SmartFinancial (SmartBank) - 10-Q quarterly report FY

United States Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2007

o	TRANSITION REPORT PURSUANT SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________to

Commission File Number:000-30497

(Exact name of small business issuer as specified in its charter)


Tennessee		62-1173944
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

835 Georgia Avenue Chattanooga, Tennessee		37402
(Address of principal executive offices)		(Zip Code)

423-385-3000
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address and formal fiscal year, if
changes since last report)

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

Yesx No o

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

Large Accelerated Filer o

Accelerated Filer o

Non-accelerated Filer x

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

YesoNox

As of June 30, 2007 there were 6,520,718 shares of common stock, $1.00 par value per share, issued and outstanding.

CORNERSTONE BANCSHARES, INC.

REPORT ON FORM 10-Q

June 30, 2007

TABLE OF CONTENTS

PART I:
Item 1. Consolidated Financial Statements and Notes (Unaudited)	2
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3. Quantitative and Qualitative Disclosures about Market Risk	18
Item 4. Evaluation of Controls and Procedures	18

Part II:
Item 1. Legal Proceedings	19
Item 1A. Risk Factors	19
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	21
Item 3. Defaults Upon Senior Securities	21
Item 4. Submission of Matters to a Vote of Security Holders	21
Item 5. Other Information	22
Item 6. Exhibits and Reports on Form 8-K	22

Signatures
Ex-31.1 Section 302 Certification
Ex-31.2 Section 302 Certification
Ex. 32.1 Section 906 Certification
Ex. 32.2 Section 906 Certification

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report which may 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 are described below and in Cornerstone’s Form 10-K, as updated by Item 1A of part II of this Form 10-Q and include, without limitation, (i) unanticipated deterioration in the financial condition of borrowers resulting in significant increases in loan losses and provisions for those losses, (ii) increased competition with other financial institutions, (iii) lack of sustained growth in the economy in the Chattanooga, Tennessee area, (iv) rapid fluctuations or unanticipated changes in interest rates, (v) the inability of our bank subsidiary, Cornerstone Community Bank to satisfy regulatory requirements for its expansion plans, (vi) the inability of Cornerstone to achieve its targeted expansion goals in the Knoxville, Tennessee and Dalton, Georgia markets, (vii) the inability of Cornerstone to grow its loan portfolio at historic or planned rates and (viii) changes in the legislative and regulatory environment, including compliance with the various provisions of the Sarbanes-Oxley Act of 2002. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.

Cornerstone Bancshares, Inc. and Subsidiaries

Consolidated Balance Sheets

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements


	Unaudited
	June 30,			December 31,
ASSETS	2007			2006

Cash and due from banks	$18,837,556			$17,635,956
Federal funds sold		-			-
Cash and cash equivalents		18,837,556			17,635,956

Securities available for sale		33,026,566			32,353,380
Securities held to maturity		220,114			236,169
Federal Home Loan Bank stock, at cost		1,911,600			1,332,100
Loans, net of allowance for loan losses of
$4,241,303 at June 30, 2007 and $4,258,352 at
December 31, 2006		352,841,538			305,879,013
Bank premises and equipment, net		6,446,433			6,134,009
Accrued interest receivable		2,264,379			2,120,778
Goodwill and amortizable intangibles		3,002,556			3,046,287
Other assets		6,207,042			6,204,541
Total Assets	$	424,757,784		$	374,942,233

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	45,589,496		$	41,722,570
Interest-bearing demand deposits		40,584,518			38,159,718
Savings deposits and money market accounts		45,980,315			56,913,225
Time deposits of $100,000 or more		65,710,833			44,544,335
Time deposits of less than $100,000		99,747,510			94,476,685
Total deposits		297,612,672			275,816,533
Federal funds purchased and securites sold under
agreements to repurchase		31,262,753			19,249,701
Federal Home Loan Bank advances and line of credit		53,000,000			39,500,000
Accrued interest payable		268,489			308,392
Other liabilities		1,826,422			1,884,342
Total Liabilities		383,970,336			336,758,968

Stockholders' Equity
Preferred stock - no par value; 2,000,000 shares
authorized; no shares issued		-			-
Common stock - $l.00 par value; 10,000,000 shares authorized;
6,522,718 and 6,511,848 issued in 2007 and 2006;
6,520,718 and 6,511,848 outstanding in 2007 and 2006		6,520,718			6,511,848
Additional paid-in capital		21,992,619			21,849,006
Retained earnings		12,445,155			9,881,029
Accumulated other comprehensive income		(171,044	)		(58,618	)
Total Stockholders' Equity		40,787,448			38,183,265
Total Liabilities and Stockholders' Equity	$	424,757,784		$	374,942,233

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

Cornerstone Bancshares, Inc. and Subsidiaries
Consolidated Statements of Income

	Unaudited				Unaudited
	Three months ended				Six months ended
	June 30				June 30
	2007		2006		2007		2006
INTEREST INCOME
Loans, including fees	$	8,292,225	$	6,779,975	$	15,952,120	$	12,907,168
Investment securities		420,665		388,778		835,427		751,741
Federal funds sold		4,460		10,885		5,091		26,780
Other earning assets		25,737		4,457		57,737		9,518
Total interest income		8,743,087		7,184,095		16,850,375		13,695,207

INTEREST EXPENSE
Interest bearing demand accounts		134,961		106,021		262,811		197,242
Money market accounts		460,901		552,044		936,146		941,509
Savings accounts		19,112		19,429		37,869		38,957
Time deposits of less than $100,000		1,277,793		875,902		2,495,863		1,719,255
Time deposits of more than $100,000		748,957		457,390		1,353,267		889,812
Federal funds purchased		211,278		113,173		403,754		209,063
Securities sold under agreements to repurchase		43,846		32,864		89,804		49,602
Other borrowings		572,459		280,821		1,022,858		548,072
Total interest expense		3,469,307		2,437,644		6,602,372		4,593,512

Net interest income before provision for loan losses		5,273,780		4,746,451		10,248,003		9,101,695
Provision for loan losses		235,000		475,000		237,000		853,000
Net interest income after the provision for loan losses		5,038,780		4,271,451		10,011,003		8,248,695

NONINTEREST INCOME
Service charges		233,472		215,275		453,087		406,653
Other income		205,932		453,178		377,881		694,814
Total noninterest income		439,404		668,453		830,968		1,101,467

