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U.S. Securities and Exchange Commission
Washington, D.C. 20549

FORM 10-QSB

(Mark One)

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

For the quarterly period ended September 30, 2001

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

For the transition period from                to               

Commission file number 000-30497

CORNERSTONE BANCHSHARES, INC.
(Exact name of small business issuer as specified in its charter)

Tennessee
(State of other jurisdiction of
incorporation or organization) 62-1175427
(IRS Employer Identification No.)

5319 Highway 153
Chattanooga, Tennessee 37343
(Address of principal executive offices)

(423) 385-3000
(Issuer's telephone number)

    Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /x/  No / /

APPLICABLE ONLY TO CORPORATE ISSUERS

    The aggregate market value of the Registrant's outstanding Common Stock held by nonaffiliates of the Registrant on September 30, 2001 was approximately $16,031,171. There were 1,233,167 shares of Common Stock outstanding as of September 30, 2001.

    Transitional Small Business Disclosure Format (check one):

    Yes / /  No /x/

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CORNERSTONE BANCSHARES

PRESENTATION OF FINANCIAL INFORMATION

    The 2001 financial information in this report has not been audited. The information included herein should be read in conjunction with the notes to consolidated financial statements included in the 2000 Annual Report to Shareholders which was furnished to each shareholder of the Company in March 2001. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices.

Consolidation

    The accompanying consolidated financial statements include the accounts of Cornerstone Bancshares Inc. and its sole subsidiary Cornerstone Community Bank.

    Substantially all intercompany transactions, profits and balances have been eliminated.

Accounting Policies

    During interim periods, Cornerstone Bancshares follows the accounting policies set forth in its 10-KSB for the year ended December 31, 2000, as filed with the Securities and Exchange Commission. Since December 31, 2000, there have been no changes in any accounting principles or practices, or in the method of applying any such principles or practices.

Interim Financial Data (Unaudited)

    In the opinion of Cornerstone management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

Earnings Per Common Share

    Basic earnings per share ("EPS") is computed by dividing income available to common shareholders (numerator) by the number of common shares outstanding (denominator). Diluted EPS is computed by dividing income available to common shareholders (numerator) by the adjusted number of shares outstanding (denominator). The adjusted number of shares outstanding reflects the potential dilution occurring if securities or other contracts to issue common stock were exercised or converted into common stock resulting in the issuance of common stock that share in the earnings of the entity.

Forward-Looking Statements

    Certain written and oral statements made by or with the approval of an authorized executive officer of the Company may constitute "forward-looking statements" as defined under the Private Securities Litigation Reform Act of 1995. Words or phrases such as "should result, are expected to, we anticipate, we estimate, we project" or similar expressions are intended to identify forward-looking statements. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from Cornerstone's historical experience and its present expectations or projections. These risks and uncertainties include, but are not limited to, unanticipated economic changes, interest rate movements and the impact of competition. Caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date of making such statements.

PART I—FINANCIAL INFORMATION

Item 1. Financial Statements

CONSOLIDATED BALANCE SHEETS

		Unaudited September 30,		December 31,		Unaudited September 30,
		2001		2000		2000
ASSETS
Cash and due from banks		$	5,750,786	4,633,514		$	4,699,263
Due from banks time deposits			1,884,199	—			—
Federal funds sold			300,000	2,400,000			—
Investment securities available for sale			15,648,234	16,047,715			15,986,300
Investment securities held to maturity			2,556,573	4,012,414			4,502,465
Loans, less allowance for loan loss			93,539,491	83,431,776			81,683,363
Premises and equipment, net			3,778,910	3,391,138			3,312,820
Accrued interest receivable			751,967	849,142			753,569
Excess cost over fair value of assets acquired			2,571,732	2,662,499			2,636,586
Other assets			1,921,017	1,950,557			1,916,621
	Total assets	$	128,702,908	119,378,755		$	115,490,990
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits
Noninterest-bearing		$	13,298,195	11,924,140		$	12,437,791
NOW accounts			16,623,155	13,687,959			14,039,343
Savings deposits and money market accounts			12,216,611	10,459,568			10,757,431
Time deposits of $100,000 or more			21,481,001	16,911,729			16,590,984
Time deposits of less than $100,000			46,609,109	48,266,503			45,152,777
Total deposits			110,228,070	101,249,899			98,978,325
Federal funds purchased and securites sold under
agreement to repurchase			1,887,016	3,144,291			3,906,041
Federal Home Loan Bank Advance			2,000,000	2,000,000			—
Accrued interest payable			190,905	183,834			179,138
Other liabilities			488,797	282,570			262,251
Total Liabilities			114,794,789	106,860,594			103,325,754
Redeemable common stock			—	—			—
Stockholders' Equity
Common stock			1,233,167	1,166,129			1,166,129
Additional paid-in capital			12,093,867	11,322,276			11,322,276
Retained Earnings (deficit)			207,321	(92,694	)		(232,591	)
Accumulated other comprehensive income			373,765	122,450			(90,578	)
Total Stockholders' Equity			13,908,120	12,518,161			12,165,236
Total liabilities and stockholders equity		$	128,702,908	119,378,755		$	115,490,990

