,000Long-term
                  advance dated November 1, 2001,requiring
                  monthly interest payments, fixedat
                  3.94% until November 2006, principal duein
                  November 2011
              
              
              2,000,000
              
              
              2,000,000Long-term
                  advance dated February 22, 2002,requiring
                  monthly interest payments, fixedat
                  3.96% until February 2005, principal duein
                  February 2012
              
              
              —
              
              
              2,000,000Long-term
                  advance dated April 26, 2002,requiring
                  monthly interest payments, fixedat
                  4.11% until conversion option is exercised,principal
                  due in April 2012
              
              
              2,000,000
              
              
              2,000,000Long-term
                  advance dated September 13, 2002,requiring
                  monthly interest payments, fixedat
                  3.51% until September 2007, principal duein
                  September 2012
              
              
              2,000,000
              
              
              2,000,000Long-term
                  advance dated January 17, 2003,requiring
                  monthly interest payments, fixedat
                  2.61% until January 2006, principal duein
                  January 2013
              
              
              4,000,000
              
              
              4,000,000Long-term
                  advance dated April 25, 2003,requiring
                  monthly interest payments, fixedat
                  2.41% until April 2006, principal duein
                  April 2013
              
              
              3,000,000
              
              
              3,000,000Long-term
                  advance dated January 23, 2004,requiring
                  monthly interest payments, fixedat
                  2.50% until January 2007, principal duein
                  January 2014
              
              
              5,000,000
              
              
              5,000,000Long-term
                  advance dated May 27, 2004,requiring
                  monthly interest payments, fixedat
                  3.46% until May 2007, principal duein
                  May 2014
              
              
              5,000,000
              
              
              5,000,000Long-term
                  advanced dated February 9, 2005,requiring
                  monthly interest payments, fixedat
                  3.86% until February 2010, principal duein
                  February 2015
              
              
              5,000,000
              
              
              —$
              30,000,000
              
              $
              27,000,000
   F-16
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        9. Federal
        Home Loan Bank Advances and Note Payable (continued)
 
 There
        are
        no scheduled maturities in 2006, 2007, 2008, or 2009. $2,000,000 matures
        in
        2010. The remaining $28,000,000 matures thereafter.
 
 During
        the fixed rate term of the above advances, the advances may be prepaid subject
        to a prepayment penalty as defined in the 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.
 
 During
        2002, the Company established a $2,500,000 line of credit with a bank that
        is
        secured by a pledge of the Bank’s common stock and bears interest at 1.50% above
        the one-month LIBOR, due in quarterly installments. During 2004, the Company
        renewed the line of credit, which matured on February 28, 2004, and
        increased the line to $5,000,000. This line of credit continues to be secured
        by
        a pledge of the Bank’s common stock and bears interest at 1.50% above the
        one-month LIBOR, due in quarterly installments. There were no borrowings
        outstanding under this line of credit at December 31, 2005 or 2004. The
        line of credit matures on February 28, 2006.
 
 Note
        10. Employee
        Benefit Plan
 
 The
        Bank
        has a 401(k) employee benefit plan covering substantially all employees who
        have
        completed at least 30 days of service and met minimum age requirements. The
        Bank’s contribution to the plan is discretionary and was $142,719 for 2005,
        $130,423 for 2004 and $104,737 for 2003.
 
 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, 2005 and 2004, undisbursed loan commitments aggregated
        $57,935,000 and $38,058,000, respectively. In addition, there were outstanding
        standby letters of credit totaling $6,037,000 and $4,752,000,
        respectively.
 
 Commitments
        to extend credit are agreements to lend to a customer as long as there is
        no
        violation of any condition established in the contract. Commitments generally
        have fixed expiration dates or other termination clauses and may require
        payment
        of a fee. Since many of the commitments are expected to expire without being
        drawn upon, the total commitment amounts do not necessarily represent future
        cash requirements. The Bank evaluates each customer’s creditworthiness on a
        case-by-case basis. The amount of collateral obtained, if deemed necessary
        by
        the Bank upon extension of credit, is based on management’s credit evaluation.
        Collateral held varies but may include accounts receivable, inventory, property
        and equipment, and income-producing commercial properties.
 
 Standby
        letters of credit are conditional commitments issued by the Bank to guarantee
        the performance of a customer to a third party. Standby letters of credit
        generally have fixed expiration dates or other termination clauses and may
        require payment of a fee. The credit risk involved in issuing letters of
        credit
        is essentially the same as that involved in extending loan facilities to
        customers. The Bank’s policy for obtaining collateral, and the nature of such
        collateral, is essentially the same as that involved in making commitments
        to
        extend credit.
 
