Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-KSB

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

For the fiscal year ended December 31, 2003

Commission file number 000-30497

CORNERSTONE BANCSHARES, INC.

(Name of Small Business Issuer in Its Charter)

Tennessee	62-1173944
(State of Incorporation)	(I.R.S. Employer Identification No.)
5319 Highway 153 Chattanooga,  Tennessee  37343
(Address of principal executive offices)(Zip Code)
(423) 385-3000
(Issuer’s telephone number)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, Par Value $1.00 Per Share

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

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. ý

Revenues for the Registrant’s fiscal year ended December 31, 2003, total $12,568,291.

The aggregate market value of the Registrant’s outstanding Common Stock held by nonaffiliates of the Registrant on January 31, 2003 was approximately $25,618,510.  There were 1,243,617 shares of Common Stock outstanding as of January 31, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrants definitive 2004 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, 2003

Table of Contents

Item Number
Part I
1.	Description of Business
2.	Description of Property
3.	Legal Proceedings
Part II
5.	Market for Common Equity and Related Stockholder Matters
6.	Management’s Discussion and Analysis or Plan of Operation
7.	Financial Statements
8.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
8A.	Controls and Procedures
Part III
9.	Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act
10.	Executive Compensation
11.	Security Ownership of Certain Beneficial Owners and Management
12.	Certain Relationships and Related Transactions
13.	Exhibits and Reports on Form 8-K
14.	Principal Accountant Fees and Services

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Forward-Looking Statements

In addition to the historical information contained herein, this report contains certain forward-looking statements including statements relating to present or future factors generally affecting the banking industry and specifically affecting the operations, markets, and products of Cornerstone Bancshares, Inc. (the “Company”) and Cornerstone Community Bank (the “Bank”).  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 and the Bank’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.

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PART I

ITEM 1.  DESCRIPTION OF BUSINESS

Business Development

Cornerstone Bancshares, Inc. (the “Company” or “Cornerstone”) 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.  Its wholly-owned subsidiary, 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.

Business of the Company

The Company

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

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

The Bank

The Bank’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, various states and their political subdivisions.  In addition to deposits, sources of funds for the Bank’s loans and other investments include amortization and prepayment of loans, sales of loans or participations in loans, sales of its investment securities and borrowing 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.

Employees

As of February 17, 2004, Cornerstone and the Bank collectively had 73 full-time equivalent employees of whom 68 are full-time, and 10 are part-time. The employees are not represented by a collective bargaining unit.  Cornerstone and the Bank believe that their relationships with their employees are good.

Customers

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

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Competition

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

Based on total deposits of approximately $159,544,000 at December 31, 2003, the Bank represents 2.43% of the deposit base in the Chattanooga, Tennessee-Georgia Metropolitan Statistical Area (“Chattanooga MSA”).  Three major regional banks represent approximately 61% 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

General

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

The Bank is a Tennessee-chartered commercial bank and is subject to the supervision and regulation of the Tennessee Department of Financial Institutions (the “TDFI”).  In addition, the Bank’s deposit accounts are insured up to applicable limits by the Bank Insurance Fund (the “BIF”) of the Federal Deposit Insurance Corporation (the “FDIC”) and is, therefore, 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

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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, 2003.  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  $20,814 in assessments during the year ended December 31, 2003.

Subsequent to the enactment of 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 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, 2003, the Bank had Tier 1 capital of $14.6 million or 8.30% 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 (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

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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 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 Federal Deposit Insurance Act (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, limits 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

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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 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 statutory and regulatory provisions and is qualified in its entirety by reference to the particular statutory and regulatory provisions.

Far-reaching legislation, including the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), and the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) have for years impacted the business of banking.  FIRREA primarily affected the regulation of savings institutions rather than the regulation of 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 the 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.

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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:

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

(ii)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;

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

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

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

(vi)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;

(vii)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;

(viii)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;

(ix)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;

(x)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);

(xi)uniform regulations regarding real estate lending; and

(xii)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

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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, 2003, the principal offices of the Company and the Bank were located at 5319 Highway 153, Chattanooga, Tennessee 37343.  This property is owned by the Company.  The Bank operates four full-service branches in Hamilton County, Tennessee:

5319 Highway 153, Chattanooga, Tennessee

4154 Ringgold Road, East Ridge, Tennessee

610 Georgia Avenue, Chattanooga, Tennessee

2280 Gunbarrel Road, Chattanooga, Tennessee

The Georgia Avenue branch contains 1800 square feet and is leased pursuant to a lease agreement, which provides for 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 and 5319 Highway 153.

The Bank owns a lot on Old Lee Highway, Ooltewah, Tennessee and is in the process of building a full-service branch on that location.  In addition, the Bank acquired through foreclosure a building located at 2433 Broad Street, Chattanooga, Tennessee for use as a storage facility.

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 7800 square feet and is leased pursuant to a lease agreement, which provides for an initial term of 5 years with one five-year renewal option.  Rent is currently $ 54,600 per annum.

ITEM 3.  LEGAL PROCEEDINGS

As of the end of 2003, the neither the Company nor the Bank was involved in any material litigation.  The Bank is periodically involved as a plaintiff or defendant in various legal actions in the ordinary course of its business.  Management believes that 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.

PART II

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 a national securities exchange.  Morgan Keegan, a subsidiary of Regions Bank, is the principal market maker for Cornerstone stock. There are five other market makers who assist in providing a market.

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The following table sets forth the high and low closing prices of the Company’s common stock for the periods indicated, as reported by published sources.  The prices reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not represent actual transactions.

	Low		High
2004 Fiscal Year
First Quarter (through March  , 2004)	$	20.0	$	22.5
2003 Fiscal Year
First Quarter	$	12.5	$	14.5
Second Quarter	$	12.1	$	17.5
Third Quarter	$	16.5	$	19.0
Fourth Quarter	$	17.9	$	23.3
2002 Fiscal Year
First Quarter	$	13.0	$	13.0
Second Quarter	$	13.0	$	13.0
Third Quarter	$	13.0	$	13.0
Fourth Quarter	$	13.0	$	13.0

There were approximately 567 holders of record of the common stock as of December 31, 2003.   This number does not include shareholders with shares in nominee name held by DTC.

Cornerstone paid its first dividend on January 26, 2004 in the amount of $0.10 per share. The Company intends to continue to pay an annual dividend.  The Company’s board of directors will decide the amount of the next dividend during the fourth quarter of 2004 after consideration of capital needs required for expected growth of assets.  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.

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 Bank 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-lookingstatements to reflect the occurrence of changes or unanticipated events, circumstances, or results.

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Management’s Discussion And Analysis Or Plan Of Operation

General

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.

Summary

Net income for 2003 was $1,881,859 a 77% increase from Cornerstone’s net income of $1,061,423 in 2002.  Net income per common share of $1.52 for 2003 was 77% higher than 2002 net income per common share of $0.86.  Pretax income of $3,071,659 for 2003 increased $1,342,645 from 2002 pretax income of $1,729,014.

The increase in net income per common share from 2002 to 2003 comes directly from the dramatic growth of the Bank’s earning assets, especially average loans, which grew 31%.  This growth coupled with tight interest expense control helped the Bank realize a 27% increase in net interest income to $8,115,619.  Also contributing to the bottom line was a 24% increase in non-interest income.  Most of the increase was due to origination of secondary mortgages, which increased 47% from $200,094 to $293,453 in 2003.  Asset quality remained at its better than industry standard level during 2003 and the Bank enjoyed success in collection of past charge-offs.  The result was net charge–offs of $124,843, which allowed the Bank, even with the dramatic loan growth, to decrease its loan loss provision to $545,000 during 2003.  Non-interest expense increased 15% in 2003 due mostly to an increase in salaries and benefits of 26% as the Bank added staff to properly manage the growth and paid out profit sharing to help retain talented employees.  The Bank is optimistic the investment in quality employees will return continued improved earnings in the foreseeable future.

Business of the Company

The Company’s earnings depend primarily on the Bank’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 Bank 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 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 Bank 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, 2003 and 2002, the Company’s weighted average rate earned on all interest-earning assets was 6.79% and 7.37%, respectively, and the Company’s weighted average rate paid on all interest-bearing liabilities for the same years was 2.25% and 2.92%, respectively.  The Company’s interest rate spread for the years ended December 31, 2003 and 2002 therefore was 4.54% and 4.46%, respectively, and its net interest income for such years was $8,115,619 and $6,393,652, respectively.  For fiscal 2003, the Company recorded net income of $1,881,859 or $1.52 basic earnings per common share as compared with net income of $1,061,423 or $0.86 basic earnings per common share for fiscal 2002.  The increase in net income was due to a 27.0% increase in the Bank’s net interest income and a 23.9% increase in non-interest income, while non-interest expense increased only 15.2%.

The table 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

12

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.

	Years Ended December 31,
	2003		2002		2001
Net Interest Margin (Net interest income divided by average interest- earning assets)	4.87	%	4.86	%	4.38	%
Return on Average Assets (Net income divided by average total assets)	1.06	%	0.74	%	0.45	%
Return on Average Equity (Net income divided by average equity)	11.68	%	7.25	%	4.20	%
Equity-to-Assets (Average equity divided by average total assets)	9.04	%	10.21	%	10.68	%
Loans to Deposits (Average loans divided by average daily deposits)	101.21	%	90.92	%	83.96	%
Dividend Payout Ratio (Dividends paid by the Company divided by net income)	0.00	%	0.00	%	0.00	%

Results of Operations

Year ended December 31, 2003 compared to year ended December 31, 2002:

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 2003 increased $1,721,967 or 26.9% over 2002.  The increase in net interest income from 2002 to 2003 is due to material growth of the balance sheet and a shift in mix of assets and liabilities.  The shift in mix was most dramatic in the Bank’s loan portfolio as it increased from 75.0% of total average assets to 79.5% while earning assets increased to 93.9% of average assets compared with 91.9% in 2002.  Loan origination fees were 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 decreased from 2002 due to a general decrease in market interest rates during the reporting period.  The drop was large enough in scale to allow the Bank to grow average interest bearing liabilities 25.6% over 2002 while decreasing interest expense by $97,841.  The Bank plans to continue to aggressively attract deposits but does not anticipate interest expense to decrease in 2004.

Interest income increased $1,624,126 or 16.7% in 2003 from 2002.  Interest income produced by the loan portfolio increased $1,781,926 or 20.9% from 2002 to 2003.  Interest income on investment securities and Federal Funds sold decreased $157,800 or 14.0% from 2002 to 2003.  The increase in loan interest income was due to a large increase in the volume 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 securities income decrease was due to the generally lower interest rate environment, which presents few opportunities to invest without material interest rate risk exposure.  Total interest expense decreased $97.841 or

13

3.0% in 2003 from 2002.  The interest expense decrease from 2002 to 2003 was a result of a reduction in interest rates in 2003.

One of the most useful tools for measuring the ability of a small 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 net interest margin remained constant in 2003 at 4.87%.  The net interest spread, defined as the rate of interest income minus the rate of interest expense, increased 8 basis points from 4.46% in 2002 to 4.54% in 2003.  The yield on earning assets decreased 58 basis points to 6.79% in 2003 from 7.37% in 2002.