NONINTEREST EXPENSE
Salaries and employee benefits		1,824,901		1,597,437		3,554,991		2,965,496
Occupancy and equipment expense		365,803		244,211		686,711		491,933
Other operating expense		821,004		699,746		1,533,595		1,326,187
Total noninterest expense		3,011,708		2,541,394		5,775,297		4,783,616

Income before provision for income taxes		2,466,476		2,398,510		5,066,674		4,566,546
Provision for income taxes		902,289		935,298		1,850,711		1,748,258

NET INCOME	$	1,564,187	$	1,463,212	$	3,215,963	$	2,818,288

EARNINGS PER COMMON SHARE
Basic net income per common share	$	0.24	$	0.23	$	0.49	$	0.44
Diluted net income per common share	$	0.23	$	0.21	$	0.47	$	0.41

DIVIDENDS DECLARED PER COMMON SHARE	$	0.05	$	0.03	$	0.10	$	0.06

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

Cornerstone Bancshares, Inc. and Subsidiaries
Consolidated Statements of Cash Flows

	Unaudited
	Six months ended June 30,
	2007			2006

CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	3,215,963		$	2,818,288
Adjustments to reconcile net income
to net cash provided by operating actvities:
Provision for loan losses		237,000			853,000
Depreciation and amortization		166,882			294,514
Loss / (Gain) on sale of loans held for sale and other assets		76,874			(77,015	)
Changes in other operating assets and liabilities:
Accrued interest receivable		(143,601	)		(59,008	)
Accrued interest payable		(39,903	)		20,450
Other assets and liabilities		(92,703	)		(1,842,615	)
Net cash provided by operating activities		3,420,512			2,007,614


CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of equity investment		-			(3,000,000	)
Purchase of investment securities: AFS		(4,636,650	)		(3,990,346	)
Proceeds from security transactions: AFS		3,899,961			1,256,780
Proceeds from security transactions: HTM		16,103			56,884
Purchase of FHLB Stock		(579,500	)		(262,500	)
Loan originations and principal collections, net		(48,102,690	)		(22,384,435	)
Proceeds from sale of bank equipment		-			1,962,935
Proceeds from sale of other real estate		1,021,191			806,906
Purchase of bank premises and equipment		(537,105	)		(286,712	)
Net cash used in investing activities		(48,918,690	)		(25,840,488	)


CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits		21,796,139			62,732
Net increase in securities sold under agreements to repurchase		12,013,052			9,900,504
Net proceeds from Federal Home Loan Bank advances and other borrowings		13,500,000			11,000,000
Dividends paid on common stock		(651,888	)		(193,397	)
Purchase of common stock		(30,450	)		(50,250	)
Issuance of common stock		72,925			257,843
Net cash provided by financing activities		46,699,778			20,977,432

NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS		1,201,600			(2,855,442	)

CASH AND CASH EQUIVALENTS, beginning of period		17,635,956			14,590,499
CASH AND CASH EQUIVALENETS, end of period	$	18,837,556		$	11,735,057


SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Cash paid during the period for interest	$	6,642,275		$	4,573,062
Cash paid during the period for taxes		1,575,600			1,267,343

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

Cornerstone Bancshares, Inc. and Subsidiaries

Consolidated Statement of Changes in Stockholders' Equity - Unaudited

For the six months ended June 30, 2007

							Additional						Other			Total
	Comprehensive			Common			Paid-in			Retained			Comprehensive			Stockholders'
	Income			Stock			Capital			Earnings			Income			Equity

BALANCE, December 31, 2006				$	6,511,848		$	21,849,006		$	9,881,029		$	(58,618	)	$	38,183,265

Issuance of common stock					10,870			62,055			-			-			72,925
under employee compensation
option plan

Employee compensation stock								110,008			-			-			110,008
option expense

Dividend - $0.10 per share					-			-			(651,837	)		-			(651,837	)

Purchase of common stock					(2,000	)		(28,450	)		-			-			(30,450	)

Comprehensive income:

Net income	$	3,215,963			-			-			3,215,963			-			3,215,963

Other comprehensive income, net of tax:
Unrealized holding gains (losses) on
securities available for sale, net of
reclassification adjustment		(112,426	)		-			-			-			(112,426	)		(112,426	)

Total comprehensive income	$	3,103,537

BALANCE, June 30, 2007				$	6,520,718		$	21,992,619		$	12,445,155		$	(171,044	)	$	40,787,448

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1. Presentation of Financial Information

Nature of Business-Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company whose primary business is conducted by its wholly-owned subsidiaries, Cornerstone Community Bank (“Bank”) and Eagle Financial, Inc (“Eagle”). The Bank provides a full range of banking services to the Chattanooga, Tennessee market. The Bank has also established a loan production office (“LPO”) in Dalton, Georgia and an LPO in Knoxville, Tennessee to further enhance the Bank’s lending markets. The Bank specializes in asset based lending, commercial lending and payment processing. Eagle is a commercial factoring company that provides financing to businesses that are relatively new or experiencing significant growth.

Interim Financial Information (Unaudited)-The financial information in this report for June 30, 2007 and June 30, 2006 has not been audited. The information included herein should be read in conjunction with the annual consolidated financial statements and footnotes thereto included in the 2006 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in March of 2007. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices. In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

Use of Estimates-The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the 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 include the determination of the allowance for loan losses.

Consolidation-The accompanying consolidated financial statements include the accounts of Cornerstone and its subsidiaries Bank and Eagle. Substantially all intercompany transactions, profits and balances have been eliminated.

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its 10-K for the year ended December 31, 2006 as filed with the Securities and Exchange Commission. Since December 31, 2006 there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following is a summary of the basic and diluted earnings per share for the three month periods ended June 30, 2007 and 2006.

	Three Months Ended June 30,
Basic earnings per share calculation:	2007		2006
Numerator: Net income available to common shareholders	$	1,564,187	$	1,463,212

Denominator: Weighted avg. common shares outstanding		6,519,213		6,491,094
Effect of dilutive stock options		371,871		344,766
Diluted Shares		6,891,084		6,835,860

Basic Earnings per share	$	0.24	$	0.23
Diluted Earnings per share	$	0.23	$	0.21

The following is a summary of the basic and diluted earnings per share for the six month periods ended June 30, 2007 and 2006.

	Six Months Ended June 30,
Basic earnings per share calculation:	2007		2006
Numerator: Net income available to common shareholders	$	3,215,963	$	2,818,288

Denominator: Weighted avg. common shares outstanding		6,516,806		6,460,984
Effect of dilutive stock options		379,463		343,068
Diluted Shares		6,896,269		6,804,052

Basic Earnings per share	$	0.49	$	0.44
Diluted Earnings per share	$	0.47	$	0.41

Note 2. Stock Based Compensation

Accounting Policies-Cornerstone, as required by FASB, applies the fair value recognition provisions of SFAS No. 123(R) Share-Based Payment. As a result, for the period ended June 30, 2007, the compensation cost charged to earnings related to the vested incentive stock options was approximately $110,000, which reduced basic earnings per share by $0.02 per share.

