UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-K





x
            ANNUAL
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For the fiscal year ended December 31,
2009




OR





o
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934





For
      transition period from
      __________  to  __________





Commission
file number 000-30497








(Exact
Name of Registrant as Specified in its Charter)




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


835
Georgia Avenue,


Chattanooga,
TN  37402


(Address
of principal executive offices)(Zip Code)





(423)
385-3000


(Registrant’s
telephone number, including area code)





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





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


Common
Stock, $1.00 Par Value





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


YesoNox





Indicate
by check mark if Registrant is not required to file reports pursuant to Section
13 or Section 15(d) of the Exchange Act.


Yes  o  No x





Indicate
by check mark whether the Registrant (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities and Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.


Yes xNo
o





Indicate by check whether the Registrant has submitted
electronically and posted on its corporate Website, if any, every Interactive
Data File required to be submitted and posted pursuant to Rule 405 of Regulation
S-T (§232.405 of this chapter) during the preceding 12 months (or for such
shorter period that the Registrant was required to submit and post such
files).


Yes oNo o





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K (229.405 of this chapter) is not contained herein, and will not
be contained, to the best of Registrant’s knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K. o




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




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




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


Yes oNo x




The
aggregate market value of the common stock held by non-affiliates of the
Registrant on June 30, 2009 was $32 million. The market value calculation
was determined using the closing sale price of the Registrant’s common stock on
June 30, 2009, as reported on the OTC Bulletin Board. For purposes of this
calculation, the term “affiliate” refers to all directors, executive officers
and 10% shareholders of the Registrant. As of the close of business on December
31, 2009 there were 6,500,396 shares of the Registrant’s common stock
outstanding.




DOCUMENTS
INCORPORATED BY REFERENCE




Portions
of the Registrant’s Proxy Statement for the 2010 Annual Meeting of Shareholders
(the “2010 Proxy Statement”) are incorporated by reference into Part III of this
Annual Report on Form 10-K to the extent described herein.









TABLE
OF CONTENTS




Item
      No.
              
              
              
              Page
      No.PART I
              
              
              
              4ITEM 1.
              
              BUSINESS
              
              4ITEM 1A.
              
              RISK FACTORS
              
              10ITEM 1B.
              
              UNRESOLVED STAFF COMMENTS
              
              16ITEM 2.
              
              PROPERTIES
              
              16ITEM 3.
              
              LEGAL PROCEEDINGS
              
              17ITEM 4.
              
              SUBMISSION OF MATTERS TO A VOTE OF SECURITY
      HOLDERS
              
              17PART II
              
              
              
              17ITEM 5.
              
              MARKET FOR THE REGISTRANT’S COMMON EQUITY,
      RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
      SECURITIES
              
              17ITEM 6.
              
              SELECTED FINANCIAL DATA
              
              18ITEM 7.
              
              MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
      CONDITION AND RESULTS OF OPERATIONS
              
              20ITEM 7A.
              
              QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
      MARKET RISK
              
              41ITEM 8.
              
              FINANCIAL STATEMENTS AND SUPPLEMENTARY
      DATA
              
              43ITEM 9.
              
              CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
      ACCOUNTING AND FINANCIAL DISCLOSURE
              
              86ITEM
    9A(T).
              
              CONTROLS AND PROCEDURES
              
              86ITEM 9B.
              
              OTHER INFORMATION
              
              86PART III
              
              
              
              86ITEM 10.
              
              DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
      GOVERNANCE
              
              86ITEM 11.
              
              EXECUTIVE COMPENSATION
              
              87ITEM 12.
              
              SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
      AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
              
              87ITEM 13.
              
              CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS,
      AND DIRECTOR INDEPENDENCE
              
              87ITEM
    14.
              
              PRINCIPAL ACCOUNTANT FEES AND
      SERVICES
              
              87ITEM 15.
              
              EXHIBITS AND FINANCIAL STATEMENT
      SCHEDULES
              
              88




2





FORWARD-LOOKING
STATEMENTS





Cornerstone
Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral
statements, including statements contained in this report (including, without
limitation, certain statements in “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” in Item 7), that constitute
forward-looking statements within the meaning of Section 21E of the
Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,”
“anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,”
“estimate,” and similar expressions are intended to identify such
forward-looking statements, but other statements may constitute forward-looking
statements. These statements should be considered subject to various risks and
uncertainties. Such forward-looking statements are made based upon management’s
belief as well as assumptions made by, and information currently available to,
management pursuant to “safe harbor” provisions of the Private Securities
Litigation Reform Act of 1995. Cornerstone’s actual results may differ
materially from the results anticipated in forward-looking statements due to a
variety of factors. Such factors include, without limitation, those specifically
described in Item 1A of Part I of this Annual Report on Form 10-K, as well
as the following:  (i) unanticipated deterioration in the
financial condition of borrowers resulting in significant increases in loan
losses and provisions for those losses, (ii) increased competition with
other financial institutions, (iii) lack of sustained growth in the economy
in the Chattanooga, Tennessee area, (iv) rapid fluctuations or
unanticipated changes in interest rates, (v) the inability of Cornerstone
to grow its loan portfolio at historic or planned rates and (vi) changes in
the legislative and regulatory environment, including compliance with the
various provisions of the Sarbanes-Oxley Act of 2002. Many of such factors are
beyond Cornerstone’s ability to control or predict, and readers are cautioned
not to put undue reliance on such forward-looking statements. Cornerstone does
not intend to update or reissue any forward-looking statements contained in this
report as a result of new information or other circumstances that may become
known to Cornerstone.




3




PART
I





ITEM
1.  BUSINESS





OVERVIEW





Cornerstone
was incorporated on September 19, 1983 under the laws of the State of
Tennessee.  Cornerstone 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 one wholly-owned subsidiary:
Cornerstone Community Bank, a Tennessee banking corporation (the “Bank”), which
resulted from the merger of The Bank of East Ridge and Cornerstone Community
Bank effective October 15, 1997.  The Bank has one wholly-owned
subsidiary: Eagle Financial Inc., a Tennessee corporation (“Eagle”), created
December 1, 2005 with the assets acquired from Eagle Financial, LLC, a Tennessee
limited liability company, and Eagle Funding, LLC, a Nevada limited liability
company.





Cornerstone





The
primary activity of Cornerstone currently is, and is expected to remain for the
foreseeable future, the ownership and operation of the Bank.  As a
bank holding company, Cornerstone intends to facilitate the Bank’s ability to
serve its customers’ requirements for financial services.  The holding
company structure also provides flexibility for expansion through the possible
acquisition of other financial institutions and the provision of additional
banking-related services, as well as certain non-banking services, which a
traditional commercial bank may not provide under present laws.  The
holding company structure also affords additional flexibility in terms of
capital formation and financing opportunities.  In prior years, Eagle
was owned and operated by Cornerstone.  However, on June 30, 2009,
Eagle was sold to the Bank.  This transaction allowed the Bank to
consolidate additional capital and improve its regulatory capital
position.





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





The
Bank





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





At
December 31, 2009, the Bank had five full-service banking offices located
in Hamilton County, Tennessee.





In 2007,
the Bank established two loan production offices (“LPO”).  The first
LPO is located in Dalton, Georgia and has expanded the Bank’s presence in North
Georgia.  In September 2009, the Bank closed the second LPO, which was
located in Knoxville, Tennessee.





Eagle





Eagle’s
business concentrates on the purchase of accounts receivable 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 employee
compensation and benefits, office expenses and other overhead
expenses.




4




Employees





As of
December 31, 2009, Cornerstone had 105 full-time equivalent
employees.  The employees are not represented by a collective
bargaining unit.  Cornerstone believes that its relationship with its
employees is good.





Competition





All
phases of the Bank’s banking activities are highly competitive.  The
Bank competes actively with over 20 commercial banks, as well as finance
companies, credit unions, and other financial institutions located in its
service area, which includes Hamilton County, Tennessee.





The
Bank’s deposits totaled approximately $405 million as of December 31,
2009.  The deposit base represents approximately 5% of the deposit
base in the Chattanooga, Tennessee Metropolitan Statistical Area
(MSA).  Three major regional banks represent approximately 70% of the
deposits in the Chattanooga, Tennessee MSA.  These larger financial
institutions have greater resources, higher lending limits than the Bank, and
each of the three institutions has over 20 branches in the Chattanooga,
Tennessee MSA.  There are also several credit unions located in
Hamilton County, Tennessee.  Credit unions are not subject to the same
income tax structure as commercial banks.  This advantage enables
credit unions to offer competitive rates to potential customers.  The
Bank also faces competition in certain areas of its business from mortgage
banking companies, consumer finance companies, insurance companies, money market
mutual funds and investment banking firms, some of which are not subject to the
same degree of regulation as the Bank.





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





Supervision
and Regulation





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





The Bank
is a Tennessee-chartered commercial bank and is subject to the supervision and
regulation of the Tennessee Department of Financial Institutions (the
“TDFI”).  In addition, the Bank’s deposit accounts are insured up to
applicable limits by the Deposit Insurance Fund (the “DIF”) 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 operations of
Cornerstone and the Bank, including reserves, loans, mortgages, capital,
issuance of securities, payment of dividends and establishment of
branches.  Federal and state banking agencies also have the general
authority to limit the dividends paid by insured banks if such payments should
be deemed to constitute an unsafe or unsound banking practice.  The
TDFI, FDIC and Federal Reserve Board have the authority to impose penalties,
initiate civil and administrative actions and take other steps intended to
prevent banks from engaging in unsafe or unsound practices.





FDIC
Insurance of Deposit Accounts





Deposits
of the Bank are insured by the FDIC to a maximum of $250,000 for each insured
depositor through the DIF.  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 other analyses, and require establishment
of general or specific reserves in amounts equal to the difference between such
reevaluation and the book value of the assets.




5





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





Subsequent
to the enactment of the Financial Institutions Reform, Recovery and Enforcement
Act of 1989 (“FIRREA”), the FDIC issued risk-based bank capital guidelines which
went into effect in stages through 1992.  In accordance with the
FDIC’s risk-based standards, an institution’s assets and off-balance sheet
activities are categorized into one of four risk categories, with either a 0%,
20%, 50%, or 100% amount of capital to be held against these
assets.  In addition, the guidelines divide capital instruments into
Tier 1 (core) capital and Tier 2 (supplementary) capital.  The
risk-based capital adequacy guidelines require that (i) Tier 1 capital equal or
exceed 4% of risk-weighted assets; (ii) Tier 2 capital may not exceed 100% of
Tier 1 capital, although certain Tier 2 capital elements are subject to
additional limitations; (iii) assets and off-balance sheet items must be
weighted according to risk; and (iv) the total capital to risk-weighted assets
ratio must be at least 8.0%.  The FDIC’s current leverage capital
requirement requires banks receiving the highest regulatory rating based upon
the FDIC’s routine examination process, to maintain Tier 1 capital equal to 3.0%
of the bank’s total assets.  The FDIC may determine that an insured
institution needs to maintain a higher capital level based on the institution’s
particular risk profile. When determining an insured institution’s minimum
capital level, the FDIC will consider whether the financial history or
condition; managerial resources; the future earnings prospects; significant
risks from concentrations of credit or nontraditional activities; excessive
interest rate risk exposure; or a significant volume of criticized assets poses
a risk to the insured institution’s capital adequacy.





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





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





Although
the Bank is not a member of the Federal Reserve System, it is subject to Federal
Reserve Board regulations that require the Bank 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 Federal Reserve Board regulations currently require that
average daily reserves be maintained against transaction accounts in the amount
of 3% of the aggregate of such net transaction accounts up to $52.6 million,
plus 10% of the total in excess of $52.6 million.





State
of Tennessee Supervision and Regulation





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





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




6





State
banks are subject to regulation by the TDFI with regard to capital requirements
and the payment of dividends.  Tennessee has adopted the provisions of
the Federal Reserve 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’s equity
capital accounts, except (i) in the case of certain loans secured by negotiable
title documents covering readily marketable nonperishable staples, or (ii) with
the prior approval of the bank’s board of directors or finance committee
(however titled), the bank may make a loan to any person, firm or corporation of
up to twenty-five percent (25%) of its equity capital
accounts.  Tennessee law requires that dividends be paid only from
retained earnings (or undivided profits) except that dividends may be paid from
capital surplus with the prior, written consent of the
TDFI.  Tennessee laws regulating banks require certain charges against
and transfers from an institution’s undivided profits account before undivided
profits can be made available for the payment of dividends.





Federal Supervision and
Regulation





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





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





In
addition to the banking regulations imposed on Cornerstone, the offer and sale
of securities of Cornerstone, as well as the securities of the Bank, is subject
to compliance with applicable federal and state securities
laws.  Accordingly, any such offering must be registered under both
the Securities Act of 1933 (the “Securities Act”) and applicable state
securities laws or qualify for exemptions from such requirements.





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 Cornerstone, the Bank
(other than a loan, discount, deposit, or trust service) or any other subsidiary
of Cornerstone; (ii) refrain from obtaining any property, credit or service from
any competitor of Cornerstone, the Bank or any subsidiary of Cornerstone; or
(iii) provide any credit, property or service to Cornerstone, the Bank (other
than those related to and usually provided in connection with a loan, discount,
deposit or trust service) or any subsidiary of Cornerstone.





Most bank
holding companies are required to give the Federal Reserve 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 Federal Reserve 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, Federal
Reserve Board order or directive or any condition imposed by, or written
agreement with, the Federal Reserve Board.  The prior notice
requirement does not apply to certain “well-capitalized” bank holding companies
that meet specified criteria.





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




7





Legislation Affecting Cornerstone and
the Bank





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





FIRREA and
FDICIA





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





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





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





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


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


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


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


§
            authorization
      for the FDIC to impose one or more special assessments on its insured
      banks to recapitalize the Bank Insurance Fund (now called the Deposit
      Insurance Fund);


§
            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.




8




Gramm-Leach-Bliley
Act





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





Temporary Liquidity
Guarantee Program





On
November 21, 2008, the Board of Directors of the FDIC adopted a final rule
relating to the Temporary Liquidity Guarantee Program (“TLGP”).  The
TLGP was announced by the FDIC on October 14, 2008, preceded by the
determination of systemic risk by the U.S. Treasury, as an initiative to counter
the system-wide crisis in the nation’s financial sector.  Under the
TLGP, the FDIC will (i) guarantee, through the earlier of maturity or June 30,
2012, certain newly issued senior unsecured debt issued by participating
institutions and (ii) provide unlimited FDIC deposit insurance coverage for
noninterest bearing transaction deposit accounts, Negotiable Order of Withdrawal
Accounts (commonly known as NOW accounts) paying less than 0.5% interest per
annum and Interest on Lawyers Trust Accounts (commonly known as IOLTA) held at
participating FDIC-insured institutions through June 30,
2010.  Coverage under the TLG Program was available for the first 30
days without charge.  The fee assessment for coverage of senior
unsecured debt ranges from 50 basis points to 100 basis points per annum,
depending on the initial maturity of the debt.  The fee assessment for
deposit insurance coverage is 10 basis points per quarter on amounts in covered
accounts exceeding $250,000.  The Bank elected to participate in the
unlimited deposit insurance coverage for noninterest bearing transaction deposit
accounts, but declined to participate in the senior unsecured debt guarantee
coverage.





Future
Legislation





Legislation
is regularly introduced in both the United States Congress and the Tennessee
General Assembly that contains wide-ranging proposals for altering the
structures, regulations and competitive relationships of the nation’s financial
institutions.  Such legislation may change banking statutes and the
operating environment of Cornerstone and/or the Bank in substantial and
unpredictable ways and could increase or decrease the cost of doing business,
limit or expand permissible activities or affect the competitive balance,
depending upon whether any of this potential legislation will be enacted and, if
enacted, the effect that it or any implementing regulations would have on the
financial condition or results of operations of Cornerstone and/or the
Bank.





Financial
Regulatory Reform Legislation – General





Financial
regulatory reform legislation pending in the United States Congress may impact
all regulated financial institutions, including Cornerstone and the Bank. Bills
pending include the “Wall Street Reform and Consumer Protection Act of 2009,”
which passed the House of Representatives on December 11, 2009 (the “Wall Street
Reform Act”). This bill included the provisions of the “Corporate and Financial
Institution Compensation Fairness Act of 2009 (the “Compensation Fairness Act”
), which the House previously passed on July 31, 2009. Examples of provisions in
pending legislation follow but are not intended to be all
inclusive.





Say
on Pay and Say on Parachutes Provisions





The
Compensation Fairness Act incorporated the principal aspects of the Obama
administration’s legislative proposal on executive compensation and includes
corporate governance provisions commonly referred to as “Say on Pay,” and “Say
on Parachutes.” The “Say on Pay” provisions apply to all companies that
distribute proxies subject to the Commission’s proxy rules. “Say on Pay”
requires companies to have an annual stockholder vote to approve the company’s
executive compensation and related compensation disclosure. The stockholder vote
is advisory only, and the new legislation would not impose any new fiduciary
duties on the company’s board of directors. If the “Say on Pay” provisions of
the Wall Street Reform Act become part of the final legislation, this practice
will be mandatory for all companies subject to the Commission’s proxy rules,
including Cornerstone.




9





The Wall
Street Reform Act also contains “Say on Parachutes” provisions that are similar
to the “Say on Pay” rules. Under the Wall Street Reform Act’s version of “Say on
Parachutes,” whenever a company asks stockholders to approve an acquisition,
merger, consolidation, or proposed sale or other disposition of all or
substantially all of the company’s assets, these companies must propose a
stockholder vote to approve any agreement or understanding with certain
executive officers concerning any type of compensation, whether present,
deferred or contingent based on or related to the proposed transaction. The
stockholder vote would be advisory and would not impose new fiduciary duties on
directors.





Compensation
Committee; Compensation Advisors





The Wall
Street Reform Act in its current form requires all companies that have a
stock-exchange listing or stock-exchange listed equity to establish a
compensation committee that is composed exclusively of independent directors.
While federal securities laws, federal tax law, and stock exchange rules already
contain definitions of director independence, the bills before Congress may
result in a new and more stringent definition of independence for this
purpose.





The Wall
Street Reform Act and other bills would require that companies grant the board’s
compensation committee the power to retain its own independent advisors. The
expenses of these advisors would be borne by the company at the discretion of
the compensation committee.





Proxy
Access





The Wall
Street Reform Act and other bills before Congress authorize the Commission to
promulgate proxy access rules that allow stockholders to have their director
nominees included in the company’s proxy materials.





Consumer
Financial Protection Agency





The Wall
Street Reform Act creates a new Consumer Financial Protection Agency (the
“Agency”) as an independent executive agency to regulate the provision of
consumer financial products or services, including (i) the Electronic Funds
Transfer Act; (ii) the Equal Credit Opportunity Act; (iii) provisions of the
Fair Credit Reporting Act; (iv) the Fair Debt Collection Practices Act; (v) the
Home Mortgage Disclosure Act; (vi) the Real Estate Settlement Procedures Act;
(vii) the Truth in Lending Act; and (viii) the Truth in Savings
Act.





The Wall
Street Reform Act further transfers to the Agency authorities concerning
consumer financial protection functions of the Federal Reserve, the Comptroller
of the Currency, the Director of the Office of Thrift Supervision, the FDIC, the
Federal Trade Commission, and the National Credit Union
Administration.





Because
the exact scope of the Agency’s powers and priorities are not yet well-defined,
Cornerstone cannot yet predict the impact of the formation of this new regulator
on the conduct of Cornerstone’s and the Bank’s businesses.





ITEM
1A. RISK FACTORS





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





There
are substantial doubts as to Cornerstone’s ability to continue as a going
concern.





In its
report dated March 29, 2010, Cornerstone’s independent registered public
accounting firm stated that uncertainty regarding Cornerstone’s holding company
loans raises substantial doubt about Cornerstone’s ability to continue as a
going concern.  In that firm’s opinion, such doubt arises from
Cornerstone’s failure to comply with certain debt covenants under two loans
totaling approximately $5.4 million and secured by a pledge of all of the Bank’s
common stock.  If Cornerstone is unable to comply with such covenants
or obtain a waiver from the lender for such violations, the lender may declare
the loans in default and take possession of the Bank’s common
stock.  If this event were to occur, Cornerstone’s assets and
operations would be substantially reduced and therefore its ability to continue
as a going concern would be in substantial doubt.  The Board of
Directors and management are actively considering strategic alternatives, which
may include a capital infusion through the issuance and sale of common stock,
preferred stock or other securities (including securities convertible into
shares of common stock) in public or private offerings, to provide sufficient
proceeds to Cornerstone to pay off the holding company
debt.  Cornerstone can give no assurance that any such alternative, if
and once consummated, will provide greater value to shareholders than that
reflected in the current stock price.  In addition, to the extent such
alternatives involve equity financing, as presently anticipated, it could result
in substantial dilution to current shareholders and could adversely affect the
price of Cornerstone’s common stock.  The going concern risk is
discussed further in Item 7 herein (Management’s Discussion and Analysis of
Financial Condition and Results of Operations) and in footnote 2 to
Cornerstone’s audited consolidated financial statements in Item 8
herein.




10





Cornerstone
may face risks with respect to future expansion.





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




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


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


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


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


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


•
              entry
      into new markets where Cornerstone lacks experience;


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


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


•
              the
      risk of loss of key employees and
customers.






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




Cornerstone’s
success depends significantly upon economic conditions in the local markets
where the Bank operates.





Substantially all of the
Bank’s loan and deposit customers live, work and bank in the Chattanooga,
Tennessee MSA. As a result, the success of the Bank and, in turn, Cornerstone
depends upon a sound local economy to provide opportunities for new business
ventures, increased loan demand and the need for deposit services.Cornerstone’s profitability is impacted by these local factors as well as
general economic conditions and interest rates. For example, Cornerstone’s
earnings may be negatively impacted by increases in unemployment rates or
reductions in population, income levels, deposits and housing starts. Adverse
economic conditions in the local markets where the Bank operates may reduce its
growth rate and diminish the ability of its customers to service their loan
obligations. A prolonged economic downturn could also negatively impact
collateral values or cash flows of borrowing businesses, and as a result the
Bank’s primary source of repayment could be insufficient to service the debt. In
addition, adverse consequences to the Bank (and, consequently, to Cornerstone)
in the event of a prolonged economic downturn in its local markets could be
compounded by the fact that many of the Bank’s commercial and real estate loans
are secured by real estate located in those market areas. Significant decline in
real estate values in these market areas would mean that the collateral for many
of the Bank’s loans would provide less security. As a result, the Bank would be
more likely to suffer losses on defaulted loans because its ability to fully
recover on defaulted loans by selling the real estate collateral would be
diminished. Adverse economic conditions in the Bank’s local markets, including
sustained periods of increased payment delinquencies, foreclosures or losses in
the State of Tennessee or the State of Georgia, could impair the Bank’s ability
to collect loans and could otherwise have a negative effect on the Bank’s and
Cornerstone’s assets, revenues, results of operations and financial
condition.





Continuing
negative developments in the financial services industry and U.S. and global
capital and credit markets may lead to additional regulation and further
deterioration of Cornerstone’s results of operations and financial
condition.





Negative
developments in the capital and credit markets during 2008 and 2009 have
resulted in uncertainty in the financial markets.  It is anticipated
that these negative economic developments will continue into
2010.  Financial institutions across the United States, including the
Bank, have experienced deteriorating asset quality.  Loan portfolios
include impaired loans to businesses struggling to stay in operation or achieve
adequate cash flow. A decline in collateral values supporting these loans have
also impacted the ability of businesses or consumers to obtain loans or
increased financial institutions’ losses in the event of foreclosure and
liquidation.  At the same time financial institutions have experienced
concerns regarding liquidity.  This concern has increased the
competition for deposits in Cornerstone’s local market as well as wholesale
funding options.  These events have impacted Cornerstone’s, as well as
other bank holding companies’, stock prices.  The potential impact of
these events may be an expansion of existing or creation of new federal or state
laws and regulations regarding lending and funding practices, liquidity
standards and compliance issues.  Continued negative developments or
Cornerstone’s inability to respond to these new operating and regulatory
requirements could further negatively impact Cornerstone’s results of
operations.  The negative consequences could limit Cornerstone’s
ability to originate new loans or obtain adequate funding or increase costs
associated with regulatory compliance.   Ultimately, these
changes could result in modifications to Cornerstone’s existing or future
strategic plans, capital requirements, compensation, financial performance
and/or stock performance.




11





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





Under the
Temporary Liquidity Guarantee Program (“TLGP”) the FDIC may offer a guarantee of
certain financial institution indebtedness in exchange for an insurance premium
to be paid to the FDIC by issuing financial
institutions.  Participation in the TLGP likely will require the
payment of additional insurance premiums to the FDIC.  We may be
required to pay higher FDIC premiums than those published for 2009 because
market developments have depleted the deposit insurance fund of the FDIC and
reduced the ratio of reserves to insured deposits.  The U.S. Congress
enacted the Emergency Economic Stabilization Act of 2008 (“EESA”) in response to
the impact of the volatility and disruption in the capital and credit markets on
the financial sector.  The U.S. Department of the Treasury (“U.S.
Treasury”) and the federal banking regulators implemented a number of programs
under this legislation to address these conditions and the asset quality,
capital and liquidity issues they have caused for certain financial institutions
and to improve the general availability of credit for consumers and
businesses.  In addition, the U.S. Congress enacted the American
Recovery and Reinvestment Act of 2009 (“ARRA”) in an effort to save and create
jobs, stimulate the U.S. economy and promote long-term growth and
stability.  The EESA and ARRAhave been
followed by numerous actions by the Federal Reserve, the U.S. Congress, the U.S.
Treasury, the FDIC, the Commission and others to address the liquidity and
credit crisis that followed the sub-prime meltdown. These measures include
homeowner relief that encourages loan restructuring and modification; the
establishment of significant liquidity and credit facilities for financial
institutions and investment banks; the lowering of the federal funds rate;
emergency action against short selling practices; a temporary guaranty program
for money market funds; the establishment of a commercial paper funding facility
to provide back-stop liquidity to commercial paper issuers; and coordinated
international efforts to address illiquidity and other weaknesses in the banking
sector. The purpose of these legislative and regulatory actions is to stabilize
the U.S. financial system. The TLGP, the EESA, theARRA and the other
regulatory initiatives described above may not have their desired effects. If
the volatility in the markets continues and economic conditions fail to improve
or worsen, Cornerstone’s business, financial condition, results of operations
and/or access to credit, as well as the trading price of its common stock, could
be materially and adversely affected.





Cornerstone
cannot fully predict the impact of future legislation on its and the Bank’s
businesses.





Financial
regulatory reform legislation pending in the U.S. Congress may impact all
regulated financial institutions, including Cornerstone and the Bank. Bills
pending include, among others, the “Wall Street Reform and Consumer Protection
Act of 2009,” which passed the House of Representatives on December 11, 2009
(the “Wall Street Reform Act”). This bill included the provisions of the
“Corporate and Financial Institution Compensation Fairness Act of 2009 (the
“Compensation Fairness Act”), which the House previously passed on July 31,
2009. The proposed legislation in its current form includes changes in corporate
governance and executive compensation that may impact how Cornerstone currently
does business. The Wall Street Reform Act also creates a new Consumer Financial
Protection Agency (the “Agency”) as an independent executive agency to regulate
the provision of consumer financial products or services. The Wall Street Reform
Act further transfers to the Agency authorities concerning consumer financial
protection functions of the Federal Reserve, the Comptroller of the Currency,
the Director of the Office of Thrift Supervision, the FDIC, the Federal Trade
Commission, and the National Credit Union Administration.  Because the
exact scope of the Agency’s powers and priorities are not yet well-defined,
Cornerstone cannot yet predict the impact of the formation of this new regulator
on the conduct of its and the Bank’s businesses and whether Cornerstone’s costs
associated with compliance with consumer protection laws and regulations will
increase.





Cornerstone
and the Bank are subject to federal and state regulations that impact their
operations and financial performance.





Cornerstone
and the Bank operate in a highly regulated industry and are subject to
examination, supervision and comprehensive regulation by various federal and
state agencies, including the Federal Reserve Board, the FDIC and the TDFI.
Compliance with the numerous banking regulations is costly and requires
investment in human and information technology resources. Certain activities of
Cornerstone and/or the Bank, such as the payment of dividends, mergers and
acquisitions, investments, loans and interest rates charged, interest rates paid
on deposits and locations of offices, are impacted by these regulations. The
Bank is also subject to capitalization guidelines established by its regulators,
which require it to maintain adequate capital to support its
growth.




12





The laws
and regulations applicable to the banking industry are subject to change at any
time. Cornerstone cannot predict the events that will result in regulatory
changes nor their impact on the banking industry in general and Cornerstone and
the Bank in particular. Because government regulation greatly affects the
business and financial results of all commercial banks and bank holding
companies, the cost of compliance for Cornerstone and the Bank could adversely
affect their ability to operate profitably.





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





As of
December 31, 2009, the most recent notification from the Federal Deposit
Insurance Corporation (FDIC) categorized the Bank as adequately capitalized
under the regulatory framework for prompt corrective action.  To be
categorized as well capitalized, an institution must maintain minimum total
risk-based, Tier 1 risk-based and Tier 1 leverage ratios.





In
situations similar to the Bank’s the FDIC has been known to issue Consent Orders
that have contained one or more of the following provisions: a requirement to
augment capital; a requirement to closely monitor criticized assets; a
requirement to closely monitor and manage liquidity; and other similar
requirements.  If the Bank were to be presented with such a
supervisory agreement, the Bank’s Board of Directors would likely consent to its
terms.





The
Bank’s  loan portfolio includes an elevated, although declining level,
of residential construction and land development loans, which have a greater
credit risk than residential mortgage loans.





The Bank
engages in residential construction and land development loans to developers.
This type of lending is generally considered to have more complex credit risks
than traditional single-family residential lending because the principal is
concentrated in a limited number of loans with repayment dependent on the
successful operation of the related real estate project. Consequently, these
loans are more sensitive to the current adverse conditions in the real estate
market and the general economy. These loans are generally less predictable and
more difficult to evaluate and monitor and collateral may be difficult to
dispose of in a market decline. Furthermore, during adverse general economic
conditions, such as are now being experienced in residential real estate
construction nationwide, borrowers involved in the residential real estate
construction and development business may suffer above normal financial strain.
Throughout 2009, the number of newly constructed homes or lots sold in the
Bank’s market areas has continued to decline, negatively affecting collateral
values. As the residential real estate development and construction market in
the Bank’s markets has deteriorated, the Bank’s borrowers in this segment have
begun to experience difficulty repaying their obligations to the Bank. As a
result, the Bank’s loans to these borrowers have deteriorated and may
deteriorate further and may result in additional charge-offs negatively
impacting the Bank’s (and consequently, Cornerstone’s) results of operations.
Additionally, to the extent repayment is dependent upon the sale of newly
constructed homes or lots, such sales are likely to be at lower prices or at a
slower rate than was expected when the loan was made, which may result in such
loans being placed on non-accrual status and subject to higher loss estimates
even if the borrower keeps interest payments current. These adverse economic and
real estate market conditions may lead to further increases in non-performing
loans and other real estate owned, increased charge-offs from the disposition of
non-performing assets, and increases in provision for loan losses, all of which
would negatively impact the Bank’s (and, consequently, Cornerstone’s) financial
condition and results of operations.





If
the Bank’s asset quality continues to decline or it continues to experience
greater loan losses than anticipated, the earnings and overall financial
condition of the Bank and Cornerstone will be adversely affected even
further.





The
assets of Cornerstone and the Bank are primarily comprised of loans. The risk of
credit losses on loans varies with, among other things, general economic
conditions, the type of loan being made, the creditworthiness of the borrower
over the term of the loan and, in the case of a collateralized loan, the value
and marketability of the collateral for the loan. While the risk of nonpayment
of loans is inherent in banking, the Bank has experienced higher nonpayment
levels than it anticipated, which has had a significant adverse effect on its
(and, consequently, Cornerstone’s) earnings and overall financial condition.
Although the Bank has taken actions to prevent further decline, including the
creation of a special asset committee to develop and review action plans for
minimizing loan losses and the dedication of resources to assist in the
collection and recovery process, there can be no assurance that the outcome of
such actions will be successful. To minimize the likelihood of a substandard
loan portfolio, the Bank assesses the credit worthiness of customers and
performs collateral valuations. Management also maintains an allowance for loan
losses based upon, among other things, historical experience and an evaluation
of economic conditions and regular reviews of delinquencies and loan portfolio
quality. Based upon such factors, management makes various assumptions and
judgments about the ultimate collectability of the loan portfolio and provides
an allowance for loan losses based upon a percentage of the outstanding balances
and takes a charge against earnings with respect to specific loans when their
ultimate collectability is considered questionable. If management’s assumptions
and judgments prove to be incorrect and the allowance for loan losses is
inadequate to absorb losses, or if regulatory authorities require the Bank to
increase its allowance for loan losses as a part of their examination process,
additional provision expense would be incurred and the earnings and capital of
the Bank and Cornerstone could be significantly and adversely affected. For
example, as previously reported, for the third quarter of 2009 the Bank was
required to fund an additional provision of $1.625 million for loan losses
following a joint examination of the Bank by the FDIC and the TDFI, and for the
fourth quarter of 2009 the Bank provided $4.15 million of additional provision
for loan losses after charging off possible losses and writing off other real
estate losses. Moreover, additions to the allowance may be necessary based on
changes in economic and real estate market conditions, new information regarding
existing loans, identification of additional problem loans and other factors,
both within and outside of management’s control. These additions may require
increased provision expense which would negatively impact Cornerstone’s results
of operations.