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 $2,011,329 as of December 31, 2003, 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, 2003, Cornerstone had $130,963 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 $239,715 or 23.9% from 2002 to 2003.  Fee income from service charges on deposit accounts increased $154,703 or 21.1% in 2003.  The Bank had no security gain in 2003.  Fees generated from the sale of loans sold to the secondary market increased $93,359 or 46.7% in 2003 due an exceptional amount of mortgage debt refinancing.  The Bank anticipates non-interest income to continue its double-digit growth in 2004 but has built a small decrease for secondary market loan sales in its expectation for 2004.

Non-interest Expense.  Non-interest expense for 2003 increased by $757,471 or 15.2% from 2002.  Salaries and employee benefits increased by $694,926 or 26.4% from $2,630,544 in 2002 to $3,325,470 in 2003.  Payroll expense increased as the Bank created a profit sharing plan to cover all employees to help retain talented personnel.  This, along with hiring of additional personnel to cover the growth of the Bank, accounted for the majority of the increase for 2003.  Occupancy expense increased 7.7% as the Bank operated four full service branches and began construction on its fifth.  All other non-interest expense increased $35,572 or 1.8% in 2003, with no material reductions or increases.

Financial Condition

Earning Assets.  Average earning assets in 2003 increased  $35.4 million or 26.8% over 2002 due to material loan growth in the first half of 2003.  This loan growth led the expansion of the balance sheet and the Bank funded the loan growth with a combination of FHLB borrowings and certificates of deposit.  The average security portfolio grew $1.8 million or 7.8% to maintain an appropriate number of securities for pledging purposes and liquidity.

Loan Portfolio.  The Bank’s average loans for 2003 were $141.6 million, an increase of 31.5% over $107.7 million in average loans for 2002.  The actual balance at the end of 2003 was $157.3 million, representing an increase of $32.6 million from 2002.  Loan growth for 2003, was uneven and heavily weighted to the first of the year with several large, high quality loans greatly increasing the Bank’s outstanding balances.  The growth was concentrated in commercial real estate.

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The Bank’s growth in loans was assisted by the new lenders hired in late 2002 who were able to complete the transfer of several material customer relationships once established with our organization.  The Bank plans to hire additional lenders in 2004 to round out our existing staff in the branches and staff the new branch in Ooltewah when it opens.  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 7.8% or $1.8 million from 2002 to 2003, while Federal Funds remained relatively constant.  The average investment portfolio and average federal funds sold for 2003 was $25.7 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 going up than down and as a result took a cautious interest rate stance and invested appropriately.  The two vehicles used the most often were US Agency LIBOR floaters that have rates tied to LIBOR and adjust their rates monthly, and US Agency callable notes structured with an interest rate cushion to protect the Bank if interest rates rise.  Both investments have a lower yield but are less likely to devalue if rates increase.  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 2003, unrealized gains in the “Available for Sale” portfolio amounted to $273,610.

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.  The Company had a third party determine that the fair value was in excess of the cost and as a result no impairment loss was required during 2003.

Deposits.  Cornerstone’s average deposits increased $21.5 million or 18.1% from 2002 to 2003.  From year-end 2002 to year-end 2003, total deposits increased $28.9 million or 22.2%.  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 2003 in attracting business and public deposits to the Bank.  Average interest bearing transaction accounts increased 29.5% while average demand deposits increased 23.0%.  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 $1.5 million or 10.0%.  The company had net income of $1,881,859 in 2003, and the value of the investment security portfolio’s unrealized gains, net of tax, decreased from $281.4 thousand to a $180.6 thousand.  The actual balance of stockholder’s equity increased $1.8 million or 11.6% from $15.1 million as of the end of 2002 to $16.9 million.

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Net Interest Income

The following table 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.

	Years Ended December 31,
	2003							2002							2001
(In thousands)	Average Balance			Interest Income/ Expense(1)		Average Yield/ Rate		Average Balance			Interest Income/ Expense(1)		Average Yield/ Rate		Average Balance			Interest Income/ Expense(1)		Average Yield/ Rate
ASSETS
Interest-earning assets:
Loans(1)(2)	$	141,586		$	10,326	7.29	%	$	107,676		$	8,544	7.94	%	$	90,680		$	8,151	8.99	%
Investment securities	24,118			980		4.16	%	22,338			1,124		5.12	%	20,299			1,261		6.21	%
Federal funds sold	1,550			20		1.29	%	1,844			34		1.84	%	4,072			168		4.14	%
Other earning assets	—					0.00	%	—					0.00	%	—					0.00	%
Total interest-earning assets	167,254			11,326		6.79	%	131,858			9,702		7.37	%	115,051			9,580		8.33	%
Allowance for loan losses	(1,843		)					(1,336		)					(1,184		)
Cash and other assets	12,791							13,035							13,043
Total assets	$	178,202						$	143,557						$	126,910
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest-bearing liabilities:
Deposits
NOW accounts	22,299			66		0.30	%	20,148			227		1.12	%	16,601			264		1.59	%
Money market / Savings accts	25,467			339		1.33	%	18,515			326		1.76	%	11,585			326		2.82	%
Time deposits, $100m and over	19,430			606		3.12	%	19,223			731		3.80	%	20,090			1,116		5.56	%
Time deposits, under $100 m	54,679			1,577		2.88	%	45,936			1,674		3.65	%	47,469			2,661		5.61	%
Total interest-bearing deposits	121,872			2,588		2.12	%	103,822			2,958		2.85	%	95,745			4,367		4.56	%
Federal funds purchased	2,248			33		1.47	%	641			12		1.91	%	36			1		2.31	%
Securities sold under agreement to repurchase	2,602			22		0.85	%	1,317			15		1.14	%	2,097			61		2.91	%
Other borrowings	16,123			568		3.52	%	7,688			324		4.21	%	2,329			113		4.84	%
Total interest-bearing liabilities	142,848			3,211		2.25	%	113,468			3,309		2.92	%	100,207			4,542		4.53	%
Other liabilities:
Demand deposits	18,017							14,607							12,263
Accrued interest payable and other liabilities	1,224							831							891
Total other liabilities	19,241							15,438							13,154
Total liabilities	162,089							128,906							113,361
Stockholders’ equity	16,113							14,651							13,549
Total Liabilities and stockholders’ equity	178,202							143,557							126,910

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	Years Ended December 31,
	2003		2002		2001
FINANCIAL RATIOS
Excess of interest-earning assets over interest-bearing liabilities	24,406		18,390		14,844
Ratio of interest-earning assets to interest-bearing liabilities	117.08	%	116.21	%	114.81	%
Net interest income	8,116		6,394		5,038
Interest rate spread (difference between rate earned on interest-earning assets and rate paid on interest-bearing liabilities)	4.54	%	4.46	%	3.80	%
Net interest margin (net interest income divided by average interest-earning assets)	4.87	%	4.86	%	4.38	%

(1)Interest income on loans includes amortization of deferred loan fees and other discounts of $ 115m, $ 33m, and $13m for the fiscal years ended December 31, 2003, 2002, and 2001, 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.

The following table 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, 2003.  Investment securities available for sale (“AFS”) and held to maturity (“HTM”) are shown at their book values.

(In thousands)	Amount	Average Yield/Rate
Interest-earning assets:
Loans	141,586	7.29	%
Investment securities	24,118	4.16	%
Federal funds sold	1,550	1.29	%
Total interest-earning assets	167,254	6.79	%
Interest-bearing liabilities:
NOW Accounts	22,299	0.30	%
Money market and savings accounts	25,467	1.33	%
Time deposits of $100,000 or more	19,430	3.12	%
Time deposits under $100m	54,679	2.88	%
Total deposits	121,875	2.12	%
Federal funds purchased	2,248	1.47	%
Securities sold under agreement to repurchase	2,602	0.85	%
Long term debt	16,123	3.52	%
Total interest-bearing liabilities	142,848	2.25	%

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Changes in interest income and interest expense 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.

	Year Ended December 31, 2003 Compared to 2002
(In thousands)	Volume	Rate	Mix	Net Change
Interest income:
Loans (1)(2)	2,472	-920	230	1,782
Investment securities	72	-255	39	-144
Federal funds sold	-4	-9	-1	-14
Other earning assets	0	0	0	0
Total interest income				1,624
Interest expense:
NOW accounts	6	-185	18	-161
Money market and saving accounts	91	-110	30	11
Time deposits, $100,000 and over	6	-132	1	-125
Time deposits, less than $100,000	252	-421	72	-97
Total deposits				-370
Other borrowings	296	-113	61	244
Federal Funds Purchased	24	-9	6	21
Securities sold under agreement to repurchase	11	19	-23	7
Total other interest-bearing liabilities				272
Total interest expense				-98
Change in net interest income (expense)				1,722

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	Year Ended December 31, 2002 Compared to 2001
(In thousands)	Volume	Rate	Mix	Net Change
Interest income:
Loans (1)(2)	1,349	-1,135	180	394
Investment securities	104	-244	3	-137
Federal funds sold	-41	-42	-51	-135
Other earning assets	0	0	0	0
Total interest income				122
Interest expense:
NOW accounts	40	-94	18	-36
Money market and saving accounts	122	-195	73	0
Time deposits, $100,000 and over	-41	-336	-19	-396
Time deposits, less than $100,000	-56	-896	-25	-977
Total deposits				-1,409
Other borrowings	226	-48	33	211
Federal Funds Purchased	12	-3	17	26
Securities sold under agreement to repurchase	-1	-37	-23	-61
Total other interest-bearing liabilities				176
Total interest expense				-1,233
Change in net interest income (expense)				1,356

(1) Loan amounts include non-accruing loans.

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

The following table sets forth the re-pricing of the Company’s interest earning assets and interest-bearing liabilities as of December 31, 2003.  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 negative one-year cumulative GAP position of (1.25%) and is actively seeking adjustable rate loans and longer-term liabilities to increase the Bank’s positive sensitivity.  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.

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(In thousands)	Less than One Year		1 to 5 Years		Over 5 Years		Total
Interest Sensitive Assets
Federal Funds sold	3,060		0		0		3,060
Investment securities
Taxable (1)	15,071		8,283		1,323		24,677
Tax-exempt (1)	0		0		1,372		1,372
Loans (2)
Fixed rate & adjustable rate 1-4 mort.	7,802		14,723		571		23,096
Scheduled payments	74,549		55,492		4,152		134,193
Total Interest-Sensitive Assets	100,482		78,498		7,418		186,398
Interest Sensitive Liabilities
NOW	14,178		21,265		0		35,443
Money market	15,601		5,200		0		20,801
Time deposits	64,551		16,249		0		80,800
Other interest-bearing liabilities	8,484		15,000		0		23,483
Long-term debt	0		0		0		0
Total Interest Sensitive Liabilities	102,814		57,714		0		160,528
Interest Sensitivity Gap	(2,332	)	20,784		7,418		25,870
Cumulative Gap	(2,332	)	18,452		25,870
Ratio of cumulative gap to total Interest sensitive assets	(1.25%	)	9.90	%	13.88	%

(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.

