Unassociated Document

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements


CONSOLIDATED BALANCE SHEET	Unaudited				Unaudited
	September 30,		December 31,		September 30,
ASSETS	2004		2003		2003

Cash and due from banks	$	5,677,330	$	7,071,075	$	4,425,507
Due from banks time deposits		—		—		—
Federal funds sold		11,290,000		3,060,000		—
Investment securities available for sale		23,021,742		24,825,961		20,748,806
Investment securities held to maturity		506,392		640,651		700,730
Federal Home Loan Bank stock		854,200		582,300		582,300
Loans, less allowance for loan loss		187,245,833		155,278,321		146,345,179
Premises and equipment, net		4,850,941		4,292,566		3,884,516
Accrued interest receivable		1,003,513		938,763		865,747
Excess cost over fair value of assets acquired		2,541,476		2,541,476		2,541,476
Other assets		2,551,955		1,765,604		1,725,991

Total Assets	$	239,543,382	$	200,996,717	$	181,820,252


LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits
Noninterest-bearing	$	32,514,366	$	22,326,841	$	17,993,693
NOW accounts		29,567,891		28,513,598		22,292,929
Savings deposits and money market accounts		36,434,436		27,712,339		24,953,992
Time deposits of $100,000 or more		30,893,490		22,264,211		18,636,977
Time deposits of less than $100,000		58,655,159		58,535,286		58,965,590
Total deposits		188,065,342		159,352,275		142,843,181
Federal funds purchased and securites sold under
agreement to repurchase		2,335,094		6,084,078		4,006,578
Federal Home Loan Bank Advance and note payable		29,150,000		17,400,000		17,000,000
Accrued interest payable		97,176		102,163		99,990
Other liabilities		1,169,523		1,154,700		1,348,199

Total Liabilities		220,817,135		184,093,216		165,297,948

Stockholders' Equity
Common stock		2,487,234		1,243,167		1,243,167
Additional paid-in capital		12,193,318		12,183,868		12,183,868
Retained Earnings		3,905,777		3,295,884		2,931,834
Accumulated other comprehensive income		139,918		180,582		163,435

Total Stockholders' Equity		18,726,247		16,903,501		16,522,304

Total liabilities and stockholders equity	$	239,543,382	$	200,996,717	$	181,820,252

CONSOLIDATED STATEMENTS OF INCOME
	Unaudited Three months ended September 30,				Unaudited Nine months ended September 30,
	2004		2003		2004		2003
INTEREST INCOME
Interest and fees on loans	$	3,422,954	$	2,672,263	$	9,421,457	$	7,587,267
Interest on investment securities		275,140		223,266		755,084		726,914
Interest on federal funds sold		5,773		1,716		8,512		16,850
Interest on other earning assets		729		6,045		1,745		16,255
Total interest income		3,704,596		2,903,290		10,186,798		8,347,286

INTEREST EXPENSE
Interest bearing demand accounts		39,252		12,213		90,486		50,907
Money market accounts		103,615		68,057		280,526		218,389
Savings accounts		9,920		8,858		28,228		38,061
Time deposits of less than $100,000		362,566		394,151		1,079,828		1,185,845
Time deposits of $100,000 or more		176,518		142,939		442,810		460,084
Federal funds purchased		9,336		12,593		26,090		28,828
Securities sold under agreements to repurchase		4,569		5,840		15,371		16,510
Other borrowings		240,984		151,910		608,856		415,405
Total interest expense		946,760		796,562		2,572,195		2,414,029

Net interest income		2,757,835		2,106,728		7,614,603		5,933,257
Provision for loan losses		175,000		255,000		585,000		410,000
Net interest income after the provision for loan losses		2,582,835		1,851,728		7,029,603		5,523,257

NONINTEREST INCOME
Service charges on deposit accounts		184,546		175,967		527,835		485,606
Net securities gains (losses)		—		—		—		—
Other income		129,894		183,683		395,133		448,723
Total noninterest income		314,439		359,650		922,968		934,329

NONINTEREST EXPENSE
Salaries and employee benefits		970,194		799,869		2,877,762		2,355,846
Occupancy and equipment expense		314,127		270,717		680,457		606,267
Other operating expense		457,656		341,871		1,366,343		1,229,180
Total noninterest expense		1,741,978		1,412,457		4,924,562		4,191,293

Income before provision for income taxes		1,155,297		798,921		3,028,009		2,266,294
Provision for income taxes		447,700		307,650		1,174,500		872,800

