10-K

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

^{______________}

FORM 10-K

^{______________}

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

For the fiscal year ended December 31, 2006

OR

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

For the transition period from _______ to ________                   

^{Commission file number 000-30497}

^{(Exact Name of Registrant as Specified in its Charter)}

Tennessee	62-1173944
(State of Incorporation)	(IRS Employer Identification No.)

835 Georgia Avenue,
Chattanooga, TN 37402

(Address of Principal Executive Offices)(Zip Code)

(423) 385-3000

(Registrant’s Telephone Number, Including Area Code)

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

Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $1.00 par value

Indicate by check mark if Registrant is a well known seasoned issuer, as defined in Rule 405 of the of the Securities Act. Yes ¨  No ý

Indicate by check mark if Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨  No ý

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 ý  No ¨

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

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

Large Accelerated Filer ¨ Accelerated Filer ¨ Non-accelerated Filer ý

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) Yes ¨  No ý

The aggregate market value of the common stock held by non-affiliates of the Registrant on June 30, 2006 was $61 million. The market value calculation was determined using the closing sale price of the Registrant’s common stock on June 30, 2006, as reported on the Over the Counter (“OTC”) Bulletin Board. For purposes of this calculation, the term “affiliate” refers to all directors, executive officers and 10% shareholders of the Registrant. As of the close of business on February 15, 2007 there were 6,511,848 shares of the Registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

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

1. Portions of Proxy Statement for 2007 Annual Meeting of Shareholders. (Part III)

CORNERSTONE BANCSHARES, INC.

Annual Report on Form 10-K
For the Fiscal Year Ended December 31, 2007

Table of Contents

Item Number		Page Number
	Part I
1.	Description of Business	2
1A.	Risk Factors	8
1B.	Unresolved Staff Comments	13
2.	Description of Property	13
3.	Legal Proceedings	13
4.	Submission of Matters to a Vote of Security Holders	13
	Part II
5.	Market for Common Equity, Related Stockholders Matters and Issuer Purchases of Equity Securities	14
6.	Selected Financial Data	15
7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
7A.	Quantitative and Qualitative Disclosures About Market Risk	38
8.	Financial Statements and Supplementary Data	39
9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	39
9A.	Controls and Procedures	39
	Part III
10.	Directors and Executive Officers of the Registrant	39
11.	Executive Compensation	39
12.	Security Ownership of Certain Beneficial Owners and Management and related Stockholder Matters	39
13.	Certain Relationships and Related Transactions	40
14.	Principal Accountant Fees and Services	40
15.	Exhibits and Reports on Form 8-K	40

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FORWARD-LOOKING STATEMENTS

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

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

PART I

Item 1. Description of Business

Business Development

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

Business of the Company

The Company

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

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

The Bank

The Bank 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, 2006, the Bank had 5 full-service banking offices located in Hamilton County, Tennessee.

On January 31, 2007, the Bank established banking services in Dalton, Georgia with the opening of its first Loan Production Office. The new office which is located in Whitfield County, Georgia expanded the Bank’s presence in North Georgia and represents the Bank’s first effort to service North West Georgia.

Eagle

Eagle’s business concentrates on the purchase of account receivables from small businesses and commercial loan placement on a conduit basis. The principal sources of Eagle’s income are fees derived from the collection of accounts receivable and fees generated from the placement of loans with conduit financial institutions. Eagle’s

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principal expenses are interest paid on borrowings, employee compensation and benefits, office expenses and other overhead expenses.

Employees

As of February 15, 2007, the Company and the Bank collectively had 102 full-time equivalent employees of whom 98 are full-time, and 9 are part-time. The employees are not represented by a collective bargaining unit. The Company and the Bank believe that their relationships with their employees are good.

Customers

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

Competition

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

Based on total deposits of approximately $275,817,000 at December 31, 2006, the Bank represents 3.61% of the deposit base in the Chattanooga, Tennessee-Georgia Metropolitan Statistical Area (“Chattanooga MSA”). Three major regional banks represent approximately 60% of the deposits in the Chattanooga MSA. These larger financial institutions have greater resources and higher lending limits than the Bank, and each of the three institutions has over 20 branches in the Chattanooga MSA. There are several credit unions located in Hamilton County. Since credit unions are not subject to income taxes in the way commercial banks are, credit unions have an advantage in offering competitive rates to potential customers. The Bank also faces competition in certain areas of its business from mortgage banking companies, consumer finance companies, insurance companies, money market mutual funds and investment banking firms, some of which are not subje ct to the same degree of regulation as the Bank.

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

Supervision and Regulation

General

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

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

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

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Insurance of Deposit Accounts

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

On September 15, 1992, the FDIC approved final regulations adopting a risk-related deposit insurance system. The risk-related regulations, which became effective January 1, 1993, resulted in a significant spread between the highest and lowest deposit insurance premiums. Under the risk-related insurance regulations, each insured depository institution is assigned to one of three risk classifications: “well capitalized,” “adequately capitalized,” or “under capitalized.”  Within each risk classification, there are three subgroups. Each insured depository institution is assigned to one of these subgroups within its risk classification based upon supervisory evaluations submitted to the FDIC by the institution’s primary federal regulator. Depending upon a BIF member’s risk classification and subgroup, applicable regulations provide that its deposit insurance premium may be as low as 0.004% of insured dep osits or as high as .31% of insured deposits. Additionally, because the BIF has exceeded its designated reserve ratio, the FDIC has now reduced to zero the assessment rate that is applicable to the most highly rated BIF members. The Bank has been notified that, based on its risk classification and supervisory subgroup, its BIF assessment rate is 0.004% of insured deposits for the period from January 1, to December 31, 2006. This is the most favorable assessment rate applicable to insured institutions. In addition, the Deposit Insurance Funds Act of 1998 (DIFA) requires that a Financing Corporation (“FICO”) assessment be paid by the Bank. The annual FICO assessment rate for banks is presently 0.0124% of deposits. The Bank paid $31,222 in assessments during the year ended December 31, 2006.

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 capita l to risk-weighted assets ratio must be at least 8.0%. The FDIC’s current leverage capital requirement requires banks receiving the highest regulatory rating based upon the FDIC’s routine examination process, to maintain Tier 1 capital equal to 3.0% of the bank’s total assets. Banks receiving lower regulatory ratings are required to maintain Tier 1 capital in an amount that is at least 100 to 200 basis points higher than 3.0% of total assets.

The Bank had Tier 1 capital of $31.6 million or 9.36% of total year to date average assets as of December 31, 2006 compared to Tier 1 capital of $26.0 million or 9.20% of total year to date average assets as of December 31, 2005.

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

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credit standards with respect to, loans and other extensions of credit to officers, directors and principal shareholders of the Bank and to related interests of such persons.

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

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

Tennessee Supervision and Regulation

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

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

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

The Company is regularly examined by the Board, and the Bank is supervised and examined by the FDIC. The Company is required to file with the Board annual reports and other information regarding its business operations and the business operations of its subsidiaries. Approval of the Board is required before the Company may acquire, directly or indirectly, ownership or control of the voting shares of any bank, if, after such acquisition, the Company would own or control, directly or indirectly, more than 5% of the voting stock of the bank. In addition, pursuant to the provisions of the Act and the regulations promulgated thereunder, the Company may only engage in, or own or

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control companies that engage in, activities deemed by the Board to be so closely related to banking as to be a proper incident thereto.

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

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

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

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

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

Legislation Affecting the Company and the Bank

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

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

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.

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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-bas ed capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (4) a “significantly undercapitalized” institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based ratio of under 3% or a leverage ratio of under 3%; and (5) a “critically undercapitalized” institution has a leverage ratio of 2% or less. Institutions in any of the three undercapitalized categories would be prohibited from declaring dividends or making capital distributions. The proposed regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital. Various other sections of the FDICIA impose substantial audit and reporting requirements and increase the role of independent accountants and outside directors. Set forth below is a list containing certain significant provisions of the FDICIA:

·

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

·

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

·

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

·

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

·

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

·

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

·

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

·

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

·

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

·

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

·

uniform regulations regarding real estate lending; and

·

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

The activities permissible to the Company and the Bank were substantially expanded by the Gramm-Leach-Bliley Act (the “Gramm Act”). The Gramm Act repeals the anti-affiliation provisions of the Glass-Steagall Act to permit the common ownership of commercial banks, investment banks and insurance companies. The Gramm Act amended the Act to permit a financial holding company to engage in any activity and acquire and retain any company that the Board determines to be (i) financial in nature or incidental to such financial activity, or (ii) complementary to a financial activity and that does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. The Gramm Act also modifies current law relating to

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financial privacy and community reinvestment. The new financial privacy provisions generally prohibit financial institutions, including the Bank and the Company, from disclosing nonpublic personal financial information to third parties unless customers have the opportunity to “opt out” of the disclosure.

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

Item 1A. Risk Factors

The Company’s business strategy includes the continuation of growth plans, and its financial condition and results of operations could be affected if its business strategies are not effectively executed.

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

·

Maintaining loan quality;

·

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

·

Maintaining adequate control and compliance functions.

Operating Results. There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits. The Company’s growth and de novo branch openings strategy necessarily entails growth in overhead expenses as it routinely adds new branch locations and staff. The Company’s historical results may not be indicative of future results or results that may be achieved as the Company continues to increase the number and concentration of its branch locations.

Development of Offices. There are considerable costs involved in opening branches and new branches generally do not generate sufficient revenues to offset their costs until they have been in operation for at least a year or more. Accordingly, the Company’s de novo branches will likely have a negative impact on its earnings during the period of time until the branches reach certain economies of scale.

Expansion into New Markets. Much of the Company’s future growth will focused in the highly competitive Knoxville metropolitan market (the Bank is in the process of establishing a Loan Production Office in Knoxville). In the Knoxville market the Company faces competition from a wide array of financial institutions. The Company’s expansion into this new market may be impacted if it is unable to meet customer demands or compete effectively with the financial institutions operating in these markets.

Regulatory and Economic Factors. The Company’s growth and expansion plans may be adversely affected by a number of regulatory and economic developments or other events. Failure to obtain required regulatory approvals, changes in laws and regulations or other regulatory developments and changes in prevailing economic conditions or other unanticipated events may prevent or adversely affect the Company’s continued growth and expansion.

Failure to successfully address the issues identified above could have a material adverse effect on the Company’s business, future prospects, financial condition or results of operations, and could adversely affect the Company’s ability to successfully implement its business strategy.

The Company could sustain losses if its asset quality declines.

The Company’s earnings are affected by its ability to properly originate, underwrite and service loans. The Company could sustain losses if it incorrectly assesses the creditworthiness of its borrowers or fails to detect or respond to deterioration in asset quality in a timely manner. Problems with asset quality could cause the Company’s interest income and net interest margin to decrease and its provisions for loan losses to increase, which could adversely affect the Company’s results of operations and financial condition.

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An inadequate allowance for loan losses would reduce the Company’s earnings.

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. Management maintains an allowance for loan losses based upon, among other things, historical experience, 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 collectibility 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 collectibility 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 the bank regulatory authorities require the Bank to increase the allowance for loan losses as a part of their examination process, the Company’s earnings and capital could be significantly and adversely affected.

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

The Company relies on dividends from the Bank as its primary source of funds. The primary source of funds of the Bank are 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 ability of borrowers to repay 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, the Company may be required from time to time to rely on secondary sources of liq uidity to meet withdrawal demands or otherwise fund operations. Such sources include Federal Home Loan Bank advances and federal funds lines of credit from correspondent banks. While the Company believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. The Company may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate.

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

The banking business is highly competitive and the Company experiences competition in each of its markets from many other financial institutions. The Company competes with 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 Company’s primary market areas and elsewhere.

Additionally, the Company 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 Company’s customers, and may attempt to hire the Company’s management and employees.

The Company competes with these other financial institutions both in attracting deposits and in making loans. In addition, the Company has to attract its customer base from other existing financial institutions and from new residents. The Company 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. The Company’s profitability depends upon its continued ability to successfully compete with an array of financial institutions in its market areas.

The Company may face risks with respect to future expansion.

From time to time the Company may engage in additional de novo branch expansion as well as the acquisition of other financial institutions or parts of those institutions. The Company may also consider and enter into new lines

9

of business or offer new products or services. In addition, the Company may receive future inquiries and have discussions with potential acquirors of the Company. 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;

·

the Company’s ability to finance an acquisition and possible dilution to its existing shareholders;

·

the diversion of the Company’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 the Company lacks experience;

·

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

·

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

·

the risk of loss of key employees and customers.

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

The Company’s business is subject to the success of the local economies where it operates.

The Company’s success significantly depends upon the growth in population, income levels, deposits and housing starts in its market areas. If the communities in which the Company operates do not grow or if prevailing economic conditions locally or nationally are unfavorable, the Company’s business may not succeed. Adverse economic conditions in the Company’s specific market areas could reduce its growth rate, affect the ability of its customers to repay their loans to the Company and generally affect its financial condition and results of operations. Moreover, the Company cannot give any assurance that it will benefit from any market growth or favorable economic conditions in its primary market areas if they do occur.

Any adverse market or economic conditions in the State of Tennessee or the State of Georgia may increase the risk that the Company’s borrowers will be unable to timely make their loan payments. In addition, the market value of the real estate securing loans as collateral could be adversely affected by unfavorable changes in market and economic conditions. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the State of Tennessee or the State of Georgia could adversely affect the value of the Company’s assets, revenues, results of operations and financial condition.

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

Changes in interest rates may affect the Company’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 the Company’s control, including general economic conditions and the policies of various governmental and regulatory authorities. Accordingly, changes in interest rates could decrease the Company’s net interest income. Changes in the level of interest rates also may negatively affect the Company’s ability to originate real estate loans, the value of the Company’s assets and the Company’s ability to realize gains from the sale of its assets, all of which ultimately affects the Company’s earnings.

10

The Company relies heavily on the services of key personnel.

The Company depends substantially on the strategies and management services of Gregory B. Jones, its Chairman of the Board and Chief Executive Officer. Although the Company has entered into an employment agreement with him, the loss of the services of Mr. Jones could have a material adverse effect on the Company’s business, results of operations and financial condition. The Company is also dependent on certain other key officers who have important customer relationships or are instrumental to its operations. Changes in key personnel and their responsibilities may be disruptive to the Company’s business and could have a material adverse effect on the Company’s business, financial condition and results of operations.

The Company believes that its future results will also depend in part upon its attracting and retaining highly skilled and qualified management and sales and marketing personnel, particularly in those areas where the Company may open new branches. Competition for such personnel is intense, and the Company cannot assure you that it will be successful in attracting or retaining such personnel.

The Company is subject to extensive regulation that could limit or restrict its activities.

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

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

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

The Company’s recent results may not be indicative of its future results.

The Company may not be able to sustain its historical rate of growth or may not even be able to grow its business at all. In addition, the Company’s recent growth may distort some of its historical financial ratios and statistics. In the future, the Company may not have the benefit of several recently favorable factors, such as a generally stable economic environment or the ability to find suitable expansion opportunities. Various factors, such as interest rate environment, regulatory and legislative considerations and competition, may also impede or prohibit the Company’s ability to expand its market presence.

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

As a Tennessee corporation, the Company is subject to various legislative acts which impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire the Company and increase the difficulty of consummating any such offers, even if the acquisition of the Company would be in its shareholders’ best interests. The Company’s amended and restated charter also contains provisions which may make it difficult for another entity to acquire it without the approval of a majority of the disinterested directors on its board of directors.

The amount of common stock owned by, and other compensation arrangements with, the Company’s officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose.

As of February 15, 2007, directors and executive officers beneficially owned approximately 22.29% of the Company’s common stock. Agreements with the Company’s senior management also provide for significant

11

payments under certain circumstances following a change in control. These compensation arrangements, together with the common stock and option ownership of the Company’s board of directors and management, could make it difficult or expensive to obtain majority support for shareholder proposals or potential acquisition proposals of us that the Company’s directors and officers oppose.

The Company’s continued pace of growth may require it to raise additional capital in the future, but such capital may not be available when it is needed or on terms acceptable to the Company.

The Company is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. While the Company’s capital resources will satisfy its capital requirements for the foreseeable future, the Company may at some point, however, need to raise additional capital to support its continued growth.

The Company’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time, which are outside its control, and on its financial performance. Accordingly, the Company cannot assure its shareholders that it will be able to raise additional capital if needed or that any such additional capital can be obtained on terms acceptable to it. If the Company cannot raise additional capital when needed, its ability to further expand its operations through internal growth and acquisitions could be materially impaired.

The success and growth of the Company’s business 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 and on-line banking capabilities and other customer expected conveniences that are cost efficient to the Company’s business processes. As these technologies are improved in the future, the Company may, in order to remain competitive, be required to make significant capital expenditures.

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

The Company 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, the Company’s shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.

The Company cannot predict the effect, if any, that future sales of its common stock in the market, or availability of shares of its common stock for sale in the market, will have on the market price of the Company’s common stock. The Company, 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.

The market price of the Company’s common stock may fluctuate in the future, and these fluctuations may be unrelated to its performance. General market price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices.

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

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

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

The Company derives its income solely from dividends on the shares of common stock of the Bank and Eagle. The Bank’s and Eagle’s ability to declare and pay dividends is limited by its obligations to maintain sufficient

12

capital and by other general restrictions on its dividends that are applicable to banks that are regulated by the FDIC and the Department of Financial Institutions. In addition, the FRB may impose restrictions on the Company’s ability to pay dividends on its common stock. As a result, the Company cannot assure its shareholders that it will declare or pay dividends on shares of its common stock in the future.