Lending Activities

Loan Policy

All lending activities of Cornerstone are under the direct supervision and control of the Directors Loan Committee, which consists of the chief executive officer and four outside directors.  Also present at meetings of the committee are the executive vice president and senior lender, the executive vice president and chief financial officer, loan review officer and other lending officers as required.  The loan committee enforces loan authorizations for each officer, makes lending decisions on loans exceeding such limits, services all requests for officer credits to extent allowable under current laws and regulations, administers all problem credits, and determines the allocation of funds for each lending category.  The Bank’s established maximum loan volume to assets is 85%.  The loan portfolio consists primarily of real estate, commercial and installment loans.

General

 At December 31, 2003, the Company’s loan portfolio constituted approximately 78.25% of the Company’s total assets.  The following table sets forth the composition of the Company’s loan portfolio at the indicated dates.

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	At December 31,
	2003			2002			2001			2000			1999
(In thousands)	Amount	Percent		Amount	Percent		Amount	Percent		Amount	Percent		Amount	Percent
Commercial, financial, and agricultural	42,420	26.97	%	28,034	22.48	%	20,425	19.40	%	16,209	19.17	%	13,661	18.89	%
Real estate – construction	24,081	15.31	%	20,517	16.46	%	13,190	12.54	%	9,976	11.80	%	5,560	7.69	%
Real estate – mortgage	28,185	17.92	%	28,331	22.72	%	30,828	29.33	%	27,224	32.19	%	24,917	34.44	%
Real Estate – commercial	56,527	35.94	%	41,926	33.62	%	34,541	32.85	%	25,496	30.15	%	21,843	30.21	%
Consumer loans	6,077	3.86	%	5,880	4.72	%	6,170	5.88	%	5,669	6.70	%	6,345	8.77	%
Total loans	157,290	100.00	%	124,688	100.00	%	105,154	100.00	%	84,574	100.00	%	72,326	100.00	%

The following table sets forth the scheduled maturities of the loans in the Company’s loan portfolio as of December 31, 2003 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
	Less Than One Year	One to Five Years	More than Five Years	Total
Commercial, financial and agricultural	32,226	9,331	863	42,420
Real estate – construction	20,034	4,047	—	24,081
Real estate – mortgage	8,912	16,222	3,051	28,185
Real estate – commercial	13,864	40,034	2,629	56,527
Consumer loans	2,095	3,926	56	6,077
Total Loans	77,131	73,560	6,599	157,290

Types of Loans

Commercial Loans

Commercial, industrial, and non-farm non-residential loans, hereinafter referred to as commercial loans (excluding commercial construction loans) totaled $42.4 million or 27.0% of the Company’s loan portfolio at December 31, 2003.  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 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 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

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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 Cornerstone also seeks to obtain the borrower’s business and personal depository accounts.

Real Estate - Construction Loans

As of December 31, 2003, Cornerstone had $24.1 million in construction and development loans outstanding, which represented 15.3% 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 salability 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, 2003, real estate mortgage loans totaled  $ 28.2 million or 17.9% 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, 2003 the Bank held $  1.0 million 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 10-15 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

22

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, 2003, commercial real estate mortgage loans totaled  $ 56.5 million or 35.9% 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.

Consumer Loans

At December 31, 2003, consumer loans totaled  $ 6.1 million or 3.9% of the Company’s loan portfolio.  These loans consist of consumer installment loans and consumer credit card balances.  As of December 31, 2003, the Bank had $ .3 million 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, 2003, commitments under standby letters of credit and undisbursed loan commitments aggregated approximately $35,132,000.  This number includes all lines that have not been fully drawn and loan commitments in the same status.

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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 ten 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 $ 150,000.  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 $ 1,000,000.  The Directors Loan Committee must approve all loans over $ 1,000,000 up to $ 2,000,000.   All loans above $2,000,000 up to the Bank’s legal lending limit must be approved by the Board of Directors of the Bank.  The Bank’s legal lending limit is 25% of the Bank’s qualifying equity for secured loans and 15% for unsecured loans.

The Bank has in the past purchased and sold commercial loan participations with correspondent banks and will continue the practice when management feels the action would be in the best interest of stockholders.  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, which it otherwise would be unable to make due to capital or other funding considerations. As of the end December 31, 2003, the Bank had no purchased participation balance but had sold participations of $13.7 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 loan fees in excess of $5,000 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, 2003, the Bank recognized origination, commitment and other loan fees totaling $1,015,099, which equaled 9.0% of the Company’s total interest income for the year.

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Problem Loans and Allowance for Loan Losses

Problem Loans

In originating loans, the Company recognizes that it will experience credit losses and that the risk of loss will vary with, among other things, the type of loan being made, the creditworthiness of the borrower over the term of the loan and, in the case of a secured loan, the guaranty 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 classifiedas 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 (defined as fair value at foreclosure) or fair value less estimated

25

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 it sold $240,000 of its real estate owned due to loan foreclosures during the year ended December 31, 2003.  The book value of real estate owned that was sold by the Bank during the year ended December 31, 2003 totaled  $240,000.  As of December 31, 2003, the Bank had $98,000 in value of real estate owned as a result of foreclosure.

The following table sets forth information regarding the Company’s delinquent and non-performing assets as of the dates indicated.

	At December 31,
(In thousands)	2003		2002
Accruing loans which are contractually past due 90 days or more:
Commercial, financial, and agricultural	0		0
Real estate - construction	0		0
Real estate - mortgage	0		0
Consumer	0		0
Total	0		0
Ratio of delinquent (30 days or more) but accruing loans to:
Total loans	0.20	%	0.22	%
Total assets	0.16	%	0.17	%
Non-accruing loans (90 days or more):
Commercial, financial, and agricultural	0		0
Real estate - construction	0		0
Real estate - mortgage	0		0
Consumer loans	0		48
Total	0		48
Real estate acquired through foreclosure	98		240
Property acquired through repossession	33		0
Total	131		288
Total loans	157,290		124,688
Ratio of non-performing assets to total loans	0.08	%	0.23	%

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Allowance for Loan Losses

The allowance or reserve for possible loan losses is a means of absorbing future losses, which could be incurred from the current loan portfolio.  The Bank maintains an allowance for possible loan losses, and management adjusts the general allowances monthly by charges to income in response to changes to outstanding loan balances.

The Bank maintains a general allowance equal to approximately 1.25% of the total principal amount of loans outstanding and management adjusts the general allowance monthly by charges or credits to income in response to changes in the outstanding loan balance.  Management also may establish specific loan loss allowances for specific loans after considering such factors as past delinquencies on the loan, the value of the underlying collateral and the size of the loan.  A loan or portion thereof is charged off against the general allowance when management has determined that losses on such loans are probable.  Recoveries on any loans charged-off in prior fiscal periods are credited to the allowance.  It is the opinion of the Bank’s management that the balance in the general allowance for loan losses as of December 31, 2003 is adequate to absorb possible losses from loans currently in the portfolio.

The following table summarizes the Company’s loan loss experience for the periods indicated.

	Years Ended December 31,
(In thousands)	2003		2002		2001		2000		1999
Average loans	141,586		107,676		90,860		80,526		69,643
Allowance for possible loan losses, beginning of the period	1,591		1,322		1,142		1,002		1,400
Charge-offs for the period:
Commercial, financial, and agricultural	223		423		129		267		1,014
Real estate - construction	0		0		45		0		0
Real estate - mortgage	6		12		169		209		111
Consumer	106		62		60		186		387
Total charge-offs	335		497		403		662		1,512
Recoveries for the period:
Commercial, financial, and agricultural	183		75		108		93		131
Real estate – construction	3		0		1		0		0
Real estate – mortgage	0		7		3		54		13
Consumer	24		27		36		95		115
Total recoveries	210		109		148		242		259
Net charge-offs for the period	125		388		255		420		1,253
Provision for loan losses	545		683		435		560		855
Adjustments	0		-26		0		0		0
Allowance for possible loan losses, end of the period	2,011		1,591		1,322		1,142		1,002
Ratio of allowance for loan losses to total average loans outstanding	1.42	%	1.48	%	1.46	%	1.42	%	1.44	%
Ratio of net charge-offs during the period to average loans outstanding during the period	0.09	%	0.36	%	0.28	%	0.52	%	1.80	%

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

The following table sets forth the Company’s allocation of the allowance for loan losses as of December 31, 2003, and 2002.

	At December 31,
	2003					2002				2001
(In thousands) Balance at end of period applicable to	Amount			Percent of loans in each category to total loans		Amount		Percent of loans in each category to total loans		Amount		Percent of loans in each category to total loans
Commercial, financial, and agricultural	$	840		26.94	%	$	537	22.48	%	$	388	19.58	%
Real estate – construction	539			15.32	%	524		16.46	%	332		12.54	%
Real estate – commercial	352			31.84	%	245		22.72	%	251		27.21	%
Real estate – mortgage	139			22.39	%	138		33.62	%	200		34.97	%
Consumer	141			3.51	%	147		4.72	%	151		5.70	%
Total	$		2,011	100.00	%	$	1,591	100.00	%	$	1,322	100.00	%

	At December 31,
	2000				1999
(In thousands) Balance at end of period applicable to	Amount		Percent of loans in each category to total loans		Amount		Percent of loans in each category to total loans
Commercial, financial, and agricultural	$	218	19.58	%	$	189	18.89	%
Real estate – construction	135		11.80	%	77		7.69	%
Real estate – commercial	344		30.15	%	303		30.21	%
Real estate – mortgage	368		31.77	%	345		34.44	%
Consumer	77		6.70	%	88		8.77	%
Total	$	1,142	100.00	%	$	1,002	100.00	%

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Investment Activities

Investment Policy

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

The Company’s investment portfolio totaled $ 26.0 million or 13.0% of total assets at December 31, 2003.

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

	At December 31,
(In thousands)	2003	2002	2001
Securities available for sale:
U.S. Government and agency obligations	11,088	10,277	13,007
Mortgage-backed and other securities	11,208	8,394	5,184
States & political subdivisions tax-exempt	1,453	1,438	914
Other Bonds & FHLB Stock	1,659	1,572	373
Total	25,408	21,681	19,478
Securities held to maturity:
U.S. Government and agency obligations	0	0	0
Mortgage-backed and other securities	641	1,025	2,197
States & political subdivisions tax-exempt	0	0	0
Total	641	1,025	2,197
Total Securities	26,049	22,706	21,675

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The following table sets forth the book value of the Bank’s investments at December 31, 2003, the weighted average yields on the Bank’s investments at December 31, 2003 and the periods to maturity of the Bank’s investments from December 31, 2003.

