SMARTFINANCIAL INC. - Quarter Report: 2015 June (Form 10-Q)

United States Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2015

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 August 1, 2015 there were 6,643,341 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		28

Item 3. Quantitative and Qualitative Disclosures About Market Risk		37

Item 4. Controls and Procedures		37

	PART II – OTHER INFORMATION	38

Item 1. Legal Proceedings		38

Item 1A. Risk Factors		38

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		38

Item 3. Defaults Upon Senior Securities		38

Item 4. Mine Safety Disclosures		38

Item 5. Other Information		38

Item 6. Exhibits		38

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 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, 2014, as well as the following: (i) the possibility that our asset quality would decline or that we experience greater loan losses than anticipated, (ii) high 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) a breach of operational or security systems, (v) ability to adapt to technological changes, (vi) competition from financial institutions and other financial service providers, (vii) economic conditions in the local markets where we operate, (viii) the impact of obtaining regulatory approval prior to the payment of dividends, (ix) the impact of preferred stock on net income available to holders of our Common Stock and earnings per common share, (x) the impact of negative developments in the financial industry and U.S. and global capital and credit markets, (xi) the impact of recently enacted legislation on our business, (xii) the relatively greater credit risk of residential construction and land development loans in our loan portfolio, (xiii) adverse impact on operations and financial condition due to changes in interest rates, (xiv) our ability to obtain additional capital and, if obtained, the possible significant dilution to current shareholders, (xv) the possibility that benefits from the merger with SmartFinancial, Inc. may not be fully realized or develop more slowly than expected because of changes in economic conditions, regulation or competition and difficulty in integrating the two businesses, (xvi) the impact of federal and state regulations on our operations and financial performance, (xvii) whether a significant deferred tax asset we have can be fully realized, (xviii) our ability to retain the services of key personnel, and (xix) the impact of Tennessee’s anti-takeover statutes and certain charter provisions on potential acquisitions of the holding company. 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
	June 30,			December 31,
	2015			2014
ASSETS

Cash and due from banks	$	2,355,547		$	1,930,751
Interest-bearing deposits at other financial institutions		31,010,120			13,596,970
Total cash and cash equivalents		33,365,667			15,527,721

Securities available for sale		74,481,436			87,192,909
Securities held to maturity (fair value $22,410 and $25,702 at June 30, 2015 and December 31, 2014, respectively)		22,131			25,428
Federal Home Loan Bank stock, at cost		2,322,900			2,322,900
Loans, net of allowance for loan losses of $3,579,280 and $3,495,129 at June 30, 2015 and December 31, 2014, respectively		306,270,553			291,869,338
Bank premises and equipment, net		6,199,666			4,828,123
Accrued interest receivable		1,072,137			1,142,899
Foreclosed assets		7,165,227			8,000,365
Other assets		4,639,533			4,830,113
Total assets	$	435,539,250		$	415,739,796

LIABILITIES AND STOCKHOLDERS' EQUITY

Deposits:
Noninterest-bearing demand deposits	$	53,469,722		$	57,034,792
Interest-bearing demand deposits		38,166,656			26,464,173
Savings deposits and money market accounts		76,739,986			80,861,110
Time deposits		163,187,036			144,294,390
Total deposits		331,563,400			308,654,465

Accrued interest payable		104,070			71,925
Federal funds purchased and securities sold under agreements to repurchase		23,992,994			29,409,505
Federal Home Loan Bank advances and other borrowings		31,000,000			36,000,000
Other liabilities		8,182,161			941,796
Total liabilities		394,842,625			375,077,691

Stockholders' equity:
Preferred stock - no par value; 2,000,000 shares authorized; 600,000 shares issued and outstanding in 2015 and 2014		15,000,000			14,964,309
Common stock - $1.00 par value; 20,000,000 shares authorized; 6,709,199 shares issued in 2015 and 2014; 6,643,341 and 6,627,398 shares outstanding in 2015 and 2014, respectively		6,643,341			6,627,398
Additional paid-in capital		21,972,860			21,821,060
Accumulated deficit		(3,020,401	)		(3,032,551	)
Accumulated other comprehensive income		100,825			281,889
Total stockholders' equity		40,696,625			40,662,105
Total liabilities and stockholders' equity	$	435,539,250		$	415,739,796

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						Six Months Ended
	June 30,						June 30,
	2015			2014			2015			2014
INTEREST INCOME
Loans, including fees	$	4,238,829		$	4,225,125		$	8,437,044		$	8,320,593
Securities and interest-bearing deposits at other financial institutions		335,766			346,507			682,829			776,997
Federal funds sold		7,932			10,112			13,203			17,275
Total interest income		4,582,527			4,581,744			9,133,076			9,114,865

INTEREST EXPENSE
Time deposits		386,877			365,537			735,188			741,027
Other deposits		71,903			75,965			141,655			143,039
Federal funds purchased and securities sold under agreements to repurchase		17,773			20,621			40,180			39,281
Federal Home Loan Bank advances and other borrowings		128,754			263,201			281,709			524,611
Total interest expense		605,307			725,324			1,198,732			1,447,958

Net interest income before provision for loan losses		3,977,220			3,856,420			7,934,344			7,666,907
(Credit) provision for loan losses		(88,368	)		350,000			261,632			515,000
Net interest income after provision for loan losses		4,065,588			3,506,420			7,672,712			7,151,907

NONINTEREST INCOME
Customer service fees		236,750			209,538			455,333			398,449
Net gains from sale of securities		113,296			300,201			113,296			402,473
Net gains from sale of loans and other assets		28,632			6,529			89,709			25,443
Net losses from sale of foreclosed assets		(474,159	)		(290,116	)		(401,374	)		(535,093	)
Other noninterest income		19,223			18,220			39,476			30,436
Total noninterest income		(76,258	)		244,372			296,440			321,708

NONINTEREST EXPENSE
Salaries and employee benefits		1,754,728			1,722,503			3,491,400			3,549,487
Net occupancy and equipment expense		314,650			324,086			601,637			632,918
Depository insurance		156,702			164,167			312,055			318,843
Foreclosed assets, net		54,563			73,006			112,178			177,399
Other operating expenses		1,192,476			801,047			2,158,341			1,462,234
Total noninterest expenses		3,473,119			3,084,809			6,675,611			6,140,881