Item 1B. Unresolved Staff Comments

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

Item 2. Description of Property

As of December 31, 2006, the principal offices of the Company and the Bank are located at 835 Georgia Avenue, Chattanooga, Tennessee 37402. This property is leased by the Company. In addition, the Bank operates five full-service branches and one loan production office that are located at:

Branches	4154 Ringgold Road, East Ridge, Tennessee
	5319 Highway 153, Hixson, Tennessee
	2280 Gunbarrel Road, Chattanooga, Tennessee
	8966 Old Lee Highway, Ooltewah, Tennessee
	835 Georgia Avenue, Chattanooga, Tennessee
Loan Production Office	202 West Crawford Street, Dalton, Georgia (Opened January 2007)

The new Georgia Avenue branch contains 9,000 square feet and is leased pursuant to a lease agreement with an initial term of ten years and with renewal options. Rent is currently $ 165,000 per annum. The space houses the former branch location at 610 Georgia Avenue and the Executive Offices of the Company. The Bank owns the properties located at 2280 Gunbarrel Road, 4154 Ringgold Road, 5319 Highway 153 and 8966 Old Lee Highway.

The Company operates a service center to house all its non-customer contact functions located at 6401 Lee Corners, Suite B, Chattanooga, Tennessee. The facility has 15,600 square feet and is leased pursuant to a lease agreement which provides for an initial term of five years with one five-year renewal option. Rent is currently $89,000 per annum.

The company opened a loan production office in Dalton, Georgia. The location is leased and the rent is currently $10,800 per annum.

Item 3. Legal Proceedings

As of the end of 2006, neither the Company, the Bank nor Eagle was involved in any material litigation. The Bank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business. Management believes that any claims pending against the Company 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 the Company’s consolidated financial position.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted during the fourth quarter of 2006 to a vote of security holders of the Company through a solicitation of proxies or otherwise.

13

PART II

Item 5. Market for the Common Equity: Related Stockholder Matters and Issuer Purchases of Equity Securities

On February 15, 2007, the Company had 6,511,848 shares of common stock outstanding. The Company’s common stock is quoted on the OTC Bulletin Board but is not listed on a national securities exchange. Morgan Keegan, a subsidiary of Regions Bank, is the principal market maker for Cornerstone stock. There are nine other market makers who assist in providing a market.

Table 1 below sets forth the high and low closing prices of the Company’s common stock for the periods indicated, as reported by published sources and as adjusted to reflect a 100% stock dividend paid on December 19, 2006 and on September 16, 2004. The prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

There were approximately 601 holders of record of the common stock as of December 31, 2006. This number does not include shareholders with shares in nominee name held by DTC. As of the end of 2006, there were 3,339,146 shares held in nominee name by DTC.

The Company paid quarterly cash dividends in 2006 in the amount of $0.03 per share. The Company announced, in December 2006, a first quarter dividend of $0.05, which was paid January 8, 2007. The Company’s board of directors will continue to evaluate the amount of future dividends, if any, after the Company’s capital needs required for expected growth of assets are reviewed. The payment of dividends is solely within the discretion of the board of directors, considering the Company’s expenses, the maintenance of reasonable capital and risk reserves, and appropriate capitalization requirements for state banks.

TABLE 1

High and Low Common Stock Share Price for the Company

	Low		High		Dividends paid Per Share
2007 Fiscal Year
First Quarter (through February 2007)	$	15.20	$	16.50	$	0.05
2006 Fiscal Year
First Quarter	$	11.63	$	13.63	$	0.03
Second Quarter	$	11.70	$	12.88	$	0.03
Third Quarter	$	11.70	$	13.39	$	0.03
Fourth Quarter	$	13.05	$	17.00	$	0.03
2005 Fiscal Year
First Quarter	$	7.87	$	9.25	$	0.05
Second Quarter	$	8.38	$	9.25	$	0.00
Third Quarter	$	8.80	$	10.25	$	0.04
Fourth Quarter	$	9.75	$	12.50	$	0.00
2004 Fiscal Year
First Quarter	$	5.00	$	6.25	$	0.03
Second Quarter	$	5.75	$	6.95	$	0.00
Third Quarter	$	5.95	$	7.50	$	0.00
Fourth Quarter	$	7.00	$	8.50	$	0.00

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

14

TABLE 2

Equity Compensation Plan
Year Ended December 31, 2006

Plan category	Number of securities to be  issued upon exercise of outstanding options	Weighted average exercise price of outstanding options		Number of securities remaining available for future issuance
Equity compensation plans approved by security holders:	736,120	$	6.23	749,720
Equity compensation plans not approved by security holders:	0	$	0.00	0
Total	736,120	$	6.23	749,720

Item 6. Selected Financial Data.

	At and for the Fiscal Years Ended December 31,
	2006			2005			2004			2003			2002
	(Dollars in Thousands)
Total interest income	$	29,158		$	20,672		$	14,058		$	11,326		$	9,702
Total interest expense		10,306			6,077			3,575			3,210			3,308
Net interest income		18,852			14,594			10,483			8,115			6,393
Provision for loan losses		1,106			1,401			840			545			683
Net interest income after provision for loan losses		17,746			13,193			9,643			7,570			5,710
Non-interest income:
Investment securities gains		—			—			—			—			—
Other income		2,111			1,904			1,405			1,241			1,002
Non-interest expense		10,718			8,216			6,885			5,740			4,983
Income before income taxes		9,139			6,881			4,163			3,071			1,729
Income tax expense		3,328			2,556			1,592			1,189			667
Net income	$	5,811		$	4,325		$	2,571		$	1,881		$	1,061
Per Share Data:
Net income, basic	$	0.90		$	0.71		$	0.52		$	0.38		$	0.22
Net income, assuming dilution	$	0.85		$	0.66		$	0.46		$	0.36		$	0.21
Dividends paid	$	0.12		$	0.09		$	0.03		$	0.00		$	0.00
Book value	$	5.86		$	5.07		$	4.32		$	3.40		$	3.07
Tangible book value(1)	$	5.40		$	4.54		$	3.88		$	2.89		$	2.56
Financial Condition Data:
Assets	$	374,942		$	323,611		$	248,614		$	200,996		$	159,902
Loans, net of unearned interest	$	305,879		$	262,008		$	202,555		$	155,278		$	123,096
Cash and investments	$	51,557		$	46,074		$	34,614		$	33,118		$	27,632
Federal funds sold	$	—		$	—		$	—		$	3,060		$	460
Deposits	$	275,816		$	252,435		$	187,832		$	159,352		$	130,446
FHLB advances and line of credit	$	39,500		$	30,000		$	27,000		$	17,400		$	10,000
Subordinated debentures	$	—		$	—		$	—		$	—		$	—
Federal funds purchased and repurchase agreements	$	19,249		$	4,790		$	7,409		$	6,084		$	3,503
Shareholders’ equity	$	38,183		$	32,466		$	24,807		$	16,903		$	15,146
Tangible shareholders’ equity(1)	$	35,137		$	29,089		$	22,266		$	14,362		$	12,605
Selected Ratios:
Interest rate spread		5.16	%		4.93	%		4.70	%		4.54	%		4.46	%
Net interest margin(2)		5.81	%		5.43	%		5.02	%		4.87	%		4.86	%
Return on average assets		1.69	%		1.51	%		1.15	%		1.06	%		0.74	%
Return on average equity		16.27	%		14.98	%		13.83	%		7.38	%		7.24	%
Return on average tangible equity(1)		17.78	%		16.96	%		16.02	%		8.76	%		8.76	%
Average equity to average assets		10.36	%		10.09	%		8.30	%		9.04	%		10.21	%
Dividend payout ratio		13.33	%		12.17	%		4.84	%		0.00	%		0.00	%
Ratio of nonperforming assets to total assets		0.40	%		0.47	%		0.08	%		0.07	%		0.18	%
Ratio of allowance for loan losses to nonperforming loans		25.90	%		20.70	%		5.33	%		0.00	%		3.06	%
Ratio of allowance for loan losses to total average loans, net of unearned income		1.50	%		1.50	%		1.47	%		1.42	%		1.48	%

15

——————

(1)

Tangible shareholders’ equity is shareholders’ equity less goodwill and intangible assets.

(2)

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

GAAP Reconciliation and Management Explanation of Non-GAAP Financial Measures

Certain financial information included in our summary consolidated financial data is determined by methods other than in accordance with U.S. generally accepted accounting principles or GAAP. These non-GAAP financial measures are “tangible book value per share,” “tangible shareholders’ equity,” and “return on average tangible equity.” The Company’s management uses these non-GAAP measures in its analysis of the Company’s 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 the Company 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. The following reconciliation table provides a more detailed analysis of these non-GAAP performance measures:

	At and for the Fiscal Years Ended December 31,
	2006			2005			2004			2003			2002
Book value per share	$	5.86		$	5.07		$	4.32		$	3.40		$	3.07
Effect of intangible assets per share	$	0.47		$	0.53		$	0.44		$	0.51		$	0.51
Tangible book value per share	$	5.40		$	4.54		$	3.88		$	2.89		$	2.56
Return on average equity		16.27	%		14.98	%		13.83	%		7.38	%		7.24	%
Effect of intangible assets		1.51	%		1.98	%		2.19	%		1.38	%		1.52	%
Return on average tangible equity		17.78	%		16.96	%		16.02	%		8.76	%		8.76	%

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation

Forward-Looking Statements

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

16

period. The purpose of this type of information is to provide readers with information relevant to understanding and assessing the financial condition and results of operations of the Company, and not to predict the future or to guarantee results. The Company is unable to predict the types of circumstances, conditions and factors that can cause anticipated results to change. The Company undertakes no obligation to publish revised forward-looking statements to reflect the occurrence of changes or unanticipated events, circumstances, or results.

Management’s Discussion And Analysis Or Plan Of Operation

General

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

Summary

The Company’s net income increased to $5,811,600 for 2006 compared to $4,324,519 for 2005 and $2,571,083 in 2004. The increase in net income represents a 34.3% increase from 2005 to 2006 and a 68.2% increase from 2004 to 2005. Net income per common share increased to $.90 for 2006 compared to $.71 for 2005 and $.52 for 2004. The increase in net income per common share from 2005 to 2006 was 26.7% and a 36.5% from 2004 to 2005. Pretax income was $9,139,123, $6,881,135 and $4,163,583 for 2006, 2005 and 2004, respectively. This represents a 32.8% increase from 2005 to 2006 and a 65.2% increase from 2004 to 2005.

The increase in net income per common share in 2006, 2005 and 2004 results directly from the dramatic growth of the Company’s earning assets. This growth coupled with repetitive loan and security repricing as the Federal Reserve increased the target Federal Funds rate throughout each of these years helped the Company realize an increase of $4,258,407 or 29.1% increase in net interest income from 2005 to 2006 and $4,110,866 or 39.2% increase from 2004 to 2005. Also contributing to improved net income was an increase in non-interest income of 10.8% from 2005 to 2006 and 35.5% from 2004 to 2005. Most of the increase was due to operating lease income, a new product line the Bank introduced in 2004, and the sale of commercial loans to conduit lenders. As the Bank continued to grow its loan portfolio at a rapid pace, the loan loss provision amounted to $1,106,000 in 2006, $1,401,600 in 2005 and $840,000 in 2004. Non-interest expense increased 3 0.4% in 2006, 19.3% in 2005 and 20.1% in 2004. The majority of the increases were attributable to additional salaries and benefits as the Bank continued to increase the number of relationship mangers and support staff as well as the addition of depreciation expense associated with leased assets.

Business of the Company

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

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

17

For the fiscal years ended December 31, 2006, 2005 and 2004, the Company’s weighted average rate earned on all interest-earning assets was 8.98%, 7.68% and 6.73% respectively. Conversely, the Company’s weighted average rate paid on all interest-bearing liabilities for the same years was 3.82%, 2.75% and 2.03%, respectively. The Company’s interest rate spread for the years ended December 31, 2006, 2005, and 2004 was 5.16%, 4.93% and 4.70% respectively. The net interest income for the same period of time was $18,852,697, $14,594,290 and $10,483,424, respectively. For fiscal year 2006, the Company recorded net income of $5,811,600 or $0.90 basic earnings per common share as compared with net income of $4,324,519 or $0.71 basic earnings per common share for fiscal year 2005 and net income of $2,571,083 or $0.52 basic earnings per common share for fiscal year 2004. During 2006, 2005 and 2004 the Bank was abl e to increase net income due to an increase in the Bank’s net interest income of 29.1%, 39.2% and 29.1%, respectively. During same period of time the Bank was able to control non-interest expense with increases of 30.4%, 19.3% and 19.9%, respectively.

Results of Operations

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

Net interest income before loan loss provision increased by $4,258,407, $4,110,866 and $2,367,805 for the years ended 2006, 2005 and 2004. This represents an increase of 29.2%, 39.2% and 29.2% respectively. The increase in net interest income during these years is due to material growth of the balance sheet and the interest rate sensitivity of the Bank’s assets compared to its liabilities. This was a favorable position to take advantage of the rapid and predictable increases due to the Bank’s loan and security portfolios being mostly variable rate instruments. Loan origination fees continued to remain strong as the Bank became more proficient at Small Business Administration (SBA) lending and asset based lending. The Bank anticipates loan growth to continue along with loan origination fees. Interest expense increased 69.6%, 70.0% and 11.4% in 2006, 2005 and 2004, respectively. Cornerstone funded the rapid asset growth primarily with certificates of deposit and money market deposits which are typically more expensive for new deposits while retaining existing deposits.

Interest income increased $8,486,724, $6,613,367 and $2,732,297 for 2006, 2005 and 2004, respectively. The increase as a percentage was 41.0% in 2006 when compared to 2005 and 47.0% when comparing 2005 to 2004. Interest income produced by the loan portfolio increased $7,963,262 or 41.2% in 2006 compared to 2005 and $6,323,768 or 48.5% from 2005 to 2004. Interest income on investment securities and Federal Funds sold increased slightly at $523,462 or 39.71% in 2006 when compared to 2005 and $289,599 or 28.2% when comparing 2005 to 2004. The increases in loan interest income were due to a large increase in the volume and rate of loans as the portfolio grew, and was increased further by loan origination fees and servicing fees generated by the origination of SBA loans. The Bank attributes the strong loan growth to an increase in the number of relationship managers and their level of expertise. The small securities income increase was due to the g enerally higher interest rate environment, which presented few opportunities to invest without material interest rate risk exposure. Total interest expense increased $4,228,317 or 69.6% in 2006 when compared to 2005 and $2,502, 501 or 70.0% when comparing 2005 to 2004.

One of the most useful tools for measuring the ability of a community bank to make money is its ability to maximize its net interest margin and its interest rate spread. The net interest margin, or the net yield on earning assets, is computed by dividing fully taxable equivalent net interest income by average-earning assets. This ratio represents the difference between the average yield on average-earning assets and the average rate paid for all funds used to support those earning assets. The Company’s net interest margin for 2006, 2005 and 2004 was 5.81%, 5.43% and 5.02%, respectively. The net interest spread, defined as the rate of interest income minus the rate of interest expense was 5.16%, 4.93%, and 4.70% in 2006, 2005 and 2004, respectively. The yield on earning assets during the same time period was 8.98%, 7.68% and 6.73%, respectively.

Allowance for Loan Loss. The allowance for possible loan loss represents management’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for possible loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. Management believes that the allowance for possible loan losses balances of $4,258,352, and $3,545,042 for the years ending 2006 and 2005 were sufficient to absorb known credit risks in the portfolio. No assurance can be given, however, that adverse economic

18

circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

Non-performing Assets. Non-performing assets include non-performing loans and foreclosed real estate held for sale. Non-performing loans include loans classified as non-accrual or renegotiated. Cornerstone’s policy is to place a loan on non-accrual status when it is contractually past due 90 days or more as to payment of principal or interest. At the time a loan is placed on non-accrual status, interest previously accrued but not collected may be reversed and charged against current earnings. Recognition of any interest after a loan has been placed on non-accrual status is accounted for on a cash basis. For the years ending December 31, 2006 and 2005 the Company had $1,482,833 and $1,731,383 of non-performing assets, respectively.

Non-interest Income. Non-interest income consists of revenues generated from a broad range of financial services and activities including fee-based services and profits and commissions earned through credit life insurance sales and other activities. In addition, gains or losses realized from the sale of investment securities are included in non-interest income. Total non-interest income increased by $206,536 in 2006 when compared to 2005 and $498,844 in 2005 when compared to 2004. This represents an increase of 10.8% from 2005 to 2006 and an increase of 35.5% from 2004 to 2005. Fee income from service charges on deposit accounts increased $313,956, $84,872 and $10,408 during 2006, 2005 and 2004, respectively. The Bank had no security gains in 2006, 2005 or 2004.

Non-interest Expense. Non-interest expense increased by $2,501,955 and $1,330,558 for 2006 and 2005, respectively. The change from 2005 to 2006 amounted to a 30.5% increase while the change from 2004 to 2005 represents a 19.3% increase. Salaries and employee benefits increased by $1,515,709, $602,405 and $575,035 for 2006, 2005 and 2004, respectively. The change represents an increase of 33.6% from 2005 to 2006 and an increase of 15.4% from 2004 to 2005. These increases primarily resulted from the hiring of additional personnel to cover the growth of the Bank. Occupancy expense increased 25.1% in 2006, 12.0% in 2005 and 12.2% in 2004 as the Bank continued to operate five full service branches and update equipment. Other non-interest expense increased $904,951 or 36.6% in 2006 and $443,055 or 21.8% in 2005. This increase was primarily related to data processing and other expenses incurred in connection with the Bank’s growth.

