SMARTFINANCIAL INC. - Quarter Report: 2014 September (Form 10-Q)

United States Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

(Mark One)

x	QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the quarterly period ended September 30, 2014

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

Commission File Number: 000-30497

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

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

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

423-385-3000		Not Applicable
(Registrant’s telephone number, including area code)		(Former name, former address and former fiscal
		year, if changes since last report)

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

Yes x No ¨

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

Yes x No ¨

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

Large accelerated filer ¨

Accelerated filer ¨

Non-accelerated filer ¨

Smaller reporting company x

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

Yes ¨ No x

As of November 1, 2014 there were 6,627,398 shares of common stock, $1.00 par value per share, issued and outstanding.

TABLE OF CONTENTS

PART I –FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	29

Item 3. Quantitative and Qualitative Disclosures About Market Risk	39

Item 4. Controls and Procedures	39

PART II – OTHER INFORMATION	39

Item 1. Legal Proceedings	39

Item 1A. Risk Factors	39

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	39

Item 3. Defaults Upon Senior Securities	39

Item 4. Mine Safety Disclosures	39

Item 5. Other Information	39

Item 6. Exhibits	39

FORWARD-LOOKING STATEMENTS

Cornerstone Bancshares, Inc. (“Cornerstone”) may from time to time make written or oral statements, including statements contained in this report (including, without limitation, certain statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I, Item 2), that constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 (the “Exchange Act”). The words “expect,” “anticipate,” “intend,” “consider,” “plan,” “believe,” “seek,” “should,” “estimate,” and similar expressions are intended to identify such forward-looking statements, but other statements may constitute forward-looking statements. These statements should be considered subject to various risks and uncertainties. Such forward-looking statements are made based upon management’s belief as well as assumptions made by, and information currently available to, management pursuant to “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Cornerstone’s actual results may differ materially from the results anticipated in forward-looking statements due to a variety of factors. Such factors include, without limitation, those specifically described in Item 1A of Part I of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013, as well as the following: (i) the possibility that our asset quality would decline or that we experience greater loan losses than anticipated, (ii) increased levels of other real estate, primarily as a result of foreclosures, (iii) the impact of liquidity needs on our results of operations and financial condition, (iv) competition from financial institutions and other financial service providers, (v) economic conditions in the local markets where we operate, (vi) the impact of obtaining regulatory approval prior to the payment of dividends, (vii) the impact of our Series A Preferred Stock on net income available to holders of our Common Stock and earnings per common share, (viii) the impact of negative developments in the financial industry and U.S. and global capital and credit markets, (ix) the impact of recently enacted legislation on our business, (x) the relatively greater credit risk of residential construction and land development loans in our loan portfolio, (xi) adverse impact on operations and financial condition due to changes in interest rates, (xii) our ability to obtain additional capital and, if obtained, the possible significant dilution to current shareholders, (xiii) the impact of federal and state regulations on our operations and financial performance, (xiv) whether a significant deferred tax asset we have can be fully realized, (xv) our ability to retain the services of key personnel, (xvi) the impact of Tennessee’s anti-takeover statutes and certain charter provisions on potential acquisitions of the holding company, and (xvii) our ability to adapt to technological changes. Many of such factors are beyond Cornerstone’s ability to control or predict, and readers are cautioned not to put undue reliance on such forward-looking statements. Cornerstone does not intend to update or reissue any forward-looking statements contained in this report as a result of new information or other circumstances that may become known to Cornerstone.

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Balance Sheets

	Unaudited
	September 30,			December 31,
	2014			2013
ASSETS

Cash and due from banks	$	1,091,657		$	2,149,467
Interest-bearing deposits at other financial institutions		14,783,017			22,702,270
Total cash and cash equivalents		15,874,674			24,851,737

Securities available for sale		78,249,672			92,208,672
Securities held to maturity (fair value $29,643 and $35,027 at September 30, 2014 and December 31, 2013, respectively)		29,374			34,165
Federal Home Loan Bank stock, at cost		2,322,900			2,322,900
Loans, net of allowance for loan losses of $3,473,954 and $3,203,158 at September 30, 2014 and December 31, 2013, respectively		294,916,467			286,236,578
Bank premises and equipment, net		4,835,378			4,992,449
Accrued interest receivable		1,179,789			977,925
Foreclosed assets		10,993,825			12,925,748
Other assets		4,975,510			7,673,179
Total assets	$	413,377,589		$	432,223,353

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	53,615,550		$	75,206,540
Interest-bearing demand deposits		25,246,319			24,563,987
Savings deposits and money market accounts		83,109,173			86,329,930
Time deposits		154,342,518			155,313,920
Total deposits		316,313,560			341,414,377

Accrued interest payable		78,425			82,320
Federal funds purchased and securities sold under agreements to repurchase		27,335,750			22,974,117
Federal Home Loan Bank advances and other borrowings		28,000,000			26,740,000
Other liabilities		1,253,778			878,811
Total liabilities		372,981,513			392,089,625

Stockholders' equity:
Preferred stock - no par value; 2,000,000 shares authorized;
600,000 shares issued and outstanding in 2014 and 2013		14,946,464			14,892,927
Common stock - $1.00 par value; 20,000,000 shares authorized;
6,709,199 shares issued in 2014 and 2013;
6,627,398 and 6,547,074 shares outstanding in 2014 and 2013, respectively		6,627,398			6,547,074
Additional paid-in capital		21,780,560			21,549,883
Accumulated deficit		(3,050,663	)		(3,099,451	)
Accumulated other comprehensive income		92,317			243,295
Total stockholders' equity		40,396,076			40,133,728
Total liabilities and stockholders' equity	$	413,377,589		$	432,223,353

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Income

	Unaudited				Unaudited
	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
INTEREST INCOME
Loans, including fees	$	4,167,994	$	4,293,583	$	12,488,587	$	12,514,688
Securities and interest-bearing deposits at other financial institutions		327,135		457,299		1,104,132		1,379,322
Federal funds sold		7,129		9,510		24,404		45,515
Total interest income		4,502,258		4,760,392		13,617,123		13,939,525

INTEREST EXPENSE
Time deposits		352,255		445,397		1,093,282		1,365,993
Other deposits		89,574		117,327		232,613		386,791
Federal funds purchased and securities sold under agreements to repurchase		18,983		21,435		58,264		56,258
Federal Home Loan Bank advances and other borrowings		230,915		284,882		755,526		941,269
Total interest expense		691,727		869,041		2,139,685		2,750,311

Net interest income before provision for loan losses		3,810,531		3,891,351		11,477,438		11,189,214
Provision for loan losses		-		-		515,000		300,000
Net interest income after provision for loan losses		3,810,531		3,891,351		10,962,438		10,889,214

NONINTEREST INCOME
Customer service fees		214,761		218,304		613,210		608,087
Net gains from sale of securities		169,037		-		571,510		424,971
Net gains from sale of loans and other assets		106,906		39,164		132,349		240,746
Other noninterest income		13,062		12,500		43,498		48,968
Total noninterest income		503,766		269,968		1,360,567		1,322,772

NONINTEREST EXPENSE
Salaries and employee benefits		1,702,352		1,619,030		5,251,839		4,838,822
Net occupancy and equipment expense		314,976		333,850		947,894		1,011,335
Depository insurance		162,798		161,956		481,641		482,920
Foreclosed assets, net		688,124		381,847		1,400,616		1,308,995
Other operating expenses		790,856		967,888		2,253,090		2,500,107
Total noninterest expenses		3,659,106		3,464,571		10,335,080		10,142,179

Income before income tax expense		655,191		696,748		1,987,925		2,069,807
Income tax expense		249,500		268,200		760,600		793,100

Net income		405,691		428,548		1,227,325		1,276,707

Preferred stock dividend requirements		375,000		375,000		1,125,000		1,125,000
Accretion on preferred stock discount		17,846		17,845		53,537		53,535

Net income available to common shareholders	$	12,845	$	35,703	$	48,788	$	98,172

EARNINGS PER COMMON SHARE
Basic	$	-	$	0.01	$	0.01	$	0.01
Diluted	$	-	$	0.01	$	0.01	$	0.01

DIVIDENDS DECLARED PER COMMON SHARE	$	-	$	-	$	-	$	-

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Comprehensive Income

	Unaudited
	Three Months Ended
	September 30
	2014			2013
Net income	$	405,691		$	428,548