 The
        Bank
        incurred an insignificant loss on its commitments during 2005, 2004 and 2003.
   F-17
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        12. Fair
        Value of Financial Instruments
 
 Fair
        value estimates are made at a specific point in time, based on relevant market
        information about the financial instrument. These estimates do not reflect
        any
        premium or discount that could result from offering for sale at one time
        the
        Company's entire holdings of a particular financial instrument. Because no
        market exists for a significant portion of the Company's financial instruments,
        fair value estimates are based on judgments regarding future expected loss
        experience, current economic conditions, risk characteristics of various
        financial instruments, and other factors. These estimates are subjective
        in
        nature; involve uncertainties and matters of judgment; and, therefore, cannot
        be
        determined with precision. Changes in assumptions could significantly affect
        the
        estimates.
 
 Fair
        value estimates are based on existing financial instruments without attempting
        to estimate the value of anticipated future business and the value of assets
        and
        liabilities that are not considered financial instruments. The following
        methods
        and assumptions were used to estimate the fair value of each class of financial
        instruments:
 
 Cash
        and
        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 note payable:
 
 The
        carrying amounts of the FHLB advances and the note payable approximate their
        fair value.
  F-18
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        12. Fair
        Value of Financial Instruments (continued)
 
 Commitments
        to extend credit:
 
 The
        fair
        value of commitments is estimated using the fees currently charged to enter
        into
        similar agreements, taking into account the remaining terms of the agreements
        and the present creditworthiness of the counterparties. For fixed-rate loan
        commitments, fair value also considers the difference between current levels
        of
        interest rates and the committed rates.
 
 The
        carrying amount and estimated fair value of the Company's financial instruments
        at December 31, 2005 and 2004, are as follows (in thousands):
 
 2005
              
              2004CarryingAmount
              
              EstimatedFair
                  Value
              
              CarryingAmount
              
              Estimated Fair
                  ValueAssets:Cash
                  and due from banks
              
              $
              14,590
              
              $
              14,590
              
              $
              6,900
              
              $
              6,900Securities
              
              
              30,450
              
              
              30,449
              
              
              26,861
              
              
              26,864Federal
                  Home Loan Bank stock
              
              
              1,034
              
              
              1,034
              
              
              854
              
              
              854Loans,
                  net
              
              
              262,009
              
              
              261,553
              
              
              202,556
              
              
              202,089Liabilities:Noninterest-bearing
                  demand deposits
              
              $
              42,118
              
              $
              42,118
              
              $
              34,024
              
              $
              34,024Interest-bearing
                  demand deposits
              
              
              33,080
              
              
              33,080
              
              
              32,855
              
              
              32,855Savings
                  deposits and money market accounts
              
              
              55,411
              
              
              55,411
              
              
              31,212
              
              
              31,212Time
                  deposits
              
              
              121,826
              
              
              120,828
              
              
              89,742
              
              
              89,548Federal
                  funds purchased and securitiessold
                  under agreements to repurchase
              
              
              4,791
              
              
              4,791
              
              
              7,409
              
              
              7,409Federal
                  Home Loan Bank advances
              
              
              30,000
              
              
              30,000
              
              
              27,000
              
              
              27,000Unrecognized
                  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 those claims are without merit and that the ultimate
        liability, if any, resulting from them will not materially affect the Bank’s
        financial condition or the Company’s consolidated financial
        position.
 
 
 Note
        14.  Liquidity
        and Capital Resources
 
 The
        Company’s primary source of funds with which to pay its future obligations is
        the receipt of dividends from its subsidiary bank. Banking regulations provide
        that the Bank must maintain capital sufficient to enable it to operate as
        a
        viable institution and, as a result, may limit the amount of dividends the
        Bank
        may pay without prior approval. It is management’s intention to limit the amount
        of dividends paid in order to maintain compliance with capital guidelines
        and to
        maintain a strong capital position in the Bank.
  F-19
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        15. Stock
        Option Plans
 
 The
        Company has a stock option plan under which members of the Board of Directors,
        at the formation of the Bank, were granted options to purchase a total of
        up to
        150,000 shares of the Bank's common stock. The option price was $10.00 per
        share
        which was the estimated fair value of the stock at the June 30, 1996, grant
        date. The options expire ten years from the date of grant and were fully
        vested
        at the grant date. On October 15, 1997, the Bank stock options were
        converted to Company stock options.
 
 During
        2004, the Company granted 5,000 options under this plan. These stock options
        vest at 50% on the first and second anniversary of the grant date. The option
        price was $21.76 per share which was the estimated fair value of the stock
        at
        the grant date.
 
 On
        September 16, 2004, the Company’s stock options were subject to a 2-for-1 stock
        dividend doubling the total number of options available in the Director’s stock
        option plan to 300,000 and reducing the existing option price in half. Amounts
        shown in the table below retroactively reflect this dividend.
 
