CORNERSTONE BANCSHARES INC (Form: 10KSB, Received: 03/27/2006 10:21:56)

Securities and Exchange Commission

Washington, D.C. 20549

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

For the fiscal year ended December 31, 2005

Commission file number 000-30497

(Name of Small Business Issuer in Its Charter)

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

5319 Highway 153

Hixson, Tennessee 37343

(Address of principal executive offices)(Zip Code)

(Issuer’s telephone number)

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

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

Common Stock, Par Value $1.00 Per Share

Check whether the issuer is required to file reports pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of 1944.

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.

Check if disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no disclosure will 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-KSB or any amendment to this Form 10-KSB. o

Check whether the issuer is a shell company (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes o No x

Revenues for the Registrant’s fiscal year ended December 31, 2005, total $22,576,802.

The aggregate market value of the Registrant's outstanding Common Stock held by nonaffiliates of the Registrant on February 15, 2006 was approximately $67,607,878. There were 3,208,284 shares of Common Stock outstanding as of February 15, 2006.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrants definitive 2006 Proxy Statement are incorporated by reference in Part III of this Form 10-KSB.

CORNERSTONE BANCSHARES, INC.

Annual Report on Form 10-KSB

For the Fiscal Year Ended December 31, 2005

Table of Contents

Item Number		Page Number
	Part I

1.	Description of Business	4

2.	Description of Property	10

3.	Legal Proceedings	10

	Part II

5.	Market for Common Equity and Related Stockholder Matters	11

6.	Management's Discussion and Analysis or Plan of Operation	12

7.	Financial Statements	34

8.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	34

8A	Controls and Procedures	34

	Part III

9.	Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act	35

10.	Executive Compensation	35

11.	Security Ownership of Certain Beneficial Owners and Management	36

12.	Certain Relationships and Related Transactions	36

13.	Exhibits and Reports on Form 8-K	36

14.	Principal Accountant Fees and Services	37

Forward-Looking Statements

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

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

ITEM 1. DESCRIPTION OF BUSINESS

Business Development

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

Business of the Company

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

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

The Bank'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. Funds not invested in the loan portfolio are invested by the Bank primarily in obligations of the U.S. Government, U.S. Government agencies, various states and their political subdivisions. In addition to deposits, sources of funds for the Bank loans and other investments include amortization and prepayment of loans, sales of loans or participations in loans, sales of its investment securities and borrowings from other financial institutions. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses and other overhead expenses.

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

As of February 15, 2006, the Company and the Bank collectively had 87 full-time equivalent employees of whom 81 are full-time, and 12 are part-time. The employees are not represented by a collective bargaining unit. The Company and the Bank believe that their relationships with their employees are good.

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

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

Based on total deposits of approximately $252,436,000 at December 31, 2005, the Bank represents 3.52% of the deposit base in the Chattanooga, Tennessee-Georgia Metropolitan Statistical Area (“Chattanooga MSA”). Three major regional banks represent approximately 60% of the deposits in the Chattanooga MSA. These larger financial institutions have greater resources and higher lending limits than the Bank, and each of the three institutions has over 20 branches in Hamilton County. There are several credit unions located in Hamilton County. Since credit unions are not subject to income taxes in the way commercial banks are, credit unions have an advantage in offering competitive rates to potential customers. The Bank also faces competition in certain areas of its business from mortgage banking companies, consumer finance companies, insurance companies, money market mutual funds and investment banking firms, some of which are not 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 will focus its resources to seek out and attract small business relationships and take advantage of the Bank’s ability to provide flexible service that meets the needs of this customer class. Management feels this market niche is the most promising business area for the future growth of the Bank.

Supervision and Regulation

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

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

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

Insurance of Deposit Accounts

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

On September 15, 1992, the FDIC approved final regulations adopting a risk-related deposit insurance system. The risk-related regulations, which became effective January 1, 1993, resulted in a significant spread between the highest and lowest deposit insurance premiums. Under the risk-related insurance regulations, each insured depository institution is assigned to one of three risk classifications: "well capitalized," "adequately capitalized," or "under capitalized." Within each risk classification, there are three subgroups. Each insured depository institution is assigned to one of these subgroups within its risk classification based upon supervisory evaluations submitted to the FDIC by the institution’s primary federal regulator . Depending upon a BIF member’s risk classification and subgroup, applicable regulations provide that its deposit insurance premium may be as low as 0.004% of insured deposits or as high as .31% of insured deposits. Additionally, because the BIF has exceeded its designated reserve ratio, the FDIC has now reduced to zero the assessment rate that is applicable to the most highly rated BIF members. The Bank has been notified that, based on its risk classification and supervisory subgroup, its BIF assessment rate is 0.004% of insured deposits for the period from January 1, to December 31, 2005. This is the most favorable assessment rate applicable to insured institutions. In addition, the Deposit Insurance Funds Act of 1998 (DIFA) requires that a Financing Corporation (“FICO”) assessment be paid by the Bank. The annual FICO assessment rate for banks is presently 0.0154% of deposits. The Bank paid $27,579 in assessments during the year ended December 31, 2005.

Subsequent to the enactment of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), the FDIC issued risk-based bank capital guidelines which went into effect in stages through 1992. In accordance with the FDIC's risk-based standards, an institution's assets and off-balance sheet activities are categorized into one of four risk categories, with either a 0%, 20%, 50%, or 100% amount of capital to be held against these assets. In addition, the guidelines divide capital instruments into Tier 1 (core) capital and Tier 2 (supplementary) capital. The risk-based capital adequacy guidelines require that (i) Tier 1 capital equal or exceed 4% of risk-weighted assets; (ii) Tier 2 capital may not exceed 100% of Tier 1 capital, although certain Tier 2 capital elements are subject to additional limitations; (iii) assets and off-balance sheet items must be weighted according to risk; and (iv) the total capital to risk-weighted assets ratio must be at least 8.0%. The FDIC's current leverage capital requirement requires banks receiving the highest regulatory rating based upon the FDIC's routine examination process, to maintain Tier 1 capital equal to 3.0% of the bank's total assets. Banks receiving lower regulatory ratings are required to maintain Tier 1 capital in an amount that is at least 100 to 200 basis points higher than 3.0% of total assets.

At December 31, 2005, the Bank had Tier 1 capital of $26.0 million or 9.20% of total year to date average assets.

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

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

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

Tennessee Supervision and Regulation

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

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

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

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

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

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

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

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

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

Legislation Affecting the Company and the Bank

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

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

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

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

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

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

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

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

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

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

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

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

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

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

§	uniform regulations regarding real estate lending; and

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

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

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

ITEM 2. DESCRIPTION OF PROPERTY

As of December 31, 2005, the principal offices of the Company and the Bank are located at 5319 Highway 153, Hixson, Tennessee 37343. This property is owned by the Company. In addition, the Bank operates four full-service branches in Hamilton County, Tennessee that are located at:

4154 Ringgold Road, East Ridge, Tennessee

610 Georgia Avenue, Chattanooga, Tennessee

2280 Gunbarrel Road, Chattanooga, Tennessee

8966 Old Lee Highway, Ooltewah, Tennessee

The Georgia Avenue branch contains 1800 square feet and is leased pursuant to a lease agreement which provides an initial term of three years with two three-year renewal options. Rent is currently $ 29,482 per annum. The Bank owns the properties located at 2280 Gunbarrel Road, 4154 Ringgold Road, 5319 Highway 153 and 8966 Old Lee Highway.

The Company completed the construction and remodeling of the branch on Ringgold Road, East Ridge, Tennessee. The branch was updated to make more efficient use of the branch’s square footage and to open two additional customer drive-thru lanes. The Bank razed a branch operations building located in the back of the branch property in the process.