13





Cornerstone
has increased levels of other real estate, primarily as a result of
foreclosures.





As the
Bank has begun to resolve non-performing real estate loans, Cornerstone has
increased the level of foreclosed properties, primarily those acquired from
builders and from residential land developers. Foreclosed real estate expense
consists of three types of charges: maintenance costs, valuation adjustments due
to new appraisal values and gains or losses on disposition. As levels of other
real estate increase and also as local real estate values decline, these charges
will likely increase, negatively affecting Cornerstone’s results of
operations.





The
Bank may require additional capital which may not be able to be
obtained.





The Bank
may require capital from sources other than earnings generation. In November
2009, the FDIC downgraded the Bank’s status to an “adequately capitalized”
institution, which, among other things, restricts the interest rates payable by
the Bank for time deposits. To restore the Bank’s status as a “well capitalized”
institution, Cornerstone intends to provide capital to the Bank through
additional sources, which may include additional equity investments, public or
private offerings of common stock (including securities convertible into common
stock), preferred stock or trust preferred securities, borrowed funds or any
combination of these sources of funds. Cornerstone’s ability to access these
alternative capital sources may be limited due to regulatory restrictions or the
condition of the capital markets. Therefore, Cornerstone’s ability to rebuild
the Bank’s capital reserves may be impaired.





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





Cornerstone
relies on dividends from the Bank as its primary source of funds. However, in
November 2009, following the conclusion of a joint examination of the Bank by
the FDIC and the TDFI, the FDIC placed restrictions on the Bank’s ability to pay
cash dividends, requiring that the Bank first obtain a non-objection from the
FDIC. Furthermore, the majority of the Bank’s funds are comprised of customer
deposits and loan repayments. While scheduled loan repayments are a relatively
stable source of funds, they are subject to the ability of borrowers to repay
the loans. The repayment of loans can be adversely affected by a number of
factors, including changes in economic conditions, adverse trends or events
affecting business industry groups, reductions in real estate values or markets,
business closings or lay-offs, inclement weather, natural disasters and
international instability. Additionally, deposit levels may be affected by a
number of factors, including rates paid by competitors, general interest rate
levels, returns available to customers on alternative investments and general
economic conditions. Accordingly, Cornerstone currently is, and may from time to
time in the future be, required to rely on secondary sources of liquidity to
meet withdrawal demands or otherwise fund operations. Alternative sources
include advances from the Federal Home Loan Bank and federal funds lines of
credit from correspondent banks. While Cornerstone believes that these sources
are currently adequate, there can be no assurance they will be sufficient to
meet future liquidity demands. Cornerstone may be required to slow or
discontinue loan growth, capital expenditures or other investments or liquidate
assets if these alternative sources are not adequate.





The
Bank has a significant deferred tax asset and cannot assure you that it will be
fully realized.





The Bank
has net deferred tax assets of $551 thousand as of December 31, 2009. The Bank
did not establish a valuation allowance against its federal net deferred tax
assets as of December 31, 2009 because it believes that it is more likely than
not that all of these assets will be realized. In evaluating the need for a
valuation allowance, the Bank estimated future taxable income based on
management prepared forecasts. This process required significant judgment by
management about matters that are by nature uncertain. If future events differ
significantly from current forecasts, the Bank may need to establish a valuation
allowance, which could have a material temporary adverse effect on its results
of operations and financial condition.





A
decline in Cornerstone’s stock price or expected future cash flows, or a
material adverse change in our results of operations or prospects, could result
in impairment of our goodwill.





A
significant and sustained decline in Cornerstone’s stock price and market
capitalization below book value, a significant decline in our expected future
cash flows, a significant adverse change in the business climate, slower growth
rates or other factors could result in impairment of our goodwill. If
Cornerstone were to conclude that a write-down of goodwill is necessary, then
the appropriate charge would likely cause a material loss.




14





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





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





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





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





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





In order to maintain
capital at desired or regulatory-required levels or to replace existing capital,
Cornerstone may be required to issue shares of common stock, preferred stock or
othersecurities, including securities convertible into, exchangeable for
or representing rights to acquire shares of common stock. The sale of these shares
may significantly dilute shareholder ownership.New investors in the
future may also have rights, preferences and privileges senior to our current
shareholders which may adversely impact our current shareholders.





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





Changes
in interest rates may affect Cornerstone’s level of interest income, the primary
component of its gross revenue, as well as the level of its interest expense.
Interest rates are highly sensitive to many factors that are beyond
Cornerstone’s control, including general economic conditions and the policies of
various governmental and regulatory authorities. Accordingly, changes in
interest rates could decrease Cornerstone’s net interest income. Changes in the
level of interest rates also may negatively affect Cornerstone’s ability to
originate real estate loans, the value of its assets and the ability to realize
gains from the sale of its assets, all of which ultimately affects earnings.
Recent economic events have prompted the Federal Reserve to reduce its federal
funds rate. Due to the rapid decline in interest rates, the Bank was unable to
recalibrate its liabilities at the same rate at which loan rates declined. As a
result, the net interest margin was impacted negatively during 2009 and is
expected to continue into 2010. If the Federal Reserve’s federal funds rate
remains at extremely low levels or does not increase above the Bank’s interest
rate floors, Cornerstone’s funding costs may increase which will negatively
impact the net interest margin and Cornerstone’s financial
performance.





Cornerstone
relies heavily on the services of key personnel and the unexpected loss of any
of those personnel could adversely affect its operations.





In November 2009, Gregory
B. Jones resigned as Cornerstone’s Chief Executive Officer, and this position
was assumed by Nathaniel F. Hughes (in addition to his then existing role as
President) on an interim basis until a permanent successor is named. The search
for the successor is ongoing and will give consideration to external and
internal candidates, including Mr. Hughes unless he declines such consideration.Cornerstone relies on the strategies and management services of Mr.
Hughes, particularly during this critical transition period. Although
Cornerstone has entered into an employment agreement with Mr. Hughes, the loss
of his services could have a material adverse effect on Cornerstone’s business,
results of operations and financial condition. Cornerstone is also dependent on
certain other key officers who have important customer relationships or are
instrumental to its lending and depository operations. Changes in key personnel
and their responsibilities may be disruptive to operations and could have a
material adverse effect on Cornerstone’s financial condition and earnings.
Cornerstone believes that its future results will also depend upon its ability
to attract and retain highly skilled and qualified personnel, particularly in
those areas where Cornerstone may open new branches.




15





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





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





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





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





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





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





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





Cornerstone
derives the majority of its income from dividends on the shares of common stock
of the Bank. The ability of the Bank to declare and pay dividends is limited by
its obligations to maintain sufficient capital and by other general restrictions
on its dividends that are applicable to banks that are regulated by the FDIC and
the TDFI. On November 12, 2009, the FDIC placed restrictions on the Bank’s
ability to pay cash dividends, requiring that the Bank first obtain a
non-objection from the FDIC. In addition, the Federal Reserve Board may impose
restrictions on Cornerstone’s ability to pay dividends on its common stock. As a
result, Cornerstone cannot assure its shareholders that it will declare or pay
dividends on shares of its common stock in the future.





ITEM
1B. UNRESOLVED STAFF COMMENTS





None





ITEM
2.  PROPERTIES





As of
December 31, 2009, the principal offices of Cornerstone are located at 835
Georgia Avenue, Chattanooga, Tennessee 37402.  In addition, the Bank
operates five full-service branches and one loan production office that are
located at:




Banking
      Branches
              4154
      Ringgold Road, East Ridge, Tennessee (owned by the
Bank)5319
      Highway 153, Hixson, Tennessee (owned by the Bank)2280
      Gunbarrel Road, Chattanooga, Tennessee (owned by the
  Bank)8966
      Old Lee Highway, Ooltewah, Tennessee (owned by the
Bank)835
      Georgia Avenue, Chattanooga, Tennessee (leased by the
  Bank)Loan
      Production Office
              202
      West Crawford Street, Dalton, Georgia (leased by the
  Bank)




16




The
Georgia Avenue facility located in downtown Chattanooga, Tennessee serves as a
branch location for the Bank’s customers as well as Cornerstone’s executive
offices.  The Bank also owns a vacant building and lot at 103 S.
Campbell Station Road Knoxville, Tennessee, which is currently for
sale.  Cornerstone leases and operates a service center located at
6401 Lee Corners, Suite 119, Chattanooga, TN. to facilitate all of its
noncustomer contact functions.





ITEM
3.  LEGAL PROCEEDINGS





As of the
end of 2009, neither Cornerstone, the Bank nor Eagle was involved in any
material litigation.  The Bank is periodically involved as a plaintiff
or defendant in various legal actions in the ordinary course of its
business.  Management believes that any claims pending against
Cornerstone or its subsidiaries are without merit or that the ultimate
liability, if any, resulting from them will not materially affect the Bank’s or
Eagle’s financial condition or Cornerstone’s consolidated financial
position.





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





No
matters were submitted during the fourth quarter of 2009 to a vote of security
holders of Cornerstone through a solicitation of proxies or
otherwise.





PART
II





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





On March
11, 2010, Cornerstone had 6,500,396 shares of common stock outstanding.
Cornerstone’s common stock is quoted on the OTC Bulletin Board under the symbol
“CSBQ” but is not listed on a national securities exchange.  There are
ten market makers who provide a market for Cornerstone’s common
stock.





There
were approximately 550 holders of record of the common stock as of December 31,
2009.   This number does not include shareholders with shares in
nominee name held by the Depository Trust Company (DTC).  As of the
end of 2009, there were approximately 3,783,000 shares held in nominee name by
DTC.  Cornerstone paid quarterly cash dividends in 2009 in the amount
of $0.10 per share.  Cornerstone’s board of directors will continue to
evaluate the amount of future dividends, if any, after capital needs required
for expected growth of assets are reviewed.  The payment of dividends
is 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.  Currently,
the Bank is under a restriction from the FDIC that no dividend can be paid from
the Bank to the holding company without prior approval.





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





TABLE 1




High
      and Low Common Stock Share Price for Cornerstone
            
            Cash
      Dividends2010
      Fiscal Year
            
            Low
            
            
            High
            
            
            Paid
      Per ShareFirst
      Quarter (through Feb. 17, 2010)
            
            $
            2.10
            
            
            $
            2.30
            
            
            
            -2009
      Fiscal YearFirst
      Quarter
            
            $
            3.50
            
            
            $
            6.00
            
            
            $
            0.07Second
      Quarter
            
            $
            4.00
            
            
            $
            6.00
            
            
            $
            0.03Third
      Quarter
            
            $
            2.65
            
            
            $
            5.77
            
            
            
            -Fourth
      Quarter
            
            $
            1.95
            
            
            $
            3.71
            
            
            
            -2008
      Fiscal YearFirst
      Quarter
            
            $
            7.99
            
            
            $
            10.90
            
            
            $
            0.07Second
      Quarter
            
            $
            5.85
            
            
            $
            8.95
            
            
            $
            0.07Third
      Quarter
            
            $
            5.25
            
            
            $
            7.25
            
            
            $
            0.07Fourth
      Quarter
            
            $
            4.75
            
            
            $
            6.00
            
            
            $
            0.07




17





ITEM
6.SELECTED FINANCIAL
DATA





Table 2
presents selected financial data for the periods indicated (amounts in
thousands, except per share data).





TABLE
2




At and for the Fiscal Years Ended December 31,2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Total
      interest income
            
            $
            26,308
            
            
            $
            30,680
            
            
            $
            34,784
            
            
            $
            29,158
            
            
            $
            20,672Total
      interest expense
            
            
            11,189
            
            
            
            12,698
            
            
            
            14,414
            
            
            
            10,306
            
            
            
            6,077Net
      interest income
            
            
            15,119
            
            
            
            17,982
            
            
            
            20,370
            
            
            
            18,852
            
            
            
            14,594Provision
      for loan losses
            
            
            14,899
            
            
            
            3,498
            
            
            
            10,409
            
            
            
            1,106
            
            
            
            1,401Net
      interest income after provision for loan losses
            
            
            220
            
            
            
            14,484
            
            
            
            9,961
            
            
            
            17,746
            
            
            
            13,193Noninterest
      income
            
            
            541
            
            
            
            1,892
            
            
            
            1,695
            
            
            
            2,111
            
            
            
            1,904Noninterest
      expense
            
            
            14,276
            
            
            
            12,568
            
            
            
            10,926
            
            
            
            10,718
            
            
            
            8,216Income
      before income taxes
            
            
            (13,515
            )
            
            
            3,808
            
            
            
            730
            
            
            
            9,139
            
            
            
            6,881Income
      tax (benefit) / expense
            
            
            (5,336
            )
            
            
            1,296
            
            
            
            (141
            )
            
            
            3,328
            
            
            
            2,556Net
      (loss) income
            
            $
            (8,179
            )
            
            $
            2,512
            
            
            $
            871
            
            
            $
            5,811
            
            
            $
            4,325Per
      Share Data:Net
      income / (loss), basic
            
            $
            (1.26
            )
            
            $
            0.39
            
            
            $
            0.13
            
            
            $
            0.87
            
            
            $
            0.69Net
      income / (loss), assuming dilution
            
            $
            (1.26
            )
            
            $
            0.38
            
            
            $
            0.12
            
            
            $
            0.83
            
            
            $
            0.64Cash
      dividends paid
            
            $
            0.10
            
            
            $
            0.28
            
            
            $
            0.20
            
            
            $
            0.12
            
            
            $
            0.09Book
      value
            
            $
            4.28
            
            
            $
            5.78
            
            
            $
            5.70
            
            
            $
            5.86
            
            
            $
            5.07Tangible
      book value(1)
            
            $
            3.89
            
            
            $
            5.33
            
            
            $
            5.24
            
            
            $
            5.40
            
            
            $
            4.54Financial
      Condition Data:Assets
            
            $
            532,404
            
            
            $
            471,803
            
            
            $
            444,421
            
            
            $
            374,942
            
            
            $
            323,611Loans,
      net of unearned interest
            
            $
            330,787
            
            
            $
            378,472
            
            
            $
            369,883
            
            
            $
            305,879
            
            
            $
            262,008Cash
      and investments
            
            $
            164,982
            
            
            $
            57,286
            
            
            $
            51,798
            
            
            $
            51,577
            
            
            $
            46,074Federal
      funds sold
            
            $
            —
            
            
            $
            11,025
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —Deposits
            
            $
            404,742
            
            
            $
            326,583
            
            
            $
            313,250
            
            
            $
            275,816
            
            
            $
            252,435FHLB
      advances and line of credit
            
            $
            72,350
            
            
            $
            71,250
            
            
            $
            47,100
            
            
            $
            39,500
            
            
            $
            30,000Federal
      funds purchased and repurchase agreements
            
            $
            26,322
            
            
            $
            35,790
            
            
            $
            41,560
            
            
            $
            19,249
            
            
            $
            4,790Shareholders’
      equity
            
            $
            27,837
            
            
            $
            36,502
            
            
            $
            36,327
            
            
            $
            38,183
            
            
            $
            32,466Tangible
      shareholders’ equity(1)
            
            $
            25,258
            
            
            $
            33,661
            
            
            $
            33,386
            
            
            $
            35,137
            
            
            $
            29,089Selected
      Ratios:Interest
      rate spread
            
            
            2.95
            %
            
            
            3.67
            %
            
            
            4.51
            %
            
            
            5.16
            %
            
            
            4.93
            %Net
      interest margin(2)
            
            
            3.27
            %
            
            
            4.16
            %
            
            
            5.22
            %
            
            
            5.80
            %
            
            
            5.43
            %Return
      on average assets
            
            
            (1.69
            )%
            
            
            0.55
            %
            
            
            0.21
            %
            
            
            1.69
            %
            
            
            1.51
            %Return
      on average equity
            
            
            (24.34
            )%
            
            
            6.71
            %
            
            
            2.14
            %
            
            
            16.27
            %
            
            
            14.98
            %Return
      on average tangible equity(1)
            
            
            (26.36
            )%
            
            
            7.26
            %
            
            
            2.31
            %
            
            
            17.78
            %
            
            
            16.96
            %Average
      equity to average assets
            
            
            6.93
            %
            
            
            8.27
            %
            
            
            9.86
            %
            
            
            10.36
            %
            
            
            10.09
            %Dividend
      payout ratio
            
            
            N/A
            
            
            
            70.59
            %
            
            
            149.71
            %
            
            
            13.33
            %
            
            
            12.17
            %Ratio
      of nonperforming assets to total assets
            
            
            3.36
            %
            
            
            1.48
            %
            
            
            0.40
            %
            
            
            0.40
            %
            
            
            0.47
            %Ratio
      of allowance for loan losses to nonperforming loans
            
            
            80.24
            %
            
            
            226.23
            %
            
            
            791.16
            %
            
            
            25.90
            %
            
            
            20.70
            %Ratio
      of allowance for loan losses to total average loans, net of unearned
      income
            
            
            1.63
            %
            
            
            2.49
            %
            
            
            3.88
            %
            
            
            1.50
            %
            
            
            1.50
            %







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




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




18
  GAAP
Reconciliation and Management Explanation of Non-GAAP Financial
Measures





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





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


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


These
disclosures should not be viewed as a substitute for results determined in
accordance with GAAP, and are not necessarily comparable to non-GAAP performance
measures which may be presented by other companies. Table 3 presents a
reconciliation to provide a more detailed analysis of these non-GAAP performance
measures:




TABLE
3




At and for the Fiscal Years Ended December 31,2009
              
              
              2008
              
              
              2007
              
              
              2006
              
              
              2005Number
      of shares outstanding
              
              
              6,500,396
              
              
              
              6,319,718
              
              
              
              6,369,718
              
              
              
              6,511,848
              
              
              
              6,401,726Book
      value
              
              $
              27,837,479
              
              
              $
              36,501,509
              
              
              $
              36,327,350
              
              
              $
              38,183,265
              
              
              $
              32,466,363Book
      value per share
              
              $
              4.28
              
              
              $
              5.78
              
              
              $
              5.70
              
              
              $
              5.86
              
              
              $
              5.07Book
      value
              
              $
              27,837,479
              
              
              $
              36,501,509
              
              
              $
              36,327,350
              
              
              $
              38,183,265
              
              
              $
              32,466,363Less:
      goodwill and other intangible assets
              
              
              2,579,211
              
              
              
              2,840,773
              
              
              
              2,941,798
              
              
              
              3,046,287
              
              
              
              3,376,892Tangible
      book value
              
              
              25,258,268
              
              
              
              33,660,736
              
              
              
              33,385,552
              
              
              
              35,136,978
              
              
              
              29,089,471Effect
      of intangible assets per share
              
              $
              0.39
              
              
              $
              0.45
              
              
              $
              0.46
              
              
              $
              0.46
              
              
              $
              0.53Tangible
      book value per share
              
              $
              3.89
              
              
              $
              5.33
              
              
              $
              5.24
              
              
              $
              5.40
              
              
              $
              4.54Net
      (loss) / income
              
              $
              (8,178,639
              )
              
              $
              2,511,824
              
              
              $
              871,152
              
              
              $
              5,811,600
              
              
              $
              4,324,519Average
      equity
              
              
              33,600,000
              
              
              
              37,435,000
              
              
              
              40,737,000
              
              
              
              35,728,000
              
              
              
              28,874,000Return
      on average equity
              
              
              (24.34
              )%
              
              
              6.71
              %
              
              
              2.14
              %
              
              
              16.27
              %
              
              
              14.98
              %Average
      equity
              
              $
              33,600,000
              
              
              $
              37,435,000
              
              
              $
              40,737,000
              
              
              $
              35,728,000
              
              
              $
              28,874,000Less:
      goodwill and other intangible assets
              
              
              2,579,211
              
              
              
              2,840,773
              
              
              
              2,941,798
              
              
              
              3,046,287
              
              
              
              3,376,892Average
      tangible equity
              
              $
              31,020,789
              
              
              $
              34,594,227
              
              
              $
              37,795,202
              
              
              $
              32,681,713
              
              
              $
              25,497,108Effect
      of intangible assets
              
              
              (2.02
              )%
              
              
              0.55
              %
              
              
              0.17
              %
              
              
              1.51
              %
              
              
              1.98
              %Return
      on average tangible equity
              
              
              (26.36
              )%
              
              
              7.26
              %
              
              
              2.31
              %
              
              
              17.78
              %
              
              
              16.96
              %
  19


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





Forward-Looking
Statements





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




Going
Concern Considerations
 
 Prior to
2009, Cornerstone Community Bank (the “Bank”) had a history of profitable
operations and sufficient sources of liquidity to meet its funding
needs.  However, the Bank’s parent holding company, Cornerstone
Bancshares, Inc. (“Cornerstone”), relies primarily on dividends from the Bank to
meet its funding needs.  Cornerstone’s funding needs as of December
31, 2009 primarily consisted of principal and interest payments on two holding
company loans totaling approximately $5.4 million secured by 100% of the Bank’s
common stock.  In January 2010, the loans were renewed and Cornerstone
received a waiver regarding previous covenant violations through September 30,
2009 with the understanding that future covenant violations would likely be
waived as they were incurred.  As of December 31, 2009, the Bank was
restricted from paying dividends to Cornerstone due to the Bank’s recent
operating losses and the Bank’s capital position of less than “well capitalized”
under the regulatory framework for prompt corrective action.  This
restriction coupled with Cornerstone’s failure to meet certain holding company
loan covenants has prompted management to perform an assessment of the going
concern of Cornerstone.
 
 Management’s
business plan for 2010 projects the Bank’s return to profitability and a well
capitalized position; however, covenant compliance is determined on a quarterly
basis with certain of the covenants being based on rolling quarterly
averages.  Thus, management’s projections do not anticipate full
compliance with the covenants during 2010.  Because it is uncertain
whether the holding company loans will be retained by the current lender or sold
to the open market, management has placed a priority on replacing the holding
company loans with capital.  Management believes Cornerstone’s ability
to continue as a going concern would be in substantial doubt if the holding
company loans were to be sold to the open market.  To avoid this
possibility, Cornerstone believes that it must raise additional capital to allow
repayment of the holding company indebtedness and further enhance the capital
position of the Bank and is actively considering strategic alternatives, which
may include a capital infusion through the issuance and sale of common stock,
preferred stock or other securities (including securities convertible into
shares of common stock) in public or private offerings.
  Management’s
Discussions and Analysis of Financial Condition and Results of
Operations





Cornerstone
is a bank holding company and the parent company of the Bank, a Tennessee
banking corporation which operates primarily in and around Chattanooga,
Tennessee.  The Bank has one wholly owned subsidiary Eagle Financial,
Inc., (“Eagle”) an accounts receivable financing company.  In prior
years, Eagle was owned and operated by Cornerstone.  However, on June
30, 2009, Eagle was sold to the Bank. The Bank has five full-service banking
offices located in Hamilton County, Tennessee, and one loan production office
located in Dalton, Georgia.  The Bank’s business consists primarily of
attracting deposits from the general public and, with these and other funds,
originating real estate loans, consumer loans, business loans, and residential
and commercial construction loans. The Bank closed a second loan production
office located in Knoxville, Tennessee as of September 2009.  The
principal sources of income for the Bank are interest and fees collected on
loans, fees collected on deposit accounts, and interest and dividends collected
on other investments.  The principal expenses of the Bank are interest
paid on deposits, employee compensation and benefits, office expenses, and other
overhead expenses. Eagle’s principal source of income is revenue received from
the purchase of receivables. Expenses are related to employee compensation and
benefits, office and overhead expenses.




20





The
following is a discussion of Cornerstone’s financial condition at December 31,
2009 and December 31, 2008 and Cornerstone’s results of operations for each
of the three-years ended December 31, 2009, 2008 and 2007. The purpose of this
discussion is to focus on information about Cornerstone’s financial condition
and results of operations which is not otherwise apparent from the consolidated
financial statements. The following discussion and analysis should be read along
with Cornerstone’s consolidated financial statements and the related notes
included elsewhere herein.





Review
of Financial Performance





As of
December 31, 2009, Cornerstone had total consolidated assets of approximately
$532 million, total loans of approximately $337 million, total deposits of
approximately $405 million and stockholders’ equity of approximately $28
million.  Cornerstone incurred a net loss of $8.2 million for 2009
compared to a net income of $2.5 million for 2008 and net income of $871
thousand for 2007.





Results
of Operations





Net Interest Income-Net
interest income represents the amount by which interest earned on various
earning assets exceeds interest paid on deposits and other interest bearing
liabilities.  Net interest income is also the most significant
component of Cornerstone’s earnings.  For the year ended December 31,
2009, Cornerstone recorded net interest income of approximately $15,119,000,
which resulted in a net interest margin of 3.27%.  For the year ended
December 31, 2008, Cornerstone recorded net interest income of approximately
$17,982,000, which resulted in a net interest margin of 4.16%.  For
the year ended December 31, 2007, Cornerstone recorded net interest income of
approximately $20,369,000, which resulted in a net interest margin of
5.22%.




21


Table 4
presents information with respect to interest income from average
interest-earning assets, expressed both in dollars and yields, and interest
expense on average interest-bearing liabilities, expressed both in dollars and
rates, for the periods indicated.  The table includes loan yields,
which reflect the amortization of deferred loan origination and commitment
fees.  Interest income from investment securities includes the
accretion of discounts and amortization of premiums.





TABLE 4




Yields
      Earned on Average Earning Assets and
              Rates
      Paid on Average Interest Bearing LiabilitiesYears
      Ended December 31,2009
            
            
            2008
            
            
            2007(In
      thousands)
              
              ASSETS
            
            Average
              Balance
            
            
            Interest
      Income/
              Expense(1)
            
            
            Yield/Rate
            
            
            Average
              Balance
            
            
            Interest
      Income/
              Expense(1)
            
            
            Yield/Rate
            
            
            Average
              Balance
            
            
            Interest
      Income/
              Expense(1)
            
            
            Yield/RateInterest-earning
      assets:Loans(1)(2)
            
            $
            363,146
            
            
            $
            24,402
            
            
            
            6.72
            %
            
            $
            385,957
            
            
            $
            28,661
            
            
            
            7.43
            %
            
            $
            353,278
            
            
            $
            32,981
            
            
            
            9.34
            %Investment
      securities(3)
            
            
            63,854
            
            
            
            1,840
            
            
            
            3.10
            %
            
            
            47,096
            
            
            
            1,996
            
            
            
            4.36
            %
            
            
            37,673
            
            
            
            1,750
            
            
            
            4.80
            %Other
      earning assets
            
            
            40,085
            
            
            
            66
            
            
            
            0.16
            %
            
            
            869
            
            
            
            23
            
            
            
            2.70
            %
            
            
            760
            
            
            
            52
            
            
            
            6.86
            %Total
      interest-earning assets
            
            
            467,085
            
            
            
            26,308
            
            
            
            5.66
            %
            
            
            433,922
            
            
            
            30,680
            
            
            
            7.08
            %
            
            
            391,711
            
            
            
            34,783
            
            
            
            8.89
            %Allowance
      for loan losses
            
            
            (8,088
            )
            
            
            
            
            
            
            
            
            
            
            (8,496
            )
            
            
            
            
            
            
            
            
            
            
            (5,009
            )Cash
      and other assets
            
            
            25,672
            
            
            
            
            
            
            
            
            
            
            
            27,179
            
            
            
            
            
            
            
            
            
            
            
            26,341Total
      assets
            
            $
            484,669
            
            
            
            
            
            
            
            
            
            
            $
            452,605
            
            
            
            
            
            
            
            
            
            
            $
            413,043TOTAL
              LIABILITIES
              AND
      EQUITYInterest-bearing
      liabilities:Deposits:NOW
      accounts
            
            $
            27,864
            
            
            $
            98
            
            
            
            0.35
            %
            
            $
            30,106
            
            
            $
            211
            
            
            
            0.70
            %
            
            $
            36,327
            
            
            $
            802
            
            
            
            2.21
            %Money
      market / Savings
            
            
            35,269
            
            
            
            303
            
            
            
            0.86
            %
            
            
            51,600
            
            
            
            826
            
            
            
            1.60
            %
            
            
            55,808
            
            
            
            2,018
            
            
            
            3.61
            %Time
      deposits, $100m andOver
            
            
            61,533
            
            
            
            2,049
            
            
            
            3.33
            %
            
            
            59,083
            
            
            
            2,371
            
            
            
            4.01
            %
            
            
            61,172
            
            
            
            3,134
            
            
            
            5.12
            %Time
      deposits, under $100m
            
            
            195,018
            
            
            
            5,559
            
            
            
            2.85
            %
            
            
            131,138
            
            
            
            5,891
            
            
            
            4.49
            %
            
            
            107,498
            
            
            
            5,387
            
            
            
            5.01
            %Total
      interest-bearing deposits
            
            
            319,684
            
            
            
            8,009
            
            
            
            2.51
            %
            
            
            271,927
            
            
            
            9,299
            
            
            
            3.42
            %
            
            
            260,805
            
            
            
            11,341
            
            
            
            4.35
            %Federal
      funds purchased
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            12,952
            
            
            
            339
            
            
            
            2.62
            %
            
            
            11,374
            
            
            
            613
            
            
            
            5.39
            %Securities
      sold underagreement
      to repurchase
            
            
            21,624
            
            
            
            174
            
            
            
            0.80
            %
            
            
            18,580
            
            
            
            261
            
            
            
            1.41
            %
            
            
            8,103
            
            
            
            244
            
            
            
            3.01
            %Other
      borrowings
            
            
            72,150
            
            
            
            3,006
            
            
            
            4.17
            %
            
            
            68,578
            
            
            
            2,799
            
            
            
            4.08
            %
            
            
            48,282
            
            
            
            2,216
            
            
            
            4.59
            %Total
      interest-bearingLiabilities
            
            
            413,458
            
            
            
            11,189
            
            
            
            2.71
            %
            
            
            372,037
            
            
            
            12,698
            
            
            
            3.41
            %
            
            
            328,564
            
            
            
            14,414
            
            
            
            4.39
            %Net
      interest spread
            
            
            
            
            
            
            
            
            
            
            2.95
            %
            
            
            
            
            
            
            
            
            
            
            3.67
            %
            
            
            
            
            
            
            
            
            
            
            4.51
            %Other
      liabilities:Demand
      deposits
            
            
            40,816
            
            
            
            
            
            
            
            
            
            
            
            42,915
            
            
            
            
            
            
            
            
            
            
            
            41,503Accrued
      interest payable andOther
      liabilities
            
            
            (3,205
            )
            
            
            
            
            
            
            
            
            
            
            218
            
            
            
            
            
            
            
            
            
            
            
            2,240Stockholders’
      equity
            
            
            33,600
            
            
            
            
            
            
            
            
            
            
            
            37,435
            
            
            
            
            
            
            
            
            
            
            
            40,737Total
      liabilitiesAnd
      stockholders’ equity
            
            $
            484,669
            
            
            
            
            
            
            
            
            
            
            $
            452,605
            
            
            
            
            
            
            
            
            
            
            $
            413,043Net
      interest margin
            
            
            
            
            
            $
            15,119
            
            
            
            3.27
            %
            
            
            
            
            
            $
            17,982
            
            
            
            4.16
            %
            
            
            
            
            
            $
            20,369
            
            
            
            5.22
            %









(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.


22




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




·
              The
      net interest margin decreased 89 basis points from 4.16% as of December
      31, 2008 to 3.27% as of December 31, 2009.  Several factors
      related to the Bank’s interest revenue were the primary reasons for the
      decrease.  First, the yield on the Bank’s loan portfolio
      decreased from 7.43% as of December 31, 2008 to 6.72% as of December 31,
      2009.  Interest income from the Bank’s loan portfolio was
      negatively affected by a combination of loan repricing and an increased
      level of nonaccrual loans.  A second factor was the change in
      the asset mix of the Bank’s earning asset
      portfolio.   During 2009, the Bank’s earning asset
      portfolio mix shifted from 85% loan to assets to 75% loan to
      assets.  The Bank anticipates that the asset portfolio mix will
      continue to decrease as the Bank reduces the amount of its loan portfolio
      to improve the Bank’s risk profile and improve
  liquidity.
 