Financial Condition

Earning Assets. Average earning assets increased $56.1 million or 20.85% in 2006 and $59.3 or 28.3% in 2005. The increase in average earnings assets can be attributed to the increase in the Bank’s loan portfolio. This loan growth led the expansion of the balance sheet and the Bank funded the loan growth with a combination of FHLB borrowings, money market deposits and certificates of deposit. The average security portfolio grew $6.5 million or 21.9% in 2006 and $2.6 million or 9.6% in 2005 to maintain an appropriate amount of securities for pledging purposes and liquidity.

Loan Portfolio. The Bank’s average loans were $284.1 million and $236.3 million for the years ended 2006 and 2005, respectively. The percentage change in the average loan balance for 2006 was an increase of 20.2% and an increase of 30.3% for 2005. The actual balance, before the loan loss allowance, at the end of 2006 and 2005 was $310.1 million and $265.6 million. This represents an increase of $44.5 million when comparing the 2005 balance to the 2006 balance and $60.3 million when comparing the 2004 balance to the 2005 balance. Loan growth for 2005 and 2006 was evenly weighted throughout these years with several large, high quality loans greatly increasing the Bank’s outstanding balances. The growth was concentrated in commercial and commercial real estate. The Bank hired additional relationship mangers during 2006 in an effort to continue the Bank’s growth. The Bank feels strongly that the key to success in lending, as well as for the Bank as a whole, is to hire talented employees to provide outstanding customer service in a safe and sound manner.

Investment Securities. Cornerstone’s average investment securities portfolio increased $6.5 million from 2005 to 2006 and $2.6 million from 2004 to 2005. At the same time Federal Funds increased $1.7 million in 2006 and $1.8 million in 2005. The average investment portfolio and average federal funds sold for 2006 was $40.9 million and $32.7 million in 2005. Cornerstone maintains an investment strategy of seeking portfolio yields within acceptable risk levels as well as providing liquidity, pledging requirements and GAP management. To accomplish these strategies, the Bank positioned the Investment Portfolio on the assumption that there was a higher probability of rates continuing to rise, and as a result took a cautious interest rate stance and invested appropriately. The majority of the purchases during 2006 were in US Agency callable notes structured with an interest rate cushion to protect the Bank if interest rates continue to r ise. The Bank allowed its US Agency LIBOR floaters to be called as

19

rates increased during 2006 without replacing them, as the agency U.S. Agency callable securities represented a better value due to the compressed spreads on the LIBOR floaters and scarcity of the security. Cornerstone maintains two classifications of investment securities:  “Held to Maturity” and “Available for Sale.”  The “Available for Sale” securities are carried at fair market value, whereas “Held to Maturity” securities are carried at book value. As of year end 2006 and 2005 the unrealized losses in the “Available for Sale” portfolio amounted to $174,457 and $341,466, respectively.

Intangibles. During 2002, the Company adopted the provisions of Statement of Financial Statement No. 142 Goodwill and other Intangible Assets concerning the $2,541,476 goodwill created by the merger with the Bank of East Ridge. Goodwill and is tested annually for impairment. If the carrying value of goodwill exceeds the fair value, a write-down is recorded. No impairment loss was recognized during 2006, 2005 or 2004. Also, in December, 2005, the Company completed the purchase of Eagle Financial, Inc. and recorded an intangible asset of 848,916. Amortization expense relating to this intangible for 2006 and 2005 was $345,388 and $13,500, respectively.

Deposits. Cornerstone’s average deposits increased $46 million or 21.2% and $43.5 million or 25.2% during 2006 and 2005, respectively. Total actual deposits increased $23.3 million or 9.26% in 2006 when compared to 2005 and $64.6 million or 34.4% when comparing 2005 to 2004. The Bank’s deposit strategy continues to be focused on attracting transaction deposits from business customers while filling funding gaps with certificate of deposit specials to attract incremental funds while not driving up the cost of certificates already on the books. The Bank saw extraordinary success during these years in attracting business and public deposits to the Bank. Average interest bearing transaction accounts increased 24% in 2006 and 25% in 2005. Furthermore, average demand deposits increased 6.7% and 24.4% in 2006 and 2005. This success partially funded the Bank’s loan growth and allowed the Bank to maintain its net interest margin at an above peer bank level. The Bank expects to continue its focus on attracting deposits from businesses, especially transaction accounts, which are less expensive and tie the customer base closely to the Bank.

Capital Resources. Stockholders average equity increased $6.8 million or 23.7% in 2006 and increased $10.3 million or 55.4% in 2005. The Company had net income of $5,811,600 in 2006, $4,324,519 in 2005 and $2,571,093 in 2004. The actual balance of stockholders’ equity increased $5.7 million or 17.6% in 2006 and $7.7 million or 30.9% in 2005. During 2005, the Company completed the 500,000 shares initial offering that began at the end of 2004 and represented approximately $7 million in additional capital. Also during 2005, several directors exercised non-qualified options adding an additional $2.2 million to the Company’s capital. In December 2006, the Company completed a 2-for-1 stock split increasing the number of outstanding common shares from 3,200,863 as of year end 2005 to a total of 6,511,848 at year end 2006. The Board of Directors decided they preferred for the stock price to remain in the historic range of $15 to $30. During the first quarter of 2007 the Company’s stock has traded between $15 and $17 per share on the OTC Bulletin Board.

Net Interest Income

Table 3 below sets forth information with respect to interest income from average interest earning assets, expressed both in dollars and yields, and interest expense on average interest bearing liabilities, expressed both in dollars and rates, for the periods indicated. The table includes loan yields, which reflect the amortization of deferred loan origination and commitment fees. Interest income from investment securities includes the accretion of discounts and amortization of premiums.

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TABLE 3

Yields Earned on Average Earning Assets and
Rates Paid on Average Interest Bearing Liabilities

	Years Ended December 31,
	2006							2005							2004
	Average Balance			Interest Income/ Expense(1)		Yield/ Rate		Average Balance			Interest Income/ Expense(1)		Yield/ Rate		Average Balance			Interest Income/ Expense(1)		Yield/ Rate
	(in thousands)
ASSETS
Interest-earning assets:
Loans(1)(2)	$	284,105		$	27,317	9.61	%	$	236,265		$	19,354	8.19	%	$	181,335		$	13,030	7.19	%
Investment securities(3)		36,218			1,584	4.48	%		29,705			1,217	4.24	%		27,115			1,006	3.87	%
Federal funds sold		4,686			258	5.51	%		2,976			101	3.39	%		1,218			23	1.89	%
Other earning assets		0			0	0.00	%		0			0	0.00	%		0			0	0.00	%
Total interest-earning assets		325,009			29,159	8.98	%		268,946			20,672	7.68	%		209,668			14,059	6.73	%
Allowance for loan losses		(4,104	)						(3,025	)						(2,293	)
Cash and other assets		23,836							20,288							16,426
Total assets	$	344,741						$	286,209						$	223,801
TOTAL LIABILITIES AND EQUITY
Interest-bearing liabilities:
Deposits:
NOW accounts	$	34,701			427	1.23	%	$	33,943			329	0.97	%	$	28,843			138	0.48	%
Money market / Savings		58,477			2,225	3.80	%		45,232			1,107	2.45	%		32,282			429	1.33	%
Time deposits, $100m and Over		43,692			1,993	4.56	%		32,611			1,145	3.51	%		25,734			649	2.52	%
Time deposits, under $100m		88,773			3,899	4.39	%		70,167			2,240	3.19	%		58,367			1,457	2.50	%
Total interest-bearing deposits		225,643			8,544	3.78	%		181,953			4,821	2.65	%		145,226			2,673	1.84	%
Federal funds purchased		4,570			232	5.07	%		4,269			143	3.35	%		2,140			33	1.54	%
Securities sold under agreement to repurchase		4,020			116	2.88	%		3,501			60	1.71	%		2,575			23	0.89	%
Other borrowings		35,429			1,414	3.98	%		30,973			1054	3.40	%		25,942			846	3.26	%
Total interest-bearing Liabilities		269,662			10,306	3.82	%		220,696			6,078	2.75	%		175,889			3,575	2.03	%
Net interest spread						5.16	%						4.93	%						4.70	%
Other liabilities:
Demand deposits		37,056							34,730							27,918
Accrued interest payable and other liabilities		2,295							1,909							1,408
Stockholders’ equity		35,728							28,874							18,586
Total liabilities and stockholders’ equity	$	344,741						$	286,209						$	223,801
Net interest margin				$	18,853	5.80	%				$	14,594	5.43	%				$	10,484	5.02	%

——————

(1)

Interest income on loans includes amortization of deferred loan fees and other discounts of $288 thousand, $262 thousand and $229 thousand for the fiscal years ended December 31, 2006, 2005, and 2004, respectively.

(2)

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

(3)

Yields on securities are calculated on a fully tax equivalent basis.

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Table 4 sets forth the changes in interest income and interest expense that are attributable to three factors: (i) a change in volume or amount of an asset or liability; (ii) a change in interest rates; or (iii) a change caused by the combination of changes in asset or deposit mix. The following table describes the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Company’s interest income and expense during the periods indicated. For each category of interest-earning assets and interest bearing liabilities, information is provided as to changes attributable to change in volume (change in volume multiplied by current rate) and change in rates (change in rate multiplied by current volume). The remaining difference has been allocated to mix.

TABLE 4

INTEREST INCOME AND EXPENSE ANALYSIS

	Year Ended December 31, 2006 Compared to 2005
	Volume		Rate		Mix			Net Change
	(in thousands)
Interest income:
Loans(1)(2)	$	4,597	$	4,034	$	(668	)	$	7,963
Investment securities		292		87		(12	)		367
Federal funds sold		106		113		(62	)		157
Other earning assets		0		0		0			0
Total interest income									8,487
Interest expense:
NOW accounts		9		90		(1	)		98
Money market and savings accounts		503		789		(174	)		1,118
Time deposits, $100,000 and over		596		459		(207	)		848
Time deposits, less than $100,000		817		1,065		(223	)		1,659
Other borrowings		177		209		(23	)		363
Federal funds purchased		15		74		(3	)		86
Securities sold under agreement to repurchase		15		51		(10	)		56
Total interest expense									4,228
Change in net interest income (expense)								$	4,259

INTEREST INCOME AND EXPENSE ANALYSIS

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

——————

(1)

Loan amounts include non-accruing loans.

(2)

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

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Lending Activities

Loan Policy

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

General

At December 31, 2006 and 2005, the Company’s loan portfolio constituted approximately 81.5% and 81.0% of the Company’s total assets, respectively. When broken down by subsidiary the loan portfolio constituted approximately 82.1% and 82.9% for the Bank, and 87.1% and 76.7% for Eagle for 2006 and 2005, respectively. Table 5 sets forth the composition of the Company’s loan portfolio at the indicated dates.

TABLE 5

Loan Portfolio Composition

	Years Ending December 31,
	2006				2005				2004				2003				2002
	Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent		Amount		Percent
	(in thousands)
Commercial, financial and agricultural	$	98,542	31.77	%	$	86,039	32.40	%	$	61,742	30.09	%	$	42,420	26.97	%	$	28,034	22.48	%
Real estate – construction		57,606	18.57	%		47,071	17.72	%		36,824	17.94	%		24,081	15.31	%		20,517	16.46	%
Real estate – mortgage		48,700	15.70	%		45,645	17.19	%		38,193	18.61	%		28,185	17.92	%		28,331	22.72	%
Real estate – commercial		99,197	31.98	%		79,608	29.98	%		61,860	30.14	%		56,527	35.94	%		41,926	33.62	%
Consumer loans		6,092	1.98	%		7,191	2.71	%		6,602	3.22	%		6,077	3.86	%		5,880	4.72	%
Total loans	$	310,137	100.00	%	$	265,554	100.00	%	$	205,221	100.00	%	$	157,290	100.00	%	$	124,688	100.00	%

Table 6 sets forth the scheduled maturities of the loans in the Company’s loan portfolio as of December 31, 2006 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.

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TABLE 6

Loans Maturing
Year-end balance as of December 31, 2006

	Less than One Year		1 to 5 Years		Over 5 Years		Total
	(in thousands)
Commercial, financial and agricultural	$	86,693	$	11,333	$	516	$	98,542
Real estate – construction		56,658		892		56		57,606
Real estate – mortgage		25,779		21,504		1,417		48,700
Real estate – commercial		53,505		44,080		1,612		99,197
Consumer		2,590		3,460		42		6,092
Total Loans	$	225,225	$	81,269	$	3,643	$	310,137

Types of Loans

Commercial Loans

Commercial, industrial, and non-farm non-residential loans, hereinafter referred to as commercial loans (excluding commercial construction loans) totaled $98.5 million or 31.77% and $86.0 million or 32.4% of the Company’s loan portfolio at December 31, 2006 and 2005, respectively. Commercial loans consist of loans and lines of credit to individuals, partnerships and corporations for a variety of business purposes, such as accounts receivable and inventory financing, equipment financing, business expansion and working capital. The terms of the Bank’s commercial loans generally range from 90 days to a 15 year amortization with a five year balloon. The loans generally carry interest rates, which adjust in accordance with changes in the prime rate, but when appropriate will be fixed to match the borrower’s needs. Substantially all of the Bank’s commercial loans are secured and are guaranteed by the principals of the borrower. T his is the fastest growing area of the loan portfolio and is being staffed to continue this trend. The Bank believes this area has the best potential for future growth and has the highest barriers of entry to our competitors.

Loans secured by marketable equipment are required to be amortized over a period not to exceed 60 months. Generally, loans secured by current assets such as inventory or accounts receivable are structured as revolving lines of credit with annual maturities. Loans secured by chattel mortgages and accounts receivable may not exceed 85% of their market value. Loans secured by listed stocks, municipal bonds and mutual funds may not exceed 70% of their market value. Unsecured short term loans and lines of credit must meet criteria set by the Bank’s Loan Committee. Current financial statements support all commercial loans, and such financial statements are updated annually. Commercial loans, which are considered small business loans, are the core business of the Bank. Most loans are made with a long-term relationship intended and the Bank also seeks to obtain the borrower’s business and personal depository accounts.

Real Estate – Construction Loans

As of December 31, 2006, Cornerstone had $57.6 million in construction and development loans outstanding, which represented 18.6%% of the loan portfolio. As of December 31, 2005 the amount in construction and development loans totaled $47.1 million or 17.7% of the loan portfolio. All construction and development loans are held in the Bank’s loan portfolio. The Bank makes residential construction loans to owner-occupants and to persons building residential properties for resale. The Bank has two main areas of construction loans: one is to residential real estate developers for speculative or custom single-family residential properties, and the other is to custom commercial construction projects with guaranteed takeout provisions. Construction loans are usually variable rate loans made for terms of one year or less, but extensions are permitted if construction has continued satisfactorily and if the loan is current and other circumstances w arrant 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

24

construction. Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages and other unpredictable contingencies, it is relatively difficult to accurately evaluate the total loan funds required to complete a project and to accurately evaluate the related loan-to-value ratios. If the estimates of construction costs and the saleability of the property upon completion of the project prove to be inaccurate, the Bank may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value proves to be inaccurate, the Bank may be confronted, at or prior to the maturity of the loan, with a project with a value that is insufficient to assure full repayment.

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

Real Estate – Mortgage Loans

At December 31, 2006 and 2005, real estate mortgage loans totaled $48.7 million or 15.7% and $45.6 million or 17.2% of the Company’s loan portfolio, respectively. Real estate mortgage loans include all one to four family residential loans secured by real estate for purposes other than construction or acquisition and development. All real estate loans are held in the Bank’s loan portfolio except for loans that are designated as loans held for sale. The loans held for sale are FHLB or FNMA qualified and have been pre-approved by an underwriting specialist prior to closing. As of December 31, 2006 and 2005, the Bank held $701 thousand and $603 thousand of these secondary market mortgages, respectively. 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 experien ce indicates that real estate loans normally remain outstanding for much shorter periods (seven years on average) than their stated maturity because the borrowers repay the loans in full either upon the sale of the secured property or upon the refinancing of the original loan.

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

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

Real Estate – Commercial

For the years ended 2006 and 2005, commercial real estate mortgage loans totaled $99.2 million or 31.89% and $79.6 million or 30.0% of the Company’s loan portfolio, respectively. 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 provisi ons 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.

25

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

For the years ended 2006 and 2005, consumer loans totaled $6.1 million or 2.0% and $7.2 million or 2.7% of the Company’s loan portfolio, respectively. These loans consist of consumer installment loans and consumer credit card balances. As of December 31, 2006 and 2005, the Bank had $504 thousand and $951 thousand credit card balances outstanding, respectively.

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

Lending Commitments

Commitments under standby letters of credit and undisbursed loan commitments increased from $63,972,000 in 2005 to $68,023,000 in 2006. 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 loans primarily in Hamilton County, Tennessee. The Bank also originates loans in Marion, Sequatchie, Knox and Bradley Counties in Tennessee, and Dade, Walker, Whitfield and Catoosa Counties in Georgia, each of which is within a 50 miles of Chattanooga. Loans are originated by fifteen loan officers who operate from the Bank’s offices in Chattanooga and one in the Bank’s Loan Production Office (“LPO”) in Dalton, Georgia and one in the proposed LPO in Knoxville, Tennessee. These loan officers actively solicit loan applications from existing customers, local manufacturers and retailers, builders, real estate developers, real estate agents and others. The Bank also receives numerous loan applications as a result of customer referrals and walk-ins to its offices.