NET INCOME	$	707,597	$	491,271	$	1,853,509	$	1,393,493

Basic net income per common share		0.28	$	0.20		0.75		0.56
Diluted net income per common share		0.25		0.18		0.67		0.51
Dividends declared per common share		—		—		—		—

CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Nine Months Ended September 30
	Unaudited			Unaudited
	2004			2003

Cash flows from operating activities:
Net income	$	1,853,509		$	1,393,493
Adjustments to reconcile net income
to net cash provided by operating actvities:
Provision for loan losses	$	585,000		$	410,000
Net Charge-offs		(135,788	)		89,600
Depreciation and amortization		385,140			251,347
Accrued interest receivable		(64,750	)		(186,149	)
Accrued interest payable		(4,987	)		(21,280	)
Changes in other assets and liabilities		(771,527	)		474,860
Net cash provided by operating activities		1,846,597			2,411,871


Cash flows from investing activities:
Purchase of investment securities: AFS		(16,944,627	)		(18,157,657	)
Purchase of investment securities: HTM		—			—
Proceeds from security transactions: AFS		19,212,356			17,972,898
Proceeds from security transactions: HTM		133,335			321,859
Purchase of due from banks time deposits		—			—
Net increase in loans		(32,416,725	)		(23,748,201	)
Purchase of bank premises and equipment		(1,708,763	)		(163,639	)
Net cash used in investing activities		(31,724,424	)		(23,774,740	)


Cash flows from financing activities:
Net increase in deposits		28,713,067			12,396,857
Net increase (decrease) in securities sold under agreements to repurchase		(3,748,985	)		503,438
Net increase of FHLB advances and other borrowings		11,750,000			7,400,000
Issuance of common stock		—			100,000
Net cash provided by financing activities		36,714,082			20,400,295

Net increase (decrease) in cash and cash equivalents		6,836,256			(962,574	)

Cash and cash equivalents beginning of period		10,131,075			5,388,080
Cash and cash equivalents end of period	$	16,967,330		$	4,425,507

Cornerstone Bancshares, Inc and Subsidiary
Consolidated Statement of Changes in Stockholders' Equity
September 30, 2004
											Accumulated
						Additional					Other			Total
	Comprehensive			Common		Paid-in		Retained			Comprehensive			Stockholders'
	Income			Stock		Capital		Earnings			Income			Equity

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

Redemption of Common Stock					—		—		—			—			—

Two for One Stock Dividend					1,243,617				(1,243,617	)					—

Issuance of Common Stock					450		9,450		—			—			9,900

Comprehensive Income:

Net Income		1,853,509			—		—		1,853,509			—			1,853,509

Other comprehensive income, net of tax:
Unrealized holding gains (losses) on
securities available for sale, net of
reclassification adjustment		(40,664	)		—		—		—			(40,664	)		(40,664	)

Total comprehensive income		1,812,845

BALANCE, September 30, 2004					2,487,234		12,193,318		3,905,776			139,918			18,726,246

The 2004 financial information in this report has not been audited. The information included herein should be read in conjunction with the notes to the consolidated financial statements included in the 2003 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone Bancshares, Inc. (“Cornerstone”) in March of 2004. The consolidated financial statements presented herein conform to generally accepted accounting principles and to general industry practices.

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

The company has two stock-based compensation plans. 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 have 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.

	Sept-04			Sept-03			Dec-03			Dec-02
Net Income, as reported	$	1,853,509		$	1,393,493		$	1,881,859		$	1,061,423

Deduct: Total Stock-based employee
compensation expense determined under
fair value method for all awards, net of
the related tax effects		($49,469	)		($36,962	)		($36,962	)		($21,348	)

Pro Forma Net Income	$	1,804,040		$	1,356,531		$	1,844,897		$	1,040,075

Earnings Per Share:
Basic-as reported	$	0.75		$	0.56		$	0.76		$	0.43
Basic-pro forma	$	0.73		$	0.54		$	0.74		$	0.42

Diluted-as reported	$	0.67		$	0.51		$	0.71		$	0.42
Diluted-pro forma	$	0.65		$	0.49		$	0.69		$	0.41

Stock Amounts
Average Common Stock
Issued as of: [1]		2,487,132			2,486,334			2,475,203			2,466,334

Effect of dilutive stock options:		297,263			184,762			184,762			88,656

The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include standby letters of credit and various commitments to extend credit. At September 30, 2004, commitments under standby letters of credit and undisbursed loan commitments aggregated $41,181,517. The Bank’s credit exposure for these financial instruments is represented by their contractual amounts. The Bank does not anticipate any material losses as a result of the commitments under standby letters of credit and undisbursed loan commitments.