The Company operates a service center to house all its non-customer contact functions located at 6401 Lee Corners, Suite B, Chattanooga, Tennessee. The facility has 15,600 square feet and is leased pursuant to a lease agreement which provides for an initial term of five years with one five-year renewal option . Rent is currently $ 86,000 per annum.

ITEM 3. LEGAL PROCEEDINGS

As of the end of 2005, neither the Company, the Bank nor Eagle was involved in any material litigation. The Bank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business. Management believes that those claims are without merit or that the ultimate liability, if any, resulting from them will not materially affect the Bank’s financial condition or the Company’s consolidated financial position.

ITEM 5. MARKET FOR THE COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's common stock is quoted on the OTC Bulletin Board but is not listed on a national securities exchange. Morgan Keegan, a subsidiary of Regions Bank, is the principal market maker for Cornerstone stock. There are nine other market makers who assist in providing a market.

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

There were approximately 610 holders of record of the common stock as of December 31, 2005. This number does not include shareholders with shares in nominee name held by DTC. As of the end of 2005, there were 1,557,885 shares held in nominee name by DTC.

Cornerstone paid two cash dividends in 2005. The first dividend was paid on January 18, 2005 in the amount of $0.10 per share and the second dividend was paid on July 11, 2005 in the amount of $0.08 per share. The Company announced quarterly dividends of $0.06 each quarter, the first of which was paid January 9, 2006. The Company’s board of directors will decide the amount of the next year’s dividends, if any, after the capital needs required for expected growth of assets are reviewed. The payment of dividends is solely within the discretion of the Board of Directors, considering Cornerstone’s expenses, the maintenance of reasonable capital and risk reserves, and appropriate capitalization requirements for state banks.

High and Low Common Stock Share Price for the Company
2006 Fiscal Year	Low	High
First Quarter (through Feb. 2006)	$23.25	$27.25

2005 Fiscal Year
First Quarter	$15.74	$18.50
Second Quarter	$16.75	$18.50
Third Quarter	$17.60	$20.50
Fourth Quarter	$19.50	$24.99

2004 Fiscal Year
First Quarter	$10.00	$12.50
Second Quarter	$11.50	$13.90
Third Quarter	$11.90	$15.00
Fourth Quarter	$14.00	$17.00

2003 Fiscal Year
First Quarter	$6.25	$7.25
Second Quarter	$6.05	$8.75
Third Quarter	$8.25	$9.50
Fourth Quarter	$8.95	$11.65

On October 12, 2004, Cornerstone filed a Form SB-2 with the Securities and Exchange Commission to register the issuance of up to 500,000 shares of common stock. On November 4, 2004, the Securities and Exchange Commission declared the registration statement effective and the offering was fully subscribed by the end of 2004. Due to administrative issues associated with IRA accounts not all of the funds were collected until January of 2005. This created a subscription receivable in the capital section on the Company’s balance sheet since the funds were not collected prior to year end. As of February 5, 2005 all funds from the subscription were collected and available for use by the Company.

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


Equity Compensation Plan
Year Ended December 31, 2005

Plan category	Number of securities to be issued upon exercise of outstanding options	Weighted average exercise price of outstanding options	Number of securities remaining available for future issuance

Equity compensation plans approved by security holders:	361,250	$ 9.08	414,350
Equity compensation plans not approved by security holders:	0	$ 0.00	0
Total	361,250	$ 9.08	414,350

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

Forward-Looking Statements

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

Management's Discussion And Analysis Or Plan Of Operation

The following should be read in conjunction with the information and tables that follow. For a discussion of liquidity and the impact of inflation, see “Capital Resources/Liquidity” below.

Net income for 2005 was $4,324,519 which represents a 68.2% increase from the Company’s net income of $2,571,083 in 2004. Net income per common share of $1.42 for 2005 was 37.9% higher than 2004 net income per common share of $1.03. Pretax income of $6,881,135 for 2005 increased $2,717,552 from 2004 pretax income of $4,163,583.

The increase in net income per common share from 2004 to 2005 comes directly from the dramatic growth of the Company’s earning assets, especially average loans, which grew 30.3%. This growth coupled with repetitive loan and security repricing as the Federal Reserve increased the target Federal Funds rate throughout 2005 helped the Company realize a 39.2% increase in net interest income to $14,594,290. Also contributing to improved net income was a 35.5% increase in non-interest income. Most of the increase was due to operating lease income, a new product line the Bank introduced in 2004, and the sale of commercial loans to conduit lenders. Asset quality remained at its better than industry standard level during 2005. Dramatic loan growth required the Bank to increase the loan loss provision to $1,401,600 during 2005. Non-interest expense increased 19.3% in 2005 due mostly to an increase in salaries and benefits of 15.4% and the addition of depreciation expense associated with leased assets.

Business of the Company

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

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

For the fiscal years ended December 31, 2005 and 2004, the Company's weighted average rate earned on all interest-earning assets was 7.68% and 6.73%, respectively, and the Company's weighted average rate paid on all interest-bearing liabilities for the same years was 2.75% and 2.03%, respectively. The Company's interest rate spread for the years ended December 31, 2005 and 2004 therefore was 4.93% and 4.70%, respectively, and its net interest income for such years was $14,594,290 and $10,483,424 respectively. For fiscal 2005, the Company recorded net income of $4,324,519 or $1.42 basic earnings per common share as compared with net income of $2,571,083 or $1.03 basic earnings per common share for fiscal 2004. The increase in net income was due to a 39.2% increase in the Bank’s net interest income and a 35.5% increase in non-interest income, while non-interest expense increased only 19.3%.

Table 3 below sets forth certain additional measures of the Company’s performance for the periods indicated. Average balances in the table, as well as all average balances presented elsewhere in this report, were derived based on daily balances whenever possible. However, some average balances, which require data from the Company, as opposed to the Bank, were derived based on month-end balances since the data processing systems for those entities do not provide daily average balance information. The use of month-end averages does not materially alter any information given, and all averages are still representative of the operations of the Company.

Performance Measures
Years Ended December 31,
	2005	2004	2003
Net Interest Margin
(Net interest income divided by average interest-earning assets)	5.43%	5.02%	4.87%

Return on Average Assets
(Net income divided by average total assets)	1.51%	1.15%	1.06%

Return on Average Equity
(Net income divided by average equity)	14.98%	13.83%	11.68%

Equity to Assets
(Average equity divided by average total assets)	10.09%	8.30%	9.04%

Loans to Deposits
(Average loans divided by average deposits)	109.04%	104.73%	101.21%

Dividend Payout Ratio
(Dividends paid by the Company divided by net income)	12.17%	4.84%	0.00%

Results of Operations

Year ended December 31, 2005 compared to year ended December 31, 2004:

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

Net interest income before loan loss provision for 2005 increased by $4,110,866 or 39.2% over 2004. The increase in net interest income from 2004 to 2005 is due to material growth of the balance sheet and interest rate sensitivity of the Bank’s assets compared to its liabilities. Interest income grew 47.0% as the Federal Reserve increased the target Federal Funds rate 200 basis points during 2005. The Bank was in a favorable position to take advantage of the rapid and predictable increases due to its loan and security portfolios being mostly variable rate instruments. Loan origination fees remained strong as the Bank became more proficient at Small Business Administration (SBA) lending and asset based lending. The Bank anticipates loan growth to continue along with loan origination fees. Interest expense increased 70.0% in 2005. Cornerstone funded the rapid asset growth primarily with certificates of deposit and money market deposits which are typically more expensive for new deposits while retaining existing deposits. This allowed the cost of the funds to only go up 72 basis points while the raw cost of the funds increased 70%.

