10-K 1 v337264_10k.htm 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2012

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

For transition period from __________ to __________

Commission file number 000-30497

(Exact Name of Registrant as Specified in its Charter)

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

835 Georgia Avenue,

Chattanooga, TN 37402

(Address of principal executive offices)(Zip Code)

(423) 385-3000

(Registrant’s telephone number, including area code)

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

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

Common Stock, $1.00 Par Value

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

Yes ¨ No x

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

Yes ¨ No x

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

Yes x No ¨

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

Yes ¨ No ¨

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

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

Large accelerated filer ¨

Accelerated filer ¨

Non-accelerated filer ¨

Smaller reporting company x

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

Yes ¨ No x

The aggregate market value of the common stock held by non-affiliates of the Registrant on June 30, 2012 was $10 million. The market value calculation was determined using the closing sale price of the Registrant’s common stock on June 30, 2012, as reported on the OTC Bulletin Board. For purposes of this calculation, the term “affiliate” refers to all directors, executive officers and 10% shareholders of the Registrant. As of the close of business on December 31, 2012 there were 6,500,396 shares of the Registrant’s common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the 2013 Annual Meeting of Shareholders (the “2013 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K to the extent described herein.

TABLE OF CONTENTS

Item No.		Page No.

PART I		1

ITEM 1.	BUSINESS	1
ITEM 1A.	RISK FACTORS	8
ITEM 1B.	UNRESOLVED STAFF COMMENTS	13
ITEM 2.	PROPERTIES	14
ITEM 3.	LEGAL PROCEEDINGS	14
ITEM 4.	MINE SAFETY DICLOSURES	14

PART II		14

ITEM 5.	MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES	14
ITEM 6.	SELECTED FINANCIAL DATA	16
ITEM 7.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	18

ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	41
ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	44
ITEM 9.	CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE	88
ITEM 9A.	CONTROLS AND PROCEDURES	88
ITEM 9B.	OTHER INFORMATION	88

PART III		88

ITEM 10.	DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE	88
ITEM 11.	EXECUTIVE COMPENSATION	89
ITEM 12.	SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS	89
ITEM 13.	CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE	89
ITEM 14.	PRINCIPAL ACCOUNTANT FEES AND SERVICES	89

PART IV		90

ITEM 15.	EXHIBITS AND FINANCIAL STATEMENT SCHEDULES	90

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of this Annual Report on Form 10-K, as well as the following: (i) the possibility that our asset quality would decline or if we experience greater loan losses than anticipated, (ii) increased levels of other real estate, primarily as a result of foreclosures, (iii) the impact of liquidity needs on our results of operations and financial condition, (iv) competition from financial institutions and other financial service providers (v) economic conditions in the local markets where we operate, (vi) the impact of obtaining regulatory approval prior to the payment of dividends, (vii) the impact of our Series A Preferred Stock on net income available to holders of our Common Stock and earnings per common share, (viii) the impact of negative developments in the financial industry and U.S. and global capital and credit markets, (ix) the impact of recently enacted legislation on our business, (x) the relatively greater credit risk of residential construction and land development loans in our loan portfolio, (xi) adverse impact on operations and financial condition due to changes in interest rates, (xii) our ability to obtain additional capital and, if obtained, the possible significant dilution to current shareholders, (xiii) the impact of recently enacted legislation on our business, (xiv) the impact of federal and state regulations on our operations and financial performance, (xv) whether a significant deferred tax asset we have can be fully realized, (xvi) our ability to retain the services of key personnel, (xvii) the impact of Tennessee’s anti-takeover statutes and certain charter provisions on potential acquisitions of the holding company, and (xviii) our ability to adapt to technological changes. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.

PART I

ITEM 1.

BUSINESS

OVERVIEW

Cornerstone was incorporated on September 19, 1983 under the laws of the State of Tennessee. Cornerstone is a bank holding company registered under the Bank Holding Company Act of 1956, as amended, and was formerly known as East Ridge Bancshares, Inc. It has one wholly-owned subsidiary: Cornerstone Community Bank, a Tennessee banking corporation (the “Bank”), which resulted from the merger of The Bank of East Ridge and Cornerstone Community Bank effective October 15, 1997. The Bank owned and operated a subsidiary, Eagle Financial, Inc. (Eagle), a finance and factoring company. On December 1, 2011, the Bank elected to transfer the operations, assets and liabilities of Eagle into the Bank. The transfer allowed the Bank to combine the operations of Eagle with the Bank’s asset based lending department. As a result, the Bank formed Eagle Financial, a division of Cornerstone Community Bank. The Bank maintains the existence of this subsidiary in an inactive status.

Cornerstone

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

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

The Bank

The Bank is a Tennessee-chartered commercial bank established in 1985 which has its principal executive offices in Chattanooga, Tennessee. The principal business of the Bank consists of attracting deposits from the general public and investing those funds, together with funds generated from operations and from principal and interest payments on loans, primarily in commercial loans, commercial and residential real estate loans, consumer loans and residential and commercial construction loans. Funds not invested in the loan portfolio are invested by the Bank primarily in obligations of the U.S. Government, U.S. Government agencies, and various states and their political subdivisions. In addition to deposits, sources of funds for the Bank’s 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, 2012, the Bank had five full-service banking offices located in Hamilton County, Tennessee and one loan production office located in Dalton, Georgia.

Eagle Financial, a Division of Cornerstone Community Bank

Eagle’s business concentrates on the purchase of accounts receivable from small businesses and commercial loan placement on a conduit basis. The principal sources of Eagle’s income are fees derived from the collection of accounts receivable and fees generated from the placement of loans with conduit financial institutions. Eagle’s principal expenses are employee compensation and benefits, office expenses and other overhead expenses.

Employees

As of December 31, 2012, Cornerstone had 105 full-time equivalent employees. The employees are not represented by a collective bargaining unit. Cornerstone believes that its relationship with its employees is good.

Competition

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

The Bank’s deposits totaled approximately $345 million as of December 31, 2012. The deposit base represents approximately 4% of the deposit base in the Chattanooga, Tennessee Metropolitan Statistical Area (MSA). Three major regional banks represent approximately 60% of the deposits in the Chattanooga, Tennessee 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, Tennessee MSA. There are also several credit unions located in Hamilton County, Tennessee. Credit unions are not subject to the same income tax structure as commercial banks. This advantage enables credit unions to offer competitive rates to potential customers. The Bank also faces competition in certain areas of its business from mortgage banking companies, consumer finance companies, insurance companies, money market mutual funds and investment banking firms, some of which are not subject to the same degree of regulation as the Bank.

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

Supervision and Regulation

Cornerstone and the Bank are subject to state and federal banking laws and regulations that impose specific requirements and restrictions and provide for general regulatory oversight over virtually all aspects of our operations. These laws and regulations generally are intended to protect depositors, not shareholders. The following discussion is only a general summary of some of the more significant statutory and regulatory provisions. This summary is qualified by reference to the particular statutory and regulatory provisions. Any change in applicable laws or regulations may have a material effect on our business and prospects.

General

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

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

Federal and state banking laws and regulations govern all areas of the operations of Cornerstone and the Bank, including reserves, loans, mortgages, capital, issuance of securities, payment of dividends and establishment of branches. Federal and state banking agencies also have the general authority to limit the dividends paid by insured banks if such payments should be deemed to constitute an unsafe or unsound banking practice. In accordance with and as a result of the exercise of this general authority, the Bank is currently prohibited from paying dividends without prior regulatory approval. The TDFI, FDIC and Federal Reserve Board have the authority to impose penalties, initiate civil and administrative actions and take other steps intended to prevent banks from engaging in unsafe or unsound practices.

On April 2, 2010, the Bank entered into a Stipulation to the Issuance of a Consent Order (the “Stipulation”) with the FDIC. Pursuant to the Stipulation, the Bank consented, without admitting or denying any charges of unsafe or unsound banking practices or violations of law or regulations, to the issuance of a Consent Order (the “Order”) by the FDIC, also effective as of April 2, 2010. On April 8, 2010, the Bank also executed a written agreement (the “Agreement”) with the TDFI.

The Order and the Agreement (collectively, the “Action Plans”) contained substantially similar terms and were based on the findings of the FDIC and TDFI during their joint examination of the Bank commenced on October 8, 2009 (the “Examination”), as disclosed in the Joint Report of Examination (the “Report”). The Order and the Agreement represented agreements between the Bank, on the one hand, and the FDIC and the TDFI, respectively, on the other hand, as to areas of the Bank’s operations that warranted improvement and presented plans for making those improvements. The Action Plans imposed no fines or penalties on the Bank.

The Action Plans required the Bank to implement several governance, budgeting, credit management, risk management and reporting procedures. The Bank substantially complied with the terms of the Action Plans. As a result, on August 17, 2012, the FDIC and the TDFI issued written confirmation to the Bank’s Board of Directors that the Action Plans had been terminated. Some of the procedures established by the Action Plans, however, remain in place, including the requirement for approval by the Regional Director of the FDIC and the Commissioner of the TDFI of any dividends declared or paid by the Bank to Cornerstone.

Cornerstone received a letter dated March 30, 2010 from its primary banking regulator, the Federal Reserve Bank of Atlanta (the “FRBA”), directing Cornerstone to obtain the FRBA’s written approval before Cornerstone (i) incurs any indebtedness; (ii) declares or pays any dividends; (iii) redeems any corporate stock; or (iv) makes any other payment representing a reduction in its capital, except for the payment of normal and routine operating expenses. As required by the letter, Cornerstone sought and received the FRBA’s approval for payment of dividends on its preferred stock in 2012. The letter notes that the condition of the Bank has caused Cornerstone to be in “troubled condition” under Regulation Y. As a result, notice to the FRBA is required before Cornerstone undertakes any changes in senior executive management or directorships, and approval of the FRBA (with the written concurrence of the FDIC) must be obtained before Cornerstone grants or enters into any agreement to provide a golden parachute or severance payment. To date, Cornerstone is in compliance with the requirements of the FRBA letter.

To date the most significant impact of the FRBA’s letter relates to the payment of dividends on Cornerstone’s preferred stock. However, Cornerstone has been able to consistently raise additional capital and the company generated positive earnings during 2012. These two elements coupled with the Bank’s stabilization of asset quality have, in Cornerstone’s estimation, led to the approval of dividend payments on the preferred stock.

FDIC Insurance of Deposit Accounts

The FDIC insures the deposit accounts of the Bank up to the maximum amount provided by law. The general insurance limit is $250,000. The Dodd-Frank Act, which is discussed in more detail below, provided for temporary, unlimited deposit insurance for all non-interest bearing transaction accounts through December 31, 2012. Beginning January 1, 2013, noninterest bearing transaction accounts are no longer insured separately from depositors’ other accounts at the same bank.

The FDIC assesses deposit insurance premiums on each insured institution quarterly based on annualized rates for one of four risk categories. Under the rules in effect through March 31, 2011, these rates were applied to the institution’s deposits. Each institution was assigned to one of four risk categories based on its capital, supervisory ratings and other factors. Well capitalized institutions that are financially sound with only a few minor weaknesses were assigned to Risk Category I. Risk Categories II, III and IV presented progressively greater risks to the DIF. A range of initial base assessment rates applied to each risk category, subject to adjustments based on an institution’s unsecured debt, secured liabilities and brokered deposits.

As required by the Dodd-Frank Act, the FDIC adopted rules effective April 1, 2011 under which insurance premium assessments are based on an institution’s total assets minus its tangible equity (defined as Tier 1 capital) instead of its deposits. Under these rules, an institution with total assets of less than $10 billion is assigned to a risk category as described above, and a range of initial base assessment rates apply to each category, subject to adjustment downward based on unsecured debt issued by the institution and, except for an institution in Risk Category I, adjustment upward if the institution’s brokered deposits exceed 10% of its domestic deposits, to produce total base assessment rates. Total base assessment rates range from 2.5 to 9 basis points for Risk Category I, 9 to 24 basis points for Risk Category II, 18 to 33 basis points for Risk Category III, and 30 to 45 basis points for Risk Category IV, all subject to further adjustment upward if the institution holds more than a de minimis amount of unsecured debt issued by another FDIC-insured institution. The FDIC may increase or decrease its rates by 2.0 basis points without further rulemaking. In an emergency, the FDIC may also impose a special assessment.

Pursuant to the Dodd-Frank Act, the FDIC has established 2.0% as the designated reserve ratio (“DRR”), which is the ratio of the DIF to insured deposits. The FDIC has adopted a plan under which it will meet the statutory minimum DRR of 1.35% by September 30, 2020, the deadline imposed by the Dodd-Frank Act. The Dodd-Frank Act requires the FDIC to offset the effect of the increase in the statutory minimum DRR to 1.35% on institutions with assets of less than $10 billion from the former statutory minimum of 1.15%.

The FDIC also collects a deposit-based assessment from insured financial institutions on behalf of the Financing Corporation (the “FICO”). The funds from these assessments are used to service debt issued by FICO in its capacity as a financial vehicle for the Federal Savings & Loan Insurance Corporation. The FICO assessment rate is set quarterly. In 2012 it was 0.66 cents per $100 of assessable deposits. These assessments will continue until the debt matures in 2017 through 2019.

State of Tennessee Supervision and Regulation

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

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

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

Federal Supervision and Regulation

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

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

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

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

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

Specific Legislation Affecting Cornerstone and the Bank

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

FIRREA and FDICIA

Far-reaching legislation, including the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”) and the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) have for years impacted the business of banking. FIRREA primarily affected the regulation of savings institutions rather than the regulation of commercial banks and bank holding companies like the Bank and Cornerstone, but did include provisions affecting deposit insurance premiums, acquisitions of thrifts by banks and bank holding companies, liability of commonly controlled depository institutions, receivership and conservatorship rights and procedures and substantially increased penalties for violations of banking statutes, regulations and orders.

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

The additional supervisory powers and regulations mandated by FDICIA include a “prompt corrective action” program based upon five regulatory zones for banks, in which all banks are placed largely based on their capital positions. Regulators are permitted to take increasingly harsh action as a bank’s financial condition declines. Regulators are also empowered to place in receivership or require the sale of a bank to another depository institution when a bank’s ratio of tangible equity to total assets 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 into one of the following five categories based upon capitalization ratios: (1) a “well capitalized” institution has a total risk-based capital ratio of at least 10%, a Tier 1 risk-based ratio of at least 6% and a leverage ratio of at least 5%; (2) an “adequately capitalized” institution has a total risk-based ratio of at least 8%, a Tier 1 risk-based ratio of at least 4% and a leverage ratio of at least 4%; (3) an “undercapitalized” institution has a total risk-based capital ratio of under 8%, a Tier 1 risk-based capital ratio of under 4% or a leverage ratio of under 4%; (4) a “significantly undercapitalized” institution has a total risk-based capital ratio of under 6%, a Tier 1 risk-based ratio of under 3% or a leverage ratio of under 3%; and (5) a “critically undercapitalized” institution has a ratio of tangible equity to total assets of 2% or less. Institutions in any of the three undercapitalized categories would generally be prohibited from declaring dividends or making capital distributions. The regulations also establish procedures for “downgrading” an institution to a lower capital category based on supervisory factors other than capital.

U.S. Banking agencies have recently proposed revisions to their risk-based and leverage capital requirements consistent with agreements reached by the Basel Committee on Banking Supervision (Basel III). The proposed rules would establish tougher capital standards through more restrictive capital definitions, higher risk-weighted assets, additional capital buffers, and higher requirements for minimum capital ratios. These reforms could have a material negative impact on the profitability and returns on equity of U.S. banks, including the Bank.

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 other 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;

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

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

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

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

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

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

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

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

uniform regulations regarding real estate lending; and

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

Gramm-Leach-Bliley Act

The activities permissible to Cornerstone and the Bank were substantially expanded by the Gramm-Leach-Bliley Act of 1999 (the “Gramm Act”). The Gramm Act repealed the anti-affiliation provisions of the Glass-Steagall Act to permit the common ownership of commercial banks, investment banks and insurance companies. The Gramm Act amended the Act to permit a financial holding company to engage in any activity and acquire and retain any company that the Federal Reserve Board determines to be (i) financial in nature or incidental to such financial activity, or (ii) complementary to a financial activity and that does not pose a substantial risk to the safety and soundness of depository institutions or the financial system generally. The Gramm Act also modified existing law relating to financial privacy and community reinvestment. The new financial privacy provisions generally prohibit financial institutions, including the Bank and Cornerstone, from disclosing nonpublic personal financial information to third parties unless customers have the opportunity to “opt out” of the disclosure.

The Dodd-Frank Act

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”). The impact of the Dodd-Frank Act on the financial services industry will be broad, with enhanced regulatory oversight and compliance, including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased capital and liquidity requirements; (iii) increased regulatory examination fees; (iv) changes to assessments to be paid to the FDIC for federal deposit insurance; and (v) numerous other provisions designed to improve supervision and oversight of, and strengthening safety and soundness for, the financial services sector. In addition, the Dodd-Frank Act established a new framework for systemic risk and oversight in the industry which has resulted and will continue to result in sweeping changes in the regulation of financial institutions aimed at strengthening safety and soundness for the financial services sector. A summary of certain provisions of the Dodd-Frank Act is set forth below:

Increased Capital Standards and Enhanced Supervision. The federal banking agencies are required to establish minimum leverage and risk-based capital requirements for banks and bank holding companies. These new standards will be no lower than current regulatory capital and leverage standards applicable to insured depository institutions and may, in fact, be higher when established by the agencies. The Dodd-Frank Act also increases regulatory oversight, supervision and examination of banks, bank holding companies and their respective subsidiaries by the appropriate regulatory agency.

Federal Deposit Insurance. The Dodd-Frank Act made permanent the $250,000 deposit insurance limit for insured deposits and provided unlimited federal deposit insurance on non-interest bearing transaction accounts at all insured depository institutions until December 31, 2012. The Dodd-Frank Act also changed the assessment base for federal deposit insurance from the amount of insured deposits to consolidated assets less tangible equity, eliminated the ceiling on the size of the DIF and increased the floor of the size of the DIF.

The Consumer Financial Protection Bureau (“Bureau”). The Dodd-Frank Act centralized responsibility for consumer financial protection by creating a new agency, the Bureau, responsible for implementing, examining and, for large financial institutions (i.e., those with more than $10 billion in assets), enforcing compliance with federal consumer financial laws. The Bureau will have broad rulemaking, supervisory and enforcement authority over consumer financial products and services, including deposit products, residential mortgages, home-equity loans and credit cards. On July 21, 2011 the Dodd-Frank Act transferred the responsibility for implementation of a wide variety of existing consumer protection rules and regulations to the Bureau. In addition, the Dodd-Frank Act tasks the Bureau with implementation of many new consumer protection initiatives required by that law. While the exact impact of these future changes is unknown, the Bank expects that it will incur additional expense related to the implementation of those rules. Another provision of the Dodd-Frank Act, commonly known as the Durbin Amendment, became effective October 1, 2011. The Durbin Amendment limits interchange fees payable on debit card transactions for financial institutions with more than $10 billion in assets. While the Durbin Amendment does not directly apply to the Bank, competitive market forces related to the reduction mandated by the Durbin Amendment may result in a decrease in revenue from interchange fees for smaller financial institutions.

Interest on Demand Deposit Accounts. The Dodd-Frank Act repeals the prohibition on the payment of interest on demand deposit accounts effective one year after the date of enactment, thereby permitting depository institutions to pay interest on business checking and other accounts.

Mortgage Reform. The Dodd-Frank Act provides for mortgage reform addressing a customer’s ability to repay, restricts variable-rate lending by requiring the ability to repay to be determined for variable rate loans by using the maximum rate that will apply during the first five years of a variable-rate loan term, and makes more loans subject to requirement for higher-cost loans, new disclosures and certain other restrictions.

We expect that many of the requirements called for in the Dodd-Frank Act will be implemented over time, and most will be subject to implementing regulations over the course of several years. Given the uncertainty associated with the manner in which the provisions of the Dodd-Frank Act will be implemented by the various regulatory agencies and through regulations, the full extent of the impact such requirements will have on financial institutions’ operations is unclear. The changes resulting from the Dodd-Frank Act may impact the profitability of our business activities, require changes to certain of our business practices, impose upon us more stringent capital, liquidity and leverage ratio requirements or otherwise adversely affect our business. These changes may also require us to invest significant management attention and resources to evaluate and make necessary changes in order to comply with new statutory and regulatory requirements.

Future Legislation

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

ITEM 1A. RISK FACTORS

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

If our asset quality were to decline or if we experienced greater loan losses than anticipated, our earnings and overall financial condition will be adversely affected.

Our assets are primarily comprised of loans. The risk of credit losses on loans varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. While the risk of nonpayment of loans is inherent in banking, we have experienced higher nonpayment levels than anticipated, which has had a significant adverse effect on our earnings and overall financial condition. We have taken actions to prevent future problems, including the creation of a special asset committee to develop and review action plans for minimizing loan losses and the dedication of resources to assist in the collection and recovery process. The Bank has also established a loan review committee comprised of a majority of non-employee directors to periodically review the Bank’s loan portfolio and identify and categorize problem credits. To minimize the likelihood of a substandard loan portfolio, we assess the credit worthiness of customers and perform collateral valuations. Management also maintains an allowance for loan losses based upon, among other things, historical experience and an evaluation of economic conditions and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and judgments about the ultimate collectability of the loan portfolio and provides an allowance for loan losses based upon a percentage of the outstanding balances and takes a charge against earnings with respect to specific loans when their ultimate collectability is considered questionable. If management’s assumptions and judgments prove to be incorrect and the allowance for loan losses is inadequate to absorb losses, or if regulatory authorities require us to increase our allowance for loan losses as a part of their examination process, additional provision expense would be incurred and our earnings and capital could be significantly and adversely affected. Moreover, additions to the allowance may be necessary based on changes in economic and real estate market conditions, new information regarding existing loans, identification of additional problem loans and other factors, both within and outside of management’s control. These additions may require increased provision expense which would negatively impact our results of operations.

We have increased levels of other real estate, primarily as a result of foreclosures.

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

Liquidity needs could adversely affect our results of operations and financial condition.

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

Competition from financial institutions and other financial service providers may adversely affect our profitability.

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

Additionally, we face 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 our customers, and may attempt to hire our management and employees.

We compete with these other financial institutions both in attracting deposits and in making loans. In addition, we have to attract our customer base from other existing financial institutions and from new residents. We expect 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.

Our success depends significantly upon economic conditions in the local markets where we operate.