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

Cornerstone Bancshares, Inc. (“Cornerstone”) is a bank holding company and the parent of Cornerstone Community Bank, a Tennessee banking corporation (the “Bank”) that operates in and around Hamilton County, Tennessee. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses.

Cornerstone ended the first nine months of 2004 with total assets of $240 million, a 19.2% increase from December 31, 2003 and a 31.7% increase from September 30, 2003. Cornerstone reported net income for the nine months ending September 30, 2004 of $1,853,509, or $0.75 basic earnings per share, compared to $1,393,493, or $0.56 basic earnings per share, for the same period in 2003. The increase in earnings during the first nine months of 2004 represents a 33% increase compared to the first nine months of 2003.

The increase in net income for the first nine months of 2004 was due primarily to the 20% growth of loans and deposits while maintaining the Bank’s net interest margin of 5.0%. This balance sheet growth enabled the Bank to increase its net-interest income by $1.7 million, or 28.39% compared to the same period in 2003. The Bank’s relationship managers accomplished this by collecting fees on newly originated loans and by selling loan participations to other banks outside of Cornerstone’s market area and retaining a servicing fee and the customer’s deposits. The Bank’s success is directly related to the quality of its relationship managers and will seek additional talented lenders to continue increasing the Bank’s market share of business banking in the Chattanooga MSA.

The Bank was also able to materially increase deposits over the first nine months of 2004. The Bank’s non-interest bearing checking accounts increased 80.7% to $32.5 million and interest bearing checking accounts increased 32.6% to $29.6 million while savings accounts and money market accounts increased 38.0% to $36.4 million compared to the same time period in 2003. The increases are due to the Bank’s continued focus on attracting these type of accounts and allowed the Bank to maintain its above peer average net interest margin . The Bank also took advantage of attractive non-traditional funding sources during the second quarter of 2004. Cornerstone increased its Federal Home Loan Bank borrowings by $10 million during the second quarter and selected longer-term maturities to reduce the Bank’s general interest rate risk. In addition, the Bank actively used its federal funds lines of credit as an inexpensive source of funds. The Bank anticipates slower deposit growth in both transaction deposits during the fourth quarter of 2004.

On the qualitative side, the Bank maintained its asset quality, which is quantified by the Bank’s below peer bank average of past due loans to net loans ratio of 0.19% and a below peer bank average non-performing asset ratio of 0.036%. This was accomplished during a time period when regional banks struggled to maintain net interest margin and suffered from a general deterioration of loan quality. For the first nine months of 2004, the Bank’s net interest margin was 5.00%, compared to 4.87% for the same time period in 2003. The Bank’s management expects the Bank’s net interest margin to decrease slightly to a more historic level of 4.9% over the remainder of 2004.

Due to a robust improvement in the growth of the United States GDP the Federal Reserve is adjusting its positioning of fiscal policy from accommodative to neutral. To date the Federal Reserve has increased rates three times in 2004 and taken the Federal Funds rate (the rate banks borrow from each other overnight) from 1.0% to 1.75% and the Bank believes the Federal Reserve will continue to increase rates repetitively until the Federal Funds rate is in the 3.0% to 3.5% range. Presently the Bank has a positive “GAP” which means the Bank’s assets will reprice quicker than its liabilities as interest rates increase or decrease and is in an appropriate position if rates were to increase as most economists have predicted.

During the third quarter of 2004 Cornerstone continued to work on improving its manpower and capital capacity as an increasing number of businesses and other banking customers that were unable to retain relationships with, or were poorly treated by, regional banking institutions became customers of the Bank. The Chattanooga banking community continued to suffer from manpower adjustments which left many quality businesses and other banking customers without previously existing banking relationships. As a result, many businesses and other banking customers changed banks. Cornerstone and other stable community banks have readily accepted these banking relationship transfers and Cornerstone expects the trend to continue.

The Bank has continued to expand its asset based lending program and has developed into a Tennessee leader in SBA lending as several SBA loan generation associations refer loans to the Bank due its depth of knowledge with respect to specialty loans and willingness to consider these loans. The Bank’s position on SBA loans is to strictly underwrite each loan to Bank credit guidelines. In addition, when SBA loans are saleable to the secondary market, the Bank will generally sell the SBA loans to increase fee income and enhance the net income of the Bank.