Officer and Employee Plans-The Company has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 1,420,000 shares of the Company’s common stock. The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant. The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant. The stock options vest at 30 percent on the second and third anniversaries of the grant date and 40 percent on the fourth anniversary. The options expire ten years from the grant date. At June 30, 2007, the total remaining compensation cost to be recognized on non-vested options is approximately $712,000. A summary of the status of this stock option plan is presented in the following table:

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

	Number			Weighted- Average Exercisable Price		Weighted- Average Contractual Remaining Term (in years)		Aggregate Intrinsic Value (000’s)
Outstanding at December 31, 2006		669,120		$	5.79		6.1 Years	$	7,169,515
Granted		53,800		$	15.24
Exercised		(5,870	)	$	3.77
Forfeited		(1,650	)	$	14.03
Outstanding at June 30, 2007		715,400		$	6.45		5.7 Years	$	6,602,792
Options exercisable at June 30, 2007		470,990		$	4.06

The weighted average grant-date fair value of share options granted during the six months ended June 30, 2007 was $3.33. This was determined using the Black-Scholes option pricing model with the following weighted -average assumptions. Dividend Yield: 1.330%, Expected Life: 7.0 years, Expected Volatility: 12.22%, Risk-free Interest Rate: 4.510%

Board of Directors Plan-The Company has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of the Bank's common stock. On October 15, 1997, the Bank stock options were converted to Company stock options. Only non-qualified stock options may be granted under the Plan. The exercise price of each option equals the market price of the Corporation’s stock on the date of grant and the option’s maximum term is ten years. Vesting for options granted during 2007, are 50% on the first and second anniversary of the grant date. At June 30, 2007, the total remaining compensation cost to be recognized on non-vested options is approximately $127,000. A summary of the status of this stock option plan is presented in the following table:

	Number			Weighted- Average Exercisable Price		Weighted- Average Contractual Remaining Term (in years)		Aggregate Intrinsic Value (000’s)
Outstanding at December 31, 2006		67,000		$	10.61		8.5 Years	$	394,555
Granted		9,000		$	15.24
Exercised		(5,000	)	$	9.32
Forfeited		(2,000	)	$	13.25
Outstanding at June 30, 2007		69,000		$	11.23		8.1 Years	$	297,124
Options exercisable at June 30, 2007		42,000		$	9.45

Note 3. Stockholder’s Equity

During 2007, Cornerstone’s Board of Director declared the following dividends:

Dividend Rate	Declaration Date	Record Date	Payment Date
(per share)
$0.05	February 28, 2007	March 16, 2007	April 9, 2007
$0.05	May 29, 2007	June 18, 2007	July 6, 2007

Any determinations relating to future dividends will be made at the discretion of our Board of Directors and will depend on a number of factors, including our earnings, capital requirements, financial conditions, future prospects, regulatory restrictions and other factors that our Board of Directors may deem relevant.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 4. Securities

The amortized cost and fair value of securities available-for-sale and held-to-maturity at June 30, 2007 and December 31, 2006 are summarized as follows:

	June 30, 2007
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government agencies	$	28,620,258	$	-	$	(287,632	)	$	28,332,626

State and municipal securities		2,552,153		23,537		(28,685	)		2,547,005

Mortgage-backed securities		2,113,295		33,640		-			2,146,935
	$	33,285,707	$	57,177	$	(316,317	)	$	33,026,566

Securities Held-to-Maturity:
Mortgage-backed securities	$	220,114	$	339	$	(469	)	$	219,984

	December 31, 2006
			Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value
Securities Available-for-Sale:
U.S. Government agencies	$	26,631,431	$	81,949	$	(243,160	)	$	26,470,220

State and municipal securities		3,209,905		51,952		(12,479	)		3,249,378

Mortgage-backed securities		2,600,860		32,922		-			2,633,782
	$	32,442,196	$	166,823	$	(255,639	)	$	32,353,380
Securities Held-to-Maturity:
Mortgage-backed securities	$	236,169	$	475	$	(455	)	$	236,189

At June 30, 2007 approximately $27,530,000 of Cornerstone’s investment portfolio was pledged to secure public funds and other deposits and securities sold under agreements to repurchase.

Note 5. Loans and Allowance for Loan Losses

At June 30, 2007 and December 31, 2006 loans are summarized as follows (in thousands):

	June 30, 2007					December 31, 2006
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	107,088		30.0	%	$	98,542		31.8	%
Real estate-construction		66,347		18.6	%		57,606		18.6	%
Real estate-mortgage		53,856		15.1	%		48,700		15.7	%
Real estate-commercial		123,904		34.7	%		99,197		32.0	%
Consumer loans		5,887		1.6	%		6,092		2.0	%
Total loans	$	357,082		100.0	%	$	310,137		100.0	%

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

A summary of transactions in the allowance for loan losses for the periods ended June 30, 2007 and December 31, 2006 is as follows:

	2007			2006
Balance, beginning of period	$	4,258		$	3,545
Loans charged-off		(330	)		(470	)
Recoveries of loans previously charged-off		76			77
Provision for loan losses		237			1,106
Balance, end of period	$	4,241		$	4,258

Note 6. Commitments and Contingent Liabilities

In the normal course of business, the Bank has entered into off-balance sheet financial instruments which include commitments to extend credit (i.e., including unfunded lines of credit) and standby letters of credit. Commitments to extend credit are usually the result of lines of credit granted to existing borrowers under agreements that the total outstanding indebtedness will not exceed a specific amount during the term of the indebtedness. Typical borrowers are commercial concerns that use lines of credit to supplement their treasury management functions, thus their total outstanding indebtedness may fluctuate during any time period based on the seasonality of their business and the resultant timing of their cash flows. Other typical lines of credit are related to home equity loans granted to consumers. Commitments to extend credit generally have fixed expiration dates or other termination clauses and may require payment of a fee.