Other comprehensive income, net of tax:
Unrealized holding gains (losses) arising during the period, net of tax (expense) benefit of $(37,530) and $104,336 in 2014 and 2013, respectively		61,233			(170,234	)

Reclassification adjustment for gains included in net income, net of tax expense of $64,234 in 2014		(104,803	)		-

Total other comprehensive loss		(43,570	)		(170,234	)

Comprehensive income	$	362,121		$	258,314

	Unaudited
	Nine Months Ended
	September 30
	2014			2013
Net income	$	1,227,325		$	1,276,707

Other comprehensive income, net of tax:
Unrealized holding gains (losses) arising during the period, net of tax (expense) benefit of $(124,639) and $531,464 in 2014 and 2013, respectively		203,359			(867,126	)

Reclassification adjustment for gains include in net income, net of tax expense of $217,173 and $161,489 in 2014 and 2013, respectively		(354,337	)		(263,482	)

Total other comprehensive loss		(150,978	)		(1,130,608	)

Comprehensive income	$	1,076,347		$	146,099

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statement of Changes in Stockholders' Equity - Unaudited

For the Nine Months Ended September 30, 2014

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

BALANCE, December 31, 2013	$	14,892,927	$	6,547,074	$	21,549,883	$	(3,099,451	)	$	243,295		$	40,133,728

Stock compensation expense		-		-		120,000		-			-			120,000

Issuance of common stock, 80,324 shares		-		80,324		110,677		-			-			191,001

Preferred stock dividends paid		-		-		-		(1,125,000	)		-			(1,125,000	)

Accretion on preferred stock		53,537		-		-		(53,537	)		-			-

Net income		-		-		-		1,227,325			-			1,227,325

Unrealized holding losses on securities available for sale, net of reclassification adjustment		-		-		-		-			(150,978	)		(150,978	)

BALANCE, September 30, 2014
	$	14,946,464	$	6,627,398	$	21,780,560	$	(3,050,663	)	$	92,317		$	40,396,076

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

	Unaudited
	Nine Months Ended September 30,
	2014			2013

CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	1,227,325		$	1,276,707
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		340,115			295,836
Provision for loan losses		515,000			300,000
Stock compensation expense		120,000			96,793
Gain on sale of securities		(571,510	)		(424,971	)
Net gains on sales of loans and other assets		(132,349	)		(240,746	)
Changes in other operating assets and liabilities:
Accrued interest receivable		(201,864	)		(8,063	)
Accrued interest payable		(3,895	)		(20,429	)
Other assets and liabilities		1,830,515			1,509,377
Net cash provided by operating activities		3,123,337			2,784,504

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security sales, maturities, and paydowns:
Securities available for sale		17,829,552			29,187,978
Securities held to maturity		4,824			8,354
Purchase of securities available for sale		(3,603,228	)		(49,745,656	)
Distribution from equity investment		2,389,971			-
Loan originations and principal collections, net		(9,023,324	)		(11,836,658	)
Purchase of bank premises and equipment		(122,404	)		(17,734	)
Proceeds from the sale of bank premises and equipment and foreclosed assets		837,392			6,098,875
Net cash provided by (used in) investing activities		8,312,783			(26,304,841	)

CASH FLOWS FROM FINANCING ACTIVITIES
Net decrease in deposits		(25,100,817	)		(4,124,305	)
Net increase in federal funds purchased and securities sold under agreements to repurchase		4,361,633			921,268
Net proceeds from (repayments of) Federal Home Loan Bank advances and other borrowings		1,260,000			(10,435,000	)
Payment of dividends on preferred stock		(1,125,000	)		(1,058,893	)
Issuance of common stock		191,001			77,019
Net cash used in financing activities		(20,413,183	)		(14,619,911	)

NET DECREASE IN CASH AND CASH EQUIVALENTS		(8,977,063	)		(38,140,248	)

CASH AND CASH EQUIVALENTS, beginning of period		24,851,737			59,395,238

CASH AND CASH EQUIVALENTS, end of period	$	15,874,674		$	21,254,990

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	2,143,580		$	2,770,740
Cash paid during the period for taxes		402,087			755,820

NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	1,316,064		$	1,604,806
Financed sales of foreclosed assets		1,410,550			3,939,495

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 1. Presentation of Financial Information

Nature of Business-Cornerstone is a bank holding company whose primary business is performed by its wholly-owned subsidiary, Cornerstone Community Bank (the “Bank”). The Bank provides a full range of banking services to the Chattanooga, Tennessee market. The Bank has also established a loan production office in Dalton, Georgia to further enhance the Bank’s lending markets.

Interim Financial Information (Unaudited)-The financial information in this report for September 30, 2014 and September 30, 2013 has not been audited. The information included herein should be read in conjunction with the annual consolidated financial statements and footnotes thereto included in the 2013 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in April of 2014. The consolidated financial statements presented herein conform to U.S. generally accepted accounting principles and to general industry practices. In the opinion of Cornerstone’s management, the accompanying interim financial statements contain all material adjustments, consisting only of normal recurring adjustments, necessary to present fairly the financial condition, the results of operations, and cash flows for the interim period. Results for interim periods are not necessarily indicative of the results to be expected for a full year.

Use of Estimates-The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities as of the balance sheet date and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term include the determination of the allowance for loan losses, foreclosed assets and deferred tax assets.

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

Reclassification-Certain amounts in the prior consolidated financial statements have been reclassified to conform to the current period presentation. The reclassifications had no effect on net income, total assets or stockholders’ equity as previously reported.

Accounting Policies-During interim periods, Cornerstone follows the accounting policies set forth in its Annual Report on Form 10-K for the year ended December 31, 2013 as filed with the Securities and Exchange Commission. Since December 31, 2013, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices, except for the following:

In May 2014, the FASB issued Accounting Standards Update 2014-09, "Revenue from Contracts with Customers." This update is a joint project with the International Accounting Standards Board initiated to clarify the principles for recognizing revenue and to develop a common revenue standard that is meant to remove inconsistencies and weaknesses in revenue requirements, provide a more robust framework for addressing revenue issues, improve comparability of revenue recognition practices, provide more useful information to users of financial statements and simplify the preparation of financial statements. The guidance in this update supersedes the revenue recognition requirements in ASC Topic 605, "Revenue Recognition" and most industry-specific guidance throughout the Industry Topics of Codification. This update is effective for annual and interim periods beginning after December 15, 2016. Cornerstone does not believe

this update will have a significant impact on the consolidated financial statements.

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following is a summary of the basic and diluted earnings per share for the three and nine month periods ended September 30, 2014 and September 30, 2013.

	Three Months Ended September 30,
	2014		2013
Net income available to common shareholders	$	12,845	$	35,703
Weighted average common shares outstanding		6,627,398		6,547,074
Effect of dilutive stock options		216,409		145,508
Diluted shares		6,843,807		6,692,582
Basic earnings per common share	$	0.00	$	0.01
Diluted earnings per common share	$	0.00	$	0.01

	Nine Months Ended September 30,
	2014		2013
Net income available to common shareholders	$	48,788	$	98,172
Weighted average common shares outstanding		6,609,975		6,547,074
Effect of dilutive stock options		180,197		127,453
Diluted shares		6,790,172		6,674,527
Basic earnings per common share	$	0.01	$	0.01
Diluted earnings per common share	$	0.01	$	0.01

For the three and nine months ended September 30, 2014 and 2013, the effects of outstanding antidilutive stock options are excluded from the computation of diluted earnings per common share because the exercise price of such options is higher than the market price. There are 222,435 and 503,075 antidilutive stock options as of September 30, 2014 and 2013, respectively.

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by the FASB, applies the fair value recognition provisions of ASC 718, “Compensation –Stock Compensation.” For the nine month period ended September 30, 2014, $120,000 in compensation cost was charged to earnings related to the vested incentive stock options.