CONSOLIDATED STATEMENTS OF INCOME

	Unaudited Three months ended September 30,				Unaudited Nine months ended September 30,
	2001		2000		2001		2000
INTEREST INCOME
Interest and fees on loans	$	2,027,066	$	2,068,694	$	6,047,723	$	5,891,285
Interest on investment securities		268,461		355,531		834,189		1,043,700
Interest on federal funds sold		55,196		27,976		155,357		47,858
Interest on due from banks time deposits		31,663		—		89,161		—
Interest on other earning aseets		6,658		267		19,830		267
Total interest income		2,389,044		2,452,468		7,146,259		6,983,110
INTEREST EXPENSE
Interest bearing demand accounts		68,105		72,492		198,359		210,089
Money market accounts		53,931		68,585		176,296		197,376
Savings accounts		24,734		32,088		82,392		91,018
Time deposits of less than $100,000		643,757		674,993		2,084,414		1,819,741
Time deposits of $100,000 or more		266,301		251,963		857,551		692,644
Federal funds purchased		—		6,626		82		35,885
Securities sold under agreements to repurchase		11,275		49,644		52,172		107,292
Other borrowings		25,205		—		74,795		—
Total interest expense		1,093,308		1,156,391		3,526,059		3,154,044
Net interest income		1,295,735		1,295,813		3,620,200		3,829,066
Provision for loan losses		80,000		90,000		350,000		504,500
Net interest income after the provision for loan losses		1,215,735		1,205,813		3,270,200		3,324,566
NONINTEREST INCOME
Service charges on deposit accounts		125,931		90,552		348,727		277,656
Net securities gains (losses)		—		25,498		83,705		25,498
Other income		66,402		68,040		246,442		178,214
Total noninterest income		192,333		184,089		678,874		481,367
NONINTEREST EXPENSE
Salaries and employee benefits		554,135		543,772		1,662,782		1,673,486
Occupancy and equipment expense		219,847		194,099		502,660		458,336
Other operating expense		311,425		382,422		1,292,422		1,265,006
Total noninterest expense		1,085,407		1,120,293		3,457,864		3,396,828
Income before provision for income taxes		322,661		269,610		491,211		409,105
Provision for income taxes		140,901		144,500		191,197		186,878
NET INCOME	$	181,760		125,110	$	300,014	$	222,227
Basic net income per common share		0.15		0.11		0.24		0.19
Diluted net income per common share		0.14		0.10		0.23		0.18
Dividends declared per common share		—		—		—		—

CONSOLIDATED STATEMENTS OF CASH FLOWS

	For the Nine Months Ended September 30
	Unaudited 2001			Unaudited 2000
Cash flows from operating activities:
Net income		300,014			222,227
Adjustments to reconcile net income
to net cash provided by operating actvities:
Provision for possible loan losses		350,000			504,500
Net Charge-offs		(293,327	)		(351,076	)
Provision for depreciation and amortization		285,540			277,249
Accrued interest receivable		97,175			(97,410	)
Accrued interest payable		7,071			(10,732	)
Changes in other assets and liabilities:		235,768			236,555
Net cash provided by (used in) operating activities		982,242			781,312
Cash flows from investing activities:
Purchase of investment securities: AFS		(8,537,561	)		(4,053,044	)
Purchase of investment securities: HTM		—			—
Proceeds from security transactions: AFS		7,059,115			1,451,387
Proceeds from security transactions: HTM		1,506,111			1,267,728
Net increase in loans		(10,164,388	)		(10,512,909	)
Purchase of bank premises and equipment		(387,772	)		(1,272,826	)
Net cash provided by (used in) investing activities		(10,524,494	)		(13,119,664	)
Cash flows from financing activities:
Net increase in deposits		8,978,171			7,632,698
Net increase (decrease) in repurchase agreements		(1,257,275	)		1,726,678
Net increase of FHLB Advance		—			—
Issuance of common stock (retirement)		838,629			(43,462	)
Net cash provided by (used in) finanacing activities		8,559,525			9,315,914
Net increase (decrease) in cash and cash equivalents		(982,727	)		(3,022,437	)
Cash and cash equivalents beginning of period		7,033,514			7,721,701
Cash and cash equivalents end of period	$	6,050,786		$	4,699,263