Income before income tax expense		516,211			665,983			1,293,541			1,332,734
Income tax expense		197,900			256,500			495,700			511,100

Net income		318,311			409,483			797,841			821,634

Preferred stock dividend requirements		375,000			375,000			750,000			750,000
Accretion on preferred stock discount		17,845			17,845			35,691			35,691

Net income (loss) available to common shareholders	$	(74,534	)	$	16,638		$	12,150		$	35,943

EARNINGS (LOSS) PER COMMON SHARE
Basic	$	(0.01	)	$	-		$	-		$	0.01
Diluted	$	(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
	June 30
	2015			2014
Net income	$	318,311		$	409,483

Other comprehensive income, net of tax:
Unrealized holding losses arising during the period, net of tax benefit of $109,228 and $131,726 in 2015 and 2014, respectively		(178,212	)		(214,920	)

Reclassification adjustment for gains included in net income, net of tax expense of $43,052 and $114,076 in 2015 and 2014, respectively		(70,244	)		(186,125	)

Total other comprehensive loss		(248,456	)		(401,045	)

Comprehensive income	$	69,855		$	8,438

	Unaudited
	Six Months Ended
	June 30
	2015			2014
Net income	$	797,841		$	821,634

Other comprehensive income, net of tax:
Unrealized holding (losses) gains arising during the period, net of tax (expense) benefit (expense) of $67,925 and $(87,111) in 2015 and 2014, respectively		(110,820	)		142,125

Reclassification adjustment for gains include in net income, net of tax expense of $43,052 and $152,940 in 2015 and 2014, respectively		(70,244	)		(249,533	)

Total other comprehensive loss		(181,064	)		(107,408	)

Comprehensive income	$	616,777		$	714,226

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 Six Months Ended June 30, 2015

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

BALANCE, December 31, 2014	$	14,964,309	$	6,627,398	$	21,821,060	$	(3,032,551	)	$	281,889		$	40,662,105

Stock compensation expense		-		-		132,000		-			-			132,000

Issuance of common stock, 15,943 shares		-		15,943		19,800		-			-			35,743

Preferred stock dividends paid		-		-		-		(750,000	)		-			(750,000	)

Accretion on preferred stock		35,691		-		-		(35,691	)		-			-

Net income		-		-		-		797,841			-			797,841

Unrealized holding losses on securities available for sale, net of reclassification adjustment		-		-		-		-			(181,064	)		(181,064	)

BALANCE, June 30, 2015
	$	15,000,000	$	6,643,341	$	21,972,860	$	(3,020,401	)	$	100,825		$	40,696,625

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

Cornerstone Bancshares, Inc. and Subsidiary

Consolidated Statements of Cash Flows

	Unaudited
	Six Months Ended June 30,
	2015			2014

CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	797,841		$	821,634
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		237,414			246,093
Provision for loan losses		261,632			515,000
Stock compensation expense		132,000			80,000
Gains from sale of securities		(113,296	)		(402,473	)
Net gains from sale of loans and other assets		(89,709	)		(25,443	)
Net losses from sale of foreclosed assets		401,374			535,093
Deferred income taxes		278,209			325,058
Changes in other operating assets and liabilities:
Accrued interest receivable		70,762			(104,597	)
Accrued interest payable		32,145			(2,243	)
Other assets and liabilities		271,502			380,185
Net cash provided by operating activities		2,279,874			2,368,307

CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from security sales, maturities, and paydowns:
Securities available for sale		12,498,468			12,673,540
Securities held to maturity		3,319			3,182
Purchase of securities available for sale		-			(3,603,228	)
Loan originations and principal collections, net		(15,039,181	)		(4,152,593	)
Purchase of bank premises and equipment		(1,574,717	)		(62,878	)
Proceeds from sale of bank premise and equipment and foreclosed assets		901,134			325,144
Net cash (used in) provided by investing activities		(3,210,977	)		5,183,167

CASH FLOWS FROM FINANCING ACTIVITIES
Net increase (decrease) in deposits		22,908,935			(10,002,373	)
Net decrease in federal funds purchased and securities sold under agreements to repurchase		(5,416,511	)		(1,060,982	)
Repayment of Federal Home Loan Bank advances and other borrowings		(5,000,000	)		(1,740,000	)
Collection of participation payments due to other institutions		6,990,882			-
Payment of dividends on preferred stock		(750,000	)		(750,000	)
Issuance of common stock		35,743			191,001
Net cash provided by (used in) financing activities		18,769,049			(13,362,354	)

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		17,837,946			(5,810,880	)

CASH AND CASH EQUIVALENTS, beginning of period		15,527,721			24,851,737

CASH AND CASH EQUIVALENTS, end of period	$	33,365,667		$	19,040,857

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
Cash paid during the period for interest	$	1,166,587		$	1,450,201
Cash paid during the period for taxes		59,090			80,010

NONCASH INVESTING AND FINANCING ACTIVITIES
Acquisition of real estate through foreclosure	$	931,720		$	1,316,064
Financed sales of foreclosed assets		464,350			433,750

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 June 30, 2015 and June 30, 2014 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 2014 Annual Report to Shareholders which was furnished to each shareholder of Cornerstone in June of 2015. 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, 2014 as filed with the Securities and Exchange Commission. Since December 31, 2014, there have been no significant changes in any accounting principles or practices, or in the method of applying any such principles or practices.

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

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following is a summary of the basic and diluted earnings per share for the three and six month periods ended June 30, 2015 and June 30, 2014.

	Three Months Ended June 30,
	2015			2014
Net income (loss) available to common shareholders	$	(74,534	)	$	16,638
Weighted average common shares outstanding		6,638,730			6,627,398
Effect of dilutive stock options		422,929			179,888
Diluted shares		7,061,659			6,807,286
Basic earnings (loss) per common share	$	(0.01	)	$	0.00
Diluted earnings (loss) per common share	$	(0.01	)	$	0.00

	Six Months Ended June 30,
	2015		2014
Net income available to common shareholders	$	12,150	$	35,943
Weighted average common shares outstanding		6,633,938		6,601,070
Effect of dilutive stock options		399,066		160,068
Diluted shares		7,033,004		6,761,138
Basic earnings per common share	$	0.00	$	0.01
Diluted earnings per common share	$	0.00	$	0.01

For the three and six months ended June 30, 2015, 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 177,175 and 222,435 antidilutive stock options for the six months ended June 30, 2015 and 2014, respectively.