 During
        2005, the Company granted 5,000 options under this plan. These stock options
        vest at 50% on the first and second anniversary of the grant date. The option
        price was $18.45 per share which was the estimated fair value of the stock
        at
        the grant date. A summary of the status of this plan is presented in the
        following table.
 
 Outstanding Options
              
              Exercisable
                  OptionsNumber
              
              Weighted
                  AverageExercise Price
              
              Number
              
              Weighted
                  AverageExercise
                  PriceOutstanding,
                  December 31, 2002
              
              
              260,000
              
              $
              5.00
              
              
              260,000
              
              $
              5.00Options
                  exercised
              
              
              (20,000
              )
              
              5.00
              
              
              (20,000
              )
              
              5.00Outstanding,
                  December 31, 2003
              
              
              240,000
              
              
              5.00
              
              
              240,000
              
              
              5.00Options
                  granted
              
              
              10,000
              
              
              10.88
              
              
              —
              
              
              —Outstanding,
                  December 31, 2004
              
              
              250,000
              
              
              5.24
              
              
              240,000
              
              
              5.00Options
                  granted
              
              
              5,000
              
              
              18.45
              
              
              —
              
              
              —Options
                  exercised
              
              
              (209,000
              )
              
              5.00
              
              
              (209,000
              )
              
              5.00Options
                  forfeited
              
              
              (1,000
              )
              
              14.67
              
              
              —
              
              
              —Options
                  which became exercisable
              
              
              —
              
              
              —
              
              
              5,000
              
              
              10.88Outstanding,
                  December 31, 2005
              
              
              45,000
              
              
              7.59
              
              
              36,000
              
              
              5.81
  The
        weighted-average fair value per share of options granted during 2005 was
        $4.10.
        At December 31, 2005, the range of exercise prices of outstanding options
        issued was $5.00-$18.45. The weighted-average remaining contractual life
        at
        December 31, 2005, was 2.9 years.
 
 The
        Company has two stock option plans under which officers and employees can
        be
        granted incentive stock options or non-qualified stock options to purchase
        shares of the Company’s common stock. The option price for incentive stock
        options shall be not less than 100 percent of the fair market value of the
        common stock on the date of the grant. The non-qualified stock options may
        be
        equal to or more or less than the fair market value of the common stock on
        the
        date of the grant. The stock options vest at 30 percent on the second and
        third anniversary of the grant date and 40 percent on the fourth
        anniversary. The options expire ten years from the grant date and the
        weighted-average remaining contractual life of outstanding stock options
        was
        5.2 years at December 31, 2005.
 
 On
        September 16, 2004, the Company’s stock options were subject to a 2-for-1
        stock dividend doubling the total number of options available under the officer
        and employee plans to 710,000 and reducing the existing option price in half.
        A
        summary of the status of these plans is presented in the following table.
        Amounts shown retroactively reflect this dividend:
  F-20
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
  Note
        15. Stock
        Option Plans (continued)
 
 Outstanding Options
              
              Exercisable
                  OptionsNumber
              
              Weighted
                  Average Exercise Price
              
              Number
              
              Weighted
                    AverageExercise PriceOutstanding,
                  December 31, 2002
              
              
              159,000
              
              $
              6.94
              
              
              31,620
              
              $
              7.13Options
                  granted
              
              
              58,500
              
              
              7.25
              
              
              —
              
              
              —Options
                  which became exercisable
              
              
              —
              
              
              —
              
              
              36,300
              
              
              6.86Outstanding,
                  December 31, 2003
              
              
              217,500
              
              
              7.02
              
              
              67,920
              
              
              6.99Options
                  granted
              
              
              68,500
              
              
              10.88
              
              
              —
              
              
              —Options
                  forfeited
              
              
              (2,250
              )
              
              8.73
              
              
              —
              
              
              —Options
                  exercised
              
              
              (1,550
              )
              
              6.57
              
              
              (1,550
              )
              
              6.57Options
                  which became exercisable
              
              
              —
              
              
              —
              
              
              41,740
              
              
              6.76Outstanding,
                  December 31, 2004
              
              
              282,200
              
              
              7.95
              
              
              108,110
              
              
              6.91Options
                  granted
              
              
              40,150
              
              
              18.45
              
              
              —
              
              
              —Options
                  forfeited
              
              
              (2,550
              )
              
              8.94
              
              
              —
              
              
              —Options
                  exercised
              
              
              (3,550
              )
              
              6.53
              
              
              (3,550
              )
              
              6.53Options
                  which became exercisable
              
              
              —
              
              
              —
              
              
              45,890
              
              
              7.01Outstanding,
                  December 31, 2005
              
              
              316,250
              
              
              9.29
              
              
              150,450
              
              
              6.93
 
 The
        weighted-average fair value per share of options granted was $4.10, $2.88,
        and
        $1.75 for the years ended December 31, 2005, 2004 and 2003, respectively.
        At December 31, 2005, the range of exercise prices of outstanding options
        issued was $6.50-$18.45.
 