Cornerstone Bancshares, Inc and Subsidiary
Changes in Stockholders' Equity
September 30, 2001

				Comprehensive Income		Common Stock		Additional Paid-in Capital		Retained Earnings (Deficit)			Accumulated Other Comprehensive Income		Total Stockholders' Equity
BALANCE, December 31, 2000						$	1,166,129	$	11,322,276	$	(92,694	)	$	122,450	$	12,518,161
	Issuance of Common Stock						67,038		771,591							838,629
	Comprehensive Income:
		Net Income		$	300,014						300,014					300,014
		Other comprehensive income, net of tax:
			Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment		251,316									251,316		251,316
		Total comprehensive income		$	551,330
BALANCE, September 30, 2001 (Unaudited)						$	1,233,167	$	12,093,867	$	207,320		$	373,765	$	13,908,120

Item 2. Management's Discussion and Analysis or Plan of Operation.

Overview

    Cornerstone Bancshares, Inc. ("Cornerstone") ended the first nine months of 2001 with total assets of $129 million, a 7.8% increase from December 31, 2000, and an 11.4% increase from September 30, 2000. Cornerstone reported net income for the first nine months ending September 30, 2001 of $300,014, or $0.24 basic earnings per share, compared to $222,227 or $0.19 basic earnings per share, for the same period in 2000. The increase in earnings represents a 35.0% increase from the first nine months of 2000 compared to the first nine months of 2001.

    The increase in net income from the first nine months of 2000 to the same period in 2001 is due to several factors. The Bank's non-interest income not including securities gains increased $139 thousand or 30.6% over the same period in 2000. The increase in non-interest income represents general increases in all categories of service income, but secondary mortgage sales strong performance stood out with an increase of 200% over the same period in 2000. The loan loss provision decreased $154 thousand, which is an expense reduction of 30.6% over the same period in 2000. Offsetting these increases and savings was a decrease in the Bank's net interest income. The Bank experienced a decrease in the Bank's net interest income, of $209 thousand or 5.5%, when compared to the same period in 2000. This decrease was due to the historic 400 basis point decrease in interest rates implemented by the Federal Reserve during 2001. Cornerstone initially saw its interest rate margin shrink to 4.25% due to its short term asset sensitivity, but since that time the net interest margin has improved to 4.54% as the Bank's deposits have repriced. As the rates stabilize and begin to increase back to normal levels the Bank will experience higher net interest margins and return to its budgeted 4.75%. The net result of these many factors was a 35.0% increase in net income and the expectation that the Bank's future earnings during the remaining quarter of 2001 will meet management's expectations unless the economy's recession is severe and the Federal Reserve continues to cut interest rates. The management of the Bank believes strongly that, at the end of 2001, it will have the amount of its substandard loans returned to, or below, peer bank standards and as a result, expects a lower provision to the loan loss allowance. Core customer relationships, which bring low cost deposits and quality loans to the balance sheet, remain a top priority for the Bank. Cornerstone also plans to continue to focus its efforts on small business relationships in the future.

    The Strategic plan of Cornerstone entails providing a competitive footprint (convenient branches) to the Chattanooga Metropolitan Statistical Area allowing Cornerstone to compete with the three major regional banks located in the area. Cornerstone will focus its efforts in the suburb branch network and not on a central Hub Bank located in downtown Chattanooga. The customer base will consist of small businesses and individual consumers.

    Cornerstone Community Bank was released from the Memorandum of Understanding with the Tennessee Department of Financial Institutions and the Federal Deposit Insurance Corporation as of August of 2001 and was released from the Board Resolution of the Federal Reserve as of September of 2001.