Substantially all of our loan and deposit customers live, work and bank in the Chattanooga, Tennessee MSA. As a result, our success depends upon a sound local economy to provide opportunities for new business ventures, increased loan demand and the need for deposit services. Our profitability is impacted by these local factors as well as general economic conditions and interest rates. For example, our earnings may be negatively impacted by increases in unemployment rates or reductions in population, income levels, deposits and housing starts. The Chattanooga, Tennessee MSA has experienced an economic downturn characterized by falling home prices, rising foreclosures, reduced economic activity, increased unemployment and an increased level of commercial and consumer delinquencies. These adverse economic conditions have inhibited our growth and diminished the ability of some of our customers to service their loan obligations. If economic conditions in our local markets do not improve or deteriorate further, we could experience any of the following consequences, each of which could further adversely affect our business:

demand for our products and services could decline;

loan delinquencies may continue to increase; and

nonperforming assets and foreclosures may continue to increase.

A prolonged economic downturn could also negatively impact collateral values or cash flows of borrowing businesses, and as a result our primary source of repayment could be insufficient to service the debt. In addition, adverse consequences to us in the event of a prolonged economic downturn in our local markets could be compounded by the fact that many of our commercial and real estate loans are secured by real estate located in those market areas. Significant decline in real estate values in these market areas would mean that the collateral for many of our loans would provide less security. As a result, we would be more likely to suffer losses on defaulted loans because our ability to fully recover on defaulted loans by selling the real estate collateral would be diminished. Adverse economic conditions in our local markets, including sustained periods of increased payment delinquencies, foreclosures or losses in the State of Tennessee or the State of Georgia, could impair our ability to collect loans and could otherwise have a negative effect on our assets, revenues, results of operations and financial condition.

Cornerstone is required to obtain regulatory approval prior to the payment of dividends.

Cornerstone’s Series A Convertible Preferred Stock requires annual dividend payments that equal ten percent of the original issue price of $25.00 per share. The dividends are scheduled to be paid at the end of each quarter. However, prior to the payment of the quarterly dividend Cornerstone must first obtain approval from the Federal Reserve Bank (“FRB”). Cornerstone provides information to the FRB which includes an evaluation of asset quality, earnings quarter and year to date and liquidity. To date Cornerstone has received authorization to make all of its declared Series A Convertible Preferred Stock dividends. Prior approval would also be required before common stock dividends could be paid.

Our Series A Convertible Preferred Stock will reduce net income available to holders of our Common Stock and earnings per common share.

The cash dividends paid or accumulated on our Series A Convertible Preferred Stock, and any future capital stock we may issue which is senior to our Common Stock, will reduce any net income available to holders of Common Stock and our earnings per common share. The preferred stock will also receive preferential treatment in the event of liquidation, dissolution or winding up of our Company. To date, we have received regulatory approval first and have made nine dividend payments on the Series A Convertible Preferred Stock. However, because of the need for regulatory approval to pay future dividends on the Series A Convertible Preferred Stock, dividends could accumulate and become quite substantial. The higher these accumulated dividends, the higher the preference payable in the event of liquidation, dissolution or winding up of our Company and the less likely the holders of our Common Stock will be to realize any proceeds in such event.

Negative developments in the financial services industry and U.S. and global capital and credit markets may lead to additional regulation and further deterioration of our results of operations and financial condition.

Negative developments in the capital and credit markets, beginning in 2008 and continuing throughout 2012, have resulted in uncertainty in the financial markets. Financial institutions across the United States, including the Bank, have experienced deteriorating asset quality. Loan portfolios include impaired loans to businesses struggling to stay in operation or achieve adequate cash flow. Further a decline in collateral values supporting these loans has also impacted the ability of a business or consumer to obtain loans or increased financial institutions losses in the event of foreclosure and liquidation. At the same time financial institutions have become concerned about liquidity. This concern has increased the competition for deposits in our local market as well as wholesale funding options. These events have impacted our stock price, as well as the stock price of other bank holding companies. The potential impact of these events may be an expansion of existing or creation of new federal or state laws and regulations regarding lending and funding practices, liquidity standards and compliance issues. See, for example, “RISK FACTORS— We cannot fully predict the impact of recently enacted legislation on our business” below. Continued negative developments below, as well as our ability to respond to these new operating and regulatory requirements could further negatively impact our results of operations. The negative consequences could limit our ability to originate new loans or obtain adequate funding or increase costs associated with regulatory compliance. Ultimately, these changes could result in modifications to our existing or future strategic plans, capital requirements, compensation, financial performance and stock performance.

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

The U.S. Congress enacted the Emergency Economic Stabilization Act of 2008 (“EESA”) in response to the impact of the volatility and disruption in the capital and credit markets on the financial sector. The Treasury and the federal banking regulators implemented a number of programs under this legislation to address these conditions and the asset quality, capital and liquidity issues they have caused for certain financial institutions and to improve the general availability of credit for consumers and businesses. In addition, the U.S. Congress enacted the American Recovery and Reinvestment Act of 2009 (“ARRA”) in an effort to save and create jobs, stimulate the U.S. economy and promote long-term growth and stability. The EESA and ARRA have been followed by numerous actions by the Federal Reserve, the U.S. Congress, the U.S. Treasury, the FDIC, the Commission and others to address the liquidity and credit crisis that followed the sub-prime meltdown. These measures include homeowner relief that encourages loan restructuring and modification; the establishment of significant liquidity and credit facilities for financial institutions and investment banks; the lowering of the federal funds rate; emergency action against short selling practices; a temporary guaranty program for money market funds; the establishment of a commercial paper funding facility to provide back-stop liquidity to commercial paper issuers; and coordinated international efforts to address illiquidity and other weaknesses in the banking sector. The purpose of these legislative and regulatory actions is to stabilize the U.S. financial system. The TLGP, the EESA, the ARRA and the other regulatory initiatives described above may not have their desired effects. If the volatility in the markets continues and economic conditions fail to improve or worsen, our business, financial condition, results of operations and/or access to credit, as well as the trading price of our common stock, could be materially and adversely affected.

Our loan portfolio includes residential construction and land development loans, which have a greater credit risk than residential mortgage loans.

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

Changes in interest rates could adversely affect our results of operations and financial condition.

Changes in interest rates may affect our level of interest income, the primary component of our gross revenue, as well as the level of our interest expense. Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and the policies of various governmental and regulatory authorities. Accordingly, changes in interest rates could decrease our net interest income. Changes in the level of interest rates also may negatively affect our ability to originate real estate loans, the value of our assets and the ability to realize gains from the sale of our assets, all of which ultimately affects earnings. Economic events prompted the Federal Reserve, beginning in September 2007, to reduce its federal funds rate. Due to the rapid decline in interest rates, we were unable to recalibrate our liabilities at the same rate at which loan rates declined. As a result, the net interest margin was impacted negatively during 2009. However, the Bank has been able to improve its net interest margin over the last three years as liabilities have been repriced to lower interest rates. If the Federal Reserve’s federal funds rate remains at extremely low levels or does not increase above our interest rate floors, our funding costs may increase which will negatively impact the net interest margin and our financial performance.

We may require additional capital which may not be able to be obtained or, if obtained, may cause significant dilution to current shareholders.

We may require capital from sources other than earnings generation. Such other sources may include an offering of equity-based securities, which could significantly dilute your investment in the event of conversion. In November 2009, the FDIC downgraded the Bank’s status to an “adequately capitalized” institution, which, among other things, restricts the interest rates payable by the Bank for time deposits. We may need to pursue additional sources of capital, which may include additional equity investments, additional offerings of equity-based securities, borrowed funds or any combination of these sources. Our ability to access these alternative capital sources may be limited due to the regulatory restrictions currently placed on us and the Bank or the condition of the capital markets. Therefore, we may have difficulty rebuilding the Bank’s capital reserves and we may provide new investors in the future certain rights, preferences and privileges senior to our current shareholders which may adversely impact our current shareholders.

We cannot fully predict the impact of recently enacted legislation on our business.

The impact of the Dodd-Frank Act on the financial services industry will be broad, with enhanced regulatory oversight and compliance, including, among other things, (i) enhanced resolution authority of troubled and failing banks and their holding companies; (ii) increased capital and liquidity requirements; (iii) increased regulatory examination fees; (iv) changes to assessments to be paid to the FDIC for federal deposit insurance; and (v) numerous other provisions designed to improve supervision and oversight of, and strengthening safety and soundness for, the financial services sector. In addition, the Dodd-Frank Act established a new framework for systemic risk and oversight in the industry which has resulted and will continue to result in sweeping changes in the regulation of financial institutions aimed at strengthening safety and soundness for the financial services sector.

We are subject to federal and state regulations that impact our operations and financial performance.

We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various federal and state agencies, including the Federal Reserve, the FDIC and the TDFI. Many of the banking regulations we are governed by are intended to protect depositors, the public or the insurance funds maintained by the FDIC, not shareholders. Compliance with the numerous banking regulations is costly and requires investment in human and information technology resources. Certain of our activities, such as the payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices, are impacted by these regulations. We are also subject to capitalization guidelines established by banking authorities, which require us to maintain adequate capital to support our growth. To be categorized as “well capitalized,” an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios.

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

The Sarbanes-Oxley Act of 2002 and the related rules and regulations promulgated by the Commission have increased the scope, complexity and cost of corporate governance, reporting and disclosure practices. These regulations are applicable to us. We have experienced, and may continue to experience, increasing compliance costs as a result of the Sarbanes-Oxley Act. These necessary costs are proportionately higher for a company of our size and will affect our profitability more than that of some of our larger competitors.

We have a significant deferred tax asset and cannot assure you that it will be fully realized.

We have net deferred tax assets of $2.3 million as of December 31, 2012. We did not establish a valuation allowance against our net deferred tax assets as of December 31, 2011 or December 31, 2012 because we believe that it is more likely than not that all of these assets will be realized. In evaluating the need for a valuation allowance, we estimated future taxable income based on management prepared forecasts. This process required significant judgment by management about matters that are by nature uncertain. If future events differ significantly from our current forecasts, we may need to establish a valuation allowance, which could have a material temporary adverse effect on our results of operations and financial condition.

We rely heavily on the services of key personnel and the unexpected loss of any of those personnel could adversely affect our operations.

We rely on the strategies and management services of Mr. Nathaniel F. Hughes our President and Chief Executive Officer. The loss of his services could have a material adverse effect on our business, results of operations and financial condition. We are also dependent on certain other key officers who have important customer relationships or are instrumental to our lending and depository operations. We believe that our future results will also depend upon our ability to attract and retain highly skilled and qualified personnel.

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

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

The success and growth of our operations will depend on our ability to adapt to technological changes.

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

ITEM 1B.

UNRESOLVED STAFF COMMENTS

None

ITEM 2.

PROPERTIES

As of December 31, 2012, the principal offices of Cornerstone are located at 835 Georgia Avenue, Chattanooga, Tennessee 37402. This property is leased by the Bank. In addition, the Bank operates five full-service branches and one loan production office that are located at:

Banking Branches	4154 Ringgold Road, East Ridge, Tennessee (owned by the Bank)
	5319 Highway 153, Hixson, Tennessee (owned by the Bank)
	2280 Gunbarrel Road, Chattanooga, Tennessee (owned by the Bank)
	8966 Old Lee Highway, Ooltewah, Tennessee (owned by the Bank)
	835 Georgia Avenue, Chattanooga, Tennessee (leased by the Bank)

Loan Production Office	202 West Crawford Street, Dalton, Georgia (leased by the Bank)

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

ITEM 3.

LEGAL PROCEEDINGS

As of the end of 2012, neither Cornerstone nor the Bank was involved in any material litigation. The Bank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business. Management believes that any claims pending against Cornerstone or its subsidiaries are without merit or that the ultimate liability, if any, resulting from them will not materially affect the Bank’s financial condition or Cornerstone’s consolidated financial position.

ITEM 4.

MINE SAFETY DICLOSURES

Not applicable.

PART II

ITEM 5.

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

On March 5, 2013, Cornerstone had 6,500,396 shares of common stock outstanding. Cornerstone’s common stock is quoted on the OTC Bulletin Board under the symbol “CSBQ” but is not listed on a national securities exchange. There are ten market makers who provide a market for Cornerstone’s common stock.

There were approximately 550 holders of record of the common stock as of December 31, 2012. This number does not include shareholders with shares in nominee name held by the Depository Trust Company (DTC). As of the end of 2012, there were approximately 3,871,000 shares held in nominee name by DTC.

Cornerstone paid no cash dividends on common stock in 2011 or 2012. Cornerstone must obtain the approval of the FRBA prior to declaring or paying a dividend on its common or preferred stock. Cornerstone’s board of directors will continue to evaluate the amount of future dividends, if any, after capital needs required for expected growth of assets are reviewed. Subject to regulatory approval, the payment of dividends is within the discretion of the board of directors, considering Cornerstone’s expenses, the maintenance of reasonable capital and risk reserves, and appropriate capitalization requirements for state banks. Currently, the Bank is under a restriction from the FDIC that no dividend can be paid from the Bank to the holding company without prior approval.

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

TABLE 1

High and Low Common Stock Price for Cornerstone					Cash Dividends
2013 Fiscal Year	Low		High		Paid Per Share
First Quarter (through February 15, 2013)	$	1.73	$	2.40		-

2012 Fiscal Year
First Quarter	$	1.20	$	2.50		-
Second Quarter	$	1.65	$	2.50		-
Third Quarter	$	1.30	$	1.95		-
Fourth Quarter	$	1.63	$	2.29		-

2011 Fiscal Year
First Quarter	$	1.50	$	1.75		-
Second Quarter	$	0.90	$	1.55		-
Third Quarter	$	1.01	$	1.20		-
Fourth Quarter	$	0.85	$	1.50		-

For information relating to compensation plans under which our equity securities are authorized for issuance, see Item 12.

There were 600,000 shares of our Series A Convertible Preferred Stock outstanding as of December 31, 2012. Table 2 presents information relating to dividends paid on the Series A Convertible Preferred Stock.

TABLE 2

Series A Convertible Preferred Stock Dividend Payments
	Year	Record Date	Date Payable	Amount Per Share
	2012	March 31, 2012	August 30, 2012	$	0.625
		June 30, 2012	November 28, 2012	$	0.625
		September 30, 2012	February 14, 2013	$	0.625

	2011	March 31, 2011	September 28, 2011	$	0.625
		June 30, 2011	November 29, 2011	$	0.625
		September 30, 2011	February 28, 2012	$	0.625
		December 31, 2011	May 30, 2012	$	0.625

ITEM 6.

SELECTED FINANCIAL DATA

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

TABLE 3

	At and for the Fiscal Years Ended December 31,
	2012			2011			2010			2009			2008
Total interest income	$	19,353		$	20,494		$	25,211		$	26,308		$	30,680
Total interest expense		4,785			6,362			9,202			11,189			12,698
Net interest income		14,568			14,132			16,009			15,119			17,982
Provision for loan losses		430			445			7,291			14,899			3,498
Net interest income after provision for loan losses		14,138			13,687			8,718			220			14,484
Noninterest income		1,019			1,183			3,081			2,327			1,887
Noninterest expense		13,178			13,652			18,042			16,062			12,563
Income before income taxes		1,979			1,218			(6,243	)		(13,515	)		3,808
Income tax expense / (benefit)		577			188			(1,535	)		(5,336	)		1,296
Net income (loss)	$	1,402		$	1,030		$	(4,708	)	$	(8,179	)	$	2,512

Per Common Share Data:
Net income / (loss), basic	$	0.02		$	0.05		$	(0.73	)	$	(1.26	)	$	0.39
Net income / (loss), assuming dilution	$	0.02		$	0.05		$	(0.73	)	$	(1.26	)	$	0.38
Cash dividends paid	$	-		$	-		$	-		$	0.10		$	0.28
Book value	$	4.01		$	3.89		$	3.55		$	4.28		$	5.78
Tangible book value(1)	$	4.01		$	3.89		$	3.55		$	3.89		$	5.33

Financial Condition Data:
Assets	$	443,446		$	422,655		$	441,499		$	532,404		$	471,803
Loans, net of unearned interest and allowance	$	270,850		$	260,365		$	276,115		$	330,787		$	378,472
Cash and investments	$	137,860		$	127,332		$	133,651		$	164,982		$	57,286
Federal funds sold	$	-		$	-		$	-		$	-		$	11,025
Deposits	$	344,881		$	314,042		$	355,447		$	404,742		$	326,583
FHLB advances and other borrowings	$	37,175		$	43,045		$	54,715		$	72,350		$	71,250
Federal funds purchased and repurchase agreements	$	19,587		$	29,391		$	24,325		$	26,322		$	35,790
Shareholders’ equity	$	40,889		$	35,208		$	25,819		$	27,837		$	36,502
Tangible shareholders’ equity(1)	$	40,878		$	35,186		$	25,782		$	25,258		$	33,661

Selected Ratios:
Interest rate spread		3.67	%		3.36	%		3.24	%		2.95	%		3.67	%
Net interest margin(2)		3.85	%		3.55	%		3.43	%		3.27	%		4.16	%
Return on average assets		0.34	%		0.24	%		(0.94	)%		(1.69	)%		0.55	%
Return on average equity		3.78	%		3.46	%		(15.79	)%		(24.34	)%		6.71	%
Return on average tangible equity(1)		3.78	%		3.47	%		(15.81	)%		(26.36	)%		7.26	%
Average equity to average assets		8.94	%		6.91	%		5.95	%		6.93	%		8.27	%
Common stock dividend payout ratio		N/A			N/A			N/A			N/A			70.59	%
Ratio of nonperforming assets to total assets		5.94	%		6.26	%		5.99	%		3.36	%		1.48	%
Ratio of allowance for loan losses to nonperforming loans		102.26	%		93.90	%		66.98	%		80.24	%		226.23	%
Ratio of allowance for loan losses to total average loans, net of unearned income		2.28	%		2.71	%		2.93	%		1.63	%		2.49	%

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

•

“Tangible book value per common share” is defined as total equity reduced by recorded preferred stock, 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 common share exclusive of changes in intangible assets. Goodwill, an intangible asset that is recorded in a purchase business combination, has the effect of increasing total book value while not increasing the tangible assets of a company. For companies, such as Cornerstone, that have engaged in business combinations, purchase accounting can result in the recording of significant amounts of goodwill related to such transactions.

•

“Tangible shareholders’ equity” is shareholders’ equity less goodwill and other intangible assets.

•

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

These disclosures should not be viewed as a substitute for results determined in accordance with GAAP, and are not necessarily comparable to non-GAAP performance measures which may be presented by other companies. Table 4 presents a reconciliation to provide a more detailed analysis of these non-GAAP performance measures:

TABLE 4

	At and for the Fiscal Years Ended December 31,
	2012			2011			2010			2009			2008
Number of common shares outstanding		6,500,396			6,500,396			6,500,396			6,500,396			6,319,718

Total stockholders’ equity	$	40,886,836		$	35,208,305		$	25,819,153		$	27,837,479		$	36,501,509
Less: preferred stock		14,821,546			9,899,544			2,727,424			-			-
Book value	$	26,065,290		$	25,308,761		$	23,091,729		$	27,837,479		$	36,501,509

Book value per common share	$	4.01		$	3.89		$	3.55		$	4.28		$	5.78

Book value	$	26,065,290		$	25,308,761		$	23,091,729		$	27,837,479		$	36,501,509
Less: goodwill and other intangible assets		10,530			22,487			37,317			2,579,211			2,840,773
Tangible book value	$	26,054,760		$	25,286,274		$	23,054,412		$	25,258,268		$	33,660,736
Effect of intangible assets per common share	$	-		$	-		$	-		$	0.39		$	0.45

Tangible book value per common share	$	4.01		$	3.89		$	3.55		$	3.89		$	5.33

Net income / (loss)	$	1,402,063		$	1,030,052		$	(4,707,521	)	$	(8,178,639	)	$	2,511,824
Average equity		37,115,000			29,740,000			29,820,000			33,600,000			37,435,000

Return on average equity		3.78	%		3.46	%		(15.79	)%		(24.34	)%		6.71	%

Average equity	$	37,115,000		$	29,740,000		$	29,820,000		$	33,600,000		$	37,435,000
Less: goodwill and other intangible assets		10,530			22,487			37,317			2,579,211			2,840,773
Average tangible equity	$	37,104,470		$	29,717,513		$	29,782,683		$	31,020,789		$	34,594,227

Effect of intangible assets		(0.00	)%		(0.01	)%		(0.02	)%		(2.02	)%		0.55	%

Return on average tangible equity		3.78	%		3.47	%		(15.81	)%		(26.36	)%		7.26	%

ITEM 7.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward-Looking Statements

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

Cornerstone is a bank holding company and the parent company of the Bank, a Tennessee banking corporation which operates primarily in and around Chattanooga, Tennessee. The Bank has five full-service banking offices located in Hamilton County, Tennessee, and one loan production office located in Dalton, Georgia. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The 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.

The following is a discussion of Cornerstone’s financial condition at December 31, 2012 and December 31, 2011 and Cornerstone’s results of operations for each of the three-years ended December 31, 2012, 2011 and 2010. The purpose of this discussion is to focus on information about Cornerstone’s financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with Cornerstone’s consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of December 31, 2012, Cornerstone had total consolidated assets of approximately $443 million, total loans of approximately $277 million, total deposits of approximately $345 million and stockholders’ equity of approximately $41 million. Cornerstone achieved a net income of approximately $1.4 million for 2012 compared to a net income of approximately $1.0 million for 2011 and net loss of approximately $4.7 million for 2010.

Results of Operations

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of Cornerstone’s earnings. For the year ended December 31, 2012, Cornerstone recorded net interest income of approximately $14,568,000, which resulted in a net interest margin of 3.85%. For the year ended December 31, 2011, Cornerstone recorded net interest income of approximately $14,132,000, which resulted in a net interest margin of 3.55%. For the year ended December 31, 2010, Cornerstone recorded net interest income of approximately $16,010,000, which resulted in a net interest margin of 3.43%.

Table 5 presents information with respect to interest income from average interest-earning assets, expressed both in dollars and yields, and interest expense on average interest-bearing liabilities, expressed both in dollars and rates, for the periods indicated. The table includes loan yields, which reflect the amortization of deferred loan origination and commitment fees. Interest income from investment securities includes the accretion of discounts and amortization of premiums.