Officer and Employee Plans-Cornerstone has two stock option plans under which officers and employees can be granted incentive stock options or non-qualified stock options to purchase a total of up to 1,420,000 shares of Cornerstone’s common stock. The exercise price for incentive stock options must be not less than 100 percent of the fair market value of the common stock on the date of the grant. The exercise price of 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 incentive stock options vest 30 percent on the second anniversary of the grant date, 60 percent on the third anniversary of the grant date and 100 percent on the fourth anniversary of the grant date, and the non-qualified stock options vest 50 percent on the first anniversary of the grant date and 100 percent on the second anniversary of the grant date. The options expire ten years from the grant date. At September 30, 2014, the total remaining compensation cost to be recognized on non-vested options is approximately $686,000.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

A summary of the status of these stock option plans is presented in the following table:

						Weighted-
						Average
				Weighted		Contractual
				Average		Remaining	Aggregate
				Exercisable		Term	Intrinsic
	Number			Price		(in years)	Value
Outstanding at December 31, 2013		810,825		$	3.51	6.5 Years	$	257,570
Granted		207,000			2.40	9.4 Years
Exercised		-			-
Forfeited		(73,640	)		5.05
Outstanding at September 30, 2014		944,185		$	3.15	7.0 Years	$	724,080
Options exercisable at September 30, 2014		345,485		$	4.89

Board of Directors Plan- Cornerstone has a stock option plan under which members of the Board of Directors, at the formation of the Bank, were granted options to purchase a total of up to 600,000 shares of common stock. Only non-qualified stock options may be granted under the Plan. In addition, members of the Board of Directors can be issued options under the Cornerstone 2002 Long-Term Incentive Plan to purchase up to 1,200,000 shares of Cornerstone stock. The options available for issuance to Board members under the 2002 Long-Term Incentive Plan are shared with officers and employees of Cornerstone. The exercise price of each option equals the market price of Cornerstone’s stock on the date of grant and the option’s maximum term is ten years, at which point they expire. Vesting for options granted are 50% on each of the first and second anniversary of the grant date with full vesting occurring at the second anniversary date. At September 30, 2014, the total remaining compensation cost to be recognized on non-vested options is approximately $146,000. A summary of the status of this stock option plan is presented in the following table:

						Weighted-
						Average
				Weighted		Contractual
				Average		Remaining	Aggregate
				Exercisable		Term	Intrinsic
	Number			Price		(in years)	Value
Outstanding at December 31, 2013		190,250		$	3.07	6.9 Years	$	64,800
Granted		80,000			2.40	9.4 Years
Exercised		-			-
Forfeited		(16,000	)		5.44
Outstanding at September 30, 2014		254,250		$	2.71	7.6 Years	$	197,850
Options exercisable at September 30, 2014		151,750		$	2.93

The weighted average grant date fair value of all stock options granted during the nine months ended September 30, 2014 was $1.30. This was determined using the Black-Scholes option-pricing model with the following weighted-average assumptions:

Dividend yield	0.0	%
Expected life	8.5 Years
Expected volatility	45.73	%
Risk-free interest rate	2.32	%

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Note 3. Securities

The amortized cost and fair value of securities available-for-sale and held to maturity at September 30, 2014 and December 31, 2013 are summarized as follows:

	September 30, 2014
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value

Debt securities available-for-sale:
U.S. Government agencies	$	665,442	$	1,129	$	-		$	666,571

State and municipal securities		8,531,200		379,818		(9,352	)		8,901,666

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		5,007,711		28,201		(2,176	)		5,033,736

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		63,878,188		103,753		(334,242	)		63,647,699

	$	78,082,541	$	512,901	$	(345,770	)	$	78,249,672

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA	$	29,374	$	269	$	-		$	29,643

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

	December 31, 2013
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value

Debt securities available-for-sale:
U.S. Government agencies	$	3,433,216	$	48,119	$	-		$	3,481,335

State and municipal securities		14,908,761		425,021		(84,544	)		15,249,238

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		7,047,076		85,203		-			7,132,279

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		66,408,975		205,025		(268,180	)		66,345,820

	$	91,798,028	$	763,368	$	(352,724	)	$	92,208,672

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA	$	34,165	$	862	$	-		$	35,027

At September 30, 2014, securities with a fair value totaling approximately $69.8 million were pledged to secure public funds, securities sold under agreements to repurchase, as collateral for federal funds purchased from other financial institutions and serve as collateral for borrowings at the Federal Home Loan Bank.

For the nine months ended September 30, 2014 and 2013, there were available-for-sale securities sold with proceeds totaling $11,303,167 and $5,328,170, respectively, which resulted in gross gains realized of $571,510 and $424,971, respectively. For the three months ended September 30 2014, there were available-for-sale securities sold with proceeds totaling $2,074,000 which resulted in gross gains realized of $169,037. For the three months ended September 30, 2013, there were no securities sold.

The amortized cost and estimated market value of securities at September 30, 2014, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

	Securities Available-for-Sale				Securities Held to Maturity
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Due in one year or less	$	-	$	-	$	-	$	-
Due from one year to five years		899,608		941,779		-		-
Due from five years to ten years		2,273,458		2,377,974		-		-
Due after ten years		6,023,576		6,248,484		-		-
		9,196,642		9,568,237		-		-

Mortgage-backed securities		68,885,899		68,681,435		29,374		29,643

	$	78,082,541	$	78,249,672	$	29,374	$	29,643

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following tables present the gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities available-for-sale have been in a continuous unrealized loss position, as of September 30, 2014 and as of December 31, 2013:

	As of September 30, 2014
	Less than 12 Months					12 Months or Greater					Total
			Gross					Gross					Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses

State and municipal securities	$	-	$	-		$	1,186,827	$	(9,352	)	$	1,186,827	$	(9,352	)

Residential mortgage guaranteed by GNMA or FNMA		1,378,605		(2,176	)		-		-			1,378,605		(2,176	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		4,791,083		(12,038	)		42,589,031		(322,204	)		47,380,114		(334,242	)
	$	6,169,688	$	(14,214	)	$	43,775,858	$	(331,556	)	$	49,945,546	$	(345,770	)

	As of December 31, 2013
	Less than 12 Months					12 Months or Greater					Total
			Gross					Gross					Gross
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
	Value		Losses			Value		Losses			Value		Losses

State and municipal securities	$	3,025,250	$	(84,544	)	$	-	$	-		$	3,025,250	$	(84,544	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		27,782,942		(221,827	)		8,761,049		(46,353	)		36,543,991		(268,180	)
	$	30,808,192	$	(306,371	)	$	8,761,049	$	(46,353	)	$	39,569,241	$	(352,724	)

Upon acquisition of a security, the Bank determines the appropriate impairment model that is applicable. If the security is a beneficial interest in securitized financial assets, the Bank uses the beneficial interests in securitized financial assets impairment model. If the security is not a beneficial interest in securitized financial assets, the Bank uses the debt and equity securities impairment model. The Bank conducts periodic reviews to evaluate each security to determine whether an other-than-temporary impairment has occurred. The Bank does not have any securities that have been classified as other-than-temporarily-impaired at September 30, 2014 or December 31, 2013.

At September 30, 2014 and December 31, 2013, the categories of temporarily impaired securities, and management’s evaluation of those securities, are as follows:

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

State and municipal securities: At September 30, 2014, two investments in obligations of state and municipal securities had unrealized losses. The Bank believes the unrealized losses on those investments were caused by the interest rate environment and do not relate to the underlying credit quality of the issuers. Because the Bank has the intent and ability to hold those investments for a time necessary to recover their amortized cost bases, which may be until maturity, the Bank does not consider those investments to be other-than-temporarily impaired at September 30, 2014.

Mortgage-backed securities: At September 30, 2014, nineteen investments in residential mortgage-backed securities had unrealized losses. This impairment is believed to be caused by the current interest rate environment. The contractual cash flows of those investments are guaranteed by an agency of the U.S. Government. Because the decline in market value is attributable to the current interest rate environment and not credit quality, and because the Bank does not intend to sell the investments and it is not more likely than not that the Bank will be required to sell the investments before recovery of their amortized cost bases, which may be maturity, the Bank does not deem those investments to be other-than-temporarily impaired at September 30, 2014.

Note 4. Loans and Allowance for Loan Losses

At September 30, 2014 and December 31, 2013, loans are summarized as follows (in thousands):

	September 30,			December 31,
	2014			2013
Commercial real estate-mortgage:
Owner-occupied	$	71,986		$	65,747
All other		72,163			64,052
Consumer real estate-mortgage		75,651			76,315
Construction and land development		32,547			41,597
Commercial and industrial		43,253			38,999
Consumer and other		2,790			2,730
Total loans		298,390			289,440
Less: Allowance for loan losses		(3,474	)		(3,203	)

Loans, net	$	294,916		$	286,237

The following describe risk characteristics relevant to each of the portfolio segments:

Real estate:

As discussed below, Cornerstone offers various types of real estate loan products. All loans within this portfolio segment are particularly sensitive to the valuation of real estate:

Commercial real estate-mortgage loans include owner-occupied commercial real estate loans and other commercial real estate loans. Owner-occupied commercial real estate loans to operating businesses are long-term financing of land and buildings. Other commercial real estate loans are generally secured by income producing properties.