 ·
              In
      September 2007, the Federal Reserve Bank initiated a series of interest
      rate reductions to the Federal Funds Target rate from 5.25% to its current
      level 0.25%, which has been in effect since January 2009.  This
      500 basis point reduction placed downward pressure on the banking
      industry’s net interest margins.  Cornerstone was also impacted
      by this reduction which lowered its net interest margin to 4.16% for the
      year ended December 31, 2008 compared to 5.22% for the year ended December
      31, 2007.
 
 ·
              As
      of December 31, 2009, the Bank’s investment portfolio resulted in a yield
      of 3.10% compared to 4.36% as of December 31, 2008.  The Bank’s
      investment portfolio is used primarily for pledging purposes with the
      State of Tennessee Collateral Pool, Federal Reserve Bank discount window,
      to secure repurchase agreements and to provide additional collateral to
      the Federal Home Loan Bank to secure the Bank’s fixed rate term
      advances.  During 2009, the Bank aggressively reshaped its
      investment portfolio to decrease its credit risk profile.  As of
      December 31, 2009, the Bank’s securities portfolio was invested
      approximately 75% in Government National Mortgage Association (GNMA)
      securities, approximately 13% in municipal general obligation securities
      and 12% in Agency-Backed securities.   During 2009, the
      Bank maintained its large position of variable rate securities and
      increased its longer term securities holdings to take advantage of the
      historically steep Treasury yield curve and artificially high spreads in
      the municipal bond market.  Currently, the Bank’s securities
      portfolio is larger than historic levels but management believes the
      higher level of liquidity is appropriate given the uncertain regulatory
      and credit environment.
 
 ·
              As
      of December 31, 2008, the Bank’s investment portfolio resulted in a yield
      of 4.36% compared to 4.80% as of December 31, 2007.  As of
      December 31, 2008, approximately 50% of the security portfolio was
      invested in Agency LIBOR floaters to protect the Bank from rapid increases
      in interest rates.
 
 23




Tables 5
and 6 present the changes in interest income and interest expense that are
attributable to three factors:







(i)
            A
      change in volume or amount of an asset or liability.(ii)
            A
      change in interest rates.


(iii)
            A
      change caused by the combination of changes in asset or deposit
      mix.





The
tables describe the extent to which changes in interest rates and changes in
volume of interest-earning assets and interest-bearing liabilities have affected
Cornerstone’s interest income and expense during the periods
indicated.  For each category of interest-earning assets and
interest-bearing liabilities, information is provided as to changes attributable
to change in volume (change in volume multiplied by current rate) and change in
rates (change in rate multiplied by current volume).  The remaining
difference has been allocated to mix.





TABLE
5




INTEREST
INCOME AND EXPENSE ANALYSIS


Year
      Ended December 31,2009
      Compared to 2008(In
      Thousands)
            
            Volume
            
            
            Rate
            
            
            Mix
            
            
            Net
              ChangeInterest
      income:Loans
      (1)(2)
            
            $
            (1,533
            )
            
            $
            (2,578
            )
            
            $
            (148
            )
            
            $
            (4,259
            )Investment
      securities
            
            
            520
            
            
            
            (805
            )
            
            
            129
            
            
            
            (156
            )Other
      earning assets
            
            
            63
            
            
            
            (1,018
            )
            
            
            998
            
            
            
            43Total
      interest income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,372
            )Interest
      expense:NOW
      accounts
            
            
            (8
            )
            
            
            (98
            )
            
            
            (7
            )
            
            
            (113
            )Money
      market and savings accounts
            
            
            (140
            )
            
            
            (261
            )
            
            
            (122
            )
            
            
            (523
            )Time
      deposits, $100,000 and over
            
            
            73
            
            
            
            (911
            )
            
            
            516
            
            
            
            (322
            )Time
      deposits, less than $100,000
            
            
            1,897
            
            
            
            (2,594
            )
            
            
            365
            
            
            
            (332
            )Other
      borrowings
            
            
            146
            
            
            
            14
            
            
            
            47
            
            
            
            207Federal
      funds purchased
            
            
            -
            
            
            
            -
            
            
            
            (339
            )
            
            
            (339
            )Securities
      sold under agreement to repurchase
            
            
            32
            
            
            
            (80
            )
            
            
            (39
            )
            
            
            (87
            )Total
      interest expense
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (1,509
            )Change
      in net interest income (expense)
            
            
            
            
            
            
            
            
            
            
            
            
            
            $
            (2,863
            )












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




24




TABLE
6




INTEREST
      INCOME AND EXPENSE ANALYSIS




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












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




Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary
to establish an allowance for loan losses that, in management’s evaluation,
should be adequate to provide coverage for the inherent losses on outstanding
loans.  The provision for loan losses amounted to $14.9 million for
the year ended December 31, 2009 compared to $3.5 million for the year ended
December 31, 2008.  Cornerstone’s policies and procedures used to
estimate the allowance for loan losses, as well as the resultant provision for
loan losses, are considered adequate by management and are periodically reviewed
by regulators.  However, there are factors beyond Cornerstone’s
control, such as conditions in the local and national economy which may (and,
for 2009, in fact did) negatively impact Cornerstone’s asset
quality.  The measurements are approximations which may require
additional provisions to loan losses based upon changing circumstances or when
additional information becomes available or known.  Other matters
relating to the changes in provision for loan losses are presented
below:




·
              Cornerstone’s
      provision for loan losses during 2009 was needed to address multiple
      credits that continued to deteriorate as a result of the prolonged
      economic downturn.  The Bank has seen material deterioration of
      its client’s cash reserves and collateral values during
      2009.  However, the rate of decline slowed during the fourth
      quarter of 2009.
 
 ·
              Cornerstone’s
      provision for loan losses during 2008 was needed to address multiple
      credits that were not able to maintain operations or cash flow due in
      large part to the economic downturn.  The provision allocation
      differs from the amount charged to earnings in 2007 which was concentrated
      in two large credits.  These large credits contained alleged
      fraud perpetrated by the customer against the
      Bank.
 
 ·
              To
      address the problem credits within the Bank’s loan portfolio a Special
      Asset Committee was created during 2008.  This committee has
      instructed the Bank’s loan review department to identify potential problem
      loans as quickly as possible.  This committee is also
      responsible for developing and reviewing action plans that identify
      possible strategies to minimize the Bank’s losses.  The early
      detection and proactive resolution process serves to assist customers with
      the severe economic environment while potentially minimizing
      losses.  During 2009, the Bank dedicated additional human
      resources to the Special Asset department to assist in the collection and
      recovery process.




Non Interest Income-Items
reported as non interest income include service charges on checking accounts,
insufficient funds charges, automated clearing house (“ACH”) processing fees and
the Bank’s secondary mortgage department earnings.  Increases in
income derived from service charges and ACH fees are primarily a function of the
Bank’s growth while fees from the origination of mortgage loans will often
reflect market conditions and fluctuate from period to period.




25




Table 7
presents the components of non interest income for the years ended December 31,
2009, 2008 and 2007 (in thousands).





TABLE
      7


2009
            
            
            2008
            
            
            2007Customer
      service fees
            
            $
            1,630
            
            
            $
            1,727
            
            
            $
            1,426Other
      noninterest income
            
            
            138
            
            
            
            108
            
            
            
            165Net
      (loss) gain from sale of loans & other assets
            
            
            (1,227
            )
            
            
            57
            
            
            
            104Total
      noninterest income
            
            $
            541
            
            
            $
            1,892
            
            
            $
            1,695





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




·
              The
      Bank experienced a slight decrease in its customer service fees from 2008
      to 2009.  One factor contributing to the decrease was the impact
      of the economic recession as consumers monitored their deposit account
      balances closely.  This change resulted in a reduction in
      insufficient funds fees from approximately $715 thousand as of December
      31, 2008 to approximately $599 thousand as of December 31,
      2009.  While traditional account service fees are included in
      the $1.6 million generated during 2009, the amount also includes fees
      associated with the Bank’s payroll processing
  services.
 
 ·
              The
      Bank had an increase in its customer service fees from 2007 to
      2008.  While traditional account service fees are included in
      the $1.7 million generated during 2008 the amount also includes fees
      associated with the Bank’s payroll processing services.  Fiscal
      year 2008 marked the first full year the Bank provided processing services
      to payroll processors located across the United States.  The
      payroll processors generate thousands of payroll transactions each week
      while depositing relatively large amounts on a short term
      basis.  These ACH transactions are then forwarded through the
      Federal Reserve Bank to the recipient’s checking
  accounts.
 
 ·
              There
      are two primary reasons for change in the net (loss) gain from sale of
      loans and other assets from 2008 to 2009.  First, the Bank
      realized a gain of approximately $400 thousand on the sale of securities
      with a book value of approximately $18.5 million.  Second, the
      Bank had a loss of $1.6 million on the sale of assets during 2009, which
      was incurred on multiple pieces of other real estate and foreclosed assets
      as values continued to decline in 2009.  The Bank could have
      additional losses in 2010 if foreclosed asset values continue to decline
      and losses are incurred on the disposition of the
      properties.  All other real estate is being carried at the lower
      of carrying amount or estimated fair value less costs to
    sell.




Non
Interest Expense-Items reported as non interest expense include salaries
and employee benefits, occupancy and equipment expense, depository insurance and
other operating expense.





Table 8
presents the components of non interest expense for the years ended December 31,
2009, 2008 and 2007 (in thousands).




TABLE
8




2009
            
            
            2008
            
            
            2007Salaries
      and employee benefits
            
            $
            6,970
            
            
            $
            7,140
            
            
            $
            6,609Net
      occupancy and equipment expense
            
            
            1,548
            
            
            
            1,520
            
            
            
            1,355Depository
      insurance
            
            
            1,199
            
            
            
            321
            
            
            
            106Other
      operating expenses
            
            
            4,559
            
            
            
            3,587
            
            
            
            2,856Total
      noninterest expense
            
            $
            14,276
            
            
            $
            12,568
            
            
            $
            10,926





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




·
              Salary
      expense decreased 2.4% from 2008 to 2009.  The reduction is
      attributable to the Bank’s layoff of approximately 10% of its workforce
      during the second quarter of 2009 and the loss of former CEO Gregory B.
      Jones.
 
 ·
              Salary expense increased 8.0%
      from 2007 to 2008.  This increase was due primarily to an
      increase in risk management personnel including one additional employee in
      the compliance department, two employees in internal audit department and
      one contracted consultant to assist with Information Technology
      security, along with cost of living
    adjustments.
  26
  ·
              For
      2009 the other operating expense category of non interest expense
      increased significantly, by 27.1%, over 2008.  While the Bank
      was able to reduce certain expenses to minimize the total expense amount,
      two areas experienced a significant increase.  First, other real
      estate expense increased approximately $420 thousand; and second, legal
      expense increased $238 thousand.  These increases are related to
      the deterioration of asset quality and the expense required to properly
      foreclose, maintain and ultimately dispose of collateral securing problem
      loans.
 
 ·
              The
      Bank continues to experience an increase in depository insurance premiums
      as a result of ongoing financial difficulties in the banking
      industry.  The Bank realized an increase of $878 thousand or
      273.5% from 2008 to 2009.  Management expects depository
      insurance premiums will continue to exceed $1 million per year for the
      next three years.
  ·
                From 2007 to 2008, the other
      operating expense and depository insurance categories of non interest
      expense increased significantly, by 31.9% and 202.8%,
      respectively.  The majority of the increases can be segmented
      into three areas.  First, the FDIC assessment increased $215
      thousand; second, other real estate expense increased $167 thousand; and
      third, legal expense increased $160 thousand.  All of these
      increases are related to the deterioration of asset quality and the
      expense required to properly obtain and ultimately dispose of collateral
      securing problem
loans.


Income
Tax Expense




·
              The
      difference between Cornerstone’s expected income tax expense, computed by
      multiplying income before income taxes by statutory income tax rates, and
      actual income tax expense, is primarily attributable to new market tax
      credits for federal and state purposes, tax exempt loans and tax exempt
      securities.


Financial
Condition





Overview-Cornerstone’s
consolidated balance sheet reflects significant changes over the last two
years.  Total assets increased approximately $60 million or 12.7% from
$472 million as of December 31, 2008 to $532 million as of December 31,
2009.  During 2009, total loans decreased $51 million or 13.1% from
approximately $388 million as of December 31, 2008 to approximately $337 million
as of December 31, 2009.  The reduction in loans was a result of the
Bank’s collection process, and an increase in the Bank’s loan underwriting
requirements.  Finally, stockholders’ equity decreased to
approximately $28 million as of December 31, 2009 from approximately $37 million
as of December 31, 2008.





Investments-The Bank’s
investment portfolio totaled $126.8 million or 23.8% of total assets as of
December 31, 2009, compared to a total of $46.4 million or 9.8% of total assets
as of December 31, 2008.  The increase was a direct result of an
increase in collateral requirements to maintain the Bank’s FHLB borrowings and
to provide sufficient collateral at the Federal Reserve Bank to give the Bank
guaranteed liquidity for daily Bank transactions. The portfolio is accounted for
in two classifications:  “Held to Maturity” and “Available for
Sale”.  The Bank also has an investment in Federal Home Loan Bank
stock.   The objective of the Bank’s investment policy is to
invest funds not otherwise needed to meet the loan demand of the Bank’s market
area and to meet the following five objectives: Gap Management, Liquidity,
Pledging, Return, and Local Community Support.  In doing so, the Bank
uses the portfolio to provide structure and liquidity that the loan portfolio
cannot.  The management investment committee balances the market and
credit risks against the potential investment return, ensures investments are
compatible with the pledge requirements of the Bank’s deposit of public funds,
maintains compliance with regulatory investment requirements, and assists
various public entities with their financing needs.  The management
investment committee is authorized to execute security transactions for the
investment portfolio based on the decisions of the Directors Asset Liability
Committee of the Board of Directors (“ALCO”).  All investment
transactions occurring since the previous ALCO meeting are reviewed by the ALCO
at its next quarterly 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.




27











Table 9
presents the carrying value of the Bank’s investments at the dates
indicated.  Available for sale securities are carried at fair market
value and securities held to maturity are held at their book value (amounts in
thousands).





TABLE
9




Investment
      Portfolio
              Years
      Ended December 31,Securities
      available for sale:
            
            2009
            
            
            2008
            
            
            2007U.S.
      Government and agency obligations
            
            $
            4,774
            
            
            $
            8,252
            
            
            $
            27,414Mortgage-backed
      securities
            
            
            102,885
            
            
            
            31,182
            
            
            
            3,836State
      & political subdivisions tax-exempt
            
            
            16,756
            
            
            
            4,623
            
            
            
            3,503Totals
            
            $
            124,415
            
            
            $
            44,057
            
            
            $
            34,753Securities
      held to maturity:Mortgage-backed
      securities
            
            $
            135
            
            
            $
            169
            
            
            $
            200Totals
            
            $
            135
            
            
            $
            169
            
            
            $
            200Federal
      Home Loan Bank stock, at cost
            
            
            2,229
            
            
            
            2,188
            
            
            
            1,912Total
      Investments
            
            $
            126,779
            
            
            $
            46,414
            
            
            $
            36,865





·
            During
      2009, the Bank elected to increase the amount of its investment in
      mortgage backed and municipal securities.  The mortgage-backed
      securities were obtained instead of U.S. Government and agency
      obligations, as traditionally acquired, to provide increased yield while
      maintaining a 20% risk weight classification for capital
      requirements.  During 2009 the Bank purchased mortgage-backed
      securities guaranteed by the Government National Mortgage Association
      (GNMA).  These securities qualify for 0% risk weight allocation
      thereby improving the Bank’s overall risk weighted capital
      position.   The increased investment in municipal
      securities was made due to higher yields when compared to alternative
      investments and to provide collateral at the Federal Reserve discount
      window.





·
            A
      second objective of the security portfolio is to provide adequate
      collateral to satisfy pledging requirements with the State of Tennessee
      collateral pool, repurchase agreements and the Federal Reserve discount
      window.  During 2009, the Bank increased its Federal Reserve
      discount window borrowing to approximately $15 million by
      year-end.  This increase allowed the Bank to obtain additional
      funding, if needed, in the event the Bank’s daily fed fund lines were
      negatively impacted.





·
            During
      2009, the Federal Home Loan Bank (“FHLB”) notified the Bank that as a
      result of the decline in the Bank’s loan asset quality, additional
      collateral was required to secure the Bank’s fixed rate term
      advances.  As of December 31, 2009, the Bank had pledged
      approximately $54 million to the
FHLB.





For
December 31, 2009, tables 10 and 11 present the book value of the Bank’s
investments, the weighted average yields on the Bank’s investments and the
periods to maturity of the Bank’s investments for the “Securities Available for
Sale” and the “Securities Held to Maturity,” respectively.  Tables 12
and 13 present this information for December 31, 2008.





TABLE 10 (amounts in
thousands)




Weighted
      Average Yields on the Available For Sale Investments
                Periods
      of Maturity from December 31, 2009Less
      than 1 year
            
            
            1
      to 5 years
            
            
            5
      to 10 years
            
            
            Over
      10 yearsSecurities
      available for sale:
            
            Amount
            
            
            Weighted
              Avg.
              Yield
      (1)
            
            
            Amount
            
            
            Weighted
              Avg.
              Yield
      (1)
            
            
            Amount
            
            
            Weighted
              Avg.
              Yield
      (1)
            
            
            Amount
            
            
            Weighted
              Avg.
              Yield
      (1)U.S.
      Government agencies
            
            $
            -
            
            
            
            -
            
            
            $
            -
            
            
            
            -
            
            
            $
            -
            
            
            
            -
            
            
            $
            4,772
            
            
            
            1.15
            %Mortgage-backed
      securities (2)
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            39
            
            
            
            5.68
            %
            
            
            103,329
            
            
            
            3.01
            %Tax-exempt
      municipal bonds
            
            
            -
            
            
            
            -
            
            
            
            599
            
            
            
            6.31
            %
            
            
            2,468
            
            
            
            5.62
            %
            
            
            13,594
            
            
            
            5.77
            %Totals
            
            $
            -
            
            
            
            -
            
            
            $
            599
            
            
            
            6.31
            %
            
            $
            2,507
            
            
            
            5.62
            %
            
            $
            121,695
            
            
            
            3.25
            %Total
      Securities Available for Sale
            
            $
            124,801
            
            
            
            3.31
            %


(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.




28




TABLE 11(amounts in
thousands)




Weighted
      Average Yields on the Held to Maturity Investments
              Periods
      of Maturity from December 31, 2009Less
      than 1 year
            
            
            1
      to 5 years
            
            
            5
      to 10 years
            
            
            Over
      10 yearsSecurities
      held to maturity:
            
            Amount
            
            
            Weighted
              Avg.
              Yield(1)
            
            
            Amount
            
            
            Weighted
              Avg.
              Yield
      (1)
            
            
            Amount
            
            
            Weighted
              Avg.
              Yield
      (1)
            
            
            Amount
            
            
            Weighted
              Avg.
              Yield
      (1)Mortgage-backed
      securities (2)
            
            $
            1
            
            
            
            6.43
            %
            
            $
            -
            
            
            
            -
            
            
            $
            23
            
            
            
            3.45
            %
            
            $
            111
            
            
            
            4.47
            %Totals
            
            $
            1
            
            
            
            6.43
            %
            
            $
            -
            
            
            
            -
            
            
            $
            23
            
            
            
            3.45
            %
            
            $
            111
            
            
            
            4.47
            %Total
      Securities held to maturity
            
            $
            135
            
            
            
            4.31
            %Federal
      Home Loan Bank stock, at cost
            
            $
            2,229
            
            
            
            4.58
            %Total
      Investments
            
            $
            127,165
            
            
            
            3.33
            %


(1)    The
weighted average yields on tax-exempt securities have been computed on a
tax-equivalent basis.




(2)    Mortgages
are allocated by maturity and not amortized.





TABLE 12(amounts in
thousands)




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


(1)    The
weighted average yields on tax-exempt securities have been computed on a
tax-equivalent basis.




(2)    Mortgages
are allocated by maturity and not amortized.





TABLE 13(amounts in
thousands)




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





(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.





29




Lending-All lending
activities of the Bank are under the direct supervision and control of the
Directors Loan Committee (DLC).  The DLC is comprised of three members
of management and five independent directors that serve only in a director
capacity and are not employees of the Bank.  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 is comprised of both management and
independent directors.  These oversight committees enforce loan
authorizations for each officer, make lending decisions on loans exceeding such
limits, review and oversee problem credits, and determine the allocation of
funds for each lending category.





At
December 31, 2009 and 2008, Cornerstone’s loan portfolio constituted
approximately 62.1% and 80.2% of Cornerstone’s total assets,
respectively.





Table 14
presents the composition of the Cornerstone’s loan portfolio at the indicated
dates.





TABLE
14




Loan
      Portfolio Composition
              Years
      Ended December 31,2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005(In
      thousands)
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentCommercial,
      financial and agricultural
            
            $
            60,560
            
            
            
            17.99
            %
            
            $
            83,140
            
            
            
            21.42
            %
            
            $
            98,065
            
            
            
            25.57
            %
            
            $
            98,542
            
            
            
            31.77
            %
            
            $
            86,039
            
            
            
            32.40
            %Real
      estate – construction
            
            
            47,651
            
            
            
            14.15
            %
            
            
            70,456
            
            
            
            18.15
            %
            
            
            76,832
            
            
            
            20.03
            %
            
            
            57,606
            
            
            
            18.57
            %
            
            
            47,071
            
            
            
            17.72
            %Real
      estate – mortgage
            
            
            70,976
            
            
            
            21.08
            %
            
            
            72,737
            
            
            
            18.74
            %
            
            
            64,585
            
            
            
            16.84
            %
            
            
            48,700
            
            
            
            15.70
            %
            
            
            48,645
            
            
            
            17.19
            %Real
      estate – commercial
            
            
            153,310
            
            
            
            45.53
            %
            
            
            155,728
            
            
            
            40.13
            %
            
            
            138,074
            
            
            
            35.99
            %
            
            
            99,197
            
            
            
            31.98
            %
            
            
            79,608
            
            
            
            29.98
            %Consumer
      loans
            
            
            4,195
            
            
            
            1.25
            %
            
            
            6,029
            
            
            
            1.56
            %
            
            
            6,037
            
            
            
            1.57
            %
            
            
            6,092
            
            
            
            1.98
            %
            
            
            7,191
            
            
            
            2.71
            %Total
      loans
            
            $
            336,692
            
            
            
            100.00
            %
            
            $
            388,090
            
            
            
            100.00
            %
            
            $
            383,593
            
            
            
            100.00
            %
            
            $
            310,137
            
            
            
            100.00
            %
            
            $
            265,554
            
            
            
            100.00
            %





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





·
            During
      2009, the Bank’s total loans materially decreased by 13.1%.  The
      largest decreases occurred in the real estate construction category which
      decreased by 32.4% and the commercial, financial and agricultural category
      which decreased by 27.2%.  The Bank anticipates that its loan
      portfolio will continue to decrease during 2010, especially in the
      commercial real estate category.  However, the Bank is focused
      on maintaining and increasing its commercial and industrial loans and
      consumer mortgages.





Table 15
presents the scheduled maturities of the loans in Cornerstone’s loan portfolio
as of December 31, 2009 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
15




Loans
      Maturing
              Year-end
      balance as of December 31, 2009(In
      thousands)
            
            Less
      than One Year
            
            
            1
      to 5 Years
            
            
            Over
      5 Years
            
            
            TotalCommercial,
      financial and agricultural
            
            $
            43,026
            
            
            $
            15,664
            
            
            $
            1,870
            
            
            $
            60,560Real
      estate – construction
            
            
            34,542
            
            
            
            12,107
            
            
            
            1002
            
            
            
            47,651Real
      estate – mortgage
            
            
            20,709
            
            
            
            40,030
            
            
            
            10,237
            
            
            
            70,976Real
      estate – commercial
            
            
            43,182
            
            
            
            97,763
            
            
            
            12,365
            
            
            
            153,310Consumer
            
            
            1,480
            
            
            
            2,693
            
            
            
            22
            
            
            
            4,195Total
      Loans
            
            $
            142,939
            
            
            $
            168,257
            
            
            $
            25,496
            
            
            $
            336,692





30




Types
of Loans





Commercial Loans-The Bank’s
commercial loan portfolio is comprised of commercial, industrial, and non-farm
non-residential loans, hereinafter referred to as commercial loans (excluding
commercial construction loans). These installment loans and lines of credit are
extended to individuals, partnerships and corporations for a variety of business
purposes, such as accounts receivable and inventory financing, equipment
financing, business expansion and working capital.  The following is a
list of terms imbedded in the Bank’s commercial loan portfolio:





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


·
            Commercial
      loans are generally tied to the prime index and adjust according with
      changes in the prime rate.


·
            The
      Bank also extends fixed interest rate loans when appropriate to match the
      borrower’s needs.


·
            Loans
      secured by marketable equipment are required to be amortized over a period
      not to exceed 60 months.


·
            Generally,
      loans secured by current assets such as inventory or accounts receivable
      are structured as revolving lines of credit with annual
      maturities.·
            Loans
      secured by chattel, mortgages and accounts receivable may not exceed 85%
      of their market value.·
            Loans
      secured by listed stocks, municipal bonds and mutual funds may not exceed
      70% of their market value.


·
            Unsecured
      short-term loans and lines of credit must meet criteria set by the Bank’s
      Loan Committee.  Current financial statements support all
      commercial loans, and such financial statements are updated
      annually.


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





Real Estate: Construction
Loans-The Bank makes residential construction loans to owner-occupants
and to persons building residential properties for resale.  The Bank
has two main areas of construction loans: one is to residential real estate
developers for speculative or custom single-family residential properties, and
the other is to custom commercial construction projects with guaranteed takeout
provisions.  Construction loans are usually variable rate loans made
for terms of one year or less, but extensions are permitted if construction has
continued satisfactorily, the loan is current and other circumstances warrant
the extension.  Construction loans are limited to 80% of the appraised
value of the lot and the completed value of the proposed structure.





Construction
financing generally is considered to involve a higher degree of credit risk than
permanent mortgage financing of residential properties, and this additional risk
usually is reflected in higher interest rates.  The higher risk of
loss on construction loans is attributable in large part to the fact that loan
funds are estimated and advanced upon the security of the project under
construction, which is of uncertain value prior to the completion of
construction.  Moreover, because of the uncertainties inherent in
estimating construction costs, delays arising from labor problems, material
shortages and other unpredictable contingencies, it is relatively difficult to
accurately evaluate the total loan funds required to complete a project and to
accurately evaluate the related loan-to-value ratios.  If the
estimates of construction costs and the saleability of the property upon
completion of the project prove to be inaccurate, the Bank may be required to
advance funds beyond the amount originally committed to permit completion of the
project.  If the estimate of value proves to be inaccurate, the Bank
may be confronted, at or prior to the maturity of the loan, with a project with
a value that is insufficient to assure full repayment.





The
Bank’s underwriting criteria are designed to evaluate and minimize the risk of
each construction loan.  Among other items, the Bank considers
evidence of the availability of permanent financing or a take-out commitment to
the borrower, the financial strength and reputation of the borrower, an
independent appraisal and review of cost estimates, market conditions, and, if
applicable, the amount of the borrower’s equity in the project, pre-construction
sale or leasing information and cash flow projections of the
borrower.





Real Estate: Mortgage
Loans-Real estate mortgage loans include all one to four family
residential loans secured by real estate for purposes other than construction or
acquisition and development.  All real estate loans are held in the
Bank’s loan portfolio except for loans that are designated as loans held for
sale.  The loans held for sale are qualified by the Federal National
Mortgage Association and have been pre-approved by an underwriting specialist
prior to closing.  The remainder of the Bank’s mortgage loans are home
equity loans and are made at fixed interest rates for terms of one to three
years with balloon payment provisions and amortized over a 10 to 15 year
period.  The Bank’s experience indicates that real estate loans
normally remain outstanding for much shorter periods (seven years on average)
than their stated maturity because the borrowers repay the loans in full either
upon the sale of the secured property or upon the refinancing of the original
loan.





31




In the
case of owner occupied single-family residences, real estate loans are made for
up to 95% of the value of the property securing the loan, based upon an
appraisal if the loan amount is over $100,000.  When the loan is
secured by real estate containing a non-owner occupied dwelling of one to four
family units, loans generally are made for up to 80% of the value, based upon an
appraisal if the loan amount is over $100,000.  The Bank also requires
title insurance to insure the priority of the property lien on its real estate
loans over $50,000 and requires fire and casualty insurance on all of its
loans.





The real
estate loans originated by the Bank contain a “due-on-sale” clause, which
provides that the Bank may declare the unpaid balance of the loan immediately
due and payable upon the sale of the mortgaged property.  Such clauses
are an important means of reducing the average loan life and increasing the
yield on existing fixed-rate real estate loans, and it is the Bank’s policy to
enforce due-on-sale clauses.





Real Estate:
Commercial-Commercial real estate mortgage loans include all one to four
family residential loans secured by real estate for purposes other than
construction or acquisition and development.  All real estate loans
are held in the Bank’s loan portfolio except for loans that have been
participated to correspondent banks.  The Bank will sell these
participations if a loan exceeds the Bank’s legal lending limit or as is deemed
appropriate by the Director’s Loan Committee.  Commercial real estate
mortgage loans are a combination of properties that are leased out or used for a
primary place of a business the Bank has a relationship
with.   Most of the commercial real estate loans have fixed
interest rates for terms of one to three years with balloon payment provisions
and are amortized over a 10 to 15 year period, but whenever possible the Bank
will seek a variable rate loan which would be tied to the New York prime rate
and adjusted monthly.  The Bank’s experience indicates that real
estate loans normally remain outstanding for much shorter periods (seven years
on average) than their stated maturity because the borrowers repay the loans in
full either upon the sale of the secured property or upon the refinancing of the
original loan.  Commercial real estate loans are made for up to 85% of
the value of the property securing the loan, based upon an appraisal if the loan
amount is over $100,000.  The Bank also requires title insurance to
insure the priority of the property lien on its real estate loans over $50,000
and requires fire and casualty insurance on all of its loans.




Consumer Loans-These loans
consist of consumer installment loans and consumer credit card
balances.  The Bank makes both secured and unsecured consumer loans
for a variety of personal and household purposes.  Most of the Bank’s
consumer loans are automobile loans, boat loans, property improvement loans and
loans to depositors on the security of their certificates of
deposit.  These loans are generally made for terms of up to five years
at fixed interest rates.  The Bank considers consumer loans to involve
a relatively high credit risk compared to real estate loans.  Consumer
loans, therefore, generally yield a relatively high return to the Bank and
provide a relatively short maturity.  The Bank believes that the
generally higher yields and the shorter terms available on various types of
consumer loans tend to offset the relatively higher risk associated with such
loans, and contribute to a profitable spread between the Bank’s average yield on
earning assets and the Bank’s cost of funds.





Lending
Commitments-Commitments under standby letters of credit and undisbursed
loan commitments totaled approximately $46 million as of December 31, 2009
compared to approximately $67 million as of December 31, 2008.  This
number includes all lines of credit that have not been fully drawn and loan
commitments in the same status.





Origination,
Purchase and Sale of Loans





The Bank
originates the majority of its loans in Hamilton County,
Tennessee.  However, the Bank also originates loans in Marion,
Sequatchie and Bradley Counties in Tennessee, and Dade, Walker, Whitfield and
Catoosa Counties in Georgia, each of which is within 150 miles of Chattanooga,
Tennessee.  Eagle markets to staffing companies in the United
States.  Loans are originated by 17 relationship managers who operate
from the Bank’s offices in Chattanooga, Tennessee and from the loan production
office in Dalton, Georgia.  These relationship managers actively
solicit loan applications from existing customers, local manufacturers and
retailers, builders, real estate developers, real estate agents and
others.  The Bank also receives numerous loan applications as a result
of customer referrals and walk-ins to its offices.





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





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





32




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





Loan
Fee Income





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





Commitment
fees are charged by the Bank to the borrower for certain loans and are
calculated as a percentage of the principal amount of the loan.  These
fees normally are deducted from the proceeds of the loan and generally range
from 0.5% to 2.0% 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
Accounting Standard Codification Topic 310, “Receivables”, and amortizes all
significant loan fees over the life of the loan.  The Bank also
receives miscellaneous fee income from late payment charges, overdraft fees,
property inspection fees, and miscellaneous services related to its existing
loans.