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

The Bank’s loan approval process is intended to be conservative but also responsive to customer needs. Loans are approved in accordance with the Bank’s written loan policy, which provides for several tiers of approval authority, based on a borrower’s aggregate debt with the Bank. Certain loan officers have the authority to approve loans of up to $1,000,000. All other loan officers have the authority to approve secured loans of up to at least $25,000. There is an Officers Loan Committee comprised of the senior officers of the Bank which must approve any loan that increases the borrower’s aggregate indebtedness above an individual officer’s limit, but that is not more than $4,000,000. The Directors Loan Committee must approve all loans over $4,000,000 up to $7,000,000. All loans above $7,000,000 up to the Bank’s legal lending limit must be approved by the Board of Directors of the Bank. The Bank’s legal lending limit is 25% of the Bank’s qualifying equity for secured loans and 15% for unsecured loans.

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

26

from $4.5 million in 2005 to $8.2 million in 2006. The Bank maintained its participations sold at a relatively constant level of $20.8 million in 2005 as compared to $19.4 million in 2006.

Loan Fee Income

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

Commitment fees are charged by the Bank to the borrower for certain loans and are calculated as a percentage of the principal amount of the loan. These fees normally are deducted from the proceeds of the loan and generally range from 1/2% to 2% of the principal amount, depending on the type and volume of loans made and market conditions such as the demand for loans, the availability of money and general economic conditions. The Bank complies with FASB 91 and amortizes all significant loan fees over the life of the loan.

The Bank also receives miscellaneous fee income from late payment charges, overdraft fees, property inspection fees, and miscellaneous services related to its existing loans. For the years ended December 31, 2006, 2005 and 2004, the Bank recognized origination, commitment and other loan fees totaling $1.4 million, $1.6 million and $1.4 million, respectively.

Problem Loans and Allowance for Loan Losses

Problem Loans

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

The Bank’s loan portfolio is systematically reviewed by the Bank’s management, internal auditors, external auditors, and State and Federal regulators to ensure that the Bank’s larger loan relationships are being maintained within the loan policy guidelines, and remain properly underwritten. Input from all the above sources is used by the Bank to take corrective actions as necessary. As discussed below, each of the Bank’s loans is assigned a rating in accordance with the Bank’s internal loan rating system. All past due loans are reviewed by the Bank’s senior lending officers and all past due loans over $25,000 are reviewed monthly by the Director’s Loan Committee. All loans classified as substandard or doubtful, as well as any “special mention” loans (defined in the following paragraph), are placed on the Bank’s watch list and reviewed at least monthly by the Director’s Loan Committee. In a ddition, 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

27

certain limits, in determining the Bank’s regulatory capital, while specific valuation allowances for loan losses do not qualify as regulatory capital.

The Bank’s collection procedures provide that when a loan becomes 15 days and 30 days delinquent, the borrower is contacted by mail and payment is requested. If the delinquency continues, subsequent efforts are made to contact and request payment from the delinquent borrower. Most loan delinquencies are cured within 60 days and no legal action is required. In certain circumstances, the Bank, for a fee, may modify the loan, grant a limited moratorium on loan payments or revise the payment schedule to enable the borrower to restructure his or her financial affairs. Generally, the Bank stops accruing interest and any accrued non collected interest will be reversed in accordance with GAAP on delinquent loans when payment is in arrears for 90 days or when collection otherwise becomes doubtful. If the delinquency exceeds 120 days and is not cured through the Bank’s normal collection procedures or through a restructuring, the Bank will inst itute measures to enforce its remedies resulting from the default, including commencing a foreclosure, repossession or collection action. In certain cases, the Bank will consider accepting a voluntary conveyance of collateral in lieu of foreclosure or repossession. Real property acquired by the Bank as a result of foreclosure or by deed in lieu of foreclosure is classified as “real estate owned” until it is sold and is carried at the lower of cost or fair value less estimated costs to dispose. Accounting standards define fair value as the amount that is expected to be received in a current sale between a willing buyer and seller other than in a forced or liquidation sale. Fair values at foreclosure are based on appraisals. Losses arising from the acquisition of foreclosed properties are charged against the allowance for loan losses. Subsequent write-downs are provided by a charge to income through losses on other real estate in the period in which the need arises.

The Bank attempts to sell real estate owned promptly after foreclosure. During 2006 and 2005 the Bank sold $806,346 and $224,696 of its real estate owned due to loan foreclosures, respectively. The book value of real estate owned that was sold by the Bank during 2006 was $773,436 and $244,916 for 2005. As of December 31, 2006, the Bank had $380,000 in value of real estate owned as a result of foreclosure compared to $781,000 in 2005.

Table 7 sets forth information regarding the Company’s delinquent and non-performing assets as of the dates indicated.

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 collectibility 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, 2006 is adequate to absorb possible losses from loans cu rrently in the portfolio.

28

TABLE 7

Delinquent and Non-performing Assets

	Actual for Years Ending December 31,
	2006			2005
	(in thousands)
Accruing loans that are contractually past due 90-days or more:
Commercial, financial and agricultural	$	0		$	216
Real estate – construction		0			0
Real estate – mortgage		0			0
Consumer		0			0
Total Loans	$	0		$	216
Non-accruing loans 90-days or more:
Commercial, financial and agricultural	$	127		$	0
Real estate – construction		186			52
Real estate – mortgage		789			670
Consumer		0			12
Total Loans	$	1,102		$	734
Real estate acquired through foreclosure	$	380		$	776
Property acquired through repossession		0			5
Total acquired		380		$	781
Total Loans	$	310,137		$	265,554
Ratio of non-performing assets to total loans		0.48	%		0.66	%
Ratio of delinquent (30-days or more) but accruing loans to:
Total loans		0.77	%		0.82	%
Total assets		0.63	%		0.67	%

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

Table 8 summarizes the Company’s loan loss experience for the periods indicated.

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TABLE 8

Loan Loss Reserve Analysis

	Years Ending December 31,
	2006			2005			2004			2003			2002
	(in thousands)
Average loans	$	284,105		$	236,265		$	181,335		$	141,586		$	107,676
Allowance for possible loan losses, Beginning of the period	$	3,545		$	2,658		$	2,011		$	1,591		$	1,322
Charge-offs for the period:
Commercial, financial and agricultural		307			275			165			223			423
Real estate – construction		0			48			0			0			0
Real estate – mortgage		104			128			138			6			12
Consumer		70			111			69			106			62
Total charge-offs		481			562			372			335			497
Recoveries for the period:
Commercial, financial and agricultural		66			12			149			183			75
Real estate – construction					1			0			3			0
Real estate – mortgage		7			6			7			0			7
Consumer		15			28			23			24			27
Total recoveries		88			47			179			210			109
Net charge-offs for the period		393			515			186			125			388
Provision for loan losses		1,106			1,402			840			545			683
Adjustments		0			0			0			0			(26	)
Allowance for possible loan losses, end of period	$	4,258		$	3,545		$	2,658		$	2,011		$	1,591
Ratio of allowance for loan losses to total average loans outstanding		1.50	%		1.50	%		1.47	%		1.42	%		1.48	%
Ratio of net charge-offs during the period to average loans outstanding during the period		0.14	%		0.22	%		0.10	%		0.09	%		0.36	%

Table 9 below sets forth the Company’s allocation of the allowance for loan losses as of December 31, 2006, 2005 and 2004.

TABLE 9

Allowance for Loan Losses

	Years Ending December 31,
	2006					2005					2004
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 Loans
	(in thousands)
Commercial, financial and agricultural	$	1,686		31.77	%	$	1,438		32.40	%	$	1,002		30.09	%
Real estate – construction		1,581		18.57	%		1,253		17.72	%		962		17.94	%
Real estate – commercial		703		31.98	%		535		29.98	%		361		30.14	%
Real estate – mortgage		77		15.70	%		79		17.19	%		122		18.61	%
Consumer		211		1.98	%		240		2.71	%		211		3.22	%
Totals	$	4,258		100.00	%	$	3,545		100.00	%	$	2,658		100.00	%

30

	2003					2002
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
	(in thousands)
Commercial, financial and agricultural	$	840		26.97	%	$	537		22.48	%
Real estate – construction		539		15.31	%		524		16.46	%
Real estate – commercial		352		35.94	%		245		33.62	%
Real estate – mortgage		139		17.92	%		138		22.71	%
Consumer		141		3.86	%		147		4.72	%
Totals	$	2,011		100.00	%	$	1,591		100.00	%

Investment Activities

Investment Policy

The objective of the Company’s investment policy is to invest funds not otherwise needed to meet the loan demand of the Company’s market area and to meet the following five objectives: Gap Management, Liquidity, Pledging, Return, and Local Community Support. In doing so, Cornerstone uses the portfolio to provide structure and liquidity that the loan portfolio cannot. The management investment committee balances the market risk and credit risks against the potential investment return, make investments compatible with the pledge requirements of the Company’s deposit of public funds, maintain compliance with regulatory investment requirements, and assists the various public entities with their financing needs. The management investment committee is authorized to execute security transactions for the investment portfolio based on the decisions of the Board of Directors Asset Liability Committee (“ALCO”). All the investment transactions occurring since the previous ALCO meeting are reviewed by the ALCO at its next monthly meeting, in addition to the entire portfolio. The investment policy allows portfolio holdings to include short-term securities purchased to provide the Bank’s needed liquidity and longer-term securities purchased to generate stable income for the Bank during periods of interest rate fluctuations.

The Bank’s investment portfolio totaled $ 33.9 million or 9.1% of total assets as of year end 2006 compared to a total of $ 31.5 million or 9.7% as of year end 2005.

Table 10 sets forth the carrying value of the Bank’s investments at the dates indicated. Securities are held in both available for sale and held to maturity categories. Securities available for sale are carried at fair market value and securities held to maturity are held at their book value.

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TABLE 10

Securities Portfolio

	Years Ending December 31,
	2006		2005		2004
Securities available for sale:
U.S. Government and agency obligations	$	26,470	$	22,349	$	10,977
Mortgage-backed and other securities		2,634		4,000		11,326
State and political subdivisions tax-exempt		3,249		3,285		3,140
Corporate debt		0		494		1,027
Totals	$	32,353	$	30,128	$	26,470
Securities held to maturity:
U.S. Government and agency obligations	$	0	$	0	$	0
Mortgage-backed and other securities		236		322		391
State and political subdivisions tax-exempt		0		0		0
Corporate debt		0		0		0
Totals	$	236	$	322	$	391
Federal Home Loan Bank stock, at cost		1,332		1,034		854
Total Securities	$	33,921	$	31,484	$	27,715

For December 31, 2006 tables 11 and 12 set forth the book value of the Bank’s investments, the weighted average yields on the Bank’s investments and the periods to maturity of the Bank’s investments for the “Securities Available for Sale” and the “Securities Held to Maturity,” respectively.

TABLE 11

Weighted Average Yields on the Available For Sale Investments
Periods of Maturity from December 31, 2006

	Less than 1 year				1 to 5 years				5 to 10 years				Over 10 years
Securities available for sale:	Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)
U.S. Treasuries	$	0	0.00	%	$	0	0.00	%	$	0	0.00	%	$	0	0.00	%
U.S. Government agencies		7,610	4.21	%		16,801	4.46	%		0	0.00	%		2,059	5.76	%
Mortgage-backed securities(2)		1	7.49	%		3	5.43	%		14	6.75	%		2,616	5.57	%
Tax-exempt municipal bonds		0	0.00	%		558	4.71	%		1,167	4.43	%		1,525	5.34	%
Other bonds, notes, debentures and securities		0		%		0	0.00	%		0	0.00	%		0	0.00	%
Totals	$	7,611	4.21	%	$	17,362	4.47	%	$	1,181	4.46	%	$	6,199	5.58	%
Total Securities Available for Sale	$	32,353	4.62	%

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TABLE 12

Weighted Average Yields on the Held To Maturity Investments
Periods of Maturity from December 31, 2006

	Less than 1 year					1 to 5 years					5 to 10 years					Over 10 years
Securities Held to Maturity:	Amount		Weighted Avg. Yield(1)			Amount		Weighted Avg. Yield(1)			Amount		Weighted Avg. Yield(1)			Amount		Weighted Avg. Yield(1)
U.S. Treasuries	$	0		0.00	%	$	0		0.00	%	$	0		0.00	%	$	0	0.00	%
U.S. Government agencies		0		0.00	%		0		0.00	%		0		0.00	%		0	0.00	%
Mortgage-backed securities(2)		0		0.00	%		19		7.50	%		0		0.00	%		217	5.59	%
Tax-exempt municipal bonds		0		0.00	%		0		0.00	%		0		0.00	%		0	0.00	%
Other bonds, notes, debentures and securities		0		0.00	%		0		0.00	%		0		0.00	%		0	0.00	%
Totals	$	0		0.00	%	$	19		7.50	%	$	0		0.00	%	$	217	5.59	%
Total Securities held to maturity	$	236		5.75	%
Federal Home Loan Bank stock, at cost	$	1,332		5.82	%
Total Securities	$	33,921		4.66	%

——————

(1)

The weighted average yields on tax exempt securities have been computed on a tax equivalent basis.

(2)

Mortgages are allocated by maturity and not amortized

For December 31, 2005 tables 13 and 14 set forth the book value of the Bank’s investments, the weighted average yields on the Bank’s investments and the periods to maturity of the Bank’s investments for the “Securities Available for Sale” and the “Securities Held to Maturity,” respectively.

TABLE 13

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

	Less than 1 year				1 to 5 years				5 to 10 years				Over 10 years
Securities Available for Sale:	Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)
U.S. Treasuries	$	0	0.00	%	$	0	0.00	%	$	0	0.00	%	$	0	0.00	%
U.S. Government agencies		0	0.00	%		22,350	4.36	%		0	0.00	%		739	5.71	%
Mortgage-backed securities(2)		0	0.00	%		10	6.67	%		20	6.68	%		3,230	4.42	%
Tax-exempt municipal bonds		0	0.00	%		565	4.71	%		619	4.16	%		2,101	5.22	%
Other bonds, notes, debentures and securities		494	7.02	%		0	0.00	%		0	0.00	%		0	0.00	%
Totals	$	494	7.02	%	$	22,925	4.37	%	$	639	4.24	%	$	6,070	4.86	%
Total Securities Available for Sale	$	30,128	4.51	%

33

TABLE 14

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

	Less than 1 year				1 to 5 years				5 to 10 years				Over 10 years
Securities held to maturity:	Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)		Amount		Weighted Avg. Yield(1)
U.S. Treasuries	$	0	0.00	%	$	0	0.00	%	$	0	0.00	%	$	0	0.00	%
U.S. Government agencies		0	0.00	%		0	0.00	%		0	0.00	%		0	0.00	%
Mortgage-backed securities(2)		0	0.00	%		29	7.50	%		37	6.68	%		256	5.87	%
Tax-exempt municipal bonds		0	0.00	%		0	0.00	%		0	0.00	%		0	0.00	%
Other bonds, notes, debentures and securities		0	0.00	%		0	0.00	%		0	0.00	%		0	0.00	%
Totals	$	0	0.00	%	$	29	7.50	%	$	37	6.68	%	$	256	5.87	%
Total Securities held to maturity	$	322	6.02	%
Federal Home Loan Bank stock, at cost	$	1,034	4.87	%
Total Securities	$	31,484	4.54	%

——————

(1)

The weighted average yields on tax exempt securities have been computed on a tax equivalent basis.

(2)

Mortgages are allocated by maturity and not amortized

Sources of Funds

General

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

Deposits

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

Table 15 sets forth the composition of deposits for the Company, excluding accrued interest payable, by type for the years ended December 31, 2006, December 31, 2005 and December 31, 2004.

34

TABLE 15

	Deposit Composition Years Ending December 31,
	2006		2005		2004
	(in thousands)
Demand deposits	$	41,723	$	42,118	$	34,024
NOW deposits		38,160		33,080		32,855
Savings & money market deposits		56,913		55,411		31,211
Time deposits under $100,000		94,476		83,119		59,653
Time deposits $100,000 and over		44,544		38,707		30,089
Total Deposits	$	275,816	$	252,435	$	187,832

Table 16 presents a breakdown by category of the average amount of deposits and the average rate paid on deposits for the periods indicated:

TABLE 16

	Average Amount and Average Rate Paid on Deposits Years Ending December 31,
	2006				2005				2004
	Amount		Rate		Amount		Rate		Amount		Rate
	(in thousands)
Demand deposits	$	37,056			$	34,730			$	27,918
NOW deposits		34,701	1.23	%		33,943	0.97	%		28,843	0.48	%
Savings & money market deposits		58,477	3.80	%		45,232	2.45	%		32,282	1.33	%
Time deposits under $100,000		88,773	4.39	%		70,167	3.19	%		58,367	2.50	%
Time deposits $100,000 and over		43,692	4.56	%		32,611	3.51	%		25,734	2.52	%
Total Deposits	$	262,699	3.78	%	$	216,683	2.65	%	$	173,144	1.55	%

Borrowings

The Bank joined the Federal Home Loan Bank of Cincinnati in October of 2000. The Federal Home Loan Bank (the “FHLB”) allows the Bank to borrow funds on a contractual basis many times at rates lower than the costs of local certificates of deposit. In addition, the FHLB has the ability to provide structured advances that best reduce or leverage the interest rate risk of the Bank. The Bank as of the end of the year had $39 million outstanding with the FHLB. The $39 million is comprised of two types of borrowing structures. The first advance structure involves a daily revolving credit advance totaling $15 million. The remaining $24 million is comprised of loans that range in amounts from $2 to $5 million in size and are structured as ten year obligations with an optional conversion to a floating rate after a stated period of time. The loans have maturities ranging from December 2010 to January 2016 and have conversion dates ranging from immediate to January 2011. Interest rates range from 2.4% to 5.0%. The Bank has several Federal Funds lines of credit available with correspondent banks with a total availability of $37 million as of the end of 2006. 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, 2006, the Company had established a line of credit of $8.5 million priced at New York Prime Rate minus 150 basis points. The loan was established to insert capital infusions to the Bank to fund growth or retire treasury stock, if any, as needed. This line allows the Company to act as a source of strength for the Bank without the expense or dilution of additional common stock. As of December 31, 2006, there was $500,000 borrowed on the line of credit and the Company has the remainder amount available to inject capital into the Bank or fund other investments.