 The
        fair
        value of each option grant is estimated on the date of grant using the
        Black-Scholes option-pricing model with the following weighted-average
        assumptions:
 
 Years Ended December 31,2005
              
              2004
              
              2003Dividend
                  yield
              
              
              0.98
              %
              
              0.60
              %
              
              0.00
              %Expected
                  life
              
              
              6.9
                  years
              
              
              6.9
                  years
              
              
              6.9
                  yearsExpected
                  volatility
              
              
              11.80
              %
              
              10.00
              %
              
              10.00
              %Risk-free
                  interest rate
              
              
              4.19
              %
              
              4.16
              %
              
              3.62
              %
 
 Note
        16. Regulatory
        Matters
 
 The
        Company (on a consolidated basis) and the Bank are subject to various regulatory
        capital requirements administered by the Tennessee Department of Financial
        Institutions and the federal banking agencies. Failure to meet minimum capital
        requirements can initiate certain mandatory and possibly additional
        discretionary actions by regulators that, if undertaken, could have a direct
        material effect on the Company’s and the Bank's financial statements. Under
        capital adequacy guidelines and the regulatory framework for prompt corrective
        action, the Company and the Bank must meet specific capital guidelines that
        involve quantitative measures of the Company’s and the Bank's assets,
        liabilities, and certain off-balance-sheet items as calculated under regulatory
        accounting practices. The Company’s and the Bank's capital amounts and
        classification are also subject to qualitative judgments by the regulators
        about
        components, risk weightings, and other factors.
  F-21
 
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        16. Regulatory
        Matters (continued)
 
 Quantitative
        measures established by regulation to ensure capital adequacy require the
        Company and the Bank to maintain minimum amounts and ratios (set forth in
        the
        table below) of total and Tier I capital (as defined in the regulations) to
        risk-weighted assets (as defined), and of Tier I capital (as defined) to
        average assets (as defined). Management believes, as of December 31, 2005
        and 2004, that the Company and the Bank meet all capital adequacy requirements
        to which they are subject.
 
 As
        of
        December 31, 2005, the most recent notification from the Federal Deposit
        Insurance Corporation categorized the Bank as well capitalized under the
        regulatory framework for prompt corrective action. There are no conditions
        or
        events since that notification that management believes have changed the
        Bank's
        prompt corrective action category for bank capital.
 
 The
        Company’s and the Bank's actual capital amounts and ratios are also presented in
        the table. Dollar amounts are presented in thousands.
 
 For
                  CapitalActual
              
              Adequacy
                  PurposesAmount
              
              Ratio
              
              Amount
              
              RatioAs
                  of December 31, 2005Total
                  capital to risk-weighted assets:Consolidated
              
              $
              32,840
              
              
              11.5
              %
              $
              22,943
              
              
              8.0
              %Cornerstone
                  Community Bank
              
              
              29,488
              
              
              10.5
              %
              
              22,435
              
              
              8.0
              %Tier
                  I capital to risk-weighted assets:Consolidated
              
              
              29,255
              
              
              10.2
              %
              
              11,471
              
              
              4.0
              %Cornerstone
                  Community Bank
              
              
              25,983
              
              
              9.3
              %
              
              11,218
              
              
              4.0
              %Tier
                  I capital to average assets:Consolidated
              
              
              29,255
              
              
              10.3
              %
              
              11,338
              
              
              4.0
              %Cornerstone
                  Community Bank
              
              
              25,983
              
              
              9.2
              %
              
              11,336
              
              
              4.0
              %As
                  of December 31, 2004Total
                  capital to risk-weighted assets:Consolidated
              
              $
              24,788
              
              
              11.4
              %
              $
              17,456
              
              
              8.0
              %Cornerstone
                  Community Bank
              
              
              22,512
              
              
              10.3
              %
              
              17,456
              
              
              8.0
              %Tier
                  I capital to risk-weighted assets:Consolidated
              
              
              22,150
              
              
              10.2
              %
              
              8,728
              
              
              4.0
              %Cornerstone
                  Community Bank
              
              
              19,873
              
              
              9.1
              %
              
              8,728
              
              
              4.0
              %Tier
                  I capital to average assets:Consolidated
              
              
              22,150
              
              
              10.0
              %
              
              8,944
              
              
              4.0
              %Cornerstone
                  Community Bank
              
              
              19,873
              
              
              9.0
              %
              
              8,843
              
              
              4.0
              %
 
  F-22
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 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, 2005, 2004 and 2003,
        is as follows:
 