	Periods to Maturity from December 31, 2003
	1 year or less			1 - 5 years			5 - 10 years			Over 10 years
(In thousands) Available for Sale:	Amount	Weighted Average Yield (1)		Amount	Weighted Average Yield (1)		Amount	Weighted Average Yield (1)		Amount	Weighted Average Yield (1)
U. S. Treasuries	0	0.00	%	0	0.00	%	0	0.00	%	0	0.00	%
U. S. Government agencies	2,999	6.40	%	6,978	4.05	%	997	4.13	%	0	0.00	%
Mortgage backed securities (2)	2	5.70	%	29	6.11	%	6	9.41	%	11,135	2.90	%
Tax-exempt municipal bonds	0	0.00	%	125	7.45	%	424	6.18	%	822	6.42	%
Other bonds, notes, debentures, and securities	582	3.74	%	1,036	4.80	%	0	0.00	%	0	0.00	%
Total	3,583	5.97	%	8,168	4.21	%	1,427	4.76	%	11,957	3.15	%
Total Available for Sale	25,135	3.99	%

	Periods to Maturity from December 31, 2003
	1 year or less			1 - 5 years			5 - 10 years			Over 10 years
(In thousands) Held to Maturity:	Amount	Weighted Average Yield (1)		Amount	Weighted Average Yield (1)		Amount	Weighted Average Yield (1)		Amount	Weighted Average Yield (1)
U. S. Treasuries	0	0.00	%	0	0.00	%	0	0.00	%	0	0.00	%
U. S. Government agencies	0	0.00	%	0	0.00	%	0	0.00	%	0	0.00	%
Mortgage backed securities (2)	3	6.10	%	10	6.48	%	49	6.71	%	579	4.23	%
Tax-exempt municipal bonds	0	0.00	%	0	0.00	%	0	0.00	%	0	0.00	%
Other bonds, notes, debentures, and securities	0	0.00	%	0	0.00	%	0	0.00	%	0	0.00	%
Total	3	6.10	%	10	6.48	%	49	6.71	%	579	4.23	%
Total Held to Maturity	641	4.46	%
Total Securities	25,776	4.00	%

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

(2) Mortgages are allocated by maturity and not amortized

Sources of Funds

General

Time, money market, savings and demand deposits are the major source of the Company’s funds for lending and other investment purposes.  All deposits are held by the Bank.  In addition, the Company obtains funds from loan principal repayments and proceeds from sales of loan participations and investment securities.  Loan repayments are a relatively stable

30

source of funds, while deposit inflows and outflows and sales of loan participations and investment securities are significantly influenced by prevailing interest rates, economic conditions and the Company’s asset and liability management strategies.  Borrowings are used on either a short-term basis to compensate for reductions in the availability of other sources of funds or on a longer-term basis to reduce interest rate risk.

Deposits

The Bank offers several types of deposit accounts, with the principal differences relating to the minimum balances required, the time period the funds must remain on deposit and the interest rate.  Deposits are obtained primarily from the Bank’s Chattanooga Metropolitan Statistical Area (MSA).  The Bank does not advertise for deposits outside of this area.  The Bank does not solicit funds from brokers, nor does it rely upon any single person or group of related persons for a material portion of its deposits.  A principal source of deposits for the Bank consists of short-term money market and other accounts, which are highly responsive to changes in market interest rates.  Accordingly, the Bank, like all financial institutions, is subject to short-term fluctuations in deposits in response to customer actions due to changing short-term market interest rates.  The ability of the Bank to attract and maintain deposits and the Bank’s cost of funds has been and will continue to be significantly affected by money market conditions.

The following tables set forth the composition of deposits for the Company, excluding accrued interest payable, by type for the years ended December 31, 2003 and December 31, 2002.

(In thousands)	2003		2002		2001
Demand deposits	$	22,327	$	20,586	$	14,206
NOW accounts	28,514		19,485		21,152
Savings & Money market deposits	27,712		21,007		15,302
Time deposits under $100,000	58,535		50,505		47,851
Time deposits $100,000 and over	22,264		18,863		20,639
Total deposits	$	159,352	$	130,446	$	119,150

The following table presents a breakdown by category of the average amount of deposits and the average rate paid on deposits for the periods indicated:

(In thousands)	2003				2002				2001
Demand deposits	$	18,017			$	14,607			12,263
NOW accounts	22,299		0.30	%	20,148		1.12	%	16,601		1.59	%
Savings & Money market deposits	25,467		1.33	%	18,515		1.76	%	11,585		2.82	%
Time deposits under $100,000	54,679		2.88	%	45,936		3.65	%	47,469		5.61	%
Time deposits $100,000 and over	19,430		3.12	%	19,223		3.80	%	20,090		5.56	%
Total deposits	$	139,892	1.85	%	$	118,429	2.50	%	$	108,008	4.04	%

31

Borrowings

The Bank joined the Federal Home Loan Bank of Cincinnati in October of 2000.  The Federal Home Loan Bank (FHLB) allows the Bank to borrow funds on a contractual basis many times at rates lower than the costs of local certificates of deposit.   In addition the FHLB has the ability to provide structured advances that best reduce or leverage the interest rate risk of the Bank.  The Bank as of the end of the year had $17 million outstanding with the FHLB. All the loans are from $2 to $4 million in size and are structured as ten year obligations with an optional conversion to a floating rate after a stated period of time.  The loans have maturities ranging from December 2010 to April 2013 and have conversion dates ranging from immediate to September 2007.  Interest rates ranges from 2.4% to 5.0%.  The Bank has several Federal Funds lines of credit available with correspondent banks with a total availability of $11 million as of the end of 2003.  In addition, the Bank has the right to borrow from the Federal Reserve Bank if necessary to supplement its supply of funds available for lending and to meet deposit withdrawal requirements.  As of December 31, 2003, the Company had established a line of credit of $2.5 million priced at 1 month LIBOR plus 150 basis points.  The loan was established to insert capital infusions to the Bank to fund growth or retire treasury stock, if any, as needed.   This line allows the Company to act as a source of strength for the Bank without the expense or dilution of additional common stock.  As of December 31, 2003 the Company had drawn $400,000 on the line and had used the funds to inject capital into the Bank.

Balance Sheet Management

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

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

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

The liability portion of the balance sheet provides liquidity through various interest bearing and non-interest bearing deposit accounts.  Other short-term liabilities, which do not qualify as a deposit, are Federal Funds purchased and securities under agreement to repurchase (REPO’s). Both are temporary solutions for liquidity as Federal Funds must be paid off at least once every 30 days and REPO’s must be collateralized by investment securities.  At year-end December 31, 2003, Cornerstone had no Federal Funds purchased and $6.1 million in REPO’s. Longer-term liabilities are limited to FHLB advances, which would be used to reduce interest rate risk, and Company loans used to repurchase common stock or finance any acquisition in the future.

Capital Resources / Liquidity

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

Cornerstone’s liquidity target is measured by adding the Bank’s net cash, short term and marketable securities not pledged and dividing this number by total deposits and short-term liabilities not secured by assets pledged.  The approved

32

liquidity policy is targeted at 10% and currently the Bank’s liquidity ratio is 12.2%.  Cornerstone is not subject to any specific liquidity requirements imposed by regulatory orders.  Cornerstone is subject to general FDIC guidelines, which do not require a minimum level of liquidity.  Management believes its liquidity ratios meet or exceed these guidelines.  Management does not know of any trends or demands, which are reasonably likely to result in liquidity increasing or decreasing in any material manner.

The following table sets forth liquidity ratios for periods indicated:

	December 31, 2003		December 31, 2002
Average loans to average deposits	101.2	%	90.9	%

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

Capital Adequacy

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

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

33

The following tables set forth the composition of the Bank’s capital at December 31, 2003 and 2002.

(In thousands)	December 31, 2003		December 31, 2002
Capital:	Amount		Amount
Tier I Capital:
Stockholders’ equity	14,759		12,390
Less Gain on AFS Securities	(181	)	(281	)
Plus loss of AFS Securities	—		—
Less disallowed intangibles	—		—
Total Tier I capital	14,578		12,109
Tier II capital:
Qualifying debt	—
Qualifying allowance for loan losses	2,011		1,530
Total Tier II capital	16,589		13,639
Total capital	16,589		13,639
Risk-adjusted assets	143,482		109,454
Average assets	175,720		141,049
Ratios:
Tier I capital to risk-adjusted assets	10.16	%	11.06	%
Tier II capital to risk-adjusted assets	11.56	%	12.46	%
Leverage – Tier I capital to average assets
Less disallowed intangibles	8.30	%	8.58	%

The Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”) established five capital categories for banks.  Under the regulation defining these five capital categories, each bank is classified into one of the five categories based on its level of risk-based capital as measured by Tier I capital, total risk-based capital, and Tier I leverage ratios and its supervisory ratings.  The following table lists the five categories of capital and each of the minimum requirements for the three risk-based ratios.

	Total Risk-Based Capital Ratio	Tier I Risk-Based Capital Ratio	Leverage Ratio
Well-capitalized	10%or above	6% or above	5% or above
Adequately capitalized	8% or above	4% or above	4% or above
Under capitalized	Less than 8%	Less than 4%	Less than 4%
Significantly undercapitalized	Less than 6%	Less than 3%	Less than 3%
Critically undercapitalized	—	—	2% or less

On December 31, 2003, Cornerstone exceeded the regulatory minimums and qualified as a well-capitalized institution under the regulations.  There are no existing accounting pronouncements or guidance that is expected to be adopted by the Bank during 2004.  Further, there are no critical accounting policies applied that have alternative applications which would likely change the results of operations in a material amount.  Management of the Bank believes it has made the proper judgements about its selection of accounting policies.

34

ITEM 7.  FINANCIAL STATEMENTS

The following consolidated financial statements of the Company and its subsidiary, together with the Report of Independent Certified Public Accountants thereon, are included on page F-1 through F-32 of this Annual Report on Form 10-KSB:

Report of Independent Certified Public Accountants

Consolidated Balance Sheets as of December 31, 2003 and 2002

Consolidated Statements of Income for the years ended
December 31, 2003, 2002 and 2001

Consolidated Statements of Changes in Stockholders’ Equity
for the years ended December 31, 2003, 2002 and 2001

Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001

Notes to Consolidated Financial Statements

ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

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

ITEM 8A.  CONTROLS AND PROCEDURES

Based on their evaluation as of a date within 90 days of the filing date of this Annual Report on Form 10-KSB, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934 (the “Exchange Act”) are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation and up to the filing date of this Annual Report on Form 10-KSB.  There were no significant deficiencies or material weaknesses, and therefore there were no corrective actions taken.

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

35

PART III

ITEM 9.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information relating to the directors and executive officers of the Company is set forth under the caption “Proposals - Election of Directors” on pages 3 through 4 of the Company’s 2004 Proxy Statement. Such information is incorporated into this report by reference.  Information relating to audit committee financial experts is set forth under the caption “Audit Committee Report – Identification of Members and Functions of Committee” on page 13 of the Company’s 2004 Proxy Statement.  Such information is incorporated into this report by reference.  Information relating to compliance with the reporting requirements of Section 16 (a) of the Securities Exchange Act of 1934, as amended, by the Company’s executive officers and directors, persons who own more than ten percent of the Company’s common stock and their affiliates who are required to comply with such reporting requirements is set forth under the caption “Section 16 (a) Beneficial Ownership Reporting Compliance” on page 14 of the Company’s 2004 Proxy Statement.  Such information is incorporated into this report by reference.

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

ITEM 10.  EXECUTIVE COMPENSATION

Information relating to director compensation is set forth under the caption “Information About the Board of Directors and its Committees – Compensation of Directors” on page 10 of the Company’s 2004 Proxy Statement, and information relating to executive compensation is set forth under the caption “Executive Compensation” on pages 6 through 8 of the Company’s 2004 Proxy Statement.  Such information is incorporated into this report by reference.