Note 2. Stock Based Compensation

Accounting Policies- Cornerstone, as required by the Financial Accounting Standards Board (“FASB”), applies the fair value recognition provisions of ASC 718, “Compensation –Stock Compensation.” For the six month period ended June 30, 2015, $132,000 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 June 30, 2015, the total remaining compensation cost to be recognized on non-vested options is approximately $567,000.

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, 2014		939,835		$	3.15	6.8 Years	$	953,940
Granted		-			-
Exercised		(5,400	)		1.76
Forfeited		(39,910	)		9.23
Outstanding at June 30, 2015		894,525		$	2.89	6.6 Years	$	1,473,549
Options exercisable at June 30, 2015		477,332		$	3.45

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 June 30, 2015, the total remaining compensation cost to be recognized on non-vested options is approximately $90,000. 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, 2014		254,250		$	2.71	7.4 Years	$	264,500
Granted		-			-
Exercised		-			-
Forfeited		(8,000	)		9.23
Outstanding at June 30, 2015		246,250		$	2.50	7.1 Years	$	415,561
Options exercisable at June 30, 2015		206,250		$	2.52

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 June 30, 2015 and December 31, 2014 are summarized as follows:

	June 30, 2015
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities available-for-sale:
U.S. Government agencies	$	521,020	$	5,423	$	-		$	526,443

State and municipal securities		4,365,290		112,960		(13,223	)		4,465,027

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		15,149,059		21,400		(52,476	)		15,117,983

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		54,265,213		259,146		(152,376	)		54,371,983

	$	74,300,582	$	398,929	$	(218,075	)	$	74,481,436

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA	$	22,131	$	285	$	(6	)	$	22,410

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

	December 31, 2014
			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
	Cost		Gains		Losses			Value
Debt securities available-for-sale:
U.S. Government agencies	$	560,183	$	2,840	$	-		$	563,023

State and municipal securities		7,028,388		302,697		-			7,331,085

Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		16,852,496		44,954		(9,179	)		16,888,271

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		62,278,948		273,571		(141,989	)		62,410,530

	$	86,720,015	$	624,062	$	(151,168	)	$	87,192,909

Debt securities held to maturity:
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA	$	25,428	$	274	$	-		$	25,702

At June 30, 2015, securities with a fair value totaling approximately $ 64 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 Reserve Discount Window and Federal Home Loan Bank.

For the six months ended June 30, 2015 and 2014, there were available-for-sale securities sold with proceeds totaling $4,559,000 and $9,229,167, respectively, which resulted in gross gains realized of $113,296 and $402,473, respectively.

The amortized cost and estimated market value of securities at June 30, 2015, 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		605,826		633,798		-		-
Due from five years to ten years		2,062,233		2,095,353		-		-
Due after ten years		2,218,251		2,262,319		-		-
		4,886,310		4,991,470		-		-

Mortgage-backed securities		69,414,272		69,489,966		22,131		22,410

	$	74,300,582	$	74,481,436	$	22,131	$	22,410

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 June 30, 2015 and as of December 31, 2014:

	As of June 30, 2015
	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	$	623,094	$	(6,722	)	$	545,635	$	(6,501	)	$	1,168,729	$	(13,223	)
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		11,531,175		(47,716	)		1,281,475		(4,760	)		12,812,650		(52,476	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		13,892,803		(99,823	)		11,134,700		(52,553	)		25,027,503		(152,376	)
	$	26,047,072	$	(154,261	)	$	12,961,810	$	(63,814	)	$	39,008,882	$	(218,075	)

	As of December 31, 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
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA	$	7,018,137	$	(9,179	)	$	-	$	-		$	7,018,137	$	(9,179	)

Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		9,504,525		(52,831	)		17,546,169		(89,158	)		27,050,694		(141,989	)
	$	16,522,662	$	(62,010	)	$	17,546,169	$	(89,158	)	$	34,068,831	$	(151,168	)

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 June 30, 2015 or December 31, 2014.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

At June 30, 2015, the categories of temporarily impaired securities, and management’s evaluation of those securities, are as follows:

State and municipal securities: At June 30, 2015, 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 June 30, 2015.

Mortgage-backed securities: At June 30, 2015, sixteen 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 or issued 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 June 30, 2015.

Note 4. Loans and Allowance for Loan Losses

At June 30, 2015 and December 31, 2014, loans are summarized as follows (in thousands):

	June 30,			December 31,
	2015			2014
Commercial real estate-mortgage:
Owner-occupied	$	73,178		$	68,581
All other		76,277			74,587
Consumer real estate-mortgage		76,707			76,907
Construction and land development		40,998			34,449
Commercial and industrial		40,433			37,863
Consumer and other		2,257			2,977
Total loans		309,850			295,364
Less: Allowance for loan losses		(3,579	)		(3,495	)

Loans, net	$	306,271		$	291,869

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.

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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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 June 30, 2015 and December 31, 2014, is summarized in the tables below (amounts in thousands):

June 30, 2015	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	147,143	$	75,217	$	40,768	$	39,452	$	2,257	$	304,837
Impaired loans		2,312		1,490		230		981		-		5,013
Total	$	149,455	$	76,707	$	40,998	$	40,433	$	2,257	$	309,850

December 31, 2014	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	138,711	$	74,828	$	33,696	$	36,314	$	2,977	$	286,526
Impaired loans		4,457		2,079		753		1,549		- .		8,838
Total	$	143,168	$	76,907	$	34,449	$	37,863	$	2,977	$	295,364

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 June 30, 2015 and December 31, 2014 (amounts in thousands):

June 30, 2015	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
Allowance related to:	Mortgage		Mortgage		Development		Industrial		and Other		Total
Performing loans	$	1,699	$	1,022	$	216	$	524	$	67	$	3,528
Impaired loans		47		-		-		4		-		51
Total	$	1,746	$	1,022	$	216	$	528	$	67	$	3,579

December 31, 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	$	1,191	$	1,082	$	130	$	361	$	35	$	2,799
Impaired loans		404		15		-		277		-		696
Total	$	1,595	$	1,097	$	130	$	638	$	35	$	3,495