Standby letters of credit are generally issued on behalf of an applicant (our customer) to a specifically named beneficiary and are the result of a particular business arrangement that exists between the applicant and the beneficiary. Standby letters of credit have fixed expiration dates and are usually for terms of two years or less unless terminated beforehand due to criteria specified in the standby letter of credit. A typical arrangement involves the applicant routinely being indebted to the beneficiary for such items as inventory purchases, insurance, utilities, lease guarantees or other third party commercial transactions. The standby letter of credit would permit the beneficiary to obtain payment from the Bank under certain prescribed circumstances. Subsequently, the Bank would then seek reimbursement from the applicant pursuant to the terms of the standby letter of credit.

The Bank follows the same credit policies and underwriting practices when making these commitments as it does for on-balance sheet instruments. Each customer’s creditworthiness is evaluated on a case-by-case basis, and the amount of collateral obtained, if any, is based on management’s credit evaluation of the customer. Collateral held varies but may include cash, real estate and improvements, marketable securities, accounts receivable, inventory, equipment, and personal property.

The contractual amounts of these commitments are not reflected in the consolidated financial statements and would only be reflected if drawn upon. Since many of the commitments are expected to expire without being drawn upon, the contractual amounts do not necessarily represent future cash requirements. However, should the commitments be drawn upon and should our customers default on their resulting obligation to us, the Bank’s maximum exposure to credit loss, without consideration of collateral, is represented by the contractual amount of those instruments.

A summary of the Bank’s total contractual amount for all off-balance sheet commitments at June 30, 2007 is as follows:

Commitments to extend credit		$	69.1 million
Standby letters of credit		$	2.6 million

Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at June 30, 2007 will not have a material effect on Cornerstone’s consolidated financial statements.

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE
INTEREST INCOME/EXPENSE AND
YIELD/RATES

Taxable Equivalent Basis	Three months ended
(in thousands)	June 30

Assets	2007								2006
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income		346,802		$	8,292		9.59	%		281,321		$	6,780		9.67	%
Investment securities		36,691			421		4.78	%		36,379			389		4.40	%
Other earning assets		1,993			30		6.04	%		666			15		9.04	%
Total earning assets		385,486		$	8,743		9.11	%		318,366		$	7,184		9.06	%
Allowance for loan losses		(4,066	)							(4,051	)
Cash and other assets		24,557								24,084
TOTAL ASSETS	$	405,977							$	338,399

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	38,863		$	135		1.39	%	$	36,149		$	106		1.18	%
Savings deposits		7,619			19		1.01	%		7,755			19		0.98	%
MMDA's		42,825			461		4.32	%		53,011			552		4.18	%
Time deposits of $100,000 or less		102,634			1,278		4.99	%		82,894			876		4.24	%
Time deposits of $100,000 or more		60,871			749		4.94	%		41,613			457		4.40	%
Federal funds purchased and securities
sold under agreements to repurchase		21,467			256		4.78	%		13,653			146		4.29	%
Other borrowings		49,588			572		4.63	%		30,143			282		3.75	%
Total interest bearing liabilities		323,867			3,470		4.30	%		265,219			2,438		3.69	%
Net interest spread				$	5,274		4.82	%				$	4,746		5.38	%
Noninterest bearing demand deposits		38,965								36,032
Accrued expenses and other liabilities		2,472								2,279
Shareholder's equity		40,674								34,870
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	405,977							$	338,399
Net yield on earning assets							5.50	%							5.99	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					16								10
Total adjustment					16								10

CORNERSTONE BANCSHARES, INC.

CONSOLIDATED AVERAGE BALANCE

INTEREST INCOME/EXPENSE AND

YIELD/RATES

Taxable Equivalent Basis	Year-to-Date
(in thousands)	June 30

Assets	2007								2006
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	333,622		$	15,952		9.64	%	$	276,512		$	12,907		9.41	%
Investment securities		36,900			835		4.69	%		35,354			752		4.41	%
Other earning assets		2,072			63		6.13	%		1,089			36		6.67	%
Total earning assets		372,594		$	16,850		9.13	%		312,955		$	13,695		8.84	%
Allowance for loan losses		(4,131	)							(3,838	)
Cash and other assets		23,675								24,394
TOTAL ASSETS	$	392,138							$	333,511

Liabilities and Shareholder's Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	38,580		$	262		1.37	%	$	35,356		$	197		1.12	%
Savings deposits		7,660			38		1.01	%		7,824			39		1.01	%
MMDA's		43,644			936		4.33	%		48,764			942		3.90	%
Time deposits of $100,000 or less		101,258			2,496		4.97	%		84,507			1,719		4.10	%
Time deposits of $100,000 or more		54,350			1,353		5.02	%		42,216			890		4.25	%
Federal funds purchased and securities
sold under agreements to repurchase		20,852			494		4.78	%		11,796			259		4.43	%
Other borrowings		44,746			1,022		4.61	%		30,398			548		3.64	%
Total interest bearing liabilities		311,090			6,602		4.28	%		260,861			4,594		3.55	%
Net interest spread				$	10,248		4.85	%				$	9,101		5.29	%
Noninterest bearing demand deposits		38,641								36,336
Accrued expenses and other liabilities		2,440								2,131
Shareholder's equity		39,967								34,183
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	392,138							$	333,511
Net yield on earning assets							5.56	%							5.89	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					23								21
Total adjustment					23								21

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of Cornerstone Community Bank, (the “Bank”) a Tennessee banking corporation, and Eagle Financial, Inc., (“Eagle”), an accounts receivable financing company that operate in and around Hamilton County, Tennessee. 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. Eagle’s principal source of income is revenue received from the purchase of receivables. Expenses are related to employee compensation and benefits, office and overhead expenses.

The following is a discussion of our financial condition at June 30, 2007 and December 31, 2006 and our results of operations for the three and six months ended June 30, 2007 and 2006. The purpose of this discussion is to focus on information about our financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with our consolidated financial statements and the related notes included elsewhere herein.

Review of Financial Performance

As of June 30, 2007 Cornerstone had total consolidated assets of $424.8 million, total loans of $352.8 million, total deposits of $297.6 million and stockholders equity of $40.8 million. Net income for the three and six month period ended June 30, 2007 was $1,564,187 and $3,215,963, respectively.

Results of Operations

Net income for the three months ended June 30, 2007 was $1,564,187 or $0.24 basic earnings per share, compared to $1,463,212 or $0.23 basic earnings per share, for the same period in 2006. The increase in earnings during the three months ended June 30, 2007 represents a 6.9% increase compared to the three months ended June 30, 2006. Net income for the six months ended June 30, 2007 was $3,215,963 or $0.49 basic earnings per share, compared to $2,818,288 or $0.44 basic earnings per share, for the same period in 2006. The increase in earnings during the six months ended June 30, 2007 represents a 14.1% increase compared to the six months ended June 30, 2006. The Bank’s continued success in expanding its loan portfolio is the primary reason for the increase in income from 2006 to 2007.