ITEM 11.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Information relating to ownership of the Company’s common stock by certain persons is set forth under the caption “Security Ownership of Certain Beneficial Owners and Management” on pages 2 through 3 of the Company’s 2004 Proxy Statement.  Such information is incorporated into this report by reference.  Information relating to equity compensation plans is set forth under the caption “Executive Compensation – Equity Compensation Plan Information as of December 31, 2003 on page 8 of the Company’s 2004 Proxy Statement.  Such information is incorporated into this report by reference.

ITEM 12.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information relating to certain transactions between the Company, and its affiliates and certain other persons is set forth under the caption “Certain Relationships and Related Transactions” on page 14 of the Company’s 2004 Proxy Statement.  Such information is incorporated into this report by reference.

36

ITEM 13.  EXHIBITS AND REPORTS ON FORM 8-K

(a)           Exhibits

(1)           The following consolidated financial statements of the Company and its subsidiary, together with the Report of Independent Certified Public Accountants thereon, are included on page F-1 through F-32 of this Annual Report on Form 10-KSB:

Report of Independent Certified Public Accountants

Consolidated Balance Sheets as of December 31, 2003 and 2002

Consolidated Statements of Income for the years ended
December 31, 2003, 2002 and 2001

Consolidated Statements of Changes in Stockholders’ Equity
for the years ended December 31, 2003, 2002 and 2001

Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001

Notes to Consolidated Financial Statements

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

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

Exhibit No.	Description
3.1	Amended and Restated Charters of the registrant.
3.2	Amended and Restated Bylaws of the registrant.
4	The right of securities holders are defined in the Charter and Bylaws provided in exhibits 3.1 and 3.2 respectively.
10.1	Cornerstone Bancshares, Inc. Statutory and Nonstatutory Stock Option Plan (1).
10.2	Cornerstone Bancshares, Inc. 2004 Long-Term Incentive Plan (2).
10.3	Cornerstone Bancshares, Inc. 2004 Non-Employee Director Plan (3).
10.4	Employment Agreement between Cornerstone Bancshares, Inc. and Gregory B. Jones (4) .
10.5	Employment Agreement between Cornerstone Bancshares, Inc. and Nathaniel F. Hughes (5).
10.6	Employment Agreement between Cornerstone Bancshares, Inc. and Jerry D. Lee (6).
14	Code of Ethics.
21	Subsidiaries of the registrant.
31	Certifications of chief executive officer and chief financial officer.
32	Section 906 certifications of chief executive officer and chief financial officer.

(1)	Incorporated by reference from Exhibit 10.1 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
(2)	Incorporated by reference from Exhibit 99.1 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).

37

(3)	Incorporated by reference from Exhibit 99.3 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).
(4)	Incorporated by reference from Exhibit 10.2 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
(5)	Incorporated by reference from Exhibit 10.3 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
(6)	Incorporated by reference from Exhibit 10.4 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).

(b)                   The following reports on Form 8-K were filed with the Securities and Exchange Commission during the three months ended December 31, 2003:

(1)                   Form 8-K filed on December 16, 2003, declaring $.10 cash dividend to shareholders of record.

(2)                   Form 8-K filed on October 17, 2003, reporting third quarter earnings

ITEM 14.               PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information relating to principal accountant fees and services is set forth under the caption “Audit Committee Report – Audit Fees” on page 13 of the Company’s 2004 Proxy Statement.  Such information is incorporated into this report by reference.

38

SIGNATURES

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

		CORNERSTONE BANCSHARES, INC.
Date: March 22, 2004	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 Chief Financial Officer
		(principal financial officer and accounting officer)

39

In accordance with the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on March 22, 2004.

Signature	Title
/s/  Gregory B. Jones	Chairman of the Board and Chief Executive Officer
Gregory B. Jones	and Director (principal executive officer)
/s/  Randy Brooks	Director
Randy Brooks
/s/  B. Kenneth Driver	Director
B. Kenneth Driver
/s/  Karl Fillauer	Director
Karl Fillauer
/s/  Nathaniel F. Hughes	President and Chief Financial Officer
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

40

/s/  Russell W. Lloyd	Director
Russell W. Lloyd
/s/  Earl A. Marler, Jr.	Director
Earl A. Marler, Jr.
/s/  Doyce G. Payne	Director
Doyce G. Payne
/s/  Turner Smith	Director
Turner Smith
/s/  Billy O. Wiggins	Director
Billy O. Wiggins
/s/  Marsha Yessick	Director
Marsha Yessick

41

INDEX OF EXHIBITS

Exhibit No.	Description
3.1	Amended and Restated Charters of the registrant.
3.2	Amended and Restated Bylaws of the registrant.
4	The right of securities holders are defined in the Charter and Bylaws provided in exhibits 3.1 and 3.2 respectively.
10.1	Cornerstone Bancshares, Inc. Statutory and Nonstatutory Stock Option Plan (1).
10.2	Cornerstone Bancshares, Inc. 2004 Long-Term Incentive Plan (2).
10.3	Cornerstone Bancshares, Inc. 2004 Non-Employee Director Plan (3).
10.4	Employment Agreement between Cornerstone Bancshares, Inc. and Gregory B. Jones (4) .
10.5	Employment Agreement between Cornerstone Bancshares, Inc. and Nathaniel F. Hughes (5).
10.6	Employment Agreement between Cornerstone Bancshares, Inc. and Jerry D. Lee (6).
14	Code of Ethics.
21	Subsidiaries of the registrant.
31	Certifications of chief executive officer and chief financial officer.
32	Section 906 certifications of chief executive officer and chief financial officer.

(1)	Incorporated by reference from Exhibit 10.1 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
(2)	Incorporated by reference from Exhibit 99.1 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).
(3)	Incorporated by reference from Exhibit 99.3 of the registrant’s Registration Statement on Form S-8 filed March 5, 2004 (File No. 333-113314).
(4)	Incorporated by reference from Exhibit 10.2 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
(5)	Incorporated by reference from Exhibit 10.3 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).
(6)	Incorporated by reference from Exhibit 10.4 of the registrant’s Registration Statement on Form S-1 filed on February 4, 2000, as amended (File No. 333-96185).

42

Report of Independent Certified Public Accountants

To the Stockholders and
Board of Directors

Cornerstone Bancshares, Inc.

Chattanooga, Tennessee

We have audited the accompanying consolidated balance sheets of Cornerstone Bancshares, Inc. and subsidiary as of December 31, 2003 and 2002, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003.  These financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Cornerstone Bancshares, Inc. and subsidiary as of December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

HAZLETT, LEWIS & BIETER, PLLC

Chattanooga, Tennessee

January 16, 2004

F-1

CORNERSTONE BANCSHARES,  INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

December 31, 2003 and 2002

	2003		2002
ASSETS
Cash and due from banks	$	7,071,075	$	4,928,080
Federal funds sold	3,060,000		460,000
Cash and cash equivalents	10,131,075		5,388,080
Securities available for sale	24,825,961		21,174,980
Securities held to maturity	640,651		1,024,726
Federal Home Loan Bank stock, at cost	582,300		506,100
Loans, net of allowance for loan losses	155,278,321		123,096,578
Bank premises and equipment, net	4,292,566		3,953,293
Accrued interest receivable	938,763		679,598
Goodwill	2,541,476		2,541,476
Other assets	1,765,604		1,537,390
Total assets	$	200,996,717	$	159,902,221
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand deposits	$	22,326,841	$	20,585,758
Interest-bearing demand deposits	28,513,598		19,484,709
Savings deposits and money market accounts	27,712,339		21,007,269
Time deposits of $100,000 or more	22,264,211		18,863,337
Time deposits under $100,000	58,535,286		50,505,251
Total deposits	159,352,275		130,446,324
Accrued interest payable	102,163		121,270
Federal funds purchased and securities sold under agreements to repurchase	6,084,078		3,503,139
Federal Home Loan Bank advances and note payable	17,400,000		10,000,000
Other liabilities	1,154,700		684,738
Total liabilities	184,093,216		144,755,471
Stockholders' equity:
Preferred stock - no par value; 2,000,000 shares authorized; no shares issued	—		—
Common stock - $1.00 par value; 2,000,000 shares authorized; shares issued and outstanding - 1,243,167 in 2003 and 1,233,167 in 2002	1,243,167		1,233,167
Additional paid-in capital	12,183,868		12,093,868
Retained earnings	3,295,884		1,538,341
Accumulated other comprehensive income	180,582		281,374
Total stockholders' equity	16,903,501		15,146,750
Total liabilities and stockholders' equity	$	200,996,717	$	159,902,221

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

F-2

CORNERSTONE BANCSHARES,  INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2003, 2002 and 2001

	2003		2002		2001
INTEREST INCOME
Loans	$	10,326,391	$	8,544,465	$	8,150,944
Securities and interest-bearing deposits in other banks	980,062		1,123,648		1,260,705
Federal funds sold	19,965		34,179		168,433
Total interest income	11,326,418		9,702,292		9,580,082
INTEREST EXPENSE
Time deposits of $100,000 or more	606,162		730,832		1,116,118
Other deposits	1,981,634		2,227,329		3,251,454
Federal funds purchased and securities sold under agreements to repurchase	54,947		26,939		61,795
Federal Home Loan Bank advances and note payable	568,056		323,540		112,738
Total interest expense	3,210,799		3,308,640		4,542,105
Net interest income before provision for loan losses	8,115,619		6,393,652		5,037,977
Provision for loan losses	545,000		683,434		435,000
Net interest income after provision for loan losses	7,570,619		5,710,218		4,602,977
NONINTEREST INCOME
Service charges	888,805		734,102		637,123
Other noninterest income	59,615		67,962		54,812
Net gains from sale of loans and securities	293,453		200,094		197,645
Total noninterest income	1,241,873		1,002,158		889,580
NONINTEREST EXPENSES
Salaries and employee benefits	3,325,470		2,630,544		2,236,728
Net occupancy and equipment expense	375,713		348,740		314,298
Other operating expenses	2,039,650		2,004,078		1,998,906
Total noninterest expenses	5,740,833		4,983,362		4,549,932
Income before income tax expense	3,071,659		1,729,014		942,625
Income tax expense	1,189,800		667,591		373,013
Net income	$	1,881,859	$	1,061,423	$	569,612
EARNINGS PER COMMON SHARE
Basic	$	1.52	$	.86	$	.47
Diluted	1.41		.83		.46

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

F-3

CORNERSTONE BANCSHARES,  INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’  EQUITY

Years Ended December 31, 2003, 2002 and 2001

	Comprehensive Income		Total Stockholders’ Equity		Common Stock		Additional Paid-in Capital		Retained Earnings (Deficit)			Accumulated Other Comprehensive Income
BALANCE, December 31, 2000			$	12,518,161	$	1,166,129	$	11,322,276	$	(92,694	)	$	122,450
Issuance of common stock			838,630		67,038		771,592		—			—
Comprehensive income:
Net income	$	569,612	569,612		—		—		569,612			—
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment	152,932		152,932		—		—		—			152,932
Total comprehensive income	$	722,544
BALANCE, December 31, 2001			14,079,335		1,233,167		12,093,868		476,918			275,382
Comprehensive income:
Net income	$	1,061,423	1,061,423		—		—		1,061,423			—
Other comprehensive income, net of tax:
Unrealized holding gains (losses) on securities available for sale, net of reclassification adjustment	5,992		5,992		—		—		—			5,992
Total comprehensive income	$	1,067,415
BALANCE, December 31, 2002			$	15,146,750	$	1,233,167	$	12,093,868	$	1,538,341		$	281,374