Interest income increased $6,613,367 or 47.0% in 2005 from 2004. Interest income produced by the loan portfolio increased $6,323,768 or 48.5% from 2004 to 2005. Interest income on investment securities and Federal Funds sold increased slightly at $289,599 or 28.2% from 2004 to 2005. The increase in loan interest income was due to a large increase in the volume and rate of loans as the portfolio grew, and was increased further by loan origination fees and servicing fees generated by the origination of SBA loans. The Bank attributes the strong loan growth to an increase in the number of relationship managers and their level of expertise. The small securities income increase was due to the generally higher interest rate environment, which presented few opportunities to invest without material interest rate risk exposure. Total interest expense increased $2,502,501 or 70.0% in 2005 from 2004.

One of the most useful tools for measuring the ability of a community bank to make money is its ability to maximize its net interest margin and its interest rate spread. The net interest margin, or the net yield on earning assets, is computed by dividing fully taxable equivalent net interest income by average-earning assets. This ratio represents the difference between the average yield on average-earning assets and the average rate paid for all funds used to support those earning assets. The Companies ended 2005 with a net interest margin of 5.43%. The net interest spread, defined as the rate of interest income minus the rate of interest expense, increased 23 basis points from 4.70% in 2004 to 4.93% in 2005. The yield on earning assets increased 95 basis points to 7.68% in 2005 from 6.73% in 2004.

Allowance for Loan Loss. The allowance for possible loan loss represents management’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for possible loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. Management believes that the allowance for possible loan losses balance of $3,545,042 as of December 31, 2005, is sufficient to absorb known credit risks in the portfolio. No assurance can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

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

Non-interest Income. Non-interest income consists of revenues generated from a broad range of financial services and activities including fee-based services and profits and commissions earned through credit life insurance sales and other activities. In addition, gains or losses realized from the sale of investment securities are included in non-interest income. Total non-interest income increased by $498,844 or 35.5% from 2004 to 2005. Fee income from service charges on deposit accounts increased $84,872 or 9.4% in 2005. The Bank had no security gain in 2005. Fees generated from the sale of loans sold to the secondary market increased $116,581 in 2005 due to an increase in SBA loan origination. Operating lease income increased $292,505 or 118.3% during 2005. This service is offered on a very selective basis and the Bank does not expect to see significant growth in this area in 2006.

Non-interest Expense. Non-interest expense for 2005 increased by $1,330,558 or 19.3% from 2004. Salaries and employee benefits increased by $602,405 or 15.4% from $3,900,505 in 2004 to $4,502,910 in 2005. Hiring of additional personnel to cover the growth of the Bank, accounted for the majority of the increase for 2005. Occupancy expense increased 12.0% as the Bank continued to operate five full service branches and update equipment. Other non-interest expense increased $443,055 or 21.8% in 2005. This increase was related to data processing and other expenses incurred due to the Bank’s growth. Lastly depreciation expense associated with the Bank’s operating leases increased $193,246 or 104.0% due to increased number of leases outstanding.

Financial Condition

Earning Assets. Average earning assets in 2005 increased $62,408 million or 27.89% over 2004 due to material loan growth in 2005. This loan growth led the expansion of the balance sheet and the Bank funded the loan growth with a combination of FHLB borrowings, money market deposits and certificates of deposit. The average security portfolio grew $2.6 million or 9.6% to maintain an appropriate amount of securities for pledging purposes and liquidity.

Loan Portfolio. The Bank’s average loans for 2005 were $236.3 million, an increase of 30.3% over $181.3 million in average loans for 2004. The actual balance, before the loan loss allowance, at the end of 2005 was $265.6 million, representing an increase of $60.3 million from 2004. Loan growth for 2005, was evenly weighted throughout the year with several large, high quality loans greatly increasing the Bank’s outstanding balances. The growth was concentrated in commercial and commercial real estate. The Bank hired additional relationship mangers during 2005 in an effort to continue the Bank’s growth. The Bank feels strongly that the key to success in lending, as well as for the Bank as a whole, is to hire talented employees to provide outstanding customer service in a safe and sound manner.

Investment Securities . Cornerstone’s average investment securities portfolio increased $2.6 million from 2004 to 2005, while Federal Funds increased $1.8 million during the same period. The average investment portfolio and average federal funds sold for 2005 was $32.7 million. Cornerstone maintains an investment strategy of seeking portfolio yields within acceptable risk levels as well as providing liquidity, pledging requirements and GAP management. To accomplish these strategies, the Bank positioned the Investment Portfolio on the assumption that there was a higher probability of rates continuing to rise, and as a result took a cautious interest rate stance and invested appropriately. The majority of the purchases during 2005 were in US Agency callable notes structured with an interest rate cushion to protect the Bank if interest rates continue to rise. The Bank allowed its US Agency LIBOR floaters to be called as rates increased during 2005 without replacing them, as the agency U.S. Agency callable securities represented a better value due to the compressed spreads on the LIBOR floaters and scarcity of the security. Cornerstone maintains two classifications of investment securities: “Held to Maturity” and “Available for Sale.” The “Available for Sale” securities are carried at fair market value, whereas “Held to Maturity” securities are carried at book value. At year-end 2005, unrealized losses in the “Available for Sale” portfolio amounted to $341,466.

Intangibles. During 2002, the Company adopted the provisions of Statement of Financial Statement No. 142 Goodwill and other Intangible Assets concerning the $2,541,476 goodwill created by the merger with the Bank of East Ridge. Goodwill and is tested annually for impairment. If the carrying value of goodwill exceeds the fair value, a write-down is recorded. No impairment loss was recognized during 2005, 2004 or 2003. Also, in December, 2005, the Company completed the purchase of Eagle Financial, Inc. and recorded an intangible asset of 848,916. Amortization expense of $13,500 was recognized on this amortizable intangible.

Deposits. Cornerstone’s average deposits increased $43.5 million or 25.2% from 2004 to 2005. From year-end 2004 to year-end 2005, total actual deposits increased $64.6 million or 34.4%. The Bank’s deposit strategy continues to be focused on attracting transaction deposits from business customers while filling funding gaps with certificate of deposit specials to attract incremental funds while not driving up the cost of certificates already on the books. The Bank saw extraordinary success during 2005 in attracting business and public deposits to the Bank. Average interest bearing transaction accounts increased 25.3% while average demand deposits increased 24.4%. This success partially funded the Bank’s loan growth and allowed the Bank to maintain its net interest margin at an above peer bank level. The Bank expects to continue its focus on attracting deposits from businesses, especially transaction accounts, which are less expensive and tie the customer base closely to the Bank.

Capital Resources. Stockholders average equity increased $10.3 million or 55.4%. The Company had net income of $4,324,519 in 2005, and the value of the investment security portfolio’s unrealized gains or losses, net of tax, decreased from a gain of $116.0 thousand to a loss of $165.9 thousand. The actual balance of stockholder’s equity increased $7.7 million or 30.9% from $24.8 million as of the end of 2004 to $32.5 million. During 2005, the Company completed the 500,000 shares initial offering that begun at the end of 2004 represented approximately $7 million in additional capital. Also during 2005, several directors exercised non-qualified options adding an additional $2.2 million to the Company’s capital.