The following table presents our results for the three and six months ended June 30, 2007 and 2006.

					2007-2006							2007-2006
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2007		2006		(Decrease)			2007		2006		(Decrease)
Interest Income	$	8,743	$	7,184		21.7	%	$	16,850	$	13,695		23.0	%
Interest Expense		3,469		2,438		42.3	%		6,602		4,594		43.7	%

Net interest income before
provision for loan loss		5,274		4,746		11.1	%		10,248		9,101		12.6	%
Provision for Loan Loss		235		475		(50.5	)%		237		853		(72.2	)%

Net interest income after
provision for loan loss		5,039		4,271		18.0	%		10,011		8,248		21.4	%

Total noninterest income		439		668		(34.3	)%		831		1,102		(24.6	)%
Total noninterest expense		3,012		2,541		18.5	%		5,775		4,784		20.7	%

Income before income taxes		2,466		2,398		2.8	%		5,067		4,566		11.0	%
Provision for income taxes		902		935		(3.5	)%		1,851		1,748		5.9	%

Net Income	$	1,564	$	1,463		6.9	%	$	3,216	$	2,818		14.1	%

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 our earnings. For the three months ended June 30, 2007, net interest income before the provision for loan loss, increased $528 thousand or 11.1% over the same period of 2006. For the six months ended June 30, 2007, net interest income before the provision for loan loss, increased $1,147 thousand or 12.6% over the same period of 2006. Cornerstone’s interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities) was 4.85% for the six month period ended June 30, 2007 compared to 5.29% for the same period in 2006. The net interest margin on a tax equivalent basis was 5.56% for the six month period ended June 30, 2007 compared to 5.89% for the same period in 2006. Management expects that downward pressure will continue to be exerted on the net interest margin for the remainder of 2007 as the cost of deposits continues to increase. Other matters related to the changes in net interest income, net interest yields and rates, and net interest margin are presented below:

The Bank’s loan yields increased from 9.41% for the first six months of 2006 to 9.64% for the first six months of 2007, whereas loan yields decreased from 9.67% for the three months ended June 30, 2006 compared to 9.59% for the three months ended June 30, 2007. While, the Bank’s lending staff continues to be successful in attracting new loans and selling participations to banks outside of the Bank’s market area, additional competition has intensified in the Bank’s local market resulting in a slight decrease in loan yields for the most current three month period.

As mentioned previously the Bank expects continued pressure on the net interest margin due to market conditions, such as increased competition in Cornerstone’s primary deposit market. Therefore, the Bank has elected to grow its funding base with a variety of solutions including local market CD specials, brokered deposits and borrowings from the Federal Home Loan Bank (the “FHLB”). As of June 30, 2007 borrowings from FHLB totaled $53 million with an interest cost of 4.58%. The Bank’s Asset Liability Committee continues to monitor and explore new avenues for depository accounts and funding solutions. An example of this is the Bank’s recent expansion of its electronic payroll processing operations.

For the six month period ended June 30, 2007, the Bank’s investment portfolio resulted in a yield of 4.69% compared to 4.41% for the same time period in 2006. The Bank continues its bias towards loans and is currently purchasing securities primarily for pledging requirements.

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 $235,000 and $475,000 for the three months ended June 30, 2007 and 2006, respectively. The provision for loan losses amounted to $237,000 and $853,000 for the six months ended June 30, 2007 and 2006, respectively. Other matters relating to the changes in provision for loan losses are presented below:

During the second quarter of 2007, the Bank identified a customer relationship in its asset based lending program totaling approximately $5.8 million in which management detected an alleged customer fraud. Management is currently in the process of evaluating its collateral position, the loans’ present value of expected future cash flows and the loans’ observable market price in accordance with SFAS 114 to properly recognize any impairment. As management is able to obtain additional, reliable information, additional reserves may be required. To date, the customer has continued to make its contractual interest payments. This customer relationship may affect loan asset quality ratios in the 3^rdquarter of 2007.

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

The following table presents the components of non interest income for the three and six months ended June 30, 2007 and 2006 (dollars in thousands).

					2007-2006							2007-2006
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2007		2006		(decrease)			2007		2006		(decrease)
Service charges on deposit accounts	$	233	$	215		8.5	%	$	453	$	406		11.4	%
Other fee income		206		453		(54.6	%)		378		695		(45.6	%)
Total non interest income	$	439	$	668		(34.3	%)	$	831	$	1,101		(24.6	%)

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

Service charges on deposits increased as a result of the growth in demand deposits and interest demand deposits.

The Bank created a new line of business during the first six months of 2007. A major service provider for the payroll processor industry recently terminated most of its processors in order to pursue its core bank lines of business. Cornerstone recognized this as an opportunity and has built the program and infrastructure to service this sector of ACH processing. The Bank plans to operate with ten processors in a beta phase and grow the line of business in 2008. This line of business has the ability to produce a material amount of non-interest income with a relatively low amount of credit and transaction risk.

One of the major components in other fee income was the Bank’s lease income. The Bank had entered into an operating lease agreement with one of its customers that resulted in monthly lease income to the Bank. The lease has been terminated with the customer, which has purchased the assets. Currently, the Bank has no income from lease agreements.

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

The following table presents the components of non interest expense for the three and six months ended June 30, 2007 and 2006 (dollars in thousands).

					2007-2006							2007-2006
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2007		2006		(decrease)			2007		2006		(decrease)
Salaries and employee benefits	$	1,825	$	1,597		14.3	%	$	3,555	$	2,965		19.9	%
Occupancy and equipment expense		366		244		50.0	%		687		492		39.6	%
Other operating expense		821		700		17.3	%		1,534		1,326		15.6	%
Total non interest expense	$	3,012	$	2,541		18.5	%	$	5,776	$	4,783		20.7	%

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

As of December 2006 Cornerstone had 98 full time equivalent employees. By June 2007, the number of full time equivalent employees had increased to 110. The positions filled by these employees included four additional relationship managers and two employees in the Bank’s ACH processing department. The addition of these employees as well as the additional staff hired should have a positive impact on the Bank’s growth and performance as the year progresses.

Occupancy and equipment expense has increased from prior periods in part due to the relocation of the Bank’s downtown branch and Cornerstone’s corporate headquarters. While the relocation has increased expenses, the Bank’s presence in downtown Chattanooga, Tennessee makes it more accessible to existing customers as well as potential new customers. The Bank also opened two loan production offices during the first half of 2007; one in Knoxville, Tennessee and one in Dalton, Georgia.