Problem
Loans and Allowance for Loan Losses





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





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





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





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





The
Bank’s collection procedures provide that when a loan becomes between 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 foreclosed assets 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.





33


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





The
allowance for loan losses is evaluated on a regular basis by management and is
based upon management’s periodic review of the collectability of loans in light
of historical experience, the nature and volume of the loan portfolio, adverse
situations that may affect the borrower’s ability to repay, estimated value of
any underlying collateral and prevailing economic conditions.  This
evaluation is inherently subjective as it requires estimates that are
susceptible to significant revision as more information becomes
available.  A loan or portion thereof is charged off against the
general allowance when management has determined that losses on such loans are
probable.  Recoveries on any loans charged-off in prior fiscal periods
are credited to the allowance.  It is the opinion of the Bank’s
management that the balance in the general allowance for loan losses as of
December 31, 2009 is adequate to absorb possible losses from loans
currently in the portfolio.





Table 16
presents the Bank’s internal watchlist for loans classified as doubtful as of
December 31, 2009 and 2008.  Table 17 presents the Bank’s internal
watchlist for loans classified as substandard as of December 31, 2009 and
2008.





TABLE
16




Internal
      Watchlist Composition-DoubtfulDecember
      31, 2009
            
            
            December
      31, 2008(In
      thousands)
            
            Amount
            
            
            Impairment
            
            
            Amount
            
            
            ImpairmentCommercial
      and industrial
            
            $
            1,350
            
            
            $
            -
            
            
            $
            5,178
            
            
            $
            2,999Construction
      and development
            
            
            -
            
            
            
            -
            
            
            
            980
            
            
            
            567Single
      family real estate
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Multi-family
      real estate
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Owner
      occupied commercial real estate
            
            
            -
            
            
            
            -
            
            
            
            109
            
            
            
            94Non-owner
      occupied commercial real estate
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Consumer
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Totals
            
            $
            1,350
            
            
            $
            -
            
            
            $
            6,267
            
            
            $
            3,660




TABLE
17




Internal
      Watchlist Composition-SubstandardDecember
      31, 2009
            
            
            December
      31, 2008(In
      thousands)
            
            Amount
            
            
            Impairment
            
            
            Amount
            
            
            ImpairmentCommercial
      and industrial
            
            $
            2,578
            
            
            $
            216
            
            
            $
            3,895
            
            
            $
            746Construction
      and development
            
            
            13,727
            
            
            
            93
            
            
            
            4,840
            
            
            
            89Single
      family real estate
            
            
            6,498
            
            
            
            689
            
            
            
            5,035
            
            
            
            157Multi-family
      real estate
            
            
            2,820
            
            
            
            52
            
            
            
            118
            
            
            
            52Owner
      occupied commercial real estate
            
            
            6,038
            
            
            
            131
            
            
            
            1,962
            
            
            
            33Non-owner
      occupied commercial real estate
            
            
            6,150
            
            
            
            159
            
            
            
            2,514
            
            
            
            648Consumer
            
            
            100
            
            
            
            6
            
            
            
            292
            
            
            
            153Totals
            
            $
            37,911
            
            
            $
            1,346
            
            
            $
            18,656
            
            
            $
            1,878




34





·
            The
      information listed in tables 16 and 17 reflect the amount of the Bank’s
      loans net of any partial charge-off amount that has been previously
      recorded.





·
            The
      Bank has received a judgment by the Federal Bankruptcy court awarding all
      proceeds from the sale of the company relating to the $1.4 million
      commercial and industrial doubtful loan as of December 31,
      2009.  Currently, there is $1.5 million on deposit to fund this
      judgment.





·
            The
      Bank’s 2008 loans classified as doubtful were subsequently charged-off in
      2009.





·
            The
      Bank saw its construction and development customer base deteriorate during
      2009 especially in land development.   Of the $13.7 million
      classified as substandard as of December 31, 2009, approximately $12.9
      million is represented by six developments.  As of December 31,
      2009, all of the classified land development loans had sufficient
      collateral to require only minor
impairment.





·
            The
      Bank’s commercial real estate saw broad based deterioration due to the
      prolonged economic recession; highlighted as the hardest hit by the
      recession is the low income economic class.  Loans that have
      deteriorated the most associated with this group have been two churches
      totaling approximately $3.0 million of exposure, customers with mini
      warehouses and low income multifamily
housing.





·
            The
      Bank has revised its appraisal policy to require all loans graded
      substandard or worse to have annual appraisals on all real estate pledged
      as collateral with a value of $500,000 or greater.  These
      appraisals are used by the Bank’s Loan Review department to verify
      appropriate real estate impairment levels during this period of unstable
      property values.





Table 18
presents Cornerstone’s allocation of the allowance for loan losses as of
December 31, 2009, 2008, 2007, 2006 and 2005.





TABLE
18




Allowance
      for Loan LossesYears
      Ended December 31,2009
            
            2008
            
            
            2007(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
            
            $
            1,607
            
            
            
            17.99
            %
            
            $
            4,955
            
            
            
            21.42
            %
            
            $
            9,482
            
            
            
            25.57
            %Real
      estate – construction
            
            
            595
            
            
            
            14.15
            %
            
            
            1,433
            
            
            
            18.15
            %
            
            
            2,447
            
            
            
            20.03
            %Real
      estate – mortgage
            
            
            1,861
            
            
            
            21.08
            %
            
            
            1,532
            
            
            
            18.74
            %
            
            
            101
            
            
            
            16.84
            %Real
      estate – commercial
            
            
            1,768
            
            
            
            45.53
            %
            
            
            1,376
            
            
            
            40.13
            %
            
            
            1,434
            
            
            
            35.99
            %Consumer
            
            
            74
            
            
            
            1.25
            %
            
            
            322
            
            
            
            1.56
            %
            
            
            246
            
            
            
            1.57
            %Totals
            
            $
            5,905
            
            
            
            100.00
            %
            
            $
            9,618
            
            
            
            100.00
            %
            
            $
            13,710
            
            
            
            100.00
            %2006
            
            2005(In
      thousands)
              Balance
      at end of period applicable to
            
            Amount
            
            
            Percent
      of loans by category to total loans
            
            
            Amount
            
            
            Percent
      of loans by category to total loansCommercial,
      financial and agricultural
            
            $
            1,686
            
            
            
            31.77
            %
            
            $
            1,438
            
            
            
            32.40
            %Real
      estate – construction
            
            
            1,581
            
            
            
            18.57
            %
            
            
            1,253
            
            
            
            17.72
            %Real
      estate – mortgage
            
            
            77
            
            
            
            15.70
            %
            
            
            79
            
            
            
            17.19
            %Real
      estate – commercial
            
            
            703
            
            
            
            31.98
            %
            
            
            535
            
            
            
            29.98
            %Consumer
            
            
            211
            
            
            
            1.98
            %
            
            
            240
            
            
            
            2.71
            %Totals
            
            $
            4,258
            
            
            
            100.00
            %
            
            $
            3,545
            
            
            
            100.00
            %





35




·
            In
      recent years Cornerstone has refined its loan loss allowance to include
      measurements such as environmental factors for growth, environmental
      factors for real estate values, historical metrics and specific loan
      products with increased levels of risk, such as asset based
      lending.  This process enables Cornerstone to support and
      estimate the necessary allowance needed to protect Cornerstone against
      possible losses.  The allowance as of December 31, 2009 totaled
      $5.9 million compared to $9.6 million as of December 31,
      2008.  The most significant events occurring in the loan loss
      allowance during 2009 were provisions totaling $14.9 million and net
      charge-offs $18.6 million.





·
            Of
      the Bank’s $5.9 million loan loss allowance, the Bank has specifically
      assigned approximately $2.1 million to cover specific impairments for
      loans the Bank has identified as classified loans.  The
      remaining $3.8 million is a general reserve derived from historical and
      economic factors mentioned above.





·
            The
      primary difference between the 2009 allowance and the 2008 allowance is
      the proactive stance the Bank took during 2009 which resulted in several
      loans being charged-off.  At the end of 2008, several large
      loans had specific reserves but were not charged-off until
      2009.  One example of the distorted level of allowance was a
      loan relationship in the commercial and industrial classification totaling
      approximately $5.2 million with a specific impairment of approximately
      $3.0 million.  As of December 31, 2008, the Bank had performed
      its loan impairment analysis and recorded the proper amount of allowance
      needed.  During 2009, the loan relationship was charged-off
      which resulted in a significant decline in the allowance for loan loss
      amount as of December 31, 2009.





Table 19
presents Cornerstone’s delinquent and non-performing assets as of December 31,
2009 and 2008.





TABLE
19




Delinquent
      and Non-Performing AssetsActual
      for Years Ended December 31,(In
      thousands)
            
            2009
            
            
            2008Accruing
      loans that are contractuallypast
      due 90-days or more:Commercial,
      financial and agricultural
            
            $
            0
            
            
            $
            0Real
      estate – construction
            
            
            0
            
            
            
            0Real
      estate – mortgage
            
            
            0
            
            
            
            0Real
      estate- commercial
            
            
            0
            
            
            
            0Consumer
            
            
            0
            
            
            
            0Total
      Loans
            
            $
            0
            
            
            $
            0Non-accruing
      loans 90-days or more:Commercial,
      financial and agricultural
            
            $
            1,498
            
            
            $
            0Real
      estate – construction
            
            
            2,770
            
            
            
            1,180Real
      estate – mortgage
            
            
            842
            
            
            
            720Real
      estate – commercial
            
            
            2,250
            
            
            
            2,352Consumer
            
            
            0
            
            
            
            0Total
      Loans
            
            $
            7,360
            
            
            $
            4,252Real
      estate acquired through foreclosure
            
            $
            10,327
            
            
            $
            2,459Property
      acquired through repossession
            
            
            217
            
            
            
            257Total
      acquired
            
            $
            10,544
            
            
            $
            2,716Total
      Loans
            
            $
            336,692
            
            
            $
            388,090Ratio
      of non-performing assets to total loans
            
            
            5.32
            %
            
            
            1.80
            %Ratio
      of delinquent (30-days or more) but accruing loans to:Total
      loans
            
            
            1.80
            %
            
            
            2.08
            %Total
      assets
            
            
            1.20
            %
            
            
            1.71
            %




·
            Adverse
      economic conditions over the past two years have negatively impacted the
      Bank’s loan portfolio.  Real estate loans in all three
      classifications were negatively impacted during 2009.  The Bank
      continues to monitor its real estate loan portfolio closely in an attempt
      to identify potential problem loans as soon as
      possible.  However, as of December 31, 2009, the Bank had
      foreclosed on residential properties totaling approximately $4.4 million,
      commercial properties totaling approximately $4.0 million and real estate
      land totaling approximately $1.9
million.





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
      Bank has developed an internal loan watchlist that identifies classified
      loans and assists management to monitor their potential risk to Bank
      earnings.  As of December 31, 2009, the Bank had approximately
      $1.3 million in loans graded as doubtful, approximately $37.9 million in
      loans graded substandard and approximately $31.7 million graded as special
      mention.





36




Table 20
presents Cornerstone’s loan loss experience for the periods
indicated.





TABLE
20




Loan
      Loss Reserve AnalysisYears
      Ending December 31,(in
      thousands)
            
            2009
            
            
            2008
            
            
            2007
            
            
            2006
            
            
            2005Average
      loans
            
            $
            363,146
            
            
            $
            385,957
            
            
            $
            353,278
            
            
            $
            284,105
            
            
            $
            236,265Allowance
      for possible loan losses,Beginning
      of the period
            
            $
            9,618
            
            
            $
            13,710
            
            
            $
            4,258
            
            
            $
            3,545
            
            
            $
            2,658Charge-offs
      for the period:Commercial,
      financial and agricultural
            
            
            10,811
            
            
            
            6,991
            
            
            
            737
            
            
            
            307
            
            
            
            275Real
      estate – construction
            
            
            6,005
            
            
            
            434
            
            
            
            84
            
            
            
            0
            
            
            
            48Real
      estate – mortgage
            
            
            692
            
            
            
            193
            
            
            
            0
            
            
            
            104
            
            
            
            50Real
      estate - commercial
            
            
            1,248
            
            
            
            210
            
            
            
            180
            
            
            
            0
            
            
            
            78Consumer
            
            
            340
            
            
            
            151
            
            
            
            74
            
            
            
            70
            
            
            
            111Total
      charge-offs
            
            
            19,096
            
            
            
            7,979
            
            
            
            1,075
            
            
            
            481
            
            
            
            562Recoveries
      for the period:Commercial,
      financial and agricultural
            
            
            358
            
            
            
            362
            
            
            
            114
            
            
            
            66
            
            
            
            12Real
      estate – construction
            
            
            4
            
            
            
            14
            
            
            
            0
            
            
            
            0
            
            
            
            1Real
      estate – mortgage
            
            
            64
            
            
            
            1
            
            
            
            4
            
            
            
            7
            
            
            
            6Real
      estate – commercial
            
            
            43
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0Consumer
            
            
            15
            
            
            
            12
            
            
            
            0
            
            
            
            15
            
            
            
            28Total
      recoveries
            
            
            484
            
            
            
            389
            
            
            
            118
            
            
            
            88
            
            
            
            47Net
      charge-offs for the period
            
            
            18,612
            
            
            
            7,590
            
            
            
            957
            
            
            
            393
            
            
            
            515Provision
      for loan losses
            
            
            14,899
            
            
            
            3,498
            
            
            
            10,409
            
            
            
            1,106
            
            
            
            1,402Adjustments
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0
            
            
            
            0Allowance
      for possible loan losses, end of period
            
            $
            5,905
            
            
            $
            9,618
            
            
            $
            13,710
            
            
            $
            4,258
            
            
            $
            3,545Ratio
      of allowance for loan losses to total average loans
      outstanding
            
            
            1.63
            %
            
            
            2.49
            %
            
            
            3.88
            %
            
            
            1.50
            %
            
            
            1.50
            %Ratio
      of net charge-offs during the period to average loans outstanding during
      the period
            
            
            5.13
            %
            
            
            1.97
            %
            
            
            0.27
            %
            
            
            0.14
            %
            
            
            0.22
            %





Intangibles-Cornerstone
follows the provisions of Accounting Standards Codification Topic 350,
“Intangibles-Goodwill and Other” concerning approximately $2.5 million in
goodwill created by the merger with the Bank of East Ridge.  Goodwill
is tested annually for impairment.  If the carrying value of goodwill
exceeds the fair value, a write-down is recorded.  No impairment loss
was recognized during 2009, 2008 or 2007.  In December, 2005,
Cornerstone completed the purchase of Eagle Financial, Inc. and recorded an
intangible asset of $848,916. Prior to June 2009, Eagle amortized a portion of
the intangible each month.  However, on June 30, 2009 the Bank
purchased Eagle from the holding company.  The transaction resulted in
a write-off of the remaining intangible balance of approximately $229 thousand
based on an appraisal of the business performed in conjunction with that
transaction.





37




Sources
of Funds





Overview-Time, money market,
savings and demand deposits are the major source of the Bank’s funds for lending
and other investment purposes.  All deposits are held by the
Bank.  In addition, the Bank 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 Bank’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.





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





Table 21
presents the Bank’s core vs. non-core funding as of December 31, 2009 and 2008
(in thousands).





TABLE
21





Core
      and Non-Core Funding(In
      thousands)
            
            December
      31, 2009
            
            
            December
      31, 2008Core
      funding:
            
            Amount
            
            
            Percent
            
            
            Amount
            
            
            PercentNoninterest
      bearing demand deposits
            
            $
            41,972
            
            
            
            8.4
            %
            
            $
            40,078
            
            
            
            9.3
            %Interest-bearing
      demand deposits
            
            
            26,533
            
            
            
            5.3
            %
            
            
            26,909
            
            
            
            6.3
            %Savings
      & money market accounts
            
            
            31,030
            
            
            
            6.2
            %
            
            
            35,848
            
            
            
            8.3
            %Time
      deposits under $100,000
            
            
            214,143
            
            
            
            43.0
            %
            
            
            147,928
            
            
            
            34.5
            %Total
      core funding
            
            
            313,678
            
            
            
            62.9
            %
            
            
            250,763
            
            
            
            58.4
            %Non-core
      funding:Brokered
      deposits
            
            
            5,852
            
            
            
            1.29
            %
            
            
            16,763
            
            
            
            3.9
            %Time
      deposits greater than $100,000
            
            
            85,212
            
            
            
            17.19
            %
            
            
            59,057
            
            
            
            13.8
            %Securities
      sold under agreements to repurchase
            
            
            26,322
            
            
            
            5.3
            %
            
            
            35,790
            
            
            
            8.3
            %Federal
      Home Loan Bank advances
            
            
            67,000
            
            
            
            13.5
            %
            
            
            67,000
            
            
            
            15.6
            %Total
      non-core funding
            
            
            184,386
            
            
            
            37.1
            %
            
            
            178,610
            
            
            
            41.6
            %Total
            
            $
            498,064
            
            
            
            100.0
            %
            
            $
            429,373
            
            
            
            100.0
            %




·
            During
      2009, the Bank materially increased its time deposits to fund an increase
      in the Bank’s investment portfolio.  The increase in the
      investment portfolio was needed for pledging and liquidity
      purposes.  The time deposits represent a more stable funding
      source for the Bank when compared to other sources such as brokered
      deposits.  Management anticipates the time deposits to remain at
      this level during 2010.





·
            During
      2010, the Bank is contractually obligated to pay off $17 million of
      Federal Home Loan Bank advances.





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





38




Table 22
presents the composition of deposits for the Bank, excluding accrued interest
payable, by type for the years ended December 31, 2009, 2008 and 2007 (in
thousands).





TABLE
22




Deposit
      CompositionYears
      Ended December 31,(In
      thousands)
            
            2009
            
            
            2008
            
            
            2007Demand
      deposits
            
            $
            41,972
            
            
            $
            40,078
            
            
            $
            45,285NOW
      deposits
            
            
            26,533
            
            
            
            26,909
            
            
            
            31,985Savings
      & money market deposits
            
            
            31,030
            
            
            
            35,848
            
            
            
            49,970Time
      deposits $100,000 and over
            
            
            91,064
            
            
            
            59,057
            
            
            
            58,250Time
      deposits under $100,000
            
            
            214,143
            
            
            
            164,692
            
            
            
            127,760Total
      Deposits
            
            $
            404,742
            
            
            $
            326,584
            
            
            $
            313,250





·
            On
      October 3, 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”)
      became law.  The EESA enabled the FDIC to temporarily increase
      the amount of FDIC deposit insurance coverage from $100,000 to $250,000
      per qualified depositor through December 31, 2013.  Also during
      the fourth quarter of 2008, the FDIC’s Temporary Liquidity Guarantee
      Program (“TLGP”) extended unlimited deposit insurance coverage for
      non-interest bearing transaction accounts at participating FDIC insured
      banks.  The FDIC also offered coverage regarding debt obligation
      coverage.  These services were offered by the FDIC with a fee
      structure for each product.  The Bank chose to accept the
      unlimited transaction account coverage but refused the debt obligation
      coverage.  The TLGP currently has an expiration date of June 30,
      2010.





·
            Time
      deposits annual percentage yields decreased materially throughout 2009,
      which allowed the Bank to increase its deposit base at a lower cost of
      funds than incurred in 2008.  In November 2009, the FDIC
      downgraded the Bank to “adequately capitalized” status, thereby
      restricting the interest rates payable by the Bank for time
      deposits.  However, as of March 2010, the restriction has not
      affected deposit growth.





Table 23
presents a breakdown by category of the average amount of deposits and the
average rate paid on deposits for the periods indicated:





TABLE
23




Average
      Amount and Average Rate Paid on DepositsYears
      Ending December 31,2009
            
            
            2008
            
            
            2007(In
      thousands)
            
            Amount
            
            
            Rate
            
            
            Amount
            
            
            Rate
            
            
            Amount
            
            
            RateDemand
      deposits
            
            $
            40,816
            
            
            
            
            
            $
            42,915
            
            
            
            
            
            $
            41,503NOW
      deposits
            
            
            27,864
            
            
            
            0.35
            %
            
            
            30,106
            
            
            
            0.70
            %
            
            
            36,327
            
            
            
            2.21
            %Savings
      & money market deposits
            
            
            35,269
            
            
            
            0.86
            %
            
            
            51,600
            
            
            
            1.60
            %
            
            
            55,808
            
            
            
            3.61
            %Time
      deposits $100,000 and over
            
            
            61,533
            
            
            
            3.33
            %
            
            
            59,083
            
            
            
            4.01
            %
            
            
            61,172
            
            
            
            5.12
            %Time
      deposits under $100,000
            
            
            195,018
            
            
            
            2.85
            %
            
            
            131,138
            
            
            
            4.49
            %
            
            
            107,498
            
            
            
            5.01
            %Total
      Deposits
            
            $
            360,500
            
            
            
            2.51
            %
            
            $
            314,842
            
            
            
            3.42
            %
            
            $
            302,308
            
            
            
            4.35
            %





Borrowings-The Bank joined
the Federal Home Loan Bank of Cincinnati in October 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 December 31, 2009, had $67 million outstanding
with the FHLB.  The FHLB offers
multiple products to assist banks in their funding needs.  The
advances from the FHLB as of December 31, 2009 are structured as an obligation
with a fixed rate with the majority of loans incorporating an optional
conversion to a floating rate after a stated period of time.  The
loans have maturities ranging from May 2010 to January 2017.  As of
December 31, 2009, the interest rates on these loans ranged from 3.52% to
5.00%.  The Bank has two Federal Funds lines of credit available with
correspondent banks with a total availability of $9 million as of December 31,
2009.  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, 2009, Cornerstone had two loans totaling approximately $5.4 million priced
at New York Prime Rate plus 300 basis points with a floor of
6.25%.  The loans were established to insert capital infusions to the
Bank to fund growth or retire treasury stock, if any, as needed.  See
Note 9 of our audited consolidated financial statements for additional
information.





39




Capital





Capital
Resources-Stockholder’s average equity for 2009 and 2008 totaled $33.6
million and $37.4 million, respectively.  As of December 31, 2009,
Cornerstone’s actual stockholder equity totaled $27.8 million compared to $36.5
million as of December 31, 2008.  The number of common shares
outstanding increased to 6,500,396 as of December 31, 2009 from 6,319,718 as of
December 31, 2008.  Changes in the number of common shares outstanding
resulted from Cornerstone’s two stock dividends totaling 0.8421% of the shares
outstanding as of June 12, 2009 and 2.0% of the shares outstanding as of
September 18, 2009.





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





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





The
Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”)
established five capital categories for banks.  Under the regulation
defining these five capital categories, each bank is classified into one of the
five categories based on its level of risk-based capital as measured by Tier I
capital, total risk-based capital, and Tier I leverage ratios and its
supervisory ratings.  Table 24 lists the five categories of capital
and each of the minimum requirements for the three risk-based
ratios.





TABLE
24




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





·
            As
      of December 31, 2009, the Bank exceeded the regulatory minimums and
      qualified as an adequately-capitalized institution under the
      regulations.  The Bank had Tier 1 capital of $29.5 million or
      6.1% of average assets as of December 31, 2009, compared to Tier 1 capital
      of $36.3 million or 7.9% of average assets as of December 31,
      2008.  The Bank had total capital of $34.0 million or 9.5% of
      risk weighted assets as of December 31, 2009, compared to total capital of
      $41.4 million or 10.3% of risk weighted assets as of December 31,
      2008.





·
            To
      provide sufficient capital to restore the Bank’s status as a “well
      capitalized” institution and to pay off Cornerstone’s holding company
      loans, Cornerstone is actively considering strategic alternatives, which
      may include a capital infusion through the issuance and sale shares of
      common stock, preferred stock or other securities (including securities
      convertible into shares of common stock) in public or private
      offerings.





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





40


The
Bank’s liquidity target is measured by adding net cash, short term and
marketable securities not pledged and dividing this number by total deposits and
short-term liabilities not secured by assets pledged.  The Bank’s
liquidity ratio at December 31, 2009 was 9.1% compared to 10.4% at December 31,
2008.  The Bank is not subject to any specific liquidity requirements
imposed by regulatory orders.  The Bank is subject however, to general
FDIC guidelines which are concerned with funding sources and dependence on
noncore deposits and does not require a specific minimum level of
liquidity.  Management believes its liquidity ratios and funding
sources meet or exceed these guidelines.





Cornerstone’s
liquidity is dependent on dividends from its subsidiary and capital
contributions from its stockholders.  Currently, the holding company’s
expenses are tied to debt service on two holding company loans totaling $5.4
million and shareholder and related Securities and Exchange Commission required
filings expense.  The Bank is presently restricted from passing up any
dividends to the holding company unless the Bank receives prior approval from
the FDIC.





As
previously reported, after initially applying in December 2008 for funding of up
to $12 million under the U.S. Treasury’s Capital Purchase Program, instituted as
part of the Troubled Asset Relief Program established under the EESA,
Cornerstone notified the FDIC of its decision to withdraw its application on
October 15, 2009.





Management
does not know of any other trends, demands, commitments, events or uncertainties
that will result in or are reasonably likely to result in liquidity increasing
or decreasing in any material manner.





Table 25
presents the average loan to deposit ratios, a liquidity measure, for periods
indicated:





TABLE
25




December
      31, 2009
            
            
            December
      31, 2008Average
      loans to average deposits
            
            
            100.73
            %
            
            
            122.59
            %




ITEM
7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





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




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




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





Table 26
presents the re-pricing of the Bank’s interest earning assets and
interest-bearing liabilities as of December 31, 2009.  This interest
sensitivity gap table is designed to monitor the Bank’s interest rate risk
exposure within the designated time period.  In order to control
interest rate risk, management regularly monitors the volume of interest
sensitive assets relative to interest sensitive liabilities over specific time
intervals.  The Bank’s interest rate management policy is to attempt
to maintain a relatively stable net interest margin in periods of interest rate
fluctuations.   The Bank’s policy is to attempt to maintain a
ratio of cumulative gap to total interest sensitive assets of negative 15.00% to
positive 15.00% in the time period of one year or less.  The
information set forth below is based on the following assumptions of
management:  (i) savings and money market and NOW accounts will be
less interest rate sensitive and the re-pricing on these accounts will be spread
out over a five-year period; and (ii) securities other than mortgage-backed
securities have been scheduled by maturity date while mortgages have been
amortized over the life of the mortgage.   Table 26 excludes the
interest sensitive assets and liabilities of Eagle and the Bank’s holding
company, Cornerstone Bancshares, Inc.  The exclusion for Eagle is an
interest sensitive asset, consisting of accounts receivable, totaling $2.0
million.  The exclusion for the holding company is an interest
sensitive liability, which consists of two loans with approximately $5.4 million
outstanding.  The interest sensitive asset of Eagle would be accounted
for in the less than one year analysis.  With respect to the interest
sensitive liability of the holding company $1.0 million would be accounted for
in the less than one year analysis and $4.4 million would be accounted for the
one to five year analysis.




41




TABLE
26




Re-pricing
      of Interest Sensitive Assets and Liabilities
              Year-end
      balance as of December 31, 2009(In
      thousands)
            
            Less
      than
              One
      Year
            
            
            1
      to
              5
      Years (3)
            
            
            Over
              5
      Years (3)
            
            
            TotalInterest
      Sensitive Assets:Investment
      securitiesTaxable
      (1)
            
            $
            47,062
            
            
            $
            61,377
            
            
            $
            639
            
            
            $
            109,078Tax-exempt
      (1)
            
            
            -
            
            
            
            599
            
            
            
            14,873
            
            
            
            15,472Loans
      (2)Fixed
      rate and adjustable rate 1-4 family mortgage
            
            
            18,408
            
            
            
            29,727
            
            
            
            10,071
            
            
            
            58,206Scheduled
      payments
            
            
            125,822
            
            
            
            137,871
            
            
            
            14,793
            
            
            
            278,486Other
            
            
            42,094
            
            
            
            -
            
            
            
            -
            
            
            
            42,094Total
      Interest Sensitive Assets
            
            $
            233,386
            
            
            $
            229,574
            
            
            $
            40,376
            
            
            $
            503,336Interest
      Sensitive Liabilities:NOW
      accounts
            
            $
            10,622
            
            
            $
            15,911
            
            
            $
            -
            
            
            $
            26,533Money
      market and savings accounts
            
            
            14,640
            
            
            
            16,390
            
            
            
            -
            
            
            
            31,030Time
      deposits
            
            
            242,982
            
            
            
            62,225
            
            
            
            -
            
            
            
            305,207Other
      interest bearing liabilities
            
            
            78,322
            
            
            
            15,000
            
            
            
            
            
            
            
            93,322Total
      Interest Sensitive Liabilities
            
            $
            346,566
            
            
            $
            109,526
            
            
            $
            -
            
            
            $
            456,092Interest
      Sensitive Gap
            
            
            (113,180
            )
            
            
            120,048
            
            
            
            40,376
            
            
            
            47,244Cumulative
      Interest Sensitive Gap
            
            
            (113,180
            )
            
            
            6,868
            
            
            
            47,244Ratio
      of cumulative gap to total Interest Sensitive Assets
            
            
            (22.49
            )%
            
            
            1.36
            %
            
            
            9.39
            %





(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.





·
            The
      majority of the Bank’s loans are indexed to the Prime rate as published in
      The Wall Street
      Journal.  These variable rate loans contain a provision
      stating that an interest rate floor ranging from 4.0% to 7.5%
      exists.  Almost all of the Bank’s variable rate loans have
      repriced to the interest rate floors.  The Bank’s interest rate
      model estimates the most likely rate adjustment
  scenario.





Impact of Inflation and Changing
Price-The financial statements and related financial data presented
herein have been prepared in accordance with U.S. generally accepted accounting
principles, which require the measurement of the financial position and
operating results in terms of historical dollars without considering the changes
in the relative purchasing power of money over time and due to
inflation.  Management is primarily concerned with two inflationary
factors; The first and most common factor is the general impact of inflation on
the operations of Cornerstone and is reflected in increased operating
costs.  The second, and more material to the Bank’s profitability,
factor is interest rate adjustments by the Federal Reserve and the general fixed
income market in reaction to inflation.  In other words, interest rate
risk, unlike most industrial companies, substantially impacts Cornerstone
because virtually all of the assets and liabilities of Cornerstone are monetary
in nature.  As a result, interest rates may have a more significant
impact on Cornerstone’s performance than the effects of general levels of
inflation.  Interest rate fluctuations 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.





42




ITEM
8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA




CORNERSTONE
BANCSHARES, INC. AND SUBSIDIARY





Consolidated
Financial Statements and Footnotes





Table
of Contents




Page
      No.Management’s
      Report on Internal Control over Financial Reporting
              
              44Report
      of Independent Registered Public Accounting Firm – Financial
      Statements
              
              45Consolidated
      Financial Statements
              
              46Consolidated
      balance sheets
              
              46Consolidated
      statements of operations
              
              47Consolidated
      statements of changes in stockholders’ equity
              
              48Consolidated
      statements of cash flows
              
              50Notes
      to consolidated financial statements
              
              51





43





MANAGEMENT’S
REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING





The
management of Cornerstone is responsible for establishing and maintaining
adequate internal control over financial reporting. Internal control over
financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under
the Exchange Act as a process designed by, or under the supervision of,
Cornerstone’s principal executive and principal financial officers and effected
by Cornerstone’s board of directors, management and other personnel, to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles and includes those polices and
procedures that:





·
            Pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of Cornerstone’s
      assets;


·
            Provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that Cornerstone’s receipts and expenditures
      are being made only in accordance with authorizations of Cornerstone’s
      management and directors; and


·
            Provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of Cornerstone’s assets that
      could have a material effect on the financial
  statements.





All
internal control systems, no matter how well designed, have inherent
limitations. Therefore, even those systems determined to be effective can
provide only reasonable assurance with respect to financial statement
preparation and presentation.





Cornerstone’s
management has assessed the effectiveness of internal controls over financial
reporting as of December 31, 2009. In making this assessment, it used the
criteria set forth by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO) in “Internal Control-Integrated Framework.”





Based on
this assessment management believes that, as of December 31, 2009, Cornerstone’s
internal control over financial reporting was effective based on those
criteria.





This
annual report does not include an attestation report of Cornerstone’s registered
public accounting firm regarding internal control over financial reporting.
Management’s report was not subject to attestation by Cornerstone’s registered
public accounting firm pursuant to transitional rules of the Securities and
Exchange Commission that permit Cornerstone to provide only management’s report
in this annual report.





44




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 subsidiary
(Company) as of December 31, 2009 and 2008, and the related consolidated
statements of operations, changes in stockholders’ equity, and cash flows
for each of the three years in the period ended December 31,
2009.  These financial statements are the responsibility of the
Company’s management.  Our responsibility is to express an opinion on
these financial statements based on our audits.