TABLE 5

Yields Earned on Average Earning Assets and Rates Paid on Average Interest-Bearing Liabilities
Years Ended December 31,
	2012								2011								2010
(In thousands) ASSETS	Average Balance			Interest Income/ Expense(1)		Yield/ Rate			Average Balance			Interest Income/ Expense(1)		Yield/ Rate			Average Balance			Interest Income/ Expense(1)		Yield/ Rate
Interest-earning assets:
Loans(1)(2)	$	268,828		$	17,289		6.43	%	$	273,523		$	18,129		6.63	%	$	311,407		$	21,498		6.90	%
Investment securities(3)		89,587			2,004		2.53	%		108,705			2,312		2.38	%		128,795			3,633		3.06	%
Other earning assets		27,010			60		0.22	%		23,232			53		0.23	%		36,319			80		0.22	%
Total interest-earning assets		385,425			19,353		5.09	%		405,460			20,494		5.12	%		476,521			25,211		5.36	%
Allowance for loan losses		(6,140	)							(7,496	)							(6,454	)
Cash and other assets		35,756								32,721								31,277
Total assets	$	415,041							$	430,685							$	501,344
TOTAL LIABILITIES AND EQUITY
Interest-bearing liabilities:
Deposits:
NOW accounts	$	26,483		$	87		0.33	%	$	25,741		$	84		0.33	%	$	32,338		$	111		0.34	%
Money market / savings		62,958			460		0.73	%		38,899			341		0.88	%		32,240			269		0.83	%
Time deposits		187,733			2,471		1.32	%		226,720			3,768		1.66	%		281,251			5,839		2.08	%
Total interest-bearing deposits		277,174			3,018		1.09	%		291,360			4,193		1.44	%		345,829			6,219		1.80	%
Federal funds purchased		-			-		-			-			-		-			197			1		0.51	%
Securities sold under agreement to repurchase		21,312			94		0.44	%		22,808			125		0.55	%		22,519			126		0.56	%
Other borrowings		39,282			1,673		4.26	%		47,745			2,044		4.28	%		66,208			2,856		4.31	%
Total interest-bearing liabilities		337,768			4,785		1.42	%		361,913			6,362		1.76	%		434,753			9,202		2.12	%
Net interest spread							3.67	%							3.36	%							3.24	%

Other liabilities:
Demand deposits		39,936								39,042								39,104

Accrued interest payable and other liabilities		222								(10	)							(2,333	)
Stockholders' equity		37,115								29,740								29,820
Total liabilities and stockholders' equity	$	415,041							$	430,685							$	501,344

Net interest margin				$	14,568		3.85	%				$	14,132		3.55	%				$	16,009		3.43	%

(1) Interest income on loans includes amortization of deferred loan fees and other discounts of $168 thousand, $67 thousand and $46 thousand for the fiscal years ended December 31, 2012, 2011 and 2010, respectively.

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

(3) Yields on securities are calculated on a fully tax equivalent basis.

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

The net interest margin increased 30 basis points from 3.55% as of December 31, 2011 to 3.85% as of December 31, 2012. The increase in net interest margin can be attributed primarily to a 34 basis point decrease in interest expense on interest-bearing liabilities from December 31, 2011 to December 31, 2012. The majority of this decrease was in certificates of deposit which declined 34 basis points. The decrease in interest expense was partially offset by a decrease in interest income attributable to a reduction in general market interest rates on loans.

As of December 31, 2012, the Bank’s investment portfolio resulted in a yield of 2.53% compared to 2.38% as of December 31, 2011. The Bank’s investment portfolio is used primarily for liquidity and pledging purposes with the State of Tennessee Collateral Pool and the Federal Reserve Bank discount window, and to secure repurchase agreements. As of December 31, 2012, the Bank’s securities portfolio was invested approximately 70% in United States Government backed securities and approximately 30% in municipal general obligation securities.

During 2013, the Bank intends to increase its loan portfolio. Management anticipates that the liquidity needed for this increase will be derived from excess cash and cash flow associated with the Bank’s mortgage-backed security inventory. Management believes this increase will offset the interest rate compression that exists in the general market. Management anticipates the Bank’s net interest margin could increase by approximately 25 basis points by yearend 2013.

Tables 6 and 7 present the changes in interest income and interest expense that are attributable to three factors:

(i)

A change in volume or amount of an asset or liability.

(ii)

A change in interest rates.

(iii)

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

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

TABLE 6

INTEREST INCOME AND EXPENSE ANALYSIS

	Year Ended December 31,
	2012 Compared to 2011
(In Thousands)	Volume			Rate			Mix			Net Change
Interest income:
Loans (1)(2)	$	(302	)	$	(538	)	$	0		$	(840	)
Investment securities		(484	)		135			41			(308	)
Other earning assets		8			(3	)		2			7
Total interest income		(778	)		(406	)		43			(1,141	)

Interest expense:
NOW accounts		(2	)		-			5			3
Money market and savings accounts		176			(94	)		37			119
Time deposits		(515	)		(638	)		(144	)		(1,297	)
Other borrowings		(361	)		(8	)		(2	)		(371	)
Federal funds purchased		-			-			-			-
Securities sold under agreement to repurchase		(7	)		(23	)		(1	)		(31	)
Total interest expense		(709	)		(763	)		(105	)		(1,577	)
Change in net interest income (expense)										$	436

(1)

Loan amounts include non-accruing loans.

(2)

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

TABLE 7

INTEREST INCOME AND EXPENSE ANALYSIS

	Year Ended December 31,
	2011 Compared to 2010
(In Thousands)	Volume			Rate			Mix			Net Change
Interest income:
Loans (1)(2)	$	(2,512	)	$	(739	)	$	(118	)	$	(3,369	)
Investment securities		(478	)		(739	)		(104	)		(1,321	)
Other earning assets		(30	)		2			1			(27	)
Total interest income		(3,020	)		(1,476	)		(221	)		(4,717	)

Interest expense:
NOW accounts		(22	)		(3	)		(2	)		(27	)
Money market and savings accounts		59			19			(6	)		72
Time deposits		(905	)		(952	)		(214	)		(2,071	)
Other borrowings		(790	)		(15	)		(7	)		(812	)
Federal funds purchased		-			-			-			-
Securities sold under agreement to repurchase		1			(2	)		-			(1	)
Total interest expense		(1,657	)		(953	)		(229	)		(2,839	)
Change in net interest income (expense)										$	(1,878	)

(1)

Loan amounts include non-accruing loans.

(2)

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

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. The provision for loan losses amounted to $430 thousand for the year ended December 31, 2012 compared to $445 thousand for the year ended December 31, 2011. Cornerstone’s policies and procedures used to estimate the allowance for loan losses, as well as the resultant provision for loan losses, are considered adequate by management and are periodically reviewed by regulators. However, there are factors beyond Cornerstone’s control, such as conditions in the local and national economy which may negatively impact Cornerstone’s asset quality. The measurements are approximations which may require additional provisions to loan losses based upon changing circumstances or when additional information becomes available or known. Other matters relating to the changes in provision for loan losses are presented below:

The relatively small provision for loan losses during 2012 was a result of the stabilization in the Bank’s loan asset quality when compared to prior years. The Bank experienced a significant decline in asset quality from 2008 to 2010. However, the rate of deterioration in asset quality improved during 2011 and 2012. Further, management maintained the methodology established in 2010 for estimating the allowance for loan and lease losses. Management believes that its allowance methodology and the inputs used in the estimation process are appropriate and consistent with generally accepted accounting principles and interagency policy statements published by the Bank’s regulatory agencies.

To address the problem credits in the Bank’s loan portfolio, a Special Asset Committee was created in 2008. The Committee continues to meet at least monthly to review problem loans. The Committee coordinates various activities across multiple departments in the Bank such as reviewing loan grades assigned by the Bank’s loan review department and overseeing the development and review of action plans that identify possible strategies to minimize the Bank’s losses. The early detection and proactive resolution process serves to assist customers in the current economic environment while potentially minimizing the Bank’s losses. During 2011 and continuing into 2012, the Bank dedicated additional human resources to the Special Asset department to assist in the collection and recovery process.

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

Table 8 presents the components of noninterest income for the years ended December 31, 2012, 2011 and 2010 (in thousands).

TABLE 8

	2012		2011		2010
Customer service fees	$	803	$	869	$	1,273
Other noninterest income		64		72		90
Net gain from sale of securities		-		107		1,698
Net gain from sale of loans & other assets		152		135		20
Total noninterest income	$	1,019	$	1,183	$	3,081

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

The Bank continues to experience a decrease in its customer service fees. The primary reason for this decrease from 2011 to 2012, is a general market contraction and “belt tightening” by bank customers in general which resulted in reduced customer overdraft and nonsufficient fund fees. The primary reason for this decrease from 2010 to 2011 was the decision by management and the board of directors to exit the payroll processor Automated Clearing House (“ACH”) payments line of business. The Bank made this decision in order to improve its risk profile and reduce the strain on the Bank’s liquidity due to the high amount of cash balances that the Bank was required to maintain at the Federal Reserve Bank of Atlanta. Exiting the line of business resulted in a significant reduction in the Bank’s commercial analysis fee income and ACH income. However, management believes this decision was appropriate given its current asset quality and liquidity needs. During 2012, the Federal Reserve Bank reduced the amount of cash balances required for ACH processing and the Bank is currently assessing its possibility of reentering the payroll processor line of business.

During 2010, the Bank converted its security portfolio to a more conservative interest rate risk position by selling its fixed rate GNMA’s and purchasing floating rate GNMA CMO’s. This created an atypical security gain in 2010. During 2011, there was relatively low activity in the Bank’s investment portfolio as realized security gains returned to a more normal level. No securities were sold during 2012.

Noninterest Expense-Items reported as noninterest expense include salaries and employee benefits, occupancy and equipment expense, depository insurance, impairment of goodwill, net foreclosed assets and other operating expenses.

Table 9 presents the components of noninterest expense for the years ended December 31, 2012, 2011 and 2010 (in thousands).

TABLE 9

	2012		2011		2010
Salaries and employee benefits	$	6,327	$	6,117	$	6,195
Net occupancy and equipment expense		1,447		1,432		1,501
Depository insurance		804		1,053		1,288
Impairment of goodwill		-		-		2,541
Foreclosed assets, net		1,101		1,923		2,790
Other operating expenses		3,499		3,127		3,727
Total noninterest expense	$	13,178	$	13,652	$	18,042

Significant matters relating to the changes to noninterest expense are presented below:

Salaries and employee benefits increased slightly during 2012 due to an increased number of relationship managers but was mitigated by a reduced number of operational personnel that retired and were not replaced during the period. Management expects further increase in salary and employee benefits during 2013 as profitability will allow.

The Bank experienced a decrease in regulatory insurance cost during 2012 as its average deposits decreased and as the rate charged by the FDIC was reduced. Management anticipates regulatory insurance to continue to decrease during 2013 as the Bank benefits from a reduced rate charged the FDIC for the entire year.

Management anticipates elevated foreclosed asset expense until the Bank is able to reduce its foreclosed asset balances. The Bank’s foreclosed asset expense is offset by commercial and residential properties that are currently receiving rental income.

Income Tax Expense

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

Financial Condition

Overview-Cornerstone’s consolidated balance sheet reflects significant changes over the last two years. Total assets increased approximately $21 million or 4.92% from $422 million as of December 31, 2011 to $443 million as of December 31, 2012. During 2012, total loans increased $9 million or 3.45% from approximately $268 million as of December 31, 2011 to approximately $277 million as of December 31, 2012. Finally, stockholders’ equity increased to approximately $41 million as of December 31, 2012 from approximately $35 million as of December 31, 2011.

Investments-The Bank’s investment portfolio totaled approximately $78 million or 17.69% of total assets as of December 31, 2012, compared to a total of approximately $88 million or 20.93% of total assets as of December 31, 2011. The decrease was a result of a decrease in the Bank’s security pledging requirements with the FHLB and correspondent banks regarding fed funds lines. Further, continued prepayment amounts associated with the Bank’s mortgage-backed security inventory has also decreased investments.

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

Table 10 presents the carrying value of the Bank's investments at the dates indicated. Available for sale securities are carried at fair market value and securities held to maturity are held at their book value (amounts in thousands).

TABLE 10

Investment Portfolio
Years Ended December 31,
	2012		2011		2010
Securities available for sale:
U.S. Government agency obligations	$	4,018	$	4,190	$	4,587
Mortgage-backed securities		48,445		57,431		82,927
State & political subdivisions tax-exempt		23,634		24,436		20,736
Totals	$	76,097	$	86,057	$	108,250

Securities held to maturity:
Mortgage-backed securities	$	45	$	69	$	96
Totals	$	45	$	69	$	96

Federal Home Loan Bank stock, at cost		2,323		2,323		2,323

Total Investments	$	78,465	$	88,449	$	110,669

Management anticipates the Bank’s investment portfolio to increase during 2013 as the Bank reduces its cash balances that were required by the Federal Reserve in previous years.

A second objective of the security portfolio is to provide adequate collateral to satisfy pledging requirements with the State of Tennessee collateral pool, repurchase agreements, correspondent banks and the Federal Reserve discount window. As of December 31, 2012, the Bank’s borrowing capacity with the Federal Reserve discount window was approximately $5 million. As of December, 31, 2012, the Bank had pledged securities with a market value of approximately $43.4 million. As of December 31, 2012, the Bank had unpledged securities with a market value of approximately $32.7 million.

During 2009, the Federal Home Loan Bank (“FHLB”) notified management that as a result of the decline in the Bank’s loan asset quality, additional collateral was required to secure the outstanding fixed rate term advances. As of December 31, 2011, the Bank had pledged securities with a market value of approximately $28 million to the FHLB. As of December 31, 2012, the Bank was not required to pledge securities to the FHLB.

For December 31, 2012, tables 11 and 12 present the book value of the Bank's investments, the weighted average yields on the Bank's investments and the periods to maturity of the Bank's investments for the “Securities Available for Sale” and the “Securities Held to Maturity,” respectively. Tables 13 and 14 present this information for December 31, 2011.

TABLE 11 (amounts in thousands)

Weighted Average Yields on the Available For Sale Investments
Periods of Maturity from December 31, 2012
	Less than 1 year					1 to 5 years					5 to 10 years					Over 10 years
	Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)
Securities available for sale:
U.S. Government agencies	$	-		-		$	-		-		$	-		-		$	3,962		1.03	%
Mortgage-backed securities (2)		-		-			-		-			16		5.48	%		48,227		1.34	%
Tax-exempt municipal bonds		-		-			1,093		6.39	%		5,502		4.98	%		14,937		5.25	%
Totals	$	-		-		$	1,093		6.39	%	$	5,518		4.98	%	$	67,126		2.19	%

Total Securities Available for Sale	$	73,737		2.46	%

(1)

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

(2)

Mortgages are allocated by maturity and not amortized.

TABLE 12 (amounts in thousands)

Weighted Average Yields on the Held to Maturity Investments
Periods of Maturity from December 31, 2012
	Less than 1 year					1 to 5 years					5 to 10 years					Over 10 years
	Amount		Weighted Avg. Yield(1)			Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)
Securities held to maturity:
Mortgage-backed securities (2)	$	-		-		$	6		1.29	%	$	16		2.36	%	$	23		2.19	%
Totals	$	-		-		$	6		1.29	%	$	16		2.36	%	$	23		2.19	%

Total Securities Held to Maturity	$	45		2.13	%

Federal Home Loan Bank stock, at cost	$	2,323		4.25	%

Total Investments	$	76,105		2.51	%

(1)

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

(2)

Mortgages are allocated by maturity and not amortized.

TABLE 13 (amounts in thousands)

Weighted Average Yields on the Available For Sale Investments
Periods of Maturity from December 31, 2011
	Less than 1 year					1 to 5 years					5 to 10 years					Over 10 years
	Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)
Securities available for sale:
U.S. Government agencies	$	-		-		$	-		-		$	-		-		$	4,176		1.02	%
Mortgage-backed securities (2)		-		-			2		6.88	%		19		5.08	%		57,134		1.56	%
Tax-exempt municipal bonds		300		6.49	%		1,174		6.21	%		4,403		5.03	%		17,026		5.36	%
Totals	$	300		6.49	%	$	1,176		6.21	%	$	4,422		5.03	%	$	78,336		2.36	%

Total Securities Available for Sale	$	84,234		2.65	%

(1)

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

(2)

Mortgages are allocated by maturity and not amortized.

TABLE 14 (amounts in thousands)

Weighted Average Yields on the Held to Maturity Investments
Periods of Maturity from December 31, 2011
	Less than 1 year					1 to 5 years				5 to 10 years					Over 10 years
	Amount		Weighted Avg. Yield(1)			Amount		Weighted Avg. Yield (1)		Amount		Weighted Avg. Yield (1)			Amount		Weighted Avg. Yield (1)
Securities held to maturity:
Mortgage-backed securities (2)	$	-		-		$	-		-	$	43		2.50	%	$	26		1.56	%
Totals	$	-		-		$	-		-	$	43		2.50	%	$	26		1.56	%

Total Securities Held to Maturity	$	69		2.82	%

Federal Home Loan Bank stock, at cost	$	2,323		4.25	%

Total Investments	$	86,626		2.63	%

(1)

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

(2)

Mortgages are allocated by maturity and not amortized.

Lending-All lending activities of the Bank are under the direct supervision and control of the Directors Loan Committee (DLC). The DLC is comprised of three members of management and five independent directors that serve only in a director capacity and are not employees of the Bank. Also present at meetings of the committee are the loan review officer and other lending officers as required. This oversight committee enforces loan authorizations for each officer, makes lending decisions on loans exceeding such limits, reviews and oversees problem credits, and determines the allocation of funds for each lending category.

At December 31, 2012 and 2011, Cornerstone’s net loan portfolio constituted approximately 61.1% and 61.6% of Cornerstone’s total assets, respectively.

Table 15 presents the composition of the Cornerstone’s loan portfolio at the indicated dates.

TABLE 15

Loan Portfolio Composition
Years Ended December 31,
(In thousands)	2012					2011					2010					2009					2008
	Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	40,140		14.49	%	$	37,458		13.99	%	$	51,160		17.94	%	$	60,560		17.99	%	$	83,140		21.42	%
Real estate – construction		38,557		13.92	%		31,031		11.59	%		29,848		10.46	%		47,651		14.15	%		70,456		18.15	%
Real estate – mortgage		71,195		25.70	%		70,543		26.34	%		71,878		25.20	%		70,976		21.08	%		72,737		18.74	%
Real estate – commercial		125,172		45.19	%		126,057		47.08	%		129,031		45.23	%		153,310		45.53	%		155,728		40.13	%
Consumer loans		1,927		0.70	%		2,676		1.00	%		3,330		1.17	%		4,195		1.25	%		6,029		1.56	%
Total loans	$	276,991		100.00	%	$	267,765		100.00	%	$	285,247		100.00	%	$	336,692		100.00	%	$	388,090		100.00	%

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

Management continues to seek commercial and industrial loan growth to re-stratify the amount of the Bank’s loan portfolio away from high risk commercial real estate, but has met significant resistance in the Chattanooga, TN market due to competition. The Bank has originated owner-occupied loans, with lower risk, by contracting with the Small Business Administration when possible. Furthermore, the Bank is exploring other lines of business to expand its commercial and industrial loan exposure.

Table 16 presents the scheduled maturities of the loans in Cornerstone’s loan portfolio as of December 31, 2012 based on their contractual terms to maturity. Overdrafts are reported as due in less than one year. Loans unpaid at maturity are renegotiated based on current market rates and terms.

TABLE 16

Loans Maturing

Year-end balance as of December 31, 2012

(In thousands)	Less than One Year		1 to 5 Years		Over 5 Years		Total
Commercial, financial and agricultural	$	22,548	$	15,287	$	2,305	$	40,140
Real estate – construction		28,782		9,528		247		38,557
Real estate – mortgage		12,852		35,678		22,665		71,195
Real estate – commercial		28,772		67,961		28,439		125,172
Consumer		1,560		367		-		1,927
Total Loans	$	94,514	$	128,821	$	53,656	$	276,991

Types of Loans

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

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

Commercial loans are generally tied to the prime index and adjust with changes in the prime rate. The Bank also extends fixed interest rate loans when appropriate to match the borrower’s needs.

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

Generally, loans secured by current assets such as inventory or accounts receivable are structured as revolving lines of credit with annual maturities.

Loans secured by chattel, mortgages and accounts receivable may not exceed 85% of their market value.

Loans secured by listed stocks, municipal bonds and mutual funds may not exceed 70% of their market value.

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

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

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

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

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

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

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

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

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

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

Lending Commitments-Commitments under standby letters of credit and undisbursed loan commitments totaled approximately $36 million as of December 31, 2012 compared to approximately $28 million as of December 31, 2011. This number includes all lines of credit that have not been fully drawn and loan commitments in the same status.

Origination, Purchase and Sale of Loans

The Bank originates the majority of its loans in Hamilton County, Tennessee. However, the Bank also originates loans in Marion, Sequatchie and Bradley Counties in Tennessee, and Dade, Walker, Whitfield and Catoosa Counties in Georgia, each of which is within 150 miles of Chattanooga, Tennessee. Eagle markets to staffing companies in the United States. Loans are originated by 16 relationship managers who operate from the Bank's offices in Chattanooga, Tennessee and from the loan production office in Dalton, Georgia. These relationship managers actively solicit loan applications from existing customers, local manufacturers and retailers, builders, real estate developers, real estate agents and others. The Bank also receives numerous loan applications as a result of customer referrals and walk-ins to its offices.

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

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

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

Loan Fee Income

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

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

Problem Loans and Allowance for Loan Losses

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

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

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

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

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 quarterly by charges to income in response to changes to outstanding loan balances.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectability of loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. A loan or portion thereof is charged-off against the 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 allowance for loan losses as of December 31, 2012 is adequate to absorb possible losses from loans currently in the portfolio.

Table 17 presents the Bank’s internal watchlist for loans classified as doubtful as of December 31, 2012 and 2011. Table 18 presents the Bank’s internal watchlist for loans classified as substandard as of December 31, 2012 and 2011.