Financial Condition

Overview-Cornerstone’s consolidated balance sheet reflects significant growth since December 31, 2006. Total assets increased $49.8 million or 13.3% from $375 million as of December 31, 2006 to $425 million as of June 30, 2007. The primary component of the growth continues to be the Bank’s loan portfolio. Total loans increased $47 million or 15.1% from $310 as of December 31, 2006 to $357 million as of June 30, 2007.

Securities-The Bank’s investment portfolio, primarily consisting of Federal Agency, mortgage-backed securities and municipal securities, amounted to $33.2 million as of June 30, 2007 compared to $32.6 million as of December 31, 2006. The investment portfolio is intended to provide the Bank with a stable and reliable source of income, collateral for pledging and liquidity.

Loans-The composition of loans at June 30, 2007 and at December 31, 2006 and the percentage (%) of each classification to total loans are summarized in the following table (dollars in thousands):

	June 30, 2007					December 31, 2006
	Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	107,088		30.0	%	$	98,542		31.8	%
Real estate-construction		66,347		18.6	%		57,606		18.6	%
Real estate-mortgage		53,856		15.1	%		48,700		15.7	%
Real estate-commercial		123,904		34.7	%		99,197		32.0	%
Consumer loans		5,887		1.6	%		6,092		2.0	%
Total loans	$	357,082		100.0	%	$	310,137		100.0	%

Allowance for Loan Losses-The allowance for loan losses represents Cornerstone’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. During the first quarter of 2007 the Bank adopted the new Federal Financial Institutions Examination Council guidance pertaining to loan loss allowance. The new guidance states that a financial institution should use a risk based approach to calculate the appropriate loan loss allowance given the risk profile of the Bank’s loan portfolio. Although the Bank performs prudent credit underwriting, no assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

The following is a summary of changes in the allowance for loan losses for the six months ended June 30, 2007 and for the year ended December 31, 2006 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

	2007			2006
Balance, beginning of period	$	4,258		$	3,545
Loans charged-off		(330	)		(470	)
Recoveries of loans previously charged-off		76			77
Provision for loan losses		237			1,106
Balance, end of period	$	4,241		$	4,258

Total Loans	$	357,082		$	310,137

Ratio of allowance for loan losses to loans
outstanding at the end of the period		1.19	%		1.37	%
Ratio of net charge-offs to average loans
outstanding for the period		0.07	%		0.13	%

Non-Performing Assets-The specific economic and credit risks associated with the Bank’s loan portfolio include, but are not limited to, a general downturn in the economy which could affect employment rates in our market area, general real estate market deterioration, interest rate fluctuations, deteriorated or non-existent collateral, title defects, inaccurate appraisals, financial deterioration of borrowers, fraud, and violation of laws and regulations.

The Bank attempts to reduce these economic and credit risks with adherence to a lending policy approved by the Bank’s board of directors. The Bank’s lending policy establishes loan to value limits, collateral perfection, credit underwriting

criteria and other acceptable lending standards. The Bank classifies loans that are ninety (90) days past due and still accruing interest, renegotiated, non-accrual loans, foreclosures and repossessed property as non-performing assets. The Bank’s policy is to categorize a loan on non-accrual status when payment of principal or interest is contractually ninety (90) or more days past due. At the time the loan is categorized as non-accrual the interest previously accrued but not collected may be reversed and charged against current earnings.

The following table presents the Bank’s non-performing assets (dollars in thousands):

	As of June 30,			As of December 31,
	2007			2006
Loans past due greater than ninety (90) days and still accruing	$			$
Non-accrual loans		190			1,102
Repossessed assets		46			0
Foreclosed properties		185			380
Total non-performing assets	$	421		$	1,482
Total loans outstanding	$	357,082		$	310,137
Ratio of nonperforming assets to total loans outstanding
at the end of the period		0.12	%		0.48	%
Ratio of nonperforming assets to total allowance for loan
losses at end of period		9.93	%		34.81	%

Deposits and Other Borrowings-The Bank’s deposits consist of non-interest bearing demand deposits, interest bearing demand accounts, savings and money market accounts, and time deposits. The Bank has agreements with some customers to sell certain of our securities under agreements to repurchase the security the following day. The Bank has also obtained advances from the Federal Home Loan Bank.

The following table presents the Bank’s deposits and other borrowings as either core funding or non-core funding. Core funding consists of all deposits other than time deposits issued in denominations of $100,000 or greater. All other funding is classified as non-core.

	June 30, 2007					December 31, 2006
Core funding:	Amount		Percent			Amount		Percent
Non interest bearing demand deposits	$	45,589		11.9	%	$	41,723		12.5	%
Interest-bearing demand deposits		40,585		10.6	%		38,160		11.4	%
Savings & money market accounts		45,980		12.0	%		56,913		17.0	%
Time deposits under $100,000		99,748		26.1	%		94,477		28.2	%
Total core funding		231,902		60.7	%	$	231,273		69.1	%
Non-core funding:
Time deposit accounts greater than $100,000
Public funds	$	149		0.0	%	$	0		0.0	%
Brokered deposits		16,016		4.2	%		1,140		0.3	%
Other time deposits		49,545		13.0	%		43,404		13.0	%
Federal funds purchased		22,790		6.0	%		14,645		4.4	%
Securities sold under agreements to repurchase		8,473		2.2	%		4,605		1.4	%
Federal Home Loan Bank advances		53,000		13.9	%		39,500		11.8	%
Total non-core funding	$	149,973		39.3	%	$	103,294		30.9	%
Total	$	381,875		100.0	%	$	334,567		100.0	%

An additional source of funding for the Bank is brokered deposits. These deposits allow the Bank to obtain deposits at lower interest rates than alternative sources. The deposits are generally purchased in sums of at least $1 million with stated terms and maturities. The Bank has increased the amount of brokered deposits since December 31, 2006 to accommodate the increase in loans during the same time period.

Federal funds purchased are lines of credit established with other financial institutions that allow the Bank to meet short term funding requirements. These lines can be used as frequently as daily with large variations in balances depending upon the Bank’s immediate funding requirements. As of June 30, 2007 the Bank had established $32 million in available federal funds lines.

Federal Home Loan Bank of Cincinnati (“FHLB”) borrowings are secured by certain qualifying residential mortgage loans and, pursuant to a blanket lien, all qualifying commercial mortgage loans as collateral. Management believes

that FHLB borrowings provide an additional source of funding at lower interest rates than alternative sources. The borrowings are structured as either term loans with call and put options after a stated conversion date and an overnight borrowing arrangement. As of June 30, 2007 the Bank had borrowed a total of $53 million from the FHLB consisting of $34 million in structured term loans and $19 million on overnight borrowing.