We conducted our audits in accordance
with the standards of the Public Company Accounting Oversight Board (United
States).  Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement.  An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements.  An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe
that our audits provide a reasonable basis for our opinion.





In our opinion, the consolidated
financial statements referred to above present fairly, in all material respects,
the financial position of Cornerstone Bancshares, Inc. and subsidiary as of
December 31, 2009 and 2008, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2009, in
conformity with United States generally accepted accounting
principles.





The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern.  As discussed in Note 2
to the consolidated financial statements, the Company was not in compliance with
certain of its debt covenants at December 31, 2009, due to recent operating
losses and reduced capital levels.  The uncertainty of the Company’s
ability to repay or replace certain of the Company’s debt or to mitigate actions
by its lender if the lender declares an event of default, accelerates the
repayment terms of the debt or attempts to foreclose on the stock of the
subsidiary that is pledged as collateral, raises substantial doubt about the
Company’s ability to continue as a going concern.  Management’s plans
in regard to these matters are also described in Note 2.  The
consolidated financial statements do not include any adjustments that might
result from the outcome of this uncertainty.





We were not engaged to examine
management’s assessment of the effectiveness of the Company’s internal control
over financial reporting as of December 31, 2009, included in Management’s Report on Internal
Control Over Financial Reporting found in Item 9A(T) of Form 10-K for the
year ended December 31, 2009, and, accordingly, we do not express an
opinion thereon.





/s/
HAZLETT, LEWIS & BIETER, PLLC





Chattanooga,
Tennessee


March 29,
2010




45




CORNERSTONE BANCSHARES, INC. AND SUBSIDIARYCONSOLIDATED BALANCE SHEETSDecember
      31, 2009 and 20082009
                
                
                2008ASSETSCash
      and due from banks
                
                $
                38,202,205
                
                
                $
                10,872,390Federal
      funds sold
                
                
                -
                
                
                
                11,025,000Cash
      and cash equivalents
                
                
                38,202,205
                
                
                
                21,897,390Securities
      available for sale
                
                
                124,415,318
                
                
                
                44,056,559Securities
      held to maturity (fair value approximates$136,062
      at 2009 and $169,759 at 2008)
                
                
                135,246
                
                
                
                169,284Federal
      Home Loan Bank stock, at cost
                
                
                2,229,200
                
                
                
                2,187,500Loans,
      net of allowance for loan losses of$5,905,054
      in 2009 and $9,618,265 in 2008
                
                
                330,787,382
                
                
                
                378,471,619Bank
      premises and equipment, net
                
                
                8,098,059
                
                
                
                8,471,955Accrued
      interest receivable
                
                
                1,520,699
                
                
                
                1,771,091Goodwill
      and amortizable intangibles
                
                
                2,579,211
                
                
                
                2,840,773Foreclosed
      assets
                
                
                10,327,297
                
                
                
                2,458,821Other
      assets
                
                
                14,109,769
                
                
                
                9,478,183Total
      assets
                
                $
                532,404,386
                
                
                $
                471,803,175LIABILITIES
      AND STOCKHOLDERS' EQUITYDeposits:Noninterest-bearing
      demand deposits
                
                $
                41,971,956
                
                
                $
                40,077,977Interest-bearing
      demand deposits
                
                
                26,533,329
                
                
                
                26,908,572Savings
      deposits and money market accounts
                
                
                31,029,587
                
                
                
                35,847,667Time
      deposits of $100,000 or more
                
                
                91,064,094
                
                
                
                59,056,590Time
      deposits under $100,000
                
                
                214,143,147
                
                
                
                164,692,417Total
      deposits
                
                
                404,742,113
                
                
                
                326,583,223Accrued
      interest payable
                
                
                351,360
                
                
                
                469,586Federal
      funds purchased and securities sold underagreements
      to repurchase
                
                
                26,321,885
                
                
                
                35,790,246Federal
      Home Loan Bank advances and other borrowings
                
                
                72,350,000
                
                
                
                71,250,000Other
      liabilities
                
                
                801,549
                
                
                
                1,208,611Total
      liabilities
                
                
                504,566,907
                
                
                
                435,301,666Stockholders'
      equity:Preferred
      stock - no par value; 2,000,000 sharesauthorized;
      no shares issued
                
                
                -
                
                
                
                -Common
      stock - $1.00 par value; 10,000,000 shares authorized;6,709,199
      and 6,522,718 shares issued in 2009 and 20086,500,396
      and 6,319,718 shares outstanding in 2009 and 2008
                
                
                6,500,396
                
                
                
                6,319,718Additional
      paid-in capital
                
                
                21,162,686
                
                
                
                20,311,638Retained
      earnings
                
                
                424,854
                
                
                
                10,056,680Accumulated
      other comprehensive income
                
                
                (250,457
                )
                
                
                (186,527
                )Total
      stockholders' equity
                
                
                27,837,479
                
                
                
                36,501,509Total
      liabilities and stockholders' equity
                
                $
                532,404,386
                
                
                $
                471,803,175The
      Notes to Consolidated Financial Statements are an integral part of these
      statements.




46




CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARYCONSOLIDATED  STATEMENTS  OF  OPERATIONSYears
      Ended December 31, 2009, 2008 and
2007
  2009
              
              
              2008
              
              
              2007INTEREST
      INCOMELoans,
      including fees
              
              $
              24,402,101
              
              
              $
              28,660,491
              
              
              $
              32,981,334Securities
      and interest-bearing deposits in other banks
              
              
              1,895,228
              
              
              
              1,996,228
              
              
              
              1,750,023Federal
      funds sold
              
              
              11,098
              
              
              
              23,455
              
              
              
              52,161Total
      interest income
              
              
              26,308,427
              
              
              
              30,680,174
              
              
              
              34,783,518INTEREST
      EXPENSETime
      deposits of $100,000 or more
              
              
              2,049,063
              
              
              
              2,370,873
              
              
              
              3,134,084Other
      deposits
              
              
              5,960,079
              
              
              
              6,928,475
              
              
              
              8,206,843Federal
      funds purchased and securitiessold
      under agreements to repurchase
              
              
              173,648
              
              
              
              600,163
              
              
              
              857,161Federal
      Home Loan Bank advances and other borrowings
              
              
              3,006,593
              
              
              
              2,798,563
              
              
              
              2,215,517Total
      interest expense
              
              
              11,189,383
              
              
              
              12,698,074
              
              
              
              14,413,605Net
      interest income before provision for loan losses
              
              
              15,119,044
              
              
              
              17,982,100
              
              
              
              20,369,913Provision
      for loan losses
              
              
              14,898,898
              
              
              
              3,498,000
              
              
              
              10,409,365Net
      interest income after provision for loan losses
              
              
              220,146
              
              
              
              14,484,100
              
              
              
              9,960,548NONINTEREST
      INCOMECustomer
      service fees
              
              
              1,630,387
              
              
              
              1,726,681
              
              
              
              1,425,822Other
      noninterest income
              
              
              138,244
              
              
              
              107,522
              
              
              
              165,495Net
      (loss) gain from sale of loans and other assets
              
              
              (1,227,414
              )
              
              
              57,828
              
              
              
              103,773Total
      noninterest income
              
              
              541,217
              
              
              
              1,892,031
              
              
              
              1,695,090NONINTEREST
      EXPENSESSalaries
      and employee benefits
              
              
              6,970,282
              
              
              
              7,139,594
              
              
              
              6,608,808Net
      occupancy and equipment expense
              
              
              1,547,630
              
              
              
              1,520,378
              
              
              
              1,354,642Depository
      insurance
              
              
              1,198,937
              
              
              
              321,164
              
              
              
              105,550Other
      operating expenses
              
              
              4,559,193
              
              
              
              3,586,629
              
              
              
              2,856,601Total
      noninterest expenses
              
              
              14,276,042
              
              
              
              12,567,765
              
              
              
              10,925,601(Loss)
      income before income tax expense
              
              
              (13,514,679
              )
              
              
              3,808,366
              
              
              
              730,037Income
      tax (benefit) expense
              
              
              (5,336,040
              )
              
              
              1,296,542
              
              
              
              (141,115
              )Net
      (loss) income
              
              $
              (8,178,639
              )
              
              $
              2,511,824
              
              
              $
              871,152EARNINGS
      (LOSS) PER COMMON SHAREBasic
              
              $
              (1.26
              )
              
              $
              .39
              
              
              $
              .13Diluted
              
              
              (1.26
              )
              
              
              .38
              
              
              
              .12The
      Notes to Consolidated Financial Statements are an integral part of these
      statements.




47




CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY CONSOLIDATED  STATEMENTS  OF  CHANGES  IN  STOCKHOLDERS'  EQUITY Years
Ended December 31, 2009, 2008 and 2007
 AccumulatedAdditional
              
              
              
              
              
              Other
              
              
              TotalComprehensive
              
              
              Common
              
              
              Paid-in
              
              
              Retained
              
              
              Comprehensive
              
              
              Stockholders'Income
              
              
              Stock
              
              
              Capital
              
              
              Earnings
              
              
              Income
              
              
              EquityBALANCE,
      December 31, 2006
              
              
              
              
              $
              6,511,848
              
              
              $
              21,849,006
              
              
              $
              9,881,029
              
              
              $
              (58,618
              )
              
              $
              38,183,265Issuance
      of common stock
              
              
              
              
              
              5,870
              
              
              
              20,446
              
              
              
              -
              
              
              
              -
              
              
              
              26,316Issuance
      of common stock under Director's stock option plan
              
              
              
              
              
              5,000
              
              
              
              41,610
              
              
              
              -
              
              
              
              -
              
              
              
              46,610Stock
      compensation expense
              
              
              
              
              
              -
              
              
              
              220,016
              
              
              
              -
              
              
              
              -
              
              
              
              220,016Dividends
      - $.22 per share
              
              
              
              
              
              -
              
              
              
              -
              
              
              
              (1,434,303
              )
              
              
              -
              
              
              
              (1,434,303
              )Repurchase
      of common stock
              
              
              
              
              
              (153,000
              )
              
              
              (1,598,291
              )
              
              
              -
              
              
              
              -
              
              
              
              (1,751,291
              )Comprehensive
      income:Net
      income
              
              $
              871,152
              
              
              
              -
              
              
              
              -
              
              
              
              871,152
              
              
              
              -
              
              
              
              871,152Other
      comprehensive income, net of tax:Unrealized
      holding gains (losses) on securities available for sale,net
      of reclassification adjustment
              
              
              165,585
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              165,585
              
              
              
              165,585Total
      comprehensive income
              
              $
              1,036,737BALANCE,
      December 31, 2007
              
              
              
              
              
              
              6,369,718
              
              
              
              20,532,787
              
              
              
              9,317,878
              
              
              
              106,967
              
              
              
              36,327,350Issuance
      of common stock
              
              
              
              
              
              
              22,000
              
              
              
              60,500
              
              
              
              -
              
              
              
              -
              
              
              
              82,500Stock
      compensation expense
              
              
              
              
              
              
              -
              
              
              
              279,400
              
              
              
              -
              
              
              
              -
              
              
              
              279,400Dividends
      - $.28 per share
              
              
              
              
              
              
              -
              
              
              
              -
              
              
              
              (1,773,022
              )
              
              
              -
              
              
              
              (1,773,022
              )Repurchase
      of common stock
              
              
              
              
              
              
              (72,000
              )
              
              
              (561,049
              )
              
              
              -
              
              
              
              -
              
              
              
              (633,049
              )Comprehensive
      income:Net
      income
              
              $
              2,511,824
              
              
              
              -
              
              
              
              -
              
              
              
              2,511,824
              
              
              
              -
              
              
              
              2,511,824Other
      comprehensive income, net of tax:Unrealized
      holding gains (losses) on securities available for sale,net
      of reclassification adjustment
              
              
              (293,494
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (293,494
              )
              
              
              (293,494
              )Total
      comprehensive income
              
              $
              2,218,330BALANCE,
      December 31, 2008
              
              
              
              
              
              $
              6,319,718
              
              
              $
              20,311,638
              
              
              $
              10,056,680
              
              
              $
              (186,527
              )
              
              $
              36,501,509


(continued
on next page)




48




CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY Years
Ended December 31, 2009, 2008 and 2007
  (continued
from previous page)




AccumulatedAdditional
              
              
              
              
              
              Other
              
              
              TotalComprehensive
              
              
              Common
              
              
              Paid-in
              
              
              Retained
              
              
              Comprehensive
              
              
              Stockholders'Income
              
              
              Stock
              
              
              Capital
              
              
              Earnings
              
              
              Income
              
              
              EquityBALANCE,
      December 31, 2008
              
              
              
              
              $
              6,319,718
              
              
              $
              20,311,638
              
              
              $
              10,056,680
              
              
              $
              (186,527
              )
              
              $
              36,501,509Stock
      compensation expense
              
              
              
              
              
              -
              
              
              
              216,600
              
              
              
              -
              
              
              
              -
              
              
              
              216,600Dividends
      - $0.10 per share
              
              
              
              
              
              -
              
              
              
              -
              
              
              
              (638,061
              )
              
              
              -
              
              
              
              (638,061
              )Stock
      dividends
              
              
              
              
              
              180,678
              
              
              
              634,448
              
              
              
              (815,126
              )
              
              
              -
              
              
              
              -Comprehensive
      loss:Net
      loss
              
              $
              (8,178,639
              )
              
              
              -
              
              
              
              -
              
              
              
              (8,178,639
              )
              
              
              -
              
              
              
              (8,178,639
              )Other
      comprehensive loss net of tax:Unrealized
      holding gains (losses) on securities available for sale,net of
      reclassification adjustment
              
              
              (63,930
              )
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (63,930
              )
              
              
              (63,930
              )Total
      comprehensive loss
              
              $
              (8,242,569
              )BALANCE,
      December 31, 2009
              
              
              
              
              
              $
              6,500,396
              
              
              $
              21,162,686
              
              
              $
              424,854
              
              
              $
              (250,457
              )
              
              $
              27,837,479


The Notes
to Consolidated Financial Statements are an integral part of these
statements.
  49


CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 CONSOLIDATED  STATEMENTS  OF  CASH  FLOWS Years
Ended December 31, 2009, 2008 and 2007


2009
              
              
              2008
              
              
              2007CASH
      FLOWS FROM OPERATING ACTIVITIESNet
      (loss) income
              
              $
              (8,178,639
              )
              
              $
              2,511,824
              
              
              $
              871,152Adjustments
      to reconcile net (loss) income to net cashprovided
      by operating activities:Depreciation
      and amortization
              
              
              958,438
              
              
              
              694,499
              
              
              
              605,062Provision
      for loan losses
              
              
              14,898,898
              
              
              
              3,498,000
              
              
              
              10,409,365Stock
      compensation expense
              
              
              216,600
              
              
              
              279,400
              
              
              
              220,016Loss
      (gain) on sales of loans and other assets
              
              
              1,227,414
              
              
              
              (57,828
              )
              
              
              (103,773
              )Deferred
      income taxes
              
              
              1,301,148
              
              
              
              3,302,186
              
              
              
              (3,478,707
              )Changes
      in other operating assets and liabilities:Net
      change in loans held for sale
              
              
              582,000
              
              
              
              (112,000
              )
              
              
              484,900Accrued
      interest receivable
              
              
              250,392
              
              
              
              636,886
              
              
              
              (287,199
              )Accrued
      interest payable
              
              
              (118,226
              )
              
              
              253,500
              
              
              
              (92,306
              )Other
      assets and liabilities
              
              
              (5,089,681
              )
              
              
              (7,509,166
              )
              
              
              3,154,062Net
      cash provided by operating activities
              
              
              6,048,344
              
              
              
              3,497,301
              
              
              
              11,782,572CASH
      FLOWS FROM INVESTING ACTIVITIESProceeds
      from security transactions:Securities
      available for sale
              
              
              36,851,917
              
              
              
              23,596,577
              
              
              
              13,008,453Securities
      held to maturity
              
              
              33,532
              
              
              
              30,594
              
              
              
              36,467Purchase
      of securities available for sale
              
              
              (117,340,105
              )
              
              
              (33,350,455
              )
              
              
              (15,037,296
              )Purchase
      of Federal Home Loan Bank stock
              
              
              (41,700
              )
              
              
              (275,900
              )
              
              
              (559,400
              )Loan
      originations and principal collections, net
              
              
              18,247,178
              
              
              
              (14,691,368
              )
              
              
              (76,239,255
              )Purchase
      of bank premises and equipment
              
              
              (310,113
              )
              
              
              (2,589,553
              )
              
              
              (840,644
              )Proceeds
      from sale of other real estate and other assets
              
              
              4,119,884
              
              
              
              1,357,027
              
              
              
              784,592Net
      cash used in investing activities
              
              
              (58,439,407
              )
              
              
              (25,923,078
              )
              
              
              (78,847,083
              )CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      increase in deposits
              
              
              78,158,890
              
              
              
              13,333,498
              
              
              
              37,433,192(Decrease)
      increase in federal funds purchased andsecurities
      sold under agreements to repurchase
              
              
              (9,468,361
              )
              
              
              (5,770,109
              )
              
              
              22,310,654Proceeds
      from Federal Home Loan Bank advances
              
              
              -
              
              
              
              20,000,000
              
              
              
              35,000,000Repayment
      of Federal Home Loan Bank advances
              
              
              -
              
              
              
              -
              
              
              
              (27,000,000
              )Net
      borrowings (repayments) under line of credit
              
              
              1,100,000
              
              
              
              4,150,000
              
              
              
              (400,000
              )Purchase
      of common stock
              
              
              -
              
              
              
              (633,049
              )
              
              
              (1,751,291
              )Payment
      of dividends
              
              
              (1,094,651
              )
              
              
              (1,773,022
              )
              
              
              (1,303,577
              )Issuance
      of common stock
              
              
              -
              
              
              
              82,500
              
              
              
              72,926Net
      cash provided by financing activities
              
              
              68,695,878
              
              
              
              29,389,818
              
              
              
              64,361,904NET
      INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
              
              
              16,304,815
              
              
              
              6,964,041
              
              
              
              (2,702,607
              )CASH
      AND CASH EQUIVALENTS, beginning of year
              
              
              21,897,390
              
              
              
              14,933,349
              
              
              
              17,635,956CASH
      AND CASH EQUIVALENTS, end of year
              
              $
              38,202,205
              
              
              $
              21,897,390
              
              
              $
              14,933,349SUPPLEMENTAL
      DISCLOSURES OF CASH FLOW INFORMATIONCash
      paid during the period for interest
              
              $
              11,307,609
              
              
              $
              12,444,574
              
              
              $
              14,505,911Cash
      paid during the period for taxes
              
              
              180,350
              
              
              
              738,886
              
              
              
              4,092,910NONCASH
      INVESTING AND FINANCING ACTIVITIESAcquisition
      of real estate through foreclosure
              
              $
              14,156,244
              
              
              $
              2,915,414
              
              
              $
              1,518,329


The Notes
to Consolidated Financial Statements are an integral part of these
statements.




50




CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY


NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS


December
31, 2009, 2008 and 2007
  
 Note
      1.
              Summary
      of Significant Accounting Policies
 
 The
accounting and reporting policies of Cornerstone Bancshares, Inc. and subsidiary
(Cornerstone) conform with United States generally accepted accounting
principles (GAAP) and practices within the banking industry.  The
policies that materially affect financial position and results of operations are
summarized as follows:
 
 Nature of
operations:
 
 Cornerstone
is a bank-holding company which owns all of the outstanding common stock of
Cornerstone Community Bank (the Bank). The Bank provides a variety of financial
services through five full service branch locations in Chattanooga, Tennessee
and a loan production office in Dalton, Georgia.  The Bank’s primary
deposit products are demand deposits, savings accounts, and certificates of
deposit.  Its primary lending products are commercial loans, real
estate loans, and installment loans.  In addition, the Bank owns Eagle
Financial, Inc. (Eagle) which is a finance and factoring company located in
Chattanooga, Tennessee.
 
 Principles
of consolidation:
 
 The
consolidated financial statements include the accounts of Cornerstone, the Bank
and Eagle.  All material intercompany accounts and transactions have
been eliminated in consolidation.
 
 Goodwill:
 
 Goodwill
represents the excess of the cost of Cornerstone’s 1997 purchase of the net
assets of the Bank of East Ridge over the underlying fair value of such net
assets at the date of acquisition.  Cornerstone applies the provisions
of Accounting Standard Codification (ASC) Topic 350 “Intangibles-Goodwill and
Other” which requires that goodwill and other intangible assets deemed to have
an indefinite life not be amortized.  Goodwill is tested annually for
impairment.  If the carrying value of goodwill exceeds the fair value,
a write-down is recorded.  There was no impairment in any of the years
ending December 31, 2009, 2008 or 2007.
 
 Use of
estimates:
 
 In
preparing financial statements in conformity with accounting principles
generally accepted in the United States of America, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the balance sheet and reported amounts of revenues
and expenses during the reporting period.  Actual results could differ
from those estimates.  Material estimates that are particularly
susceptible to significant change in the near term relate to the determination
of the allowance for loan losses, the valuation of deferred tax assets,
other-than-temporary impairments of securities, and the fair value of financial
instruments.
 
 Significant
group concentrations of credit risk:
 
 Most of
Cornerstone’s activities are with customers located in middle and eastern
Tennessee.  The types of securities that Cornerstone invests in are
included in Note 4.  The types of lending Cornerstone engages in are
included in Note 5.  Cornerstone does not have any significant
concentrations to any one industry or customer.
 
 Commercial
real estate, including commercial construction loans, represented
57 percent of the loan portfolio at December 31, 2009, and
54 percent of the loan portfolio at December 31, 2008.
 
 Securities:
 
 Debt
securities are classified as held to maturity when the Bank has the intent and
ability to hold the securities to maturity.  Securities held to
maturity are carried at amortized cost.  The amortization of premiums
and accretion of discounts are recognized in interest income using methods
approximating the interest method over the period to maturity.
 
 Debt
securities not classified as held to maturity are classified as available for
sale. Securities available for sale are carried at fair value with unrealized
gains and losses reported in other comprehensive income.  Realized
gains and losses on securities available for sale are included in other income
and, when applicable, are reported as a reclassification adjustment, net of tax,
in other comprehensive income.
 
 51
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      1.
              Summary
      of Significant Accounting Policies
(continued)
 
 Securities:
(continued)
 
 Gains and
losses on sales of securities are determined on the specific-identification
method.  Purchase premiums and discounts are recognized in interest
income using the interest method over the terms of the securities.
 
 Prior to
a change in accounting guidance on April 1, 2009, in determining whether
other-than-temporary impairment existed, management considered (1) the length of
time and the extent to which the fair value has been less than cost, (2) the
financial condition and near-term prospects of the issuer, and (3) the intent
and ability of Cornerstone to retain its investment in the issuer for a period
of time sufficient to allow for any anticipated recovery in fair
value.  Declines in the fair value of individual securities below
their cost that are deemed to be other-than-temporary are reflected in earnings
as realized losses.
 
 Effective
April 1, 2009, Cornerstone adopted new accounting guidance related to
other-than-temporary impairment of securities.  The new guidance
amended the criteria for recognizing other-than-temporary impairments of debt
securities and expanded the disclosure requirements for impairment losses on
debt and equity securities.  The new guidance specifies that (1) if a
company does not have the intent to sell a debt security prior to recovery and
(2) it is more likely than not that it will not have to sell the debt security
prior to recovery, the security would not be considered other-than-temporarily
impaired unless there is a credit loss.  The credit loss component is
the amount of principal cash flows not expected to be received over the
remaining term of the security based on cash flow projections.  For
debt securities that management has no intent to sell and believes that it
more-likely-than-not will not be required to sell prior to recovery, only the
credit loss component of the impairment is recognized in earnings, while the
non-credit loss is included in accumulated other comprehensive
income.
 
 Federal
Home Loan Bank stock:
 
 Cornerstone,
as a member of the Federal Home Loan Bank (FHLB) system, is required to maintain
an investment in capital stock of the FHLB.  Based on redemption
provisions of the FHLB, the stock has no quoted market value and is carried at
cost.  At its discretion, the FHLB may declare dividends on the
stock.  Management reviews for impairment based on the ultimate
recoverability of the cost basis in the FHLB stock.
 
 Loans:
 
 Cornerstone
grants mortgage, commercial and consumer loans to customers.  A
substantial portion of the loan portfolio is represented by real estate loans
secured by properties located in Chattanooga, Tennessee and surrounding
areas.  The ability of Cornerstone’s debtors to honor their contracts
is somewhat dependent on the real estate and economic conditions in these
areas.
 
 Loans
that management has the intent and ability to hold for the foreseeable future or
until maturity are stated at unpaid principal balances, less the allowance for
loan losses and net deferred loan fees and costs.  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 based on the unpaid principal balance.  Loan
origination and commitment fees, as well as certain direct origination costs,
are deferred and amortized as a yield adjustment over the lives of the related
loans using the interest method.  Amortization of deferred loan fees
is discontinued when a loan is placed on nonaccrual status.
 
 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 consumer 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
nonaccrual 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 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.
 
 52
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      1.
              Summary
      of Significant Accounting Policies
(continued)
 
 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 allocated and general components.  The allocated
component relates to loans that are classified as impaired. For those loans that
are 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 charge-off experience and
expected loss given default derived from the Bank’s internal risk rating
process. Other adjustments may be made to the allowance for pools of loans after
an assessment of internal or external influences on credit quality that are not
fully reflected on the historical loss or risk rating data.
 
 A loan is
considered impaired when, based on current information and events, it is
probable that Cornerstone will be unable to collect the scheduled payments of
principal or interest when due according to the contractual terms of the loan
agreement.  Factors considered by management in determining impairment
include payment status, collateral value, and the probability of collecting
scheduled principal and interest payments when due.  Loans that
experience insignificant payment delays and payment shortfalls generally are not
classified as impaired.  Management determines the significance of
payment delays and payment shortfalls on a case-by-case basis, taking into
consideration all of the circumstances surrounding the loan and the borrower,
including the length of the delay, the reasons for the delay, the borrower’s
prior payment record, and the amount of the shortfall in relation to the
principal and interest owed.  Impairment is measured on a loan by loan
basis for commercial and construction loans by either the present value of
expected future cash flows discounted at the loan’s effective interest rate, the
loan’s obtainable market price, or the fair value of the collateral if the loan
is collateral dependent.
 
 Large
groups of smaller balance homogeneous loans are collectively evaluated for
impairment.  Accordingly, Cornerstone does not separately identify
individual consumer and residential loans for impairment disclosures, unless
such loans are the subject of a restructuring agreement due to financial
difficulties of the borrower.
 
 Derivative
loan commitments:
 
 Mortgage
loan commitments are referred to as derivative loan commitments if the loan that
will result from exercise of the commitment will be held for sale upon
funding.  Loan commitments that are derivatives are recognized at fair
value on the consolidated balance sheet in derivative assets or derivative
liabilities with changes in their fair values recorded in net gains on sales of
loans.
 
 Cornerstone
records a zero value for the loan commitment at inception, when the commitment
is issued to a borrower.  Subsequent to inception, changes in the fair
value of the loan commitment are recognized based on changes in the fair value
of the underlying mortgage loan due to interest rate changes, changes in the
probability the derivative loan commitment will be exercised, and the passage of
time.  In estimating fair value, Cornerstone assigns a probability to
a loan commitment based on an expectation that it will be exercised and the loan
will be funded.
 
 53
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      1.
              Summary
      of Significant Accounting Policies
(continued)
 
 Premises
and equipment:
 
 Land is
carried at cost.  Buildings and equipment are carried at cost, less
accumulated depreciation and amortization computed on the straight-line and
declining balance methods over 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.
 
 Investment
in partnership:
 
 Cornerstone’s
investment in a partnership consists of an equity interest in a lending
partnership for the purposes of investing in the New Market Tax Credit
Program.  This program permits taxpayers to claim a credit against
federal income taxes for Qualified Equity Investments made to acquire stock or a
capital interest in designated Community Development Entities (CDEs). 
These designated CDEs must use substantially all (defined as 85 percent) of
these proceeds to make qualified low-income community investments.
 
 Cornerstone
uses the equity method when it owns an interest in a partnership and can exert
significant influence over the partnership’s operations but cannot control the
partnership’s operations.  Under the equity method, Cornerstone’s
ownership interest in the partnership’s capital is reported as an investment on
its consolidated balance sheets and Cornerstone’s allocable share of the income
or loss from the partnership is reported in noninterest income or expense in the
consolidated statements of income.  Cornerstone ceases recording
losses on an investment in partnership when the cumulative losses and
distributions from the partnership exceed the carrying amount of the investment
and any advances made by Cornerstone.  After Cornerstone’s investment
in such partnership reaches zero, cash distributions received from these
investments are recorded as income.
 
 Foreclosed
assets:
 
 Assets
acquired through, or in lieu of, loan foreclosure are held for sale and are
initially recorded at fair value less cost to sell at the date of foreclosure,
establishing a new cost basis.  Subsequent to foreclosure, valuations
are periodically performed by management and the assets are carried at the lower
of carrying amount or fair value less cost to sell.  Revenues and
expenses from operations and changes in the valuation allowance are included in
net expenses from foreclosed assets.
 
 Securities
sold under agreements to repurchase:
 
 Cornerstone
enters into sales of securities under agreements to repurchase identical
securities the next day.  Securities sold under agreements to
repurchase amounted to $26,321,885 at December 31, 2009, mature on a daily
basis and are secured by securities available for sale with a fair value of
$47,002,088.
 
 Income
taxes:
 
 Cornerstone
accounts for income taxes in accordance with income tax accounting guidance in
ASC Topic 740.  The income tax accounting guidance results in two
components of income tax expense – current and deferred.  Current
income tax expense reflects taxes to be paid or refunded for the current period
by applying the provisions of the enacted tax law to taxable income or
loss.  Cornerstone determines deferred income taxes using the
liability method.  Under this method, the net deferred tax asset or
liability is based on the tax effects of the differences between the book and
tax bases of assets and liabilities.  Cornerstone’s deferred taxes
relate primarily to differences between the basis of the allowance for loan
losses and accumulated depreciation.  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.  Cornerstone files consolidated income tax returns with its
subsidiary.
 
 54
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      1.
              Summary
      of Significant Accounting Policies
(continued)
 
 Income
taxes: (continued)
 
 Cornerstone
recognizes deferred tax assets if it is more likely than not, based on the
technical merits, that the tax position will be realized or sustained upon
examination.  Cornerstone follows the statutory requirements for its
income tax accounting and generally avoids risks associated with potentially
problematic tax positions that may be challenged upon examination.
 
 Transfers
of financial assets:
 
 Transfers
of financial assets are accounted for as sales, when control over the assets has
been surrendered.  Control over assets is deemed to be surrendered
when (1) the assets have been isolated from Cornerstone, (2) the transferee
obtains the right (free of conditions that constrain it from taking advantage of
that right) to pledge or exchange the transferred assets, and (3) Cornerstone
does not maintain effective control over the transferred assets through an
agreement to repurchase them before their maturity, or the ability to
unilaterally cause the holder to return specific assets.
 
 Advertising
costs:
 
 Cornerstone
expenses all advertising costs as incurred.  Advertising expense was
$97,734, $92,252, and $83,632, for the years ended December 31, 2009, 2008 and
2007, respectively.
 
 Statements
of cash flows:
 
 Cornerstone
considers all cash and amounts due from depository institutions,
interest-bearing deposits in other banks, and federal funds sold to be cash
equivalents for purposes of the statements of cash flows.
 
 Stock
option plan:
 
 Cornerstone
recognizes compensation cost relating to share-based payment transactions in
accordance with ASC Topic 718.  Compensation cost has been measured
based on the grant date fair value of the equity or liability instruments
issued.  Compensation cost is calculated and recognized over the
employee service period, generally defined as the vesting
period.  Cornerstone uses a stock option pricing model to determine
the fair value of the award on the grant date.
 
 Segment
reporting:
 
 Accounting
Standards Codification Topic 280, “Segment Reporting,” provides for the
identification of reportable segments on the basis of distinct business units
and their financial information to the extent such units are reviewed by an
entity’s chief decision maker (which can be an individual or group of management
persons).  ASC Topic 280 permits aggregation or combination of
segments that have similar characteristics.  In Cornerstone’s
operations, each bank branch is viewed by management as being a separately
identifiable business or segment from the perspective of monitoring performance
and allocation of financial resources.  Although the branches operate
independently and are managed and monitored separately, each is substantially
similar in terms of business focus, type of customers, products and
services.  Further, the results of Eagle for 2009, 2008 and 2007 were
not significant for separate disclosure.  Accordingly, Cornerstone’s
consolidated financial statements reflect the presentation of segment
information on an aggregated basis in one reportable segment.
 