Financial Condition

    Earning Assets.  Average earning assets for the nine months ending September 30, 2001, increased $10.6 million, or 10.52%, above the nine months ending September 30, 2000, while actual earning assets increased $11.7 million or 11.3% during the same time period. The average balance increase was due to strong loan demand in the third quarter of 2001 and a steady growth in core deposits during the current reporting period. Management expects average earning assets to steadily increase during the rest of 2001 and anticipates similar growth in 2002.

    Loan Portfolio.  Cornerstone's average loans for the first nine months of 2001 were $87.4 million, an increase of $8.1 million or 10.2% from the first nine months of 2000, while actual balances increased to $94.7 million, an increase of 14.2% above $82.9 million in loans in the first nine months of 2000. Management is anticipating increased loan growth for the remainder of the year in both average and actual balances.

    Investment Portfolio.  Cornerstone's average investment securities portfolio and Federal Funds sold increased by 9.7% or $2.1 million for the nine months ending September 30, 2000 compared to the nine months ending September 30, 2001, while actual balances decreased $0.1 million, an decrease of 0.0%. The average growth is the direct result of deposit growth. While the actual balance stability is due the strong funding requirement for the Bank's loan growth. The Bank has seen an acceleration of mortgage prepayments but the core of the Bank's holdings non-callable FHLB and FNMA Agency notes have performed well and provided the Bank with stable earnings from the Bank's portfolio of investments. Cornerstone maintains an investment strategy of making prudent investment decisions with active management of the portfolio to optimize, within the constraints of established policies, an adequate return and value. Investment objectives include, in order of priority, Gap Management, Liquidity, Pledging, Return, and Local Community Support. Cornerstone maintains two classifications of investment securities: "Held to Maturity" (HTM) and "Available for Sale" (AFS). The "Available for Sale" securities are carried at fair market value, whereas "Held to Maturity" securities are carried at book value. As of September 30, 2001, net unrealized gains in the "Available for Sale" portfolio amounted to $566,311, a 2.9% increase in value.

    Deposits.  Cornerstone's average deposits increased $8.6 million or 8.8% for the nine month period ending September 30, 2000 compared to the same period ending September 30, 2001, while actual deposit balances increased $11.3 million or 11.4%. The actual deposit growth was broad based with the exception of large certificates of deposit, which increased 29.5% during the same time period. Management will continue to focus its efforts on attracting core deposits and expects certificates of deposit to decrease over the remainder of 2001 while deposits in general to increase in the 10% level for the next several quarters. Transaction accounts will be continuously solicited from new customers and existing customers, and represent one of Cornerstone's highest priorities and should provide Cornerstone with an increased net interest margin.

    Other Liabilities.  During the last quarter of 2000, Cornerstone acquired an advance from the Federal Home Loan Bank of Cincinnati (FHLB). The advance was in the amount of $2,000,000 and had a maturity of 10 years with call and put options after two years. Management of the Cornerstone believes the FHLB provides an inexpensive method to reduce interest rate risk by obtaining longer term liabilities to match the typically longer termed assets the Bank has on its Balance sheet and usually below the cost of certificates of deposit. Management intends to borrow additional funds from the FHLB during the 4^th quarter of 2001 to offset an increasing number of fixed rate loans being booked due to the historically low interest rates. The additional target borrowings will range from $4 to $8 million.

    Capital Resources.  Stockholders' average equity increased $1.4 million or 11.8% to $13.4 million for the nine months ending September 30, 2001, compared with an average $12.0 million during the same nine months ending September 30, 2000. Actual equity increased $1.7 million or 14.3% from September 30, 2000 to September 30, 2001. This increase was primarily due to a registered stock offering with net proceeds of approximately $.8 million. The balance of the increase represents current year earnings from operations and net unrealized gains in available for sale investment securities.

CONSOLIDATED AVERAGE BALANCE SHEET
INTEREST INCOME/EXPENSE AND YIELD/RATES
Taxable equivalent basis
(in thousands)