 TaxBefore-Tax
              
              (Expense)
              
              Net-of-TaxAmount
              
              Benefit
              
              AmountYear
                  ended December 31, 2005:Unrealized
                  holding gains and lossesarising
                  during the period
              
              $
              (427,257
              )
              $
              145,268
              
              $
              (281,989
              )Less
                  reclassification adjustment forgains
                  realized in net income
              
              
              —
              
              
              —
              
              
              —$
              (427,257
              )
              $
              145,268
              
              $
              (281,989
              )Year
                  ended December 31, 2004:Unrealized
                  holding gains and lossesarising
                  during the period
              
              $
              (97,800
              )
              $
              33,252
              
              $
              (64,548
              )Less
                  reclassification adjustment forgains
                  realized in net income
              
              
              —
              
              
              —
              
              
              —$
              (97,800
              )
              $
              33,252
              
              $
              (64,548
              )Year
                  ended December 31, 2003:Unrealized
                  holding gains and lossesarising
                  during the period
              
              $
              (152,714
              )
              $
              51,922
              
              $
              (100,792
              )Less
                  reclassification adjustment forgains
                  realized in net income
              
              
              —
              
              
              —
              
              
              —$
              (152,714
              )
              $
              51,922
              
              $
              (100,792
              )
  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 the Company relate to outstanding stock
        options, determined using the treasury stock method.
  F-23
 
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        18. Earnings
        Per Common Share (continued)
 
 Earnings
        per common share have been computed based on the following:
 
 2005
              
              2004
              
              2003Net
                  income
              
              $
              4,324,519
              
              $
              2,571,083
              
              $
              1,881,859Less:
                  Preferred stock dividends
              
              
              —
              
              
              —
              
              
              —Net
                  income applicable to common stock
              
              $
              4,324,519
              
              $
              2,571,083
              
              $
              1,881,859Average
                  number of common shares outstanding
              
              
              3,045,625
              
              
              2,490,340
              
              
              2,479,156Effect
                  of dilutive stock options
              
              
              220,235
              
              
              308,873
              
              
              184,762Average
                  number of common shares outstanding usedto
                  calculate diluted earnings per common share
              
              
              3,265,860
              
              
              2,799,213
              
              
              2,663,918
 
 During
        2004, the Company issued a 2-for-1 stock dividend. The average number of
        common
        shares outstanding and the effect of dilutive stock options for 2003 has
        have
        been retroactively adjusted to reflect this transaction.
 
 Note
        19. Stock
        Subscriptions Receivable
 
 Effective
        October 8, 2004, the Company filed an offering with the Securities and Exchange
        Commission to sell up to 500,000 shares of newly issued Company common stock.
        At
        December 31, 2004, the Company had sold the entire 500,000 shares for an
        issue
        price of $15 per share. However, of this amount, there were 119,961 shares
        of
        common stock subscribed for which the Company had not yet received funds
        and
        issued common stock certificates. The Company recognized stock subscriptions
        receivable of $1,799,415 as of December 31, 2004, related to this
        transaction. As of December 31, 2005, the stock subscriptions receivable
        has been fully settled and the related common stock certificates have been
        issued.
 
 Note
        20. Recent
        Accounting Pronouncements
 
 In
        April
        2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on Derivative
        Instruments and Hedging Activities." This Statement amends and clarifies
        financial accounting and reporting for derivative instruments, including
        certain
        embedded derivatives, and for hedging activities under SFAS No. 133, "Accounting
        for Derivative Instruments and Hedging Activities." This Statement amends
        SFAS
        No. 133 to reflect the decisions made as part of the Derivatives Implementation
        Group and in other FASB projects or deliberations. SFAS No. 149 is
        effective for contracts entered into or modified after June 30, 2003, and
        for hedging relationships designated after June 30, 2003. Adoption of this
        Standard had no material effect on the Company's consolidated financial
        statements.
 
 In
        May
        2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
        Instruments with Characteristics of Both Liabilities and Equity." This Statement
        establishes standards for how an entity classifies and measures certain
        financial instruments with characteristics of both liabilities and equity.
        This
        Statement is effective for financial instruments entered into or modified
        after
        May 31, 2003, and otherwise is effective at the beginning of the first interim
        period beginning after June 15, 2003. Adoption of this Standard had no
        material effect on the Company's consolidated financial statements.
  F-24
 
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 Note
        20. Recent
        Accounting Pronouncements (continued)
 