The following tables detail the changes in the allowance for loan losses for the six month period ended June 30, 2015 and year ended December 31, 2014, by loan classification (amounts in thousands):

June 30, 2015	Commercial			Consumer			Construction		Commercial
	Real Estate-			Real Estate-			and Land		and			Consumer
	Mortgage			Mortgage			Development		Industrial			and Other			Total
Beginning balance	$	1,595		$	1,097		$	130	$	638		$	35		$	3,495
Charged-off loans		(132	)		(17	)		-		(209	)		(14	)		(372	)
Recovery of charge-offs		42			27			85		22			18			194
Provision for (reallocation of) loan losses		241			(85	)		1		77			28			262
Ending balance	$	1,746		$	1,022		$	216	$	528		$	67		$	3,579

December 31, 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		(470	)		(896	)		(58	)		(108	)		(50	)		(1,582	)
Recovery of charge-offs		156			324			771			58			50			1,359
Provision for (reallocation of) loan losses		360			731			(902	)		336			(10	)		515
Ending balance	$	1,595		$	1,097		$	130		$	638		$	35		$	3,495

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 June 30, 2015 and December 31, 2014 (amounts in thousands):

June 30, 2015	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Pass	$	145,041	$	74,072	$	39,967	$	38,141	$	2,257	$	299,478
Special mention		2,347		1,089		525		957		-		4,918
Substandard		2,067		1,546		506		1,335		-		5,454
	$	149,455	$	76,707	$	40,998	$	40,433	$	2,257	$	309,850

December 31, 2014	Commercial		Consumer		Construction		Commercial
	Real Estate-		Real Estate-		and Land		and		Consumer
	Mortgage		Mortgage		Development		Industrial		and Other		Total
Pass	$	135,586	$	72,753	$	33,201	$	32,684	$	2,977	$	277,201
Special mention		3,096		1,452		17		3,187		-		7,752
Substandard		4,486		2,702		1,231		1,992		-		10,411
	$	143,168	$	76,907	$	34,449	$	37,863	$	2,977	$	295,364

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 June 30, 2015 and December 31, 2014 (in thousands):

							For the quarter ended
	At June 30, 2015						June 30, 2015
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	1,918	$	1,970	$	-	$	2,248	$	59
Consumer real estate – mortgage		1,490		1,507		-		1,580		51
Construction and land development		230		243		-		405		6
Commercial and industrial		964		1,007		-		998		19
Total	$	4,602	$	4,727	$	-	$	5,231	$	135

Impaired loans with a valuation allowance:
Commercial real estate – mortgage	$	394	$	431	$	47	$	949	$	12
Consumer real estate – mortgage								114		-
Construction and land development		-		-		-		-		-
Commercial and industrial		17		17		4		253		1
Total	$	411	$	448	$	51	$	1,316	$	13
Total impaired loans	$	5,013	$	5,175	$	51	$	6,547	$	148

							For the year ended
	At December 31, 2014						December 31, 2014
			Unpaid				Average		Interest
	Recorded		Principal		Related		Recorded		Income
	Investment		Balance		Allowance		Investment		Recognized
Impaired loans without a valuation allowance:
Commercial real estate – mortgage	$	2,428	$	2,480	$	-	$	4,386	$	127
Consumer real estate – mortgage		1,738		1,742		-		1,880		114
Construction and land development		753		766		-		462		44
Commercial and industrial		1,033		1,085		-		1,186		41
Total	$	5,952	$	6,073	$	-	$	7,914	$	326

Impaired loans with a valuation allowance:
Commercial real estate – mortgage	$	2,029	$	2,029	$	404	$	683	$	98
Consumer real estate – mortgage		341		476		15		676		24
Construction and land development		-		-		-		-		-
Commercial and industrial		516		516		277		401		52
Total	$	2,886	$	3,021	$	696	$	1,760	$	174

Total impaired loans	$	8,838	$	9,094	$	696	$	9,674	$	500

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The following tables present an aged analysis of past due loans as of June 30, 2015 and December 31, 2014 (amounts in thousands):

June 30, 2015	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	$	377	$	-	$	444	$	821	$	72,357	$	73,178
All other		392		-		-		392		75,885		76,277
Consumer real estate-mortgage		510		-		436		946		75,761		76,707
Construction and land development		25		-		-		25		40,973		40,998
Commercial and industrial		95		-		10		105		40,328		40,433
Consumer and other		23		-		-		23		2,234		2,257
Total	$	1,422	$	-	$	890	$	2,312	$	307,538	$	309,850

December 31, 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	$	664	$	-	$	496	$	1,160	$	67,421	$	68,581
All other		-		-		-		-		74,587		74,587
Consumer real estate-mortgage		419		-		1,134		1,553		75,354		76,907
Construction and land development		521		-		40		561		33,888		34,449
Commercial and industrial		54		-		1,195		1,249		36,614		37,863
Consumer and other		8		-		-		8		2,969		2,977
Total	$	1,666	$	-	$	2,865	$	4,531	$	290,833	$	295,364

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 June 30, 2015 and December 31, 2014, the Bank has loans of approximately $2,778,000 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 were no loans modified as troubled debt restructurings during the six month period ending June 30, 2015. 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 six month period ending June 30, 2014.

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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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.

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 June 30, 2015 is as follows:

Commitments to extend credit		$	40.8 million
Standby letters of credit		$	239 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 June 30, 2015 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:

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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.

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 June 30, 2015 and December 31, 2014.

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.”