In August the Bank had the grand opening of its new branch on Old Lee Highway, Ooltewah, Tennessee, and during the first quarter of operation the branch reached $5 million in deposits and management believes the branch will reach $10 million in deposits by the end of 2004. The opening provides Cornerstone five full service branches in Hamilton County and provides customers in the Cleveland, Tennessee area a branch slightly south of Cleveland’s city limits. The Bank intends to continue opening new branch locations as opportunities present themselves.

The Bank, pursuant to its strategic plan, intends to continue to focus on providing a competitive footprint (convenient branches) to the Chattanooga Metropolitan Statistical Area allowing it to compete with the three major regional banks located in the area. The Bank also intends to focus its efforts in the suburb branch network and not on a central hub bank located in downtown Chattanooga. It is also intended that special emphasis will be placed on providing services specifically targeted to small businesses and individual consumers.

Earning Assets. Average earning assets for the nine months ending September 30, 2004, increased by $40.7 million, or 24.9% compared to the nine months ending September 30, 2003, while actual earning assets increased $55.8 million or 32.3% during the same period. The average and actual balance increases were due to strong loan demand in the nine months of 2004 and a strong growth in transaction account deposits during the current reporting period. Management expects average earning assets to grow at a similar pace during the remainder of 2004.

Investment Portfolio. The Bank’s average investment securities portfolio and Federal Funds Sold increased by 11.9% or $2.9 million for the nine months ending September 30, 2004 compared to the nine months ending September 30, 2003, while actual balances increased $13.6 million or 65.4% for the same period. The difference in growth is due to a surge of checking deposits of which five million is temporary deposits and invested in Federal Funds sold. Management believes the appropriate current level of investment securities for the Bank is $30.0 million and will carefully purchase securities that provide acceptable return versus the interest rate risk. Management expects the average and actual balance of securities to increase over the remainder of 2004 up to the level mentioned above. The Bank expects to maintain an investment strategy of making prudent investment decisions with active management of the portfolio to optimize, within the constraints of established policies, an adequate return and value. Investment objectives include, in order of priority, gap management, liquidity, pledging, return, and local community support. The Bank maintains two classifications of investment securities: “Held to Maturity” (HTM) and “Available for Sale” (AFS). The “Available for Sale” securities are carried at fair market value, whereas “Held to Maturity” securities are carried at book value. As of September 30, 2004, net unrealized gains in the “Available for Sale” portfolio amounted to $211,997, a 0.9% increase in value.

Deposits. The Bank’s average deposits increased by $32.4 million or 23.8% for the nine-month period ending September 30, 2004 compared to the same period ending September 30, 2003, while actual deposit balances increased by $45.2 million or 31.7%. The actual deposit growth was broad based with non-interest bearing transaction accounts increasing by 80.7% during the same time period. Management intends to continue to focus its efforts on attracting core deposits and expects certificates of deposit of less than $100,000 to increase over the remainder of 2004 as loan growth continues. The Bank intends to maintain as one of its highest priorities the continued solicitation of transaction accounts from new and existing customers, which should provide the Bank with an increased net interest margin.

Liquidity and Capital Resources. As of the end of the third quarter of 2004 the Bank had $27 million of Federal Home Loan Bank of Cincinnati (“FHLB”) borrowings and the ability to borrow another $15 million. The borrowings are designed with a maturity of 10 years with call and put options after a stated conversion date. Management believes that FHLB borrowings provide an inexpensive method to reduce interest rate risks by obtaining longer term liabilities to match the typically longer term assets the Bank has on its balance sheet that are usually below the cost of certificates of deposit. Cornerstone, under its $5.0 million guidance line with Fifth Third Bank, borrowed $2.1 million to inject capital into the Bank. The injection was needed to maintain an 8% capital leverage ratio, which the regulators consider appropriate, given the size of our Bank. The loan is priced at 30-day LIBOR index plus 150 basis points, which as of September 30, 2004 was 3.44%.

Due to its rapid asset growth, the Bank has been forced to address issues of liquidity and capital resources. The Bank is currently earning a return on equity of approximately 15% while growing assets at a rate of approximately 30%, which leaves a shortfall of approximately 15%. Having no desire to reduce or slow-down the Bank’s current growth, Cornerstone’s board of directors and management is in the process of raising additional capital to allow the Bank to continue to grow its market share and above average earnings growth. Pursuant to a prospectus filed with the SEC, Cornerstone intends to sell in the open market a secondary stock issue of up to 500,000 shares of Cornerstone’s common stock. If fully subscribed, the amount raised will be in excess of $7 million and should provide sufficient capital for future growth.