		Nine months ended September 30,
		2001				2000
		Average Balance		Income/ Expense	Yield/ Rate	Average Balance		Income/ Expense	Yield/ Rate
Assets
Earning Assets:
Loans, net of unearned income		87,428		6,048	9.25%	79,347		5,891	9.92%
Investment securities		19,539		925	6.33%	21,064		1,045	6.63%
Federal Funds Sold		4,710		155	4.41%	1,037		48	6.16%
Other earning assets		360		20	7.36%	—		0	0.00%
Total earning assets		112,037		7,148	8.53%	101,448		6,984	9.20%
Allowance for loan losses		(1,167	)			(1,038	)
Cash and other assets		13,117				12,840
	TOTAL ASSETS	123,987				113,250
Liabilities and Stockholders' Equity
Interest bearing liabilities:
Interest bearing demand deposits		15,853		198	1.67%	16,108		210	1.74%
Savings deposits		10,917		259	3.17%	11,157		288	3.45%
Time deposits		47,283		2,084	5.89%	42,327		1,820	5.74%
Time deposits of $100,000 or more		19,503		858	5.88%	15,988		693	5.79%
Federal funds and securities sold under Agreement to repurchase		2,027		52	3.45%	3,482		143	5.49%
Other borrowings		2,000		75	5.00%	—		—	0.00%
Total interest bearing liabilities		97,583		3,526	4.83%	89,062		3,154	4.73%
Net interest spread				3,622				3,830
Noninterest bearing demand deposits		12,152				11,559
Accrued expenses and other liabilities		873				657
Stockholders' equity		13,381				11,972
	TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	123,987				113,250
Net interest margin on earning assets					4.32%				5.04%
Net interest spread on earning assets					3.70%				4.47%
Taxable equivalent adjustment:
Loans				—				—
Investment Securities				2				1
	Total adjustment			2				1

Results of Operations—Nine months ended September 30, 2001 compared to nine months ended September 30, 2000

    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 deposits. The following discussion is on a fully taxable equivalent basis.

    Net interest income before loan loss provision for the first nine months of 2001 decreased $208,866 or 5.5% below net interest income before loan loss provision as of first nine months of 2000. The decrease in net interest income as of September 30, 2001 is primarily due to a sharp change in policy of the Federal Reserve who decreased the Fed Discount rate 400 basis points during the first nine months of 2001. Compounding the compression of the net interest margin was the large concentration of certificates of deposit and the time required to reprice the certificates to lower levels. The decrease in net interest margin was above Cornerstone's management's expectation and management anticipates the possibility of further cuts by the Federal Reserve if the economy slips into a recession. Management foresees the margin returning to the budgeted 4.75% by the end of the fourth quarter. Three factors contribute to this net interest margin forecast: First, Cornerstone certificates of deposit repriced rapidly during the second and third quarter from an average 6.50% to an average 4.75%; Second, Cornerstone will continue to solicit transaction accounts from small businesses and reduce Cornerstone's percentage of certificates of deposit to total deposits; and Third, Cornerstone plans to continue to grow Cornerstone's earning assets as a percentage of total assets.

    Interest income increased $163,149 or 2.3% for the period ended September 30, 2001 compared the same period ended September 30, 2000. Interest income produced by the loan portfolio increased $156,438 or 2.7% for the nine month period ended September 30, 2000 compared to nine month period ended September 30, 2001 due to the increase in average loans outstanding and origination fees associated with loan growth for the period. The increase of loan interest income was partially offset by the sharp decrease in interest rates on the Bank's variable rate loans. Management estimates the average balances will continue to increase but will restrain origination of these loans to insure quality standards and documentation are maintained. Interest income on investment securities, federal funds and other investments increased $6,712 or 0.6% for the nine month period ending September 30, 2000 compared to the nine month period ended September 30, 2001, due primarily to an increase in the average balance of Federal Funds sold raised to fund loan growth for the third and fourth quarter of 2001.

    Total interest expense increased $372,015 or 11.8% from September 30, 2000 to September 30, 2001. The interest expense increase from the first nine months of 2000 to the first nine months of 2001 is primarily due to an increase in the rates for certificates of deposit during the fourth quarter of 2000 and the first quarter of 2001. In addition the Bank grew the average balance of deposits 8.8% during the first nine months of 2001 compared with the same period of 2000.

    The trend in net interest income is commonly evaluated in terms of average rates using the net interest margin and the 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 net interest margin for the first nine months of 2001 was 4.32%. The yield on earning assets decreased 67 basis points to 8.53% for the period ended September 30, 2001 compared to 9.20% for the period ended September 30, 2000.

    The interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing sources of funds. The interest rate spread eliminates the impact of non-interest bearing funds and gives a direct perspective on the effect of market interest rate movements. As a result of fluctuations of interest rates during the early part of 2001 and an asset sensitivity during the first six months of an interest rate movement, the interest rate spread was 3.70% for the nine month period ending September 30, 2001 compared to 4.47% for the same period ending September 30, 2000, a decrease of 77 basis points.