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.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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
	June 30,		Assets		Inputs		Inputs
	2015		(Level 1)		(Level 2)		(Level 3)
Debt securities available-for-sale:

U.S. Government agencies	$	526,443	$	-	$	526,443	$	-
State and municipal securities		4,465,027		-		4,465,027		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		15,117,983		-		15,117,983		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		54,371,983		-		54,371,983		-

Total securities available-for-sale	$	74,481,436	$	-	$	74,481,436	$	-

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)
Debt securities available-for-sale:

U.S. Government agencies	$	563,023	$	-	$	563,023	$	-
State and municipal securities		7,331,085		-		7,331,085		-
Mortgage-backed securities:
Residential mortgage guaranteed by GNMA or FNMA		16,888,271		-		16,888,271		-
Collateralized mortgage obligations issued or guaranteed by U.S. Government agencies or sponsored agencies		62,410,530		-		62,410,530		-

Total securities available-for-sale	$	87,192,909	$	-	$	87,192,909	$	-

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

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 June 30, 2015 and December 31, 2014, 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
	June 30,		Assets		Inputs		Inputs
	2015		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	360,164	$	-	$	-	$	360,164
Foreclosed assets		7,165,227		-		-		7,165,227

			Quoted Prices in		Significant		Significant
			Active Markets		Other		Other
	Balance as of		for Identical		Observable		Unobservable
	December 31,		Assets		Inputs		Inputs
	2014		(Level 1)		(Level 2)		(Level 3)

Impaired loans	$	2,190,522	$	-	$	-	$	2,190,522
Foreclosed assets		8,000,365		-		-		8,000,365

Loans considered impaired under ASC 310-10-35, “Receivables”, are loans for which, based on current information and events, it is probable that Cornerstone will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. Impaired loans can be measured based on the present value of expected payments using the loan’s original effective rate as the discount rate, the loan’s observable market price, or the fair value of the collateral less selling costs if the loan is collateral dependent.

The fair value of impaired loans were primarily measured based on the value of the collateral securing these loans. Impaired loans are classified within Level 3 of the fair value hierarchy. Collateral may be real estate and/or business assets including equipment, inventory, and/or accounts receivable. Cornerstone determines the value of the collateral based on independent appraisals performed by qualified licensed appraisers. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Appraised values are discounted for costs to sell and may be discounted further based on management’s historical knowledge, changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts by management are subjective and are typically significant unobservable inputs for determining fair value. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors discussed above.

Foreclosed assets, consisting of properties obtained through foreclosure or in satisfaction of loans, are initially recorded at the lower of the loan’s carrying amount or the fair value less estimated costs to sell upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less costs to sell. Fair values are generally based on third party appraisals of the property and are classified within Level 3 of the fair value hierarchy. The appraisals are sometimes further discounted based on management’s historical knowledge, and/or changes in market conditions from the date of the most recent appraisal, and/or management’s expertise and knowledge of the customer and the customer’s business. Such discounts are typically significant unobservable inputs for determining fair value. In cases where the carrying amount exceeds the fair value, less estimated costs to sell, a loss is recognized.

CORNERSTONE BANCSHARES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

For Level 3 assets measured at fair value on a nonrecurring basis as of June 30, 2015, the significant unobservable inputs used in the fair value measurements are presented below.

Significant Other

Weighted

Balance as of

Valuation

Unobservable

Average

June 30, 2015

Technique

Input

of Input

Impaired loans

360,164

Appraisal

Appraisal discounts (%)

10.3

Foreclosed assets

7,165,227

Appraisal

Appraisal discounts (%)

17.0

The carrying amount and estimated fair value of Cornerstone's financial instruments at June 30, 2015 and December 31, 2014, are as follows (in thousands):

	June 30, 2015				December 31, 2014
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value
Assets:
Cash and cash equivalents	$	33,366	$	33,366	$	15,528	$	15,528
Securities		74,504		74,504		87,218		87,219
Federal Home Loan Bank stock		2,323		2,323		2,323		2,323
Loans, net		306,271		305,957		291,869		292,490
Accrued interest receivable		1,072		1,072		1,143		1,143

Liabilities:
Noninterest-bearing demand deposits		53,470		53,470		57,035		57,035
Interest-bearing demand deposits		38,167		38,167		26,464		26,464
Savings deposits and money market accounts		76,740		76,740		80,861		80,861
Time deposits		163,187		164,928		144,294		145,907
Federal funds purchased and securities sold under agreements to repurchase		23,993		23,993		29,410		29,410
Federal Home Loan Bank advances and other borrowings		31,000		31,163		36,000		36,321
Accrued interest payable		104		104		72		72

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
	June 30
	2015								2014
	Average			Income/		Yield/			Average			Income/		Yield/
(Amounts in thousands)	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Earning assets:
Loans, net of unearned income	$	303,953		$	4,239		5.59	%	$	292,039		$	4,225		5.80	%
Investment securities		84,369			336		1.67	%		93,074			347		1.64	%
Other earning assets		14,151			8		0.23	%		15,647			10		0.26	%
Total earning assets		402,473		$	4,583		4.58	%		400,760		$	4,582		4.62	%
Allowance for loan losses		(3,565	)							(3,112	)
Cash and other assets		21,512								29,303
TOTAL ASSETS	$	420,420							$	426,951

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	36,610		$	11		0.12	%	$	28,462		$	11		0.16	%
Savings deposits		13,675			3		0.09	%		15,054			4		0.11	%
MMDA's		60,471			58		0.38	%		65,740			61		0.37	%
Time deposits		164,292			387		0.94	%		160,174			366		0.92	%
Federal funds purchased and securities sold under agreements to repurchase		19,464			18		0.37	%		22,580			21		0.37	%
Federal Home Loan Bank and other borrowings		31,000			129		1.67	%		27,776			263		3.80	%
Total interest-bearing liabilities		325,512			606		0.75	%		319,786			726		0.91	%
Net interest spread				$	3,977		3.83	%				$	3,856		3.71	%
Noninterest-bearing demand deposits		53,044								65,528
Accrued expenses and other liabilities		1,103								927
Shareholders' equity		40,761								40,710
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	420,420							$	426,951
Net yield on earning assets							3.98	%							3.89	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					14								33
Total adjustment					14								33

Cornerstone Bancshares, Inc. and Subsidiary

Net Interest Margin Analysis

Taxable Equivalent Basis

	Six months ended
	June 30
	2015								2014
	Average			Income/		Yield/			Average			Income/		Yield/
(Amounts in thousands)	Balance			Expense		Rate			Balance			Expense		Rate
Assets
Earning assets:
Loans, net of unearned income	$	299,565		$	8,437		5.68	%	$	291,935		$	8,321		5.75	%
Investment securities		86,504			683		1.66	%		94,513			777		1.81	%
Other earning assets		13,379			13		0.20	%		13,760			17		0.25	%
Total earning assets		399,448		$	9,133		4.63	%		400,208		$	9,115		4.63	%
Allowance for loan losses		(3,483	)							(3,109	)
Cash and other assets		21,604								29,519
TOTAL ASSETS	$	417,569							$	426,618