TABLE 17

Internal Watchlist Composition-Doubtful

	December 31, 2012				December 31, 2011
(In thousands)	Amount		Impairment		Amount		Impairment
Commercial and industrial	$	-	$	-	$	-	$	-
Construction and development		-		-		-		-
Single family real estate		-		-		-		-
Multi-family real estate		-		-		-		-
Owner occupied commercial real estate		-		-		-		-
Non-owner occupied commercial real estate		-		-		2,500		548
Consumer		-		-		-		-
Totals	$	-	$	-	$	2,500	$	548

TABLE 18

Internal Watchlist Composition-Substandard

	December 31, 2012				December 31, 2011
(In thousands)	Amount		Impairment		Amount		Impairment
Commercial and industrial	$	3,328	$	780	$	3,412	$	464
Construction and development		1,557		460		3,020		653
Single family real estate		4,710		576		7,604		1,087
Multi-family real estate		125		-		2,657		167
Owner occupied commercial real estate		4,105		681		8,648		663
Non-owner occupied commercial real estate		5,609		1,549		3,943		1,394
Consumer		5		-		21		-
Totals	$	19,439	$	4,046	$	29,305	$	4,428

The information listed in tables 17 and 18 reflect the amount of the Bank’s loans net of any partial charge-off amount that has been previously recorded.

During 2012, the Bank saw a decrease in the number and dollar volume of substandard loans. This was due, in part, to management being more aggressive in moving substandard loans to foreclosed asset status. The Bank will continue its aggressive stance toward the conversion of substandard loans until the Bank returns to a more historic level of classified assets.

Table 19 presents Cornerstone's allocation of the allowance for loan losses as of December 31, 2012, 2011, 2010, 2009 and 2008.

TABLE 19

Allowance for Loan Losses

Years Ended December 31,

	2012					2011					2010
(In thousands) Balance at end of period applicable to	Amount		Percent of loans by category to total loans			Amount		Percent of loans by category to total loans			Amount		Percent of loans by category to total loans
Commercial, financial and agricultural	$	809		14.49	%	$	482		13.99	%	$	925		17.94	%
Real estate – construction		1,241		13.92	%		827		11.59	%		3,238		10.46	%
Real estate – mortgage		1,528		25.70	%		2,518		26.34	%		3,111		25.20	%
Real estate – commercial		2,549		45.19	%		3,557		47.08	%		1,793		45.23	%
Consumer		14		0.70	%		16		1.00	%		65		1.17	%
Totals	$	6,141		100.00	%	$	7,400		100.00	%	$	9,132		100.00	%

	2009					2008
(In thousands) Balance at end of period applicable to	Amount		Percent of loans by category to total loans			Amount		Percent of loans by category to total loans
Commercial, financial and agricultural	$	1,607		17.99	%	$	4,955		21.42	%
Real estate – construction		595		14.15	%		1,433		18.15	%
Real estate – mortgage		1,861		21.08	%		1,532		18.74	%
Real estate – commercial		1,768		45.53	%		1,376		40.13	%
Consumer		74		1.25	%		322		1.56	%
Totals	$	5,905		100.00	%	$	9,618		100.00	%

In recent years, Cornerstone has refined its allowance for loan and leases losses (“ALLL”) to include measurements such as environmental factors for growth, environmental factors for real estate values, historical metrics and specific loan products with increased levels of risk, such as asset based lending. Beginning in 2011 and continuing throughout 2012, management received new appraisals on all impaired loans greater than $200 thousand. While expensive, the action reassured management of an accurate estimate of its impaired assets as of December 31, 2012. The Bank maintained a 1 year historic look-back as elected as of December 31, 2010. The Bank’s methodology used to calculate allowance for loan losses required a minimal loan loss provision for 2012 bringing the total ALLL balance as of December 31, 2012 to $6.1 million. Management believes its allowance methodology is consistent with generally accepted accounting principles and interagency policy statements published by the Bank’s regulatory agencies.

Table 20 represents the scheduled maturities of floating and fixed interest rate loans in Cornerstone’s loan portfolio as of December 31, 2012 based on their contractual terms to maturity. Overdrafts are reported as loans due in less than one year.

TABLE 20

	Less than		1 to 5		Over
	1 Year		Years		5 Years		Total
Floating Interest Rate Loans:
Commercial, financial and agricultural	$	2,766	$	164	$	747	$	3,677
Real estate-construction		1,205		-		-		1,205
Real estate-commercial		8,378		1,293		3,670		13,341
Real estate-mortgage		615		447		346		1,408
Consumer		324		10		-		334
Total floating interest rate loans	$	13,288	$	1,914	$	4,763	$	19,965

Fixed Interest Rate Loans:
Commercial, financial and agricultural	$	19,782	$	15,123	$	1,558	$	36,463
Real estate-construction		27,577		9,528		247		37,352
Real estate-commercial		20,394		66,668		24,769		111,831
Real estate-mortgage		12,237		35,231		22,319		69,787
Consumer		1,236		357		-		1,593
Total fixed interest rate loans	$	81,226	$	126,907	$	48,893	$	257,026
Total loans	$	94,514	$	128,821	$	53,656	$	276,991

Table 21 presents Cornerstone's delinquent, non-accrual loans and troubled debt restructuring loans as of December 31 for the five years indicated.

TABLE 21

Delinquent, Non-Accrual and Troubled Debt Restructured Loans

	2012			2011			2010			2009			2008
Ratio of non-performing assets to total loans		9.51	%		9.86	%		9.27	%		5.32	%		1.80	%
Ratio of delinquent (30-days or more) but accruing loans to:
Total loans		2.38	%		3.05	%		0.81	%		1.80	%		2.08	%
Total assets		1.49	%		1.93	%		0.52	%		1.20	%		1.71	%

Actual for Years Ended December 31,

(In thousands)	2012		2011		2010		2009		2008
Accruing loans that are contractually past due 90-days or more:
Commercial, financial and agricultural	$	-	$	-	$	-	$	-	$	-
Real estate-construction		-		-		-		-		-
Real estate-commercial		-		-		-		-		-
Real estate-mortgage		-		-		-		-		-
Consumer		-		-		-		-		-
Total loans	$	-	$	-	$	-	$	-	$	-

Non-accruing loans 90-days or more:
Commercial, financial and agricultural	$	2,467	$	42	$	75	$	1,498	$	-
Real estate-construction		53		1,622		-		2,770		1,180
Real estate-commercial		2,869		2,563		8,426		2,250		2,352
Real estate-mortgage		616		3,641		5,114		842		720
Consumer		-		14		18		-		-
Total loans	$	6,005	$	7,882	$	13,633	$	7,360	$	4,252

Troubled debt restructurings not included above	$	5,316	$	2,671	$	948	$	409	$	375
Total loans	$	276,991	$	267,765	$	285,247	$	336,692	$	338,090

The Bank experienced a decrease in its non-accrual loans during 2012. The reduction was, primarily, the result of multiple large credits being moved to foreclosed assets. Management anticipates further reduction in non-accrual balances as several more large credits move to foreclosed assets during 2013.

In addition to the Bank's loan rating system for problem assets described above (see “Problem Loans,” above), the Bank has established a loan rating system for all categories of loans which assists management and the Board of Directors in determining the adequacy of the Bank's allowance for loan losses. Each loan in the Bank's portfolio is assigned a rating which is reviewed by management periodically to ensure its continued suitability. An exception is made in the case of (i) monthly installment loans which are grouped together by delinquency status such as over 10, 30, 60, or 90 days past due and (ii) problem assets which are rated as substandard, doubtful, or loss as discussed above. All other loans are assigned a rating of excellent, good, or average.

The Bank has developed an internal loan watchlist that identifies classified loans and assists management in monitoring their potential risk to Bank earnings. The Bank also had approximately $19.4 million in loans graded substandard and approximately $13.1 million graded as special mention.

Table 22 presents Cornerstone’s loan loss experience for the periods indicated.

TABLE 22

Loan Loss Reserve Analysis

Years Ending December 31,

(in thousands)	2012			2011			2010			2009			2008
Average loans	$	268,828		$	273,523		$	311,407		$	363,146		$	385,957

Allowance for possible loan losses,
Beginning of the period	$	7,400		$	9,132		$	5,905		$	9,618		$	13,710

Charge-offs for the period:
Commercial, financial and agricultural		74			36			433			10,811			6,991
Real estate – construction		782			232			1,260			6,005			434
Real estate – mortgage		1,022			1,613			562			692			193
Real estate – commercial		958			1,238			2,309			1,248			210
Consumer		33			29			114			340			151

Total charge-offs		2,869			3,148			4,688			19,096			7,979

Recoveries for the period:
Commercial, financial and agricultural		144			94			282			358			362
Real estate – construction		145			532			19			4			14
Real estate – mortgage		36			65			54			64			1
Real estate – commercial		838			259			213			43			0
Consumer		17			21			56			15			12

Total recoveries		1,180			971			624			484			389

Net charge-offs for the period		1,689			2,177			4,064			18,612			7,590

Provision for loan losses		430			445			7,291			14,899			3,498

Allowance for possible loan losses, end of period	$	6,141		$	7,400		$	9,132		$	5,905		$	9,618

Ratio of allowance for loan losses to total average loans outstanding		2.28	%		2.71	%		2.93	%		1.63	%		2.49	%

Ratio of net charge-offs during the period to average loans outstanding during the period		0.63	%		0.80	%		1.31	%		5.13	%		1.97	%

Intangibles-Cornerstone follows the provisions of Accounting Standards Codification Topic 350, “Intangibles-Goodwill and Other,” concerning approximately $2.5 million in goodwill created by the merger with the Bank of East Ridge. Goodwill is tested annually for impairment. If the carrying value of goodwill exceeds the implied fair value, a write-down is recorded. No impairment loss was recognized in years prior to 2010. However, in 2010, management’s annual impairment analysis revealed that the goodwill was fully impaired. Therefore, as of December 31, 2010, the goodwill recorded on Cornerstone’s balance sheet was written off through noninterest expense.

Sources of Funds

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

Table 23 presents the Bank’s core vs. non-core funding as of December 31, 2012 and 2011.

TABLE 23

Core and Non-Core Funding
(In thousands)
	December 31, 2012					December 31, 2011
Core funding:	Amount		Percent			Amount		Percent
Noninterest-bearing demand deposits	$	60,054		15.0	%	$	43,990		11.5	%
Interest-bearing demand deposits		30,179		7.6	%		22,353		5.8	%
Savings & money market accounts		80,994		20.3	%		46,857		12.2	%
Time deposits under $100,000		85,917		21.5	%		98,734		25.8	%
Total core funding		257,144		64.4	%		211,934		55.3	%

Non-core funding:
Time deposits greater than $100,000		87,737		22.0	%		102,107		26.6	%
Securities sold under agreements to repurchase		19,587		4.9	%		29,391		7.7	%
Federal Home Loan Bank advances		35,000		8.7	%		40,000		10.4	%
Total non-core funding		142,324		35.6	%		171,498		44.7	%

Total	$	399,468		100.0	%	$	383,432		100.0	%

The Bank’s total funding increased from approximately $383 million as of December 31, 2011 to approximately $399 million as of December 31, 2012. The Bank continues to change its mix of deposits. Specifically, the Bank was able to increase transactional accounts by approximately $58 million while reducing certificates of deposits by approximately $27 million. In addition, the Bank reduced its Federal Home Loan Bank outstandings by $5 million as a fixed rate advance matured. These changes in funding mix allowed the Bank to reduce its interest expense by approximately $1.6 million for 2012. Management believes there will be further interest expense savings in 2013 as well. Finally, the Bank is contractually obligated to pay off $10 million of FHLB advances in 2013.

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

Table 24 presents the composition of deposits for the Bank, excluding accrued interest payable, by type for the years ended December 31, 2012, 2011 and 2010 (in thousands).

TABLE 24

Deposit Composition
Years Ended December 31,
(In thousands)	2012		2011		2010
Demand deposits	$	60,054	$	43,990	$	28,980
NOW deposits		30,179		22,353		24,834
Savings & money market deposits		80,994		46,857		34,042
Time deposits $100,000 and over		87,737		102,107		113,965
Time deposits under $100,000		85,917		98,734		133,626
Total Deposits	$	344,881	$	314,041	$	335,447

Table 25 presents a breakdown by category of the average amount of deposits and the average rate paid on deposits for the periods indicated:

TABLE 25

Average Amount and Average Rate Paid on Deposits
Years Ending December 31,
(In thousands)	2012					2011					2010
	Amount		Rate			Amount		Rate			Amount		Rate
Demand deposits	$	39,936				$	39,042				$	39,104
NOW deposits		26,483		0.33	%		25,741		0.33	%		32,338		0.34	%
Savings & money market deposits		62,958		0.73	%		38,899		0.88	%		32,240		0.83	%
Time deposits		187,733		1.32	%		226,720		1.66	%		281,251		2.08	%
Total Deposits	$	317,110		0.95	%	$	330,402		1.44	%	$	384,933		1.80	%

Table 26 presents a breakdown as of December 31, 2012, of the Bank’s scheduled maturity of time deposits (in thousands):

TABLE 26

	Balances
Denominations less than $100,000
Three months or less	$	9,954
Over three but less than six months		10,766
Over six but less than twelve months		30,837
Over twelve months		34,360
	$	85,917
Denomination greater than $100,000
Three months or less	$	13,843
Over three but less than six months		8,671
Over six but less than twelve months		27,274
Over twelve months		37,949
	$	87,737
Totals	$	173,654

Borrowings-The Bank joined the Federal Home Loan Bank of Cincinnati in October 2000. The Federal Home Loan Bank (the “FHLB”) allows the Bank to borrow funds on a contractual basis many times at rates lower than the costs of local certificates of deposit. In addition, the FHLB has the ability to provide structured advances that best reduce or leverage the interest rate risk of the Bank. During 2012, the Bank reduced its FHLB borrowings by $5 million. The reduction lowered the amount owed to the FHLB as of December 31, 2012, to $35 million. The FHLB offers multiple products to assist banks in their funding needs. The advances from the FHLB as of December 31, 2012 are structured as an obligation with a fixed rate with the majority of loans incorporating an optional conversion to a floating rate after a stated period of time. The loans have maturities ranging from January 2013 to January 2017. As of December 31, 2012, the interest rates on these loans ranged from 3.52% to 4.50%. The Bank has three Federal Funds lines of credit available with correspondent banks with a total availability of $9 million as of December 31, 2012. In addition, the Bank has the right to borrow from the FHLB and Federal Reserve Bank, if necessary, to supplement its supply of funds available for lending and to meet deposit withdrawal requirements. As of December 31, 2012, Cornerstone had one loan totaling approximately $2.2 million priced at New York Prime Rate plus 300 basis points with a floor of 6.50%. The loan was established to insert capital infusions to the Bank to fund growth or retire treasury stock, if any, as needed. See Note 10 of our audited consolidated financial statements for additional information.

Cornerstone’s short-term borrowings (borrowings which mature within the next fiscal year) consist primarily of federal funds purchased and securities sold under agreements to repurchase, Federal Home Loan Bank (FHLB) advances, and other borrowings. Information concerning these short-term borrowings as of and for each of the years in the three-year period ended December 31, 2012 is as follows (dollars in thousands):

TABLE 27

	At December 31,
	2012			2011			2010
Amounts outstanding at year-end:
Federal funds purchased and securities sold under agreements to repurchase	$	19,587		$	29,391		$	24,325
FHLB advances		10,000			5,000			10,000
Other borrowings		870			870			1,670

Weighted average interest rates at year-end:
Federal funds purchased and securities sold under agreements to repurchase		0.37	%		0.52	%		0.56	%
FHLB advances		4.05	%		4.11	%		4.14	%
Other borrowings		6.50	%		6.50	%		6.25	%

Maximum amount of borrowings at any month-end:
Federal funds purchased and securities sold under agreements to repurchase	$	28,399		$	29,391		$	37,182
FHLB advances		10,000			10,000			17,000
Other borrowings		870			1,620			1,820

Average balances for the year:
Federal funds purchased and securities sold under agreements to repurchase	$	21,312		$	22,808		$	22,519
FHLB advances		8,462			7,500			16,417
Other borrowings		870			995			1,620

Weighted average interest rates for the year:
Federal funds purchased and securities sold under agreements to repurchase		0.44	%		0.55	%		0.56	%
FHLB advances		4.08	%		4.12	%		4.15	%
Other borrowings		6.50	%		6.29	%		6.37	%

Capital

Capital Resources-Stockholder’s average equity for 2012 and 2011 totaled $37.1 and $29.7 million, respectively. As of December 31, 2012, Cornerstone’s actual stockholder equity totaled $40.9 million compared to $35.2 million as of December 31, 2011. As of December 31, 2012 and 2011, the number of shares of Series A Preferred Stock outstanding was 600,000 and 403,989, respectively. The number of common shares outstanding remained unchanged at 6,500,396 as of December 31, 2012 and December 31, 2011.

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

The FDIC has adopted capital guidelines governing the activities of banks. These guidelines require the maintenance of an amount of capital based on risk-adjusted assets so that categories of assets with potentially higher credit risk will require more capital backing than assets with lower risk. In addition, banks are required to maintain capital to support, on a risk-adjusted basis, certain off-balance sheet activities such as loan commitments. The capital guidelines classify capital into two tiers, referred to as Tier I and Tier II. Under risk-based capital requirements, total capital consists of Tier I capital, which is generally common shareholder’s equity less goodwill, and Tier II, which is primarily Tier I capital plus a portion of the loan loss allowance. In determining risk-based capital requirements, assets are assigned risk-weights of 0% to 100%, depending primarily on the regulatorily 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 28 lists the five categories of capital and each of the minimum requirements for the three risk-based ratios.

TABLE 28

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

The Bank’s capital ratios as of December 31, 2012 were as follows:

Tier 1 leverage ratio	8.37	%
Tier 1 risk-based capital ratio	11.65	%
Total risk-based capital ratio	12.91	%

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

The Bank’s liquidity target is measured by adding net cash, short-term and marketable securities not pledged and dividing this number by total deposits and short-term liabilities not secured by assets pledged. The Bank’s liquidity ratio at December 31, 2012 was 28.8% The Bank is not subject to any specific liquidity requirements imposed by regulatory orders. The Bank is subject, however, to general FDIC guidelines which are concerned with funding sources and dependence on noncore deposits and does not require a specific minimum level of liquidity. Management believes its liquidity ratios and funding sources meet or exceed these guidelines.

Cornerstone’s liquidity is dependent on dividends from its subsidiary and capital contributions from its stockholders. Currently, the holding company’s expenses are tied to debt service on one holding company loan totaling approximately $2.2 million and shareholder and related Securities and Exchange Commission required filings expense. The Bank is presently restricted from passing up any dividends to the holding company unless the Bank receives prior approval from the FDIC.

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

Table 29 presents the average loan to deposit ratios, a liquidity measure, for periods indicated:

TABLE 29

		December 31, 2012				December 31, 2011
Average loans to average deposits			84.77	%			82.78	%

Off-Balance Sheet Arrangements

Cornerstone does not have any off-balance sheet arrangements.

Critical Accounting Policies

Cornerstone’s accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Our significant accounting policies are described in Note 1, “Summary of Significant Accounting Policies,” to the consolidated financial statements and are integral to understanding the MD&A. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that Cornerstone reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. The following is a description of our critical accounting policies.

Allowance for Loan Losses

The allowance for loan losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The allowance is increased through the provision for loan and lease losses and reduced through loan and lease charge-offs, net of recoveries. The level of the allowance is based on known and inherent risks in the portfolio, past loan loss experience, underlying estimated values of collateral securing loans, current economic conditions and other factors as well as the level of specific impairments associated with impaired loans. This process involves our analysis of complex internal and external variables and it requires that management exercise judgment to estimate an appropriate allowance.

Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact Cornerstone’s net income as a result of the change in the provision for loan losses. Refer to the “Problem Loans and Allowance for Loan Losses” section within the MD&A for a discussion of Cornerstone’s methodology of establishing the allowance as well as Note 1 in the notes to Cornerstone’s consolidated financial statements.

Estimates of Fair Value

Fair value is used on a recurring basis for certain assets and liabilities in which fair value is the primary basis of accounting. Cornerstone’s available for sale securities and cash surrender value of life insurance are measured at fair value on a recurring basis. Additionally, fair value is used to measure certain assets and liabilities on a nonrecurring basis. Cornerstone uses fair value on a nonrecurring basis for foreclosed assets and collateral associated with impaired collateral-dependent loans. Fair value is also used in certain impairment valuations, including assessments of goodwill, other intangible assets and long-lived assets.

Fair value is the price that could be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Estimating fair value in accordance with applicable accounting guidance requires that Cornerstone make a number of significant judgments. Accounting guidance provides three levels of fair value. Level 1 fair value refers to observable market prices for identical assets or liabilities. Level 2 fair value refers to similar assets or liabilities with observable market data. Level 3 fair value refers to assets and liabilities where market prices are unavailable or impracticable to obtain for similar assets or liabilities. Level 3 valuations require modeling techniques, such as discounted cash flow analyses. These modeling techniques incorporate Cornerstone’s assessments regarding assumptions that market participants would use in pricing the asset or the liability.

Changes in fair value could materially impact our financial results. Refer to Note 13, “Fair Value Disclosures,” in the notes to Cornerstone’s consolidated financial statements for a discussion of the methodology in calculating fair value.

Goodwill

Cornerstone’s policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount. Impairment is a condition that exists when the carrying amount of goodwill exceeds its implied fair value. As more fully described in Note 7, “Goodwill,” in the notes to Cornerstone’s consolidated financial statements, Cornerstone recorded a full goodwill impairment during 2010.

Income Taxes

Cornerstone is subject to various taxing jurisdictions where Cornerstone conducts business. Cornerstone estimates income tax expense based on amounts expected to be owed to these jurisdictions. Cornerstone evaluates the reasonableness of our effective tax rate based on a current estimate of annual net income, tax credits, non-taxable income, non-deductible expenses and the applicable statutory tax rates. The estimated income tax expense or benefit is reported in the consolidated statements of income.

The accrued tax liability or receivable represents the net estimated amount due or to be received from tax jurisdictions either currently or in the future and are reported in other liabilities or other assets, respectively, in Cornerstone’s consolidated balance sheets. Cornerstone assesses the appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other pertinent information and maintains tax accruals consistent with management’s evaluation. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations by tax authorities and newly enacted statutory, judicial and regulatory guidance that could impact the relative merits of tax positions. These changes, if or when they occur, could impact accrued taxes and future tax expense and could materially affect our financial results.

Cornerstone periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, Cornerstone evaluates its deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 9, “Income Taxes,” in the notes to Cornerstone’s consolidated financial statements for more information.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Sensitivity

The Bank’s Asset Liability Management Committee (“ALCO”) is responsible for making decisions regarding liquidity and funding solutions based upon approved liquidity, loan, capital and investment policies. The ALCO must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing. To assist in this process the Bank has contracted with an independent third party to prepare quarterly reports that summarize several key asset-liability measurements. In addition, the third party will also provide recommendations to the Bank’s ALCO regarding future balance sheet structure, earnings and liquidity strategies. The following is a brief discussion of the primary tools used by the ALCO to perform its responsibilities:

Earnings at Risk Model

The Bank uses an earnings at risk model to analyze interest rate risk. Forecasted levels of earning assets, interest-bearing liabilities, and off-balance sheet financial instruments are combined with ALCO forecasts of interest rates for the next 12 months and are combined with other factors in order to produce various earnings simulations.