 In
        December 2003, the FASB issued revised Interpretation No. 46 (FIN 46),
        "Consolidation of Variable Interest Entities." This Interpretation clarifies
        the
        application of ARB No. 51, "Consolidated Financial Statements," for certain
        entities in which equity investors do not have the characteristics of a
        controlling financial interest or do not have sufficient equity at risk for
        the
        entity to finance its activities without additional subordinated support
        from
        other parties. This Interpretation requires variable interest entities to
        be
        consolidated by the primary beneficiary which represents the enterprise that
        will absorb the majority of the variable interest entities' expected losses
        if
        they occur, receive a majority of the variable interest entities' residual
        returns if they occur, or both. This Interpretation was effective for variable
        interest entities created after January 31, 2003, and for variable interest
        entities in which an enterprise obtains an interest after that date. This
        Interpretation is effective in the first fiscal year or interim period beginning
        after December 15, 2004, for variable interest entities in which an
        enterprise holds a variable interest that was acquired before February 1,
        2003, with earlier adoption permitted. Adoption of this Standard did not
        have a
        material effect on the Company's consolidated financial statements.
 
 In
        December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
        Payment,” which is a revision of SFAS No. No. 123, “Accounting for
        Stock-Based Compensation.” SFAS No. 123(R) supersedes APB Opinion No. 25,
“Accounting for Stock Issued to Employees,” and amends SFAS Statement No. 95,
“Statement of Cash Flows.” Generally, the approach to accounting for share-based
        payments in SFAS No. 123(R) is similar to the approach described in SFAS
        No. 123. However, SFAS No. 123(R) requires all share-based payments to
        employees, including grants of employee stock options, to be recognized in
        the
        financial statements based on their fair values (i.e., pro forma disclosure
        is
        no longer an alternative to financial statement recognition). SFAS
        No. 123(R) is effective for the Company beginning January 1, 2006. The
        Company is currently evaluating the provisions of SFAS No. 123(R) to
        determine its impact on the Company’s consolidated financial statements in
        future periods.
 
 Note
        21. Acquisition
 
 On
        December 1, 2005, the Company acquired certain assets and assumed liabilities
        of
        Eagle for a purchase price of $1,380,000 in cash plus assumption of
        approximately $1,609,000 in liabilities. Assets acquired, primarily accounts
        receivable, amounted to approximately $2,140,000. The excess of purchase
        price
        over the fair value of the assets acquired of $848,916 was recorded as an
        intangible asset separable from goodwill, as it pertained to customer
        relationships, active customer contracts and brand recognition, and met the
        separability criteria of SFAS No. 141, “Business Combinations” (SFAS
        141). The Company is amortizing the intangible assets over their benefit
        periods
        which range from 2 to 7 years. The Company recognized amortization expense
        of
        $13,500 for the period ended December 31, 2005.
 
 The
        acquisition was accounted for under the provisions of SFAS 141 and the results
        of operations have been included in the accompanying consolidated financial
        statements since its date of acquisition. Pro-forma disclosures of the
        acquisition have not been included, as the overall impact the acquisition
        was
        not material to the Company’s operating results.
  F-25
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
  Note
        22.  Quarterly
        Data (unaudited)
  Years
                    Ended December 31,2005
                
                2004Fourth
                
                Third
                
                Second
                
                First
                
                Fourth
                
                Third
                
                Second
                
                FirstQuarter
                
                Quarter
                
                Quarter
                
                Quarter
                
                Quarter
                
                Quarter
                
                Quarter
                
                QuarterInterest
                    income
                
                $
                6,067,709
                
                $
                5,437,881
                
                $
                4,843,999
                
                $
                4,322,493
                
                $
                3,871,916
                
                $
                3,704,596
                
                $
                3,404,307
                
                $
                3,077,896Interest
                    expense
                
                
                1,873,554
                
                
                1,641,591
                
                
                1,427,333
                
                
                1,135,314
                
                
                1,003,096
                
                
                946,760
                
                
                817,978
                
                
                807,457Net
                    interest income, beforeprovision
                    for loan losses
                
                
                4,194,155
                
                
                3,796,290
                
                
                3,416,666
                
                
                3,187,179
                
                
                2,868,820
                
                
                2,757,836
                
                
                2,586,329
                
                
                2,270,439Provision
                    for loan losses
                
                
                502,000
                
                
                349,600
                
                
                340,000
                
                
                210,000
                
                
                255,000
                
                
                175,000
                
                
                250,000
                
                
                160,000Net
                    interest income, after provisionfor
                    loan losses
                