Net Interest Income

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

Yields Earned on Average Earning Assets and Rates Paid on Average Interest Bearing Liabilities
Years Ended December 31,
	2005								2004								2003
(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)	$	236,265		$	19,354		8.19	%	$	181,335		$	13,030		7.19	%	$	141,586		$	10,326		7.29	%
Investment securities(3)		29,705			1,217		4.24	%		27,115			1,006		3.87	%		24,118			980		4.16	%
Federal funds sold		2,976			101		3.39	%		1,218			23		1.89	%		1,550			20		1.29	%
Other earning assets		0			0		0.00	%		0			0		0.00	%		0			0		0.00	%
Total interest-earning assets		268,946			20,672		7.68	%		209,668			14,059		6.73	%		167,254			11,326		6.79	%
Allowance for loan losses		(3,025	)							(2,293	)							(1,843	)
Cash and other assets		20,288								16,426								12,791
Total assets	$	286,209							$	223,801							$	178,202
TOTAL LIABILITIES AND EQUITY
Interest-bearing liabilities:
Deposits:
NOW accounts	$	33,943			329		0.97	%	$	28,843			138		0.48	%	$	22,299			66		0.30	%
Money market / Savings		45,232			1,107		2.45	%		32,282			429		1.33	%		25,467			339		1.33	%
Time deposits, $100m and
Over		32,611			1,145		3.51	%		25,734			649		2.52	%		19,430			606		3.12	%
Time deposits, under $100 m		70,167			2,240		3.19	%		58,367			1,457		2.50	%		54,679			1,577		2.88	%
Total interest-bearing deposits		181,953			4,821		2.65	%		145,226			2,673		1.84	%		121,872			2,588		2.12	%
Federal funds purchased		4,269			143		3.35	%		2,140			33		1.54	%		2,248			33		1.47	%
Securities sold under
agreement to repurchase		3,501			60		1.71	%		2,575			23		0.89	%		2,602			22		0.85	%
Other borrowings		30,973			1054		3.40	%		25,942			846		3.26	%		16,123			568		3.52	%
Total interest-bearing
Liabilities		220,696			6,078		2.75	%		175,889			3,575		2.03	%		142,848			3,211		2.25	%
Net interest spread							4.93	%							4.70	%							4.54	%

Other liabilities:
Demand deposits		34,730								27,918								18,017
Accrued interest payable and
other liabilities		1,909								1,408								1,224
Stockholders' equity		28,874								18,586								16,113
Total liabilities
And stockholders' equity	$	286,209							$	223,801							$	178,202

Net interest margin				$	14,594		5.43	%				$	10,484		5.02	%				$	8,116		4.87	%

(1) Interest income on loans includes amortization of deferred loan fees and other discounts of $262 million, $229 million, and $115 million for the fiscal years ended December 31, 2005, 2004, and 2003, 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.

T able 5 below sets forth information regarding the weighted average contractual yields earned on the Company's interest-earning assets and the weighted average interest rates paid on the Company's interest-bearing liabilities outstanding at December 31, 2005. Investment securities available for sale (“AFS”) are held at market value and held to maturity (“HTM”) are shown at amortized costs.

Weighted Average of Interest Earning Assets and Interest Bearing Liabilities
Actual Year End Balance for December 31, 2005

(In thousands)	Amount		Average Yield/Rate
Interest-earning assets:
Loans	$	236,265		8.19	%
Investment securities		29,705		4.10	%
Federal funds sold		2,976		3.39	%
Total interest-earning assets	$	268,946		7.68	%

Interest bearing liabilities:
NOW account deposits	$	33,943		0.97	%
Savings and money market deposits		45,232		2.45	%
Time deposits under $100,000		70,167		3.19	%
Time deposits of $100,000 or more		32,611		3.51	%
Federal funds purchased		4,269		3.35	%
Securities sold under agreements to repurchase		3,501		1.71	%
Long-term debt		30,973		3.40	%
Total interest bearing liabilities	$	220,696		2.75	%

Table 6 sets forth the changes in interest income and interest expense that are attributable to three factors: (i) a change in volume or amount of an asset or liability; (ii) a change in interest rates; or (iii) a change caused by the combination of changes in asset or deposit mix. The following table describes the extent to which changes in interest rates and changes in volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and expense during the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided as to changes attributable to change in volume (change in volume multiplied by current rate) and change in rates (change in rate multiplied by current volume). The remaining difference has been allocated to mix.

Table 7 sets forth the re-pricing of the Company's interest earning assets and interest-bearing liabilities as of December 31, 2005. This interest sensitivity gap table is designed to monitor the Company's interest rate risk exposure within the designated time period. In order to control interest rate risk, management regularly monitors the volume of interest sensitive assets relative to interest sensitive liabilities over specific time intervals. The Company's interest rate management policy is to attempt to maintain a relatively stable net interest margin in periods of interest rate fluctuations. The Company's policy is to attempt to maintain a ratio of cumulative gap to total interest sensitive assets of negative 15.00% to positive 15.00% in the time period of one year or less. Presently, the Bank is in a positive one-year cumulative GAP position of 22.3% and is confident that it is positioned properly for the Federal Reserve’s FOMC anticipated actions during 2006. Due to the Federal Reserve’s announcement that the Federal Funds rates are approaching a neutral position, the Bank has begun the process of moving the Bank’s interest sensitivity to a more neutral position. This will be accomplished by purchasing longer term securities with call protection and increasing the number of fixed rate loans. The Bank to date has not participated in any derivative products to address this issue and does not foresee the need to do so in the immediate future. Below is a table, which reflects the Company's interest-earning assets and interest-bearing liabilities. The information set forth below is based on the following assumptions of management: (i) savings and money market and NOW accounts will be less interest rate sensitive and the re-pricing on these accounts will be spread out over a five-year period; and (ii) securities other than mortgage-backed securities have been scheduled by maturity date while mortgages have been amortized over the life of the mortgage.

INTEREST INCOME AND EXPENSE ANALYSIS

	Year Ended December 31, 2005 Compared to 2004
(In Thousands)	Volume		Rate		Mix			Net Change
Interest income:
Loans (1)(2)	$	4,499	$	2,363		($541	)	$	6,321
Investment securities		110		110		(9	)		211
Federal funds sold		54		36		(12	)		78
Other earning assets		0		0		0			0
Total interest income									6,610

Interest expense:
NOW accounts		49		166		(25	)		190
Money market and savings accounts		317		507		(146	)		678
Time deposits, $100,000 and over		171		303		22			496
Time deposits, less than $100,000		376		484		(78	)		782
Other borrowings		171		40		(9	)		202
Federal funds purchased		73		82		(41	)		114
Securities sold under agreement to repurchase		15		24		(2	)		37
Total interest expense									2,499
Change in net interest income (expense)								$	4,111

INTEREST INCOME AND EXPENSE ANALYSIS

	Year Ended December 31, 2004 Compared to 2003
(In Thousands)	Volume			Rate			Mix			Net Change
Interest income:
Loans (1)(2)	$	2,858		$	(181	)	$	27		$	2,704
Investment securities		116			(52	)		(38	)		26
Federal funds sold		(6	)		7			2			3
Other earning assets		0			0			0			0
Total interest income											2,733

Interest expense:
NOW accounts		31			345			(304	)		72
Money market and savings accounts		91			0			(1	)		90
Time deposits, $100,000 and over		159			0			(116	)		43
Time deposits, less than $100,000		92			(5	)		(207	)		(120	)
Other borrowings		320			0			(42	)		278
Federal funds purchased		(2	)		0			1			(1	)
Securities sold under agreement to repurchase		0			149			(147	)		2
Total interest expense											364
Change in net interest income (expense)										$	2,369

(1) Loan amounts include non-accruing loans.