 55
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      1.
              Summary
      of Significant Accounting Policies
(continued)
 
 Earnings
per share:
 
 Basic
earnings per share represents income available to common stockholders divided by
the weighted-average number of common shares outstanding during the
period.  Diluted earnings per share reflects additional common shares
that would have been outstanding if dilutive potential common shares had been
issued, as well as any adjustment to income that would result from the assumed
issuance.  Potential common shares that may be issued by Cornerstone
relate solely to outstanding stock options, and are determined using the
treasury stock method.
 
 Variable
interest entities:
 
 An entity
is referred to as a variable interest entity (VIE) if it meets the criteria
outlined in ASC Topic 810, which are: (1) the entity has equity that is
insufficient to permit the entity to finance its activities without additional
subordinated financial support from other parties, or (2) the entity has equity
investors that cannot make significant decisions about the entity’s operations
or that do not absorb the expected losses or receive the expected returns of the
entity.  A VIE must be consolidated by Cornerstone if it is deemed to
be the primary beneficiary of the VIE, which is the party involved with the VIE
that has a majority of the expected losses, expected residual returns, or
both.  At December 31, 2009, Cornerstone has an investment in
Appalachian Fund for Growth II Partnership that qualifies as an unconsolidated
VIE.
 
 Comprehensive
income:
 
 Comprehensive
income consists of net income and other comprehensive income.  Other
comprehensive income includes unrealized gains on securities available for sale,
and unrealized losses related to factors other than credit losses on debt
securities.
 
 Reclassification:
 
 Certain
amounts in the prior consolidated financial statements have been reclassified to
conform to the current year presentation.  The reclassifications had
no effect on net income or stockholders’ equity as previously
reported.
 
 Off-balance
sheet credit related financial instruments:
 
 In the
ordinary course of business, Cornerstone has entered into commitments to extend
credit, including commitments under credit card arrangements, commercial letters
of credit, and standby letters of credit.  Such financial instruments
are recorded when they are funded.
 
 Subsequent
events:
 
 Cornerstone
has evaluated subsequent events for potential recognition and/or disclosures in
the consolidated financial statements and accompanying notes included in this
Annual Report on Form 10-K.
 
 Note
      2.
              Going
      Concern Considerations
 
 The going
concern assumption is a fundamental principle in the preparation of financial
statements.  It is the responsibility of management to assess our
ability to continue as a going concern.  In assessing this assumption,
we have taken into account all available information we have deemed relevant
about our foreseeable future, which is at least, but is not limited to, twelve
months from the balance sheet date of December 31,
2009.
 
 56
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      2.
              Going
      Concern Considerations (continued)
 
 Prior to
2009, the Bank had a history of profitable operations and sufficient sources of
liquidity to meet its funding needs.  However, the Bank’s parent
holding company, Cornerstone Bancshares, Inc., primarily relies on dividends
from the Bank to meet its funding needs.  The holding company’s
funding needs as of December 31, 2009, primarily consisted of principal and
interest payments on two holding company loans totaling $5,350,000 secured by
100% of the subsidiary Bank’s common stock.  The loans were renewed in
January 2010, with Cornerstone subsequently receiving a waiver regarding
previous covenant violations through December 31, 2009.  As of
December 31, 2009, the Bank was restricted from paying dividends to the
holding company due to recent operating losses and the Bank’s capital position
of less than well capitalized under the regulatory framework for prompt
corrective action, as further described in Note 16.  This restriction,
coupled with the holding company’s failure to meet certain loan covenants as of
December 31, 2009, as further described in Note 9, has prompted management to
perform an assessment of the Cornerstone’s ability to continue as a going
concern.
 
 Management’s
business plan for 2010 projects a return to profitability and a well capitalized
position; however, covenant compliance is determined on a quarterly basis with
certain of the covenants being based on rolling quarterly averages; thus,
management’s projections are not anticipating full compliance with the covenants
during 2010. The uncertainty surrounding the lender’s intention to continue
granting quarterly waivers of the covenant defaults on the loans through
December 31, 2010, combined with the lender’s unwillingness to amend the loan
covenants, raises substantial doubt about the ability of Cornerstone to continue
as a going concern.  Should the lender not grant a waiver of the
covenant defaults for a future quarter, the lender would have the ability to
call the loans and require the holding company to secure an alternate source of
financing to repay the outstanding balance on the loans within a short period of
time.  Management has assessed the potential consequences of this
action and believes that its current strategy to raise additional capital to
allow repayment of this debt and further enhance the capital position of the
Bank will enable the holding company to deal with this event.  As an
alternative, management will continue looking for suitable alternative sources
of financing to cure this situation. If management is unable to raise sufficient
capital or find an alternative source of financing, the lender could take steps
to foreclose on the Bank stock serving as collateral for the
loans.   The impact of this condition would negatively impact the
shareholders of Cornerstone since the condition would result in a material
decrease in the holding company’s assets and therefore the going concern ability
of Cornerstone.
 
 As a
result of management’s assessment of Cornerstone’s ability to continue as a
going concern, the accompanying consolidated financial statements for
Cornerstone have been prepared on a going concern basis, which contemplates the
realization of assets and the discharge of liabilities in the normal course of
business for the foreseeable future, and does not include any adjustments to
reflect the possible future effects on the recoverability or classification of
assets, and the amounts or classification of liabilities that may result from
the outcome of a potential future default due to noncompliance with covenants on
the debt, which could affect Cornerstone’s ability to continue as a going
concern.
  Note
      3.
              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, 2009 and 2008,
these reserve balances were approximately $1,011,000 and $2,321,000,
respectively.
  57
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      4.
              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 fair value of securities at
December 31, 2009 and 2008, are as follows:
 
 December
      31, 2009Gross
              
              
              GrossAmortized
              
              
              Unrealized
              
              
              Unrealized
              
              
              FairCost
              
              
              Gains
              
              
              Loss
              
              
              ValueDebt
      securities available for sale:U.S.
      Government agencies
              
              $
              4,772,461
              
              
              $
              4,703
              
              
              $
              (3,144
              )
              
              $
              4,774,020State
      and municipal securities
              
              
              16,660,518
              
              
              
              268,343
              
              
              
              (173,221
              )
              
              
              16,755,640Mortgage-backed
      securities:Residential
      mortgageguaranteed
      by GNMA
              
              
              53,207,225
              
              
              
              217,897
              
              
              
              (698,355
              )
              
              
              52,726,767Collateralized
      mortgageobligations
      issued orguaranteed
      by U.S.Government
      agencies orsponsored
      agencies
              
              
              49,956,882
              
              
              
              77,852
              
              
              
              (74,286
              )
              
              
              49,960,448Other
              
              
              203,961
              
              
              
              -
              
              
              
              (5,518
              )
              
              
              198,443$
              124,801,047
              
              
              $
              568,795
              
              
              $
              (954,524
              )
              
              $
              124,415,318Debt
      securities held to maturity:Mortgage-backed
      securities:Residential
      mortgageguaranteed
      by GNMA
              
              $
              135,246
              
              
              $
              1,193
              
              
              $
              (377
              )
              
              $
              136,062
 
 U.S.
Government sponsored agencies include entities such as Federal National Mortgage
Association, Federal Home Loan Mortgage Corporation, and Federal Home Loan
Banks.
 
 December
      31, 2008Gross
              
              
              GrossAmortized
              
              
              Unrealized
              
              
              Unrealized
              
              
              FairCost
              
              
              Gains
              
              
              Loss
              
              
              ValueDebt
      securities available for sale:U.S.
      Government securities
              
              $
              7,976,040
              
              
              $
              275,731
              
              
              $
              -
              
              
              $
              8,251,771State
      and municipal securities
              
              
              4,609,632
              
              
              
              82,013
              
              
              
              (68,830
              )
              
              
              4,622,815Mortgage-backed
      securities
              
              
              31,753,504
              
              
              
              160,387
              
              
              
              (731,918
              )
              
              
              31,181,973$
              44,339,176
              
              
              $
              518,131
              
              
              $
              (800,748
              )
              
              $
              44,056,559Debt
      securities held to maturity:Mortgage-backed
      securities
              
              $
              169,284
              
              
              $
              1,158
              
              
              $
              (683
              )
              
              $
              169,759
 
 
 58
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      4.
              Securities
      (continued)
 
 At
December 31, 2009 and 2008, securities with a carrying value of
approximately $22,835,000 and $11,262,000, respectively, were pledged to secure
public deposits and for other purposes required or permitted by
law.
 
 At
December 31, 2009 and 2008, the carrying amount of securities pledged to secure
repurchase agreements was approximately $47,002,000 and $32,516,000,
respectively.
 
 At
December 31, 2009, the Bank had pledged securities with a carrying amount of
approximately $54,380,000 to the Federal Home Loan Bank as collateral for the
Bank’s borrowings.  At December 31, 2008, the Bank had no securities
pledged to the Federal Home Loan Bank as collateral for the Bank’s
borrowings.
 
 The
amortized cost and fair value of securities at December 31, 2009, 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
                  
                  
                  Fair
                  
                  
                  Amortized
                  
                  
                  FairCost
                  
                  
                  Value
                  
                  
                  Cost
                  
                  
                  ValueDue
      in one year or less
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  -Due
      from one year to five years
                  
                  
                  599,132
                  
                  
                  
                  626,059
                  
                  
                  
                  -
                  
                  
                  
                  -Due
      from five years to ten years
                  
                  
                  2,468,408
                  
                  
                  
                  2,553,683
                  
                  
                  
                  -
                  
                  
                  
                  -Due
      after ten years
                  
                  
                  18,365,439
                  
                  
                  
                  18,349,918
                  
                  
                  
                  -
                  
                  
                  
                  -21,432,979
                  
                  
                  
                  21,529,660
                  
                  
                  
                  -
                  
                  
                  
                  -Mortgage-backed
      securities
                  
                  
                  103,368,068
                  
                  
                  
                  102,885,658
                  
                  
                  
                  135,246
                  
                  
                  
                  136,062$
                  124,801,047
                  
                  
                  $
                  124,415,318
                  
                  
                  $
                  135,246
                  
                  
                  $
                  136,062
 For the
year ended December 31, 2009, there were available for sale securities sold with
proceeds totaling $18,951,608 which resulted in gross gains and losses realized
of $414,193 and $14,439, respectively.  There were no sales of
securities available for sale for the years ended December 31, 2008 and
2007.
  59
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      4.
              Securities
      (continued)
 
 The
following tables present gross unrealized losses and fair value, aggregated by
investment category and length of time that individual securities available for
sale have been in a continuous unrealized loss position, at December 31,
2009 and 2008:
  As
      of December 31, 2009Less
      than 12 Months
                        
                        
                        12
      Months or Greater
                        
                        
                        TotalFair
                          Value
                        
                        
                        Gross
      Unrealized Losses
                        
                        
                        Fair
                          Value
                        
                        
                        Gross
                          Unrealized
                          Losses
                        
                        
                        Fair
                          Value
                        
                        
                        Gross
                          Unrealized
                          LossesDebt
      securities available for sale:U.S.
      Governmental agencies
                        
                        $
                        971,400
                        
                        
                        $
                        (3,144
                        )
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        971,400
                        
                        
                        $
                        (3,144
                        )State
      and municipal securities
                        
                        
                        8,222,297
                        
                        
                        
                        (159,907
                        )
                        
                        
                        734,848
                        
                        
                        
                        (13,314
                        )
                        
                        
                        8,957,145
                        
                        
                        
                        (173,221
                        )Mortgage-backed
      securities:Residential
      mortgage guaranteed by GNMA
                        
                        
                        40,492,722
                        
                        
                        
                        (698,343
                        )
                        
                        
                        5,516
                        
                        
                        
                        (12
                        )
                        
                        
                        40,498,238
                        
                        
                        
                        (698,355
                        )Collateralized
      mortgage obligations issued or guaranteed by U.S. Government agencies or
      sponsored agencies
                        
                        
                        22,538,122
                        
                        
                        
                        (74,286
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        22,538,122
                        
                        
                        
                        (74,286
                        )Other
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        198,443
                        
                        
                        
                        (5,518
                        )
                        
                        
                        198,443
                        
                        
                        
                        (5,518
                        )$
                        72,224,541
                        
                        
                        $
                        (935,680
                        )
                        
                        $
                        938,807
                        
                        
                        $
                        (18,844
                        )
                        
                        $
                        73,163,348
                        
                        
                        $
                        (954,524
                        )Debt
      securities held to maturity:Mortgage-backed
      securities:Residential
      mortgage guaranteed by GNMA
                        
                        $
                        48,767
                        
                        
                        $
                        (70
                        )
                        
                        $
                        25,594
                        
                        
                        $
                        (307
                        )
                        
                        $
                        74,361
                        
                        
                        $
                        (377
                        )
  As
      of December 31, 2008Less
      than 12 Months
                        
                        
                        12
      Months or Greater
                        
                        
                        TotalFair
      Value
                        
                        
                        Gross
      Unrealized Losses
                        
                        
                        Fair
      Value
                        
                        
                        Gross
      Unrealized Losses
                        
                        
                        Fair
      Value
                        
                        
                        Gross
      Unrealized LossesDebt
      securities available for sale:State
      and municipal securities
                        
                        $
                        1,125,144
                        
                        
                        $
                        (48,772
                        )
                        
                        $
                        206,650
                        
                        
                        $
                        (20,058
                        )
                        
                        $
                        1,331,794
                        
                        
                        $
                        (68,830
                        )Mortgage-backed
      securities
                        
                        
                        19,234,621
                        
                        
                        
                        (719,051
                        )
                        
                        
                        642,457
                        
                        
                        
                        (12,867
                        )
                        
                        
                        19,877,078
                        
                        
                        
                        (731,918
                        )$
                        20,359,765
                        
                        
                        $
                        (767,823
                        )
                        
                        $
                        849,107
                        
                        
                        $
                        (32,925
                        )
                        
                        $
                        21,208,872
                        
                        
                        $
                        (800,748
                        )Debt
      securities held to maturity:Mortgage-backed
      securities
                        
                        $
                        26,405
                        
                        
                        $
                        (289
                        )
                        
                        $
                        30,897
                        
                        
                        $
                        (394
                        )
                        
                        $
                        57,302
                        
                        
                        $
                        (683
                        )
 60
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      4.
              Securities
      (continued)
  Upon
acquisition of a security, Cornerstone determines the appropriate impairment
model that is applicable.  If the security is a beneficial interest in
securitized financial assets, Cornerstone uses the beneficial interests in
securitized financial assets impairment model.  If the security is not
a beneficial interest in securitized financial assets, Cornerstone uses the debt
and equity securities impairment model.  Cornerstone conducts periodic
reviews to evaluate each security to determine whether an other-than-temporary
impairment has occurred.  Cornerstone does not have any securities
that have been classified as other-than-temporarily-impaired at December 31,
2009.
 
 At
December 31, 2009, the significant categories of temporarily impaired
securities, and management’s evaluation of those securities are as
follows:
 
 State and municipal
securities:At December 31, 2009, 20 investments in
obligations of state and municipal securities had unrealized
losses.  Cornerstone believes the unrealized losses on those
investments were caused by the interest rate environment and does not relate to
the underlying credit quality of the issuers.  Because the Company has
the intent and ability to hold those investments for a time necessary to recover
their amortized cost bases, which may be maturity, the Company does not consider
those investments to be other-than-temporarily impaired at December 31,
2009.
 
 Mortgage-backed securities issued or
guaranteed by FNMA, FHLMC, or GNMA:At December 31, 2009,
17 investments in residential mortgage-backed securities issued or
guaranteed by FNMA, FHLMC, or GNMA had unrealized losses.  This
impairment is believed to be caused by the current interest rate
environment.  The contractual cash flows of those investments are
guaranteed or issued by an agency of the U.S. Government.  Because the
decline in market value is attributable to the current interest rate environment
and not credit quality, and because Cornerstone does not intend to sell the
investments and it is not more likely than not that Cornerstone will be required
to sell the investments before recovery of their amortized cost bases, which may
be maturity, Cornerstone does not deem those investments to be
other-than-temporarily impaired at December 31, 2009.
 
 61
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      5.
              Loans
      and Allowance for Loan Losses
 
 At
December 31, 2009 and 2008, the Bank’s loans consist of the following (in
thousands):
  2009
                  
                  
                  2008Mortgage
      loans on real estate:Residential
      1-4 family
                  
                  $
                  43,249
                  
                  
                  $
                  42,136Residential
      multifamily (5 or more)
                  
                  
                  12,770
                  
                  
                  
                  14,747Held
      for sale
                  
                  
                  686
                  
                  
                  
                  104Commercial
                  
                  
                  153,310
                  
                  
                  
                  155,728Construction
                  
                  
                  47,651
                  
                  
                  
                  70,456Second
      mortgages
                  
                  
                  3,798
                  
                  
                  
                  3,030Equity
      lines of credit
                  
                  
                  10,473
                  
                  
                  
                  12,720271,937
                  
                  
                  
                  298,921Commercial
      loans
                  
                  
                  60,560
                  
                  
                  
                  83,140Consumer
      installment loans:Personal
                  
                  
                  3,630
                  
                  
                  
                  5,486Credit
      cards
                  
                  
                  565
                  
                  
                  
                  5434,195
                  
                  
                  
                  6,029Total
      loans
                  
                  
                  336,692
                  
                  
                  
                  388,090Less:
      Allowance for loan losses
                  
                  
                  (5,905
                  )
                  
                  
                  (9,618
                  )Loans,
      net
                  
                  $
                  330,787
                  
                  
                  $
                  378,472
  2009
                  
                  
                  2008
                  
                  
                  2007An
      analysis of the allowance for loan losses follows:Balance,
      beginning of year
                  
                  $
                  9,618,265
                  
                  
                  $
                  13,710,109
                  
                  
                  $
                  4,258,352Provision
      charged to operations
                  
                  
                  14,898,898
                  
                  
                  
                  3,498,000
                  
                  
                  
                  10,409,365Charge-offs
                  
                  
                  (19,095,793
                  )
                  
                  
                  (7,978,767
                  )
                  
                  
                  (1,075,670
                  )Recoveries
                  
                  
                  483,684
                  
                  
                  
                  388,923
                  
                  
                  
                  118,062Balance,
      end of year
                  
                  $
                  5,905,054
                  
                  
                  $
                  9,618,265
                  
                  
                  $
                  13,710,109
 
 Cornerstone
follows the loan impairment accounting guidance in ASC Topic 310.  A
loan is considered impaired when, based on current information and events, it is
probable that Cornerstone will be unable to collect all amounts due from the
borrower in accordance with the contractual terms of the
loan.  Impaired loans include nonperforming commercial loans and loans
modified in troubled debt restructurings where concessions have been granted to
borrowers experiencing financial difficulties.  These concessions
could include a reduction in interest rates, payment extensions, forgiveness of
principal, forbearance or other actions intended to maximize
collections.
 
 Included
in impaired loans are troubled debt restructurings that are classified as
impaired.  At December 31, 2009, the Bank has loans of
approximately $2,312,000 that were modified in troubled debt restructurings and
impaired.
 
 62
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      5.
              Loans
      and Allowance for Loan Losses
(continued)
 
 At
December 31, 2009 and 2008, information pertaining to impaired loans is as
follows:
  December
      31,2009
                    
                    
                    2008Impaired
      loans without a valuation allowance
                    
                    $
                    7,138,077
                    
                    
                    $
                    2,543,320Impaired
      loans with a valuation allowance
                    
                    
                    23,956,594
                    
                    
                    
                    17,375,043Total
      impaired loans
                    
                    $
                    31,094,671
                    
                    
                    $
                    19,918,363Valuation
      allowance related to impaired loans
                    
                    $
                    2,145,383
                    
                    
                    $
                    5,872,373
  Years
      Ended December 31,2009
                
                
                2008
                
                
                2007Average
      investment in impaired loans
                
                $
                28,555,483
                
                
                $
                10,891,357
                
                
                $
                3,348,873Interest
      income recognized on impaired loans
                
                $
                2,900,652
                
                
                $
                966,011
                
                
                $
                1,182,407Interest
      income recognized on a cash basis onimpaired
      loans
                
                $
                -
                
                
                $
                -
                
                
                $
                28,900
  At December 31, 2009 and 2008,
information pertaining to nonperforming loans is as follows:
  December
      31,2009
                
                
                2008Loans
      past due over 90 days still on accrual
                
                $
                -
                
                
                $
                -Loans
      on nonaccrual
                
                
                7,359,542
                
                
                
                4,252,791Total
      nonperforming loans
                
                $
                7,359,542
                
                
                $
                4,252,791
 
 Nonperforming
loans include both smaller balance homogeneous loans that are collectively
evaluated for impairment and individually classified
impaired loans.
 
 In the
ordinary course of business, the Bank has granted loans to principal officers
and directors and their affiliates. Annual activity of these
related party loans were as follows:
  2009
                
                
                2008Beginning
      balance
                
                $
                189,673
                
                
                $
                772,942New
      loans
                
                
                65,196
                
                
                
                65,177Repayments
                
                
                (64,828
                )
                
                
                (648,446
                )Ending
      balance
                
                $
                190,041
                
                
                $
                189,673
 63
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      6.
              Bank
      Premises and Equipment
 
 A summary
of bank premises and equipment at December 31, 2009 and 2008, is as
follows:
  2009
                
                
                2008Land
                
                $
                3,315,050
                
                
                $
                3,338,413Buildings
      and improvements
                
                
                4,578,792
                
                
                
                4,537,349Furniture,
      fixtures and equipment
                
                
                4,414,075
                
                
                
                4,255,23712,307,917
                
                
                
                12,130,999Accumulated
      depreciation
                
                
                (4,209,858
                )
                
                
                (3,659,044
                )$
                8,098,059
                
                
                $
                8,471,955
 
 Depreciation
expense for the years ended December 31, 2009, 2008 and 2007, amounted to
$670,054, $588,490, and $500,573, respectively.
 
 Certain
bank facilities and equipment are leased under various operating
leases.  Total rent expense on these leases for the years ended
December 31, 2009, 2008 and 2007, was $426,861, $386,714, and $384,004,
respectively.
 
 Future
minimum rental commitments under non-cancelable leases are as
follows:
  2010
                
                $
                367,4272011
                
                
                350,9982012
                
                
                344,2372013
                
                
                341,0032014
                
                
                341,003Thereafter
                
                
                533,911Total
                
                $
                2,278,579
  Note
      7.
              Time
      and Related-Party Deposits
 
 At
December 31, 2009, the scheduled maturities of time deposits are as
follows:
  2010
                
                $
                242,9822011
                
                
                43,6552012
                
                
                14,4932013
                
                
                2,2862014
                
                
                1,687Thereafter
                
                
                104Total
                
                $
                305,207
 Deposits
from related parties held by the Bank at December 31, 2009 and 2008, amounted to
approximately $564,000, and $1,007,000, respectively.
   64
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      8.
              Income
      Taxes
 
 Cornerstone
files consolidated income tax returns with its subsidiary.  Under the
terms of a tax-sharing agreement, the subsidiary’s 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 consolidated statements of income for the years ended
December 31, 2009, 2008 and 2007, consists of the following:
  2009
                
                
                2008
                
                
                2007Current
      tax expense (benefit)
                
                $
                (6,637,188
                )
                
                $
                (2,005,644
                )
                
                $
                3,337,592Deferred
      tax expense (benefit) related to:Allowance
      for loan losses
                
                
                1,241,231
                
                
                
                3,158,858
                
                
                
                (3,623,934
                )Other
                
                
                59,917
                
                
                
                143,328
                
                
                
                145,227Income
      tax expense (benefit)
                
                $
                (5,336,040
                )
                
                $
                1,296,542
                
                
                $
                (141,115
                )
 
 The
income tax expense is different from the expected tax expense computed by
multiplying income before income
tax expense by the statutory federal income tax rates. These differences are
reconciled as follows:
 2009
                
                
                2008
                
                
                2007Expected
      tax at statutory rates
                
                $
                (4,594,991
                )
                
                $
                1,294,844
                
                
                $
                248,213(Decrease)
      increase resulting from tax effect of:State
      income taxes, net of federal tax benefit
                
                
                (579,780
                )
                
                
                163,379
                
                
                
                31,318New
      market tax credits
                
                
                (150,000
                )
                
                
                (150,000
                )
                
                
                (300,000
                )Other
                
                
                (11,269
                )
                
                
                (11,681
                )
                
                
                (120,646
                )Income
      tax expense (benefit)
                
                $
                (5,336,040
                )
                
                $
                1,296,542
                
                
                $
                (141,115
                )
 
 The
components of the net deferred tax asset, included in other assets, are as
follows:
 
 2009
                
                
                2008Deferred
      tax assets:Deferred
      compensation
                
                $
                118,724
                
                
                $
                124,583Deferred
      loan fees
                
                
                29,866
                
                
                
                52,150Allowance
      for loan losses
                
                
                694,702
                
                
                
                1,935,933Net
      unrealized loss on securities available for sale
                
                
                39,183
                
                
                
                151,194Other
                
                
                -
                
                
                
                28,334882,475
                
                
                
                2,292,194Deferred
      tax liabilities:Depreciation
                
                
                121,420
                
                
                
                126,979Life
      insurance
                
                
                199,077
                
                
                
                186,721Other
                
                
                10,808
                
                
                
                14,165331,305
                
                
                
                327,865Net
      deferred tax asset
                
                $
                551,170
                
                
                $
                1,964,329
 
 ASC Topic
740, “Income Taxes,” clarifies the accounting for uncertainty in tax positions.
ASC Topic 740 requires that Cornerstone recognize in its financial statements,
the impact of a tax position, if that position is more likely than not of being
sustained on audit, based on the technical merits of the
position.  Cornerstone recognized no interest and penalties assessed
by taxing authorities on any underpayment of income tax for 2009, 2008 or
2007.
  65
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      9.
              Federal
      Home Loan Bank Advances and Other
Borrowings
 
 The Bank
has agreements with the Federal Home Loan Bank of Cincinnati (FHLB) that can
provide advances to the Bank in an amount up to approximately
$71,000,000.  All of the Bank’s loans secured by first mortgages on
1-4 family residential, multi-family properties and commercial properties are
pledged as collateral for these advances.  Additionally, the Bank has
pledged securities with a carrying amount of approximately $54,380,000 as of
December 31, 2009.
 
 At
December 31, 2009 and 2008, FHLB advances consist of the following:
  2009
                  
                  
                  2008Long-term
      advance dated December 27, 2000, requiring monthly interest payments,
      fixed at 5.00% until conversion option is exercised, principal due in
      December 2010
                  
                  $
                  2,000,000
                  
                  
                  $
                  2,000,000Long-term
      advance dated February 9, 2005, requiring monthly interest payments, fixed
      at 3.86%, convertible on February 2010, principal due in February
      2015
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated May 14, 2007, requiring monthly interest payments, fixed at
      4.78%, with a put option exercisable in November 2007 and then quarterly
      thereafter, principal due in May 2010
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated December 6, 2007, requiring monthly interest payments, fixed
      at 3.87%, until maturity, principal due in December 2010
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated June 26, 2008, requiring monthly interest payments, fixed at
      3.64%, until maturity, principal due in July 2010
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated July 2, 2008, requiring monthly interest payments, fixed at
      3.85%, until maturity, principal due in July 2011
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated January 18, 2008, requiring monthly interest payments, fixed
      at 3.59%, until maturity, principal due in January 2013
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated May 11, 2007, requiring monthly interest payments, fixed at
      4.66%, with a put option exercisable in February 2008 and then quarterly
      thereafter, principal due in May 2011
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated May 15, 2007, requiring monthly interest payments, fixed at
      4.58%, with a put option exercisable in May 2008 and then quarterly
      thereafter, principal due in May 2012
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000Long-term
      advance dated July 31, 2007, requiring monthly interest payments, fixed at
      4.50%, with a put option exercisable in July 2008 and then quarterly
      thereafter, principal due in July 2013
                  
                  
                  5,000,000
                  
                  
                  
                  5,000,000
 66
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      9.
              Federal
      Home Loan Bank Advances and Other Borrowings
  (continued)
  2009
                
                
                2008Long-term
      advance dated August 7, 2007, requiring monthly interest payments, fixed
      at 4.43%, with a put option exercisable in February 2009 and then
      quarterly thereafter, principal due in August 2014
                
                $
                5,000,000
                
                
                $
                5,000,000Long-term
      advance dated January 2, 2008, requiring monthly interest payments, fixed
      at 3.52% with a put option exercisable in January 2011 and the quarterly
      thereafter, principal due in January 2015
                
                
                5,000,000
                
                
                
                5,000,000Long-term
      advance dated January 20, 2006, requiring monthly interest payments, fixed
      at 4.18%, with a put option exercisable in January 2009 and then quarterly
      thereafter, principal due in January 2016
                
                
                5,000,000
                
                
                
                5,000,000Long-term
      advance dated January 10, 2007, requiring monthly interest payments, fixed at 4.25%, with a put option
      exercisable in January 2008 and then quarterly thereafter, principal due
      in January 2017
                
                
                5,000,000
                
                
                
                5,000,000$
                67,000,000
                
                
                $
                67,000,000
 During
the fixed rate term, the advances may be prepaid subject to a prepayment penalty
as defined in the agreements.  On convertible agreements, the FHLB has
the right to convert the fixed rate on the above advances at the end of the
initial fixed rate period and on a quarterly basis thereafter.  If the
conversion option is exercised, the advances will bear interest at the
three-month London Interbank Offered Rate (LIBOR) adjusted quarterly at a spread
of zero basis points to the LIBOR index.  Subsequent to any
conversion, the Bank has the option to prepay the advances, in full or in part,
without penalty on the conversion date or any subsequent quarterly repricing
date.  On agreements with put options, the FHLB has the right, at its
discretion, to terminate only the entire advance prior to the stated maturity
date.  The termination option may only be exercised on the expiration
date of the predetermined lockout period and on a quarterly basis
thereafter.
 
 Cornerstone
had an $8,500,000 line of credit with Silverton Bank (now known as Silverton
Bridge Bank, N.A.) that was secured by 100% of the Bank’s common stock with
borrowings outstanding of $4,250,000 at December 31, 2008.  During
March 2009, the line of credit matured and was reworked into two loans, a
$4,350,000 amortizing term loan and a $1,000,000 revolving line of
credit.  Borrowings outstanding under these agreements were $5,350,000
at December 31, 2009.
 
 In
January 2010 these loans were modified with Silverton Bridge Bank,
N.A.  These loans continue to be secured by 100% of the Bank’s common
stock and bear interest at the greater of Prime plus 3% or 6.25%.  The
first loan has an original principal balance of $4,350,000 with semi-annual
principal payments of $435,000 beginning July 2010, quarterly interest payments
beginning April 2010, and final payment of outstanding principal and accrued
interest due July 2014.   The second loan has an original
principal balance of $1,000,000 with a quarterly payment of principal of $50,000
plus accrued interest beginning January 2010 and final payment of outstanding
principal and accrued interest due April 1, 2011.
 
 Both of
these loans with Silverton Bridge Bank, N.A. contain certain compliance
covenants which have been waived through December 31,
2009.  However, due to the increased nonperforming assets of the Bank
and capital reductions due to net losses of both Cornerstone and the Bank,
Cornerstone was not in compliance with several of the covenants on the loans at
December 31, 2009.  The covenants include stated minimum or
maximum target amounts for Cornerstone’s capital levels, the Bank’s capital
levels, nonperforming asset
 
 67
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      9.
              Federal
      Home Loan Bank Advances and Other Borrowings
  (continued)
 
 levels at
the Bank and the ability of Cornerstone to meet the required annual debt service
requirements, which are computed on a rolling quarter
average.  Cornerstone has been unable to receive covenant
modifications for 2010 which would enable compliance in future
quarters.  Covenant violations are considered an “Event of Default”
which, at Silverton Bridge Bank, N.A.’s option, could cause these two loans to
become due and payable in full.
 
 The
primary source of liquidity for Cornerstone is the payment of dividends from the
Bank.  As of December 31, 2009, the Bank was under a dividend
restriction that requires regulatory approval prior to the payment of a dividend
from the Bank to Cornerstone.
 