F-4

	Comprehensive Income			Total Stockholders’ Equity			Common Stock		Additional Paid-in Capital		Retained Earnings (Deficit)			Accumulated Other Comprehensive Income
BALANCE, December 31, 2002				$	15,146,750		$	1,233,167	$	12,093,868	$	1,538,341		$	281,374
Issuance of common stock				100,000			10,000		90,000		—			—
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 adjustment	(100,792		)	(100,792		)	—		—		—			(100,792		)
Total comprehensive income	$	1,781,067
BALANCE, December 31, 2003				$	16,903,501		$	1,243,167	$	12,183,868	$	3,295,884		$	180,582

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

F-5

CORNERSTONE BANCSHARES, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years Ended December 31, 2003, 2002 and 2001

	2003			2002			2001
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	1,881,859		$	1,061,423		$	569,612
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization	390,383			278,372			399,045
Provision for loan losses	545,000			683,434			435,000
Gains on sales of securities and loans	(293,453		)	(200,094		)	(197,645		)
Deferred income taxes	(272,751		)	(54,873		)	52,877
Changes in other operating assets and liabilities:
Net change in loans held for sale	2,486,457			1,308,199			115,471
Accrued interest receivable	(259,165		)	74,995			94,546
Accrued interest payable	(19,107		)	(87,573		)	25,009
Other assets and liabilities	235,048			136,720			(92,586		)
Net cash provided by operating activities	4,694,271			3,200,603			1,401,329
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security transactions:
Securities available for sale	20,475,056			12,117,007			5,607,875
Securities held to maturity	386,892			1,167,259			1,797,499
Purchase of securities available for sale	(24,394,458		)	(14,255,030		)	(8,373,659		)
Net increase in loans	(35,029,960		)	(21,264,952		)	(21,505,706		)
Purchase of bank premises and equipment	(630,746		)	(265,739		)	(620,074		)
Proceeds from sale of other real estate and other assets	255,050			342,504			611,748
Net cash used in investing activities	(38,938,166		)	(22,158,951		)	(22,482,317		)
CASH FLOWS FROM FINANCING ACTIVITIES
Net increase in deposits	28,905,951			11,297,034			17,899,391
Increase (decrease) in federal funds purchased and securities sold under repurchase agreements	2,580,939			(1,080,386		)	1,439,233
Proceeds from Federal Home Loan Bank advances	7,000,000			6,000,000			2,000,000
Proceeds from note payable	400,000			—			—
Issuance of common stock	100,000			—			838,630
Net cash provided by financing activities	38,986,890			16,216,648			22,177,254
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS	4,742,995			(2,741,700		)	1,096,266
CASH AND CASH EQUIVALENTS, beginning of year	5,388,080			8,129,780			7,033,514
CASH AND CASH EQUIVALENTS, end of year	$	10,131,075		$	5,388,080		$	8,129,780
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	3,229,906		$	3,396,213		$	4,517,096
Cash paid during the period for taxes	1,316,985			672,309			388,262
NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	104,261		$	195,787		$	863,092
Transfer of other real estate to bank premises	—			230,019			—

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

F-6

Note 1.Summary of Significant Accounting Policies

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

Nature of operations and geographic concentration:

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

Principles of consolidation:

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

Goodwill:

Goodwill represents the excess of the cost of the Company’s 1997 purchase of the net assets of the Bank of East Ridge over the underlying book value of such net assets at the date of acquisition.  The Company adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” in 2002, which requires that goodwill and other intangible assets deemed to have an indefinite life not be amortized.  Goodwill is tested annually for impairment.  If the carrying value of goodwill exceeds the fair value, a write-down is recorded.  No impairment loss was recognized during 2003 or 2002.

Through December 31, 2001, goodwill was amortized over 25 years using the straight-line method.  Amortization expense for the year ended December 31, 2001, amounted to $121,023, net of tax.  The pro forma effect on earnings per share (EPS) for 2001 would result in an increase in basic and diluted EPS of $.10.

Use of estimates:

The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from those estimates.

F-7

The determination of the adequacy of the allowance for loan losses is based on estimates that are particularly susceptible to significant changes in the economic environment and market conditions. In connection with the determination of the estimated losses on loans, management obtains independent appraisals for significant collateral.

The Bank’s loans are generally secured by specific items of collateral including real property, consumer assets, and business assets.  Although the Bank has a diversified loan portfolio, a substantial portion of its debtors’ ability to honor their contracts is dependent on local economic conditions.

While management uses available information to recognize losses on loans, further reductions in the carrying amounts of loans may be necessary based on changes in local economic conditions.  In addition, regulatory agencies, as an integral part of their examination process, periodically review the estimated losses on loans.  Such agencies may require the Bank to recognize additional losses based on their judgments about information available to them at the time of their examination.  Because of these factors, it is reasonably possible that the estimated losses on loans may change materially in the near term.  However, the amount of the change that is reasonably possible cannot be estimated.

Securities:

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

Debt securities not classified as held to maturity are classified as available for sale. Securities available for sale are carried at market value with unrealized gains and losses reported in other comprehensive income.  Realized gains (losses) on securities available for sale are included in other income (expense) and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income.  Gains and losses on sales of securities are determined on the specific-identification method.

Declines in the market value of individual held to maturity and available for sale securities below their cost that are other than temporary result in write-downs of the individual securities to their market value.  The related write-downs are included in earnings as realized losses.

F-8

Loans:

Loans are stated at unpaid principal balances, less the allowance for loan losses and net deferred loan fees.

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

The accrual of interest on real estate and commercial loans is discontinued at the time the loan is 90 days delinquent unless the credit is well-secured and in process of collection.  Installment loans and other personal loans are typically charged off no later than 120 days past due.  In all cases, loans are placed on nonaccrual or charged off at an earlier date if collection of principal or interest is considered doubtful.

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

Allowance for loan losses:

The allowance for loan losses is maintained at a level which, in management’s judgment, is adequate to absorb credit losses inherent in the loan portfolio.  The amount of the allowance is based on management’s evaluation of the collectibility of the loan portfolio, including the nature of the portfolio, credit concentrations, trends in historical loss experience, specific impaired loans, economic conditions, and other risks inherent in the portfolio.  Allowances for impaired loans are generally determined based on collateral values or the present value of estimated cash flows.  Although management uses available information to recognize losses on loans, because of uncertainties associated with local economic conditions, collateral values, and future cash flows on impaired loans, it is reasonably possible that a material change could occur in the allowance for loan losses in the near term.  However, the amount of the change that is reasonably possible cannot be estimated.  The allowance is increased by a provision for loan losses, which is charged to expense and reduced by charge-offs, net of recoveries.  Changes in the allowance relating to impaired loans are charged or credited to the provision for loan losses.

F-9

Premises and equipment:

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

Other real estate owned:

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

Income taxes:

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

Statements of cash flows:

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

F-10

Stock-based compensation:

At December 31, 2003, the Company has two stock-based compensation plans, which are described fully in Note 13.  The company applies the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations in accounting for those plans.  No stock-based employee compensation is reflected in net income as all options granted under these plans had an exercise price equal to or above the market value of the underlying common stock on the date of the grant.  The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of FASB Statement No. 123, “Accounting for Stock-Based Compensation,”to stock-based compensation.

	2003			2002			2001
Net income, as reported	$	1,881,859		$	1,061,423		$	569,612
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of the related tax effects	(36,962		)	(21,348		)	(7,309		)
Pro forma net income	$	1,844,897		$	1,040,075		$	562,303
Earnings per share:
Basic-as reported	$	1.52		$	0.86		$	0.47
Basic-pro forma	$	1.49		$	0.84		$	0.46
Diluted-as reported	$	1.41		$	0.83		$	0.46
Diluted-pro forma	$	1.39		$	0.81		$	0.45

Advertising costs:

The company expenses all advertising costs as incurred.  Advertising expense was $33,146, $31,258, and $56,274 for the years ended December 31, 2003, 2002 and 2001, respectively.

Note 2.Securities

Securities have been classified in the balance sheet according to management’s intent as either securities held to maturity or securities available for sale.

F-11

The amortized cost and approximate market value of securities at December 31, 2003 and 2002, is as follows:

	2003
	Amortized Cost				Gross Unrealized Gains			Gross Unrealized Losses					Market Value
Securities available for sale:
U.S. Government agencies and corporations	$	10,973,538			$	114,438		$	(184		)		$	11,087,792
State and municipal securities	1,371,059				82,500			—					1,453,559
Mortgage-backed securities	11,172,048				50,214			(14,646			)		11,207,616
Corporate debt securities	1,035,706				41,288			—					1,076,994
	$	24,552,351			$	288,440		$	(14,830		)		$	24,825,961
Securities held to maturity:
Mortgage-backed securities	$	640,651			$	9,042		$	(1,614		)		$	648,079
	2002
	Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses					Market Value
Securities available for sale:
U.S. Government agencies and corporations	$		9,963,857	$		312,203	$		—			$		10,276,060
State and municipal securities	1,372,263			65,883			—					1,438,146
Mortgage-backed securities	8,355,923			38,888			(602			)		8,394,209
Corporate debt securities	1,056,613			9,952			—					1,066,565
	$		20,748,656	$		426,926	$		(602	)		$		21,174,980
Securities held to maturity:
Mortgage-backed securities	$		1,024,726	$		19,279	$		(1,722	)		$		1,042,283

F-12

At December 31, 2003 and 2002, securities with a carrying value of approximately $13,263,000 and $11,520,000, respectively, were pledged to secure public deposits and for other purposes required or permitted by law.

At December 31, 2003 and 2002, the carrying amount of securities pledged to secure repurchase agreements was approximately $4,901,000 and $2,625,000, respectively.

The amortized cost and estimated market value of securities at December 31, 2003, by contractual maturity, are shown below.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Securities Available for Sale				Securities Held to Maturity
	Amortized Cost		Market Value		Amortized Cost		Market Value
Due in one year or less	$	2,998,607	$	3,038,203	$	—	$	—
Due from one year to five years	8,138,618		8,267,916		—		—
Due from five years to ten years	1,719,769		1,757,976		—		—
Due after ten years	523,309		554,250		—		—
	13,380,303		13,618,345		—		—
Mortgage-backed securities	11,172,048		11,207,616		640,651		648,079
	$	24,552,351	$	24,825,961	$	640,651	$	648,079

For the years ended December 31, 2003 and 2002, there were no sales of securities available for sale.  Proceeds from the sale of securities available for sale for the year ended December 31, 2001, amounted to $2,104,740.  The Bank had gross realized gains of $83,705, in 2001.  There were no gross realized losses in 2001.