Consumer real estate-mortgage loans include loans secured by 1-4 family and multifamily residential properties. These loans are repaid by various means such as a borrower’s income, sale of the property, or rental income derived from the property.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Construction and land development loans include extensions of credit to real estate developers or investors where repayment is dependent on the sale of the real estate or income generated from the real estate collateral. These loans are repaid through cash flow related to the operations, sale or refinance of the underlying property. This portfolio segment also includes owner-occupied construction loans for commercial businesses for the development of land or construction of a building. These loans are repaid by cash flow generated from the business operation. Real estate loans for income-producing properties such as apartment buildings, office and industrial buildings, and retail shopping centers are repaid from rent income derived from the properties.

Commercial and industrial:

The commercial and industrial loans include those loans to commercial customers for use in normal business operations to finance working capital needs, equipment purchases, or expansion projects. Loans are repaid by business cash flows. Collection risk in this portfolio is driven by the creditworthiness of the underlying borrower, particularly cash flows from the customers’ business operations.

Consumer and other:

The consumer loan portfolio segment includes direct consumer installment loans, overdrafts and other revolving credit loans, and educational loans. Loans in this portfolio are sensitive to unemployment and other key consumer economic measures.

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

The composition of loans by loan classification for impaired and performing loan status at September 30, 2014 and December 31, 2013, is summarized in the tables below (amounts in thousands):

September 30, 2014	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	138,921	$	73,195	$	32,184	$	41,805	$	2,790	$	288,895
Impaired loans		5,228		2,456		363		1,448		-		9,495
Total	$	144,149	$	75,651	$	32,547	$	43,253	$	2,790	$	298,390

December 31, 2013	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	121,817	$	72,868	$	41,228	$	37,007	$	2,730	$	275,650
Impaired loans		7,982		3,447		369		1,992		- .		13,790
Total	$	129,799	$	76,315	$	41,597	$	38,999	$	2,730	$	289,440

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following tables show the allowance for loan losses allocation by loan classification for impaired and performing loans as of September 30, 2014 and December 31, 2013 (amounts in thousands):

September 30, 2014	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
Allowance related to:	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	1,258	$	1,302	$	27	$	425	$	73	$	3,085
Impaired loans		259		34		-		96		-		389
Total	$	1,517	$	1,336	$	27	$	521	$	73	$	3,474

December 31, 2013	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
Allowance related to:	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	1,051	$	927	$	319	$	297	$	45	$	2,639
Impaired loans		498		11		-		55		-		564
Total	$	1,549	$	938	$	319	$	352	$	45	$	3,203

The following tables detail the changes in the allowance for loan losses for the nine month period ending September 30, 2014 and year ending December 31, 2013, by loan classification (amounts in thousands):

September 30, 2014	Commercial			Consumer			Construction			Commercial
	Real Estate-			Real Estate-			and Land			and			Consumer
	Mortgage			Mortgage			Development			Industrial			and Other			Total
Beginning balance	$	1,549		$	938		$	319		$	352		$	45		$	3,203
Charged-off loans		(432	)		(767	)		(31	)		(75	)		(44	)		(1,349	)
Recovery of charge-offs		138			307			576			45			39			1,105
Provision for (reallocation of) loan losses		262			858			(837	)		199			33			515
Ending balance	$	1,517		$	1,336		$	27		$	521		$	73		$	3,474

December 31, 2013	Commercial			Consumer			Construction			Commercial
	Real Estate-			Real Estate-			and Land			and			Consumer
	Mortgage			Mortgage			Development			Industrial			and Other			Total
Beginning balance	$	2,549		$	1,528		$	1,241		$	809		$	14		$	6,141
Charged-off loans		(1,879	)		(842	)		(1,193	)		(699	)		(96	)		(4,709	)
Recovery of charge-offs		68			241			1,058			99			5			1,471
Provision for (reallocation of) loan losses		811			11			(787	)		143			122			300
Ending balance	$	1,549		$	938		$	319		$	352		$	45		$	3,203

Credit quality indicators:

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

The Bank’s loan grading process is as follows:

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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

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

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

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

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

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

The following tables outline the amount of each loan classification and the amount categorized into each risk rating as of September 30, 2014 and December 31, 2013 (amounts in thousands):

September 30, 2014	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Pass	$	135,399	$	70,489	$	31,840	$	38,333	$	2,790	$	278,851
Special mention		3,158		1,660		269		3,312		-		8,399
Substandard		5,592		3,502		438		1,608		-		11,140
	$	144,149	$	75,651	$	32,547	$	43,253	$	2,790	$	298,390

December 31, 2013	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Pass	$	119,398	$	67,444	$	40,850	$	33,394	$	2,730	$	263,816
Special mention		3,538		3,536		73		3,468		-		10,615
Substandard		6,863		5,335		674		2,137		-		15,009
	$	129,799	$	76,315	$	41,597	$	38,999	$	2,730	$	289,440

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

After the Bank’s independent loan review department completes the loan grade assignment, a loan impairment analysis is performed on loans graded substandard or worse. The following tables present summary information pertaining to impaired loans by loan classification as of September 30, 2014 and December 31, 2013 (amounts in thousands):

							For the quarter ended
	At September 30, 2014						September 30, 2014
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	4,797	$	4,839	$	-	$	5,225	$	182
Consumer real estate – mortgage		1,806		1,821		-		1,991		89
Construction and land development		362		375		-		366		18
Commercial and industrial		1,104		1,147		-		1,318		32
Total		8,069		8,182		-		8,900		321

Impaired loans with a valuation allowance:
Commercial real estate – mortgage		431		440		259		725		18
Consumer real estate – mortgage		650		831		34		908		32
Construction and land development		-		-		-		-		-
Commercial and industrial		345		345		96		379		33
Total		1,426		1,616		389		2,012		83

Total impaired loans	$	9,495	$	9,798	$	389	$	10,912	$	404

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

							For the year ended
	At December 31, 2013						December 31, 2013
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	5,786	$	5,854	$	-	$	4,657	$	340
Consumer real estate – mortgage		2,177		2,202		-		2,669		96
Construction and land development		369		383		-		358		23
Commercial and industrial		1,563		1,621		-		1,857		60
Total		9,895		10,060		-		9,541		519

Impaired loans with a valuation allowance:
Commercial real estate – mortgage		2,196		2,285		498		4,869		118
Consumer real estate – mortgage		1,270		1,281		11		1,353		90
Construction and land development		-		-		-		177		-
Commercial and industrial		429		430		55		597		53
Total		3,895		3,996		564		6,996		261

Total impaired loans	$	13,790	$	14,056	$	564	$	16,537	$	780

The following tables present an aged analysis of past due loans as of September 30, 2014 and December 31, 2013 (amounts in thousands):

September 30, 2014	30-89 Days		Past Due 90
	Past Due and		Days or More				Total		Current		Total
	Accruing		and Accruing		Nonaccrual		Past Due		Loans		Loans
Commercial real estate-mortgage:
Owner-occupied	$	746	$	-	$	320	$	1,066	$	70,920	$	71,986
All other		30		-		-		30		72,133		72,163
Consumer real estate-mortgage		853		-		1,979		2,832		72,819		75,651
Construction and land development		407		-		42		449		32,098		32,547
Commercial and industrial		808		-		1,259		2,067		41,186		43,253
Consumer and other		2		-		-		2		2,788		2,790
Total	$	2,846	$	-	$	3,600	$	6,446	$	291,944	$	298,390

December 31, 2013	30-89 Days		Past Due 90
	Past Due and		Days or More				Total		Current		Total
	Accruing		and Accruing		Nonaccrual		Past Due		Loans		Loans
Commercial real estate-mortgage:
Owner-occupied	$	678	$	-	$	838	$	1,516	$	64,231	$	65,747
All other		867		-		44		911		63,141		64,052
Consumer real estate-mortgage		419		-		1,006		1,425		74,890		76,315
Construction and land development		50		-		47		97		41,500		41,597
Commercial and industrial		201		-		1,631		1,832		37,167		38,999
Consumer and other		35		-		-		35		2,695		2,730
Total	$	2,250	$	-	$	3,566	$	5,816	$	283,624	$	289,440

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Impaired loans also include loans that the Bank has elected to formally restructure when, due to the weakening credit status of a borrower, the restructuring may facilitate a repayment plan that seeks to minimize the potential losses that the Bank may have to otherwise incur. At September 30, 2014 and December 31, 2013, the Bank has loans of approximately $4,802,000 and $5,753,000, respectively, that were modified in troubled debt restructurings. Troubled commercial loans are restructured by specialists within our Special Asset department and all restructurings are approved by committees and credit officers separate and apart from the normal loan approval process. These specialists are trained to reduce the Bank’s overall risk and exposure to loss in the event of a restructuring through obtaining either or all of the following: improved documentation, additional guaranties, increase in curtailments, reduction in collateral terms, additional collateral or other similar strategies.