 At
December 31, 2009, scheduled maturities of the Federal Home Loan Bank advances
and other borrowings are as follows:
  2010
                
                $
                17,635,0002011
                
                
                11,670,0002012
                
                
                5,870,0002013
                
                
                10,870,0002014
                
                
                6,305,000Thereafter
                
                
                20,000,000Total
                
                $
                72,350,000
 
 Note
      10.
              Employee
      Benefit Plans
 
 401(k)
plan:
 
 Cornerstone
has a 401(k) employee benefit plan covering substantially all employees that
have completed at least 30 days of service and met minimum age
requirements.  Cornerstone’s contribution to the plan is
discretionary.  Cornerstone elected not to make a contribution to the
plan for 2009.  Cornerstone’s contribution to the plan was $87,408 for
2008 and $230,732 for 2007.
 
 Employee
Stock Ownership Plan:
 
 Cornerstone
has a non-leveraged employee stock ownership plan (ESOP) to which Cornerstone
makes 100% of the contributions for purchasing Cornerstone’s common stock, and
allocates the contributions among the participants based on regulatory
guidelines.  Cornerstone’s contribution is discretionary, as
determined by the Compensation Committee. Employer contributions are available
to all employees after 1,000 hours of service.  There are certain age
and years-of-service requirements before contributions can be made for the
benefit of the employee.  The ESOP plan also provides for a three year
100% vesting requirement; therefore, employees terminating employment before
their third anniversary date will forfeit their accrued benefit under the
ESOP.  The forfeiture will be re-allocated among the remaining ESOP
participants.  No contributions were made to the ESOP in 2009 or
2007.Cornerstone made a contribution of $166,347 in 2008.
 
 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, 2009 and 2008, undisbursed loan
commitments aggregated $42,287,000, and $63,426,000, respectively.  In
addition, there were outstanding standby letters of credit totaling $3,708,000
and $3,983,000, respectively.
  68
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 
 Note
      11.
              Financial
      Instruments With Off-Balance-Sheet Risk
  (Continued)
 
 Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract. Commitments generally
have fixed expiration dates or other termination clauses and may require payment
of a fee.  Since many of the commitments are expected to expire
without being drawn upon, the total commitment amounts do not necessarily
represent future cash requirements.  The Bank evaluates each
customer’s creditworthiness on a case-by-case basis.  The amount of
collateral obtained, if deemed necessary by the Bank upon extension of credit,
is based on management’s credit evaluation.  Collateral held varies
but may include accounts receivable, inventory, property and equipment, and
income-producing commercial properties.
 
 Standby
letters of credit are conditional commitments issued by the Bank to guarantee
the performance of a customer to a third party.  Standby letters of
credit generally have fixed expiration dates or other termination clauses and
may require payment of a fee.  The credit risk involved in issuing
letters of credit is essentially the same as that involved in extending loan
facilities to customers.  The Bank’s policy for obtaining collateral,
and the nature of such collateral, is essentially the same as that involved in
making commitments to extend credit.
 
 The Bank
incurred insignificant losses on its commitments during 2009, 2008 and
2007.
 
 Note
      12.
              Fair
      Value Disclosures
 
 Cornerstone
uses fair value measurements to record fair value adjustments to certain assets
and liabilities and to determine fair value disclosures.  In
accordance with the “Fair Value Measurements and Disclosures” ASC Topic 820, the
fair value of a financial instrument is the price that would be received to sell
an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date.  Fair value is best
determined based upon quoted market prices.  In cases where quoted
market prices are not available, fair values are based on estimates using
present value or other valuation techniques.  Those techniques are
significantly affected by the assumptions used, including the discount rate and
estimates of future cash flows.  Accordingly, the fair value estimates
may not be realized in an immediate settlement of the instrument.
 
 ASC Topic
820 provides a consistent definition of fair value, which focuses on exit price
in an orderly transaction between market participants at the measurement date
under current market conditions.  If there has been a significant
decrease in the volume and level of activity for the asset or liability, a
change in valuation technique or the use of multiple valuation techniques may be
appropriate.  In such instances, determining the price at which
willing market participants would transact at the measurement date under current
market conditions depends on the facts and circumstances and requires the use of
significant judgment.  The fair value is a reasonable point within the
range that is most representative of fair value under current market
conditions.
 
 ASC Topic
820 also establishes a three-tier fair value hierarchy which requires an entity
to maximize the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value, as follows:
 
 Level 1 -
Quoted prices (unadjusted) in active markets for identical assets or liabilities
that Cornerstone has the ability to access.
 
 Level 2 -
Significant other observable inputs other than Level 1 prices, such as quoted
prices for similar assets or liabilities in active markets, quoted prices in
markets that are not active and other inputs that are observable or can be
corroborated by observable market data.
 
 Level 3 -
Significant unobservable inputs that reflect a company’s own assumptions about
the assumptions that market participants would use in pricing an asset or
liability.
 
 A
financial instrument’s categorization within the valuation hierarchy is based
upon the lowest level of input that is significant to the fair value
measurement.
 
 69
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      12.
              Fair
      Value Disclosures (continued)
 
 The
following methods and assumptions were used by Cornerstone in estimating fair
value disclosures for financial instruments:
 
 Cash and
cash equivalents:
 
 The
carrying amounts of cash and cash equivalents approximate fair values based on
the short-term nature of the assets.
 
 Securities:
 
 Fair
values are estimated using pricing models and discounted cash flows that
consider standard input factors such as observable market data, benchmark
yields, interest rate volatilities, broker/dealer quotes, and credit
spreads.  Securities classified as available for sale are reported at
fair value utilizing Level 2 inputs.
 
 The
carrying value of Federal Home Loan Bank stock approximates fair value based on
the redemption provisions of the Federal Home Loan Bank.
 
 Loans:
 
 For
variable-rate loans that reprice frequently and with no significant change in
credit risk, fair values are based on carrying values.  Fair values
for fixed-rate loans are estimated using discounted cash flow analyses, using
market interest rates for comparable loans.  Loans for which it is
probable that payment of interest and principal will not be made in accordance
with the contractual terms of the loan agreement are considered
impaired.  Once a loan is identified as individually impaired,
management measures impairment in accordance with ASC Topic 310, “Accounting by
Creditors for Impairment of a Loan”.  The fair value of impaired loans
is estimated using several methods including collateral value, liquidation value
and discounted cash flows.
 
 Those
impaired loans not requiring an allowance represent loans for which the fair
value of the expected repayments or collateral exceed the recorded investments
in such loans.  At December 31, 2009 and 2008, substantially all of
the total impaired loans were evaluated based on the fair value of
collateral.  In accordance with ASC Topic 820, impaired loans where an
allowance is established based on the fair value of collateral require
classification in the fair value hierarchy.  When the fair value of
the collateral is based on an observable market price or a current appraised
value, Cornerstone records the impaired loan as nonrecurring
Level 2.  When an appraised value is not available or management
determines the fair value of the collateral is further impaired below the
appraised value and there is no observable market price, Cornerstone records the
impaired loan as nonrecurring Level 3.
 
 Cash
surrender value of life insurance:
 
 The
carrying amounts of cash surrender value of life insurance approximate their
fair value.  The carrying amount is based on information received from
the insurance carriers indicating the financial performance of the policies and
the amount Cornerstone would receive should the policies be
surrendered.  Cornerstone reflects these assets within Level 2 of
the valuation hierarchy.
 
 Foreclosed
assets:
 
 Foreclosed
assets, consisting of properties obtained through foreclosure or in satisfaction
of loans, is initially recorded at fair value, determined on the basis of
current appraisals, comparable sales, and other estimates of value obtained
principally from independent sources, adjusted for estimated selling
costs.  At the time of foreclosure, any excess of the loan balance
over the fair value of the real estate held as collateral is treated as a charge
against the allowance for loan losses.  Gains or losses on sale and
any subsequent adjustment to the fair value are recorded as a component of
foreclosed real estate expense.  Foreclosed assets are included in
Level 2 of the valuation hierarchy.
  70
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY


NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      12.
                Fair
      Value Disclosures
(continued)
 
 Deposits:
 
 The fair
value of deposits with no stated maturity, such as noninterest-bearing and
interest-bearing demand deposits, savings deposits, and money market accounts,
is equal to the amount payable on demand at the reporting date.  The
carrying amounts of variable-rate, fixed-term certificates of deposit
approximate their fair values at the reporting date.  Fair values for
fixed-rate certificates of deposit are estimated using a discounted cash flow
calculation that applies market interest rates on comparable instruments to a
schedule of aggregated expected monthly maturities on time
deposits.
 
 Securities
sold under agreements to repurchase:
 
 The
estimated fair value of these liabilities approximates their carrying
value.
 
 Federal
Home Loan Bank advances and other borrowings:
 
 The
carrying amounts of FHLB advances and other borrowings approximate their fair
value.
 
 Accrued
interest:
 
 The
carrying amounts of accrued interest approximate fair value.
 
 Commitments
to extend credit, letters of credit and lines of 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
tables below present the recorded amount of assets and liabilities measured at
fair value on a recurring basis.
  Balance
      as of
                  December
      31,
                  2009
                
                
                Quoted
      Prices in
                  Active
      Markets
                  for
      Identical
                  Assets
                  (Level
      1)
                
                
                Significant
                  Other
                  Observable
                  Inputs
                  (Level
      2)
                
                
                Significant
                  Other
                  Unobservable
                  Inputs
                  (Level
      3)Debt
      securities available for sale:U.S.
      Government agencies
                
                $
                4,774,020
                
                
                $
                -
                
                
                $
                4,774,020
                
                
                $
                -State
      and municipal securities
                
                
                16,755,640
                
                
                
                -
                
                
                
                16,755,640
                
                
                
                -Mortgage-backed
      securities:Residential
      mortgage guaranteed by GNMA
                
                
                52,726,767
                
                
                
                -
                
                
                
                52,726,767
                
                
                
                -Collateralized
      mortgage obligations issued or guaranteed by U.S.Government
      agencies or sponsored agencies
                
                
                49,960,448
                
                
                
                -
                
                
                
                49,960,448
                
                
                
                -Other
                
                
                198,443
                
                
                
                -
                
                
                
                198,443
                
                
                
                -Total
      securities available for sale
                
                $
                124,415,318
                
                
                $
                -
                
                
                $
                124,415,318
                
                
                $
                -Cash
      surrender value of life insurance
                
                $
                1,100,874
                
                
                $
                -
                
                
                $
                1,100,874
                
                
                $
                -
 71
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      12.
                            Fair
      Value Disclosures
(continued)
 Balance
      as of
                  December
      31,
                  2008
                
                
                Quoted
      Prices in
                  Active
      Markets
                  for
      Identical
                  Assets
                  (Level
      1)
                
                
                Significant
                  Other
                  Observable
                  Inputs
                  (Level
      2)
                
                
                Significant
                  Other
                  Unobservable
                  Inputs
                  (Level
      3)Debt
      securities available for sale:U.S.
      Government securities
                
                $
                8,251,771
                
                
                $
                -
                
                
                $
                8,251,771
                
                
                $
                -State
      and municipal securities
                
                
                4,622,815
                
                
                
                -
                
                
                
                4,622,815
                
                
                
                -Mortgage-backed
      securities
                
                
                31,181,973
                
                
                
                -
                
                
                
                31,181,973
                
                
                
                -Total
      securities available for sale
                
                $
                44,056,559
                
                
                $
                -
                
                
                $
                44,056,559
                
                
                $
                -Cash
      surrender value of life insurance
                
                $
                1,067,924
                
                
                $
                -
                
                
                $
                1,067,924
                
                
                $
                -
  Cornerstone
has no assets or liabilities whose fair values are measured using Level 3
inputs.
 
 Certain
assets and liabilities are measured at fair value on a nonrecurring basis, which
means the assets and liabilities are not measured at fair value on an ongoing
basis but are subject to fair value adjustments in certain circumstances (for
example, when there is evidence of impairment).  The tables below
present information about assets and liabilities on the balance sheet at
December 31, 2009 and 2008, for which a nonrecurring change in fair value
was recorded.
  Balance
      as of
                  December
      31,
                  2009
                
                
                Quoted
      Prices in
                  Active
      Markets
                  for
      Identical
                  Assets
                  (Level
      1)
                
                
                Significant
                  Other
                  Observable
                  Inputs
                  (Level
      2)
                
                
                Significant
                  Other
                  Unobservable
                  Inputs
                  (Level
      3)Impaired
      loans
                
                $
                21,811,211
                
                
                $
                -
                
                
                $
                21,811,211
                
                
                $
                -Foreclosed
      assets
                
                
                10,327,297
                
                
                
                -
                
                
                
                10,327,297
                
                
                
                -
  Balance
      as of
                  December
      31,
                  2008
                
                
                Quoted
      Prices in
                  Active
      Markets
                  for
      Identical
                  Assets
                  (Level
      1)
                
                
                Significant
                  Other
                  Observable
                  Inputs
                  (Level
      2)
                
                
                Significant
                  Other
                  Unobservable
                  Inputs
                  (Level
      3)Impaired
      loans
                
                $
                11,502,670
                
                
                $
                -
                
                
                $
                11,502,670
                
                
                $
                -
  Loans
include impaired loans held for investment for which an allowance for loan
losses has been calculated based upon the fair value of the loans at December
31, 2009 and 2008.  Losses derived from Level 2 inputs were calculated
by models incorporating significant observable market data.
 
 72
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
  Note
      12.
                      Fair
      Value Disclosures
(continued)
 The
carrying amount and estimated fair value of the Cornerstone’s financial
instruments at December 31, 2009 and 2008, are as follows (in
thousands):
  2009
                
                
                2008Carrying
                  Amount
                
                
                Estimated
                  Fair
      Value
                
                
                Carrying
                  Amount
                
                
                Estimated
                  Fair
      ValueAssets:Cash
      and cash equivalents
                
                $
                38,202
                
                
                $
                38,202
                
                
                $
                21,897
                
                
                $
                21,897Securities
                
                
                124,551
                
                
                
                124,551
                
                
                
                44,226
                
                
                
                44,226Federal
      Home Loan Bank stock
                
                
                2,229
                
                
                
                2,229
                
                
                
                2,188
                
                
                
                2,188Loans,
      net
                
                
                330,787
                
                
                
                331,456
                
                
                
                378,472
                
                
                
                380,394Cash
      surrender value of life insurance
                
                
                1,101
                
                
                
                1,101
                
                
                
                1,068
                
                
                
                1,068Accrued
      interest receivable
                
                
                1,521
                
                
                
                1,521
                
                
                
                1,771
                
                
                
                1,771Liabilities:Noninterest-bearing
      demand deposits
                
                
                41,972
                
                
                
                41,972
                
                
                
                40,078
                
                
                
                40,078Interest-bearing
      demand deposits
                
                
                26,533
                
                
                
                26,533
                
                
                
                26,909
                
                
                
                26,909Savings
      deposits and money market accounts
                
                
                31,030
                
                
                
                31,030
                
                
                
                35,848
                
                
                
                35,848Time
      deposits
                
                
                305,207
                
                
                
                307,596
                
                
                
                223,749
                
                
                
                225,882Federal
      funds purchased and securities sold under agreements to
      repurchase
                
                
                26,322
                
                
                
                26,322
                
                
                
                35,790
                
                
                
                35,790Federal
      Home Loan Bank advances and other borrowings
                
                
                72,350
                
                
                
                72,350
                
                
                
                71,250
                
                
                
                71,250Accrued
      interest payable
                
                
                351
                
                
                
                351
                
                
                
                470
                
                
                
                470Unrecognized
      financial instruments (net of contract amount):Commitments
      to extend credit
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Letters
      of credit
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -Lines
      of credit
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                -
 Note
      13.
                  Contingencies
  The Bank
is involved in certain claims arising from normal business
activities.  Management believes that the impact of those claims are
without merit and that the ultimate liability, if any, resulting from them will
not materially affect the Bank’s financial condition or Cornerstone’s
consolidated financial position, results of operations or cash
flows.
 Note
      14.
                  Stock
      Option
Plans
  Cornerstone
has stock option plans which are more fully described below.  For the
years ended December 31, 2009, 2008 and 2007, Cornerstone recognized
$216,600, $279,400 and $220,016, respectively, in compensation expense for all
stock options.
 
 The fair
value of each option granted is estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions:
  Years
      Ended December 31,2009
                
                
                2008
                
                
                2007Dividend
      yield
                
                
                2.97
                %
                
                
                1.47
                %
                
                
                1.33
                %Expected
      life
                
                7.0
      years
                
                
                8.0
      years
                
                
                7.0
      yearsExpected
      volatility
                
                
                38.74
                %
                
                
                20.27
                %
                
                
                12.22
                %Risk-free
      interest rate
                
                
                2.69
                %
                
                
                4.22
                %
                
                
                4.51
                %
  73
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      14.
                      Stock
      Option Plans
(continued)
 The
expected volatility is based upon historical volatility.  The
risk-free interest rates for periods within the contractual life of the awards
are based on the U.S. Treasury yield curve in effect at the time of the
grant.  The expected life is based on historical exercise
experience.   The dividend yield assumption is based on
Cornerstone’s history and expectation of dividend payouts.
 
 Board of
Directors plan:
 
 Cornerstone
has a stock option plan under which members of the Board of Directors, at the
formation of the Bank, were granted options to purchase a total of up to 600,000
shares of common stock.  Only non-qualified stock options may be
granted under the Plan.  In addition, members of the Board of
Directors can be issued options under the Cornerstone 2002 Long-Term Incentive
Plan to purchase up to 1,200,000 shares of Cornerstone stock.  The
options available for issuance to Board members under the 2002 Long-Term
Incentive Plan are shared with officers and employees of
Cornerstone.  The exercise price of each option equals the market
price of Cornerstone’s stock on the date of grant and the option’s maximum term
is ten years, at which point they expire.  Vesting for options granted
during 2007, 2008 and 2009, are 50% on each of the first and second anniversary
of the grant date with full vesting occurring at the second anniversary
date.  At December 31, 2009, the total remaining compensation
cost to be recognized on non-vested options is approximately
$37,000.  An analysis of this stock option plan is presented in the
following table:
  Years
      Ended December 31,2009
                
                
                2008
                
                
                2007Shares
                
                
                Average
                  Exercise
                  Price
                
                
                Aggregate
                  Intrinsic
                  Value(1)
                
                
                Shares
                
                
                Average
                  Exercise
                  Price
                
                
                Shares
                
                
                Average
                  Exercise
                  PriceOutstanding
      at beginning of year
                
                
                81,800
                
                
                $
                10.73
                
                
                
                
                
                
                69,000
                
                
                $
                11.23
                
                
                
                67,000
                
                
                $
                10.61Granted
                
                
                20,500
                
                
                
                3.65
                
                
                
                
                
                
                12,800
                
                
                
                7.99
                
                
                
                9,000
                
                
                
                15.25Exercised
                
                
                -
                
                
                
                -
                
                
                
                
                
                
                -
                
                
                
                -
                
                
                
                (5,000
                )
                
                
                9.32Forfeited
                
                
                (2,050
                )
                
                
                3.65
                
                
                
                
                
                
                -
                
                
                
                -
                
                
                
                (2,000
                )
                
                
                13.25Outstanding
      at end of year
                
                
                100,250
                
                
                $
                9.42
                
                
                $
                -
                
                
                
                81,800
                
                
                $
                10.73
                
                
                
                69,000
                
                
                $
                11.23Options
      exercisable at year-end
                
                
                75,400
                
                
                $
                10.96
                
                
                $
                -
                
                
                
                64,500
                
                
                $
                10.95
                
                
                
                42,000
                
                
                $
                9.51Weighted-average
      fair value of options granted during the year
                
                $
                1.13
                
                
                
                
                
                
                
                
                
                
                $
                2.23
                
                
                
                
                
                
                $
                3.33
  74
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      14.
                            Stock
      Option Plans
(continued)
 (1)
              The
      aggregate intrinsic value of a stock option in the table above represents
      the total pre-tax intrinsic value (the amount by which the current market
      value of the underlying stock exceeds the exercise price of the option)
      that would have been received by the option holders had all option holders
      exercised their options on December 31, 2009. This amount changes based on
      changes in the market value of the Cornerstone’s stock. The fair value
      (present value of the estimated future benefit to the option holder) of
      each option grant is estimated on the date of grant using the
      Black-Scholes option pricing model.
 
 Information
pertaining to options outstanding at December 31, 2009, is as
follows:
  Options
      Outstanding
                
                
                Options
      ExercisableExercise
      Prices
                
                
                Number
      Outstanding
                
                Weighted
      Average Remaining Life
                
                Weighted
      Average Exercise Price
                
                
                Number
      Exercisable
                
                
                Weighted
      Average Exercise Price$5.44
                
                
                
                16,000
                
                4.2
      Years
                
                $
                5.44
                
                
                
                16,000
                
                
                $
                5.449.23
                
                
                
                8,000
                
                5.2
      Years
                
                
                9.23
                
                
                
                8,000
                
                
                
                9.2313.25
                
                
                
                36,000
                
                6.2
      Years
                
                
                13.25
                
                
                
                36,000
                
                
                
                13.2515.25
                
                
                
                9,000
                
                7.2
      Years
                
                
                15.25
                
                
                
                9,000
                
                
                
                15.257.99
                
                
                
                12,800
                
                8.2
      Years
                
                
                7.99
                
                
                
                6,400
                
                
                
                7.993.65
                
                
                
                18,450
                
                9.2
      Years
                
                
                3.65
                
                
                
                -
                
                
                
                -Outstanding
      at end of year
                
                
                
                100,250
                
                6.7
      Years
                
                $
                9.42
                
                
                
                75,400
                
                
                $
                10.96
  Information
pertaining to non-vested options for the year ended December 31, 2009, is as
follows:
  Number
      of Shares
                
                
                Weighted
      Average Grant Date Fair ValueNon-vested
      options, December 31, 2008
                
                
                17,300
                
                
                $
                9.88Granted
                
                
                20,500
                
                
                
                3.65Vested
                
                
                (10,900
                )
                
                
                10.99Forfeited
                
                
                (2,050
                )
                
                
                3.65Non-vested
      options, December 31, 2009
                
                
                24,850
                
                
                $
                4.77
  The total
fair value of shares vested during 2009 was approximately $45,000.
  Officer
and Employee Plans:
 Cornerstone
has two stock option plans, the 1996 Cornerstone Statutory and Non-statutory
Option Plan and the Cornerstone 2002 Long-Term Incentive Plan, under which
officers and employees can be granted incentive stock options or non-qualified
stock options to purchase a total of up to 220,000 and 1,200,000 shares,
respectively, of Cornerstone’s common stock.  The option price for
incentive stock options shall be not less than 100 percent of the fair
market value of the common stock on the date of the grant.  The
non-qualified stock options may be equal to or more or less than the fair market
value of the common stock on the date of the grant.  The stock options
vest at 30 percent on the second and third anniversaries of the grant date
and 40 percent on the fourth anniversary of the grant
date.  These options expire ten years from the grant
date.  At December 31, 2009, the total remaining compensation cost to
be recognized on non-vested options is approximately $500,000.  An
analysis of the activity for each of the years ending December 31, 2009, 2008
and 2007, for this stock option plan follows:
  75
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      14.
                  Stock
      Option Plans
(continued)
  Officer
and Employee Plans: (continued)
  Years
      Ended December 31,2009
                
                
                2008
                
                
                2007Shares
                
                
                Average
                  Exercise
                  Price
                
                
                Aggregate
                  Intrinsic
                  Value(1)
                
                
                Shares
                
                
                Average
                  Exercise
                  Price
                
                
                Shares
                
                
                Average
                  Exercise
                  PriceOutstanding
      at beginning of year
                
                
                755,425
                
                
                $
                6.63
                
                
                
                
                
                
                715,075
                
                
                $
                6.52
                
                
                
                669,120
                
                
                $
                5.79Granted
                
                
                115,850
                
                
                
                3.65
                
                
                
                
                
                
                71,500
                
                
                
                7.99
                
                
                
                53,800
                
                
                
                15.25Exercised
                
                
                -
                
                
                
                -
                
                
                
                
                
                
                (22,000
                )
                
                
                3.75
                
                
                
                (5,870
                )
                
                
                4.48Forfeited
                
                
                (71,600
                )
                
                
                6.77
                
                
                
                
                
                
                (9,150
                )
                
                
                13.34
                
                
                
                (1,975
                )
                
                
                14.03Outstanding
      at end of year
                
                
                799,675
                
                
                $
                6.18
                
                
                $
                -
                
                
                
                755,425
                
                
                $
                6.63
                
                
                
                715,075
                
                
                $
                6.52Options
      exercisable at year-end
                
                
                592,648
                
                
                $
                5.69
                
                
                $
                -
                
                
                
                549,516
                
                
                $
                4.87
                
                
                
                470,990
                
                
                $
                4.06Weighted-average
      fair value of options granted during the year
                
                $
                1.13
                
                
                
                
                
                
                
                
                
                
                $
                2.23
                
                
                
                
                
                
                $
                3.33
  (1)
              The
      aggregate intrinsic value of a stock option in the table above represents
      the total pre-tax intrinsic value (the amount by which the current market
      value of the underlying stock exceeds the exercise price of the option)
      that would have been received by the option holders had all option holders
      exercised their options on December 31, 2009.  This amount
      changes based on changes in the market value of the Cornerstone’s stock.
      The fair value (present value of the estimated future benefit to the
      option holder) of each option grant is estimated on the date of grant
      using the Black-Scholes option pricing
model.
 
 Information
pertaining to options outstanding at December 31, 2009, is as
follows:
  Options
      Outstanding
                
                
                Options
      ExercisableExercise
      Prices
                
                
                Number
      Outstanding
                
                Weighted
      Average Remaining Life
                
                Weighted
      Average Exercise Price
                
                
                Number
      Exercisable
                
                
                Weighted
      Average Exercise Price$3.25
      - $3.75
                
                
                
                324,600
                
                1.8
      Years
                
                $
                3.48
                
                
                
                324,600
                
                
                $
                3.485.44
                
                
                
                131,440
                
                4.2
      Years
                
                
                5.44
                
                
                
                131,440
                
                
                
                5.449.23
                
                
                
                77,410
                
                5.2
      Years
                
                
                9.23
                
                
                
                77,410
                
                
                
                9.2313.25
                
                
                
                70,000
                
                6.2
      Years
                
                
                13.25
                
                
                
                45,120
                
                
                
                13.2515.25
                
                
                
                38,925
                
                7.2
      Years
                
                
                15.25
                
                
                
                13,253
                
                
                
                15.2515.20
                
                
                
                2,750
                
                7.3
      Years
                
                
                15.20
                
                
                
                825
                
                
                
                15.207.99
                
                
                
                59,000
                
                8.2
      Years
                
                
                7.99
                
                
                
                -
                
                
                
                -3.65
                
                
                
                95,550
                
                9.2
      Years
                
                
                3.65
                
                
                
                -
                
                
                
                -Outstanding
      at end of year
                
                
                
                799,675
                
                4.5
      Years
                
                $
                6.18
                
                
                
                592,648
                
                
                $
                5.69
  76
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      14.
                            Stock
      Option Plans
(continued)
 Information
pertaining to non-vested options for the year ended December 31, 2009, is as
follows:
  Number
      of Shares
                
                
                Weighted
      Average Grant Date Fair ValueNon-vested
      options, December 31, 2008
                
                
                205,909
                
                
                $
                11.31Granted
                
                
                115,850
                
                
                
                3.65Vested
                
                
                (69,582
                )
                
                
                11.92Forfeited
                
                
                (45,150
                )
                
                
                7.88Non-vested
      options, December 31, 2009
                
                
                207,027
                
                
                $
                7.57
  The total
fair value of shares vested during 2009 was approximately $288,000.
 Note
      15.
                  Liquidity
      and Capital
Resources
  Cornerstone’s
primary source of funds with which to pay its future obligations is the receipt
of dividends from its subsidiary Bank.  Banking regulations provide
that the Bank must maintain capital sufficient to enable it to operate as a
viable institution and, as a result, has limited the amount of dividends the
Bank may pay without prior approval.
 Note
      16.
                  Minimum
      Regulatory Capital
  Requirements
  Cornerstone
(on a consolidated basis) and the Bank are subject to various regulatory capital
requirements administered by the Tennessee Department of Financial Institutions
and the federal banking agencies.  Failure to meet minimum capital
requirements can initiate certain mandatory and possibly additional
discretionary actions by regulators that, if undertaken, could have a direct
material effect on Cornerstone’s and the Bank’s financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, Cornerstone and the Bank must meet
specific capital guidelines that involve quantitative measures of Cornerstone’s
and the Bank’s assets, liabilities, and certain off-balance-sheet items as
calculated under regulatory accounting practices.  Cornerstone’s and
the Bank’s capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings and other
factors.  Prompt corrective action provisions are not applicable to
bank holding companies.
 
 Quantitative
measures established by regulation to ensure capital adequacy require
Cornerstone and the Bank to maintain minimum amounts and ratios (set forth in
the table below) of total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined), and of Tier I capital
(as defined) to average assets (as defined).
 
 As of
December 31, 2009, the most recent notification from the Federal Deposit
Insurance Corporation (FDIC) categorized the Bank as adequately capitalized
under the regulatory framework for prompt corrective action.  To be
categorized as well capitalized, an institution must maintain minimum total
risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in
the following tables.  There are no conditions or events since that
notification that management believes have changed the Bank’s prompt corrective
action category for bank capital.
 
 In
situations similar to the Bank’s, the FDIC has been known to issue Consent
Orders that have contained one or more of the following provisions: a
requirement to augment capital; a requirement to closely monitor criticized
assets; a requirement to closely monitor and manage liquidity; and other similar
requirements.  If the Bank were to be presented with such a
supervisory agreement, the Bank’s Board of Directors would likely consent to its
terms.
 
 77
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      16.
                      Minimum
      Regulatory Capital Requirements
      (continued)
 Cornerstone’s
and the Bank’s actual capital amounts and ratios are also presented in the
table.  Dollar amounts are presented in thousands.
  Actual
                
                
                Minimum
      Capital
      Requirements
                
                
                Minimum
      To Be
                  Well
      CapitalizedAmount
                
                
                Ratio
                
                
                
                Amount
                
                
                Ratio
                
                
                Amount
                
                
                RatioAs
      of December 31, 2009:Total
      capital to risk-weighted assets:Consolidated
                
                $
                29,472
                
                
                
                8.3
                %
                
                $
                28,556
                
                
                
                8.0
                %
                
                
                N/A
                
                
                
                N/ACornerstone
      Community Bank
                
                
                33,963
                
                
                
                9.5
                %
                
                
                28,532
                
                
                
                8.0
                %
                
                $
                35,666
                
                
                
                10.0
                %Tier
      1 capital to risk-weighted assets:Consolidated
                
                
                24,992
                
                
                
                7.0
                %
                
                
                14,278
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/ACornerstone
      Community Bank
                
                
                29,487
                
                
                
                8.3
                %
                
                
                14,266
                
                
                
                4.0
                %
                
                
                21,399
                
                
                
                6.0
                %Tier
      1 capital to average assets:Consolidated
                
                
                24,992
                
                
                
                5.2
                %
                
                
                19,241
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/ACornerstone
      Community Bank
                
                
                29,487
                
                
                
                6.1
                %
                
                
                19,216
                
                
                
                4.0
                %
                
                
                24,020
                
                
                
                5.0
                %As
      of December 31, 2008:Total
      capital to risk-weighted assets:Consolidated
                
                $
                38,974
                
                
                
                9.7
                %
                
                $
                32,282
                
                
                
                8.0
                %
                
                
                N/A
                
                
                
                N/ACornerstone
      Community Bank
                
                
                41,410
                
                
                
                10.3
                %
                
                
                32,130
                
                
                
                8.0
                %
                
                $
                40,163
                
                
                
                10.0
                %Tier
      1 capital to risk-weighted assets:Consolidated
                
                
                33,873
                
                
                
                8.4
                %
                
                
                16,141
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/ACornerstone
      Community Bank
                
                
                36,336
                
                
                
                9.1
                %
                
                
                16,065
                
                
                
                4.0
                %
                
                
                24,098
                
                
                
                6.0
                %Tier
      1 capital to average assets:Consolidated
                
                
                33,873
                
                
                
                7.4
                %
                
                
                18,390
                
                
                
                4.0
                %
                
                
                N/A
                
                
                
                N/ACornerstone
      Community Bank
                
                
                36,336
                
                
                
                7.9
                %
                
                
                18,339
                
                
                
                4.0
                %
                
                
                22,924
                
                
                
                5.0
                %
  78
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 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, 2009,
2008 and 2007, is as follows:
  Before-Tax
                  Amount
                
                
                (Expense)
                  Benefit
                
                
                Tax
      Net-of-Tax
                  AmountYear
      ended December 31, 2009:Unrealized
      holding gains and losses arising during the period
                
                $
                262,642
                
                
                $
                (113,884
                )
                
                $
                182,758Less
      reclassification adjustment for gains realized in net
    income
                
                
                399,754
                
                
                
                (153,066
                )
                
                
                246,688$
                (103,112
                )
                
                $
                39,182
                
                
                $
                (63,930
                )Year
      ended December 31, 2008:Unrealized
      holding gains and losses arising during the period
                
                $
                (444,690
                )
                
                $
                151,196
                
                
                $
                (293,494
                )Less
      reclassification adjustment for gains realized in net
    income
                
                
                -
                
                
                
                -
                
                
                
                -$
                (444,690
                )
                
                $
                151,196
                
                
                $
                (293,494
                )Year
      ended December 31, 2007:Unrealized
      holding gains and losses arising during the period
                
                $
                250,886
                
                
                $
                (85,301
                )
                
                $
                165,585Less
      reclassification adjustment for gains realized in net
    income
                
                
                -
                
                
                
                -
                
                
                
                -$
                250,886
                
                
                $
                (85,301
                )
                
                $
                165,585
  Note
      18.
                  Earnings
      (Loss) Per Common
      Share
  Basic
earnings (loss) per share represents income (loss) available to common
stockholders divided by the weighted-average number of common shares outstanding
during the period.  Diluted earnings (loss) per share reflects
additional common shares that would have been outstanding if dilutive potential
common shares had been issued, as well as any adjustment to income that would
result from the assumed issuance.
 