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

Re-pricing of Interest Sensitive Assets and Liabilities

Year-end balance as of December 31, 2005

(In thousands) Interest Sensitive Assets:	Less than One Year			1 to 5 Years (3)			Over 5 Years (3)			Total
Federal funds sold	$	0		$	0		$	0		$	0
Investment securities
Taxable (1)		5,581			22,427			187			28,195
Tax-exempt (1)		0			565			2,724			3,289
Loans (2)
Fixed rate and adjustable rate 1-4 family mortgage		27,265			8,378			631			36,274
Scheduled payments		192,219			36,142			919			229,280
Total Interest Sensitive Assets	$	225,065		$	67,512		$	4,461		$	297,038

Interest Sensitive Liabilities:
NOW accounts	$	17,401		$	26,100		$	0		$	43,501
Money market and savings accounts		35,533			11,844			0			47,377
Time deposits		92,401			29,425			0			121,826
Other interest bearing liabilities		13,430			17,000			2,000			32,430
Total Interest Sensitive Liabilities	$	158,765		$	84,369		$	2,000		$	245,134

Interest Sensitive Gap	$	66,300			($16,857	)	$	2,461		$	51,904
Cumulative Interest Sensitive Gap	$	66,300		$	49,443		$	51,904

Ratio of cumulative gap to total Interest Sensitive Assets		22.32	%		16.65	%		17.47	%

(1) All AFS securities are shown at the market value and HTM are shown at book value.

(2) Non-performing loans are included as interest-earning assets.

(3) All assets and liabilities in these categories are fixed rates.

Lending Activities

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

At December 31, 2005, the Company's loan portfolio constituted approximately 81.0% of the Company's total assets, approximately 82.9% for the Bank, and 76.7% for Eagle. Table 8 sets forth the composition of the Company's loan portfolio at the indicated dates.

Loan Portfolio Composition
Years Ending December 31,

	2005					2004					2003					2002					2001
	Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent			Amount		Percent
Commercial, financial and agricultural	$	86,039		32.40	%	$	61,742		30.09	%	$	42,420		26.97	%	$	28,034		22.48	%	$	20,424		19.42	%
Real estate - construction		47,071		17.72	%		36,824		17.94	%		24,081		15.31	%		20,517		16.46	%		13,190		12.54	%
Real estate - mortgage		45,645		17.19	%		38,193		18.61	%		28,185		17.92	%		28,331		22.72	%		30,828		29.32	%
Real estate - commercial		79,608		29.98	%		61,860		30.14	%		56,527		35.94	%		41,926		33.62	%		34,541		32.85	%
Consumer loans		7,191		2.71	%		6,602		3.22	%		6,077		3.86	%		5,880		4.72	%		6,170		5.87	%
Total loans	$	265,554		100.00	%	$	205,221		100.00	%	$	157,290		100.00	%	$	124,688		100.00	%	$	105,154		100.00	%

Table 9 sets forth the scheduled maturities of the loans in the Company's loan portfolio as of December 31, 2005 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.

Loans Maturing

Year-end balance as of December 31, 2005

(In thousands)	Less than One Year		1 to 5 Years		Over 5 Years		Total
Commercial, financial and agricultural	$	77,239	$	8,795	$	5	$	86,039
Real estate - construction		46,229		842		0		47,071
Real estate - mortgage		36,636		8,378		631		45,645
Real estate - commercial		55,815		22,991		802		79,608
Consumer		3,565		3,514		112		7,191
Total Loans	$	219,484	$	44,520	$	1,550	$	265,554

Types of Loans

Commercial, industrial, and non-farm non-residential loans, hereinafter referred to as commercial loans (excluding commercial construction loans) totaled $86.0 million or 32.4% of the Company’s loan portfolio at December 31, 2005. Commercial loans consist of loans and lines of credit to individuals, partnerships and corporations for a variety of business purposes, such as accounts receivable and inventory financing, equipment financing, business expansion and working capital. The terms of the Bank's commercial loans generally range from 90 days to a 15 year amortization with a five year balloon. The loans generally carry interest rates, which adjust in accordance with changes in the prime rate, but when appropriate will be fixed to match the borrower’s needs. Substantially all of the Bank's commercial loans are secured and are guaranteed by the principals of the borrower. This is the fastest growing area of the loan portfolio and is being staffed to continue this trend. The Bank believes this area has the best potential for future growth and has the highest barriers of entry to our competitors.

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

Real Estate - Construction Loans

As of December 31, 2005, Cornerstone had $47.1 million in construction and development loans outstanding, which represented 17.7% of the loan portfolio. All construction and development loans are held in the Bank’s loan portfolio. The Bank makes residential construction loans to owner-occupants and to persons building residential properties for resale. The Bank has two main areas of construction loans: one is to residential real estate developers for speculative or custom single-family residential properties, and the other is to custom commercial construction projects with guaranteed takeout provisions. Construction loans are usually variable rate loans made for terms of one year or less, but extensions are permitted if construction has continued satisfactorily and if the loan is current and other circumstances warrant the extension. Construction loans are limited to 80% of the appraised value of the lot and the completed value of the proposed structure.

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

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

Real Estate - Mortgage Loans

At December 31, 2005, real estate mortgage loans totaled $45.6 million or 17.2% of the Company's loan portfolio. Real estate mortgage loans include all one to four family residential loans secured by real estate for purposes other than construction or acquisition and development. All real estate loans are held in the Bank’s loan portfolio except for loans that are designated as loans held for sale. The loans held for sale are FHLB or FNMA qualified and have been pre-approved by an underwriting specialist prior to closing. As of December 31, 2005, the Bank held $603 thousand of these secondary market mortgages. The remainder of the Bank’s mortgage loans are home equity loans and are made at fixed interest rates for terms of one to three years with balloon payment provisions and amortized over a 10 to 15 year period. The Bank's experience indicates that real estate loans normally remain outstanding for much shorter periods (seven years on average) than their stated maturity because the borrowers repay the loans in full either upon the sale of the secured property or upon the refinancing of the original loan.

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

At December 31, 2005, commercial real estate mortgage loans totaled $ 79.6 million or 30.0% of the Company's loan portfolio. Commercial real estate mortgage loans include all one to four family residential loans secured by real estate for purposes other than construction or acquisition and development. All real estate loans are held in the Bank’s loan portfolio except for loans that have been participated to correspondent banks. The Bank will sell these participations once a loan exceeds the Bank’s legal lending limit or 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 10-15 year period, but whenever possible the Bank will seek a variable rate loan which would be tied to the New York prime rate and adjusted monthly. The Bank's experience indicates that real estate loans normally remain outstanding for much shorter periods (seven years on average) than their stated maturity because the borrowers repay the loans in full either upon the sale of the secured property or upon the refinancing of the original loan.

Commercial real estate loans are made for up to 85% of the value of the property securing the loan, based upon an appraisal if the loan amount is over $100,000. The Bank also requires title insurance to insure the priority of the property lien on its real estate loans over $50,000 and requires fire and casualty insurance on all of its loans.

At December 31, 2005, consumer loans totaled $7.2 million or 2.7% of the Company's loan portfolio. These loans consist of consumer installment loans and consumer credit card balances. As of December 31, 2005, the Bank had $951 thousand credit card balances outstanding

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

As of December 31, 2005, commitments under standby letters of credit and undisbursed loan commitments aggregated approximately $63,972,000. This number includes all lines that have not been fully drawn and loan commitments in the same status.

Origination, Purchase and Sale of Loans

The Bank originates loans primarily in Hamilton County, Tennessee. The Bank also originates loans in Marion, Sequatchie, and Bradley Counties in Tennessee, and Dade, Walker and Catoosa Counties in Georgia, each of which is contiguous to Hamilton County. Loans are originated by thirteen loan officers who operate from the Bank's offices in Chattanooga. These loan officers actively solicit loan applications from existing customers, local manufacturers and retailers, builders, real estate developers, real estate agents and others. The Bank also receives numerous loan applications as a result of customer referrals and walk-ins to its offices.