There was one commercial real estate-mortgage loan with a pre-modification and post-modification outstanding recorded investment of $480,000 that was modified as a troubled debt restructuring during the nine month period ended September 30, 2014.

The following table presents a summary of loans that were modified as troubled debt restructurings during the nine month period ended September 30, 2013 (amounts in thousands):

			Pre-Modification		Post-Modification
			Outstanding Recorded		Outstanding Recorded
September 30, 2013	Number of Contracts		Investment		Investment

Commercial real estate-mortgage		2	$	2,073	$	2,073
Consumer real estate-mortgage		1		66		66
Construction and land development		3		898		898
Commercial and industrial		3		2,389		2,389

There were no loans that were modified as troubled debt restructurings during the past twelve months and for which there was a subsequent payment default.

Note 5. Commitments and Contingent Liabilities

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

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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

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

A summary of the Bank’s total contractual amount for all off-balance sheet commitments at September 30, 2014 is as follows:

Commitments to extend credit		$	46.7 million
Standby letters of credit		$	305 thousand

Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at September 30, 2014 will not have a material effect on Cornerstone’s consolidated financial statements.

Note 6. Fair Value Disclosures

Fair Value Measurements:

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

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

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

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

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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

A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.

The following methods and assumptions were used by Cornerstone in estimating fair value disclosures for financial instruments. There have been no changes in the methodologies used at September 30, 2014 and December 31, 2013.

Cash and cash equivalents:

The carrying amounts of cash and cash equivalents approximate fair values based on the short-term nature of the assets. Cash and cash equivalents are classified as Level 1 of the fair value hierarchy.

Securities:

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

The carrying value of Federal Home Loan Bank stock approximates fair value based on the redemption provisions of the Federal Home Loan Bank. Federal Home Loan Bank stock is classified as Level 3 of the fair value hierarchy.

Loans:

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

Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. At September 30, 2014, substantially all of the total impaired loans were evaluated based on the fair value of collateral. The remaining impaired loans were evaluated based on a discounted cash flow methodology. In accordance with ASC Topic 820, these impaired loans with a valuation allowance require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, Cornerstone records the impaired loan as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value or is based on a discounted cash flow methodology and there is no observable market price, Cornerstone records the impaired loan as nonrecurring Level 3. At December 31, 2013, impaired loans were evaluated based on the fair value of collateral and on the discounted cash flow methodology.

Foreclosed assets:

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Deposits:

The fair value of deposits with no stated maturity, such as noninterest-bearing and interest-bearing demand deposits, savings deposits, and money market accounts, is equal to the amount payable on demand at the reporting date. The carrying amounts of variable-rate, fixed-term certificates of deposit approximate their fair values at the reporting date. Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies market

interest rates on comparable instruments to a schedule of aggregated expected monthly maturities on time deposits. Generally, Level 3 inputs are utilized in this estimate.

Federal funds purchased and securities sold under agreements to repurchase:

The carrying amount of these liabilities approximates their estimated fair value. These liabilities are included in Level 3 of the fair value hierarchy.

Federal Home Loan Bank advances and other borrowings:

The fair value of these fixed rate advances is estimated based on discounted contractual cash flows using current incremental borrowing rates for similar type borrowing arrangements. These liabilities are included in Level 3 of the fair value hierarchy.

Accrued interest:

The carrying amounts of accrued interest approximate fair value. Accrued interest is included in Level 3 of the fair value hierarchy.

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.

Assets and liabilities recorded at fair value on a recurring basis are as follows.

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	September 30,		Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)
Debt securities available-for-sale:

U.S. Government agencies	$	666,571	$	-	$	666,571	$	-
State and municipal securities		8,901,666		-		8,901,666		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		5,033,736		-		5,033,736		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		63,647,699		-		63,647,699		-

Total securities available-for-sale	$	78,249,672	$	-	$	78,249,672	$	-

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)
Debt securities available-for-sale:

U.S. Government agencies	$	3,481,335	$	-	$	3,481,335	$	-
State and municipal securities		15,249,238		-		15,249,238		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		7,132,279		-		7,132,279		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		66,345,820		-		66,345,820		-

Total securities available-for-sale	$	92,208,672	$	-	$	92,208,672	$	-

Cornerstone has no assets or liabilities whose fair values are measured on a recurring basis using Level 3 inputs. Additionally, there were no transfers between Level 1 and Level 2 in the fair value hierarchy.

Certain assets and liabilities are measured at fair value on a nonrecurring basis, which means the assets and liabilities are not measured at fair value on an ongoing basis but are subject to fair value adjustments in certain circumstances (for example, when there is evidence of impairment). The tables below present information about assets and liabilities on the balance sheet at September 30, 2014 and December 31, 2013 for which a nonrecurring change in fair value was recorded (amounts in thousands).

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	September 30,		Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	1,037	$	-	$	1,023	$	14
Foreclosed assets		10,994		-		10,994		-

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2013		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	3,331	$	-	$	891	$	2,440
Foreclosed assets		12,926		-		12,926		-

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

Loans include impaired loans held for investment for which an allowance for loan losses has been calculated based upon the fair value of the loans at September 30, 2014 and December 31, 2013.

The carrying amount and estimated fair value of Cornerstone's financial instruments at September 30, 2014 and December 31, 2013 are as follows (in thousands):

	September 30, 2014				December 31, 2013
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Assets:
Cash and cash equivalents	$	15,875	$	15,875	$	24,852	$	24,852
Securities		78,279		78,279		92,243		92,244
Federal Home Loan Bank stock		2,323		2,323		2,323		2,323
Loans, net		294,916		295,369		286,237		287,411
Accrued interest receivable		1,180		1,180		978		978

Liabilities:
Noninterest-bearing demand deposits		53,616		53,616		75,207		75,207
Interest-bearing demand deposits		25,246		25,246		24,564		24,564
Savings deposits and money market accounts		83,109		83,109		86,330		86,330
Time deposits		154,343		155,652		155,314		156,698
Federal funds purchased and securities sold under agreements to repurchase		27,336		27,336		22,974		22,974
Federal Home Loan Bank advances and other borrowings		28,000		28,389		26,740		27,449
Accrued interest payable		78		78		82		82

Unrecognized financial instruments (net of contract amount):
Commitments to extend credit		-		-		-		-
Letters of credit		-		-		-		-
Lines of credit		-		-		-		-

Cornerstone Bancshares, Inc. and Subsidiary

Net Interest Margin Analysis

Taxable Equivalent Basis

	Three months ended
(Amounts in thousands)	September 30
Assets	2014								2013
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	295,566		$	4,168		5.59	%	$	281,341		$	4,294		6.05	%
Investment securities		84,524			327		1.64	%		104,261			457		1.89	%
Other earning assets		14,066			7		0.20	%		14,937			9		0.24	%
Total earning assets		394,156		$	4,502		4.55	%		400,539		$	4,760		4.75	%
Allowance for loan losses		(3,489	)							(3,933	)
Cash and other assets		25,580								34,462
TOTAL ASSETS	$	416,247							$	431,068

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	25,784		$	10		0.16	%	$	25,388		$	10		0.16	%
Savings deposits		14,105			4		0.10	%		12,858			7		0.22	%
MMDA's		72,628			76		0.42	%		78,715			100		0.50	%
Time deposits		155,184			352		0.90	%		166,401			445		1.06	%
Federal funds purchased and securities
sold under agreements to repurchase		21,445			19		0.35	%		25,102			22		0.34	%
Federal Home Loan Bank and other borrowings		31,161			231		2.94	%		29,012			285		3.90	%
Total interest-bearing liabilities		320,307			692		0.86	%		337,476			869		1.02	%
Net interest spread				$	3,810		3.69	%				$	3,891		3.73	%
Noninterest-bearing demand deposits		54,400								51,727
Accrued expenses and other liabilities		1,060								1,483
Shareholders' equity		40,480								40,382
TOTAL LIABILITIES AND
SHAREHOLDERS' EQUITY	$	416,247							$	431,068
Net yield on earning assets							3.86	%							3.89	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					22								39
Total adjustment					22								39