Balance Sheet Management

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

35

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

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

The liability portion of the balance sheet provides liquidity through various interest bearing and non-interest bearing deposit accounts. Other short-term liabilities, which do not qualify as a deposit, are Federal Funds purchased and securities under agreement to repurchase (REPO’s). Both are temporary solutions for liquidity as Federal Funds must be paid off at least once every 30 days and REPO’s must be collateralized by investment securities. At year end 2005 the Company had $2.4 million Federal Funds purchased and $2.4 million in REPO’s. By year end 2006 the amount in Federal Funds purchased had increased to $14.6 million and $4.6 million in REPO’s. The increase in Fed Funds purchased varies daily but began to trend higher as the volume of payment processing increased. The increase in payments was actively sought as a source of non interest income and the Bank expects the trend to continue upward as the Bank continues to expand its payment processing line of business. Longer-term liabilities are limited to FHLB advances, which would be used to reduce interest rate risk, and Company loans used to repurchase common stock or finance any acquisition in the future.

Capital Resources / Liquidity

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

The Company’s liquidity target is measured by adding the Bank’s net cash, short term and marketable securities not pledged and dividing this number by total deposits and short-term liabilities not secured by assets pledged. The approved liquidity policy is targeted at 10%. The Bank’s liquidity ratio at year end 2006 was 8.4% compared to 7.9% at year end 2005. The Company is not subject to any specific liquidity requirements imposed by regulatory orders. The Company is subject to general FDIC guidelines, which do not require a minimum level of liquidity. Management believes its liquidity ratios meet or exceed these guidelines. Management does not know of any trends or demands, which are reasonably likely to result in liquidity increasing or decreasing in any material manner.

Table 17 sets forth the average loan to deposit ratios, a liquidity measure, for periods indicated:

TABLE 17

	December 31, 2006		December 31, 2005
Average loans to average deposits	108.15	%	109.04	%

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

36

Interest rates do not necessarily move in the same direction or in the same magnitude as the price of goods and services and each issue must be dealt with independently.

Capital Adequacy

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

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

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

TABLE 18

	Minimum Requirements for Risk-Based Capital Ratios
	Total Risk-Based Capital Ratio	Tier I Risk-Based Capital Ratio	Leverage Ratio
Well capitalized	10% or above	6% or above	5% or above
Adequately capitalized	8% or above	4% or above	4% or above
Under 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, 2006 and 2005, the Company exceeded the regulatory minimums and qualified as a well-capitalized institution under the regulations. The Bank adopted Statement of Financial Accounting Standard number 123R in 2006. There are no critical accounting policies applied that have alternative applications which would likely change the results of operations in a material amount. Management of the Bank believes it has made the proper judgments about its selection of accounting policies.

The Company’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 the Company’s asset/liability management policies, overseeing the formulation and implementation of strategies to improve balance sheet positioning and earnings, and reviewing the Company’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

37

of interest rates over one- and two-year time horizons would have on net interest income. The results help the Company 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.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Table 19 sets forth the re-pricing of the Company’s interest earning assets and interest-bearing liabilities as of December 31, 2006. This interest sensitivity gap table is designed to monitor the Company’s interest rate risk exposure within the designated time period. In order to control interest rate risk, management regularly monitors the volume of interest sensitive assets relative to interest sensitive liabilities over specific time intervals. The Company’s interest rate management policy is to attempt to maintain a relatively stable net interest margin in periods of interest rate fluctuations. The Company’s policy is to attempt to maintain a ratio of cumulative gap to total interest sensitive assets of negative 15.00% to positive 15.00% in the time period of one year or less. At year end, the Bank was in a positive one-year cumulative GAP position of 0.99% and is confident that it is positioned properly for the Federa l Reserve’s FOMC anticipated actions during 2007. The Bank to date has not participated in any derivative products to address this issue and does not foresee the need to do so in the immediate future. 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 19

	Re-pricing of Interest Sensitive Assets and Liabilities Year-end balance as of December 31, 2006
Interest Sensitive Assets:	Less than One Year			1 to 5 Years(3)			Over 5 Years(3)			Total
	(in thousands)
Federal funds sold	$	0		$	0		$	0		$	0
Investment securities
Taxable(1)		8,943			16,823			4,906			30,672
Tax-exempt(1)		0			558			2,691			3,249
Loans(2)
Fixed rate and adjustable rate 1-4 family mortgage		25,779			21,504			1,417			48,700
Scheduled payments		199,446			59,766			2,225			261,437
Total Interest Sensitive Assets	$	234,168		$	98,651		$	1,239		$	344,058
Interest Sensitive Liabilities:
NOW accounts	$	18,264		$	27,396		$	0		$	45,660
Money market and savings accounts		37,048			12,349			0			49,397
Time deposits		127,209			11,812			0			139,021
Other interest bearing liabilities		48,250			10,000			0			58,250
Total Interest Sensitive Liabilities	$	230,771		$	61,557		$	0		$	292,328
Interest Sensitive Gap		3,397			37,094			11,239			51,730
Cumulative Interest Sensitive Gap		3,397			40,491			51,730
Ratio of cumulative gap to total Interest Sensitive Assets		0.99	%		11.77	%		15.04	%

——————

(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.

38

Item 8. Financial Statements and Supplementary Data

The consolidated financial statements of the Company and its subsidiary, together with the Report of Independent Certified Public Accountants thereon, are included on pages F-1 through F-30 of this Annual Report on Form 10-K.

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

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

Item 9A. Controls and Procedures

Our principal executive officer and principal financial officer have evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13(a)-15(e) and 15(d)-15(e)) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of December 31, 2006 (the “Evaluation Date”). Based upon such evaluation, such officers have concluded that, as of the Evaluation Date, our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to us (including our consolidated subsidiaries) required to be included in our periodic filings under the Exchange Act.

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

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

PART III

Item 10. Directors and Executive Officers of the Registrant

Information relating to the directors and executive officers of the Company is set forth under the caption “Proposals - Election of Directors” in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference. Information relating to audit committee financial experts is set forth under the caption “Audit Committee Report – Identification of Members and Functions of Committee” in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference.

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

Item 11. Executive Compensation

Information relating to director compensation is set forth under the caption “Information About the Board of Directors and its Committees – Compensation of Directors” in the Company’s 2007 Proxy Statement, and information relating to executive compensation is set forth under the caption “Executive Compensation” in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

Information relating to ownership of the Company’s common stock by certain persons is set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference. Information relating to equity compensation plans is set forth under the caption “Executive Compensation – Equity Compensation Plan Information as of December 31, 2006 in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference. Information relating to compliance with the reporting requirements of Section 16(a) of

39

the Exchange Act by the Company’s executive officers and directors, persons who own more than ten percent of the Company’s common stock and their affiliates who are required to comply with such reporting requirements is set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference.

Item 13. Certain Relationships and Related Transactions

Information relating to certain transactions between the Company, and its affiliates and certain other persons is set forth under the caption “Certain Relationships and Related Transactions” in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference.

Item 14. Principal Accountant Fees and Services

Information relating to principal accountant fees and services is set forth under the caption “Audit Committee Report – Audit Fees” in the Company’s 2007 Proxy Statement. Such information is incorporated into this report by reference.

Item 15. Exhibits and Reports on Form 8-K

(a) Exhibits

(1) The following consolidated financial statements of the Company and its subsidiary, together with the Report of Independent Certified Public Accountants thereon, are included on pages F-1 through F-30 of this Annual Report on Form 10-K:

Report of Independent Registered Public Accounting Firm

Consolidated Balance Sheets as of December 31, 2006 and 2005

Consolidated Statements of Income for the years ended
December 31, 2006, 2005 and 2004

Consolidated Statements of Changes in Stockholders’ Equity
for the years ended December 31, 2006, 2005 and 2004

Consolidated Statements of Cash Flows for the years ended
December 31, 2006, 2005 and 2004

Notes to Consolidated Financial Statements

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

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

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

——————

(1)

Incorporated by reference from Exhibit 3.1 of the registrant’s Form 10-KSB filed on March 27, 2006 (File No. 000-30497).

40

(2)

Incorporated by reference from Exhibit 3 of the registrant’s Form 10-Q filed on May 12, 2006 (File No. 000-30497).

(3)

Incorporated by reference from Exhibit 3 of the registrant’s Form 10-Q filed on August 14, 2006 (File No. 000-30497).

(4)

Incorporated by reference from Exhibit 3 of the registrant’s Form 10-Q filed on November 09, 2006 (File No. 000-30497)

(5)

Incorporated by reference from Exhibit 14 of the registrant’s Form 10-KSB on March 21, 2005 (File No. 000-30497)

(b) The following reports on Form 8-K were filed with the Securities and Exchange Commission during 2006:

(1)

Form 8-K filed on January 17, 2006 reporting earnings results for the fiscal quarter ended December 31, 2005.

(2)

Form 8-K filed on February 27, 2006 reporting the declaration of a cash dividend.

(3)

Form 8-K filed on April 21, 2006 reporting earnings results for the fiscal quarter ended March 31, 2006

(4)

Form 8-K filed on June 1, 2006 reporting the declaration of a cash dividend.

(5)

Form 8-K filed on July 17, 2006 reporting earnings results for the fiscal quarter ended June 30, 2006.

(6)

Form 8-K filed on September 1, 2006 reporting the declaration of a cash dividend.

(7)

Form 8-K filed on October 17, 2006 reporting earnings results for the fiscal quarter ended September 30, 2006.

(8)

Form 8-K filed on November 15, 2006 reporting the declaration of a stock dividend in the form of a 2 for 1 stock split.

(9)

Form 8-K filed on November 28, 2006 reporting the declaration of a cash dividend.

41

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.

Date: March 15, 2007		CORNERSTONE BANCSHARES, INC.
	By:	/s/ Gregory B. Jones
		Gregory B. Jones Chairman and Chief Executive Officer (principal executive officer)
	By:	/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes President and Treasurer (principal financial officer and accounting officer)

42

In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 15, 2007.

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

43

INDEX OF EXHIBITS

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

——————

(1)

Incorporated by reference from Exhibit 3.1 of the registrant’s Form 10-KSB filed on March 27, 2006 (File No. 000-30497).

(2)

Incorporated by reference from Exhibit 3 of the registrant’s Form 10-Q filed on May 12, 2006 (File No. 000-30497).

(3)

Incorporated by reference from Exhibit 3 of the registrant’s Form 10-Q filed on August 14, 2006 (File No. 000-30497).

(4)

Incorporated by reference from Exhibit 3 of the registrant’s Form 10-Q filed on November 09, 2006 (File No. 000-30497).

(5)

Incorporated by reference from Exhibit 14 of the registrant’s Form 10-KSB on March 21, 2005 (File No. 000-30497).

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 subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cornerstone Bancshares, Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

/s/ HAZLETT, LEWIS & BIETER, PLLC

Chattanooga, Tennessee
February 20, 2007

F-1

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
December 31, 2006 and 2005

	2006			2005
ASSETS
Cash and due from banks	$	17,635,956		$	14,590,499
Securities available for sale		32,353,380			30,127,486
Securities held to maturity (fair value approximates $236,189 at 2006 and $321,408 at 2005)		236,169			322,180
Federal Home Loan Bank stock, at cost		1,332,100			1,033,900
Loans, net of allowance for loan losses of $4,258,352 in 2006 and $3,545,042 in 2005		305,879,013			262,008,632
Bank premises and equipment, net		6,134,009			7,207,146
Accrued interest receivable		2,120,778			1,739,460
Goodwill and amortizable intangibles		3,046,287			3,376,892
Other assets		6,204,541			3,205,706
Total assets	$	374,942,233		$	323,611,901
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Non-interest-bearing demand deposits	$	41,722,570		$	42,118,351
Interest-bearing demand deposits		38,159,718			33,080,446
Savings deposits and money market accounts		56,913,225			55,410,928
Time deposits of $100,000 or more		44,544,335			38,707,366
Time deposits under $100,000		94,476,685			83,118,799
Total deposits		275,816,533			252,435,890
Accrued interest payable		308,392			242,864
Federal funds purchased and securities sold under agreements to repurchase		19,249,701			4,790,737
Federal Home Loan Bank advances and line of credit		39,500,000			30,000,000
Other liabilities		1,884,342			3,676,047
Total liabilities		336,758,968			291,145,538
Stockholders' equity:
Preferred stock – no par value; 2,000,000 shares authorized; no shares issued		—			—
Common stock – $1.00 par value; 10,000,000 shares authorized; 6,511,848 and 3,201,334 shares issued in 2006 and 2005; 6,511,848 and 3,200,863 outstanding in 2006 and 2005		6,511,848			3,200,863
Additional paid-in capital		21,849,006			21,201,903
Retained earnings		9,881,029			8,229,552
Accumulated other comprehensive income		(58,618	)		(165,955	)
Total stockholders’ equity		38,183,265			32,466,363
Total liabilities and stockholders’ equity	$	374,942,233		$	323,611,901

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

F-2

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2006, 2005 and 2004

	2006		2005		2004
Interest Income
Loans, including fees	$	27,317,002	$	19,353,740	$	13,029,972
Securities and interest-bearing deposits in other banks		1,583,984		1,217,405		1,006,068
Federal funds sold		257,820		100,937		22,675
Total interest income		29,158,806		20,672,082		14,058,715
Interest Expense
Time deposits of $100,000 or more		1,993,796		1,144,939		648,651
Other deposits		6,550,906		3,675,702		2,024,596
Federal funds purchased and securities sold under agreements to repurchase		347,861		203,476		56,269
Federal Home Loan Bank advances and line of credit		1,413,546		1,053,675		845,775
Total interest expense		10,306,109		6,077,792		3,575,291
Net interest income before provision for loan losses		18,852,697		14,594,290		10,483,424
Provision for loan losses		1,106,600		1,401,600		840,000
Net interest income after provision for loan losses		17,746,097		13,192,690		9,643,424
Non-interest Income
Customer service fees		1,298,041		984,085		899,213
Other non-interest income		91,047		67,956		63,070
Operating lease income		300,932		539,756		247,251
Net gains from sale of loans and other assets		421,236		312,923		196,342
Total non-interest income		2,111,256		1,904,720		1,405,876
Non-interest Expenses
Salaries and employee benefits		6,018,619		4,502,910		3,900,505
Net occupancy and equipment expense		1,075,081		859,313		767,461
Depreciation on leased assets		244,580		379,053		185,807
Other operating expenses		3,379,950		2,474,999		2,031,944
Total non-interest expenses		10,718,230		8,216,275		6,885,717
Income before income tax expense		9,139,123		6,881,135		4,163,583
Income tax expense		3,327,523		2,556,616		1,592,500
Net income	$	5,811,600	$	4,324,519	$	2,571,083
Earnings Per Common Share
Basic	$	0.90	$	0.71	$	0.52
Diluted		0.85		0.66		0.46

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

F-3

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY – (continued on next page)
Years Ended December 31, 2006, 2005 and 2004

	Comprehensive Income			Common Stock			Common Stock Subscribed			Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income			Stock Subscriptions Receivable			Total Stockholders’ Equity
BALANCE, December 31, 2003				$	1,243,167		$	—		$	12,183,868		$	3,295,884		$	180,582		$	—		$	16,903,501
Issuance of common stock					382,039			—			5,297,614			—			—			—			5,679,653
Dividends – $.10 per share					—			—			—			(282,369	)		—			—			(282,369	)
Split-up effected in the form of a dividend					1,243,617			—			—			(1,243,617	)		—			—			—
Stock subscriptions subscribed					—			119,961			1,679,454			—			—			(1,799,415	)		—
Comprehensive income:
Net income	$	2,571,083			—			—			—			2,571,083			—			—			2,571,083
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		(64,548	)		—			—			—			—			(64,548	)		—			(64,548	)
Total comprehensive income	$	2,506,535
BALANCE, December 31, 2004					2,868,823			119,961			19,160,936			4,340,981			116,034			(1,799,415	)		24,807,320
Issuance of common stock					7,079			—			98,172			—			—			—			105,251
Issuance of common stock under Director's stock option plan					209,000			—			836,000			—			—			—			1,045,000
Tax benefit received from Director's stock option exercise					—			—			1,185,315			—			—			—			1,185,315
Dividends – $.14 per share					—			—			—			(435,948	)		—			—			(435,948	)
Stock subscriptions settled					119,961			(119,961	)		—			—			—			1,799,415			1,799,415
Purchase of common stock					(4,000	)		—			(78,520	)		—			—			—			(82,520	)
Comprehensive income:
Net income	$	4,324,519			—			—			—			4,324,519			—			—			4,324,519
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		(281,989	)		—			—			—			—			(281,989	)		—			(281,989	)
Total comprehensive income	$	4,042,530
BALANCE, December 31, 2005				$	3,200,863		$	—		$	21,201,903		$	8,229,552		$	(165,955	)	$	—		$	32,466,363

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

F-4

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY – (continued from previous page)
Years Ended December 31, 2006, 2005 and 2004