At December 31, 2012, the Bank’s earnings at risk model demonstrated that the Bank was within its policy limits for a 200 or 300 basis point change in interest rates. The policy limits have been established by the Directors ALCO committee and are calculated and reported quarterly.

Economic Value of Equity

The Bank’s economic value of equity model measures the extent that estimated economic values of the Bank’s assets and liabilities will change as a result of interest rate changes. Economic values are determined by discounting expected cash flows from assets and liabilities, which establishes a base case economic value of equity.

As of December 31, 2012, the Bank’s economic value of equity model demonstrated that the Bank was within its policy limits for a 200 or 300 basis point change in interest rates. The policy limits have been established by the Directors ALCO committee and are calculated and reported quarterly.

Liquidity Analysis

The Bank uses a liquidity analysis model to examine the current liquidity position and analyze the potential sources of coverage in the event of a liquidity crisis. The following is a brief description of the key measurements contained in the analysis:

Regular Liquidity Position-This is a measurement used to capture the ability of an institution to cover its current debt obligations.

As of December 31, 2012, the Bank’s regular liquidity measurements indicated that the liquidity position was within policy limits. The policy limits have been established by the Directors ALCO committee and are calculated and reported quarterly.

Basic Surplus-The basic surplus ratio is used to determine the number of times non-obligated assets could be used to meet immediate liquidity needs.

As of December 31, 2012, the Bank’s basic surplus measurement indicated that the Bank was within policy limits. The policy limits have been established by the Directors ALCO committee and are calculated and reported quarterly.

Dependency Ratio-The dependency ratio determines the reliance on short-term liabilities.

As of December 31, 2012, the Bank’s dependency ratio measurement indicated that the current position was within policy limits. The policy limits have been established by the Directors ALCO committee and are calculated and reported quarterly.

Leverage Analysis

The leverage analysis examines the potential of the institution to absorb additional debt. The key measurements included in this analysis are the Bank’s Tier 1 capital, leverage and total capital ratios.

Balance Sheet Analytics

Balance sheet analytics involve an in depth examination of the balance sheet structure, including diversification of structure and most recent pricing practices. This review uses trend analysis to compare previous balance sheet positions. The analysis enables the ALCO to review significant changes in the Bank’s loan and security portfolios as well as the Bank’s deposit composition.

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.

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

Impact of Inflation and Changing Price- The financial statements and related financial data presented herein have been prepared in accordance with U.S. generally accepted accounting principles, which require the measurement of the financial position and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time and due to inflation. Management is primarily concerned with two inflationary factors. The first, and most common, factor is the general impact of inflation on the operations of Cornerstone and is reflected in increased operating costs. The second, and more material to the Bank’s profitability, factor is interest rate adjustments by the Federal Reserve and the general fixed income market in reaction to inflation. In other words, interest rate risk, substantially impacts Cornerstone differently than most industrial companies, because virtually all of the assets and liabilities of Cornerstone are monetary in nature. As a result, interest rates may have a more significant impact on Cornerstone’s performance than the effects of general levels of inflation. Interest rate fluctuations do not necessarily move in the same direction or in the same magnitude as the price of goods and services and each issue must be dealt with independently.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

Consolidated Financial Statements and Footnotes

Table of Contents

	Page No.
Management’s Report on Internal Control over Financial Reporting	45
Report of Independent Registered Public Accounting Firm – Financial Statements	46
Consolidated Financial Statements
Consolidated balance sheets	47
Consolidated statements of operations	48
Consolidated statements of comprehensive income	49
Consolidated statements of changes in stockholders’ equity	50
Consolidated statements of cash flows	51
Notes to consolidated financial statements	52

MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

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

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

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

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

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

Cornerstone’s management has assessed the effectiveness of internal controls over financial reporting as of December 31, 2012. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in “Internal Control-Integrated Framework.”

Based on this assessment management believes that, as of December 31, 2012, Cornerstone’s internal control over financial reporting was effective based on those criteria.

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

Report of Independent Registered Public Accounting Firm

To the Stockholders and

Board of Directors

Cornerstone Bancshares, Inc.

Chattanooga, Tennessee

We have audited the accompanying consolidated balance sheets of Cornerstone Bancshares, Inc. and subsidiary (Company) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cornerstone Bancshares, Inc. and subsidiary as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with United States generally accepted accounting principles.

/s/ Hazlett, Lewis & Bieter, PLLC

Chattanooga, Tennessee

March 28, 2013

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31, 2012 and 2011

	2012			2011

ASSETS

Cash and due from banks	$	3,222,139		$	1,660,204
Interest-bearing deposits at other financial institutions		56,173,099			37,222,487

Total cash and cash equivalents		59,395,238			38,882,691

Securities available for sale		76,096,646			86,057,437
Securities held to maturity (fair value approximates $46,212 at 2012 and $70,484 at 2011)		45,086			68,643
Federal Home Loan Bank stock, at cost		2,322,900			2,322,900
Loans, net of allowance for loan losses of $6,141,281 in 2012 and $7,400,049 in 2011		270,850,465			260,364,569
Bank premises and equipment, net		5,399,340			5,712,003
Accrued interest receivable		1,213,778			1,327,458
Foreclosed assets		20,332,313			18,523,960
Other assets		7,790,634			9,395,721

Total assets	$	443,446,400		$	422,655,382

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	60,053,838		$	43,989,943
Interest-bearing demand deposits		30,178,624			22,353,384
Savings deposits and money market accounts		80,994,239			46,857,118
Time deposits		173,653,892			200,841,499

Total deposits		344,880,593			314,041,944

Accrued interest payable		120,558			110,703
Federal funds purchased and securities sold under agreements to repurchase		19,587,387			29,390,810
Federal Home Loan Bank advances and other borrowings		37,175,000			43,045,000
Other liabilities		794,026			858,620

Total liabilities		402,557,564			387,447,077

Stockholders' equity:
Preferred stock - no par value; 2,000,000 shares authorized; 600,000 and 403,989 shares issued and outstanding in 2012 and 2011, respectively		14,821,546			9,899,544
Common stock - $1.00 par value; 20,000,000 shares authorized in 2012 and 2011; 6,709,199 shares issued in 2012 and 2011; 6,500,396 shares outstanding in 2012 and 2011		6,500,396			6,500,396
Additional paid-in capital		21,390,486			21,316,438
Retained deficit		(3,274,986	)		(3,627,208	)
Accumulated other comprehensive income		1,451,394			1,119,135

Total stockholders' equity		40,888,836			35,208,305

Total liabilities and stockholders' equity	$	443,446,400		$	422,655,382

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

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS

Years Ended December 31, 2012, 2011, and 2010

	2012		2011		2010

INTEREST INCOME
Loans, including fees	$	17,288,855	$	18,128,907	$	21,498,120
Securities and interest-bearing deposits at other financial institutions		2,003,620		2,311,690		3,633,367
Federal funds sold		60,404		53,139		79,941

Total interest income		19,352,879		20,493,736		25,211,428

INTEREST EXPENSE
Time deposits		2,471,135		3,767,582		5,838,571
Other deposits		546,812		424,387		379,810
Federal funds purchased and securities sold under agreements to repurchase		94,402		125,538		127,308
Federal Home Loan Bank advances and other borrowings		1,672,478		2,044,361		2,856,125

Total interest expense		4,784,827		6,361,868		9,201,814

Net interest income before provision for loan losses		14,568,052		14,131,868		16,009,614

Provision for loan losses		430,000		445,000		7,291,000

Net interest income after provision for loan losses		14,138,052		13,686,868		8,718,614

NONINTEREST INCOME
Customer service fees		803,251		868,935		1,272,893
Other noninterest income		64,519		71,542		90,268
Net gains from sale of securities		-		107,413		1,698,136
Net gains from sale of loans and other assets		151,710		134,997		19,632

Total noninterest income		1,019,480		1,182,887		3,080,929

NONINTEREST EXPENSES
Salaries and employee benefits		6,327,226		6,117,063		6,194,504
Net occupancy and equipment expense		1,447,204		1,431,863		1,501,504
Depository insurance		803,902		1,052,591		1,287,676
Impairment of goodwill		-		-		2,541,476
Foreclosed assets, net		1,100,670		1,922,988		2,789,708
Other operating expenses		3,498,867		3,126,998		3,727,493

Total noninterest expenses		13,177,869		13,651,503		18,042,361

Income (loss) before income tax expense (benefit)		1,979,663		1,218,252		(6,242,818	)

Income tax expense (benefit)		577,600		188,200		(1,535,297	)

Net income (loss)		1,402,063		1,030,052		(4,707,521	)

Preferred stock dividend requirements		1,229,780		651,119		34,463
Accretion on preferred stock discount		63,924		36,718		-

Net income (loss) available to common stockholders	$	108,359	$	342,215	$	(4,741,984	)

EARNINGS (LOSS) PER COMMON SHARE
Basic	$	0.02	$	0.05	$	(0.73	)
Diluted		0.02		0.05		(0.73	)

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

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

Years Ended December 31, 2012, 2011, and 2010

	2012			2011			2010

Net income (loss)	$	1,402,063		$	1,030,052		$	(4,707,521	)

Other comprehensive income, before tax:
Unrealized holding gains arising during the year		535,902			2,442,847			1,571,720

Reclassification adjustment for gains included in net income		-			(107,413	)		(1,698,136	)

Other comprehensive income (loss), before tax		535,902			2,335,434			(126,416	)

Income tax (expense) benefit related to other comprehensive income items		(203,643	)		(887,464	)		48,038

Other comprehensive income (loss), net of tax		332,259			1,447,970			(78,378	)

Comprehensive income (loss)	$	1,734,322		$	2,478,022		$	(4,785,899	)

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

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

Years Ended December 31, 2012, 2011 and 2010

										Accumulated
					Additional					Other			Total
	Preferred		Common		Paid-in		Retained			Comprehensive			Stockholders'
	Stock		Stock		Capital		Earnings (Deficit)			Income			Equity

BALANCE, December 31, 2009	$	-	$	6,500,396	$	21,162,686	$	424,854		$	(250,457	)	$	27,837,479

Stock compensation expense		-		-		74,612		-			-			74,612

Issuance of Series A Convertible Preferred Stock		2,727,424		-		-		-			-			2,727,424

Preferred stock dividends		-		-		-		(34,463	)		-			(34,463	)

Net loss		-		-		-		(4,707,521	)		-			(4,707,521	)

Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment and taxes		-		-		-		-			(78,378	)		(78,378	)

BALANCE, December 31, 2010		2,727,424		6,500,396		21,237,298		(4,317,130	)		(328,835	)		25,819,153

Stock compensation expense		-		-		79,140		-			-			79,140

Issuance of Series A Convertible Preferred Stock		7,135,402		-		-		-			-			7,135,402

Preferred stock dividends		-		-		-		(303,412	)		-			(303,412	)

Accretion on preferred stock		36,718		-		-		(36,718	)		-			-

Net income		-		-		-		1,030,052			-			1,030,052

Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment and taxes		-		-		-		-			1,447,970			1,447,970

BALANCE, December 31, 2011		9,899,544		6,500,396		21,316,438		(3,627,208	)		1,119,135			35,208,305

Stock compensation expense		-		-		74,048		-			-			74,048

Issuance of Series A Convertible Preferred Stock		4,858,078		-		-		-			-			4,858,078

Preferred stock dividends		-		-		-		(985,917	)		-			(985,917	)

Accretion on preferred stock		63,924		-		-		(63,924	)		-			-

Net income		-		-		-		1,402,063			-			1,402,063

Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment and taxes		-		-		-		-			332,259			332,259

BALANCE, December 31, 2012	$	14,821,546	$	6,500,396	$	21,390,486	$	(3,274,986	)	$	1,451,394		$	40,888,836

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

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2012, 2011, and 2010

	2012			2011			2010
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	1,402,063		$	1,030,052		$	(4,707,521	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		529,001			510,280			555,235
Impairment of goodwill		-			-			2,541,476
Provision for loan losses		430,000			445,000			7,291,000
Stock compensation expense		74,048			79,140			74,612
Gain on sales of securities		-			(107,413	)		(1,698,136	)
Loss on sales and write-downs of foreclosed assets, loans, and other assets		747,824			1,458,797			1,448,508
Deferred income taxes		(383,150	)		110,921			(1,012,915	)
Changes in other operating assets and liabilities:
Net change in loans held for sale		262,750			262,750			(43,500	)
Accrued interest receivable		113,680			(978	)		194,219
Accrued interest payable		9,855			(66,058	)		(174,599	)
Other assets and liabilities		1,720,001			(1,000,404	)		5,641,354

Net cash provided by operating activities		4,906,072			2,722,087			10,109,733

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale		43,951,252			43,761,765			127,818,220
Securities held to maturity		24,032			27,560			40,111
Purchase of securities available for sale		(33,522,131	)		(19,160,612	)		(110,123,951	)
Purchase of Federal Home Loan Bank stock		-			-			(93,700	)
Loan originations and principal collections, net		(19,536,686	)		3,868,694			37,003,774
Purchase of bank premises and equipment		(160,164	)		(123,670	)		(835,007	)
Proceeds from sale of other real estate and other assets		5,812,785			5,982,633			7,094,142

Net cash (used in) provided by investing activities		(3,430,912	)		34,356,370			60,903,589

CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in deposits		30,838,649			(21,405,146	)		(69,295,023	)
(Decrease) increase in federal funds purchased and securities sold under agreements to repurchase		(9,803,423	)		5,065,438			(1,996,513	)
Repayment of Federal Home Loan Bank advances		(5,000,000	)		(10,000,000	)		(17,000,000	)
Net repayments of other borrowings		(870,000	)		(1,670,000	)		(635,000	)
Payment of dividends		(985,917	)		(303,412	)		(34,463	)
Issuance of preferred stock		4,858,078			7,135,402			2,727,424

Net cash provided by (used in) financing activities		19,037,387			(21,177,718	)		(86,233,575	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		20,512,547			15,900,739			(15,220,253	)

CASH AND CASH EQUIVALENTS, beginning of year		38,882,691			22,981,952			38,202,205

CASH AND CASH EQUIVALENTS, end of year	$	59,395,238		$	38,882,691		$	22,981,952

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	4,774,972		$	6,427,926		$	9,376,413
Cash paid during the period for taxes		965,888			44,600			500,000

NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	8,530,357		$	11,300,888		$	10,645,773

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

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 1.

Summary of Significant Accounting Policies

The accounting and reporting policies of Cornerstone Bancshares, Inc. and subsidiary (Cornerstone) conform with United States generally accepted accounting principles (GAAP) and practices within the banking industry. The Financial Accounting Standards Board (FASB) has adopted the FASB Accounting Standards Codification (ASC) as the single source of authoritative nongovernmental GAAP. Rules and interpretive releases of the Securities and Exchange Commission (SEC) are also sources of authoritative GAAP for SEC registrants. The policies that materially affect financial position and results of operations are summarized as follows:

Nature of operations:

Cornerstone is a bank-holding company which owns all of the outstanding common stock of Cornerstone Community Bank (the Bank). The Bank provides a variety of financial services through five full service branch locations in Chattanooga, Tennessee and a loan production office in Dalton, Georgia. The Bank's primary deposit products are demand deposits, savings accounts, and certificates of deposit. Its primary lending products are commercial loans, real estate loans, and installment loans. Previously, the Bank owned and operated a subsidiary, Eagle Financial, Inc. (Eagle), which operated a finance and factoring company located in Chattanooga, Tennessee. On December 1, 2011, the Bank elected to transfer the operations, assets and liabilities of Eagle into the Bank. At the time of the transfer, the assets of Eagle were approximately $3.7 million and the liabilities were approximately $255 thousand. The transfer allowed the Bank to combine the operations of Eagle with the Bank’s asset based lending department. As a result, the Bank formed Eagle Financial, a division of Cornerstone Community Bank. The Bank still retains the subsidiary in legal form in an inactive status.

Principles of consolidation:

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

Goodwill:

Goodwill represents the excess of the cost of Cornerstone’s 1997 purchase of the net assets of the Bank of East Ridge over the underlying fair value of such net assets at the date of acquisition. Cornerstone applies the provisions of ASC Topic 350, “Intangibles-Goodwill and Other,” which requires that goodwill and other intangible assets deemed to have an indefinite life not be amortized. Goodwill is tested annually for impairment. If the carrying value of goodwill exceeds the fair value, a write-down is recorded. See Note 7 for further discussion regarding goodwill.

Use of estimates:

In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of deferred tax assets, other-than-temporary impairments of securities, and the fair value of financial instruments.

Significant group concentrations of credit risk:

Most of Cornerstone’s activities are with customers located in middle and eastern Tennessee. The types of securities that Cornerstone invests in are included in Note 4. The types of lending Cornerstone engages in are included in Note 5. Cornerstone does not have any significant concentrations to any one industry or customer.

Commercial real estate, including commercial construction loans, represented 54 percent of the loan portfolio at December 31, 2012 and 2011.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 1.

Summary of Significant Accounting Policies (continued)

Securities:

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

Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at fair value, with unrealized gains and losses excluded from earnings and 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. Gains and losses on sales of securities are determined using the specific-identification method. Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities.

The Bank conducts a regular assessment of its securities portfolio to determine whether any are other-than-temporarily impaired. In estimating other-than-temporary impairment losses, management considers, among other factors, the length of time and extent to which the fair value has been less than cost, the financial condition and near term prospects of the issuer, and the intent and ability of the Bank to retain its investment for a period of time sufficient to allow for any anticipated recovery. The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the prospects for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment. Once a decline in value for a debt security is determined to be other-than-temporary, the other-than-temporary impairment is separated into (a) the amount of the total other-than-temporary impairment related to a decrease in cash flows expected to be collected from the debt security (the credit loss) and (b) the amount of the total other-than-temporary impairment related to all other factors. The amount of the total other-than-temporary impairment related to the credit loss is recognized in earnings. The amount of the total other-than-temporary impairment related to all other factors is recognized in other comprehensive income.

Federal Home Loan Bank stock:

Cornerstone, as a member of the Federal Home Loan Bank (FHLB) system, is required to maintain an investment in capital stock of the FHLB. Based on redemption provisions of the FHLB, the stock has no quoted market value and is carried at cost. At its discretion, the FHLB may declare dividends on the stock. Management reviews for impairment based on the ultimate recoverability of the cost basis in the FHLB stock.

Loans:

Cornerstone grants mortgage, commercial and consumer loans to customers. A substantial portion of the loan portfolio is represented by real estate loans secured by properties located in Chattanooga, Tennessee and surrounding areas. The ability of Cornerstone’s debtors to honor their contracts is somewhat dependent on the real estate and economic conditions in these areas.

Loans that management has the intent and ability to hold for the foreseeable future or until maturity are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees and costs. Mortgage loans originated and intended for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate.

Interest income is accrued based on the unpaid principal balance. Loan origination and commitment fees, as well as certain direct origination costs, are deferred and amortized as a yield adjustment over the lives of the related loans using the interest method. Amortization of deferred loan fees is discontinued when a loan is placed on nonaccrual status.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 1.

Summary of Significant Accounting Policies (continued)

Loans: (continued)

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

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

A troubled-debt restructuring (TDR) is a loan that the Bank has granted a concession to the borrower, which would not otherwise be considered due to the borrower experiencing financial difficulty. If a loan is in nonaccrual status before it is determined to be a TDR, then the loan remains in nonaccrual status. TDR loans in nonaccrual status may be returned to accrual status if there has been at least a six month sustained period of repayment performance by the borrower. When the Bank modifies the terms of an existing loan that is not considered a TDR, the Bank accounts for the loan modification as a new loan if the terms of the new loan resulting from the refinancing or restructuring are at least as favorable to the Bank as the terms for comparable loans to other customers with similar risk characteristics who are not undergoing a refinancing or restructuring and the modifications are more than minor.

Allowance for loan losses:

The allowance for loan losses is maintained at a level that management believes to be adequate to absorb probable losses in the loan portfolio. Loan losses are charged against the allowance when management believes that the full collectability of the loan is unlikely. As such, a loan may be partially charged-off after a "confirming event" has occurred which serves to validate that full repayment pursuant to the terms of the loan is unlikely. Subsequent recoveries are credited to the allowance.

Management’s determination of the adequacy of the allowance is based on an evaluation of the portfolio, current economic conditions, volume, growth, composition of the loan portfolio, homogeneous pools of loans, risk ratings of specific loans, historical loan loss factors, loss experience of various loan segments, identified impaired loans, and other factors related to the portfolio. This evaluation is performed at least quarterly and is inherently subjective, as it requires material estimates that are susceptible to significant change including the amounts and timing of future cash flows expected to be received on any impaired loans.

As part of management’s quarterly assessment of the allowance, management divides the loan portfolio into five segments: commercial real estate-mortgage (includes owner-occupied and all other), consumer real estate-mortgage, construction and land development, commercial and industrial, and consumer and other. Each segment is then analyzed such that a specific and general allocation of the allowance is estimated for each loan segment.

The general component involves the use of a historic loss model to estimate future losses. The model includes each of the five loan portfolio segments and utilizes the incurred losses over the last twelve months to estimate future losses. The historic loss percentages derived from this model are then applied to the outstanding non-impaired loan balance for each loan category. The amounts for each loan category are then summed to determine the amount of loan and lease loss allowance required.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 1.

Summary of Significant Accounting Policies (continued)

Allowance for loan losses: (continued)

The estimated general loan loss allocation for all five loan portfolio segments is then adjusted for management’s estimate of probable losses for several environmental factors. The allocation for environmental factors is particularly subjective. This amount represents estimated probable inherent credit losses which exist, but have not yet been identified, as of the balance sheet date, and is based upon quarterly trend assessments in delinquent and nonaccrual loans, unanticipated charge-offs, credit concentration changes, prevailing economic conditions, changes in lending personnel experience, changes in lending policies, or procedures and other influencing factors. These environmental factors are considered for each of the loan segments, and the general allowance allocation, as determined by the processes noted above for each component, is increased or decreased based on the incremental assessment of these various environmental factors.