Cornerstone Bancshares, Inc. and Subsidiary

Net Interest Margin Analysis

Taxable Equivalent Basis

	Nine months ended
(Amounts in thousands)	September 30
Assets				2014								2013
	Average			Income/		Yield/			Average			Income/		Yield/
Earning assets:	Balance			Expense		Rate			Balance			Expense		Rate
Loans, net of unearned income	$	293,159		$	12,489		5.70	%	$	276,606		$	12,515		6.05	%
Investment securities		91,147			1,104		1.76	%		97,786			1,379		2.10	%
Other earning assets		13,855			24		0.24	%		23,232			45		0.26	%
Total earning assets		398,161		$	13,617		4.60	%		397,624		$	13,939		4.74	%
Allowance for loan losses		(3,237	)							(5,053	)
Cash and other assets		28,198								36,808
TOTAL ASSETS	$	423,122							$	429,379

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	27,398		$	30		0.15	%	$	26,477		$	46		0.23	%
Savings deposits		14,841			11		0.10	%		12,235			22		0.24	%
MMDA's		67,916			192		0.38	%		76,729			319		0.56	%
Time deposits		158,560			1,093		0.92	%		167,406			1,366		1.09	%
Federal funds purchased and securities sold under agreements to repurchase		21,862			58		0.36	%		22,330			56		0.34	%
Federal Home Loan Bank and other borrowings		30,198			756		3.34	%		31,142			941		4.04	%
Total interest-bearing liabilities		320,775			2,140		0.89	%		336,319			2,750		1.09	%
Net interest spread				$	11,477		3.71	%				$	11,189		3.65	%
Noninterest-bearing demand deposits		60,970								50,338
Accrued expenses and other liabilities		831								1,865
Shareholders' equity		40,546								40,857
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	423,122							$	429,379
Net yield on earning assets							3.89	%							3.81	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					94								156
Total adjustment					94								156

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

Cornerstone is a bank holding company and the parent company of the Bank, a Tennessee banking corporation which operates primarily in and around Chattanooga, Tennessee. The Bank has five full-service banking offices located in Hamilton County, Tennessee, and one loan production office located in Dalton, Georgia. The Bank’s business consists primarily of attracting deposits from the general public and, with these and other funds, originating real estate loans, consumer loans, business loans, and residential and commercial construction loans. The principal sources of income for the Bank are interest and fees collected on loans, fees collected on deposit accounts, and interest and dividends collected on other investments. The principal expenses of the Bank are interest paid on deposits, employee compensation and benefits, office expenses, and other overhead expenses.

The following is a discussion of Cornerstone’s financial condition at September 30, 2014 and December 31, 2013 and our results of operations for the three months and nine months ended September 30, 2014 and 2013. The purpose of this discussion is to focus on information about Cornerstone’s financial condition and results of operations which is not otherwise apparent from the consolidated financial statements. The following discussion and analysis should be read along with Cornerstone’s consolidated financial statements and the related notes included elsewhere herein.

Critical Accounting Policies

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

Allowance for Loan Losses

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

Changes in the financial condition of individual borrowers, economic conditions or changes to our estimated risks could require us to significantly decrease or increase the level of the allowance. Such a change could materially impact Cornerstone’s net income as a result of the change in the provision for loan losses. Refer to Note 1 and 4 in the notes to Cornerstone’s consolidated financial statements for a discussion of Cornerstone’s methodology of establishing the allowance.

Estimates of Fair Value

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

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

Changes in fair value could materially impact our financial results. Refer to Note 6, “Fair Value Disclosures,” in the notes to Cornerstone’s consolidated financial statements for a discussion of the methodology in calculating fair value.

Income Taxes

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

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

Cornerstone periodically evaluates uncertain tax positions and estimates the appropriate level of tax reserves related to each of these positions. Additionally, Cornerstone evaluates its deferred tax assets for possible valuation allowances based on the amounts expected to be realized. The evaluation of uncertain tax positions and deferred tax assets involves a high degree of judgment and subjectivity. Changes in the results of these evaluations could have a material impact on our financial results. Refer to Note 8, “Income Taxes,” to Cornerstone’s consolidated financial statements set forth in its Annual Report on Form 10-K for the year ended December 31, 2013 for more information.

Review of Financial Performance

As of September 30, 2014, Cornerstone had total consolidated assets of approximately $413 million, total loans of approximately $298 million, total securities of approximately $78 million, total deposits of approximately $ 316 million and stockholders’ equity of approximately $40 million. Net income for the three and nine month period ended September 30, 2014 totaled $405,691 and $1,227,325, respectively.

Results of Operations

Net income for the three months ended September 30, 2014 was $405,691 or $0.00 basic earnings per common share, compared to a net income of $428,548 or $0.00 basic earnings per common share for the same period in 2013. Net income for the nine months ended September 30, 2014 was $1,227,325 or $0.01 basic earnings per common share, compared to a net income of $1,276,707 or $0.01 basic earnings per common share for the same period in 2013.

The following table presents our results for the three and nine months ended September 30, 2014 compared to the three and nine months ended September 30, 2013 (amounts in thousands).

					2014-2013										2014-2013
	Three months				Percent			Dollar			Nine months				Percent			Dollar
	ended September 30,				Increase			Amount			ended September 30,				Increase			Amount
	2014		2013		(Decrease)			Change			2014		2013		(Decrease)			Change
Interest income	$	4,502	$	4,760		(5.42	)%	$	(258	)	$	13,617	$	13,939		(2.31	)%	$	(322	)
Interest expense		692		869		(20.37	)%		(177	)		2,140		2,750		(22.18	)%		(610	)
Net interest income
before provision for loan loss		3,810		3,891		(2.08	)%		(81	)		11,477		11,189		2.57	%		288

Provision for loan loss		-		-		-			-			515		300		71.67	%		215

Net interest income after
provision for loan loss		3,810		3,891		(2.08	)%		(81	)		10,962		10,889		0.67	%		73

Total noninterest income		504		270		86.67	%		234			1,361		1,323		2.87	%		38
Total noninterest expense		3,659		3,464		5.60	%		195			10,335		10,142		1.90	%		193

Income before income taxes		655		697		(6.03	)%		(42	)		1,988		2,070		(3.96	)%		(82	)

Provision for income taxes		249		268		(7.09	)%		(19	)		761		793		(4.04	)%		(32	)

Net income	$	406	$	429		(5.36	)%	$	(23	)	$	1,227	$	1,277		(3.92	)%	$	(50	)

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended September 30, 2014, net interest income before provision for loan loss, decreased approximately $81 thousand or 2.08 percent over the same period of 2013. For the nine months ended September 30, 2014, net interest income before provision for loan loss increased $288 thousand or 2.57 percent.

Cornerstone’s interest rate spread on a tax equivalent basis (which is the difference between the average yield on earning assets and the average rate paid on interest-bearing liabilities) was 3.69 percent compared to 3.73 percent for the three month periods ended September 30, 2014 and 2013, respectively. The interest rate spread on a tax equivalent basis was 3.71 percent compared to 3.65 percent for the nine months periods ended September 30, 2014 and 2013, respectively.

The net interest margin on a tax equivalent basis was 3.86 percent and 3.89 percent for the three month periods ended September 30, 2014 and 2013, respectively. The net interest margin on a tax equivalent basis was 3.89 percent and 3.81 percent for the nine month periods ended September 30, 2014 and 2013, respectively.

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

For the nine month period ended September 30, 2014, the Bank’s net interest income has been positively impacted by a reduction in interest expense of the funding of the Bank. The primary savings have been a reduction in the Federal Home Loan Bank (FHLB) balances and a decrease in interest rates on deposit accounts.

The Bank’s loan portfolio yield decreased to 5.59 percent for the three months ended September 30, 2014 compared to 6.05 percent for the three months ended September 30, 2013. Management believes loan yields will continue to see downward pressure during 2014 as customers continue to refinance existing loans due to general market conditions with a low interest rate environment. Cornerstone will attempt to increase its outstanding loan balances during 2014 to offset the possible yield reduction.

For the three month period ended September 30, 2014, the Bank’s investment portfolio yield decreased to 1.64 percent compared to 1.89 percent for the same time period in 2013. The decrease in the investment portfolio yield was due to the liquidation of approximately $2.1 million in higher yielding securities during the third quarter of 2014.