F-13

Note 3.Loans and Allowance for Loan Losses

At December 31, 2003 and 2002, the Bank’s loans consist of the following (in thousands):

	2003			2002
Mortgage loans on real estate:
Residential 1-4 family	$	14,821		$	16,584
Residential multifamily (5 or more)	7,036			7,005
Commercial	56,527			41,926
Construction	24,081			20,517
Second mortgages	2,130			2,488
Equity lines of credit	4,198			2,254
	108,793			90,774
Commercial loans	42,420			28,034
Consumer installment loans:
Personal	5,821			5,643
Credit cards	255			237
	6,076			5,880
Total loans	157,289			124,688
Less:  Allowance for loan losses	(2,011		)	(1,591		)
Loans, net	$	155,278		$	123,097

A summary of transactions in the allowance for loan losses for the years ended December 31, 2003, 2002 and 2001, is as follows:

	2003			2002			2001
Balance, beginning of year	$	1,591,152		$	1,322,152		$	1,141,869
Provision for loan losses	545,000			683,434			435,000
Loans charged-off	(334,884		)	(497,070		)	(403,417		)
Recoveries of loans previously charged-off	210,061			82,636			148,700
Balance, end of year	$	2,011,329		$	1,591,152		$	1,322,152

F-14

The Bank’s only significant concentration of credit at December 31, 2003, occurred in real estate loans which totaled approximately $108,906,000.  While real estate loans accounted for 69 percent of total loans, these loans were primarily residential development and construction loans, residential mortgage loans, and commercial loans secured by commercial properties.  Substantially all real estate loans are secured by properties located in Tennessee.

In the normal course of business, the Bank makes loans to executive officers and directors and their affiliates of the Bank on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with other borrowers.  Loans to executive officers, principal shareholders, and directors and their affiliates were approximately $750,000 and $1,004,000 at December 31, 2003 and 2002, respectively.

Impaired loans without a valuation allowance were insignificant in relation to the Bank’s loan portfolio at December 31, 2003 and 2002.

Interest income recognized on impaired loans was insignificant to total interest income on loans for each of the years ending December 31, 2003, 2002 and 2001.

Note 4.Bank Premises and Equipment

A summary of bank premises and equipment at December 31, 2003 and 2002, is as follows:

	2003			2002
Land	$	1,685,568		$	1,685,568
Buildings and improvements	2,225,759			2,081,352
Furniture, fixtures and equipment	1,865,498			1,395,267
	5,776,825			5,162,187
Accumulated depreciation	(1,484,259		)	(1,208,894		)
	$	4,292,566		$	3,953,293

Depreciation expense for the years ended December 31, 2003, 2002 and 2001, amounted to $288,637, $270,233 and $259,483, respectively.

F-15

Certain bank facilities and equipment are leased under various operating leases.  Total rent expense for the years ended December 31, 2003, 2002 and 2001, was $166,318, $141,729 and $113,571, respectively.

Future minimum rental commitments under noncancelable leases are as follows:

2004	$	110,599
2005	43,180
2006	21,881
2007	8,722
Total	$	184,382

Note 5.Time Deposits

At December 31, 2003, the scheduled maturities of time deposits are as follows:

2004	$	64,531,603
2005	10,288,834
2006	5,288,189
2007	121,099
2008	569,772
Total	$	80,799,497

Note 6.Income Taxes

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

Income tax expense in the statements of income for the years ended December 31, 2003, 2002 and 2001, consists of the following:

	2003			2002			2001
Current tax expense	$	1,462,551		$	722,464		$	320,136
Deferred tax expense (benefit) related to:
Provision for loan losses	(133,011		)	(59,877		)	(18,679		)
Net operating loss carryforward	—			—			26,700
Deferred loan origination fees	(157,606		)	(41,980		)	(7,764		)
Other	17,866			46,984			52,620
Income tax expense	$	1,189,800		$	667,591		$	373,013

F-16

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

	2003		2002		2001
Expected tax at statutory rates	$	1,044,364	$	587,865	$	320,492
Increase (decrease) resulting from tax effect of:
State income taxes, net of federal tax benefit	131,774		74,175		37,328
Nondeductible amortization	—		—		45,989
Other	13,662		5,551		(30,796		)
Income tax expense	$	1,189,800	$	667,591	$	373,013

Deferred tax assets recognized for deductible temporary differences totaled approximately $868,908 at December 31, 2003 and $539,183 at December 31, 2002.  Deferred tax liabilities for taxable temporary differences totaled approximately $387,415 at December 31, 2003 and $439,931 at December 31, 2002.

Note 7.Federal Home Loan Bank Advances and Note Payable

The Bank has agreements with the Federal Home Loan Bank of Cincinnati (FHLB) that can provide convertible fixed rate advances to the Bank in an amount up to $17,000,000.  All of the Bank’s loans secured by first mortgages on 1-4 family residential properties are pledged as collateral for these advances.

At December 31, 2003 and 2002, FHLB advances consist of the following:

	2003		2002
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		2,000,000

F-17

	2003		2002
Long-term advance dated April 26, 2002, requiring monthly interest payments, fixed at 4.11% until April 2005, 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		—
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		—
	$	17,000,000	$	10,000,000

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

During 2002, the Company established a $2,500,000 line of credit with a bank that is secured by a pledge of the Bank’s common stock and bears interest at 1.50% above the one month LIBOR, due in quarterly installments.  The total borrowings on the line of credit amounted to $400,000 at December 31, 2003.  The line of credit and the outstanding payable balance mature on February 28, 2004.

F-18

Note 8.Employee Benefit Plan

The Bank has a 401(k) employee benefit plan covering substantially all employees who have completed at least 30 days of service and met minimum age requirements.  The Bank’s contribution to the plan is discretionary and was $104,737 for 2003, $37,084 for 2002 and $14,752 for 2001.

Note 9.Financial Instruments With Off-Balance-Sheet Risk

In the normal course of business, the Bank has outstanding commitments and contingent liabilities, such as commitments to extend credit and standby letters of credit, which are not included in the accompanying financial statements. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instruments for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Bank uses the same credit policies in making such commitments as it does for instruments that are included in the balance sheet.  At December 31, 2003 and 2002, commitments under standby letters of credit and undisbursed loan commitments aggregated $35,132,000 and $18,356,000, respectively.

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

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

The Bank incurred an insignificant loss on its commitments during 2003.  During 2002 and 2001, the Bank was not required to perform on any financial guarantees and did not incur any losses on its commitments.

F-19

Note 10.Fair Value of Financial Instruments

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

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

Cash and cash equivalents:

For cash and cash equivalents, the carrying amount is a reasonable estimate of fair value.

Securities:

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

Federal Home Loan Bank stock:

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

Loans:

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

Deposits:

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

F-20

Federal funds purchased and securities sold under agreements to repurchase:

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

Federal Home Loan Bank advances and note payable:

The carrying amounts of the FHLB advances and the note payable approximate their fair value.

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

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

The carrying amount and estimated fair value of the Company’s financial instruments at December 31, 2003 and 2002, are as follows (in thousands):

	2003				2002
	Carrying Amount		Estimated Fair Value		Carrying Amount		Estimated Fair Value
Assets:
Cash and due from banks	$	7,071	$	7,071	$	4,928	$	4,928
Federal funds sold	3,060		3,060		460		460
Securities	25,467		25,474		22,200		22,217
Federal Home Loan Bank stock	582		582		506		506
Net loans	155,278		156,378		123,097		128,087
Liabilities:
Noninterest-bearing demand deposits	$	22,327	$	22,327	$	20,586	$	20,586
Interest-bearing demand deposits	28,514		28,514		19,485		19,485
Savings deposits and money market accounts	27,712		27,712		21,007		21,007
Time deposits	80,799		82,135		69,369		70,684
Federal funds purchased and securities sold under agreements to repurchase	6,084		6,084		3,503		3,503
Federal Home Loan Bank advances and note payable	17,400		17,400		10,000		10,000
Unrecognized financial instruments (net of contract amount):
Commitments to extend credit	—		—		—		—
Letters of credit	—		—		—		—
Lines of credit	—		—		—		—

F-21

Note 11.Contingencies

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

Note 12.Liquidity and Capital Resources

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

Note 13.Stock Option Plans

The Company has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of 150,000 shares of the Bank’s common stock.  These options were granted for the specific purpose of raising capital.

The option price was $10.00 per share which was the estimated fair value of the stock at the June 30, 1996, grant date.  The options expire ten years from the date of grant and were fully vested at the grant date.  On October 15, 1997, the Bank stock options were converted to Company stock options.  A summary of the status of this plan is presented as follows:

	Outstanding Options
	Number		Weighted Average Exercise Price
Outstanding, December 31, 2000	130,000		$	10.00
Outstanding, December 31, 2001	130,000		10.00
Outstanding, December 31, 2002	130,000		10.00
Options exercised	(10,000	)	10.00
Outstanding, December 31, 2003	120,000		10.00

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Note 13.Stock Options Plans (continued)

The Company also has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase up to 355,000 shares of the Company’s common stock.  The option price for incentive stock options shall be not less than 100 percent of the fair market value of the common stock on the date of the grant.  The non-qualified stock options may be equal to or more or less than the fair market value of the common stock on the date of the grant.  The stock options vest at 30 percent on the second and third anniversary of the grant date and 40 percent on the fourth anniversary.  The options expire ten years from the grant date and the weighted-average remaining contractual life of outstanding stock options was 7.5 years.  A summary of the status of this plan is presented below:

	Outstanding Options				Exercisable Options
	Number		Weighted Average Exercise Price		Number	Weighted Average Exercise Price
Outstanding, December 31, 2000	36,200		$	13.92	—	$	—
Options which became exercisable	—		—		4,950	15.00
Options granted	18,800		13.00		—	—
Outstanding, December 31, 2001	55,000		13.60		4,950	15.00
Options granted	25,000		14.50		—	—
Options forfeited	(500	)	14.50		—	—
Options which became exercisable	—		—		10,860	13.91
Outstanding, December 31, 2002	79,500		13.87		15,810	14.25
Options granted	29,250		14.50		—	—
Options which became exercisable	—		—		18,150	13.73
Outstanding, December 31, 2003	108,750		14.04		33,960	13.97

The weighted-average fair value per share of options granted during the year was $3.50, $3.86, and $3.79 for the years ended December 31, 2003, 2002 and 2001, respectively.  At December 31, 2003, the range of exercise prices of outstanding options issued was $13-$15.

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

	Years Ended December 31,
	2003		2002		2001
Dividend yield	0.00	%	0.00	%	0.00	%
Expected life	6.9 years		6.9 years		6.9 years
Expected volatility	10.00	%	10.00	%	10.00	%
Risk-free interest rate	3.62	%	4.19	%	4.77	%

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Note 14.Regulatory Matters

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

Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined).  Management believes, as of December 31, 2003, that the Company and the Bank meet all capital adequacy requirements to which they are subject.

As of December 31, 2003, the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as well capitalized under the regulatory framework for prompt corrective action.  There are no conditions or events since that notification that management believes have changed the Bank’s prompt corrective action category for bank capital.