The Bank’s allowance for loan losses includes a specific allocation for loans classified as impaired. In assessing the adequacy of the allowance, Cornerstone considers the results of our ongoing independent loan review process. Cornerstone undertakes this process both to ascertain whether there are loans in the portfolio whose credit quality has weakened over time and to assist in the overall evaluation of the risk characteristics of the entire loan portfolio. Cornerstone’s loan review process includes the judgment of management, independent loan reviewers, and reviews that may have been conducted by third-party reviewers. Cornerstone incorporates relevant loan review results in the loan impairment determination. For each impaired loan, management determines the impaired amount and assigns a specific reserve. In addition, regulatory agencies, as an integral part of their examination process, will periodically review Cornerstone’s allowance for loan losses, and may require the company to record adjustments to the allowance based on their judgment about information available to them at the time of their examinations.

A loan is considered impaired when, based on current information and events, it is probable that Cornerstone will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.

Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, Cornerstone does not separately identify individual consumer loans for impairment disclosures, unless such loans are the subject of a restructuring agreement due to financial difficulties of the borrower.

Derivative loan commitments:

Mortgage loan commitments are referred to as derivative loan commitments if the loan that will result from exercise of the commitment will be held for sale upon funding. Loan commitments that are derivatives are recognized at fair value on the consolidated balance sheet in derivative assets or derivative liabilities with changes in their fair values recorded in net gains on sales of loans.

Cornerstone records a zero value for the loan commitment at inception, when the commitment is issued to a borrower. Subsequent to inception, changes in the fair value of the loan commitment are recognized based on changes in the fair value of the underlying mortgage loan due to interest rate changes, changes in the probability the derivative loan commitment will be exercised, and the passage of time. In estimating fair value, Cornerstone assigns a probability to a loan commitment based on an expectation that it will be exercised and the loan will be funded.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 1.

Summary of Significant Accounting Policies (continued)

Premises and equipment:

Land is carried at cost. Buildings and equipment are carried at cost, less accumulated depreciation and amortization computed on the straight-line and declining balance methods over the estimated useful lives of the assets. Maintenance and repairs are expensed as incurred while major additions and improvements are capitalized. Gains and losses on dispositions are included in current operations.

Investment in partnership:

Cornerstone’s investment in a partnership consists of an equity interest in a lending partnership for the purposes of investing in the New Market Tax Credit Program. This program permits taxpayers to claim a credit against federal income taxes for Qualified Equity Investments made to acquire stock or a capital interest in designated Community Development Entities (CDEs). These designated CDEs must use substantially all (defined as 85 percent) of these proceeds to make qualified low-income community investments.

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

Foreclosed assets:

Assets acquired through, or in lieu of, loan foreclosure are held for sale and are initially recorded at fair value less cost to sell at the date of foreclosure, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less cost to sell. Revenues and expenses from operations and changes in the valuation allowance are included in net expenses from foreclosed assets.

Securities sold under agreements to repurchase:

Cornerstone enters into sales of securities under agreements to repurchase identical securities the next day. Securities sold under agreements to repurchase amounted to $19,587,387 at December 31, 2012, mature on a daily basis and are secured by securities available for sale with a fair value of approximately $25,130,000.

Income taxes:

Cornerstone accounts for income taxes in accordance with income tax accounting guidance in ASC Topic 740. The income tax accounting guidance results in two components of income tax expense – current and deferred. Current income tax expense reflects taxes to be paid or refunded for the current period by applying the provisions of the enacted tax law to taxable income or loss. Cornerstone determines deferred income taxes using the liability method. Under this method, the net deferred tax asset or liability is based on the tax effects of the differences between the book and tax bases of assets and liabilities. Cornerstone’s deferred taxes relate primarily to differences between the basis of the allowance for loan losses and accumulated depreciation. Deferred tax assets and liabilities are reflected at income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. As changes in tax laws or rates are enacted, deferred tax assets and liabilities are adjusted through the provision for income taxes. Cornerstone files consolidated income tax returns with its subsidiary. With few exceptions, Cornerstone is no longer subject to tax examinations by tax authorities for years before 2009.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 1.

Summary of Significant Accounting Policies (continued)

Income taxes: (continued)

Cornerstone recognizes deferred tax assets if it is more likely than not, based on the technical merits, that the tax position will be realized or sustained upon examination. Cornerstone follows the statutory requirements for its income tax accounting and generally avoids risks associated with potentially problematic tax positions that may be challenged upon examination. Cornerstone recognizes interest and penalties on income taxes as a component of income tax expense.

Transfers of financial assets:

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

Advertising costs:

Cornerstone expenses all advertising costs as incurred. Advertising expense was $89,068, $78,097, and $79,790, for the years ended December 31, 2012, 2011 and 2010, respectively.

Statements of cash flows:

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

Stock option plan:

Cornerstone recognizes compensation cost relating to share-based payment transactions in accordance with ASC Topic 718. Compensation cost has been measured based on the grant date fair value of the equity or liability instruments issued. Compensation cost is calculated and recognized over the employee service period, generally defined as the vesting period. Cornerstone uses a stock option pricing model to determine the fair value of the award on the grant date.

Segment reporting:

ASC Topic 280, “Segment Reporting,” provides for the identification of reportable segments on the basis of distinct business units and their financial information to the extent such units are reviewed by an entity’s chief decision maker (which can be an individual or group of management persons). ASC Topic 280 permits aggregation or combination of segments that have similar characteristics. In Cornerstone’s operations, each bank branch is viewed by management as being a separately identifiable business or segment from the perspective of monitoring performance and allocation of financial resources. Although the branches operate independently and are managed and monitored separately, each is substantially similar in terms of business focus, type of customers, products and services. Further, the results of Eagle for 2012, 2011 and 2010 were not significant for separate disclosure. Accordingly, Cornerstone’s consolidated financial statements reflect the presentation of segment information on an aggregated basis in one reportable segment.

Earnings per common share:

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

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 1.

Summary of Significant Accounting Policies (continued)

Variable interest entities:

An entity is referred to as a variable interest entity (VIE) if it meets the criteria outlined in ASC Topic 810, which are: (1) the entity has equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, or (2) the entity has equity investors that cannot make significant decisions about the entity’s operations or that do not absorb the expected losses or receive the expected returns of the entity. A VIE must be consolidated by Cornerstone if it is deemed to be the primary beneficiary of the VIE, which is the party involved with the VIE that has a majority of the expected losses, expected residual returns, or both. At December 31, 2012, Cornerstone has an investment in Appalachian Fund for Growth II Partnership that qualifies as an unconsolidated VIE.

Comprehensive income:

Comprehensive income consists of net income and other comprehensive income. Other comprehensive income includes unrealized gains on securities available for sale, and unrealized losses related to factors other than credit losses on debt securities.

Off-balance sheet credit related financial instruments:

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

Subsequent events:

Cornerstone has evaluated subsequent events for potential recognition and/or disclosures in the consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K.

Note 2.

Preferred Stock

During 2010, Cornerstone initiated a preferred stock offering. The offering period was scheduled to end on June 30, 2011. In an effort to obtain its goal of $15 million in preferred stock sales, Cornerstone elected to extend the offering in 2011 through June 30, 2012 and in 2012 through December 31, 2012. Specifics of the preferred stock offering are as follows:

Issuance of up to 600,000 shares of Series A Convertible Preferred Stock at a price of $25.00 per share.

The annual cash dividend on each share of Series A Preferred Stock is $2.50, which is equal to 10% of the original issue price of $25.00 per share, and is payable quarterly in arrears, if, as and when declared on the 15^th day of February, May, August and November that immediately follows the end of the dividend period to which such dividends relate. Any dividend payable on shares of Series A Preferred Stock that is not declared by our board of directors or paid will accumulate.

Each share of Series A Preferred Stock will be convertible at the shareholder’s option at any time into five (5) shares of our common stock reflecting an initial conversion price of $5.00 per share of common stock. The shares of Series A Preferred Stock are also convertible at Cornerstone’s option, in whole or in part, into shares of Cornerstone’s common stock at the conversion rate, at any time on or after July 31, 2015, if the closing price of Cornerstone’s common stock equals or exceeds 150% of the conversion price on each of the thirty (30) consecutive trading days immediately preceding the date Cornerstone gives notice of its election to so convert.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 2.

Preferred Stock (continued)

At December 31, 2011, preferred stock, as presented in the consolidated statements of changes in stockholders’ equity, includes 56,440 shares or $1,399,665 in irrevocable stock subscriptions received in December 2011 which were subsequently paid during January 2012.

At December 31, 2012 and 2011, preferred stock dividends accumulated for each period, which were not declared, totaled $683,893 and $440,031, respectively.

Note 3.

Restrictions on Cash and Due From Banks

The Bank is required to maintain balances on hand or with the Federal Reserve Bank based on a percentage of deposits. At December 31, 2012 and 2011, these reserve balances were approximately $594,000 and $1,230,000, respectively.

Note 4.

Securities

Securities have been classified in the balance sheet according to management’s intent as either securities held to maturity or securities available for sale. The amortized cost and approximate fair value of securities at December 31, 2012 and 2011 are as follows:

	December 31, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities available for sale:
U.S. Government agencies	$	3,961,956	$	56,195	$	-		$	4,018,151

State and municipal securities		21,531,727		2,101,590		-			23,633,317

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		9,092,205		132,038		(1,824	)		9,222,419

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		39,151,568		86,099		(14,908	)		39,222,759

	$	73,737,456	$	2,375,922	$	(16,732	)	$	76,096,646

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA	$	45,086	$	1,134	$	(8	)	$	46,212

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 4.

Securities (continued)

	December 31, 2011
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities available for sale:
U.S. Government agencies	$	4,176,301	$	13,978	$	-		$	4,190,279

State and municipal securities		22,902,892		1,584,284		(50,919	)		24,436,257

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		11,723,499		150,767		(3,096	)		11,871,170

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		45,431,456		131,215		(2,940	)		45,559,731

	$	84,234,148	$	1,880,244	$	(56,955	)	$	86,057,437

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA	$	68,643	$	1,841	$	-		$	70,484

U.S. Government sponsored agencies include entities such as Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association.

At December 31, 2012 and 2011, securities with a carrying value of approximately $14,817,000 and $18,182,000, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.

At December 31, 2012 and 2011, the carrying amount of securities pledged to secure repurchase agreements was approximately $25,130,000 and $28,409,000, respectively.

At December 31, 2012, the Bank did not pledge any securities to the Federal Home Loan Bank as collateral for the Bank’s borrowings. At December 31, 2011, securities with a carrying value of approximately $27,897,000 were pledged to the Federal Home Loan Bank as collateral for the Bank’s borrowings.

At December 31, 2012 and 2011, the Bank had pledged securities with a carrying amount of approximately $3,428,000 and $9,048,000, respectively, to other financial institutions as collateral for federal funds purchased.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 4.

Securities (continued)

The amortized cost and fair value of securities at December 31, 2012, 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		Fair		Amortized		Fair
	Cost		Value		Cost		Value

Due in one year or less	$	-	$	-	$	-	$	-
Due from one year to five years		1,092,445		1,169,616		-		-
Due from five years to ten years		5,502,258		6,111,659		-		-
Due after ten years		18,898,980		20,370,193		-		-

		25,493,683		27,651,468		-		-

Mortgage-backed securities		48,243,773		48,445,178		45,086		46,212

	$	73,737,456	$	76,096,646	$	45,086	$	46,212

For the year ended December 31, 2012, there were no securities sold. For the year ended December 31, 2011, there were available for sale securities sold with proceeds totaling $18,954,410 which resulted in gross gains realized of $107,413. For the year ended December 31, 2010, there were available for sale securities sold with proceeds totaling $85,186,273 which resulted in gross gains and losses realized of $1,699,276 and $1,140, respectively.

The following tables present gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities available for sale have been in a continuous unrealized loss position, at December 31, 2012 and 2011:

	As of December 31, 2012
	Less than 12 Months					12 Months or Greater				Total
			Gross					Gross				Gross
	Fair		Unrealized			Fair		Unrealized		Fair		Unrealized
	Value		Losses			Value		Losses		Value		Losses

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA and FNMA	$	667,325	$	(1,824	)	$	-	$	-	$	667,325	$	(1,824	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		22,514,641		(14,908	)		-		-		22,514,641		(14,908	)

	$	23,181,966	$	(16,732	)	$	-	$	-	$	23,181,966	$	(16,732	)

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 4.

Securities (continued)

	As of December 31, 2011
	Less than 12 Months					12 Months or Greater					Total
			Gross					Gross					Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses

Debt securities available for sale:
State and municipal securities	$	1,735,771	$	(50,919	)	$	-	$	-		$	1,735,771	$	(50,919	)

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		-		-			3,133,826		(3,096	)		3,133,826		(3,096	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		-		-			6,954,999		(2,940	)		6,954,999		(2,940	)

	$	1,735,771	$	(50,919	)	$	10,088,825	$	(6,036	)	$	11,824,596	$	(56,955	)

Upon acquisition of a security, Cornerstone determines the appropriate impairment model that is applicable. If the security is a beneficial interest in securitized financial assets, Cornerstone uses the beneficial interests in securitized financial assets impairment model. If the security is not a beneficial interest in securitized financial assets, Cornerstone uses the debt and equity securities impairment model. Cornerstone conducts periodic reviews to evaluate each security to determine whether an other-than-temporary impairment has occurred. Cornerstone does not have any securities that have been classified as other-than-temporarily-impaired at December 31, 2012.

At December 31, 2012, the significant categories of temporarily impaired securities, and management’s evaluation of those securities are as follows:

Mortgage-backed securities: At December 31, 2012, eight investments in residential mortgage-backed securities had unrealized losses. This impairment is believed to be caused by the current interest rate environment. The contractual cash flows of those investments are guaranteed or issued by an agency of the U.S. Government. Because the decline in market value is attributable to the current interest rate environment and not credit quality, and because Cornerstone does not intend to sell the investments and it is not more likely than not that Cornerstone will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, Cornerstone does not deem those investments to be other-than-temporarily impaired at December 31, 2012.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 5.

Loans and Allowance for Loan Losses

At December 31, 2012 and 2011, the Bank's loans consist of the following (in thousands):

				2012			2011
Commercial real estate-mortgage:
Owner-occupied				$	58,425		$	62,999
All other					66,747			63,058
Consumer real estate-mortgage					71,195			70,543
Construction and land development					38,557			31,031
Commercial and industrial					40,140			37,458
Consumer and other					1,927			2,676

Total loans					276,991			267,765
Less: Allowance for loan losses					(6,141	)		(7,400	)

Loans, net				$	270,850		$	260,365

	2012			2011			2010

An analysis of the allowance for loan losses follows:

Balance, beginning of year	$	7,400,049		$	9,132,171		$	5,905,054

Provision for loan losses		430,000			445,000			7,291,000
Charge-offs		(2,868,576	)		(3,148,314	)		(4,688,054	)
Recoveries		1,179,808			971,192			624,171

Balance, end of year	$	6,141,281		$	7,400,049		$	9,132,171

Cornerstone follows the loan impairment accounting guidance in ASC Topic 310. A loan is considered impaired when, based on current information and events, it is probable that Cornerstone will be unable to collect all amounts due from the borrower in accordance with the contractual terms of the loan. Impaired loans include nonperforming loans and loans modified in troubled debt restructurings where concessions have been granted to borrowers experiencing financial difficulties. These concessions could include a reduction in interest rates, payment extensions, forgiveness of principal, forbearance or other actions intended to maximize collections.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 5.

Loans and Allowance for Loan Losses (continued)

The composition of loans by loan classification for impaired and performing loans at December 31, 2012 and 2011, is summarized in the tables below (in thousands):

As of December 31, 2012:

	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total

Performing loans	$	115,959	$	69,329	$	37,607	$	36,980	$	1,927	$	261,802
Impaired loans		9,213		1,866		950		3,160		-		15,189

Total	$	125,172	$	71,195	$	38,557	$	40,140	$	1,927	$	276,991

As of December 31, 2011:

	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total

Performing loans	$	112,064	$	64,026	$	29,323	$	34,259	$	2,676	$	242,348
Impaired loans		13,993		6,517		1,708		3,199		-		25,417

Total	$	126,057	$	70,543	$	31,031	$	37,458	$	2,676	$	267,765

The following tables show the allowance for loan losses allocation by loan classification for impaired and performing loans as of December 31, 2012 and 2011 (in thousands):

As of December 31, 2012:

	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Allowance related to:
Performing loans	$	319	$	952	$	781	$	29	$	14	$	2,095
Impaired loans		2,230		576		460		780		-		4,046

Total	$	2,549	$	1,528	$	1,241	$	809	$	14	$	6,141

As of December 31, 2011:

	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total

Allowance related to:
Performing loans	$	952	$	1,264	$	174	$	18	$	16	$	2,424
Impaired loans		2,605		1,254		653		464		-		4,976

Total	$	3,557	$	2,518	$	827	$	482	$	16	$	7,400

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 5.

Loans and Allowance for Loan Losses (continued)

The following tables detail the changes in the allowance for loan losses during December 31, 2012 and 2011, by loan classification (in thousands):

As of December 31, 2012:

	Commercial			Consumer			Construction			Commercial
	Real Estate-			Real Estate-			and Land			and			Consumer
	Mortgage			Mortgage			Development			Industrial			and Other			Total

Balance, beginning of year	$	3,557		$	2,518		$	827		$	482		$	16		$	7,400
Provision for loan losses		(888	)		(4	)		1,051			257			14			430
Charge-offs		(958	)		(1,022	)		(782	)		(74	)		(33	)		(2,869	)
Recoveries		838			36			145			144			17			1,180

Balance, end of year	$	2,549		$	1,528		$	1,241		$	809		$	14		$	6,141

As of December 31, 2011:

	Commercial			Consumer			Construction			Commercial
	Real Estate-			Real Estate-			and Land			and			Consumer
	Mortgage			Mortgage			Development			Industrial			and Other			Total

Balance, beginning of year	$	1,793		$	3,111		$	3,238		$	925		$	65		$	9,132
Provision for loan losses		2,743			955			(2,711	)		(501	)		(41	)		445
Charge-offs		(1,238	)		(1,613	)		(232	)		(36	)		(29	)		(3,148	)
Recoveries		259			65			532			94			21			971

Balance, end of year	$	3,557		$	2,518		$	827		$	482		$	16		$	7,400

Credit quality indicators:

Federal regulations require the Bank to review and classify its assets on a regular basis. To fulfill this requirement, the Bank systematically reviews its loan portfolio to ensure the Bank’s large loan relationships are being maintained within its loan policy guidelines, remain properly underwritten and are properly classified by loan grade. This review process is performed by the Bank's management, internal and external loan review, internal auditors, and state and federal regulators.

The Bank’s loan grading process is as follows:

All loans are assigned a loan grade at the time of origination by the relationship manager. Typically, a loan is assigned a loan grade of “pass” at origination.

Loans relationships greater than or equal to $500 thousand are reviewed by the Bank’s external loan review provider on an annual basis.

Additionally, the Bank's external loan review provider samples other loan relationships between $100 thousand and $500 thousand with an emphasis on commercial and commercial real estate loans and insider loans.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 5.

Loans and Allowance for Loan Losses (continued)

Credit quality indicators: (continued)

The Bank’s internal loan review department samples approximately 33 percent of all loan relationships less than $500 thousand on an annual basis for review.

If a loan is delinquent 60 days or more or a pattern of delinquency exists, the loan will be selected for review.

Generally, all loans on the Bank’s internal watchlist are reviewed annually by internal loan review or external loan review providers.

If a loan is classified as a problem asset, it will be assigned one of the following loan grades: substandard, substandard-impaired, doubtful, and loss. “Substandard assets” must have one or more defined weaknesses and are characterized by the distinct possibility that we 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 questionable, and there is a high possibility of loss. An asset classified “loss” is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. The regulations also provide for a “special mention” category, described as assets which do not currently expose an institution to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving close attention. When the Bank classifies an asset as substandard or doubtful, a specific allowance for loan losses may be established.

The following tables outline the amount of each loan classification and the amount categorized into each risk rating as of December 31, 2012 and 2011 (in thousands):

As of December 31, 2012:

	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total

Pass	$	111,313	$	57,959	$	36,802	$	36,482	$	1,904	$	244,460
Special mention		4,145		8,401		198		330		18		13,092
Substandard		501		2,969		607		168		5		4,250
Substandard-impaired		9,213		1,866		950		3,160		-		15,189
	$	125,172	$	71,195	$	38,557	$	40,140	$	1,927	$	276,991

As of December 31, 2011:

	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total

Pass	$	101,161	$	55,160	$	27,207	$	31,426	$	2,648	$	217,602
Special mention		9,805		5,122		804		2,620		7		18,358
Substandard		1,098		3,744		1,312		213		21		6,388
Substandard-impaired		11,493		6,517		1,708		3,199		-		22,917
Doubtful		2,500		-		-		-		-		2,500

	$	126,057	$	70,543	$	31,031	$	37,458	$	2,676	$	267,765

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 5.

Loans and Allowance for Loan Losses (continued)

After the Bank’s independent loan review department completes the loan grade assignment, a loan impairment analysis is performed on loans graded substandard or worse. The following tables present summary information pertaining to impaired loans by loan classification as of December 31, 2012 and 2011 (in thousands):

							For the Year Ended
	At December 31, 2012						December 31, 2012
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized

Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	3,406	$	3,453	$	-	$	4,389	$	180
Consumer real estate – mortgage		513		540		-		1,538		52
Construction and land development		244		251		-		358		19
Commercial and industrial		2,111		2,155		-		2,277		55
Consumer and other		-		-		-		-		-

Total		6,274		6,399		-		8,562		306

Impaired loans with a valuation allowance:
Commercial real estate – mortgage		5,807		5,848		2,230		6,616		215
Consumer real estate – mortgage		1,353		1,353		576		2,606		61
Construction and land development		706		706		460		642		49
Commercial and industrial		1,049		1,049		780		700		132
Consumer and other		-		-		-		-		-

Total		8,915		8,956		4,046		10,564		457

Total impaired loans	$	15,189	$	15,355	$	4,046	$	19,126	$	763

							For the Year Ended
	At December 31, 2011						December 31, 2011
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized

Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	4,354	$	4,354	$	-	$	5,378	$	330
Consumer real estate – mortgage		322		322		-		3,589		21
Construction and land development		829		1,023		-		1,099		59
Commercial and industrial		2,691		2,691		-		1,207		165
Consumer and other		-		-		-		-		-

Total		8,196		8,390		-		11,273		575

Impaired loans with a valuation allowance:
Commercial real estate – mortgage		9,639		9,694		2,605		5,912		645
Consumer real estate – mortgage		6,195		6,257		1,254		5,333		294
Construction and land development		879		879		653		294		62
Commercial and industrial		508		508		464		784		65
Consumer and other		-		-		-		-		-

Total		17,221		17,338		4,976		12,323		1,066

Total impaired loans	$	25,417	$	25,728	$	4,976	$	23,596	$	1,641

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 5.