Capital Resources-At June 30, 2007 and December 31, 2006 Cornerstone’s stockholders’ equity amounted to $40.8 million and $38.2, respectively. Management believes the company has sufficient capital to allow for additional loan and asset growth in the near future.

Market and Liquidity Risk Management

Interest Rate Sensitivity

The Bank’s Asset Liability Management Committee (“ALCO”) is responsible for making decision regarding liquidity and marketing solutions based upon approved liquidity, loan, capital and investment policies. The ALCO committee must consider interest rate sensitivity and liquidity risk management when rendering a decision on funding solutions and loan pricing. The following is a brief discussion of one of the primary tools used by the ALCO committee to perform its responsibilities:

Gap Analysis-is a technique of asset-liability management that can be used to assess interest rate risk or liquidity risk. The Bank has developed a gap analysis to assist the ALCO committee in its decision making. The analysis provides the committee information regarding the interest rate-sensitivity of the Bank. The interest rate-sensitivity is the difference between the interest-earning assets and interest-bearing liabilities scheduled to mature or reprice within a stated time period. The gap is considered positive when the amount of interest rate-sensitive assets exceeds the amount of interest rate-sensitive liabilities. Conversely, the gap is considered negative when the amount of interest rate-sensitive liabilities exceeds the amount of interest rate-sensitive assets. The gap position coupled with interest rate movements will result in either an increase or decrease in net interest income depending upon the Bank’s position and the nature of the movement.

Liquidity Risk Management

Liquidity is measured by the Bank's ability to raise cash at a reasonable cost or with a minimum of loss. These funds are used to primarily fund loans and satisfy deposit withdrawals. Several factors must be considered by management when attempting to minimize liquidity risk. Examples include changes in interest rates, competition, loan demand, and general economic conditions. Minimizing liquidity risk is a responsibility of the ALCO committee and is reviewed by the Bank’s regulatory agencies on a regular basis.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

A comprehensive qualitative and quantitative analysis regarding market risk was disclosed in Cornerstone’s Form 10-K for the year ended December 31, 2006. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2006.

Item 4. Evaluation of Controls and Procedures

Cornerstone’s Chief Executive Officer and Treasurer have evaluated the effectiveness of Cornerstone’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Cornerstone (including its consolidated subsidiaries) required to be included in Cornerstone’s periodic filings under the Exchange Act. Since the Evaluation Date, there have not been any significant changes in Cornerstone’s internal controls or in other factors that could significantly affect such controls.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 1A. RISK FACTORS

Growth Strategy-Cornerstone intends to continue pursuing a growth strategy for its business through acquisitions and de novo branching. Cornerstone’s prospects must be considered in light of the risks, expenses and difficulties occasionally encountered by financial services companies in growth stages, including maintaining loan quality, maintaining adequate management personnel and information systems to oversee such growth while maintaining adequate controls and compliance functions. Failure to successfully address the growth effectively and efficiently could have a material adverse effect on Cornerstone’s business, future prospects, financial condition or results of operations and could adversely affect Cornerstone’s ability to successfully implement its business strategy.

Cornerstone may also consider and enter into new lines of business or offer new products or services. Acquisitions and mergers involve a number of risks, including;

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

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

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

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

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

Entry into new markets where Cornerstone lacks experience;

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

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

The risk of loss of key employees and customers.

In the case of acquisitions or mergers, the success of integrating the separate operations depends on the ability to consolidate systems, procedures, operations and controls while eliminating redundant costs. Integration difficulties may have an adverse affect on any economic benefits Cornerstone expects to achieve.

Competition-Much of Cornerstone’s recent growth has been focused in the highly competitive Chattanooga metropolitan markets. We compete with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds, and other mutual funds, as well as other community banks and super-regional and national financial institutions that operate offices in Cornerstone’s primary market areas. Cornerstone’s continued expansion into this market may be impacted if it is unable to meet customer demands or compete effectively with the financial institutions operating in these markets. Cornerstone’s historical accomplishments may not be indicative of future results. There is no assurance that existing offices or future offices will maintain or achieve deposit levels, loan balances or other operating results necessary to avoid losses or produce profits.

Economic Conditions-Cornerstone’s success significantly depends upon the growth in population, income levels, deposits and housing starts in its market areas. If the communities in which Cornerstone operates do not grow or

prevailing economic conditions locally or nationally are unfavorable, Cornerstone’s business may not succeed. Adverse economic conditions in Cornerstone’s specific market areas could reduce its growth rate, affect the ability of its customers to repay their loans to the Bank and generally affect its financial condition and results of operations.

In addition, the market value of the real estate securing loans as collateral could be adversely affected by unfavorable changes in market and economic conditions. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in the state of Tennessee could adversely affect the value of Cornerstone’s assets, revenues results of operations and financial condition.

Liquidity-Cornerstone relies on dividends from the Bank as its primary source of funds. The Bank’s primary sources of funds are customer deposits and loan repayments. While scheduled loan repayments are a relatively stable source of funds, they are subject to the ability of borrowers to repay the loans. The borrowers’ resources can be adversely affected by changes in economic conditions, adverse trends or events affecting business industry group, reductions in real estate values or markets, natural disasters or international instability. Accordingly, Cornerstone may be required from time to time to rely on secondary sources of liquidity to accommodate any funding needs,. Such sources include Federal Home Loan Bank advances and federal funds lines of credit from correspondent banks. While Cornerstone believes that these sources are currently adequate, there can be no assurance they will be sufficient to meet future liquidity demands. Cornerstone may be required to slow or discontinue loan growth, capital expenditures or other investments or liquidate assets should such sources not be adequate.

Credit Risks-The risk of credit losses varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a collateralized loan, the value and marketability of the collateral for the loan. Management maintains an allowance for credit losses based upon historical experience and regular analysis of the ultimate collectibility of the loan portfolio. Capital could be significantly adversely affected if these assumptions and adjustments in the allowance for loan losses prove to be inadequate to absorb unforeseen losses.