Liabilities and Shareholders' Equity

Interest-bearing liabilities:
Interest-bearing demand deposits	$	34,470		$	20		0.12	%	$	28,218		$	20		0.14	%
Savings deposits		13,703			7		0.10	%		15,216			7		0.09	%
MMDA's		61,937			115		0.37	%		65,521			116		0.36	%
Time deposits		159,168			735		0.93	%		160,278			741		0.93	%
Federal funds purchased and securities sold under agreements to repurchase		24,258			40		0.33	%		22,074			39		0.36	%
Federal Home Loan Bank and other borrowings		31,409			282		1.81	%		29,708			525		3.56	%
Total interest-bearing liabilities		324,945			1,199		0.74	%		321,015			1,448		0.91	%
Net interest spread				$	7,934		3.89	%				$	7,667		3.72	%
Noninterest-bearing demand deposits		50,754								64,310
Accrued expenses and other liabilities		1,118								714
Shareholders' equity		40,752								40,579
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	417,569							$	426,618
Net yield on earning assets							4.02	%							3.90	%

Taxable equivalent adjustment:
Loans					0								0
Investment securities					31								72
Total adjustment					31								72

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

Introduction and Recent Developments

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.

On December 8, 2014, Cornerstone announced the signing of a definitive agreement to merge with SmartFinancial, Inc. which would create a combined company that will operate under the name SmartFinancial, Inc. Under the terms of the agreement, each outstanding share of common stock of SmartFinancial will be converted into 4. 20 shares of Cornerstone common stock, subject to adjustment based on an anticipated reverse stock split of Cornerstone’s common stock, which is expected to adjust the ratio to 1.05 shares of Cornerstone common stock for each share of SmartFinancial common stock. Additionally, each outstanding share of SmartFinancial preferred stock will be converted into a share of Cornerstone preferred stock with similar rights and preferences. In June 2015, current holders of Cornerstone’s preferred stock voted and passed an amendment to Cornerstone’s charter to allow Cornerstone to redeem its outstanding preferred stock prior to the completion of the merger. Completion of the merger has been approved by both SmartFinancial’s and Cornerstone’s shareholders and bank regulatory authorities.

The following is a discussion of Cornerstone’s financial condition at June 30, 2015 and December 31, 2014 and our results of operations for the three months and six months ended June 30, 2015 and 2014. 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, 2014 for more information.

Review of Financial Performance

As of June 30, 2015, Cornerstone had total consolidated assets of approximately $436 million, total loans of approximately $306 million, total securities of approximately $75 million, total deposits of approximately $332 million and stockholders’ equity of approximately $41 million. Net income for the three and six month period ended June 30, 2015 totaled $318,311 and $797,841, respectively.

Results of Operations

Net income for the three months ended June 30, 2015 was $318,311 or ($0.01) basic earnings per common share, compared to a net income of $409,483 or $0.00 basic earnings per common share, for the same period in 2014. Net income for the six months ended June 30, 2015 was $797,841 or $0.00 basic earnings per common share, compared to a net income of $821,634 or $0.01 basic earnings per common share, for the same period in 2014.

The following table presents our results for the three and six months ended June 30, 2015 compared to the three and six months ended June 30, 2014 (amounts in thousands).

						2015-2014										2015-2014
	Three months					Percent			Dollar			Six months				Percent			Dollar
	ended June 30,					Increase			Amount			ended June 30,				Increase			Amount
	2015			2014		(Decrease)			Change			2015		2014		(Decrease)			Change
Interest income	$	4,583		$	4,582		0.02	%	$	1		$	9,133	$	9,115		0.20	%	$	18
Interest expense		606			725		(16.41	)%		(119	)		1,199		1,448		(17.20	)%		(249	)
Net interest income before provision for loan loss		3,977			3,857		3.11	%		120			7,934		7,667		3.48	%		267

(Credit) provision for loan loss		(88	)		350		(125.14	)%		(438	)		262		515		(49.13	)%		(253	)

Net interest income after (credit) provision for loan loss		4,065			3,507		15.91	%		558			7,672		7,152		7.27	%		520

Total noninterest income		(76	)		244		(131.15	)%		(320	)		296		322		(8.07	)%		(26	)
Total noninterest expense		3,473			3,085		12.58	%		388			6,675		6,141		8.70	%		534

Income before income taxes		516			666		(22.52	)%		(150	)		1,293		1,333		(3.00	)%		(40	)

Provision for income taxes		198			257		(22.96	)%		(59	)		495		511		(3.13	)%		(16	)

Net income	$	318		$	409		(22.25	)%	$	(91	)	$	798	$	822		(2.92	)%	$	(24	)

Net Interest Income-Net interest income represents the amount by which interest earned on various earning assets exceeds interest paid on deposits and other interest-bearing liabilities. Net interest income is also the most significant component of our earnings. For the three months ended June 30, 2015, net interest income before provision for loan loss increased approximately $120 thousand or 3.11 percent over the same period of 2014. For the six months ended June 30, 2015, net interest income before provision for loan loss increased $267 thousand or 3.48 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 3.83 percent compared to 3.71 percent for the three month periods ended June 30, 2015 and 2014, respectively. The interest rate spread on a tax equivalent basis was 3.89 percent compared to 3.72 percent for the six month periods ended June 30, 2015 and 2014, respectively.

The net interest margin on a tax equivalent basis was 3.98 percent and 3.89 percent for the three month periods ended June 30, 2015 and 2014, respectively. The net interest margin on a tax equivalent basis was 4.02 percent and 3.90 percent for the six month periods ended June 30, 2015 and 2014, 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 six month period ended June 30, 2015, the Bank’s net interest income has been positively impacted by a reduction in interest expense incurred by the Bank. During the six month period ending June 30, 2015, the Bank has been able to reprice $18 million in Federal Home Loan Bank advances which had a weighted average annual interest rate of 2.15 percent. The Bank elected to renew $13 million of these maturing FHLB advances which range from 12 months to 18 months in maturity, and had a weighted-average annual interest rate of 0.51 percent.

The Bank’s loan portfolio yield decreased to 5.68 percent for the six months ended June 30, 2015 compared to 5.75 percent for the six months ended June 30, 2014. Management believes loan yields will continue to see downward pressure during 2015 as customers continue to refinance existing loans and due to general market conditions. Cornerstone will attempt to increase its outstanding loan balances during 2015 to offset the possible yield reduction.