The Bank’s net interest margin increased 8 basis points for the nine month period ended September 30, 2014 compared to the nine month period ended September 30, 2013. The majority of the increase is due to reduced interest expense relating to decreases in deposit rates and a reduction in FHLB borrowing expense. Management continues to try and adjust the Bank’s balance sheet composition by reducing foreclosed assets and increasing the Bank’s loan balances. Management anticipates continued improvement in the Bank’s net interest margin with the increase in loans and reduction of FHLB advance rates, as they mature, in the next five months.

Cornerstone paid off approximately $1.7 million in other borrowings on June 30, 2014 to reduce interest expense. The repayment has no effect on liquidity since the borrowing was fully secured by cash.

Provision for Loan Losses-The provision for loan losses represents a charge to earnings necessary to establish an allowance for loan losses that, in management’s evaluation, should be adequate to provide coverage for the inherent losses on outstanding loans. There was no provision for loan losses recorded in the three months ended September 30, 2014 due to the amount of loan loss recoveries that were recorded from previous loans that were charged off. Additionally, Cornerstone recorded no provision for the three months ended September 30, 2013. For the nine months period ended September 30, 2014, the Bank recorded $515 thousand of provision compared to $300 thousand for the same period in 2013.

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

The following table presents the components of noninterest income for the three and nine months ended September 30, 2014 and 2013 (dollars in thousands):

					2014-2013							2014-2013
	Three months ended				Percent			Nine months ended				Percent
	September 30,				Increase			September 30,				Increase
	2014		2013		(Decrease)			2014		2013		(Decrease)
Service charges on deposit accounts	$	215	$	218		(1.38	)%	$	613	$	608		0.82	%
Net gains on sale of securities		169		-		-			572		425		34.59	%
Net gains on sale of loans and other assets		107		39		174.36	%		132		241		(45.23	)%
Other noninterest income		13		13		-			44		49		(10.20	)%
Total noninterest income	$	504	$	270		86.67	%	$	1,361	$	1,323		2.87	%

Significant matters relating to the changes in noninterest income are presented below:

The Bank sold approximately $2.1 million of securities and recorded a gain of approximately $169 thousand during the third quarter of 2014. For the nine months ended September 30, 2014, approximately $11.3 million of securities were sold with a recorded gain of approximately $572 thousand. The Bank chose to liquidate the securities to offset foreclosed asset expense.

During the first nine months of 2013, the Bank recorded approximately $111 thousand in a gain from the sale of a Small Business Administration ( “SBA”) 7A loan and approximately $128 thousand in gains from the sale of mortgage loans while during the first nine months of 2014, the Bank recorded approximately $77 thousand in a gain from the sale of an SBA loan and approximately $77 thousand from gains from the sale of mortgage loans coupled with approximately $22 thousand loss on sale of other assets.

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

The following table presents the components of noninterest expense for the three and nine months ended September 30, 2014 and 2013 (dollars in thousands).


					2014-2013							2014-2013
	Three months ended				Percent			Nine months ended				Percent
	September 30,				Increase			September 30,				Increase
	2014		2013		(Decrease)			2014		2013		(Decrease)
Salaries and employee benefits	$	1,702	$	1,619		5.13	%	$	5,251	$	4,839		8.51	%
Occupancy and equipment expense		315		334		(5.69	)%		948		1,011		(6.23	)%
Foreclosed assets expense, net		688		382		80.10	%		1,401		1,309		7.03	%
FDIC depository insurance		163		162		0.62	%		482		483		(0.21	)%
Other operating expense		791		967		(18.20	)%		2,253		2,500		(9.88	)%
Total noninterest expense	$	3,659	$	3,464		5.63	%	$	10,335	$	10,142		1.90	%

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

Cornerstone’s employee expense increased when comparing both the three and nine months ended September 30, 2014 and September 30, 2013. The increase is primarily attributable to the Bank addressing employee wage increases that were not provided for in the past three years. In addition, during the nine months ended September 30, 2014, the Bank recorded compensation expense in the amount of $196 thousand for stock grants issued to the Board of Directors and stock options issued to the employees versus none in the first nine months of September 2013. Management does not anticipate additional stock grants or stock options to be issued in 2014.

For the nine month period ended September 30, 2014, the Bank recorded approximately $1.4 million in foreclosed assets expense compared to approximately $1.3 million during the nine months ended September 30, 2013. The increase in foreclosed asset expense can be attributed to a strategy to reduce foreclosed assets. For the nine month period ended September 30, 2014, the majority of the $1.4 million in foreclosed assets expense was comprised of approximately $1.0 million in appraisal write downs and losses incurred on the disposal of foreclosed assets. The Bank incurred approximately $361 thousand in net carrying cost for its foreclosed assets during the nine months ended September 30, 2014. A majority of the incremental expense was due to maintenance and repairs of the existing properties. Management anticipates approximately $1.9 million of expense, write-downs and losses on disposal of its foreclosed assets during 2014. Management nets the expense and write-downs of foreclosed assets against the income generated from income producing real estate to calculate net foreclosed assets expense.

Financial Condition

Overview-Cornerstone’s consolidated assets totaled approximately $432 million as of December 31, 2013. As of September 30, 2014, total consolidated assets had decreased approximately $19 million or 4.36 percent to approximately $413 million.

Liabilities as of September 30, 2014 and December 31, 2013 totaled approximately $373 million and $392 million, respectively.

Stockholders’ equity as of September 30, 2014 and December 31, 2013 totaled approximately $40 million.

Securities-The Bank’s investment portfolio, primarily consisting of collateralized mortgage obligations, mortgage backed securities and municipal securities, amounted to approximately $78 million as of September 30, 2014 compared to approximately $92 million as of December 31, 2013. The primary purposes of the Bank’s investment portfolio is to provide earniings, liquidity, satisfy pledging requirements, collateralize the Bank’s repurchase accounts and secure the Bank’s FHLB borrowings.

Loans-The composition of loans at September 30, 2014 and at December 31, 2013 and the percentage of each classification to total loans are summarized in the following table (dollars in thousands):

	September 30, 2014						December 31, 2013
	Amount			Percent			Amount			Percent
Commercial real estate-mortgage
Owner-occupied	$	71,986			24.12	%	$	65,747			22.72	%
All other		72,163			24.18	%		64,052			22.13	%
Consumer real estate-mortgage		75,651			25.35	%		76,315			26.37	%
Construction and land development		32,547			10.91	%		41,597			14.37	%
Commercial and industrial		43,253			14.50	%		38,999			13.47	%
Consumer and other		2,790			0.94	%		2,730			0.94	%
Total loans		298,390			100.00	%		289,440			100.00	%
Less: Allowance for loan losses		(3,474	)					(3,203	)

Loans, net	$	294,916					$	286,237

The Bank’s gross loans increased from approximately $284 million as of September 30, 2013 to approximately $298 million as of September 30, 2014 or 4.9 percent. The primary increase was in commercial real estate loans as the Bank’s relationship managers are marketing business loan products to business owners and the demand for business property continues to increase in the Chattanooga market. Management anticipates continued loan growth for the remainder of 2014.

Allowance for Loan Losses-The allowance for loan losses represents Cornerstone’s assessment of the risks associated with extending credit and its evaluation of the quality of the loan portfolio. Management analyzes the loan portfolio quarterly to determine the adequacy of the allowance for loan losses and the appropriate provisions required to maintain a level considered adequate to absorb anticipated loan losses. The Bank uses a risk based approach to calculate the appropriate loan loss allowance in accordance with guidance issued by the Federal Financial Institutions Examination Council. Although the Bank performs prudent credit underwriting, no assurances can be given 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.

During the nine months ended September 30, 2014, the Bank recorded $515 thousand in provision expense to the loan loss allowance. The Bank’s loan charge-offs decreased from approximately $4.5 million for the nine month period ended September 30, 2013 to approximately $1.3 million for the nine month period ended September 30, 2014 or approximately 71 percent. The decrease in loan charge-offs is attributed to the decrease in problem loans. Cornerstone utilizes a ten quarter look-back time frame for its historic loan loss analysis for loan charge-offs and recoveries. Management believes its allowance methodology is consistent with generally accepted accounting principles and interagency policy statements published by the Bank’s regulatory agencies. However, additional provision to the loan loss allowance may be needed in future quarters as the Bank works its problem assets through the collection cycle and as the loan portfolio continues to grow.