	Comprehensive Income		Common Stock			Common Stock Subscribed		Additional Paid-in Capital			Retained Earnings			Accumulated Other Comprehensive Income			Stock Subscriptions Receivable		Total Stockholders’ Equity
BALANCE, December 31, 2005			$	3,200,863		$	—	$	21,201,903		$	8,229,552		$	(165,955	)	$	—	$	32,466,363
Issuance of common stock				15,526			—		246,333			—			—			—		261,859
Issuance of common stock under
Director's stock option plan				51,500			—		249,940			—			—			—		301,440
Tax benefit received from Director's stock option exercise				—			—		202,012			—			—			—		202,012
Stock compensation expense				—			—		147,925			—			—			—		147,925
Dividends – $.23 per share				—			—		—			(908,464	)		—			—		(908,464	)
Split-up effected in the form of a dividend				3,251,659			—		—			(3,251,659	)		—			—		—
Purchase of common stock				(7,700	)		—		(199,107	)		—			—			—		(206,807	)
Comprehensive income:
Net income	$	5,811,600		—			—		—			5,811,600			—			—		5,811,600
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		107,337		—			—		—			—			107,337			—		107,337
Total comprehensive income	$	5,918,937
BALANCE, December 31, 2006			$	6,511,848		$	—	$	21,849,006		$	9,881,029		$	(58,618	)	$	—	$	38,183,265

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

F-5

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2006, 2005 and 2004

	2006			2005			2004
Cash Flows From Operating Activities
Net income	$	5,811,600		$	$4,324,519		$	$2,571,083
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		990,052			764,127			710,686
Provision for loan losses		1,106,600			1,401,600			840,000
Stock compensation expense		147,925			—			—
Gains on sales of loans and other assets		(421,236	)		(312,923	)		(196,342	)
Deferred income taxes		(481,466	)		(460,452	)		(120,176	)
Changes in other operating assets and liabilities:
Net change in loans held for sale		(97,752	)		(257,148	)		808,978
Accrued interest receivable		(381,318	)		(554,982	)		(245,715	)
Accrued interest payable		65,528			151,269			(10,568	)
Other assets and liabilities		(1,438,845	)		1,629,962			192,752
Net cash provided by operating activities		5,301,088			6,685,972			4,550,698
Cash Flows From Investing Activities
Proceeds from security transactions:
Securities available for sale		1,865,807			11,818,836			20,441,782
Securities held to maturity		85,400			69,067			251,816
Purchase of securities available for sale		(3,975,324	)		(15,901,889	)		(22,327,373	)
Purchase of Federal Home Loan Bank stock		(247,700	)		(136,000	)		(237,100	)
Loan originations and principal collections, net		(43,432,372	)		(59,112,700	)		(48,784,301	)
Purchase of bank premises and equipment		(1,278,809	)		(1,978,538	)		(2,424,228	)
Acquisition of business		—			(1,380,000	)		—
Purchase of equity investment		(3,000,000	)		—			—
Proceeds from sale of other real estate and other assets		806,406			300,464			336,637
Net cash used in investing activities		(49,176,592	)		(66,320,760	)		(52,742,767	)
Cash Flows From Financing Activities
Net increase in deposits		23,380,643			64,602,988			28,480,627
Increase (decrease) in federal funds purchased and securities sold under agreements to repurchase		14,458,964			(2,618,425	)		1,325,084
Proceeds from Federal Home Loan Bank advances		20,000,000			5,000,000			10,000,000
Repayment of Federal Home Loan Bank advances		(11,000,000	)		(2,000,000	)		—
Net borrowings (repayments) under line of credit		500,000			—			(400,000	)
Purchase of common stock		(206,807	)		(82,520	)		—
Payment of dividends		(775,138	)		(526,476	)		(124,316	)
Issuance of common stock		563,299			2,949,666			5,679,653
Net cash provided by financing activities		46,920,961			67,325,233			44,961,048
Net Increase (Decrease) in Cash and Cash Equivalents		3,045,457			7,690,445			(3,231,021	)
Cash and Cash Equivalents, beginning of year		14,590,499			6,900,054			10,131,075
Cash and Cash Equivalents, end of year	$	17,635,956		$	14,590,499		$	6,900,054
Supplemental Disclosures of Cash Flow Information
Cash paid during the period for interest	$	10,240,581		$	5,926,523		$	3,585,859
Cash paid during the period for taxes		3,259,073			1,910,850			1,988,062
Non-cash Investing and Financing Activities
Acquisition of real estate through foreclosure	$	493,588		$	1,010,555		$	53,111
Loan extended in lieu of receiving cash for sale of assets		1,950,435			—			—

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

F-6

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies

The accounting and reporting policies of Cornerstone Bancshares, Inc. and subsidiaries (Company) conform with generally accepted accounting principles and practices within the banking industry. The policies that materially affect financial position and results of operations are summarized as follows:

Nature of operations and geographic concentration:

The Company is a bank-holding company which owns all of the outstanding common stock of Cornerstone Community Bank (Bank) and Eagle Financial, Inc. (Eagle). The Bank provides a variety of financial services through five locations in Chattanooga, Tennessee and surrounding areas. The Bank’s primary deposit products are demand deposits, savings accounts, and certificates of deposit. Its primary lending products are commercial loans, real estate loans, and installment loans. Eagle is a finance and factoring company located in Chattanooga, Tennessee.

Principles of consolidation:

The consolidated financial statements include the accounts of the Company, the Bank and Eagle. All material intercompany accounts and transactions have been eliminated in consolidation.

Goodwill:

Goodwill represents the excess of the cost of the Company’s 1997 purchase of the net assets of the Bank of East Ridge over the underlying fair value of such net assets at the date of acquisition. The Company has adopted the provisions of Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” which requires that goodwill and other intangible assets deemed to have an indefinite life not be amortized. Goodwill is tested annually for impairment. If the carrying value of goodwill exceeds the fair value, a write-down is recorded. No impairment loss was recognized during 2006, 2005 or 2004.

Use of estimates:

In preparing consolidated financial statements in conformity with U.S. generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses.

Securities:

Debt securities are classified as held to maturity when the Bank has the positive intent and ability to hold the securities to maturity. Securities held to maturity are carried at amortized cost. The amortization of premiums and accretion of discounts are recognized in interest income using methods approximating the interest method over the period to maturity.

Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at market value with unrealized gains and losses reported in other comprehensive income. Realized gains and losses on securities available for sale are included in other income and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income.

Declines in the market value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary impairment losses, management considers (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

F-7

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies – (continued)

Loans:

The Company grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by mortgage loans throughout Chattanooga, Tennessee and surrounding areas. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off generally are reported at their outstanding unpaid principal balances adjusted for the allowance for loan losses and any deferred fees or costs on originated loans. Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Interest income is accrued on the unpaid principal balance. Loan origination fees, net of certain direct origination costs, are deferred and recognized as an adjustment of the related loan yield using the interest method.

The accrual of interest on mortgage and commercial loans is discontinued at the time the loan is 90 days past due unless the credit is well-secured and in process of collection. Credit card loans and other personal loans are typically charged off no later than 120 days past due. Past due status is based on contractual terms of the loan. In all cases, loans are placed on non-accrual or charged-off at an earlier date if collection of principal or interest is considered doubtful.

All interest accrued but not collected for loans that are placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash-basis or cost-recovery method, until qualifying for return to accrual. Loans are returned to accrual status when all the principal and interest amounts contractually due are brought current and future payments are reasonably assured.

Allowance for loan losses:

The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.

The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that

F-8

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies – (continued)

experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures, unless such loans are the subject of a restructuring agreement.

Premises and equipment:

Land is carried at cost. Other premises and equipment are carried at cost net of accumulated depreciation. Depreciation is computed using the straight-line method based principally on the estimated useful lives of the assets. Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations.

Investment in partnership:

The Company’s investment in a partnership consists of an equity interest in a new market tax credit lending partnership. The Company’s investment in the partnership is accounted for using the equity method of accounting. The Company uses the equity method when the Company owns an interest in a partnership and can exert significant influence over the partnership’s operations but cannot control the partnership’s operations. Under the equity method, the Company’s ownership interest in the partnership’s capital is reported as an investment on its consolidated balance sheets and the Company’s allocable share of the income or loss from the partnership is reported in noninterest income or expense in the consolidated statements of income. The Company ceases recording losses on an investment in partnership when the cumulative losses and distributions from the partnership exceed the carrying amount of the investment and any advances made by the Company. After the Company’s investment in such partnership reaches zero, cash distributions received from these investments are recorded as income.

Other real estate owned:

Real estate properties acquired through or in lieu of loan foreclosure are initially recorded at the lower of the Company’s carrying amount or fair value less estimated selling cost at the date of foreclosure. Any write-downs based on the asset’s fair value at the date of acquisition are charged to the allowance for loan losses. After foreclosure, these assets are carried at the lower of their new cost basis or fair value less cost to sell. Costs of significant property improvements are capitalized, whereas costs relating to holding property are expensed. The portion of interest costs relating to development of real estate is capitalized. Valuations are periodically performed by management, and any subsequent write-downs are recorded as a charge to operations, if necessary, to reduce the carrying value of a property to the lower of its cost or fair value less cost to sell.

Income taxes:

Income taxes are provided for the tax effects of the transactions reported in the financial statements and consist of taxes currently due plus deferred income taxes related primarily to differences between the tax basis and the financial statement carrying amounts of the allowance for loan losses and accumulated depreciation. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be taxable or deductible when the assets and liabilities are recovered or settled. Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes.

F-9

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies – (continued)

Transfers of financial assets:

Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity.

Advertising costs:

The Company expenses all advertising costs as incurred. Advertising expense was $84,233, $84,564, and $85,564 for the years ended December 31, 2006, 2005 and 2004, respectively.

Cash and cash equivalents:

The Bank considers all cash and amounts due from depository institutions, interest-bearing deposits in other banks, and federal funds sold to be cash equivalents for purposes of the statements of cash flows.

Stock-based compensation:

At December 31, 2006, the Company has two stock-based compensation plans, which are described fully in Note 15. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement 123 (revised 2004), “Share-Based Payment” (SFAS 123(R)). SFAS 123(R) requires that the compensation cost relating to share-based payment transactions be recognized in financial statements. That cost will be measured based on the fair value of the equity or liability instruments issued. SFAS 123(R) covers a wide range of share-based compensation arrangements including stock options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. SFAS 123(R) is a replacement of SFAS 123, “Accounting for Stock-Based Compensation,” and supersedes APB Opinion 25, “Accounting for Stock Issued to Employees,” and its related interpretive guidance. The effect of the Statemen t is to require entities to measure the cost of employee services received in exchange for stock options based on the grant-date fair value of the award, and to recognize the cost over the period the employee is required to provide services for the award. SFAS 123(R) permits entities to use any option-pricing model that meets the fair value objective in the Statement.

The Company adopted SFAS 123(R) on January 1, 2006, under the modified prospective method. Compensation cost has been measured using the fair value of an award on the grant date and is recognized over the service period, which is usually the vesting period. Compensation cost related to the non-vested portion of awards outstanding as of that date was based on the grant-date fair value of those awards as calculated under the original provisions of SFAS 123; that is, the Company was not required to re-measure the grant-date fair value estimate of the unvested portion of awards granted prior to the effective date of SFAS 123(R).

The Company had applied APB Opinion No. 25 and related Interpretations, in accounting for the stock option plans prior to January 1, 2006. Under APB Opinion No. 25, stock options issued under the Company’s stock option plan have no intrinsic value at the grant date, and therefore, no compensation cost is recognized for them.

Segment reporting:

Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information” provides for the identification of reportable segments on the basis of discreet business units and their financial information to the extent such units are reviewed by an entity’s chief decision maker (which can be an individual or group of management persons). The Statement permits aggregation or combination of segments that have similar characteristics. In the Company’s operations, each bank branch is viewed by management as being

F-10

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 1 — Summary of Significant Accounting Policies – (continued)

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 2006 and 2005 were not significant for separate disclosure. Accordingly, the Company’s consolidated financial statements reflect the presentation of segment information on an aggregated basis in one reportable segment.

Earnings per share:

Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Corporation relate solely to outstanding stock options, and are determined using the treasury stock method.

Variable interest entities:

An entity is referred to as a variable interest entity (VIE) if it meets the criteria outlined in FASB Interpretation No. 46-R, “Consolidation of Variable Interest Entities (revised December 2003)” (FASBI 46 R), which are: (1) the entity has equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (2) the entity has equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the expected losses or receive the expected returns of the entity.

In addition, as specified in FASBI 46-R, a VIE must be consolidated by the Company if it is deemed to be the primary beneficiary of the VIE, which is the party involved with the VIE that has a majority of the expected losses, expected residual returns, or both.

Reclassification:

Certain amounts in the 2005 and 2004 consolidated financial statements have been reclassified to conform to the 2006 presentation.

Off-balance sheet credit related financial instruments:

In the ordinary course of business, the Corporation has entered into commitments to extend credit, including commitments under credit card arrangements, commercial letters of credit, and standby letters of credit. Such financial instruments are recorded when they are funded.

Note 2 — Restrictions on Cash and Due From Banks

The Bank is required to maintain balances on hand or with the Federal Reserve Bank based on a percentage of deposits. At December 31, 2006 and 2005, these reserve balances were approximately $2,617,000 and $2,635,000, respectively.

F-11

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 3 — Securities

Securities have been classified in the balance sheet according to management’s intent as either securities held to maturity or securities available for sale. The amortized cost and approximate market value of securities at December 31, 2006 and 2005, is as follows:

	2006
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Market Value
Securities available for sale:
U.S. Government agencies	$	26,631,431	$	81,949	$	(243,160	)	$	26,470,220
State and municipal securities		3,209,905		51,952		(12,479	)		3,249,378
Mortgage-backed securities		2,600,860		32,922		—			2,633,782
	$	32,442,196	$	166,823	$	(255,639	)	$	32,353,380
Securities held to maturity:
Mortgage-backed securities	$	236,169	$	475	$	(455	)	$	236,189
	2005
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Market Value
Securities available for sale:
U.S. Government agencies	$	22,652,365	$	—	$	(303,023	)	$	22,349,342
State and municipal securities		3,261,104		54,620		(30,855	)		3,284,869
Mortgage-backed securities		3,964,527		35,399		(401	)		3,999,526
Corporate debt securities		500,937		—		(7,187	)		493,750
	$	30,378,933	$	90,019	$	(341,466	)	$	30,127,486
Securities held to maturity:
Mortgage-backed securities	$	322,180	$	985	$	(1,757	)	$	321,408

At December 31, 2006 and 2005, securities with a carrying value of approximately $11,476,000 and $12,424,000, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.

At December 31, 2006 and 2005, the carrying amount of securities pledged to secure repurchase agreements was approximately $9,936,000 and $6,936,000, respectively.

The amortized cost and estimated market value of securities at December 31, 2006, 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 Maturity
	Amortized Cost		Market Value		Amortized Cost		Market Value
Due in one year or less	$	7,667,176	$	7,610,371	$	—	$	—
Due from one year to five years		17,545,938		17,358,895		—		—
Due from five years to ten years		1,117,105		1,166,505		—		—
Due after ten years		3,511,117		3,583,827		—		—
		29,841,336		29,719,598		—		—
Mortgage-backed securities		2,600,860		2,633,782		236,169		236,189
	$	32,442,196	$	32,353,380	$	236,169	$	236,189

F-12

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 3 — Securities – (continued)

For the years ended December 31, 2006, 2005 and 2004, there were no sales of securities available for sale. At December 31, 2006 and 2005, gross unrealized losses on investments were insignificant in relation to the Company’s investment portfolio.

Note 4 — Loans and Allowance for Loan Losses

At December 31, 2006 and 2005, the Bank’s loans consist of the following (in thousands):

	2006			2005
Mortgage loans on real estate:
Residential 1-4 family	$	23,681		$	26,118
Residential multifamily (5 or more)		14,421			9,374
Held for sale		701			603
Commercial		98,904			79,608
Construction		57,606			47,071
Second mortgages		2,564			3,216
Equity lines of credit		7,333			6,334
		205,210			172,324
Commercial loans		97,933			86,039
Consumer installment loans:
Personal		6,490			6,240
Credit cards		504			951
		6,994			7,191
Total loans		310,137			265,554
Less: Allowance for loan losses		(4,258	)		(3,545	)
Loans, net	$	305,879		$	262,009

A summary of transactions in the allowance for loan losses for the years ended December 31, 2006, 2005 and 2004, is as follows:

	2006			2005			2004
Balance, beginning of year	$	3,545,042		$	2,665,464		$	2,011,329
Provision for loan losses		1,106,600			1,401,600			840,000
Loans charged-off		(470,367	)		(557,227	)		(364,657	)
Recoveries of loans previously charged-off		77,077			35,205			178,792
Balance, end of year	$	4,258,352		$	3,545,042		$	2,665,464

The Bank’s only significant concentration of credit at December 31, 2006, occurred in real estate loans which totaled approximately $205 million. While real estate loans accounted for 66 percent of total loans, these loans were primarily residential development and construction loans, residential mortgage loans, and commercial loans secured by commercial properties. Substantially all real estate loans are secured by properties located in Tennessee.

Loans classified as impaired were insignificant in relation to the Bank’s loan portfolio at December 31, 2006 and 2005.

Interest income recognized on impaired loans was insignificant to total interest income on loans for each of the years ending December 31, 2006, 2005 and 2004.

F-13

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 4 — Loans and Allowance for Loan Losses – (continued)

In the ordinary course of business, the Bank has granted loans to principal officers and directors and their affiliates. Annual activity consisted of the following:

	2006			2005
Beginning balance	$	771,270		$	1,133,316
New loans		95,936			648,832
Repayments		(115,710	)		(1,010,878	)
Ending balance	$	751,496		$	771,270

Note 5 — Bank Premises and Equipment

A summary of bank premises and equipment at December 31, 2006 and 2005, is as follows:

	2006			2005
Land	$	1,625,567		$	1,625,567
Buildings and improvements		4,060,313			3,388,834
Furniture, fixtures and equipment		3,123,929			5,113,021
		8,809,809			10,127,422
Accumulated depreciation		(2,675,800	)		(2,920,276	)
	$	6,134,009		$	7,207,146

Depreciation expense for the years ended December 31, 2006, 2005 and 2004, amounted to $644,664, $736,731, and $527,167, respectively.