                
                3,692,155
                
                
                3,446,690
                
                
                3,076,666
                
                
                2,977,179
                
                
                2,613,820
                
                
                2,582,836
                
                
                2,336,329
                
                
                2,110,439Noninterest
                    income
                
                
                840,877
                
                
                491,748
                
                
                270,378
                
                
                301,717
                
                
                415,308
                
                
                314,439
                
                
                328,514
                
                
                347,615Noninterest
                    expenses
                
                
                2,485,197
                
                
                1,969,647
                
                
                1,856,724
                
                
                1,904,707
                
                
                1,893,554
                
                
                1,741,978
                
                
                1,645,977
                
                
                1,604,208Income
                    before income taxes
                
                
                2,047,835
                
                
                1,968,791
                
                
                1,490,320
                
                
                1,374,189
                
                
                1,135,574
                
                
                1,155,297
                
                
                1,018,866
                
                
                853,846Income
                    tax expense
                
                
                706,116
                
                
                738,000
                
                
                578,500
                
                
                534,000
                
                
                418,000
                
                
                447,700
                
                
                396,300
                
                
                330,500Net
                    income
                
                $
                1,341,719
                
                $
                1,230,791
                
                $
                911,820
                
                $
                840,189
                
                $
                717,574
                
                $
                707,597
                
                $
                622,566
                
                $
                523,346Earnings
                    per common share:Basic
                
                $
                0.43
                
                $
                0.40
                
                $
                0.30
                
                $
                0.29
                
                $
                0.29
                
                $
                0.28
                
                $
                0.25
                
                $
                0.21Diluted
                
                $
                0.41
                
                $
                0.37
                
                $
                0.28
                
                $
                0.26
                
                $
                0.24
                
                $
                0.25
                
                $
                0.23
                
                $
                0.20
   F-26
  CORNERSTONE
          BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
          TO
          CONSOLIDATED FINANCIAL STATEMENTS
 December
          31, 2005, 2004 and 2003
 Note
        23. Condensed
        Parent Information
 
 BALANCE
                  SHEETS2005
              
              2004ASSETSCash
              
              $
              516,559
              
              $
              2,675,690Investment
                  in subsidiaries
              
              
              27,511,971
              
              
              19,989,410Loan
                  to subsidiary
              
              
              1,428,794
              
              
              —Goodwill
              
              
              2,541,476
              
              
              2,541,476Other
                  assets
              
              
              726,626
              
              
              1,370Total
                  assets
              
              $
              32,725,426
              
              $
              25,207,946LIABILITIES
                  AND STOCKHOLDERS’ EQUITYOther
                  liabilities
              
              $
              259,063
              
              $
              400,626Stockholders’
                  equity
              
              
              32,466,363
              
              
              24,807,320Total
                  liabilities and stockholders’ equity
              
              $
              32,725,426
              
              $
              25,207,946
  
 
 STATEMENTS
                  OF INCOME2005
              
              2004
              
              2003INCOMEDividends
              
              $
              200,000
              
              $
              177,039
              
              $
              —Interest
                  income
              
              
              10,000
              
              
              —
              
              
              —210,000
              
              
              177,039
              
              
              —EXPENSESInterest
                  expense
              
              
              —
              
              
              38,485
              
              
              5,540Other
                  operating expenses
              
              
              263,824
              
              
              203,881
              
              
              133,317Loss
                  before equity in undistributed earnings of subsidiary
              
              
              (53,824
              )
              
              (65,327
              )
              
              (138,857
              )Equity
                  in undistributed earnings of subsidiary
              
              
              4,261,344
              
              
              2,544,910
              
              
              1,969,516Income
                  tax benefit
              
              
              116,999
              
              
              91,500
              
              
              51,200Net
                  income
              
              $
              4,324,519
              
              $
              2,571,083
              
              $
              1,881,859
 
  F-27
 CORNERSTONE
        BANCSHARES, INC. AND SUBSIDIARIES
 
 NOTES
        TO
        CONSOLIDATED FINANCIAL STATEMENTS
 December
        31, 2005, 2004 and 2003
 
 
 Note
        23. Condensed
        Parent Information (continued)
 
 2005
              
              2004
              
              2003STATEMENTS
                  OF CASH FLOWSCASH
                  FLOWS FROM OPERATING ACTIVITIESNet
                  income
              
              $
              4,324,519
              
              $
              2,571,083
              
              $
              1,881,859Adjustments
                  to reconcile net income to net cashprovided
                  by (used in) operating activities:Equity
                  in undistributed income of subsidiary
              
              
              (4,261,344
              )
              
              (2,544,910
              )
              
              (1,969,516
              )Other
              
              
              20,818
              
              
              52,056
              
              
              9,555Net
                  cash provided by (used in) operating activities
              
              
              83,993
              
              
              78,229
              
              
              (78,102
              )CASH
                  FLOWS FROM INVESTING ACTIVITIESAcquisition
                  of business
              
              
              (1,380,000
              )
              
              —
              
              
              —Loan
                  to subsidiary
              
              
              (1,428,794
              )
              