The following is a summary of changes in the allowance for loan losses for the nine months ended September 30, 2014 and for the year ended December 31, 2013 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

	September 30,			December 31,
	2014			2013
Balance, beginning of period	$	3,203		$	6,141
Loans charged-off		(1,349	)		(4,709	)
Recoveries of loans previously charged-off		1,105			1,471
Provision for loan losses		515			300
Balance, end of period	$	3,474		$	3,203

Total loans	$	298,390		$	289,440

Ratio of allowance for loan losses to loans outstanding at the end of the period		1.16	%		1.11	%

Ratio of net charge-offs to total loans outstanding for the period		0.08	%		1.12	%

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

The Bank attempts to reduce these economic and credit risks by adherence to a lending policy approved by the Bank’s board of directors. The Bank’s lending policy establishes loan to value limits, collateral perfection, credit underwriting criteria and other acceptable lending standards. The Bank classifies loans that are ninety (90) days past due and still accruing interest, renegotiated loans, nonaccrual loans, foreclosures and repossessed property as non-performing assets. The Bank’s policy is to categorize a loan on nonaccrual status when payment of principal or interest is ninety (90) or more days past due. At the time the loan is categorized as nonaccrual the interest previously accrued but not collected may be reversed and charged against current earnings.

The Bank has been able to reduce its non-performing assets over the last twelve months. As of September 30, 2014, the Bank had approximately $14.6 million in non-performing assets. The majority of this amount is comprised of foreclosed assets. The Bank has attempted to be proactive in its approach of minimizing the time a loan is recorded in nonaccrual status. Management has been able to transition loans from nonaccrual into foreclosed assets or, in some limited instances, upgrade the loan to a performing status. Management anticipates additional loans could transition into foreclosed assets in the future. However, management anticipates the balance of foreclosed and non-performing assets overall will continue to reduce as the Bank continues to allocate both financial and human resources towards this objective.

The following table summarizes Cornerstone’s non-performing assets at each quarter end from December 31, 2013 to September 30, 2014 (amounts in thousands):

	September 30,			June 30,			March 31,			December 31,
	2014			2014			2014			2013
Nonaccrual loans	$	3,600		$	2,852		$	4,779		$	3,566
Foreclosed assets		10,994			12,996			12,559			12,926
Total non-performing assets	$	14,594		$	15,848		$	17,338		$	16,492

30-89 days past due loans	$	2,846		$	1,641		$	2,193		$	5,816

Total loans outstanding	$	298,390		$	292,369		$	292,952		$	289,440

Allowance for loan losses	$	3,474		$	3,330		$	3,011		$	3,203

Ratio of non-performing loans to total loans outstanding at the end of the period		1.21	%		0.98	%		1.63	%		1.23	%

Ratio of total allowance for loan losses to nonaccrual loans at the end of the period		96.50	%		116.76	%		63.00	%		89.82	%

The Bank’s total non-performing asset balances decreased during the third quarter of 2014 compared to the last three quarters. The nonaccrual loans have decreased from approximately $4.1 million as of September 30, 2013 to approximately $3.6 million to September 30, 2014 or approximately 12 percent. Management has attempted to proactively resolve loans that have been classified as nonaccrual when possible. Management anticipates that nonaccrual balances will start to decline even further as the Bank continues to see a decline in the rate of loans being downgraded and management continues to proactively address these loans.

The Bank’s foreclosed assets decreased from approximately $15 million as of September 30, 2013 to approximately $11 million as of September 30, 2014 or approximately 27 percent. The Bank has seen an improvement in the level of interest in its properties by potential buyers and has provided $1.4 million for foreclosed asset expense again in the 2014 budget to decrease foreclosed assets. Management is targeting a net reduction in foreclosed asset levels by approximately $3 million during the remainder of 2014.

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

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

	September 30, 2014					December 31, 2013
	Amount		Percent			Amount		Percent
Core funding:
Noninterest-bearing demand deposits	$	53,616		14.4	%	$	75,206		19.3	%
Interest-bearing demand deposits		25,246		6.8	%		24,564		6.3	%
Savings and money market accounts		83,109		22.4	%		86,330		22.2	%
Time deposits under $100,000		60,863		16.4	%		74,080		19.0	%
Total core funding		222,834		60.0	%		260,180		66.8	%

Non-core funding:
Time deposit of $100,000 or more	$	93,479		25.1	%	$	81,234		20.9	%
Fed funds purchased and securities sold under agreements to repurchase		27,336		7.4	%		22,974		5.9	%
Federal Home Loan Bank advances		28,000		7.5	%		25,000		6.4	%
Total non-core funding		148,815		40.0	%		129,208		33.2	%

Total	$	371,649		100.0	%	$	389,388		100.0	%

In 2011, the Bank began to address its reliance on non-core funding. Over the last several years, the Bank has been able to increase the amount of local core deposits. Management continues to evaluate different pricing, product and customer service options to further increase the core-funding position. The Bank has seen a decrease in funds as of September 30, 2014 when compared to December 31, 2013. However, the Bank historically, and in 2013 as well, experiences an increase in overall deposits during December of each year. Finally, the Bank, primarily through its Asset Liability Management Committee, will review the structure and nature of additional Federal Home Loan Bank advances as they mature. Over the next twelve months, the Bank will have $18 million in advances mature. Management anticipates maintaining the level of borrowings from FHLB at approximately $20-$35 million over this time period. However, the Bank will be able to obtain additional advances or substitute the maturing advances with other forms of liability at a significantly lower interest cost than the current interest rates paid on the existing advances.

Capital Resources-At September 30, 2014 and December 31, 2013, Cornerstone’s stockholders’ equity amounted to approximately $40.4 million and $40.1 million, respectively.

The following is a summary of the Bank’s capital ratios as of September 30, 2014:

Tier 1 leverage ratio	9.19	%
Tier 1 risk-based capital ratio	12.10	%
Total risk-based capital ratio	13.20	%

Cornerstone has received permission from the Federal Reserve Bank of Atlanta (the “Federal Reserve”) to pay its scheduled June 30, 2014 dividend on its Series A convertible preferred stock in the amount of $0.625 per share.

Market and Liquidity Risk Management

Interest Rate Sensitivity

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

Earnings at Risk Model

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

Economic Value of Equity

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

Liquidity Analysis

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

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

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

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

Leverage Analysis

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

Balance Sheet Analytics

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

Liquidity Risk Management

Liquidity is measured by the Bank's ability to raise cash at a reasonable cost or with a minimum of loss. These funds are used primarily to fund loans and satisfy deposit withdrawals. Several factors must be considered by management when attempting to minimize liquidity risk. Examples include changes in interest rates, competition, loan demand, and general economic conditions. Minimizing liquidity risk is a responsibility of the ALCO and is reviewed by the Bank’s regulatory agencies on a regular basis. Net non-core funding dependency on time deposits of $250,000 and over was 12.83% at September 30, 2014 compared to 9.43% at December 31, 2013.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

A comprehensive qualitative and quantitative analysis regarding market risk was disclosed in Cornerstone’s Annual Report on Form 10-K for the year ended December 31, 2013. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2013.

Item 4. Controls and Procedures

Under the supervision and with the participation of management, including Cornerstone’s Chief Executive Officer and Chief Financial Officer, Cornerstone has evaluated the effectiveness of its disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of September 30, 2014 (the “Evaluation Date”.) Based on such evaluation, such officers have concluded that, as of the Evaluation Date, Cornerstone’s disclosure controls and procedures were effective in alerting them on a timely basis to material information relating to Cornerstone (including its consolidated subsidiary) required to be included in Cornerstone’s periodic filings under the Exchange Act.

There were no changes in Cornerstone’s internal control over financial reporting during Cornerstone’s fiscal quarter ended September 30, 2014 that have materially affected, or are reasonably likely to materially affect, Cornerstone’s internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

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

Item 1A. Risk Factors

Cornerstone, as a smaller reporting company, is not required to provide the information required by this Item.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults Upon Senior Securities

None

Item 4. Mine Safety Disclosures

Item 5. Other Information

None

Item 6. Exhibits

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

SIGNATURES

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

		Cornerstone Bancshares, Inc.

Date:	November 14, 2014		/s/ Nathaniel F. Hughes
			Nathaniel F. Hughes,
			President and Chief Executive Officer
			(principal executive officer)

Date:	November 14, 2014		/s/ Gary W. Petty, Jr.
			Gary W. Petty, Jr.
			Executive Vice President and Chief Financial Officer
			(principal financial officer and accounting officer)

EXHIBIT INDEX

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