 Potential
common shares that may be issued by Cornerstone relate to outstanding stock
options, determined using the treasury stock method.
 
 79
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      18.
                    Earnings
      (Loss) Per Common Share
      (continued)
  Earnings
(loss) per common share have been computed based on the following:
  2009
                
                
                2008
                
                
                2007Net
      (loss) income
                
                $
                (8,178,639
                )
                
                $
                2,511,824
                
                
                $
                871,152Less:
      Preferred stock dividends
                
                
                -
                
                
                
                -
                
                
                
                -Net
      (loss) income applicable to common stock
                
                $
                (8,178,639
                )
                
                $
                2,511,824
                
                
                $
                871,152Average
      number of common shares outstanding
                
                
                6,500,396
                
                
                
                6,508,631
                
                
                
                6,685,275Effect
      of dilutive stock options
                
                
                -
                
                
                
                136,826
                
                
                
                339,346Average
      number of common shares outstanding used to calculate diluted earnings
      (loss) per common share
                
                
                6,500,396
                
                
                
                6,645,457
                
                
                
                7,024,621
  The
effects of outstanding antidilutive stock options are excluded from the
computation of diluted earnings (loss) per share.  There were 933,725,
329,526 and 62,150 antidilutive stock options for 2009, 2008 and 2007,
respectively.  The average number of common shares outstanding and the
effect of dilutive stock options for 2008 and 2007 have been retroactively
adjusted to reflect two stock dividends that occurred during 2009.
 Note
      19.
                    Recent
      Accounting
      Pronouncements
  On July
1, 2009, the FASB Accounting Standards Codification became the officially
recognized source of authoritative U.S. generally accepted accounting principles
applicable to all public and non-public, non-governmental entities, superseding
existing FASB, AICPA, EITF and related literature.  Rules and
interpretive releases of the SEC under the authority of federal securities laws
are also sources of authoritative GAAP for SEC registrants.  All other
accounting literature is considered non-authoritative.  The switch to
the ASC affects the way companies refer to U.S. GAAP in financial statements and
accounting policies.  The Codification is not intended to change U.S.
GAAP, but rather is expected to simplify accounting research by reorganizing
current GAAP into approximately 90 accounting topics.
 
 ASC Topic
820, “Fair Value Measurements and Disclosures”, defines fair value, establishes
a framework for measuring fair value in generally accepted accounting
principles, and expands disclosures about fair value measurements. The
provisions of ASC Topic 820 became effective for periods beginning after
November 15, 2007. Cornerstone adopted these provisions on January 1,
2008 for financial assets and financial liabilities and on January 1, 2009
for non-financial assets and non-financial liabilities.
 
 Additional
new authoritative accounting guidance under ASC Topic 820 affirms that the
objective of fair value when the market for an asset is not active is the price
that would be received to sell the asset in an orderly transaction, and
clarifies and includes additional factors for determining whether there has been
a significant decrease in market activity for an asset when the market for that
asset is not active. ASC Topic 820 requires an entity to base its conclusion
about whether a transaction was not orderly on the weight of the evidence. The
new accounting guidance amended prior guidance to expand certain disclosure
requirements. Cornerstone adopted the new authoritative accounting guidance
under ASC Topic 820 during the first quarter of 2009. Adoption of the new
guidance did not significantly impact the financial statements.
 
 80
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2009, 2008 and 2007
 Note
      19.
                              Recent
      Accounting Pronouncements
      (Continued)
 Further
new authoritative accounting guidance, Accounting Standards Update (ASU)
No. 2009-5, provides guidance for measuring the fair value of a liability
in circumstances in which a quoted price in an active market for the identical
liability is not available. In such instances, a reporting entity is required to
measure fair value utilizing a valuation technique that uses (i) the quoted
price of the identical liability when traded as an asset, (ii) quoted
prices for similar liabilities or similar liabilities when traded as assets, or
(iii) another valuation technique that is consistent with the existing
principles of ASC Topic 820, such as an income approach or market approach. The
new authoritative accounting guidance also clarifies that when estimating the
fair value of a liability, a reporting entity is not required to include a
separate input or adjustment to other inputs relating to the existence of a
restriction that prevents the transfer of the liability. The forgoing new
authoritative accounting guidance under ASC Topic 820 became effective for
periods ending after October 1, 2009 and did not have a significant impact
on Cornerstone’s financial statements.
 
 ASC Topic
825, “Financial Instruments”, permits entities to choose to measure eligible
financial instruments at fair value at specified election dates. The fair value
measurement option (i) may be applied instrument by instrument, with
certain exceptions, (ii) is generally irrevocable and (iii) is applied only
to entire instruments and not to portions of instruments. Unrealized gains and
losses on items for which the fair value measurement option has been elected
must be reported in earnings at each subsequent reporting date. The forgoing
provisions of ASC Topic 825 became effective for Cornerstone on January 1,
2008.  However, it had no impact on the consolidated financial
statements of Cornerstone as the Company did not elect the fair value option for
any financial instrument not presently being accounted for at fair
value.
 
 ASC Topic
715-60, “Defined Benefit Plans – Other Postretirement”, covers postretirement
benefit aspects of endorsement split-dollar life insurance
arrangements.  This topic concluded that deferred compensation or
postretirement benefit aspects of an endorsement split-dollar life insurance
arrangement should be recognized as a liability by the employer and the
obligation is not effectively settled by the purchase of a life insurance
policy. The effective date for this topic was for fiscal years beginning after
December 15, 2007. Adoption of this topic on January 1, 2008 did not
have a material impact on Cornerstone’s consolidated financial
statements.
 
 ASC Topic
855, “Subsequent Events”, establishes general standards of accounting for and
disclosure of events that occur after the balance sheet date but before
financial statements are issued. Cornerstone adopted the provisions of ASC Topic
855 during the period ended June 30, 2009. The adoption of ASC Topic 855
did not impact our financial statements.
 
 ASC Topic
815, “Derivatives and Hedging”, amends prior guidance to expand the disclosure
requirements for derivatives and hedging activities to provide greater
transparency about (i) how and why an entity uses derivative instruments,
(ii) how derivative instruments and related hedge items are accounted for
under ASC Topic 815, and (iii) how derivative instruments and related
hedged items affect an entity’s financial position, results of operations and
cash flows. To meet those objectives, the new authoritative accounting guidance
requires qualitative disclosures about objectives and strategies for using
derivatives, quantitative disclosures about fair value amounts of gains and
losses on derivative instruments and disclosures about credit-risk-related
contingent features in derivative agreements. ASC Topic 815 was effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008.
 
 ASC Topic
320, “Investments—Debt and Equity Securities”, (i) changes existing
guidance for determining whether an impairment is other than temporary to debt
securities and (ii) replaces the existing requirement that the entity’s
management assert it has both the intent and ability to hold an impaired
security until recovery with a requirement that management assert: (a) it
does not have the intent to sell the security; and (b) it is more likely
than not it will not have to sell the security before recovery of its cost
basis. Under ASC Topic 320, declines in the fair 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 to the extent the
impairment is related to credit losses. The amount of the impairment related to
other factors is recognized in other comprehensive income. We adopted the
provisions of the new authoritative accounting guidance under ASC Topic 320
during the second quarter of 2009. There was no impact from the adoption of this
new guidance.
 
 81
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      19.
                          Recent
      Accounting Pronouncements
      (Continued)
 ASC Topic
860, “Transfers and Servicing”, amended previous guidance on accounting for
transfers of financial assets. The amended guidance eliminates the concept of
qualifying special-purpose entities and requires that these entities be
evaluated for consolidation under applicable accounting guidance, and it also
removes the exception that permitted sale accounting for certain mortgage
securitizations when control over the transferred assets had not been
surrendered. Based on this new standard, many types of transferred financial
assets that would previously have been derecognized will now remain on the
transferor’s financial statements. The guidance also requires enhanced
disclosures about transfers of financial assets and the transferor’s continuing
involvement with those assets and related risk exposure. The new guidance is
effective for Cornerstone beginning January 1, 2010. Adoption of this new
guidance is not expected to have a significant impact on Cornerstone’s financial
condition or results of operations, given Cornerstone’s current involvement in
financial asset transfer activities.
 
 Also in
June 2009, the FASB issued amended guidance on accounting for variable
interest entities (VIEs). This guidance replaces the quantitative-based risks
and rewards calculation for determining which enterprise might have a
controlling financial interest in a VIE. The new, more qualitative evaluation
focuses on who has the power to direct the significant economic activities of
the VIE and also has the obligation to absorb losses or rights to receive
benefits from the VIE. It also requires an ongoing reassessment of whether an
enterprise is the primary beneficiary of a VIE and calls for certain expanded
disclosures about an enterprise’s involvement with variable interest entities.
The new guidance is effective for Cornerstone in 2010. Management does not
expect the new guidance to have a material effect, if any, on the Cornerstone’s
financial position or results of operations.
 
 Other
than disclosures contained within these statements, Cornerstone has determined
that all other recently issued accounting pronouncements will not have a
material impact on its consolidated financial statements or do not apply to its
operations.
 Note
      20.
                        Equity
      Investment
  During
2006, Cornerstone invested $3,000,000 for a 25% share of the Appalachian Fund
for Growth II Partnership (AFG), which is managed by the Southeast Local
Development Corporation (General Partner).   AFG is targeting
high job creation and retention businesses and businesses providing important
community services.  The funds are being deployed to
help:  1) attract new businesses to under-served service areas by
offering creative financing; 2) supply creative financing for businesses to
rehabilitate existing distressed properties to facilitate community development;
and 3) leverage other private investment into its targeted
communities.  In return for its investment in AFG, Cornerstone and
other investors will receive new market tax credits.  For 2009, 2008
and 2007 Cornerstone received approximately $150,000, $150,000 and $300,000,
respectively, in new market tax credits.
 
 AFG meets
the criteria of a VIE outlined in ASC Topic 810 “Consolidation”.  AFG
has not been consolidated by Cornerstone as Cornerstone is not the primary
beneficiary.
 
 82
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
 Note
      21.
                            Condensed
      Parent
      Information
 BALANCE
      SHEETSDecember
      31,
                
                
                December
      31,2009
                
                
                2008ASSETSCash
                
                $
                620,471
                
                
                $
                439,440Investment
      in subsidiary
                
                
                29,790,633
                
                
                
                37,295,042Loan
      to subsidiary
                
                
                -
                
                
                
                450,000Goodwill
                
                
                2,541,476
                
                
                
                2,541,476Other
      assets
                
                
                294,899
                
                
                
                513,738Total
      assets
                
                $
                33,247,479
                
                
                $
                41,239,696LIABILITIES
      AND STOCKHOLDERS’ EQUITYOther
      liabilities
                
                $
                60,000
                
                
                $
                488,187Other
      borrowings
                
                
                5,350,000
                
                
                
                4,250,000Total
      liabilities
                
                
                5,410,000
                
                
                
                4,738,187Stockholders’
      equity
                
                
                27,837,479
                
                
                
                36,501,509Total
      liabilities and stockholders’ equity
                
                $
                33,247,479
                
                
                $
                41,239,696
  STATEMENTS
      OF INCOMEYears
      Ended December 31,2009
                
                
                2008
                
                
                2007INCOMEDividends
                
                $
                1,180,260
                
                
                $
                1,475,325
                
                
                $
                1,280,260Interest
      income
                
                
                4,110
                
                
                
                33,336
                
                
                
                158,0391,184,370
                
                
                
                1,508,661
                
                
                
                1,438,299EXPENSESInterest
      expense
                
                
                221,093
                
                
                
                137,421
                
                
                
                24,882Other
      operating expenses
                
                
                802,084
                
                
                
                1,225,402
                
                
                
                623,405Income
      before equity in undistributed (loss) earnings
                
                
                161,193
                
                
                
                145,838
                
                
                
                790,012Equity
      in undistributed (loss) earnings of subsidiary
                
                
                (8,740,480
                )
                
                
                1,830,862
                
                
                
                (228,170
                )Income
      tax benefit
                
                
                400,648
                
                
                
                535,124
                
                
                
                309,310Net
      (loss) income
                
                $
                (8,178,639
                )
                
                $
                2,511,824
                
                
                $
                871,152
 83
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS December
31, 2009, 2008 and 2007
  Note
      21.
                                  Condensed
      Parent Information
      (continued)
 2009
                
                
                2008
                
                
                2007STATEMENTS
      OF CASH FLOWSCASH
      FLOWS FROM OPERATING ACTIVITIESNet
      (loss) income
                
                $
                (8,178,639
                )
                
                $
                2,511,824
                
                
                $
                871,152Adjustments
      to reconcile net (loss) income to net cash provided by operating
      activities:Stock
      compensation expense
                
                
                216,600
                
                
                
                279,400
                
                
                
                220,016Equity
      in undistributed (loss) income of subsidiary
                
                
                8,740,480
                
                
                
                (1,830,862
                )
                
                
                228,170Other
                
                
                247,241
                
                
                
                (534,415
                )
                
                
                19,095Net
      cash provided by operating activities
                
                
                1,025,682
                
                
                
                425,947
                
                
                
                1,338,433CASH
      FLOWS FROM INVESTING ACTIVITIESRepayment
      from subsidiary
                
                
                450,000
                
                
                
                300,000
                
                
                
                2,119,500Capital
      contribution to subsidiary
                
                
                (1,300,000
                )
                
                
                (2,500,000
                )
                
                
                -Net
      cash (used in) provided by investing activities
                
                
                (850,000
                )
                
                
                (2,200,000
                )
                
                
                2,119,500CASH
      FLOWS FROM FINANCING ACTIVITIESNet
      borrowings (repayments) under other borrowings
                
                
                1,100,000
                
                
                
                4,150,000
                
                
                
                (400,000
                )Purchase
      of common stock
                
                
                -
                
                
                
                (633,049
                )
                
                
                (1,751,291
                )Payment
      of dividends
                
                
                (1,094,651
                )
                
                
                (1,773,022
                )
                
                
                (1,303,577
                )Issuance
      of common stock
                
                
                -
                
                
                
                82,500
                
                
                
                72,926Net
      cash provided by (used in) financing activities
                
                
                5,349
                
                
                
                1,826,429
                
                
                
                (3,381,942
                )NET
      INCREASE IN CASH AND CASH EQUIVALENTS
                
                
                181,031
                
                
                
                52,376
                
                
                
                75,991CASH
      AND CASH EQUIVALENTS, beginning of year
                
                
                439,440
                
                
                
                387,064
                
                
                
                311,073CASH
      AND CASH EQUIVALENTS, end of year
                
                $
                620,471
                
                
                $
                439,440
                
                
                $
                387,064SUPPLEMENTAL
      DISCLOSURES OF CASH FLOW INFORMATIONCash
      paid during the year for:Interest
                
                $
                221,093
                
                
                $
                137,421
                
                
                $
                24,882Income
      taxes
                
                
                -
                
                
                
                -
                
                
                
                3,592,300
 
 84
 CORNERSTONE  BANCSHARES,  INC.  AND  SUBSIDIARY
 NOTES  TO  CONSOLIDATED  FINANCIAL  STATEMENTS
 December
31, 2009, 2008 and 2007
 Note
      22.
                            Quarterly
      Data
      (unaudited)
 Years
      Ended December 31,2009
                
                
                2008Fourth
                
                
                Third
                
                
                Second
                
                
                First
                
                
                Fourth
                
                
                Third
                
                
                Second
                
                
                FirstQuarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                Quarter
                
                
                QuarterInterest
      income
                
                $
                6,609,921
                
                
                $
                6,406,525
                
                
                $
                6,427,866
                
                
                $
                6,864,115
                
                
                $
                7,400,732
                
                
                $
                7,462,473
                
                
                $
                7,756,905
                
                
                $
                8,060,064Interest
      expense
                
                
                2,761,685
                
                
                
                2,765,954
                
                
                
                2,791,068
                
                
                
                2,870,676
                
                
                
                2,977,990
                
                
                
                3,026,759
                
                
                
                3,223,449
                
                
                
                3,469,876Net
      interest income, beforeprovision for loan
      losses
                
                
                3,848,236
                
                
                
                3,640,571
                
                
                
                3,636,798
                
                
                
                3,993,439
                
                
                
                4,422,742
                
                
                
                4,435,714
                
                
                
                4,533,456
                
                
                
                4,590,188Provision
      for loan losses
                
                
                4,150,000
                
                
                
                3,390,000
                
                
                
                1,633,898
                
                
                
                5,725,000
                
                
                
                2,571,000
                
                
                
                440,000
                
                
                
                170,000
                
                
                
                317,000Net
      interest (loss) income, after provisionfor loan
      losses
                
                
                (301,764
                )
                
                
                250,571
                
                
                
                2,002,900
                
                
                
                (1,731,561
                )
                
                
                1,851,742
                
                
                
                3,995,714
                
                
                
                4,363,456
                
                
                
                4,273,188Noninterest
      income (charges)
                
                
                (636,420
                )
                
                
                184,232
                
                
                
                730,291
                
                
                
                263,114
                
                
                
                496,420
                
                
                
                476,733
                
                
                
                524,572
                
                
                
                394,306Noninterest
      expenses
                
                
                3,930,984
                
                
                
                3,278,956
                
                
                
                3,773,359
                
                
                
                3,292,743
                
                
                
                3,104,109
                
                
                
                3,151,037
                
                
                
                3,215,991
                
                
                
                3,096,628(Loss)
      income before income taxes
                
                
                (4,869,168
                )
                
                
                (2,844,153
                )
                
                
                (1,040,168
                )
                
                
                (4,761,190
                )
                
                
                (755,947
                )
                
                
                1,321,410
                
                
                
                1,672,037
                
                
                
                1,570,866Income
      tax (benefit) expense
                
                
                (1,904,367
                )
                
                
                (1,144,617
                )
                
                
                (437,369
                )
                
                
                (1,849,687
                )
                
                
                (319,640
                )
                
                
                461,194
                
                
                
                598,981
                
                
                
                556,007Net
      (loss) income
                
                $
                (2,964,801
                )
                
                $
                (1,699,536
                )
                
                $
                (602,799
                )
                
                $
                (2,911,503
                )
                
                $
                (436,307
                )
                
                $
                860,216
                
                
                $
                1,073,056
                
                
                $
                1,014,859Earnings
      (loss) per common share:Basic
                
                $
                (0.46
                )
                
                $
                (0.26
                )
                
                $
                (0.09
                )
                
                $
                (0.45
                )
                
                $
                (0.07
                )
                
                $
                0.14
                
                
                $
                0.16
                
                
                $
                0.16Diluted
                
                $
                (0.46
                )
                
                $
                (0.26
                )
                
                $
                (0.09
                )
                
                $
                (0.45
                )
                
                $
                (0.07
                )
                
                $
                0.14
                
                
                $
                0.16
                
                
                $
                0.15
  85





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





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





ITEM
9A(T).  CONTROLS AND PROCEDURES





Disclosure
Controls and Procedures





Cornerstone
maintains disclosure controls and procedures, as defined in Rule 13a-15(e)
promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”), that
are designed to ensure that information required to be disclosed by it in the
reports that it files or submits under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Commission’s
rules and forms and that such information is accumulated and communicated to
Cornerstone’s management, including its Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required
disclosure. Cornerstone carried out an evaluation, under the supervision and
with the participation of its management, including its Chief Executive Officer
and Chief Financial Officer, of the effectiveness of the design and operation of
its disclosure controls and procedures as of the end of December 31,
2009.  Based on the evaluation of these disclosure controls and
procedures, the Chief Executive Officer and Chief Financial Officer have
concluded that as of December 31, 2009, Cornerstone’s disclosure controls and
procedures were effective.





Management’s Report on Internal
Control over Financial Reporting





The
report of Cornerstone’s management on internal control over financial reporting
is set forth in Item 8 of this Annual Report on Form 10-K and incorporated
herein by reference.





Changes in Internal
Controls





There
were no changes in Cornerstone’s internal control over financial reporting
during Cornerstone’s fiscal quarter ended December 31, 2009 that have
materially affected, or are reasonably likely to materially affect,
Cornerstone’s internal control over financial reporting.





ITEM
9B. OTHER INFORMATION





None





PART
III





ITEM
10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE





Information
relating to the directors and executive officers of Cornerstone is set forth
under the caption “Proposals—Election of Directors” in Cornerstone’s 2010 Proxy
Statement. Such information is incorporated into this report by
reference.





Information
relating to Cornerstone’s audit committee and audit committee financial experts
is set forth under the caption “Corporate Governance and the Board of
Directors—Audit Committee” in Cornerstone’s 2010 Proxy Statement. Such
information is incorporated into this report by reference.





Information
relating to compliance with the reporting requirements of Section 16(a) of the
Exchange Act by Cornerstone’s executive officers and directors, persons who
beneficially own more than ten percent of Cornerstone’s common stock and their
affiliates who are required to comply with such reporting requirements is set
forth under the caption “Other Matters—Section 16(a) Beneficial Ownership
Reporting Compliance” in Cornerstone’s 2010 Proxy Statement. Such information is
incorporated into this report by reference.





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




86




ITEM
      11.
            EXECUTIVE
      COMPENSATION





Information
relating to executive compensation is set forth under the captions “Executive
Compensation” and “Director Compensation” in Cornerstone’s 2010 Proxy Statement.
Such information is incorporated into this report by reference.





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





Information
relating to beneficial ownership of Cornerstone’s common stock by certain
persons is set forth under the caption “Security Ownership of Certain Beneficial
Owners and Management” in Cornerstone’s 2010 Proxy Statement. Such information
is incorporated into this report by reference.





Information
relating to Cornerstone’s equity compensation plans is set forth under the
caption “The Company’s Long-Term Equity and Qualified Retirements Plans—Equity
Compensation Plan Information as of December 31, 2009” in Cornerstone’s 2010
Proxy Statement. Such information is incorporated into this report by
reference.





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





Information
relating to certain transactions between Cornerstone and its affiliates and
certain other persons and to Cornerstone’s policies and procedures for approval
of such transactions is set forth under the captions “Certain Relationships and
Related Transactions” and “Corporate Governance and the Board of
Directors—Policies and Procedures for Approval of Related Person Transactions”
in Cornerstone’s 2010 Proxy Statement. Such information is incorporated into
this report by reference.





Information
relating to director independence is set forth under the caption “Corporate
Governance and the Board of Directors—Board Composition and Director
Independence” in Cornerstone’s 2010 Proxy Statement. Such information is
incorporated into this report by reference.





ITEM
      14.
            PRINCIPAL
      ACCOUNTANT FEES AND SERVICES





Information
relating to principal accountant fees and services is set forth under the
caption “Audit Committee—Audit and Non-Audit Fees” in Cornerstone’s 2010 Proxy
Statement. Such information is incorporated into this report by
reference.




87




ITEM
      15.
            EXHIBITS
      AND FINANCIAL STATEMENT SCHEDULES





(a)
            The
      following documents are filed as part of this report:(1)
            Financial
      StatementsThe
      following report and consolidated financial statements of Cornerstone and
      Subsidiaries are included in Item 8:Report
      of Independent Registered Public Accounting FirmConsolidated
      Balance Sheets as of December 31, 2009 and 2008Consolidated
      Statements of Income for the years ended December 31, 2009, 2008 and
      2007Consolidated
      Statement of Changes in Stockholders’ Equity for the years ended December
      31, 2009, 2008 and 2007Consolidated
      Statements of Cash Flows for the years ended December 31, 2009, 2008 and
      2007Notes
      to Consolidated Financial Statements(2)
            Financial
      Statement Schedules:Schedule
      II: Valuation and Qualifying AccountsAll
      other schedules for which provision is made in the applicable accounting
      regulation of the Securities and Exchange Commission are not required
      under the related instructions or are inapplicable and therefore have been
      omitted.(3)
            The
      following documents are filed or incorporated by reference as exhibits to
      this report:





Exhibit
      No.
            Description





3.1
            Amended
      and Restated Charter of Cornerstone Bancshares, Inc.
  (1)


3.2
            First
      Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc.
      (2)


3.3
            Amended
      and Restated Bylaws of Cornerstone Bancshares, Inc.
  (3)


4
            The
      right of securities holders are defined in the Charter and Bylaws provided
      in exhibits 3.1, 3.2 and 3.3
respectively.


10.1*
            Cornerstone
      Bancshares, Inc. Statutory and Nonstatutory Stock Option Plan.
      (4)


10.2*
            Cornerstone
      Bancshares, Inc. 2002 Long-Term Incentive Plan.
  (5)


10.3*
            Cornerstone
      Bancshares, Inc. 2004 Non-Employee Director Plan.
  (6)


10.4*
            Cornerstone
      Community Bank Employee Stock Ownership Plan.
  (7)


10.5*
            Key
      Executive and Employment Agreement with Nathaniel F. Hughes, as amended.
      (8)


10.6*
            Key
      Executive and Employment Agreement with Jerry D. Lee, as amended.
      (9)


10.7*
            Separation
      Agreement dated November 12, 2009, by and among Gregory B. Jones,
      Cornerstone Community Bank and Cornerstone Bancshares,
  Inc.


14
            Code
      of Ethics. (10)


21
            Subsidiaries
      of the registrant.


31.1
            Certification
      of principal executive officer.


31.2
            Certification
      of principal financial officer.


32
            Section
      906 certifications of chief executive officer and chief financial
      officer.







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


(1)
            Incorporated
      by reference to Exhibit 3.1 of the registrant’s Form 10-KSB filed on March
      24, 2004.


(2)
            Incorporated
      by reference to Exhibit 3 of the registrant’s Form 10-Q filed on May 14,
      2004.


(3)
            Incorporated
      by reference to Exhibit 3.2 of the registrant’s Form 10-KSB filed on March
      24, 2004.


(4)
            Incorporated
      by reference to Exhibit 10.1 of the registrant’s Registration Statement on
      Form S-1 filed on February 4, 2000, as amended (File No.
      333-96185).


(5)
            Incorporated
      by reference to Exhibit 99.1 of the registrant’s Registration Statement on
      Form S-8 filed March 5, 2004 (File No.
  333-113314).


(6)
            Incorporated
      by reference to Exhibit 99.3 of the registrant’s Registration Statement on
      Form S-8 filed March 5, 2004 (File No.
  333-113314).


(7)
            Incorporated
      by reference to Exhibit 10.1 of the registrant’s Form 8-K filed on July
      19, 2005.


(8)
            Incorporated
      by reference to Exhibit 10.3 of the registrant’s Registration Statement on
      Form S-1 filed on February 4, 2000 (File No.
  333-96185).


(9)
            Incorporated
      by reference to Exhibit 10.4 of the registrant’s Registration Statement on
      Form S-1 filed on February 4, 2000 (File No.
  333-96185).


(10)
            Incorporated
      by reference to Exhibit 14 of the registrant’s Form 10-KSB filed on March
      24, 2004.




88




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 30,
      2010
              By:
              /s/  Nathaniel F.
      HughesNathaniel
      F. HughesPresident
      & Chief Executive Officer(principal
      executive officer)


By:
              /s/  Gary W.
      Petty, Jr.Gary
      W. Petty, Jr.Senior
      Vice President and Chief Financial Officer(principal
      financial officer and accounting officer)
  89





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 30, 2010.




Signature
              
              
              Title/s/  W.
      Miller Welborn
              
              
              Chairman of the Board of DirectorsW.
      Miller Welborn/s/  Nathaniel
      F. Hughes
              
              
              President and Chief Executive OfficerNathaniel
      F. Hughes
              
              
              (principalexecutive officer) and Director/s/  B.
      Kenneth Driver
              
              
              DirectorB.
      Kenneth Driver/s/  Karl
      Fillauer
              
              
              DirectorKarl
      Fillauer/s/  David
      Fussell
              
              
              DirectorDavid
      Fussell/s/  Jerry
      D. Lee
              
              
              Executive Vice President and Senior LenderJerry
      D. Lee
              
              
              and
    Director/s/  Lawrence
      D. Levine
              
              
              DirectorLawrence
      D. Levine/s/ Frank
      S. McDonald
              
              
              DirectorFrank
      S. McDonald/s/  Doyce
      G. Payne
              
              
              DirectorDoyce
      G. Payne/s/  Billy
      O. Wiggins
              
              
              DirectorBilly
      O. Wiggins/s/  Marsha
      Yessick
              
              
              DirectorMarsha
      Yessick/s/  Gary
      W. Petty, Jr.
              
              
              Senior Vice President and Chief Financial OfficerGary
      W. Petty, Jr.
              
              
              (principal financial
      officer and accounting officer)





90





INDEX OF
EXHIBITS





Exhibit
      No.
            Description





3.1
            Amended
      and Restated Charter of Cornerstone Bancshares, Inc.
  (1)


3.2
            First
      Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc.
      (2)


3.3
            Amended
      and Restated Bylaws of Cornerstone Bancshares, Inc.
  (3)


4
            The
      right of securities holders are defined in the Charter and Bylaws provided
      in exhibits 3.1, 3.2 and 3.3
respectively.


10.1*
            Cornerstone
      Bancshares, Inc. Statutory and Nonstatutory Stock Option Plan.
      (4)


10.2*
            Cornerstone
      Bancshares, Inc. 2002 Long-Term Incentive Plan.
  (5)


10.3*
            Cornerstone
      Bancshares, Inc. 2004 Non-Employee Director Plan.
  (6)


10.4*
            Cornerstone
      Community Bank Employee Stock Ownership Plan.
  (7)


10.5*
            Key
      Executive and Employment Agreement with Nathaniel F. Hughes, as amended.
      (8)


10.6*
            Key
      Executive and Employment Agreement with Jerry D. Lee, as amended.
      (9)


10.7*
            Separation
      Agreement dated November 12, 2009, by and among Gregory B. Jones,
      Cornerstone Community Bank and Cornerstone Bancshares,
  Inc.


14
            Code
      of Ethics. (10)


21
            Subsidiaries
      of the registrant.


31.1
            Certification
      of principal executive officer.


31.2
            Certification
      of principal financial officer.


32
            Section
      906 certifications of chief executive officer and chief financial
      officer.





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


(1)
            Incorporated
      by reference to Exhibit 3.1 of the registrant’s Form 10-KSB filed on March
      24, 2004.


(2)
            Incorporated
      by reference to Exhibit 3 of the registrant’s Form 10-Q filed on May 14,
      2004.


(3)
            Incorporated
      by reference to Exhibit 3.2 of the registrant’s Form 10-KSB filed on March
      24, 2004.


(4)
            Incorporated
      by reference to Exhibit 10.1 of the registrant’s Registration Statement on
      Form S-1 filed on February 4, 2000, as amended (File No.
      333-96185).


(5)
            Incorporated
      by reference to Exhibit 99.1 of the registrant’s Registration Statement on
      Form S-8 filed March 5, 2004 (File No.
  333-113314).


(6)
            Incorporated
      by reference to Exhibit 99.3 of the registrant’s Registration Statement on
      Form S-8 filed March 5, 2004 (File No.
  333-113314).


(7)
            Incorporated
      by reference to Exhibit 10.1 of the registrant’s Form 8-K filed on July
      19, 2005.


(8)
            Incorporated
      by reference to Exhibit 10.3 of the registrant’s Registration Statement on
      Form S-1 filed on February 4, 2000 (File No.
  333-96185).


(9)
            Incorporated
      by reference to Exhibit 10.4 of the registrant’s Registration Statement on
      Form S-1 filed on February 4, 2000 (File No.
  333-96185).


(10)
            Incorporated
      by reference to Exhibit 14 of the registrant’s Form 10-KSB filed on March
      24, 2004.




91