Certain bank facilities and equipment are leased under various operating leases. Total rent expense for the years ended December 31, 2006, 2005 and 2004, was $235,455, $160,626, and $147,451, respectively.

Future minimum rental commitments under non-cancelable leases are as follows:

2007	$	303,905
2008		312,479
2009		323,270
2010		302,768
2011		314,243
Thereafter		1,217,843
Total	$	2,774,508

Note 6 — Time and Related-Party Deposits

At December 31, 2006, the scheduled maturities of time deposits are as follows:

2007	$	124,979,011
2008		9,503,641
2009		2,259,631
2010		1,749,901
2011		528,836
Total	$	139,021,020

Deposits from related parties held by the Bank at December 31, 2006 and 2005, amounted to approximately $829,000 and $1,300,000, respectively.

F-14

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 7 — Concentrations in Deposits

At December 31, 2006 and 2005, the Company had a concentration in the money market account of one customer totaling approximately $15,000,000 and $20,500,000, respectively. These balances accounted for approximately 5 and 8 percent of total deposits at December 31, 2006 and 2005, respectively.

Note 8 — Income Taxes

The Company files consolidated income tax returns with its subsidiaries. Under the terms of a tax-sharing agreement, the subsidiaries’ allocated portion of the consolidated tax liability is computed as if they were reporting income and expenses to the Internal Revenue Service as a separate entity.

Income tax expense in the statements of income for the years ended December 31, 2006, 2005 and 2004, consists of the following:

	2006			2005			2004
Current tax expense	$	3,808,989		$	3,017,068		$	1,712,676
Deferred tax expense (benefit) related to:
Allowance for loan losses		(356,910	)		(361,227	)		(236,309	)
Other		(124,556	)		(99,225	)		116,133
Income tax expense	$	3,327,523		$	2,556,616		$	1,592,500

The income tax expense is different from the expected tax expense computed by multiplying income before income tax expense by the statutory federal income tax rates. The reasons for this difference are as follows:

	2006			2005			2004
Expected tax at statutory rates	$	3,107,302		$	2,339,586		$	1,415,618
Increase (decrease) resulting from tax effect of:
State income taxes, net of federal tax benefit		(392,068	)		(295,201	)		(178,618	)
New market tax credits		(150,000	)		—			—
Other		(21,847	)		(78,171	)		(1,736	)
Income tax expense	$	3,327,523		$	2,556,616		$	1,592,500

The components of the net deferred tax asset, included in other assets, are as follows:

	2006		2005
Deferred tax assets:	$	140,954	$	140,716
Deferred compensation		128,605		213,710
Deferred loan fees		1,470,857		1,113,947
Allowance for loan losses		30,197		85,492
Net unrealized loss on securities available for sale		177,170		108,612
Other		1,947,783		1,662,477
Deferred tax liabilities:
Depreciation	$	78,656	$	260,174
Life insurance		166,918		156,443
Other		35,398		5,220
		280,972		421,837
Net deferred tax asset	$	1,666,811	$	1,240,640

F-15

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 9 — Federal Home Loan Bank Advances and Line of Credit

The Bank has agreements with the Federal Home Loan Bank of Cincinnati (FHLB) that can provide convertible fixed rate advances to the Bank in an amount up to approximately $53,900,000. All of the Bank’s loans secured by first mortgages on 1-4 family residential, multi-family properties, and commercial properties are pledged as collateral for these advances.

At December 31, 2006 and 2005, FHLB advances consist of the following:

	2006		2005
Long-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	$	2,000,000
Long-term advance dated November 1, 2001, requiring monthly interest payments, fixed at 3.94% until November 2006, principal due in November 2011		—		2,000,000
Long-term advance dated April 26, 2002, requiring monthly interest payments, fixed at 4.11% until conversion option is exercised, principal due in April 2012		—		2,000,000
Long-term advance dated September 13, 2002, requiring monthly interest payments, fixed at 3.51% until September 2007, principal due in September 2012		2,000,000		2,000,000
Long-term advance dated January 17, 2003, requiring monthly interest payments, fixed at 2.61% until January 2006, principal due in January 2013		—		4,000,000
Long-term advance dated April 25, 2003, requiring monthly interest payments, fixed at 2.41% until April 2006, principal due in April 2013		—		3,000,000
Long-term advance dated January 23, 2004, requiring monthly interest payments, fixed at 2.50% until January 2007, principal due in January 2014		5,000,000		5,000,000
Long-term advance dated May 27, 2004, requiring monthly interest payments, fixed at 3.46% until May 2007, principal due in May 2014		5,000,000		5,000,000
Long-term advance dated February 9, 2005, requiring monthly interest payments, fixed at 3.86% until February 2010, principal due in February 2015		5,000,000		5,000,000
Long-term advance dated January 20, 2006, requiring monthly interest payments, fixed at 4.18% until January 2011, principal due in January 2016		5,000,000		—
Daily revolving credit advances under agreement dated May 18, 2006, rates are variable based on three-month LIBOR rate, requires monthly interest payments		15,000,000		—
	$	39,000,000	$	30,000,000

F-16

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 9 — Federal Home Loan Bank Advances and Line of Credit – (continued)

Scheduled maturities of the Federal Home Loan Bank advances are as follows:

2007	$	15,000,000
2008		—
2009		—
2010		2,000,000
2011		—
Thereafter		22,000,000
Total	$	39,000,000

During the fixed rate term, the advances may be prepaid subject to a prepayment penalty as defined in the agreements. The FHLB has the right to convert the fixed rate on the above advances at the end of the initial fixed rate period and on a quarterly basis thereafter. If the conversion option is exercised, the advances will bear interest at the three-month London Interbank Offered Rate (LIBOR) adjusted quarterly at a spread of zero basis points to the LIBOR index. Subsequent to any conversion, the Bank has the option to prepay the advances, in full or in part, without penalty on the conversion date or any subsequent quarterly repricing date.

The $5,000,000 line of credit previously maintained by the Company expired February 28, 2006 and was not renewed. However, during 2006 the Company established an $8,500,000 line of credit with another bank that is secured by 100% of the Bank’s common stock and bears interest at Prime minus 1.50%, due quarterly. Outstanding principal and accrued interest will be due at the maturity date of July 19, 2008. The loan agreement contains certain financial and non-financial quarterly covenants. At December 31, 2006, the Company was not in violation of any covenants with respect to the loan agreement. Borrowings outstanding under the agreements were $500,000 at December 31, 2006. There were no borrowings outstanding at December 31, 2005.

Note 10 — Employee Benefit Plans

401(k) plan:

The Bank has a 401(k) employee benefit plan covering substantially all employees who have completed at least 30 days of service and met minimum age requirements. The Bank’s contribution to the plan is discretionary and was $195,445 for 2006, $142,719 for 2005, and $130,423 for 2004.

Employee Stock Ownership Plan:

The Company has a non-leveraged employee stock ownership plan (ESOP) to which the Company makes 100% of the contributions for purchasing the Company’s common stock, and allocates the contribution among the participants based on regulatory guidelines. The Company’s contribution is discretionary, as determined by the Compensation Committee. Employer contributions are available to all employees after 1,000 hours of service. There are certain age and years-of-service requirements before contributions can be made for the benefit of the employee. The ESOP plan also provides for a three year 100% vesting requirement; therefore employees terminating employment before their third anniversary date will forfeit their accrued benefit under the ESOP. The forfeiture will be re-allocated among the remaining ESOP participants. The Company contributed $248,261 and $82,049 to the ESOP for 2006 and 2005, respectively.

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

F-17

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 11 — Financial Instruments With Off-Balance-Sheet Risk – (continued)

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, 2006 and 2005, undisbursed loan commitments aggregated $65,682,000 and $57,935,000 respectively. In addition, there were outstanding standby letters of credit totaling $2,341,000 and $6,037,000 respectively.

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment, and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. Standby letters of credit generally have fixed expiration dates or other termination clauses and may require payment of a fee. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Bank’s policy for obtaining collateral, and the nature of such collateral, is essentially the same as that involved in making commitments to extend credit.

The Bank incurred insignificant losses on its commitments during 2006, 2005 and 2004.

Note 12 — Fair Value of Financial Instruments

Fair value estimates are made at a specific point in time, based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument. Because no market exists for a significant portion of the Company’s financial instruments, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments, and other factors. These estimates are subjective in nature; involve uncertainties and matters of judgment; and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates.

Fair value estimates are based on existing financial instruments without attempting to estimate the value of anticipated future business and the value of assets and liabilities that are not considered financial instruments. The following methods and assumptions were used to estimate the fair value of each class of financial instruments:

Cash and due from banks:

For cash and due from banks, the carrying amount is a reasonable estimate of fair value.

Securities:

The fair value of securities is estimated based on bid prices published in financial newspapers or bid quotations received from securities dealers.

Federal Home Loan Bank stock:

The carrying amount of Federal Home Loan Bank stock approximates fair value based on the stock redemption provisions of the Federal Home Loan Bank.

F-18

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 12 — Fair Value of Financial Instruments – (continued)

Loans, net:

The fair value of loans is calculated by discounting scheduled cash flows through the estimated maturity using estimated market discount rates, adjusted for credit risk and servicing costs. The estimate of maturity is based on historical experience with repayments for each loan classification, modified, as required, by an estimate of the effect of current economic and lending conditions.

Deposits:

The fair value of deposits with no stated maturity, such as demand deposits, money market accounts, and savings deposits, is equal to the amount payable on demand. The fair value of time deposits is based on the discounted value of contractual cash flows. The discount rate is estimated using the rates currently offered for deposits of similar remaining maturities.

Federal funds purchased and securities sold under agreements to repurchase:

The estimated value of these liabilities, which are extremely short term, approximates their carrying value.

Federal Home Loan Bank advances and line of credit:

The carrying amounts of the FHLB advances and the line of credit approximate their fair value.

Commitments to extend credit:

The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates.

The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2006 and 2005, are as follows (in thousands):

	2006				2005
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Assets:
Cash and due from banks	$	17,636	$	17,636	$	14,590	$	14,590
Securities		32,590		32,590		30,450		30,449
Federal Home Loan Bank stock		1,332		1,332		1,034		1,034
Loans, net		305,879		305,248		262,009		261,553
Liabilities:
Noninterest-bearing demand deposits	$	41,723	$	41,723	$	42,118	$	42,118
Interest-bearing demand deposits		38,160		38,160		33,080		33,080
Savings deposits and money market accounts		56,913		56,913		55,411		55,411
Time deposits		139,021		140,713		121,826		120,828
Federal funds purchased and securities
sold under agreements to repurchase		19,250		19,250		4,791		4,791
Federal Home Loan Bank advances and line of credit		39,500		39,500		30,000		30,000
Unrecognized financial instruments (net of contract amount):
Commitments to extend credit		—		—		—		—

F-19

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 13 — Contingencies

The Bank is involved in certain claims arising from normal business activities. Management believes that those claims are without merit and that the ultimate liability, if any, resulting from them will not materially affect the Bank’s financial condition or the Company’s consolidated financial position.

Note 14 — Liquidity and Capital Resources

The Company’s primary source of funds with which to pay its future obligations is the receipt of dividends from its subsidiary bank. Banking regulations provide that the Bank must maintain capital sufficient to enable it to operate as a viable institution and, as a result, may limit the amount of dividends the Bank may pay without prior approval. It is management’s intention to limit the amount of dividends paid in order to maintain compliance with capital guidelines and to maintain a strong capital position in the Bank.

Note 15 — Stock Option Plans

The Company has stock option plans which are more fully described below. Effective January 1, 2006, the Company adopted SFAS 123(R), “Share-Based Payment” which requires that compensation cost relating to share-based payment transactions be recognized in the financial statements with measurement based upon the fair value of the equity or liability instruments issued. For the year ended December 31, 2006, the Company recognized $147,925 in compensation expense for all stock options.

The following table illustrates the effect on the Company’s reported net income and earnings per share if the Company had applied the fair value recognition provision of SFAS 123 to stock-based employee compensation prior to the adoption date:

Stock-based compensation:

	2005			2004
Net income, as reported	$	4,324,519		$	2,571,083
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of the related tax effects		(61,402	)		(49,469	)
Pro forma net income	$	4,263,117		$	2,521,614
Earnings per share:
Basic – as reported	$	0.71		$	0.52
Basic – pro forma	$	0.70		$	0.51
Diluted – as reported	$	0.66		$	0.46
Diluted – pro forma	$	0.65		$	0.45

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

	Years Ended December 31,
	2006		2005		2004
Dividend yield	0.98	%	0.98	%	0.60	%
Expected volatility	11.80	%	11.80	%	10.00	%
Expected life	6.6	years	6.9	years	6.9	years
Risk-free interest rate	5.11	%	4.19	%	4.16	%

F-20

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 15 — Stock Option Plans – (continued)

During both 2006 and 2004, the Company’s stock options were subject to 2-for-1 stock dividends. The impact of each dividend was to double the total number of options available under each of the stock option plans and reduce the existing option price in half. The information shown below retroactively reflects the impact of these dividends. The following information more fully describes the Company’s stock option plans.

Board of Directors plan:

The Company has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of the Bank’s common stock. On October 15, 1997, the Bank stock options were converted to Company stock options. Only non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of the Corporation’s stock on the date of grant and the option’s maximum term is ten years. Vesting for options granted during 2004, 2005 and 2006, are 50% on the first and second anniversary of the grant date. At December 31, 2006, the total remaining compensation cost to be recognized on non-vested options is approximately $139,000. A summary of the status of this stock option plan is presented in the following table:

	Years Ended December 31,
	2006							2005					2004
	Shares			Average Exercise Price		Aggregate Intrinsic Value(1)		Shares			Average Exercise Price		Shares		Average Exercise Price
Outstanding at beginning of year		90,000		$	3.80				500,000		$	2.62		480,000	$	2.50
Granted		40,000			13.25				10,000			9.23		20,000		5.44
Exercised		(63,000	)		2.55				(418,000	)		2.50		—		—
Forfeited		—			—				(2,000	)		7.33		—		—
Outstanding at end of year		67,000		$	10.61	$	394,555		90,000		$	3.80		500,000	$	2.62
Options exercisable at year-end		22,500		$	6.20	$	231,818		72,000		$	2.91		480,000	$	2.50
Weighted-average fair value of Options granted during the year	$	3.24						$	2.05				$	1.44

——————

(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, 2006. This amount changes based on changes in the market value of the Company’s stock. The total intrinsic value of options exercised during 2006 was approximately $686,000. The fair value (present value of the estimated future benefit to the option holder) of each option grant is estimated on the date of grant using the Black-Scholes option pricing model.

Information pertaining to options outstanding at December 31, 2006, is as follows:

	Options Outstanding				Options Exercisable
Exercise Prices	Number Outstanding	Weighted Average Remaining Life	Weighted Average Exercise Price		Number Exercisable	Weighted Average Exercise Price
$5.44	18,000	7.2 Years	$	5.44	18,000	$	5.44
9.23	9,000	8.2 Years		9.23	4,500		9.23
13.25	40,000	9.2 Years		13.25	—		—
Outstanding at end of year	67,000	8.5 Years		10.61	22,500		6.20

F-21

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 15 — Stock Option Plans – (continued)

Information pertaining to non-vested options for the year ended December 31, 2006, is as follows:

	Number of Shares			Weighted Average Grant Date Fair Value
Non-vested options, December 31, 2005		18,000		$	7.33
Granted		40,000			13.25
Vested		(13,500	)		6.20
Forfeited/expired		—			—
Non-vested options, December 31, 2006		44,500			12.84

The total fair value of shares vested during 2006 was $222,750.

Officer and Employee Plans:

The Company has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 1,420,000 shares of the Company’s common stock. The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant. The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary. The options expire ten years from the grant date. At December 31, 2006, the total remaining compensation cost to be recognized on non-vested options is approximately $607,000. A summary of the status of this stock option plan is presented in the following table:

	Years Ended December 31,
	2006							2005					2004
	Shares			Average                     Exercise Price		Aggregate Intrinsic Value(1)		Shares			Average Exercise Price		Shares			Average Exercise Price
Outstanding at beginning of year		632,500		$	4.64				564,400		$	3.97		435,000		$	3.51
Granted		82,800			13.25				80,300			9.23		137,000			5.44
Exercised		(46,180	)		3.54				(5,100	)		4.47		(4,500	)		4.37
Forfeited		—							(7,100	)		3.27		(3,100	)		3.29
Outstanding at end of year		669,120		$	5.79	$	7,169,515		632,500		$	4.64		564,400		$	3.97
Options exercisable at year-end		367,120		$	3.71	$	4,695,499		300,900		$	3.47		216,220		$	3.46
Weighted-average fair value of
Options granted during the year	$	3.24						$	2.05				$	1.44

——————

(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, 2006. This amount changes based on changes in the market value of the Company’s stock. The total intrinsic value of options exercised during 2006 was approximately $457,000. The fair value (present value of the estimated future benefit to the option holder) of each option grant is estimated on the date of grant using the Black-Scholes option pricing model.