    Allowance for Loan Losses.  The allowance for possible loan losses 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 $1.2 million in the allowance for loan loss account at September 30, 2001 reflects the full known extent of credit exposure. Cornerstone made a $350,000 provision during the first nine months of 2001 and anticipates reduced provisions as the quality of the loan portfolio continues to improve, with the majority of the provision being dedicated to future loan growth. No assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio, and require greater provisions for possible loan losses in the future.

    Non-performing Assets.  Non-performing assets include non-performing loans and foreclosed real estate held for sale. Non-performing loans include loans classified as non-accrual or renegotiated. Cornerstone's policy is to place a loan on non-accrual status when payment of principal or interest is contractually 90 or more days past due. 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. As of September 30, 2001, Cornerstone had $36,530 in non-accrual loans and $548,537 in non-performing assets versus $60,487 and $702,746 respectively at September 30, 2000 a 23.4% reduction.

    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, commissions earned through credit life insurance sales and other activities. In addition, gains or losses realized from the sale of loans are included in non-interest income. Total non-interest income increased by $197,507 or 41.0% from the first nine months of 2000 compared with the first nine months of 2001. The gain in non-interest income was broad based in almost every category, but was especially strong in secondary market mortgage lending, which was benefited by a low interest rate environment and strong consumer confidence. Included in this increase was a security gain taken in January of 2001 in the amount of $83,705.

    Non-interest Expense.  Non-interest expense for the first nine months of 2001 increased by $61,036 or 1.8% as compared to the first nine months in 2000. Salaries and employee benefits decreased by $10,704 or 0.6% for the nine months ending September 30, 2001 over the same period ending September 30, 2000. Occupancy expense as of September 30, 2001 increased by $44,324 or 9.7% over the same period in 2000. All other non-interest expenses for the nine month period ended September 30, 2001 increased $27,416 or 2.2% over the non-interest expenses for the same period ended September 30, 2000.

CONSOLIDATED AVERAGE BALANCE SHEET
INTEREST INCOME/EXPENSE AND YIELD/RATES
Taxable equivalent basis
(in thousands)

		Three months ended September 30,
		2001					2000
		Average Balance			Income/ Expense	Yield/ Rate	Average Balance		Income/ Expense	Yield/ Rate
Assets
Earning Assets:
Loans, net of unearned income			89,589		2,027	8.98%	82,333		2,069	10.00%
Investment securities			19,094		301	6.25%	21,432		356	6.61%
Federal Funds Sold			5,847		55	3.75%	1,720		28	6.47%
Other earning assets			367		7	7.20%	—		—	0.00%
Total earning assets			114,896		2,390	8.25%	105,485		2,453	9.25%
Allowance for loan losses			(1,180	)			(1,107	)
Cash and other assets			12,914				12,846
	TOTAL ASSETS	$	126,631				117,224
Liabilities and Stockholders' Equity
Interest bearing liabilities:
Interest bearing demand deposits		$	17,109		68	1.58%	15,986		72	1.80%
Savings deposits			11,770		79	2.65%	11,325		101	3.54%
Time deposits			46,910		644	5.44%	44,304		665	5.97%
Time deposits of $100,000 or more			19,960		266	5.29%	16,995		262	6.13%
Federal funds and securities sold under Agreement to repurchase			1,842		11	2.43%	3,858		56	5.80%
Other borrowings			2,000		25	5.00%	—		—	0.00%
Total interest bearing liabilities			99,590		1,093	4.36%	92,468		1,156	4.98%
Net interest spread					1,296				1,296
Noninterest bearing demand deposits			12,377				11,957
Accrued expenses and other liabilities			912				751
Stockholders' equity			13,752				12,048
	TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY		126,631				117,224
Net interest margin on earning aseets						4.48%				4.89%
Net interest spread on earning assets						3.90%				4.28%
Taxable equivalent adjustment:
Loans					—				—
Investment Securities					1				1
	Total adjustment				1				1

Results of Operations—Quarter ended September 30, 2001 compared to quarter ended September 30, 2000

    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 deposits. The following discussion is on a fully taxable equivalent basis.