Nine months ended

September 30,


2004

2003

Assets

Average

Income /

Yield /

Average

Income /

Yield /

Balance

Expense

Rate

Balance

Expense

Rate

Loans, net of unearned income

$

176,210

$

9,421

7.15

%

$

137,585

$

7,587

7.37

%

Investment securities

26,920

755

3.87

%

24,051

743

4.23

%

Other earning assets

949

10

1.41

%

1,714

17

1.31

%

Total earning assets

204,079

$

10,187

6.68

%

163,350

$

8,347

6.84

%

Allowance for loan losses

(2,229

)

(1,766

)

Cash and other assets

16,031

12,759

    TOTAL ASSETS

$

217,881

$

174,343

Liabilities and Stockholders' Equity

Interest bearing liabilities:

Interest bearing demand deposits

$

28,023

$

90

0.43

%

$

21,776

$

51

0.31

%

Savings deposits

7,386

28

0.51

%

6,837

38

0.74

%

MMDA's

24,693

281

1.52

%

18,184

218

1.61

%

Time deposits

58,305

1,080

2.48

%

53,336

1,187

2.97

%

Time deposits of $100,000 or more

23,988

443

2.47

%

18,881

460

3.26

%

Federal funds and securities sold under

agreements to repurchase

4,904

41

1.12

%

5,125

49

1.29

%

Other borrowings

25,105

609

3.24

%

15,692

411

3.51

%

Total interest bearing liabilities

172,404

2,572

1.99

%

139,831

2,414

2.31

%

Net interest spread

$

7,615

$

5,933

Noninterest bearing demand deposits

26,431

17,448

Accrued expenses and other liabilities

1,238

1,166

Stockholders' equity

17,808

15,898

    TOTAL LIABILITIES AND

    STOCKHOLDERS' EQUITY

$

217,881

$

174,343

Net interest margin on earning assets

5.00

%

4.87

%

Net interest spread on earning assets

4.68

%

4.53

%

Net interest income before loan loss provision for the first nine months of 2004 increased $1,681,346 or 28.3% above net interest income before loan loss provision for the first nine months of 2003. The increase in net interest income as of September 30, 2004 was primarily due to the growth in interest income and fees associated with loan growth, which grew $1.8 million or 22%, while interest expense increased only $158 thousand or 6.6% compared to the same time period. The loan income growth was mainly in the commercial and commercial real estate areas and was supplemented by SBA fees and loan participation fees. Deposits and interest expense had a rather small increase for the first nine months of 2004 even with a 23.3% growth of average interest bearing liabilities due to the cost of funds decreasing from 2.31% for the first nine months of 2003 to 1.99% for the first nine months of 2004. The yield from earning assets decreased from 6.84% to 6.68% over the same time period. Two additional factors assisted net interest income growth. First, the Bank’s asset mix shifted as the percentage of average loans to average total assets increased to 80.9% for the first nine months of 2004 from 78.9% for the first nine months of 2003, providing the majority of the Bank’s asset growth in higher yielding assets. Second, SBA loan production that is not reflected in the average loan balances was sold to the secondary market generating fee income. The increase in net interest margin exceeded the Bank’s projections by approximately 13 basis points and can be directly attributed to the above-mentioned factors. Management foresees the net interest margin remaining at these levels for the remainder of 2004 and having a slight compression as rates adjust during the first half of 2005.

Interest income increased $1,839,512 or 22% for the period ended September 30, 2004 compared to the same period ended September 30, 2003. Interest income produced by the loan portfolio increased $1,834,190 or 24.2% for the nine month period ended September 30, 2004 compared to nine month period ended September 30, 2003, due to the increase in average loans outstanding and origination fees associated with loan growth for the period. The increase of loan interest income was partially offset by the general repricing of the loan portfolio in a low interest rate environment. Management estimates the average and actual balances will continue to increase throughout the remainder of 2004. Interest income on investment securities, Federal Funds and other investments increased $5,322 or 0.7% for the nine month period ending September 30, 2004 compared to the nine month period ended September 30, 2003, due primarily to an increase in the average number of securities owned during the reporting period but mostly offset by a decease in general market rates and lower average outstanding balances for a prolonged period of time.

The trend in net interest income is commonly evaluated in terms of average rates using the net interest margin and the interest rate spread. The net interest margin, or the net yield on earning assets, is computed by dividing fully taxable equivalent net interest income by average earning assets. This ratio represents the difference between the average yield on average earning assets and the average rate paid for all funds used to support those earning assets. The net interest margin for the first nine months of 2004 was 5.00%. The yield on earning assets decreased 16 basis points to 6.68% for the period ended September 30, 2004, compared to 6.84% for the period ended September 30, 2003.

The interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing sources of funds. The interest rate spread eliminates the impact of non-interest bearing funds and gives a direct perspective on the effect of market interest rate movements. As the Federal Reserve decreased interest rates during the first six months of 2003, certificates of deposits and transaction accounts were able to reprice at a much lower levels and assisted the interest rate spread increase to 4.68% for the nine month period ending September 30, 2004 compared to 4.53% for the same period ending September 30, 2003, an increase of 15 basis points.

Allowance for Loan Losses. The allowance for possible loan losses represents management’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for possible loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. Management believes that the $2.5 million allowance for loan losses as of September 30, 2004 reflects the full known extent of credit exposure. Cornerstone made a $585,000 provision during the first nine months of 2004 and anticipates similar provisions in the future as the loan portfolio grows and unanticipated loan losses occur. No assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

Non-performing Assets. Non-performing assets include non-performing loans and foreclosed real estate held for sale. Non-performing loans include loans classified as non-accrual or renegotiated. The Bank’s policy is to place a loan on non-accrual status when payment of principal or interest is contractually 90 or more days past due. At the time a loan is placed on non-accrual status, interest previously accrued but not collected may be reversed and charged against current earnings. As of September 30, 2004, the Bank had $68,893 in non-accruing loans and no other 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, commissions earned through credit life insurance sales and other activities. In addition, gains or losses realized from the sale of residential mortgage loans are included in non-interest income. Total non-interest income decreased by $11,361 or 1.2% from the first nine months of 2003 compared with the first nine months of 2004. During the first nine months of 2004 the Bank purchased customer’s assets for the purpose of leasing them back to these existing customers. The product line should produce accelerated depreciation for the Bank while de-leveraging the customer’s balance sheet. The expected internal rates of return on these types of leases range from 15% to 25%. The leases are scheduled over three years and the customer will be given the option to buy back the assets at the end of the lease at fair market value or renew the existing lease. Management believes the line of business will provide above average returns with similar risk to a loan. Offsetting this increase due to a new product line was a general slow down of the sale of mortgage loans driven by higher long term interest rates.

Non-interest Expense. Non-interest expense for the first nine months of 2004 increased by $733,269 or 17.5% compared to the first nine months of 2003. Expenses for salaries and employee benefits increased by $521,916 or 22.2% for the nine months ending September 30, 2004 over the same period ending September 30, 2003. Occupancy and equipment expense as of Septmeber 30, 2004 increased by $74,190 or 12.2% over the same period in 2003. All other non-interest expenses for the nine-month period ended September 30, 2004 increased $137,163 or 11.2% over the non-interest expenses for the same period ended September 30, 2003. The increase in all other non-interest expense is due primarily to the growth of the Bank and its needs to properly manage the growth. The Bank added one talented lender and has had to add two back office personnel to handle the increased volume of activity from the new transaction accounts opened over the last year. The growth in occupancy expense can be attributed to the expenses associated with opening the Bank’s new Ooltewah branch in June of 2004. In addition the bank data processing cost has grown concurrently with the Bank’s deposit growth.

	Three months ended September 30,
				2004								2003
Assets	Average			Income /		Yield /			Average			Income /		Yield /
	Balance			Expense		Rate			Balance			Expense		Rate

Loans, net of unearned income	$	190,151		$	3,423		7.14	%	$	148,873		$	2,672		7.12	%
Investment securities		28,645			275		3.93	%		23,079			229		3.94	%
Other earning assets		1,675			7		1.66	%		312			2		1.98	%
Total earning assets		220,471		$	3,705		6.68	%		172,264		$	2,903		6.69	%
Allowance for loan losses		(2,398	)							(1,916	)
Cash and other assets		17,324								12,796
TOTAL ASSETS	$	235,397							$	183,144

Liabilities and Stockholders' Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	31,313		$	39		0.49	%	$	22,038		$	12		0.22	%
Savings deposits		7,729			10		0.51	%		6,885			9		0.51	%
MMDA's		26,976			104		1.53	%		18,328			68		1.47	%
Time deposits		59,808			363		2.41	%		57,227			394		2.73	%
Time deposits of $100,000 or more		26,958			177		2.60	%		18,467			143		3.07	%
Federal funds and securities sold under
agreements to repurchase		4,256			14		1.31	%		6,449			22		1.38	%
Other borrowings		29,150			240		3.27	%		17,400			148		3.37	%
Total interest bearing liabilities		186,190			947		2.02	%		146,794			796		2.15	%
				$	2,758							$	2,107
Noninterest bearing demand deposits		29,491								18,742
Accrued expenses and other liabilities		1,306								1,256
Stockholders' equity		18,410								16,352
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY	$	235,397							$	183,144