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

The Bank’s loan approval process is intended to be conservative but also responsive to customer needs. Loans are approved in accordance with the Bank's written loan policy, which provides for several tiers of approval authority, based on a borrower's aggregate debt with the Bank. Certain loan officers have the authority to approve loans of up to $ 500,000. All other loan officers have the authority to approve secured loans of up to at least $ 25,000. There is an Officers Loan Committee comprised of the senior officers of the Bank which must approve any loan that increases the borrower’s aggregate indebtedness above an individual officer’s limit, but that is not more than $ 2,000,000. The Directors Loan Committee must approve all loans over $ 2,000,000 up to $ 4,500,000. All loans above $4,500,000 up to the Bank’s legal lending limit must be approved by the Board of Directors of the Bank. The Bank’s legal lending limit is 25% of the Bank’s qualifying equity for secured loans and 15% for unsecured loans.

The Bank has in the past purchased and sold commercial loan participations with correspondent banks and will continue the practice when management feels the action would be in the best interest of shareholders. The purchase of loan participations allows the Bank to expand its loan portfolio and increase profitability while still maintaining the high credit standards, which are applied to all extensions of credit made by the Bank. The sale of loan participations allows the Bank to make larger loans and retain a servicing fee for its labor, which it otherwise would be unable to make due to capital or other funding considerations. As of the end December 31, 2005, the Bank had participations purchased totaling $4.5 million and participations sold of $20.8 million.

Loan Fee Income

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

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

The Bank also receives miscellaneous fee income from late payment charges, overdraft fees, property inspection fees, and miscellaneous services related to its existing loans. For the year ended December 31, 2005, the Bank recognized origination, commitment and other loan fees totaling $1,631,844, which equaled 8.4% of the Company’s total loan interest income for the year.

Problem Loans and Allowance for Loan Losses

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

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

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

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

The Bank's collection procedures provide that when a loan becomes 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 "real estate owned" until it is sold and is carried at the lower of cost or fair value less estimated costs to dispose. Accounting standards define fair value as the amount that is expected to be received in a current sale between a willing buyer and seller other than in a forced or liquidation sale. Fair values at foreclosure are based on appraisals. Losses arising from the acquisition of foreclosed properties are charged against the allowance for loan losses. Subsequent write-downs are provided by a charge to income through losses on other real estate in the period in which the need arises.

The Bank attempts to sell real estate owned promptly after foreclosure, and sold $224,696 of its real estate owned due to loan foreclosures during the year ended December 31, 2005. The book value of real estate owned that was sold by the Bank during the year ended December 31, 2005 totaled $244,916. As of December 31, 2005, the Bank had $776,136 in value of real estate owned as a result of foreclosure.

Table 10 sets forth information regarding the Company's delinquent and non-performing assets as of the dates indicated.

Allowance for Loan Losses

(in thousands)		2005			2004			2003			2002			2001
Average loans	$	236,265		$	181,335		$	141,586		$	107,676		$	90,860

Allowance for possible loan losses,
Beginning of the period	$	2,658		$	2,011		$	1,591		$	1,322		$	1,142

Charge-offs for the period:
Commercial, financial and agricultural		275			165			223			423			129
Real estate - construction		48			0			0			0			0
Real estate - mortgage		128			138			6			12			69
Consumer		111			69			106			2			60

Total charge-offs		562			372			335			497			403

Recoveries for the period:
Commercial, financial and agricultural		12			149			183			75			108
Real estate - construction		1			0			3			0			1
Real estate - mortgage		6			7			0			7			3
Consumer		28			23			24			27			36

Total recoveries		47			179			210			109			148

Net charge-offs for the period		515			186			125			388			255

Provision for loan losses		1402			840			545			683			435
Adjustments		0			0			0			(26	)		0

Allowance for possible loan losses, end of period	$	3,545		$	2,658		$	2,011		$	1,591		$	1,322

Ratio of allowance for loan losses to total average loans outstanding		1.50	%		1.47	%		1.42	%		1.48	%		1.46	%

Ratio of net charge-offs during the period to average loans outstanding during the period		0.22	%		0.10	%		0.09	%		0.36	%		0.28	%

Securities available for sale:	2005		2004		2003
U.S. Government and agency obligations	$	22,349	$	10,977	$	11,088
Mortgage-backed and other securities		4,000		11,326		11,208
State & political subdivisions tax-exempt		3,285		3,140		1,453
Corporate debt		494		1,027		1,659
Totals	$	30,128	$	26,470	$	24,408

Securities held to maturity:
U.S. Government and agency obligations	$	0	$	0	$	0
Mortgage-backed and other securities		322		391		641
State & political subdivisions tax-exempt		0		0		0
Corporate debt		0		0		0
Totals	$	322	$	391	$	641

Federal Home Loan Bank stock, at cost		1,034		854		582

Total Securities	$	31,484	$	27,715	$	26,049

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

Total Securities Available for Sale	$	30,128		4.51	%


Total Securities held to maturity	$	322	6.02	%

Federal Home Loan Bank stock, at cost	$	1,034	4.87	%

Total Securities	$	31,484	4.54	%

(In thousands)	2005		2004		2003
Demand deposits	$	42,118	$	34,024	$	22,327
NOW deposits		33,080		32,855		28,514
Savings & money market deposits		55,411		31,211		27,712
Time deposits under $100,000		83,119		59,653		58,535
Time deposits $100,000 and over		38,707		30,089		22,264
Total Deposits	$	252,435	$	187,832	$	159,352

Delinquent and Non-performing Assets
Actual for Years Ending December 31,

	2002					2001
(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	$	537		22.48	%	$	388		19.42	%
Real estate - construction		524		16.46	%		332		12.54	%
Real estate - commercial		245		22.71	%		251		32.85	%
Real estate - mortgage		138		33.62	%		200		29.32	%
Consumer		147		4.72	%		151		5.87	%
Totals	$	1,591		100.00	%	$	1,322		100.00	%

TABLE 18
	December 31, 2005			December 31, 2004
Average loans to average deposits		109.04	%		104.73	%

	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

Exhibit No.		Description

3.1		Amended and Restated Charters of Cornerstone Bancshares, Inc. (1)
3.2		First Amendment to Amended and Restated Charter of Cornerstone Bancshares, Inc. (2)
3.3		Amended and Restated Bylaws of Cornerstone Bancshares, Inc. (3)
4		The right of securities holders are defined in the Charter and Bylaws provided in exhibits 3.1, 3.2 and 3.3 respectively.

10.1		Cornerstone Community Bank Employee Stock Ownership Plan
14		Code of Ethics. (5)
21		Subsidiaries of the registrant.
31		Certifications of chief executive officer and chief financial officer
32		Section 906 certifications of chief executive officer and chief financial officer.