    Net interest income before provision for loan loss for the three month period ended 2001 decreased $78 or 0.0% below net interest income before provision for loan loss for three month period ended 2000. The small decrease in net interest income for the third quarter of 2001 is primarily due to the growth of earning assets and decrease in the average cost of interest bearing liabilities which offset the continued sharp decrease in asset yields caused by the historic drop of the target Federal Funds rate of 400 basis points during 2001. Average earning assets increased to 90.5% for the three month period ending September 30, 2001 compared with 89.5% during the same time period in 2000. While average interest bearing liabilities as a percentage of total assets remained at 78.7%. These facts allowed Cornerstone net interest income to remain stable while the net interest margin decreased 41 basis points. The decrease of Federal Funds rate was above Cornerstone management's expectation and management anticipates the possibility of further cuts by the Federal Reserve if the US economy slips into a recession. Management foresees the margin returning to budgeted 4.75% by the end of the fourth quarter.

    Interest income decreased $63,424 or 2.6% for the third quarter of 2001 compared to the third quarter of 2000. Interest income produced by the loan portfolio decreased $41,628 or 2.0% from the third quarter 2000 to the third quarter 2001, due to the decrease in average yields, which decreased from 10.00% to 8.98% for the period. Management estimates the average balances will increase, but will closely monitor origination of these loans to insure quality standards and documentation are maintained. Interest income on investment securities and Federal Funds sold decreased $21,796 or 5.7% from third quarter 2000 to third quarter 2001, due to increase in the amount of average Federal Funds sold and a rapid decrease in the interest paid for these balances.

    Total interest expense decreased $63,083 or 5.5% from the third quarter of 2000 to the third quarter of 2001. From the third quarter of 2000 to the third quarter of 2001, the interest expense decrease is primarily due to repricing of deposits, which were mostly concentrated in certificates of deposit. Management is actively pursuing customer relationships with small business and municipalities to obtain lower cost deposits and reduce Cornerstone's exposure to certificates of deposit. Management anticipates total interest expense to drop during the fourth quarter of 2001.

    The trend in net interest income is commonly evaluated in terms of average rates, using the net interest margin and the interest rate spread. The net interest margin, or the net yield on earning assets, is computed by dividing the fully taxable equivalent net interest income by the 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 net interest margin for the third quarter of 2001 was 4.48%. The yield on earning assets decreased 100 basis points to 8.25% for the three month period ended September 30, 2001 from 9.25% for the same period ended September 30, 2000. While the yield on interest bearing liabilities decreased only 62 basis points during the same time period.

    The interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing sources of funds. The interest rate spread eliminates the impact of noninterest bearing funds and gives a direct perspective on the effect of market interest rate movements. As a result of changes in the asset and liability mix during late 2000 and reduced loan rates during the current period, the interest rate spread was 3.90%, a decrease of 38 basis points for the three month period ending September 30, 2000 compared to the same period ending September 30, 2001.

    Allowance for Loan Losses.  The allowance for possible loan losses 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 $1.2 million for the second quarter ended September 30, 2001 in the allowance for loan loss account reflects the full known extent of credit exposure. Cornerstone made a $80,000 provision during the first nine months of 2001 and anticipates reduced provisions as the quality of the loan portfolio continues to improve, with the majority of the provision being dedicated to future loan growth. No assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio, and require greater provisions for possible loan losses in the future.

    Non-performing Assets.  Non-performing assets include non-performing loans and foreclosed real estate held for sale. Non-performing loans include loans classified as non-accrual or renegotiated. Cornerstone's policy is to place a loan on non-accrual status when payment of principal or interest is contractually 90 or more days past due. 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. As of September 30, 2001, Cornerstone had $36,530 in non-accrual loans and $548,537 in non-performing assets versus $60,487 and $702,746 respectively at September 30, 2000 a 23.4% reduction.

    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, commissions earned through credit life insurance sales and other activities. In addition, gains or losses realized from the sale of loans are included in non-interest income. Total non-interest income increased by $8,244. Excluding a security gain taken during the third quarter of 2000, the total increase is $33,742 for a 21.3% increase from the third quarter of 2000. The gain in non-interest income was broad based in almost every category, but was especially strong in secondary market mortgage lending, which was benefited by a low interest rate environment and strong consumer confidence.