Net interest margin on earning assets							4.98	%							4.85	%

Net interest spread on earning assets							4.66	%							4.53	%

Net Interest Income. Net interest income before loan loss provision for the third quarter of 2004 increased $651,107 or 30.9% above net interest income before loan loss provision for the third quarter of 2003. The increase in net interest income was primarily due to an increase in interest income from earning asset growth while deposit cost increased at a slower rate. Two factors assisted net interest income growth. First and most importantly was the growth of earning assets. Earning assets increased $48.2 million over the previous year’s third quarter a increase of 28.0%. Second, the interest income from earning assets decreased only from 6.69% to 6.68% while interest cost from the Bank’s liabilities decreased from 2.15% to 2.02% over the same time period. The major contributor to this decrease of interest expense was the Bank’s deposit mix which shifted as the percentage of average transaction accounts to average total deposits grew from 46.6% for the third quarter of 2003 to 52.4% for the third quarter of 2004, providing the majority of the Bank’s deposit growth in less expensive deposits. The increase in net interest margin was above the Bank’s projections and can be directly attributed to the above-mentioned change in the Bank’s deposit mix and the recent addition of commercial finance department fee income and SBA fees. Management foresees the margin decreasing to more historic levels for the remainder of 2004.

Total interest income increased $801,306 or 27.6% for the three month period ended September 30, 2004 compared to the same period ended September 30, 2003. Interest income produced by the loan portfolio increased $750,691 or 28.1% for the three month period ended September 30, 2004 compared to the three month period ended September 30, 2003, due to the increase in average loans outstanding and origination fees associated with loan growth for the period. The increase in the volume of loan interest income was only slightly offset by the general repricing of the loan portfolio in a low interest rate environment. Management estimates the average balances will continue to increase. Interest income on investment securities, Federal Funds and other investments increased $50,615 or 21.9% for the three-month period ending September 30, 2004 compared to the three-month period ended September 30, 2003. This was due primarily to the growth of the securities portfolio as interest rates increased with the improvement of the U.S. economy and provided a more acceptable risk versus return ratio. As interest rates increase the Bank will make further investments in securities to provide liquidity and stability to the Bank’s balance sheet.

Even with the Federal Reserve increasing rates three times during 2004, the Bank’s deposits were able to remain below the level of interest paid during the third quarter of 2003 due to a lag in repricing of the Bank’s deposits. As the Federal Reserve increases interest rates further during 2005, the Bank’s deposits will reprice and show increases in the interest expense but should not negatively affect the Bank’s net interest margin as the Bank’s earning assets will increase at a faster rate than its liabilities. The net interest spread on earning assets increased to 4.66% for the three month period ending September 30, 2004 compared to 4.53% for the same period ending September 30, 2003, an increase of 13 basis points.

Allowance for Loan Losses. The allowance for possible loan losses represents management’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio to determine the adequacy of the allowance for possible loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. Management believes that the $2.5 million allowance for loan losses as of September30, 2004 reflects the full known extent of credit exposure. Cornerstone made a $175,000 provision during the third quarter of 2004 and anticipates similar provisions in the future as the loan portfolio grows and unanticipated loan losses occur. No assurances can be given, however, that adverse economic circumstances will not result in increased losses in the loan portfolio and require greater provisions for possible loan losses in the future.

	2004						2003
Quarter Ending	September 30		June 30		March 31		December 31		September 30

Balance at beginning of period	2,312,218		2,113,930		2,011,329		2,090,751		1,827,734
Loans charged-off	(33,024	)	(68,763	)	(202,060	)	(220,401	)	(3,802	)
Loans recovered	6,347		17,050		144,662		5,978		11,819
Net charge-offs (recoveries)	26,677		51,712		57,399		214,423		(8,018	)
Provision for loan losses charged
to expense	175,000		250,000		160,000		135,000		255,000
Balance at end of period	2,460,541		2,312,218		2,113,930		2,011,329		2,090,751

Allowance for loan losses as a
percentage of average loans
outstanding for the period	1.294	%	1.318	%	1.299	%	1.311	%	1.439	%