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
December 31, 2005 and 2004

	2005			2004

ASSETS

Cash and due from banks	$	14,590,499		$	6,900,054
Securities available for sale		30,127,486			26,470,691
Securities held to maturity (fair value of
$321,408 in 2005 and $393,097 in 2004)		322,180			390,599
Federal Home Loan Bank stock, at cost		1,033,900			854,200
Loans, net of allowance for loan losses of
$3,545,042 in 2005 and $2,665,464 in 2004		262,008,632			202,555,862
Bank premises and equipment, net		7,207,146			5,967,735
Accrued interest receivable		1,739,460			1,184,478
Goodwill and amortizable intangibles		3,376,892			2,541,476
Other assets		3,205,706			1,749,539

Total assets	$	323,611,901		$	248,614,634

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	42,118,351		$	34,024,241
Interest-bearing demand deposits		33,080,446			32,855,396
Savings deposits and money market accounts		55,410,928			31,211,457
Time deposits of $100,000 or more		38,707,366			30,089,057
Time deposits under $100,000		83,118,799			59,652,751
Total deposits		252,435,890			187,832,902

Accrued interest payable		242,864			91,595
Federal funds purchased and securities sold under
agreements to repurchase		4,790,737			7,409,162
Federal Home Loan Bank advances		30,000,000			27,000,000
Other liabilities		3,676,047			1,473,655

Total liabilities		291,145,538			223,807,314

Stockholders' equity:
Preferred stock - no par value; 2,000,000 shares
authorized; no shares issued		—			—
Common stock - $1.00 par value; 10,000,000 shares authorized
in 2005 and 2004; shares issued and outstanding - 3,201,334
in 2005 and 2,868,823 in 2004		3,201,334			2,868,823
Common stock subscribed; 119,961 shares in 2004		—			119,961
Additional paid-in capital		21,211,135			19,160,936
Retained earnings		8,229,552			4,340,981
Accumulated other comprehensive income		(165,955	)		116,034

		32,476,066			26,606,735
Treasury stock, 471 shares in 2005, at cost		(9,703	)		—
Stock subscriptions receivable		—			(1,799,415	)

Total stockholders' equity		32,466,363			24,807,320

Total liabilities and stockholders' equity	$	323,611,901		$	248,614,634


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

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
Years Ended December 31, 2005, 2004 and 2003

													Accumulated
						Common		Additional					Other					Stock			Total
	Comprehensive			Common		Stock		Paid-in		Retained			Comprehensive			Treasury		Subscriptions			Stockholders'
	Income			Stock		Subscribed		Capital		Earnings			Income			Stock		Receivable			Equity

BALANCE, December 31, 2002				$	1,233,167	$	—	$	12,093,868	$	1,538,341		$	281,374		$	—	$	—		$	15,146,750

Issuance of common stock					10,000		—		90,000		—			—			—		—			100,000

Dividends - $.10 per share					—		—		—		(124,316	)		—			—		—			(124,316	)

Comprehensive income:
Net income	$	1,881,859			—		—		—		1,881,859			—			—		—			1,881,859

Other comprehensive income, net of tax:
Unrealized holding gains (losses) on
securities available for sale, net of
reclassification adjustments		(100,792	)		—		—		—		—			(100,792	)		—		—			(100,792	)

Total comprehensive income	$	1,781,067

BALANCE, December 31, 2003					1,243,167		—		12,183,868		3,295,884			180,582			—		—			16,903,501

Issuance of common stock					382,039		—		5,297,614		—			—			—		—			5,679,653

Dividends - $.10 per share					—		—		—		(282,369	)		—			—		—			(282,369	)

Split-up effected in the form of a dividend					1,243,617		—		—		(1,243,617	)		—			—		—			—

Stock subscriptions subscribed					—		119,961		1,679,454		—			—			—		(1,799,415	)		—

Comprehensive income:
Net income	$	2,571,083			—		—		—		2,571,083			—			—		—			2,571,083

Other comprehensive income, net of tax:
Unrealized holding gains (losses) on
securities available for sale, net of
reclassification adjustment		(64,548	)		—		—		—		—			(64,548	)		—		—			(64,548	)

Total comprehensive income	$	2,506,535

BALANCE, December 31, 2004				$	2,868,823	$	119,961	$	19,160,936	$	4,340,981		$	116,034		$	—	$	(1,799,415	)	$	24,807,320


(continued on page F-5)

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 2005, 2004 and 2003

	2005
	Gross		Gross
	Amortized		Unrealized		Unrealized			Market
	Cost		Gains		Losses			Value

Securities available for sale:
U.S. Government agencies	$	22,652,365	$	—	$	(303,023	)	$	22,349,342

State and municipal securities		3,261,104		54,620		(30,855	)		3,284,869

Mortgage-backed securities		3,964,527		35,399		(401	)		3,999,526

Corporate debt securities		500,937		—		(7,187	)		493,750

	$	30,378,933	$	90,019	$	(341,466	)	$	30,127,486

Securities held to maturity:
Mortgage-backed securities	$	322,180	$	985	$	(1,757	)	$	321,408


		2004
		Gross		Gross
		Amortized		Unrealized		Unrealized			Market
		Cost		Gains		Losses			Value

Securities available for sale:
U.S. Government agencies	$	10,980,741	$	14,936	$	(18,565	)	$	10,977,112

State and municipal securities		3,075,221		83,549		(18,484	)		3,140,286

Mortgage-backed securities		11,224,993		102,076		(137	)		11,326,932

Corporate debt securities		1,013,926		12,435		—			1,026,361

	$	26,294,881	$	212,996	$	(37,186	)	$	26,470,691

Securities held to maturity:
Mortgage-backed securities	$	390,599	$	3,578	$	(1,080	)	$	393,097

	Securities Available for Sale				Securities Held to Maturity
	Amortized		Market		Amortized		Market
	Cost		Value		Cost		Value

Due in one year or less	$	500,937	$	493,750	$	—	$	—
Due from one year to five years		23,218,578		22,914,417		—		—
Due from five years to ten years		598,171		618,663		—		—
Due after ten years		2,096,720		2,101,130		—		—

		26,414,406		26,127,960		—		—

Mortgage-backed securities		3,964,527		3,999,526		322,180		321,408

	$	30,378,933	$	30,127,486	$	322,180	$	321,408

	2005			2004
Mortgage loans on real estate:
Residential 1-4 family	$	26,118		$	23,521
Residential multifamily (5 or more)		9,374			6,153
Held for sale		603			346
Commercial		79,608			61,860
Construction		47,071			36,824
Second mortgages		3,216			2,032
Equity lines of credit		6,334			6,141
		172,324			136,877
Commercial loans		86,039			61,742

Consumer installment loans:
Personal		6,240			6,273
Credit cards		951			329
		6,602			7,191
Total loans		265,554			205,221
Less: Allowance for loan losses		(3,545	)		(2,665	)
Loans, net	$	262,009		$	202,556

	2005			2004

Land	$	1,625,567		$	1,625,567
Buildings and improvements		3,388,834			3,076,321
Furniture, fixtures and equipment		5,113,021			3,248,714
		10,127,422			7,950,602
Accumulated depreciation		(2,920,276	)		(1,982,867	)
	$	7,207,146		$	5,967,735

2006	$	152,000
2007		156,258
2008		130,518
2009		134,325
2010		137,700
Thereafter		626,805

Total	$	1,337,606

2006	$	92,418,648
2007		21,847,389
2008		4,359,272
2009		1,124,036
2010		2,074,786
Thereafter		2,034

Total	$	121,826,165


	2005		2004

Deferred tax assets:
Deferred compensation	$	140,716	$	141,864
Deferred loan fees		213,710		236,316
Allowance for loan losses		1,113,947		752,720
Deferred gains		—		56,344
Net unrealized loss on securities available for sale		85,492		—
Other		108,612		24,432

		1,662,477		1,211,676

Deferred tax liabilities:
Net unrealized gain on securities available for sale		—		59,775
Depreciation		260,174		364,975
Life insurance		156,443		148,632
Other		5,220		3,373

		421,837		576,755

Net deferred tax asset	$	1,240,640	$	634,921

	2005		2004
Long-term advance dated December 27, 2000,
requiring monthly interest payments, fixed
at 5.00% until conversion option is exercised,
principal due in December 2010	$	2,000,000	$	2,000,000

Long-term advance dated November 1, 2001,
requiring monthly interest payments, fixed
at 3.94% until November 2006, principal due
in November 2011		2,000,000		2,000,000

Long-term advance dated February 22, 2002,
requiring monthly interest payments, fixed
at 3.96% until February 2005, principal due
in February 2012		—		2,000,000

Long-term advance dated April 26, 2002,
requiring monthly interest payments, fixed
at 4.11% until conversion option is exercised,
principal due in April 2012		2,000,000		2,000,000