For the six month period ended June 30, 2015, the Bank’s investment portfolio yield decreased to 1.66 percent compared to 1.81 percent for the same time period in 2014. The Bank’s average balance also decreased from approximately $95 million as of June 30, 2014 to approximately $87 million as of June 30, 2015. The reduction in yield and average balance is attributable to the Bank liquidating approximately $9.2 million of its municipal security inventory and the receipt of approximately $8.5 million in mortgage-backed security payments from March 31, 2014 to December 31, 2014. In the fourth quarter of 2014, the Bank elected to increase its investment portfolio by approximately $11 million to offset the decreases in interest income. The Bank purchased new and seasoned fixed mortgage-backed securities to increase the investment yield and provide consistent cash flow from the portfolio.

The Bank’s net interest margin increased from 3.90 percent for the six months ended as of June 30, 2014 compared to 4.02 percent for the six months ended as of June 30, 2015. Management believes opportunities exist for the net interest margin to remain close to the June 30, 2015 percentage. However, local market pressure on loans and deposit relationships continue to present significant challenges in this area.

(Credit) 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. Cornerstone recorded a credit for loan losses of $88 thousand for the three months ended June 30, 2015 and a provision of $350 thousand for the three months ended June 30, 2014. For the six month period ended June 30, 2015, the Bank recorded provisions of $262 thousand compared to $515 thousand for the same period in 2014.

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 six months ended June 30, 2015 and 2014 (dollars in thousands):

							2015-2014									2015-2014
	Three months ended						Percent			Six months ended						Percent
	June 30,						Increase			June 30,						Increase
	2015			2014			(Decrease)			2015			2014			(Decrease)
Service charges on deposit accounts	$	237		$	210			12.86	%	$	455		$	399			14.04	%
Net gains on sale of securities		113			300			(62.33	)%		113			403			(71.96	)%
Net gains on sale of loans and other assets		29			6			383.33	%		90			25			260.00	%
Net losses on sale of foreclosed assets		(474	)		(290	)		63.45	%		(401	)		(535	)		(25.05	)%
Other noninterest income		19			18			5.56	%		39			30			30.00	%
Total noninterest income	$	(76	)	$	244			(131.15	)%	$	296		$	322			(8.07	)%

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

The Bank sold approximately $4.4 million of securities and recorded a gain of approximately $113 thousand during the second quarter of 2015. For the six months ended June 30, 2014, approximately $8.8 million of securities were sold with a recorded gain of approximately $403 thousand. The Bank chose to liquidate the securities to offset foreclosed asset expense.

During the first six months of 2015, the Bank recorded approximately $401 in losses on the sale and write down of foreclosed assets compared to losses and write downs of approximately $535 thousand for the first six months of June 30, 2014.

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 six months ended June 30, 2015 and 2014 (dollars in thousands).


					2015-2014							2015-2014
	Three months ended				Percent			Six months ended				Percent
	June 30,				Increase			June 30,				Increase
	2015		2014		(Decrease)			2015		2014		(Decrease)
Salaries and employee benefits	$	1,755	$	1,723		1.86	%	$	3,491	$	3,550		(1.66	)%
Occupancy and equipment expense		314		324		(3.09	)%		602		633		(4.90	)%
Foreclosed assets expense, net		55		73		(24.66	)%		112		177		(36.72	)%
FDIC depository insurance		157		164		(4.27	)%		312		319		(2.19	)%
Other operating expense		1,192		801		48.81	%		2,158		1,462		47.61	%
Total noninterest expense	$	3,473	$	3,085		12.58	%	$	6,675	$	6,141		8.70	%

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

For the six month period ended June 30, 2015, the Bank recorded approximately $112 thousand in net foreclosed assets expense compared to approximately $177 thousand during the six months ended June 30, 2014. The decrease in foreclosed asset expense can be attributed to a reduction of approximately $5.8 million in foreclosed assets from June 30, 2014 through June 30, 2015. Management nets the expense against the income generated from income producing real estate to calculate net foreclosed assets expense.

During the first six months of 2015, other operating expense were approximately $2.2 million compared to approximately $1.5 million during the first six months of 2014 or an increase of approximately $696 thousand. The majority of this increase was a direct result of approximately $395 thousand incurred in merger expenses during 2015 for the Company to merge with SmartFinancial, Inc. Merger expenses include legal and accounting fees to prepare and review the Form S-4 Registration Statement and fees to file, print and mail the Form S-4 Registration Statement to the shareholders of record. In addition to merger expenses, legal fees also increased during the first six months of 2015 versus the first six months of 2014 by approximately $167 thousand. This increase is a result of expensing legal fees on loans charged off and other collection efforts.

Financial Condition

Overview-Cornerstone’s consolidated assets totaled approximately $416 million as of December 31, 2014. As of June 30, 2015, total consolidated assets had increased approximately $20 million or 4.76 percent to approximately $436 million.

Liabilities as of June 30, 2015 and December 31, 2014 totaled approximately $395 million and $375 million, respectively.

Stockholders’ equity as of June 30, 2015 and December 31, 2014 totaled approximately $41 million.

Securities-The Bank’s investment portfolio, primarily consisting of collateralized mortgage obligations, mortgage backed securities and municipal securities, amounted to approximately $75 million as of June 30, 2015 compared to approximately $87 million as of December 31, 2014. The primary purposes of the Bank’s investment portfolio is to provide liquidity, satisfy pledging requirements, collateralize the Bank’s repurchase accounts and secure the Bank’s FHLB borrowings.

Loans-The composition of loans at June 30, 2015 and at December 31, 2014 and the percentage of each classification to total loans are summarized in the following table (dollars in thousands):

	June 30, 2015						December 31, 2014
	Amount			Percent			Amount			Percent
Commercial real estate-mortgage
Owner-occupied	$	73,178			23.62	%	$	68,581			23.22	%
All other		76,277			24.62	%		74,587			25.25	%
Consumer real estate-mortgage		76,707			24.76	%		76,907			26.04	%
Construction and land development		40,998			13.23	%		34,449			11.66	%
Commercial and industrial		40,433			13.05	%		37,863			12.82	%
Consumer and other		2,257			0.72	%		2,977			1.01	%
Total loans		309,850			100.00	%		295,364			100.00	%
Less: Allowance for loan losses		(3,579	)					(3,495	)

Loans, net	$	306,271					$	291,869

The Bank’s gross loans increased from approximately $295 million as of December 30, 2014 to approximately $310 million as of June 30, 2015 or 4.9 percent. The primary increase was in construction and land development which is primarily attributed to commercial construction. Commercial real estate loans also increased 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 2015.