Loans and Allowance for Loan Losses (continued)

The following tables present an aged analysis of past due loans as of December 31, 2012 and 2011 (in thousands):

As of December 31, 2012:

	30-89 Days		Past Due 90
	Past Due and		Days or More				Total		Current		Total
	Accruing		and Accruing		Nonaccrual		Past Due		Loans		Loans
Commercial real estate-mortgage:
Owner-occupied	$	2,738	$	-	$	956	$	3,694	$	54,731	$	58,425
All other		636		-		1,913		2,549		64,198		66,747
Consumer real estate-mortgage		1,858		-		616		2,474		68,721		71,195
Construction and land development		100		-		53		153		38,404		38,557
Commercial and industrial		1,227		-		2,467		3,694		36,446		40,140
Consumer and other		35		-		-		35		1,892		1,927

Total	$	6,594	$	-	$	6,005	$	12,599	$	264,392	$	276,991

As of December 31, 2011:

	30-89 Days		Past Due 90
	Past Due and		Days or More				Total		Current		Total
	Accruing		and Accruing		Nonaccrual		Past Due		Loans		Loans

Commercial real estate-mortgage:
Owner-occupied	$	4,791	$	-	$	63	$	4,854	$	58,145	$	62,999
All other		497		-		2,500		2,997		60,061		63,058
Consumer real estate-mortgage		1,163		-		3,641		4,804		65,739		70,543
Construction and land development		103		-		1,622		1,725		29,306		31,031
Commercial and industrial		1,578		-		42		1,620		35,838		37,458
Consumer and other		26		-		14		40		2,636		2,676

Total	$	8,158	$	-	$	7,882	$	16,040	$	251,725	$	267,765

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 5.

Loans and Allowance for Loan Losses (continued)

Impaired loans also include loans that the Bank has elected to formally restructure when, due to the weakening credit status of a borrower, the restructuring may facilitate a repayment plan that seeks to minimize the potential losses that the Bank may have to otherwise incur. At December 31, 2012 and 2011, the Bank has loans of approximately $9,403,000 and $5,026,000, respectively, that were modified in troubled debt restructurings. Troubled commercial loans are restructured by specialists within our Special Asset department and all restructurings are approved by committees and credit officers separate and apart from the normal loan approval process. These specialists are trained to reduce the Bank’s overall risk and exposure to loss in the event of a restructuring through obtaining either or all of the following: improved documentation, additional guaranties, increase in curtailments, reduction in collateral terms, additional collateral or other similar strategies.

The following tables present a summary of loans that were modified as troubled debt restructurings during the years ended December 31, 2012 and 2011 (amounts in thousands):

During the year ended December 31, 2012:

		Pre-Modification		Post-Modification
	Number of	Outstanding Recorded		Outstanding Recorded
	Contracts	Investment		Investment

Commercial real estate-mortgage	5	$	5,971	$	5,971
Consumer real estate-mortgage	1		65		65
Construction and land development	3		1,178		1,178
Commercial and industrial	5		2,432		2,432

During the year ended December 31, 2011:

		Pre-Modification		Post-Modification
	Number of	Outstanding Recorded		Outstanding Recorded
	Contracts	Investment		Investment

Consumer real estate-mortgage	5	$	3,573	$	3,573
Construction and land development	2		778		778
Commercial and industrial	1		20		20

There were no loans that were modified as troubled debt restructurings during the year ended December 31, 2012, for which there was a subsequent payment default during the year. The following table presents a summary of loans that were modified as troubled debt restructurings during the year ended December 31, 2011, and for which there was a subsequent payment default during the year (amounts in thousands):

In the ordinary course of business, the Bank has granted loans to principal officers and directors and their affiliates. Annual activity of these related party loans were as follows:

	2012			2011

Beginning balance	$	1,514,908		$	666,336

New loans		436,051			1,957,088
Repayments		(116,977	)		(1,108,516	)

Ending balance	$	1,833,982		$	1,514,908

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 6.

Bank Premises and Equipment

A summary of bank premises and equipment at December 31, 2012 and 2011, is as follows:

	2012			2011

Land	$	2,145,003		$	2,145,003
Buildings and improvements		4,284,293			4,302,862
Furniture, fixtures and equipment		3,713,758			3,735,576

		10,143,054			10,183,441
Accumulated depreciation		(4,743,714	)		(4,471,438	)

	$	5,399,340		$	5,712,003

Depreciation expense for the years ended December 31, 2012, 2011 and 2010, amounted to $461,905, $475,938, and $513,468, respectively.

Certain bank facilities and equipment are leased under various operating leases. Total rent expense on these leases for the years ended December 31, 2012, 2011 and 2010, was $390,571, $392,114, and $423,580, respectively.

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

2013	$	348,444
2014		348,444
2015		233,649
2016		128,600

Total	$	1,059,137

Note 7.

Goodwill

There was no change in the carrying amount of goodwill for the years ended December 31, 2012 and 2011.

Cornerstone’s policy is to assess goodwill for impairment on an annual basis or between annual assessments if an event occurs or circumstances change that would more likely than not reduce the fair value of goodwill below its carrying amount as required by authoritative accounting guidance. Impairment is the condition that exists when the carrying amount of goodwill exceeds its implied fair value. The impairment testing is a two-step process. Step one compares the fair value of the reporting unit to the carrying value. If the fair value is below the carrying value, step two is performed. Step two involves a process similar to business combination accounting in which fair value is assigned to all assets, liabilities and other (non-goodwill) intangibles. The result of step two is the implied fair value of goodwill. If the implied fair value of goodwill is below the recorded goodwill amount, an impairment charge is recorded for the difference.

Cornerstone performed its annual impairment analysis in December 2010. ASC Topic 350, “Intangibles-Goodwill and Other,” states that the fair value of a reporting unit refers to the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date. Quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for the measurement, if available. Cornerstone obtained published information on the market price to book value and market price to tangible book value for other financial institutions located in Tennessee and Georgia, financial institutions in the southeastern region of the United States, and recently completed merger and acquisition transactions. This information was compared to Cornerstone’s market price to book value and market price to tangible book value. Based on this testing, step two analysis was required.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 7.

Goodwill (continued)

The results from the impairment analysis led management and the board of directors to conclude that Cornerstone’s goodwill was fully impaired as of December 31, 2010. The impairment amount of $2,541,476 was recorded in noninterest expenses in the Consolidated Statements of Income. The impairment was primarily a result of the continuing economic downturn and its implications on entity valuations. Cornerstone’s goodwill was originally recorded as a non-taxable stock purchase. Therefore, the $2,541,476 goodwill impairment was not deductible for taxes and thus no tax benefit was recognized.

Note 8.

Time and Related-Party Deposits

At December 31, 2012, the scheduled maturities of time deposits are as follows (in thousands):

2013	$	101,345
2014		40,203
2015		14,730
2016		5,974
2017		11,402

Total	$	173,654

Deposits from related parties held by the Bank at December 31, 2012 and 2011, amounted to approximately $788,000 and $709,000, respectively.

As of December 31, 2012 and 2011, certificates of deposit equal to or greater than $100,000 amounted to approximately $87,737,000 and $102,107,000, respectively.

Note 9.

Income Taxes

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

Income tax expense in the consolidated statements of income for the years ended December 31, 2012, 2011 and 2010, consists of the following:

	2012			2011			2010

Current tax expense (benefit)	$	960,750		$	77,279		$	(522,382	)
Deferred tax expense (benefit) related to:
Allowance for loan losses		(255,287	)		509,358			(1,030,423	)
Other		(127,863	)		(398,437	)		17,508

Income tax expense (benefit)	$	577,600		$	188,200		$	(1,535,297	)

The income tax expense is different from the expected tax expense computed by multiplying income before income tax expense by the statutory federal income tax rates. These differences are reconciled as follows:

	2012			2011			2010

Expected tax at statutory rates	$	673,085		$	414,206		$	(2,122,558	)
Increase (decrease) resulting from tax effect of:
State income taxes, net of federal tax benefit		84,928			52,263			(267,817	)
New market tax credits		(180,000	)		(277,500	)		(112,500	)
Impairment of goodwill		-			-			973,131
Other		(413	)		(769	)		(5,553	)

Income tax expense (benefit)	$	577,600		$	188,200		$	(1,535,297	)

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 9.

Income Taxes (continued)

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

	2012		2011
Deferred tax assets:
Deferred compensation	$	104,709	$	110,724
Deferred loan fees		107,143		38,370
Allowance for loan losses		1,471,054		1,215,767
Foreclosed assets		1,770,380		1,711,688

		3,453,286		3,076,549

Deferred tax liabilities:
Depreciation		83,150		90,269
Life insurance		204,386		204,386
Net unrealized gain on securities available for sale		907,797		704,153
Other		6,990		6,284

		1,202,323		1,005,092

Net deferred tax asset	$	2,250,963	$	2,071,457

ASC Topic 740, “Income Taxes,” clarifies the accounting for uncertainty in tax positions. ASC Topic 740 requires that Cornerstone recognize in its financial statements, the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. Cornerstone recognized no interest and penalties assessed by taxing authorities on any underpayment of income tax for 2012, 2011 or 2010.

Note 10.

Federal Home Loan Bank Advances and Other Borrowings

The Bank has agreements with the Federal Home Loan Bank of Cincinnati (FHLB) that can provide advances to the Bank in an amount up to $35,000,000. All of the Bank’s loans secured by first mortgages on 1-4 family residential, multi-family properties and commercial properties are pledged as collateral for these advances. Additionally, the Bank had pledged securities with a carrying amount of approximately $27,897,000 as of December 31, 2011. No securities were pledged to the FHLB at December 31, 2012.

At December 31, 2012 and 2011, FHLB advances consist of the following:

	2012		2011

Long-term advance dated February 9, 2005, requiring monthly interest payments, fixed at 3.86%, convertible on February 2010, principal due in February 2015	$	5,000,000	$	5,000,000

Long-term advance dated January 22, 2008, requiring monthly interest payments, fixed at 3.59%, until maturity, principal due in January 2013		5,000,000		5,000,000

Long-term advance dated May 15, 2007, requiring monthly interest payments, fixed at 4.58%, with a put option exercisable in May 2008 and then quarterly thereafter, principal due in May 2012		-		5,000,000

Long-term advance dated August 1, 2007, requiring monthly interest payments, fixed at 4.50%, with a put option exercisable in July 2008 and then quarterly thereafter, principal due in August 2013		5,000,000		5,000,000

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 10.

Federal Home Loan Bank Advances and Other Borrowings (continued)

	2012		2011

Long-term advance dated August 13, 2007, requiring monthly interest payments, fixed at 4.43%, with a put option exercisable in February 2009 and then quarterly thereafter, principal due in August 2014	$	5,000,000	$	5,000,000

Long-term advance dated January 7, 2008, requiring monthly interest payments, fixed at 3.52%, with a put option exercisable in January 2011 and then quarterly thereafter, principal due in January 2015		5,000,000		5,000,000

Long-term advance dated January 20, 2006, requiring monthly interest payments, fixed at 4.18%, with a put option exercisable in January 2009 and then quarterly thereafter, principal due in January 2016		5,000,000		5,000,000

Long-term advance dated January 10, 2007, requiring monthly interest payments, fixed at 4.25%, with a put option exercisable in January 2008 and then quarterly thereafter, principal due in January 2017		5,000,000		5,000,000

	$	35,000,000	$	40,000,000

During the fixed rate term, the advances may be prepaid subject to a prepayment penalty as defined in the agreements. On convertible agreements, the FHLB has the right to convert the fixed rate on the above advances at the end of the initial fixed rate period and on a quarterly basis thereafter. If the conversion option is exercised, the advances will bear interest at the three-month London Interbank Offered Rate (LIBOR) adjusted quarterly at a spread of zero basis points to the LIBOR index. Subsequent to any conversion, the Bank has the option to prepay the advances, in full or in part, without penalty on the conversion date or any subsequent quarterly repricing date. On agreements with put options, the FHLB has the right, at its discretion, to terminate only the entire advance prior to the stated maturity date. The termination option may only be exercised on the expiration date of the predetermined lockout period and on a quarterly basis thereafter.

As of December 31, 2011, Cornerstone had a borrowing outstanding of $3,045,000 with the Federal Deposit Insurance Corporation (FDIC) after Silverton Bank (subsequently known as Silverton Bride Bank, N.A.) was placed into receivership. The borrowing agreement contained financial covenants that Cornerstone was not in compliance with as of December 31, 2011. Cornerstone obtained a waiver from the FDIC of the covenant compliance requirements through December 31, 2012. As of December 31, 2012, the outstanding balance was $2,175,000.

In March 2013, Cornerstone refinanced the existing debt with a correspondent financial institution. The new loan does not include financial covenants, but is secured with cash collateral of approximately $1.7 million and bears interest at an annual rate of two percent.

The primary source of liquidity for Cornerstone is the payment of dividends from the Bank. As of December 31, 2012, the Bank was under a dividend restriction that requires regulatory approval prior to the payment of a dividend from the Bank to Cornerstone.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 10.

Federal Home Loan Bank Advances and Other Borrowings (continued)

At December 31, 2012, scheduled maturities of the Federal Home Loan Bank advances and other borrowings are as follows:

2013	$	10,870,000
2014		6,305,000
2015		10,000,000
2016		5,000,000
2017		5,000,000

Total	$	37,175,000

Note 11.

Employee Benefit Plans

401(k) plan:

Cornerstone has a 401(k) employee benefit plan covering substantially all employees that have completed at least 30 days of service and met minimum age requirements. Cornerstone’s contribution to the plan is discretionary. Cornerstone elected not to make a contribution to the plan for 2012, 2011 and 2010.

Employee Stock Ownership Plan:

Cornerstone has a non-leveraged employee stock ownership plan (ESOP) to which Cornerstone makes 100% of the contributions for purchasing Cornerstone’s common stock, and allocates the contributions among the participants based on regulatory guidelines. Cornerstone’s contribution is discretionary, as determined by the Compensation Committee. Employer contributions are available to all employees after 1,000 hours of service. There are certain age and years-of-service requirements before contributions can be made for the benefit of the employee. The ESOP plan also provides for a three year 100% vesting requirement; therefore, employees terminating employment before their third anniversary date will forfeit their accrued benefit under the ESOP. The forfeiture will be re-allocated among the remaining ESOP participants. Contributions were made to the ESOP of $3,500 in 2012. No contributions were made in 2011 or 2010.

Note 12.

Financial Instruments With Off-Balance-Sheet Risk

In the normal course of business, the Bank has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Bank uses the same credit policies in making such commitments as it does for instruments that are included in the balance sheet. At December 31, 2012 and 2011, undisbursed loan commitments aggregated approximately $37,415,000 and $24,972,000, respectively. In addition, there were outstanding standby letters of credit totaling approximately $3,214,000 and $2,598,000, 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.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 12.

Financial Instruments With Off-Balance-Sheet Risk (continued)

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

The Bank incurred insignificant losses on its commitments during 2012, 2011 and 2010.

Note 13.

Fair Value Disclosures

Cornerstone uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. In accordance with ASC Topic 820, “Fair Value Measurements and Disclosures,” the fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.

ASC Topic 820 provides a consistent definition of fair value, which focuses on exit price in an orderly transaction between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value is a reasonable point within the range that is most representative of fair value under current market conditions.

ASC Topic 820 also establishes a three-tier fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value, as follows:

Level 1 - Quoted prices (unadjusted) in active markets for identical assets or liabilities that Cornerstone has the ability to access.

Level 2 - Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities in active markets, quoted prices in markets that are not active and other inputs that are observable or can be corroborated by observable market data.

Level 3 - Significant unobservable inputs that reflect a company’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. There have been no changes in the methodologies used at December 31, 2012 and 2011.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 13.

Fair Value Disclosures (continued)

The following methods and assumptions were used by Cornerstone in estimating fair value disclosures for financial instruments:

Cash and cash equivalents:

The carrying amounts of cash and cash equivalents approximate fair values based on the short-term nature of the assets.

Securities:

Fair values are estimated using pricing models and discounted cash flows that consider standard input factors such as observable market data, benchmark yields, interest rate volatilities, broker/dealer quotes, and credit spreads. Securities classified as available for sale are reported at fair value utilizing Level 2 inputs.

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

Loans:

For variable-rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. Fair values for fixed-rate loans are estimated using discounted cash flow analyses, using market interest rates for comparable loans. Generally, Level 3 inputs are utilized for this estimate. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures impairment in accordance with ASC Topic 310, “Accounting by Creditors for Impairment of a Loan”. The fair value of impaired loans is estimated using several methods including collateral value, liquidation value and discounted cash flows.

Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At December 31, 2012 and 2011, substantially all of the total impaired loans were evaluated based on the fair value of collateral. In accordance with ASC Topic 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, Cornerstone records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, Cornerstone records the impaired loan as nonrecurring Level 3.

Cash surrender value of life insurance:

The carrying amounts of cash surrender value of life insurance approximate their fair value. The carrying amount is based on information received from the insurance carriers indicating the financial performance of the policies and the amount Cornerstone would receive should the policies be surrendered. Cornerstone reflects these assets within Level 2 of the valuation hierarchy.

Foreclosed assets:

Foreclosed assets, consisting of properties obtained through foreclosure or in satisfaction of loans, are initially recorded at fair value, determined on the basis of current appraisals, comparable sales, and other estimates of value obtained principally from independent sources, adjusted for estimated selling costs. At the time of foreclosure, any excess of the loan balance over the fair value of the real estate held as collateral is treated as a charge against the allowance for loan losses. Gains or losses on sale and any subsequent adjustment to the fair value are recorded as a component of foreclosed assets, net expense. Foreclosed assets are included in Level 2 of the valuation hierarchy.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 13.

Fair Value Disclosures (continued)

Deposits:

The fair value of deposits with no stated maturity, such as noninterest-bearing and interest-bearing demand deposits, savings deposits, and money market accounts, is equal to the amount payable on demand at the reporting date. The carrying amounts of variable-rate, fixed-term certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market interest rates on comparable instruments to a schedule of aggregated expected monthly maturities on time deposits. Generally, Level 3 inputs are utilized for this estimate.

Securities sold under agreements to repurchase:

The carrying value of these liabilities approximates their estimated fair value.

Federal Home Loan Bank advances and other borrowings:

The carrying amounts of FHLB advances and other borrowings approximate their fair value.

Accrued interest:

The carrying amounts of accrued interest approximate fair value.

Commitments to extend credit, letters of credit and lines of credit:

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

The tables below present the recorded amount of assets and liabilities measured at fair value on a recurring basis.

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)

Debt securities available for sale:

U.S. Government agencies	$	4,018,151	$	-	$	4,018,151	$	-
State and municipal securities		23,633,317		-		23,633,317		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		9,222,419		-		9,222,419		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		39,222,759		-		39,222,759		-

Total securities available for sale	$	76,096,646	$	-	$	76,096,646	$	-

Cash surrender value of life insurance	$	1,199,725	$	-	$	1,199,725	$	-

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 13.

Fair Value Disclosures (continued)

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2011		(Level 1)		(Level 2)		(Level 3)

Debt securities available for sale:

U.S. Government agencies	$	4,190,279	$	-	$	4,190,279	$	-
State and municipal securities		24,436,257		-		24,436,257		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		11,871,170		-		11,871,170		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		45,559,731		-		45,559,731		-

Total securities available for sale	$	86,057,437	$	-	$	86,057,437	$	-

Cash surrender value of life insurance	$	1,166,774	$	-	$	1,166,774	$	-

Cornerstone has no assets or liabilities whose fair values are measured on a recurring basis using Level 3 inputs.

Certain assets and liabilities are measured at fair value on a nonrecurring basis, which means the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The tables below present information about assets and liabilities on the balance sheet at December 31, 2012 and 2011, for which a nonrecurring change in fair value was recorded.

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2012		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	4,869,154	$	-	$	4,869,154	$	-
Foreclosed assets		20,332,313		-		20,332,313		-

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2011		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	12,245,260	$	-	$	12,245,260	$	-
Foreclosed assets		18,523,960		-		18,523,960		-

Loans include impaired loans held for investment for which an allowance for loan losses has been calculated based upon the fair value of the loans at December 31, 2012 and 2011. Fair values derived from Level 2 inputs were calculated by models incorporating significant observable market data.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 13.

Fair Value Disclosures (continued)

The carrying amount and estimated fair value of the Cornerstone's financial instruments at December 31, 2012 and 2011, are as follows (in thousands):

	2012				2011
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Assets:
Cash and cash equivalents	$	59,395	$	59,395	$	38,883	$	38,883
Securities		76,142		76,143		86,126		86,128
Federal Home Loan Bank stock		2,323		2,323		2,323		2,323
Loans, net		270,850		271,128		260,365		260,515
Cash surrender value of life insurance		1,200		1,200		1,167		1,167
Accrued interest receivable		1,214		1,214		1,327		1,327
Liabilities:
Noninterest-bearing demand deposits		60,054		60,054		43,990		43,990
Interest-bearing demand deposits		30,179		30,179		22,353		22,353
Savings deposits and money market accounts		80,994		80,994		46,857		46,857
Time deposits		173,654		175,177		200,841		203,453
Federal funds purchased and securities sold under agreements to repurchase		19,587		19,587		29,391		29,391
Federal Home Loan Bank advances and other borrowings		37,175		37,175		43,045		43,045
Accrued interest payable		121		121		111		111
Unrecognized financial instruments (net of contract amount):
Commitments to extend credit		-		-		-		-
Letters of credit		-		-		-		-
Lines of credit		-		-		-		-

Note 14.

Contingencies

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

Note 15.

Stock Option Plans

Cornerstone has stock option plans which are more fully described below. For the years ended December 31, 2012, 2011 and 2010, Cornerstone recognized $74,048, $79,140 and $74,612, respectively, in compensation expense for all stock options.

No options were issued during 2010. For the years ended December 31, 2012 and 2011, the fair value of each option granted is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:

	Years Ended December 31,
	2012			2011

Dividend yield		0.0	%		0.0	%
Expected life		7.0 years			7.0 years
Expected volatility		44.62	%		43.11	%
Risk-free interest rate		1.44	%		2.81	%

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 15.