    Non-interest Expense.  Non-interest expense for the three month period ended 2001 decreased by $34,886 or 3.1% as compared to the three month period ended 2000. Salaries and employee benefits increased by $10,363 or 1.9% in third quarter of 2001 compared with the third quarter of 2000. Occupancy expense as of for the third quarter of 2001 increased by $25,748 or 12.9% over the same period in 2000. All other non-interest expenses for the third quarter of 2001 decreased $70,997 or 18.6% over the non-interest expenses for the third quarter of 2000.

ALLOWANCE FOR LOAN LOSSES

	2001						2000
Quarter Ending
	September 30		June 30		March 31		December 31		September 30		June 30		March 31
Balance at beginning of period	1,167,436		1,204,491		1,141,869		1,155,233		1,086,054		1,028,838		1,001,809
Loans charged-off	(65,213	)	(184,858	)	(115,132	)	(159,494	)	(72,003	)	(259,543	)	(170,891	)
Loans recovered	16,319		43,303		12,254		90,929		51,183		60,758		39,420
Net Charge-offs (recoveries)	(48,894	)	(141,555	)	(102,878	)	(68,564	)	(20,820	)	(198,784	)	(131,471	)
Provision for loan losses charged to expense	80,000		104,500		165,500		55,200		90,000		256,000		158,500
Balance at end of period	1,198,542		1,167,436		1,204,491		1,141,869		1,155,233		1,086,054		1,028,838
Allowance for loan losses as a percentage of average loans outstanding for the period	1.337	%	1.339	%	1.409	%	1.360	%	1.402	%	1.358	%	1.358	%
Allowance for loan losses as a percentage of nonperforming assets and loans 90 days past due outstanding for the period	218.498	%	211.013	%	100.959	%	142.709	%	164.388	%	136.980	%	83.251	%
Annualized QTD net charge-offs as a percentage of average loans outstanding for the period	(0.218	)%	(0.649	)%	(0.481	)%	(0.327	)%	(0.101	)%	(0.994	)%	(0.694	)%
Annualized YTD net charge-offs as a percentage of average loans outstanding for the period	(0.447	)%	(0.566	)%	(0.481	)%	(0.521	)%	(0.590	)%	(0.849	)%	(0.694	)%
YTD Average Outstanding Loans	87,484,800		86,384,793		85,465,574		80,525,815		79,399,688		77,837,484		75,760,000
QTD Average Outstanding Loans	89,648,815		87,179,692		85,465,574		83,980,913		82,375,120		79,974,088		75,760,000
Nonperforming assets and loans 90 days past due	548,537		553,254		1,193,044		800,137		702,746		792,858		1,235,826

PART II—OTHER INFORMATION

Item 1. Legal Proceedings

    There are various claims and lawsuits in which the Bank is periodically involved incidental to the Bank's business. In the opinion of management, no material loss is expected from any of such pending claims or lawsuits.

Item 2. Changes in Securities

    On February 4, 2000 the Company filed a registration statement on Form S-1 (SEC File Number 333-96185) to issue 150,000 shares of common stock at $13.00 a share. The Company terminated the offering on December 31, 2000 and sold 67,038 shares and received $871,494. $600,000 of the proceeds were contributed to the Bank while the Company retained the balance for working capital.

Item 3. Defaults on Senior Securities

    N/A

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

    N/A

Item 5. Other Information

    None

Item 6. Exhibits and reports on Form 8-K

    None

SIGNATURES

    In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date:  November 12, 2001	/s/ GREGORY B. JONES Gregory B. Jones, President & CEO
Date:  November 12, 2001	/s/ NATHANIEL F. HUGHES Nathaniel F. Hughes, EVP & CFO

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CORNERSTONE BANCSHARES

Item 1. Financial Statements

CONSOLIDATED BALANCE SHEETS
CONSOLIDATED STATEMENTS OF INCOME
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cornerstone Bancshares, Inc and Subsidiary Changes in Stockholders' Equity September 30, 2001

Item 2. Management's Discussion and Analysis or Plan of Operation.

CONSOLIDATED AVERAGE BALANCE SHEET INTEREST INCOME/EXPENSE AND YIELD/RATES Taxable equivalent basis (in thousands)
CONSOLIDATED AVERAGE BALANCE SHEET INTEREST INCOME/EXPENSE AND YIELD/RATES Taxable equivalent basis (in thousands)
ALLOWANCE FOR LOAN LOSSES
PART II—OTHER INFORMATION

Item 1. Legal Proceedings
Item 2. Changes in Securities
Item 3. Defaults on Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and reports on Form 8-K

SIGNATURES