Long-term advance dated September 13, 2002,
requiring monthly interest payments, fixed
at 3.51% until September 2007, principal due
in September 2012		2,000,000		2,000,000

Long-term advance dated January 17, 2003,
requiring monthly interest payments, fixed
at 2.61% until January 2006, principal due
in January 2013		4,000,000		4,000,000

Long-term advance dated April 25, 2003,
requiring monthly interest payments, fixed
at 2.41% until April 2006, principal due
in April 2013		3,000,000		3,000,000

Long-term advance dated January 23, 2004,
requiring monthly interest payments, fixed
at 2.50% until January 2007, principal due
in January 2014		5,000,000		5,000,000

Long-term advance dated May 27, 2004,
requiring monthly interest payments, fixed
at 3.46% until May 2007, principal due
in May 2014		5,000,000		5,000,000

Long-term advanced dated February 9, 2005,
requiring monthly interest payments, fixed
at 3.86% until February 2010, principal due
in February 2015		5,000,000		—
	$	30,000,000	$	27,000,000

	2005				2004
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value

Assets:
Cash and due from banks	$	14,590	$	14,590	$	6,900	$	6,900
Securities		30,450		30,449		26,861		26,864
Federal Home Loan Bank stock		1,034		1,034		854		854
Loans, net		262,009		261,553		202,556		202,089

Liabilities:
Noninterest-bearing demand deposits	$	42,118	$	42,118	$	34,024	$	34,024
Interest-bearing demand deposits		33,080		33,080		32,855		32,855
Savings deposits and money market accounts		55,411		55,411		31,212		31,212
Time deposits		121,826		120,828		89,742		89,548
Federal funds purchased and securities
sold under agreements to repurchase		4,791		4,791		7,409		7,409
Federal Home Loan Bank advances		30,000		30,000		27,000		27,000

Unrecognized financial instruments
(net of contract amount):
Commitments to extend credit		—		—		—		—

	Outstanding Options					Exercisable Options
	Number			Weighted Average Exercise Price		Number			Weighted Average Exercise Price

Outstanding, December 31, 2002		260,000		$	5.00		260,000		$	5.00
Options exercised		(20,000	)		5.00		(20,000	)		5.00

Outstanding, December 31, 2003		240,000			5.00		240,000			5.00
Options granted		10,000			10.88		—			—

Outstanding, December 31, 2004		250,000			5.24		240,000			5.00
Options granted		5,000			18.45		—			—
Options exercised		(209,000	)		5.00		(209,000	)		5.00
Options forfeited		(1,000	)		14.67		—			—
Options which became exercisable		—			—		5,000			10.88

Outstanding, December 31, 2005		45,000			7.59		36,000			5.81

						For Capital
	Actual					Adequacy Purposes
	Amount		Ratio			Amount		Ratio

As of December 31, 2005
Total capital to risk-weighted assets:
Consolidated	$	32,840		11.5	%	$	22,943		8.0	%
Cornerstone Community Bank		29,488		10.5	%		22,435		8.0	%

Tier I capital to risk-weighted assets:
Consolidated		29,255		10.2	%		11,471		4.0	%
Cornerstone Community Bank		25,983		9.3	%		11,218		4.0	%

Tier I capital to average assets:
Consolidated		29,255		10.3	%		11,338		4.0	%
Cornerstone Community Bank		25,983		9.2	%		11,336		4.0	%

As of December 31, 2004
Total capital to risk-weighted assets:
Consolidated	$	24,788		11.4	%	$	17,456		8.0	%
Cornerstone Community Bank		22,512		10.3	%		17,456		8.0	%

Tier I capital to risk-weighted assets:
Consolidated		22,150		10.2	%		8,728		4.0	%
Cornerstone Community Bank		19,873		9.1	%		8,728		4.0	%

Tier I capital to average assets:
Consolidated		22,150		10.0	%		8,944		4.0	%
Cornerstone Community Bank		19,873		9.0	%		8,843		4.0	%

				Tax
	Before-Tax			(Expense)		Net-of-Tax
	Amount			Benefit		Amount

Year ended December 31, 2005:
Unrealized holding gains and losses
arising during the period	$	(427,257	)	$	145,268	$	(281,989	)

Less reclassification adjustment for
gains realized in net income		—			—		—

	$	(427,257	)	$	145,268	$	(281,989	)

Year ended December 31, 2004:
Unrealized holding gains and losses
arising during the period	$	(97,800	)	$	33,252	$	(64,548	)

Less reclassification adjustment for
gains realized in net income		—			—		—

	$	(97,800	)	$	33,252	$	(64,548	)

Year ended December 31, 2003:
Unrealized holding gains and losses
arising during the period	$	(152,714	)	$	51,922	$	(100,792	)

Less reclassification adjustment for
gains realized in net income		—			—		—

	$	(152,714	)	$	51,922	$	(100,792	)

BALANCE SHEETS

	2005		2004

ASSETS
Cash	$	516,559	$	2,675,690
Investment in subsidiaries		27,511,971		19,989,410
Loan to subsidiary		1,428,794		—
Goodwill		2,541,476		2,541,476
Other assets		726,626		1,370

Total assets	$	32,725,426	$	25,207,946

LIABILITIES AND STOCKHOLDERS’ EQUITY
Other liabilities	$	259,063	$	400,626

Stockholders’ equity		32,466,363		24,807,320

Total liabilities and stockholders’ equity	$	32,725,426	$	25,207,946

STATEMENTS OF INCOME

	2005			2004			2003

INCOME
Dividends	$	200,000		$	177,039		$	—
Interest income		10,000			—			—

		210,000			177,039			—

EXPENSES
Interest expense		—			38,485			5,540
Other operating expenses		263,824			203,881			133,317

Loss before equity in undistributed earnings of subsidiary		(53,824	)		(65,327	)		(138,857	)

Equity in undistributed earnings of subsidiary		4,261,344			2,544,910			1,969,516

Income tax benefit		116,999			91,500			51,200

Net income	$	4,324,519		$	2,571,083		$	1,881,859


	CORNERSTONE BANCSHARES, INC.

Date: March 15, 2006	By:	/s/ Gregory B. Jones
		Gregory B. Jones Chairman and Chief Executive Officer (principal executive officer)


	By	/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes President and Treasurer (principal financial officer and accounting officer)

Signature		Title


/s/ Gregory B. Jones		Chairman of the Board and Chief Executive Officer
Gregory B. Jones		and Director (principal executive officer)



/s/ B. Kenneth Driver		Director
B. Kenneth Driver



/s/ Karl Fillauer		Director
Karl Fillauer



/s/ Nathaniel F. Hughes		President and Treasurer
Nathaniel F. Hughes		(principal financial officer and accounting officer) and
		Director


/s/ Jerry D. Lee		Executive Vice President and Senior Lender
Jerry D. Lee		and Director



/s/ James H. Large		Director
James H. Large



/s/ Lawrence D. Levine		Director
Lawrence D. Levine



/s/ Earl A. Marler, Jr.		Director
Earl A. Marler, Jr.



/s/ Frank S. McDonald		Director
Frank S. McDonald



/s/ Doyce G. Payne		Director
Doyce G. Payne



/s/ Turner Smith		Director
Turner Smith



/s/ W. Miller Welborn		Director
Miller Welborn



/s/ Billy O. Wiggins		Director
Billy O. Wiggins



/s/ Marsha Yessick		Director
Marsha Yessick

Name of Subsidiary	State of Incorporation

Cornerstone Community Bank	Tennessee

Eagle Financial, Inc.	Tennessee

	/ s/ Gregory B. Jones
	Gregory B. Jones
	Chairman and Chief Executive Officer




	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes
	President and Treasurer