F-22

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 15 — Stock Option Plans – (continued)

Information pertaining to options outstanding at December 31, 2006, is as follows:

	Options Outstanding						Options Exercisable
Exercise Prices	Number Outstanding		Weighted Average Remaining Life		Weighted Average Exercise Price		Number Exercisable		Weighted Average Exercise Price
$3.25 – $3.75		372,520		4.7 Years	$	3.52		326,920	$	3.50
5.44		134,000		7.2 Years		5.44		40,200		5.44
9.23		79,800		8.2 Years		9.23		—		—
13.25		82,800		9.2 Years		13.25		—		—
Outstanding at end of year		669,120		6.1 Years		5.79		367,120		3.71

Information pertaining to non-vested options for the year ended December 31, 2006, is as follows:

	Number of Shares			Weighted Average Grant Date Fair Value
Non-vested options, December 31, 2005		331,600		$	5.72
Granted		82,800			13.25
Vested		(112,400	)		4.27
Forfeited/expired		—			—
Non-vested options, December 31, 2006		302,000			8.32

The total fair value of shares vested during 2006 was $1,854,600.

Note 16 — Regulatory Matters

The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the Tennessee Department of Financial Institutions and the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company’s and the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company’s and the Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components , risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2006 and 2005, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2006, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. There are no conditions or events since that notification that management believes have changed the Bank’s prompt corrective action category for bank capital.

F-23

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 16 — Regulatory Matters – (continued)

The Company’s and the Bank’s actual capital amounts and ratios are also presented in the table. Dollar amounts are presented in thousands.

	Actual				For Capital Adequacy Purposes
	Amount		Ratio		Amount		Ratio
As of December 31, 2006:
Total capital to risk-weighted assets:
Consolidated	$	39,311	12.0	%	$	26,243	8.0	%
Cornerstone Community Bank		35,770	10.9	%		26,164	8.0	%
Tier I capital to risk-weighted assets:
Consolidated		35,210	10.7	%		13,121	4.0	%
Cornerstone Community Bank		31,681	9.7	%		13,082	4.0	%
Tier I capital to average assets:
Consolidated		35,210	10.2	%		13,790	4.0	%
Cornerstone Community Bank		31,681	9.4	%		13,541	4.0	%
As of December 31, 2005:
Total capital to risk-weighted assets:
Consolidated	$	32,840	11.5	%	$	22,943	8.0	%
Cornerstone Community Bank		29,488	10.5	%		22,435	8.0	%
Tier I capital to risk-weighted assets:
Consolidated		29,255	10.2	%		11,471	4.0	%
Cornerstone Community Bank		25,983	9.3	%		11,218	4.0	%
Tier I capital to average assets:
Consolidated		29,255	10.3	%		11,338	4.0	%
Cornerstone Community Bank		25,983	9.2	%		11,336	4.0	%

F-24

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

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, 2006, 2005 and 2004, is as follows:

	Before-Tax Amount			Tax (Expense) Benefit			Net-of-Tax Amount
Year ended December 31, 2006:
Unrealized holding gains and losses arising during the period	$	162,632		$	(55,295	)	$	107,337
Less reclassification adjustment for gains realized in net income		—			—			—
	$	162,632		$	(55,295	)	$	107,337
Year ended December 31, 2005:
Unrealized holding gains and losses arising during the period	$	(427,257	)	$	145,268		$	(281,989	)
Less reclassification adjustment for gains realized in net income		—			—			—
	$	(427,257	)	$	145,268		$	(281,989	)
Year ended December 31, 2004:
Unrealized holding gains and losses arising during the period	$	(97,800	)	$	33,252		$	(64,548	)
Less reclassification adjustment for gains realized in net income		—			—			—
	$	(97,800	)	$	33,252		$	(64,548	)

Note 18 — Earnings Per Common Share

Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued, as well as any adjustment to income that would result from the assumed issuance.

Potential common shares that may be issued by the Company relate to outstanding stock options, determined using the treasury stock method.

Earnings per common share have been computed based on the following:

	2006		2005		2004
Net income	$	5,811,600	$	4,324,519	$	2,571,083
Less: Preferred stock dividends		—		—		—
Net income applicable to common stock	$	5,811,600	$	4,324,519	$	2,571,083
Average number of common shares outstanding		6,481,568		6,091,250		4,980,680
Effect of dilutive stock options		352,630		440,470		617,746
Average number of common shares outstanding used to calculate diluted earnings per common share		6,834,198		6,531,720		5,598,426

During both 2006 and 2004, the Company enacted 2-for-1 split-ups effected in the form of stock dividends. The average number of common shares outstanding and the effect of dilutive stock options for 2005 and 2004 have been retroactively adjusted to reflect these transactions.

F-25

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 19 — Stock Subscriptions Receivable

Effective October 8, 2004, the Company filed an offering with the Securities and Exchange Commission to sell up to 500,000 shares of newly issued Company common stock. At December 31, 2004, the Company had sold the entire 500,000 shares for an issue price of $15 per share. However, of this amount, there were 119,961 shares of common stock subscribed for which the Company had not yet received funds and issued common stock certificates. The Company recognized stock subscriptions receivable of $1,799,415 as of December 31, 2004, related to this transaction. As shown in the consolidated statements of changes in stockholders’ equity, the stock subscriptions receivable were fully settled and the related common stock certificates were issued during 2005.

Note 20 — Recent Accounting Pronouncements

SFAS 156, “Accounting for Servicing of Financial Assets – An Amendment of FASB Statement No. 140” requires an entity to recognize a servicing asset or servicing liability each time it undertakes a contractual obligation to service a financial asset in certain circumstances. All separately recognized servicing assets and servicing liabilities are required to be initially measured at fair value. Subsequent measurement methods include the amortization method, whereby servicing assets or servicing liabilities are amortized in proportion to and over the period of estimated net servicing income or net servicing loss, or the fair value method, whereby servicing assets or servicing liabilities are measured at fair value at each reporting date and changes in fair value are reported in earnings in the period in which they occur. If the amortization method is used, an entity must assess servicing assets or servicing liabi lities for impairment or increased obligation based on the fair value at each reporting date. SFAS 156 is effective for fiscal years beginning after September 15, 2006. The Company is currently evaluating the impact of SFAS 156 on its consolidated financial statements.

SFAS 157, “Fair Value Measurements” defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 applies only to fair-value measurements that are already required or permitted by other accounting standards and is expected to increase the consistency of those measurements. The definition of fair value focuses on the exit price, i.e., the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not the entry price, i.e., the price that would be paid to acquire the asset or received to assume the liability at the measurement date. The statement emphasizes that fair value is a market-based measurement; not an entity-specific measurement. Therefore, the fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. The effective date for SFAS 157 is for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the impact of SFAS 157 on its consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes” (FIN 48). FIN 48 defines the threshold for recognizing the benefits of tax return positions in the financial statements as “more-likely-than-not” to be sustained by the taxing authority. The recently issued literature also provides guidance on the derecognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. FIN 48 also includes guidance concerning accounting for income tax uncertainties in interim periods and increases the level of disclosures associated with any recorded income tax uncertainties. FIN 48 is effective for fiscal years beginning after December 15, 2006. The differences between the amounts recognized in the statements of financial position prior to the adoption of FIN 48 and the amounts reported after adoption will be account ed for as a cumulative-effect adjustment recorded to the beginning balance of retained earnings. The Company is currently evaluating the impact of FIN 48 on its consolidated financial statements.

In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both the balance sheet and income statement approach when quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the Company’s fiscal year ending December 31, 2006. SAB 108 did not have a material impact on our 2006 consolidated financial statements.

F-26

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 21 — Acquisition

On December 1, 2005, the Company acquired certain assets and assumed liabilities of Eagle for a purchase price of $1,380,000 in cash plus assumption of approximately $1,609,000 in liabilities. Assets acquired, primarily accounts receivable, amounted to approximately $2,140,000. The excess of purchase price over the fair value of the assets acquired of $848,916 was recorded as an intangible asset separable from goodwill, as it pertained to customer relationships, active customer contracts and brand recognition, and met the separability criteria of SFAS No. 141, “Business Combinations” (SFAS 141). The Company is amortizing the intangible assets over their benefit periods which range from 1 to 7 years. The Company recognized amortization expense of $345,388 and $13,500 for the period ended December 31, 2006 and 2005, respectively. Amortization expense for each of the following five years is estimated as follo ws: 2007 - $107,691; 2008 - $107,691; 2009 - $107,691; 2010 - $107,691; 2011 - $36,382; thereafter $22,882.

The acquisition was accounted for under the provisions of SFAS 141 and the results of operations have been included in the accompanying consolidated financial statements since its date of acquisition. Pro-forma disclosures of the acquisition have not been included, as the overall impact the acquisition was not significant in relation to the Company’s operating results.

Note 22 — Equity Investment

During 2006, the Company invested $3,000,000 for a 25% share of the Appalachian Fund for Growth II partnership (AFG), which is managed by the Southeast Local Development Corporation (General Partner). AFG will use the investments received in formation to make below-market rate senior and subordinated debt products to businesses seeking to build, renovate, expand and equip their business facilities. AFG will target high job creation and retention businesses and businesses providing important community services. The funds will be deployed to help: 1) attract new businesses to its under-served service area 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 their investment the Company and the other investors will receive new market tax c redits. For 2006 the Company received approximately $150,000 in new market tax credits.

AFG meets the criteria of a VIE outlined in FASBI 46-R. AFG has not been consolidated by the Company as the Company is not the primary beneficiary.

F-27

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 23 — Quarterly Data (unaudited)

	Years Ended December 31,
	2006								2005
	Fourth Quarter		Third Quarter		Second Quarter		First Quarter		Fourth Quarter		Third Quarter		Second Quarter		First Quarter
Interest income	$	7,931,542	$	7,533,801	$	7,184,095	$	6,509,368	$	6,067,709	$	5,437,881	$	4,843,999	$	4,322,493
Interest expense		2,932,985		2,781,355		2,437,644		2,154,125		1,873,554		1,641,591		1,427,333		1,135,314
Net interest income, before provision for loan losses		4,998,557		4,752,446		4,746,451		4,355,243		4,194,155		3,796,290		3,416,666		3,187,179
Provision for loan losses		48,800		204,800		475,000		378,000		502,000		349,600		340,000		210,000
Net interest income, after provision for loan losses		4,949,757		4,547,646		4,271,451		3,977,243		3,692,155		3,446,690		3,076,666		2,977,179
Non-interest income		591,689		418,102		668,453		433,012		840,877		491,748		270,378		301,717
Non-interest expenses		3,512,381		2,422,234		2,541,394		2,242,221		2,485,197		1,969,647		1,856,724		1,904,707
Income before income taxes		2,029,065		2,543,514		2,398,510		2,168,034		2,047,835		1,968,791		1,490,320		1,374,189
Income tax expense		582,200		997,065		935,298		812,960		706,116		738,000		578,500		534,000
Net income	$	1,446,865	$	1,546,449	$	1,463,212	$	1,355,074	$	1,341,719	$	1,230,791	$	911,820	$	840,189
Earnings per common share:
Basic (1)	$	0.22	$	0.24	$	0.23	$	0.21	$	0.22	$	0.20	$	0.15	$	0.14
Diluted (1)	$	0.20	$	0.23	$	0.22	$	0.20	$	0.21	$	0.18	$	0.14	$	0.13

——————

(1)

During 2006, the Company enacted a 2-for-1-split-up effected in the form of a stock dividend.  Therefore, previously reported EPS amounts disclosed herein have been retroactively adjusted to reflect this transaction.

F-28

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 24 — Condensed Parent Information

BALANCE SHEETS

	2006		2005
ASSETS
Cash	$	311,073	$	516,559
Investment in subsidiaries		33,320,259		27,511,971
Loan to subsidiary		2,869,500		1,428,794
Goodwill		2,541,476		2,541,476
Other assets		158,524		726,626
Total assets	$	39,200,832	$	32,725,426
LIABILITIES AND STOCKHOLDERS’ EQUITY
Other liabilities	$	517,567	$	259,063
Line of credit		500,000		—
Total liabilities		1,017,567		259,063
Stockholders’ equity		38,183,265		32,466,363
Total liabilities and stockholders’ equity	$	39,200,832	$	32,725,426

STATEMENTS OF INCOME

	2006			2005			2004
Income
Dividends	$	590,130		$	200,000		$	177,039
Interest income		139,935			10,000			—
		730,065			210,000			177,039
Expenses
Interest expense		1,632			—			38,485
Other operating expenses		914,786			263,824			203,881
Loss before equity in undistributed earnings of subsidiary		(186,353	)		(53,824	)		(65,327	)
Equity in undistributed earnings of subsidiary		5,700,951			4,261,344			2,544,910
Income tax benefit		297,002			116,999			91,500
Net income	$	5,811,600		$	4,324,519		$	2,571,083

F-29

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006, 2005 and 2004

Note 24 — Condensed Parent Information – (continued)

STATEMENTS OF CASH FLOWS

	2006			2005			2004
Cash Flows from Operating Activities
Net income	$	5,811,600		$	4,324,519		$	2,571,083
Adjustments to reconcile net income to net cash provided by operating activities:
Stock compensation expense		147,925			—			—
Equity in undistributed income of subsidiary		(5,700,951	)		(4,261,344	)		(2,544,910	)
Other		895,292			20,818			52,056
Net cash provided by operating activities		1,153,866			83,993			78,229
Cash Flows from Investing Activities
Acquisition of business		—			(1,380,000	)		—
Loan to subsidiary		(1,440,706	)		(1,428,794	)		—
Capital contribution to subsidiary		—			(1,775,000	)		(2,750,000	)
Net cash used in investing activities		(1,440,706	)		(4,583,794	)		(2,750,000	)
Cash Flows from Financing Activities
Net borrowings (repayments) under line of credit		500,000			—			(400,000	)
Purchase of common stock		(206,807	)		(82,520	)		—
Payment of dividends		(775,138	)		(526,476	)		(124,316	)
Issuance of common stock		563,299			2,949,666			5,679,653
Net cash provided by financing activities		81,354			2,340,670			5,155,337
Net Increase (Decrease) in Cash and Cash Equivalents		(205,486	)		(2,159,131	)		2,483,566
Cash and Cash Equivalents, beginning of year		516,559			2,675,690			192,124
Cash and Cash Equivalents, end of year	$	311,073		$	516,559		$	2,675,690
Supplemental Disclosures of Cash Flow Information
Cash paid during the year for:
Interest	$	1,632		$	—		$	40,503
Income taxes		2,944,000			1,190,850			1,988,062

F-30

EX-21

EXHIBIT 21

CORNERSTONE BANCSHARES, INC.

LIST OF SUBSIDIARIES

Name of Subsidiary	State of Incorporation
Cornerstone Community Bank	Tennessee
Eagle Financial, Inc.	Tennessee

EX-31.1

EXHIBIT 31

CERTIFICATIONS

I, Gregory B. Jones, certify that:

1.I have reviewed this report on Form 10-K of Cornerstone Bancshares, Inc. (the “Issuer”) for the fiscal year ended December 31, 2006.

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Issuer as of, and for, the periods presented in this period report;

4.The Issuer’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the Issuer and have:

(a)designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Issuer, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)designed such internal controls over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;

(c)evaluated the effectiveness of the Issuer’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)disclosed in this report any change in the Issuer’s internal control over financial reporting that occurred during the Issuer’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Issuer’s internal control over financial reporting.

5.The Issuer’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting to the Issuer’s auditors and the audit committee of Issuer’s board of directors:

(a)all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Issuer’s ability to record, process, summarize and report financial information; and

(b)any fraud, whether or not material, that involves management or other employees who have a significant role in the Issuer’s internal control over financial reporting.

Date: March 15, 2007	/s/ Gregory B. Jones
	Gregory B. Jones, Chairman and
	Chief Executive Officer

EX-31.2

EXHIBIT 31

CERTIFICATIONS

I, Nathaniel F. Hughes certify that:

1.I have reviewed this report on Form 10-K of Cornerstone Bancshares, Inc. (the “Issuer”) for the fiscal year ended December 31, 2006.

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the Issuer as of, and for, the periods presented in this period report;

4.The Issuer’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f) for the Issuer and have:

(a)designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Issuer, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b)designed such internal controls over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;

(c)evaluated the effectiveness of the Issuer’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d)disclosed in this report any change in the Issuer’s internal control over financial reporting that occurred during the Issuer’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Issuer’s internal control over financial reporting.

5.The Issuer’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting to the Issuer’s auditors and the audit committee of Issuer’s board of directors:

(a)all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Issuer’s ability to record, process, summarize and report financial information; and

(b)any fraud, whether or not material, that involves management or other employees who have a significant role in the Issuer’s internal control over financial reporting.

Date: March 15, 2007	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes, President and
	Treasurer

EX-32

Exhibit 32

CERTIFICATIONS OF CEO AND CFO PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT

CERTIFICATIONS PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

(18 U.S.C. SECTION 1350)

In connection with the Annual Report of Cornerstone Bancshares, Inc., a Tennessee corporation (the “Company”), on Form 10-KSB for the fiscal year ended December 31, 2006, as filed with the Securities and Exchange Commission (the “Report”), each of Gregory B. Jones, Chairman and Chief Executive Officer of the Company, and Nathaniel F. Hughes, President and Treasurer of the Company, do hereby certify, pursuant to § 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. § 1350), that to his knowledge:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company.

/s/ Gregory B. Jones                            

Gregory B. Jones

Chairman and Chief Executive Officer

____________________________         

/s/ Nathaniel F. Hughes                     

Nathaniel F. Hughes

President and Treasurer

____________________________

[A signed original of this written statement required by Section 906 has been provided to Cornerstone Bancshares, Inc. and will be retained by Cornerstone Bancshares, Inc. and furnished to the Securities and Exchange Commission or its staff upon request.]