Stock Option Plans (continued)

The expected volatility is based upon historical volatility. The risk-free interest rates for periods within the contractual life of the awards are based on the U.S. Treasury yield curve in effect at the time of the grant. The expected life is based on historical exercise experience. The dividend yield assumption is based on Cornerstone’s history and expectation of dividend payouts.

Board of Directors plan:

Cornerstone has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of common stock. Only non-qualified stock options may be granted under the Plan. In addition, members of the Board of Directors can be issued options under the Cornerstone 2002 Long-Term Incentive Plan to purchase up to 1,200,000 shares of Cornerstone stock. The options available for issuance to Board members under the 2002 Long-Term Incentive Plan are shared with officers and employees of Cornerstone. The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the option’s maximum term is ten years, at which point they expire. Vesting for options granted during 2012 are 50% on each of the first and second anniversary of the grant date with full vesting occurring at the second anniversary date. At December 31, 2012, the total remaining compensation cost to be recognized on non-vested options is approximately $70,000. An analysis of this stock option plan is presented in the following table:

	Years Ended December 31,
	2012						2011				2010
			Aggregate		Average				Average				Average
			Exercise		Intrinsic				Exercise				Exercise
	Shares		Price		Value(1)		Shares		Price		Shares		Price
Outstanding at beginning of year		55,250	$	5.98				100,250	$	9.42		100,250	$	9.42
Granted		90,000	$	1.65				-		-		-		-
Exercised		-		-				-		-		-		-
Forfeited		-		-				45,000	$	13.65		-		-
Outstanding at end of year		145,250	$	3.30	$	57,600		55,250	$	5.98		100,250	$	9.42
Options exercisable at year-end		55,250	$	5.98	$	-		55,250	$	5.98		91,025	$	10.01
Weighted-average fair value of options granted during the year	$	0.78					$	-			$	-

(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, 2012. This amount changes based on changes in the market value of Cornerstone's stock.

Information pertaining to options outstanding at December 31, 2012, is as follows:

				Options Outstanding			Options Exercisable
				Weighted	Weighted				Weighted
				Average	Average				Average
Exercise		Number		Remaining	Exercise		Number		Exercise
Prices		Outstanding		Life	Price		Exercisable		Price

$	5.44		16,000	1.2 Years	$	5.44		16,000	$	5.44
	9.23		8,000	2.2 Years		9.23		8,000		9.23
	7.99		12,800	5.2 Years		7.99		12,800		7.99
	3.60		18,450	6.2 Years		3.60		18,450		3.60
	1.65		90,000	9.2 Years		1.65		-		-

	Outstanding at end of year		145,250	7.2 Years	$	3.30		55,250	$	5.98

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 15.

Stock Option Plans (continued)

Board of Directors plan: (continued)

Information pertaining to non-vested options for the year ended December 31, 2012, is as follows:

			Weighted Average
	Number		Grant Date
	of Shares		Fair Value

Non-vested options, December 31, 2011		-	$	-
Granted		90,000		1.65
Vested		-		-
Forfeited		-		-

Non-vested options, December 31, 2012		90,000	$	1.65

The total fair value of shares that vested during 2011 and 2010 was approximately $11,900 and $34,000, respectively.

Officer and Employee plans:

Cornerstone has two stock option plans, the 1996 Cornerstone Statutory and Non-statutory Option Plan and the Cornerstone 2002 Long-Term Incentive Plan, under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 220,000 and 1,200,000 shares, respectively, of Cornerstone’s common stock. The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant. The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary of the grant date. These options expire ten years from the grant date. At December 31, 2012, the total remaining compensation cost to be recognized on non-vested options is approximately $380,000. An analysis of the activity for each of the years ended December 31, 2012, 2011 and 2010, for this stock option plan follows:

	Years Ended December 31,
	2012							2011					2010
				Average		Aggregate					Average					Average
				Exercise		Intrinsic					Exercise					Exercise
	Shares			Price		Value(1)		Shares			Price		Shares			Price

Outstanding at beginning of year		572,600		$	4.63				520,900		$	5.79		799,675		$	6.18

Granted		202,000		$	1.65				221,000		$	1.67		-			-

Exercised		-			-				-			-		-			-

Forfeited		(104,300	)	$	3.89				(169,300	)	$	4.31		(278,775	)	$	6.90

Outstanding at end of year		670,300		$	3.86	$	232,900		572,600		$	4.63		520,900		$	5.79

Options exercisable at year-end		274,680		$	6.82	$	-		295,415		$	6.67		385,270		$	5.88

Weighted-average fair value of options granted during the year	$	0.78						$	0.95				$	-

(1)

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 15.

Stock Option Plans (continued)

Officer and Employee plans: (continued)

Information pertaining to options outstanding at December 31, 2012, is as follows:

		Options Outstanding					Options Exercisable
				Weighted	Weighted				Weighted
				Average	Average				Average
Exercise		Number		Remaining	Exercise		Number		Exercise
Prices		Outstanding		Life	Price		Exercisable		Price

$	3.63		49,000	0.2 Years	$	3.63		49,000	$	3.63
	5.44		65,640	1.2 Years		5.44		65,640		5.44
	9.23		39,910	2.2 Years		9.23		39,910		9.23
	13.25		17,000	3.2 Years		13.25		17,000		13.25
	15.25		11,950	4.2 Years		15.25		11,950		15.25
	15.20		2,750	4.3 Years		15.20		2,750		15.20
	7.99		45,500	5.2 Years		7.99		45,500		7.99
	3.60		71,550	6.2 Years		3.60		42,930		3.60
	1.70		174,000	8.2 Years		1.70		-		-
	1.55		3,000	8.3 Years		1.55		-		-
	1.10		5,000	8.6 Years		1.10		-		-
	1.02		5,000	8.8 Years		1.02		-		-
	1.65		180,000	9.2 Years		1.65		-		-

	Outstanding at end of year		670,300	6.2 Years	$	3.86		274,680	$	6.82

Information pertaining to non-vested options for the year ended December 31, 2012, is as follows:

				Weighted Average
	Number			Grant Date
	of Shares			Fair Value

Non-vested options, December 31, 2011		277,185		$	2.47
Granted		202,000			1.65
Vested		(39,665	)		5.61
Forfeited		(43,900	)		1.79

Non-vested options, December 31, 2012		395,620		$	1.80

The total fair value of shares that vested during 2012, 2011 and 2010 was approximately $73,000, $56,000 and $125,000, respectively.

Note 16.

Liquidity and Capital Resources

Cornerstone’s primary source of funds with which to pay its future obligations is the receipt of dividends from its subsidiary Bank. Banking regulations provide that the Bank must maintain capital sufficient to enable it to operate as a viable institution and, as a result, has limited the amount of dividends the Bank may pay without prior approval.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 17.

Minimum Regulatory Capital Requirements

Cornerstone (on a consolidated basis) and the Bank are subject to various regulatory capital requirements administered by the Tennessee Department of Financial Institutions and the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on Cornerstone’s and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, Cornerstone and the Bank must meet specific capital guidelines that involve quantitative measures of Cornerstone’s and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. Cornerstone’s and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Prompt corrective action provisions are not applicable to bank holding companies.

Quantitative measures established by regulation to ensure capital adequacy require Cornerstone and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2012 and 2011, that Cornerstone and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2012, the most recent notification from the Federal Deposit Insurance Corporation (FDIC) categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total-risk based, Tier I risk-based, and Tier I leverage ratios as set forth in the following tables. There are no conditions or events since that notification that management believes have changed the Bank's prompt corrective action category. Cornerstone’s and the Bank's capital amounts and ratios are also presented in the table. Dollar amounts are presented in thousands.

											To be Well
											Capitalized Under
						For Capital					Prompt Corrective
	Actual					Adequacy Purposes					Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio

As of December 31, 2012:
Total capital to risk-weighted assets:
Consolidated	$	35,795		11.8	%	$	24,179		8.0	%		N/A		N/A
Cornerstone Community Bank		38,930		12.9	%		24,123		8.0	%	$	30,154		10.0	%

Tier I capital to risk-weighted assets:
Consolidated		31,988		10.6	%		12,090		4.0	%		N/A		N/A
Cornerstone Community Bank		35,132		11.7	%		12,061		4.0	%		18,092		6.0	%

Tier I capital to average assets:
Consolidated		31,988		7.6	%		16,807		4.0	%		N/A		N/A
Cornerstone Community Bank		35,132		8.4	%		16,787		4.0	%		20,984		5.0	%

As of December 31, 2011:
Total capital to risk-weighted assets:
Consolidated	$	35,246		12.2	%	$	23,043		8.0	%		N/A		N/A
Cornerstone Community Bank		37,158		13.0	%		22,876		8.0	%	$	28,594		10.0	%

Tier I capital to risk-weighted assets:
Consolidated		31,599		11.0	%		11,521		4.0	%		N/A		N/A
Cornerstone Community Bank		33,536		11.7	%		11,438		4.0	%		17,157		6.0	%

Tier I capital to average assets:
Consolidated		31,599		7.6	%		16,713		4.0	%		N/A		N/A
Cornerstone Community Bank		33,536		8.0	%		16,686		4.0	%		20,857		5.0	%

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 18.

Earnings (Loss) Per Common Share

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

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

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

	2012		2011		2010

Net income (loss)	$	1,402,063	$	1,030,052	$	(4,707,521	)
Less: Preferred stock dividend requirements		1,229,780		651,119		34,463
Less: Preferred stock accretion		63,924		36,718		-

Net income (loss) applicable to common stock	$	108,359	$	342,215	$	(4,741,984	)

Average number of common shares outstanding		6,500,396		6,500,396		6,500,396

Effect of dilutive stock options		50,136		-		-

Average number of common shares outstanding used to calculate diluted earnings (loss) per common share		6,550,532		6,500,396		6,500,396

The effects of outstanding antidilutive stock options are excluded from the computation of diluted earnings (loss) per common share. There were 358,550, 672,850, and 621,150 antidilutive stock options for 2012, 2011 and 2010, respectively.

Note 19.

Recent Accounting Pronouncements

Cornerstone has determined that all recently issued accounting pronouncements will not have a material impact on its consolidated financial statements or do not apply to its operations.

Note 20.

Equity Investment

During 2006, Cornerstone invested $3,000,000 for a 25% share of the Appalachian Fund for Growth II Partnership (AFG), which is managed by the Southeast Local Development Corporation (General Partner). AFG is targeting high job creation and retention businesses and businesses providing important community services. The funds are being deployed to help: 1) attract new businesses to under-served service areas by offering creative financing; 2) supply creative financing for businesses to rehabilitate existing distressed properties to facilitate community development; and 3) leverage other private investment into its targeted communities. In return for its investment in AFG, Cornerstone and other investors will receive new market tax credits. For 2012, 2011, and 2010 Cornerstone received approximately $180,000, $277,500, and $112,500, respectively, in new market tax credits.

AFG meets the criteria of a VIE outlined in ASC Topic 810, “Consolidation”. AFG has not been consolidated by Cornerstone, as Cornerstone is not the primary beneficiary.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 21.

Condensed Parent Information

BALANCE SHEETS
	December 31,		December 31,
	2012		2011

ASSETS
Cash	$	5,341,137	$	919,561
Investment in subsidiary		37,417,245		35,309,068
Other assets		416,104		2,067,839

Total assets	$	43,174,486	$	38,296,468

LIABILITIES AND STOCKHOLDERS’ EQUITY
Other liabilities	$	110,650	$	43,163
Other borrowings		2,175,000		3,045,000

Total liabilities		2,285,650		3,088,163

Stockholders’ equity		40,888,836		35,208,305

Total liabilities and stockholders’ equity	$	43,174,486	$	38,296,468

STATEMENTS OF OPERATIONS

	Years Ended December 31,
	2012			2011			2010

INCOME
Dividends	$	-		$	-		$	-
Interest income		-			-			-

		-			-			-

EXPENSES
Interest expense		170,872			219,250			319,361
Goodwill impairment		-			-			2,541,476
Other operating expenses		436,283			359,409			384,813

Loss before equity in undistributed earnings (loss)		(607,155	)		(578,659	)		(3,245,650	)

Equity in undistributed earnings (loss) of subsidiary		1,775,918			1,386,711			(1,737,868	)

Income tax benefit		233,300			222,000			275,997

Net income (loss)		1,402,063			1,030,052			(4,707,521	)

Preferred stock dividend requirements		1,229,780			651,119			34,463
Accretion on preferred stock discount		63,924			36,718			-

Net income (loss) available to common shareholders	$	108,359		$	342,215		$	(4,741,984	)

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 21.

Condensed Parent Information (continued)

	2012			2011			2010

STATEMENTS OF CASH FLOWS

CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	1,402,063		$	1,030,052		$	(4,707,521	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Stock compensation expense		74,048			79,140			74,612
Equity in undistributed loss (income) of subsidiary		(1,775,918	)		(1,386,711	)		1,737,868
Goodwill impairment		-			-			2,541,476
Other		1,719,222			(1,726,685	)		(63,092	)

Net cash provided by (used in) operating activities		1,419,415			(2,004,204	)		(416,657	)

CASH FLOWS FROM INVESTING ACTIVITIES
Capital contribution to subsidiary		-			(4,500,000	)		-

Net cash used in investing activities		-			(4,500,000	)		-

CASH FLOWS FROM FINANCING ACTIVITIES
Net repayments under other borrowings		(870,000	)		(1,670,000	)		(635,000	)
Issuance of preferred stock		4,858,078			7,135,402			2,727,424
Payment of preferred dividends		(985,917	)		(303,412	)		(34,463	)

Net cash provided by financing activities		3,002,161			5,161,990			2,057,961

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		4,421,576			(1,342,214	)		1,641,304

CASH AND CASH EQUIVALENTS, beginning of year		919,561			2,261,775			620,471

CASH AND CASH EQUIVALENTS, end of year	$	5,341,137		$	919,561		$	2,261,775

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest	$	174,473		$	249,555		$	319,361
Income taxes		-			-			-

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2012, 2011, and 2010

Note 22. Quarterly Data (unaudited)

	Years Ended December 31,
	2012									2011
	Fourth			Third		Second		First		Fourth			Third		Second			First
	Quarter			Quarter		Quarter		Quarter		Quarter			Quarter		Quarter			Quarter

Interest income	$	5,174,178		$	4,735,311	$	4,817,353	$	4,626,037	$	5,001,095		$	5,114,358	$	5,159,803		$	5,218,480
Interest expense		1,081,424			1,172,398		1,217,231		1,313,774		1,405,101			1,510,208		1,690,837			1,755,722

Net interest income, before provision for loan losses		4,092,754			3,562,913		3,600,122		3,312,263		3,595,994			3,604,150		3,468,966			3,462,758

Provision for loan losses		330,000			100,000		-		-		300,000			115,000		15,000			15,000

Net interest income, after provision for loan losses		3,762,754			3,462,913		3,600,122		3,312,263		3,295,994			3,489,150		3,453,966			3,447,758

Noninterest income		241,420			258,652		252,022		267,386		273,665			323,412		316,053			269,757
Noninterest expenses		3,477,359			3,203,019		3,423,359		3,074,132		3,500,712			3,076,769		3,657,407			3,416,615

Income before income taxes		526,815			518,546		428,785		505,517		68,947			735,793		112,612			300,900
Income tax (benefit) expense		156,100			154,300		118,200		149,000		(43,875	)		212,125		(28,675	)		48,625

Net income		370,715			364,246		310,585		356,517		112,822			523,668		141,287			252,275

Preferred stock dividend requirement		375,000			308,893		280,031		265,856		252,493			187,538		118,013			93,075
Accretion on preferred stock dividends		17,845			16,370		15,241		14,468		14,299			13,419		9,000			-

Net (loss) income available to common shareholders	$	(22,130	)	$	38,983	$	15,313	$	76,193	$	(153,970	)	$	322,711	$	14,274		$	159,200

Earnings (loss) per common share:
Basic	$	-		$	0.01	$	-	$	0.01	$	(0.02	)	$	0.05	$	-		$	0.02
Diluted		-			0.01		-		0.01		(0.02	)		0.05		-			0.02

ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

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

ITEM 9A.

CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Cornerstone maintains disclosure controls and procedures, as defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by it in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms and that such information is accumulated and communicated to Cornerstone’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Cornerstone carried out an evaluation, under the supervision and with the participation of its management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of its disclosure controls and procedures as of the end of December 31, 2012. Based on the evaluation of these disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer have concluded that as of December 31, 2012, Cornerstone’s disclosure controls and procedures were effective.

Management’s Report on Internal Control over Financial Reporting

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

Changes in Internal Controls

There were no changes in Cornerstone’s internal control over financial reporting during Cornerstone’s fiscal quarter ended December 31, 2012 that have materially affected, or are reasonably likely to materially affect, Cornerstone’s internal control over financial reporting.

ITEM 9B.

OTHER INFORMATION

None

PART III

ITEM 10.

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Information relating to the directors and executive officers of Cornerstone is set forth under the caption “Proposals—Election of Directors” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to Cornerstone’s audit committee and audit committee financial experts is set forth under the caption “Corporate Governance and the Board of Directors—Audit Committee” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to compliance with the reporting requirements of Section 16(a) of the Exchange Act by Cornerstone’s executive officers and directors, persons who beneficially own more than ten percent of Cornerstone’s common stock and their affiliates who are required to comply with such reporting requirements is set forth under the caption “Other Matters—Section 16(a) Beneficial Ownership Reporting Compliance” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

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

ITEM 11.

EXECUTIVE COMPENSATION

Information relating to executive compensation is set forth under the captions “Executive Compensation” and “Director Compensation” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

ITEM 12.

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Information relating to beneficial ownership of Cornerstone’s common stock by certain persons is set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to Cornerstone’s equity compensation plans is set forth under the caption “The Company’s Long-Term Equity and Qualified Retirements Plans—Equity Compensation Plan Information as of December 31, 2012” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

ITEM 13.

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

Information relating to certain transactions between Cornerstone and its affiliates and certain other persons and to Cornerstone’s policies and procedures for approval of such transactions is set forth under the captions “Certain Relationships and Related Transactions” and “Corporate Governance and the Board of Directors—Policies and Procedures for Approval of Related Person Transactions” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

Information relating to director independence is set forth under the caption “Corporate Governance and the Board of Directors—Board Composition and Director Independence” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

ITEM 14.

PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information relating to principal accountant fees and services is set forth under the caption “Audit Committee—Audit and Non-Audit Fees” in Cornerstone’s 2013 Proxy Statement. Such information is incorporated into this report by reference.

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a)

The following documents are filed as part of this report:

	(1)	Financial Statements

		The following report and consolidated financial statements of Cornerstone and Subsidiary are included in Item 8:

		Report of Independent Registered Public Accounting Firm
		Consolidated Balance Sheets as of December 31, 2012 and 2011
		Consolidated Statements of Operations for the years ended December 31, 2012, 2011 and 2010
		Consolidated Statements of Comprehensive Income for the years ended December 31, 2012, 2011 and 2010
		Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2012, 2011 and 2010
		Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010
		Notes to Consolidated Financial Statements

	(2)	Financial Statement Schedules:

		Schedule II: Valuation and Qualifying Accounts

		All other schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are not required under the related instructions or are inapplicable and therefore have been omitted.

	(3)	The following documents are filed, furnished or incorporated by reference as exhibits to this report:

Exhibit No.		Description
3.1		Amended and Restated Charter of Cornerstone Bancshares, Inc. as amended.
3.2		Amended and Restated Bylaws of Cornerstone Bancshares, Inc. (1)
4		The right of securities holders are defined in the Charter and Bylaws provided in exhibits 3.1 and 3.2.
10.1*		Cornerstone Bancshares, Inc. Statutory - Nonstatutory Stock Option Plan. (2)
10.2*		Cornerstone Bancshares, Inc. 2002 Long-Term Incentive Plan. (3)
10.3*		Cornerstone Bancshares, Inc. 2004 Non-Employee Director Compensation Plan. (4)
10.4*		Cornerstone Community Bank Employee Stock Ownership Plan. (5)
14		Code of Ethics. (6)
21		Subsidiaries of the registrant.
23		Consent of Hazlett, Lewis and Bieter, PLLC.
31.1		Certification of principal executive officer.
31.2		Certification of principal financial officer.
32		Section 906 certifications of chief executive officer and chief financial officer.

____________________

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

(1)

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

(2)

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

(3)

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

(4)

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

(5)

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

(6)

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

SIGNATURES

In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

		CORNERSTONE BANCSHARES, INC.

Date: March 28, 2013	By:	/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes
		President and Chief Executive Officer
		(principal executive officer)

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

In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 28, 2013.

Signature		Title

/s/ W. Miller Welborn		Chairman of the Board of Directors
W. Miller Welborn

/s/ Nathaniel F. Hughes		President & Chief Executive Officer
Nathaniel F. Hughes		(principal executive officer) and Director

/s/ B. Kenneth Driver		Director
B. Kenneth Driver

/s/ Karl Fillauer		Director
Karl Fillauer

/s/ David Fussell		Director
David Fussell

/s/ Lawrence D. Levine		Director
Lawrence D. Levine

/s/ Frank S. McDonald		Director
Frank S. McDonald

/s/ Doyce G. Payne		Director
Doyce G. Payne

/s/ Billy O. Wiggins		Director
Billy O. Wiggins

/s/ Marsha Yessick		Director
Marsha Yessick

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

INDEX OF EXHIBITS

Exhibit No.		Description

3.1		Amended and Restated Charter of Cornerstone Bancshares, Inc., as amended.
3.2		Amended and Restated Bylaws of Cornerstone Bancshares, Inc. (1)
4		The right of securities holders are defined in the Charter and Bylaws provided in exhibits 3.1 and 3.2.
10.1*		Cornerstone Bancshares, Inc. Statutory - Nonstatutory Stock Option Plan. (2)
10.2*		Cornerstone Bancshares, Inc. 2002 Long-Term Incentive Plan. (3)
10.3*		Cornerstone Bancshares, Inc. 2004 Non-Employee Director Compensation Plan. (4)
10.4*		Cornerstone Community Bank Employee Stock Ownership Plan. (5)
14		Code of Ethics. (6)
21		Subsidiaries of the registrant.
23		Consent of Hazlett, Lewis & Bieter, PLLC.
31.1		Certification of principal executive officer.
31.2		Certification of principal financial officer.
32		Section 906 certifications of chief executive officer and chief financial officer.

_______________________

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

(1)

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

(2)

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

(3)

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

(4)

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

(5)

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

(6)

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

Investment

Consumer real estate-mortgage