Allowance for loan losses as a
percentage of nonperforming assets
and loans 90 days past due
outstanding for the period	3571.540	%	5125.050	%	4802.094	%	696.646	%	482.654	%

Annualized QTD net charge-offs as
a percentage of average loans
outstanding for the period	0.056	%	0.118	%	0.141	%	0.559	%	-0.022	%

Annualized YTD net charge-offs as
a percentage of average loans
outstanding for the period	0.103	%	0.129	%	0.141	%	0.088	%	-0.087	%



YTD Average Outstanding Loans	175,190,146		169,078,607		162,760,681		141,586,000		137,585,459

QTD Average Outstanding Loans	190,151,000		175,396,703		162,760,681		153,454,946		148,873,000

Nonperforming assets and
loans 90 days past due	68,893		45,116		44,021		288,716		433,178

Non-interest Expense. Non-interest expense for the third quarter of 2004 increased by $329,521 or 23.3% compared to the same three months in 2003. Expenses for salaries and employee benefits increased by $170,325 or 21.3% for the three months ending September 30, 2004 over the same period ending September 30, 2003. Occupancy and equipment expense as of September 30, 2004 increased by $43,410 or 16.0% over the same period in 2003. All other non-interest expenses for the three-month period ended September 30, 2004 increased $115,785 or 33.9% above the non-interest expenses for the same period ended September 30, 2003. The increase in non-interest expense is broad based and used to support the rapid growth of the Bank’s assets and liabilities in a safe and sound manner. In addition, the Bank took a $45 thousand provision to build an allowance against possible losses associated with electronic transfer of funds. The allowance is equal to the Bank’s deductible of its insurance policy purchased to mitigate this risk and to date the Bank has not charged off any amount associated with this line of business.

Cornerstone’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of Cornerstone’s disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to Cornerstone (including its consolidated subsidiaries) required to be included in Cornerstone’s periodic filings under the Exchange Act.

	Exhibit Number		Description

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

	Exhibit Number		Description

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


	Cornerstone Bancshares, Inc.

Date: November 12, 2004	By:	/s/ Gregory B. Jones
		Gregory B. Jones,
		Chairman and Chief Executive Officer




Date: November 12, 2004	By:	/s/ Nathaniel F. Hughes
		Nathaniel F. Hughes
		President and Chief Financial Officer

Tennessee (State of Jurisdiction of Incorporation or Organization)		62-1173944 (I.R.S. Employer Identification Number)
	5319 Highway 153 Chattanooga, Tennessee 37423 (423) 385-3000 (Address, and Telephone Number of Principal Executive Offices and Principal Place of Business)

	Nine months ended September 30,
				2004								2003
Assets	Average			Income /		Yield /			Average			Income /		Yield /
	Balance			Expense		Rate			Balance			Expense		Rate

Loans, net of unearned income	$	176,210		$	9,421		7.15	%	$	137,585		$	7,587		7.37	%
Investment securities		26,920			755		3.87	%		24,051			743		4.23	%
Other earning assets		949			10		1.41	%		1,714			17		1.31	%
Total earning assets		204,079		$	10,187		6.68	%		163,350		$	8,347		6.84	%
Allowance for loan losses		(2,229	)							(1,766	)
Cash and other assets		16,031								12,759
TOTAL ASSETS	$	217,881							$	174,343

Liabilities and Stockholders' Equity

Interest bearing liabilities:
Interest bearing demand deposits	$	28,023		$	90		0.43	%	$	21,776		$	51		0.31	%
Savings deposits		7,386			28		0.51	%		6,837			38		0.74	%
MMDA's		24,693			281		1.52	%		18,184			218		1.61	%
Time deposits		58,305			1,080		2.48	%		53,336			1,187		2.97	%
Time deposits of $100,000 or more		23,988			443		2.47	%		18,881			460		3.26	%
Federal funds and securities sold under
agreements to repurchase		4,904			41		1.12	%		5,125			49		1.29	%
Other borrowings		25,105			609		3.24	%		15,692			411		3.51	%
Total interest bearing liabilities		172,404			2,572		1.99	%		139,831			2,414		2.31	%
Net interest spread				$	7,615							$	5,933
Noninterest bearing demand deposits		26,431								17,448
Accrued expenses and other liabilities		1,238								1,166
Stockholders' equity		17,808								15,898
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY	$	217,881							$	174,343

Net interest margin on earning assets							5.00	%							4.87	%

Net interest spread on earning assets							4.68	%							4.53	%