Regulatory-Cornerstone’s growth and expansion plans may be adversely affected by a number of regulatory developments or events. Failure to obtain required regulatory approvals, changes in laws and regulations may prevent or adversely affect Cornerstone’s continued growth and expansion. Cornerstone operates in a highly regulated industry and is subject to examination, supervision, and comprehensive regulation by various federal and state agencies including the Board of Governors of the Federal Reserve Bank (FRB), the FDIC and the Tennessee Department of Financial Institutions. Cornerstone’s regulatory compliance is costly and restricts certain of its activities, including payment of dividends, mergers and acquisitions, investments, loans, and interest rates charged, interest rates paid on deposits and locations of offices. Cornerstone is also subject to capitalization guidelines established by its regulators, which require it to maintain adequate capital to support its growth.

Loss of Key Employees-Cornerstone depends on the strategies and management services of Gregory B. Jones, its Chairman of the Board and Chief Executive Officer. Although Cornerstone has entered into an employment agreement with him, the loss of Mr. Jones’ services could have a material adverse effect on Cornerstone’s business, results of operations and financial condition. Cornerstone is also dependent on certain other key officers who have important customer relationships or are instrumental to its daily operations. Changes in key personnel and their responsibilities may be disruptive to Cornerstone’s business and could have a material adverse effect on Cornerstone’s business, financial condition and results of operations. Cornerstone believes that its future results will also depend in part upon its attracting and retaining highly skilled and qualified management, sales and marketing personnel.

Interest Rate Fluctuations-Changes in interest rates may affect Cornerstone’s level of interest income, the primary component of its gross revenue, as well as the level of its interest expense. Interest rates are highly sensitive to many factors that are beyond Cornerstone’s control, including general economic conditions and the policies of various governmental and regulatory authorities. Accordingly, changes in interest rates up or down could ultimately affect Cornerstone’s earnings. Changes in the level of interest rates also may negatively affect the Bank’s ability to originate real estate loans and may lower the value of Cornerstone’s assets.

Risks of Corporate Buyout-As a Tennessee corporation, Cornerstone is subject to various legislative acts which impose restrictions on and require compliance with procedures designed to protect shareholders against unfair or coercive mergers and acquisitions. These statutes may delay or prevent offers to acquire Cornerstone and increase the difficulty of consummating any such offers, even if the acquisition of Cornerstone would be in its shareholders’ best interests.

The amount of common stock owned by, and other compensation arrangements with, Cornerstone’s officers and directors may make it more difficult to obtain shareholder approval of potential takeovers that they oppose. Also, these arrangements with Cornerstone’s senior management provide for significant payments under certain circumstances following a change in control.

Capital Adequacy and Market Fluctuations-Cornerstone is required by federal and state regulatory authorities to maintain adequate levels of capital to support its operations. While Cornerstone’s capital resources will satisfy its capital requirements for the foreseeable future, Cornerstone may at some point, however, need to raise additional capital to support its continued growth. Cornerstone’s ability to raise additional capital, if needed, will depend on conditions in the capital markets at that time and on its financial performance. We cannot assure you of our ability to raise additional capital if needed on terms acceptable to us.

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

Cornerstone cannot predict the effect, if any, that future sales of its common stock in the market, or availability of shares of its common stock for sale in the market, will have on the market price of Cornerstone’s common stock. The market price of Cornerstone’s common stock may fluctuate in the future, and these fluctuations may be unrelated to its performance. General market price declines or overall market volatility in the future could adversely affect the price of our common stock, and the current market price may not be indicative of future market prices. Cornerstone cannot say with any certainty when a more active and liquid trading market for its common stock will develop or be sustained. Because of this, Cornerstone’s shareholders may not be able to sell their shares at the volumes, prices, or times that they desire.

Ability to Pay Dividends-Cornerstone derives its income solely from dividends on the shares of common stock of the Bank. The Bank’s ability to declare and pay dividends is limited by its obligations to maintain sufficient capital and by other general restrictions on its dividends that are applicable to banks that are regulated by the FDIC and the Tennessee Department of Financial Institutions. In addition, the FRB may impose restrictions on Cornerstone’s ability to pay dividends on its common stock. As a result Cornerstone cannot assure its shareholders that it will declare or pay dividends on shares of its common stock in the future.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCCEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

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

Cornerstone’s annual shareholder meeting was held on April 19, 2007. At the meeting, the individuals whose names appear below were elected to Cornerstone’s board of directors. In addition, the shareholders ratified the appointment of Hazlett, Lewis & Bieter, PLLC as its independent auditors for the fiscal year ending December 31, 2007. The shareholders’ votes were cast as follows with 78.8% of total shares voting:

Election of Directors	For	Against	Abstain
B. Kenneth Driver	99.9%	0.0%	0.1%
Karl Fillauer	99.8%	0.0%	0.2%
Nathaniel F. Hughes	99.9%	0.0%	0.1%
Gregory B. Jones	99.9%	0.0%	0.1%
Jerry D. Lee	99.9%	0.0%	0.1%
Lawrence D. Levine	99.9%	0.0%	0.1%
Frank McDonald	99.2%	0.0%	0.8%
Doyce G. Payne, M.D.	97.5%	0.0%	2.5%
Turner Smith	99.9%	0.0%	0.1%
Miller Welborn	99.9%	0.0%	0.1%
Billy O. Wiggins	99.9%	0.0%	0.1%
Marsha Yessick	97.2%	0.0%	2.8%

Ratification of Appointment of Hazlett,
Lewis & Bieter, PLLC	99.9%	0.0%	0.1%

ITEM 5. OTHER INFORMATION

None

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

Exhibit Number		Description
31		Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32		Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

(b) Reports on Form 8-K

(1) Form 8-K dated January 12, 2007 reporting earnings results for the fiscal quarter ended December 31, 2006.

(2) Form 8-K dated February 28, 2007 reporting the declaration of a cash dividend.

(3) Form 8-K dated April 16, 2007 reporting earnings results for the fiscal quarter ended March 31, 2007.

(4) Form 8-K dated May 29, 2007 reporting the declaration of a cash dividend.

(5) Form 8-K dated July 19, 2007 reporting earnings results for the fiscal quarter ended June 30, 2007.

SIGNATURES

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



		Cornerstone Bancshares, Inc.
Date: August 14, 2007		/s/ Gregory B. Jones
		Gregory B. Jones,
		Chairman and Chief Executive Officer



Date: August 14, 2007		/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes
		President and Treasurer

EXHIBIT INDEX

Exhibit Number		Description

3		First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (1)
31		Certifications under Section 302 of the Sarbanes-Oxley Act of 2002.
32		Certifications under Section 906 of the Sarbanes-Oxley Act of 2002.

_____________________

(1)

Incorporated by reference from Exhibit 3 of the registrant’s Form 10-QSB filed on May 14, 2004.

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