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 six months ended for June 30, 2015, the Bank recorded approximately $262 thousand in provision expense and approximately $194 thousand in loan loss recoveries to the loan loss allowance. The provision expense was needed to address loan charge-offs of approximately $372 thousand. The Bank’s net loan charge offs decreased from approximately $880 thousand for the six month period ended June 30, 2014 to approximately $372 thousand for the six month period ended June 30, 2015 or approximately 58 percent. The decrease in net 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 six months ended June 30, 2015 and for the year ended December 31, 2014 and the ratio of the allowance for loan losses to total loans as of the end of each period (dollars in thousands):

	June 30,			December 31,
	2015			2014
Balance, beginning of period	$	3,495		$	3,203
Loans charged-off		(372	)		(1,582	)
Recoveries of loans previously charged-off		194			1,359
Provision for loan losses		262			515
Balance, end of period	$	3,579		$	3,495

Total loans	$	309,850		$	295,364

Ratio of allowance for loan losses to loans outstanding at the end of the period		1.16	%		1.18	%

Ratio of net charge-offs to total loans outstanding for the period		0.06	%		0.08	%

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 from approximately $15.8 million as of June 30, 2014 to approximately $8.1 million as of June 30, 2015. The majority of this amount is comprised of foreclosed assets. 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 September 30, 2014 to June 30, 2015 (amounts in thousands):

	June 30,			March 31,			December 31,			September 30,
	2015			2015			2014			2014
Nonaccrual loans	$	890		$	1,450		$	2,865		$	3,600
Foreclosed assets		7,165			8,523			8,000			10,994
Total non-performing assets	$	8,055		$	9,973		$	10,865		$	14,594

30-89 days past due loans	$	1,422		$	107		$	1,666		$	2,846

Total loans outstanding	$	309,850		$	296,034		$	295,364		$	298,390

Allowance for loan losses	$	3,579		$	3,657		$	3,495		$	3,474

Ratio of non-performing loans to total loans outstanding at the end of the period		0.29	%		0.49	%		0.97	%		1.21	%

Ratio of total allowance for loan losses to nonaccrual loans at the end of the period		402.13	%		252.21	%		121.99	%		96.50	%

The Bank’s nonaccrual balances decreased during the second quarter of 2015 compared to the last three quarters. The nonaccrual loans have decreased from approximately $3 million as of June 30, 2014 to approximately $900 thousand as of June 30, 2015 or approximately 69 percent. Management anticipates nonaccrual loans to remain relatively flat during the remainder of 2015.

The Bank’s foreclosed assets decreased from approximately $13 million as of June 30, 2014 to approximately $7 million as of June 30, 2015 or approximately 45 percent. Management is targeting a net reduction in foreclosed asset levels by approximately $3 million during the remainder of 2015.

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).

	June 30, 2015					December 31, 2014
	Amount		Percent			Amount		Percent
Core funding:
Noninterest-bearing demand deposits	$	53,470		13.9	%	$	57,035		15.2	%
Interest-bearing demand deposits		38,167		10.0	%		26,464		7.1	%
Savings and money market accounts		73,740		19.2	%		80,861		21.6	%
Time deposits under $100,000		56,403		14.7	%		57,128		15.3	%
Total core funding		221,780		57.8	%		221,488		59.2	%

Non-core funding:
Time deposit of $100,000 or more	$	106,784		27.8	%	$	87,166		23.3	%
Fed funds purchased and securities sold under agreements to repurchase		23,993		6.3	%		29,410		7.9	%
Federal Home Loan Bank advances		31,000		8.1	%		36,000		9.6	%
Total non-core funding		161,777		42.2	%		152,576		40.8	%

Total	$	383,557		100.0	%	$	374,064		100.0	%

The Bank was able to maintain its level of core funding to non-core funding during the first half of 2015. Management believes this is important given the increased level of competition in the Chattanooga, Tennessee market. The Bank has been able to reduce its reliance on FHLB borrowings by $5 million since December 31, 2014. Management considers FHLB borrowings to be a potential funding source for new loan growth in the near future. The Bank also ran a local market time deposit special during the first quarter of 2015 to improve its overall liquidity position and increase the level of core funding. Management anticipates that funding for asset growth will be derived from a number of sources to ensure adequate liquidity is maintained and the lowest cost of funds can be obtained.

Capital Resources-At June 30, 2015 and December 31, 2014, Cornerstone’s stockholders’ equity amounted to approximately $40.7 million.

The following is a summary of the Bank’s capital ratios as of June 30, 2015:

Tier 1 leverage ratio	9.45	%
Common equity tier 1 capital ratio	11.33	%
Tier 1 capital ratio	11.33	%
Total risk-based capital ratio	12.35	%

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.

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, 2014. No material changes in the assumptions used in preparing, or results obtained from, the model have occurred since December 31, 2014.

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 March 31, 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 June 30, 2015 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. Various legal claims also arise from time to time in the normal course of business. In the opinion of management, the resolution of claims outstanding at June 30, 2015 will not have a material effect on Cornerstone’s consolidated financial statements.

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.
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema
101.CAL		XBRL Taxonomy Extension Calculation Linkbase
101.DEF		XBRL Taxonomy Extension Definition Linkbase
101.LAB		XBRL Taxonomy Extension Label Linkbase
101.PRE		XBRL Taxonomy Extension Presentation Linkbase

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: August 14, 2015	/s/ Nathaniel F. Hughes
	Nathaniel F. Hughes,
	President and Chief Executive Officer
	(principal executive officer)

Date: August 14, 2015	/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.
101.INS		XBRL Instance Document
101.SCH		XBRL Taxonomy Extension Schema
101.CAL		XBRL Taxonomy Extension Calculation Linkbase
101.DEF		XBRL Taxonomy Extension Definition Linkbase
101.LAB		XBRL Taxonomy Extension Label Linkbase
101.PRE		XBRL Taxonomy Extension Presentation Linkbase