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

	Actual				For Capital Adequacy Purposes
	Amount		Ratio		Amount		Ratio
As of December 31, 2003
Total capital to risk-weighted assets:
Consolidated	$	16,192	11.3	%	$	11,479	8.0	%
Cornerstone Community Bank	16,589		11.6	%	11,479		8.0	%
Tier I capital to risk-weighted assets:
Consolidated	14,181		9.9	%	5,739		4.0	%
Cornerstone Community Bank	14,578		10.2	%	5,739		4.0	%
Tier I capital to average assets:
Consolidated	14,181		8.1	%	7,036		4.0	%
Cornerstone Community Bank	14,578		8.3	%	7,029		4.0	%

F-24

Note 14.Regulatory Matters (continued)

	Actual				For Capital Adequacy Purposes
	Amount		Ratio		Amount		Ratio
As of December 31, 2002
Total capital to risk-weighted assets:
Consolidated	$	13,852	12.7	%	$	8,756	8.0	%
Cornerstone Community Bank	13,637		12.5	%	8,756		8.0	%
Tier I capital to risk-weighted assets:
Consolidated	12,324		11.3	%	4,378		4.0	%
Cornerstone Community Bank	12,109		11.1	%	4,378		4.0	%
Tier I capital to average assets:
Consolidated	12,324		8.7	%	5,651		4.0	%
Cornerstone Community Bank	12,109		8.6	%	5,642		4.0	%

Note 15.Other Comprehensive Income

Other comprehensive income consists of unrealized holding gains and losses on securities available for sale.  A summary of other comprehensive income and the related tax effects for the years ended December 31, 2003, 2002 and 2001, is as follows:

	Before-Tax Amount			Tax (Expense) Benefit			Net-of-Tax Amount
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	)
Year ended December 31, 2002:
Unrealized holding gains and losses arising during the period	$	9,078		$	(3,086	)	$	5,992
Less reclassification adjustment for gains realized in net income	—			—			—
	$	9,078		$	(3,086	)	$	5,992

F-25

Note 15.Other Comprehensive Income (continued)

	Before-Tax Amount		Tax (Expense) Benefit			Net-of-Tax Amount
Year ended December 31, 2001:
Unrealized holding gains and losses arising during the period	$	330,374	$	(125,541	)	$	204,833
Less reclassification adjustment for gains realized in net income	83,705		(31,804		)	51,901
	$	246,669	$	(93,737	)	$	152,932

Note 16.Earnings Per Common Share

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

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

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

	2003		2002		2001
Net income	$	1,881,859	$	1,061,423	$	569,612
Less:  Preferred stock dividends	—		—		—
Net income applicable to common stock	$	1,881,859	$	1,061,423	$	569,612
Average number of common shares outstanding	1,239,578		1,233,167		1,219,729
Effect of dilutive stock options	92,381		44,328		30,000
Average number of common shares outstanding used to calculate diluted earnings per common share	1,331,959		1,277,495		1,249,729

F-26

Note 17.Adoption of Recently Issued Statements of Financial Accounting Standards

In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which supercedes Statement of Financial Accounting Standards No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of” and the provisions for the disposal of a segment of a business in Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.”  This statement requires that long-lived assets to be disposed of by sale be measured at the lower of its carrying amount or fair value less cost to sell, and recognition of impairment losses on long-lived assets to be held if the carrying amount of the long-lived asset is not recoverable from its undiscounted cash flows and exceeds its fair value.  Additionally, Statement of Financial Accounting Standards No. 144 resolved various implementation issues related to Statement of Financial Accounting Standards No. 121.  The provisions of Statement of Financial Accounting Standards No. 144 were adopted on July 1, 2002, and had no effect on the Company’s consolidated financial statements.

In April 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections.”  This statement eliminates Statement of Financial Accounting Standards No. 4, “Reporting Gains and Losses from Extinguishment of Debt” as amended by Statement of Financial Accounting Standards No. 64, “Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements.”  As a result, gains and losses from extinguishment of debt are required to be classified as extraordinary items if they meet the definition of unusual and infrequent as prescribed in Accounting Principles Board Opinion No. 30.  Additionally, Statement of Financial Accounting Standards No. 145 amends Statement of Financial Accounting Standards No. 13, “Accounting for Leases” to require that lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. Statement of Financial Accounting Standards No. 145 addresses a number of additional issues that were not substantive in nature.  The provisions of this statement are effective at various dates in 2002 and 2003 and are not expected to have a material impact on the Company’s consolidated financial statements.

In June 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  This statement nullifies Emerging Issues Task Force Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)” and requires that a liability for costs associated with an exit or disposal activity be recognized when the liability is probable and represents obligations to transfer assets or provide services as a result of past transactions.  The provisions of the statement are effective for exit or disposal activities that are initiated after December 31, 2002, and its adoption did not have a material impact on the Company’s consolidated financial statements.

F-27

In October 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 147, “Acquisitions of Certain Financial Institutions - an Amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9.”  This statement removes acquisitions of financial institutions from the scope of both Statement of Financial Accounting Standards No. 72 and Interpretation No. 9 and requires that those transactions be accounted for in accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations” and No. 142, “Goodwill and Other Intangible Assets.” As a result, the requirement in paragraph 5 of Statement 72 to recognize (and subsequently amortize) any excess of the fair value of liabilities assumed over the fair value of assets acquired as an unidentifiable intangible asset (SFAS No. 72 goodwill) no longer applies to acquisitions within the scope of the statement.  Adoption of this standard had no material effect on the Company’s consolidated financial statements.

In December 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123.” This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. As permitted by SFAS No. 148, the Company will continue to apply the provisions of APB Opinion No. 25, “Accounting for Stock-Based Compensation”, for all employee stock option grants and has elected to disclose pro forma net income and earnings per share amounts as if the fair value based method had been applied in measuring compensation costs.  These disclosures have been included in Note 1.  In addition, the Company is awaiting further guidance that may result from current FASB stock compensation projects and will continue to evaluate any developments concerning mandated, as opposed to optional, fair value based expense recognition.

In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.”  This Statement amends and clarifies financial accounting and reporting for derivative instruments, including certain embedded derivatives, and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  This Statement amends SFAS No. 133 to reflect the decisions made as part of the Derivatives Implementation Group and in other FASB projects or deliberations. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003.  Adoption of this Standard had no material effect on the Company’s consolidated financial statements.

F-28

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.”  This Statement establishes standards for how an entity classifies and measures certain financial instruments with characteristics of both liabilities and equity.  This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. Adoption of this Standard had no material effect on the Company’s consolidated financial statements.

In November 2002, the FASB issued Interpretation No. 45, (FIN 45) “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which elaborates on the disclosures to be made by a guarantor about its obligations under certain guarantees issued.  It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee.  The Interpretation expands on the accounting guidance of SFAS No. 5, “Accounting for Contingencies,” SFAS No. 57, “Related Party Disclosures,” and SFAS No. 107, “Disclosures about Fair Value of Financial Instruments.”  It also incorporates without change the provisions of FASB Interpretation No. 34, “Disclosure of Indirect Guarantees of Indebtedness of Others,” which is superseded.  The initial recognition and measurement provisions of this Interpretation apply on a prospective basis to guarantees issued or modified after December 31, 2002.  The disclosure requirements in this Interpretation were effective for periods ending after December 15, 2002.  Adoption of this Standard did not have a material effect on the Company’s consolidated financial statements.

In December 2003, the FASB issued revised Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities.” This Interpretation clarifies the application of ARB No. 51, “Consolidated Financial Statements,” for certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties.  This Interpretation requires variable interest entities to be consolidated by the primary beneficiary which represents the enterprise that will absorb the majority of the variable interest entities’ expected losses if they occur, receive a majority of the variable interest entities’ residual returns if they occur, or both.  This Interpretation was effective for variable interest entities created after January 31, 2003, and for variable interest entities in which an enterprise obtains an interest after that date.  This Interpretation is effective in the first fiscal year or interim period beginning after March 15, 2004, for variable interest entities in which an enterprise holds a variable interest that was acquired before February 1, 2003, with earlier adoption permitted. Adoption of this Standard did not have a material effect on the Company’s consolidated financial statements.

F-29

Note 18.Quarterly Data (unaudited)

	Years Ended December 31,
	2003								2002
	Fourth Quarter		Third Quarter		Second Quarter		First Quarter		Fourth Quarter		Third Quarter		Second Quarter		First Quarter
Interest income	$	2,979,131	$	2,903,290	$	2,804,023	$	2,639,974	$	2,593,733	$	2,455,479	$	2,357,465	$	2,295,615
Interest expense	796,769		796,562		805,337		812,131		827,447		807,052		803,911		870,230
Net interest income, before provision for loan losses	2,182,362		2,106,728		1,998,686		1,827,843		1,766,286		1,648,427		1,553,554		1,425,385
Provision for loan losses	135,000		255,000		50,000		105,000		263,434		150,000		155,000		115,000
Net interest income, after provision for loan losses	2,047,362		1,851,728		1,948,686		1,722,843		1,502,852		1,498,427		1,398,554		1,310,385
Noninterest income	307,544		359,650		289,168		285,511		285,659		235,448		257,304		223,747
Noninterest expenses	1,549,539		1,412,457		1,425,145		1,353,692		1,311,156		1,290,381		1,200,568		1,181,257
Income before income taxes	805,367		798,921		812,709		654,662		477,355		443,494		455,290		352,875
Income tax expense	317,000		307,650		312,500		252,650		168,792		177,800		180,999		140,000
Net income	$	488,367	$	491,271	$	500,209	$	402,012	$	308,563	$	265,694	$	274,291	$	212,875
Earnings per common share:
Basic	$	0.39	$	0.40	$	0.40	$	0.33	$	0.25	$	0.22	$	0.22	$	0.17
Diluted	$	0.36	$	0.37	$	0.37	$	0.31	$	0.23	$	0.21	$	0.22	$	0.17

F-30

Note 19.Condensed Parent Information

	2003			2002
BALANCE SHEETS
ASSETS
Cash	$	192,124		$	270,226
Investment in subsidiary	14,759,049			12,390,325
Goodwill	2,541,476			2,541,476
Other assets	5,869			—
Total assets	$	17,498,518		$	15,202,027
LIABILITIES AND STOCKHOLDERS’ EQUITY
Note payable	$	400,000		$	—
Other liabilities	195,017			55,277
Total liabilities	595,017			55,277
Stockholders’ equity	16,903,501			15,146,750
Total liabilities and stockholders’ equity	$	17,498,518		$	15,202,027
STATEMENTS OF INCOME
INCOME	$	—		$	—
EXPENSES
Interest expense on note payable	5,540			—
Other operating expenses	133,317			154,260
Loss before equity in undistributed earnings of subsidiary	(138,857		)	(154,260		)
Equity in undistributed earnings of subsidiary	1,969,516			1,160,296
Income tax benefit	51,200			55,387
Net income	$	1,881,859		$	1,061,423

F-31

	2003			2002
STATEMENTS OF CASH FLOWS
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	1,881,859		$	1,061,423
Adjustments to reconcile net income to net cash used in operating activities:
Equity in undistributed income of subsidiary	(1,969,516		)	(1,160,296		)
Other	9,555			56,501
Net cash used in operating activities	(78,102		)	(42,372		)
CASH FLOWS FROM INVESTING ACTIVITIES
Capital contribution to subsidiary	(500,000		)	—
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from note payable	400,000			—
Issuance of common stock	100,000			—
Net cash provided by financing activities	500,000			—
NET DECREASE IN CASH AND CASH EQUIVALENTS	(78,102		)	(42,372		)
CASH AND CASH EQUIVALENTS, beginning of year	270,226			312,598
CASH AND CASH EQUIVALENTS, end of year	$	192,124		$	270,226
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest on note payable	$	3,522		$	—
Income taxes	1,316,985			672,309

F-32