              —
              
              
              —Capital
                  contribution to subsidiary
              
              
              (1,775,000
              )
              
              (2,750,000
              )
              
              (500,000
              )Net
                  cash used in investing activities
              
              
              (4,583,794
              )
              
              (2,750,000
              )
              
              (500,000
              )CASH
                  FLOWS FROM FINANCING ACTIVITIESProceeds
                  from note payable
              
              
              —
              
              
              2,500,000
              
              
              400,000Repayment
                  of note payable
              
              
              —
              
              
              (2,900,000
              )
              
              —Purchase
                  of treasury stock
              
              
              (82,506
              )
              
              —
              
              
              —Proceeds
                  from re-issuance of treasury stock
              
              
              82,049
              
              
              —
              
              
              —Payment
                  of dividends
              
              
              (526,476
              )
              
              (124,316
              )
              
              —Issuance
                  of common stock
              
              
              2,867,603
              
              
              5,679,653
              
              
              100,000Net
                  cash provided by financing activities
              
              
              2,340,670
              
              
              5,155,337
              
              
              500,000NET
                  INCREASE (DECREASE) IN CASH AND CASHEQUIVALENTS
              
              
              (2,159,131
              )
              
              2,483,566
              
              
              (78,102
              )CASH
                  AND CASH EQUIVALENTS, beginning of year
              
              
              2,675,690
              
              
              192,124
              
              
              270,226CASH
                  AND CASH EQUIVALENTS, end of year
              
              $
              516,559
              
              $
              2,675,690
              
              $
              192,124SUPPLEMENTAL
                  DISCLOSURES OF CASH FLOWINFORMATIONCash
                  paid during the year for:Interest
              
              $
              —
              
              $
              40,503
              
              $
              3,522Income
                  taxes
              
              
              1,190,850
              
              
              1,988,062
              
              
              1,316,985


F-28


**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
              15, 2006
            By:
            /s/ Gregory B. JonesGregory
                B. Jones
              Chairman
                and Chief Executive Officer
              (principal
                executive officer)By
            /s/
              Nathaniel F. HughesNathaniel
                F. Hughes
              President
                and Treasurer
              (principal
                financial officer and accounting officer)












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 15, 2006.


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) andDirector/s/
                  Jerry D. Lee
              
              Executive
                  Vice President and Senior LenderJerry
                  D. Lee
              
              and
                  Director/s/
                  James H. Large
              
              DirectorJames
                  H. Large/s/
                  Lawrence D. Levine
              
              DirectorLawrence
                  D. Levine/s/
                  Earl A. Marler, Jr.
              
              DirectorEarl
                  A. Marler, Jr./s/
                  Frank S. McDonald
              
              DirectorFrank
                  S. McDonald/s/
                  Doyce G. Payne
              
              DirectorDoyce
                  G. Payne/s/
                  Turner Smith
              
              DirectorTurner
                  Smith/s/
                  W. Miller Welborn
              
              DirectorMiller
                  Welborn/s/
                  Billy O. Wiggins
              
              DirectorBilly
                  O. Wiggins/s/
                  Marsha Yessick
              
              DirectorMarsha
                  Yessick
















INDEX
      OF EXHIBITS




Exhibit No.
              
              Description3.1
              
              Amended and Restated Charters of Cornerstone
                Bancshares, Inc. (1)3.2
              
              First Amendment to Amended and Restated
                Charter of Cornerstone Bancshares, Inc. (2)3.3
              
              Amended and Restated Bylaws of Cornerstone
                Bancshares, Inc. (3)4
              
              The right of securities holders are
                defined
                in the Charter and Bylaws provided in exhibits 3.1, 3.2 and 3.3
                respectively.
 10.1
              
              Cornerstone Community Bank Employee
                Stock
                Ownership Plan14
              
              Code of Ethics. (5)21
              
              Subsidiaries of the registrant.31
              
              Certifications of chief executive
                officer and
                chief financial officer32
              
              Section
                906 certifications of chief executive officer and chief financial
                officer.
 
 _______________________
 
 (1)
              
              Incorporated
                  by reference from Exhibit 3.1 of the registrant’s Form 10-KSB filed on
                  March 24, 2005 (File No. 000-30497).
 (2)
              
              Incorporated
                  by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on May
                  14, 2005 (File No. 000-30497).
 (3)
                
                Incorporated
                        by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on March
                        24, 2005 (File No.
                        000-30497)
 (4)
                
                Incorporated
                        by reference from Exhibit 10.1 of the registrant’s Form 8-K filed on
                        August 18, 2005,as
                        amended (File No. 333).
 (5)
                
                Incorporated
                      by reference from Exhibit 14 of the registrant’s Form 10-KSB on March 24,
                      2004 (File No. 000-30497)