SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K
(MARK ONE)

[X]      ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
         EXCHANGE ACT OF 1934 (FEE REQUIRED) For the fiscal year ended December
         31, 1996 OR

[ ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
         EXCHANGE ACT OF 1934 (NO FEE REQUIRED) 
         For the transition period from ________________ to ________________
                       Commission file number 34-015178A

                            ROYCE LABORATORIES, INC.
              -----------------------------------------------------
             (Exact Name of Registrant as Specified in its Charter)


            FLORIDA                                      59-2202295
  ------------------------------               ---------------------------------
  State or Other Jurisdiction of               (IRS Employer Identification No.)
  Incorporation or Organization

 5350 N.W. 165TH STREET, MIAMI, FLORIDA                   33014
 --------------------------------------                   -----
(Address of Principal Executive Offices)                (Zip Code)

                                 (305) 624-1500
                                 --------------
               Registrant's Telephone Number, Including Area Code

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

    TITLE OF EACH CLASS         NAME OF EACH EXCHANGE ON WHICH REGISTERED
    -------------------         -----------------------------------------
           None                                   None

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

                     COMMON STOCK, $.005 PAR VALUE PER SHARE
                     ---------------------------------------
                                (Title of class)


    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
filing requirements for the past 90 days. Yes [X] No[ ]


    Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]


    Aggregate market value as of March 21, 1997, of Common Stock held by
non-affiliates of the Registrant: $91,564,054 based on the last reported sale
price on the NASDAQ Small Cap Market.


    Number of shares of Common Stock outstanding on March 21, 1997: 13,565,045


                       DOCUMENTS INCORPORATED BY REFERENCE


    Certain exhibits listed in Part IV of this Annual Report on Form 10-K are
incorporated by reference from prior filings made by the Registrant under the
Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as
amended.

<PAGE>


                                     PART I

ITEM 1.    BUSINESS.

GENERAL

           The Company develops, manufactures and markets generic prescription
drugs in solid dosage form (tablets and capsules). Tablets and capsules comprise
the largest portion of the prescription pharmaceutical market. At present, the
Company manufactures and markets 20 generic prescription drugs in 42 dosage
strengths and has received approval on an additional drug in 3 dosage strengths
which it has not yet commenced manufacturing and marketing. Additionally, the
Company has, at present, abbreviated new drug applications ("ANDAs") pending
with the Food and Drug Administration ("FDA") for 9 new products in 15 dosage
strengths.

           The Company's objective is to increase the number of products offered
while being an efficient, low cost manufacturer of generic pharmaceuticals. The
Company's product development strategy is to focus on selected niche or
overlooked products and on products whose brand name equivalents have U.S. sales
of over $100 million. The Company has identified a number of products that it
believes offer growth opportunities, such as drugs having a controlled substance
as one of their active ingredients and used in pain management, and selected
drugs with difficult-to-develop formulations. The Company sells its products,
manufactured under its own or a customer's private label, primarily to drug
wholesalers, generic drug distributors, retail buying groups, managed care
organizations and drug chains. The Company also manufactures products for
private label customers.

PENDING MERGER

           On December 24, 1996, the Company and Watson Pharmaceuticals, Inc.
("Watson"), a pharmaceutical company, signed a definitive merger agreement for
Watson to acquire the Company in a stock-for-stock merger transaction to be
accounted for as a "pooling-of-interests" ("Merger"). Under the terms of the
definitive agreement, the Company will become a wholly-owned subsidiary of
Watson, and Patrick McEnany will become President of the wholly-owned
subsidiary, Royce Laboratories, Inc., as well as Vice President of Corporate
Development for Watson. The proposed transaction is subject to approval by the
Company's stockholders and other customary conditions to closing. The Company's
special meeting of stockholders is scheduled for April 16, 1997 and assuming a
majority of such stockholders vote for the Merger, the transaction will close
immediately thereafter. See Note 1 (II) to the accompanying consolidated
financial statements for a more detailed discussion on the Merger. For further
information about the terms of the Merger, see also the Company's proxy
statement dated March 17, 1997, which has been sent to the Company's
shareholders to solicit proxies to be voted at the above-referenced special
meeting of stockholders at which the stockholders will vote on the proposed
Merger with Watson.

PRODUCTS

           The Company has received the required approvals for the following
products, all except one of which it currently markets:

<TABLE>
<CAPTION>

                                                                                                   NUMBER OF
                                                BRAND NAME                      THERAPEUTIC         DOSAGE
PRODUCT NAME                                    EQUIVALENT                         CLASS           STRENGTHS          APPROVAL DATE
<S>                                     <C>                                     <C>                     <C>             <C>
1.   Alprazolam(1)                         Xanax/registered trademark/          Tranquilizer           3              January 1997

2.   Pentazocine and Naloxone              Talwin NX/registered trademark/      Narcotic               1              January 1997
      Hydrochloride                                                              analgesic

3.   Propoxyphene Hydrochloride and        Wygesic/registered trademark/        Narcotic               1              December 1996
      Acetaminophen                                                              analgesic

4.   Carisoprodol(1)                       Soma/registered trademark/           Muscle relaxant        1              December 1996

5.   Hydrocodone Bitartrate/               Lorcet/registered trademark/         Narcotic               6              March 1996
      Acetaminophen                       Vicodin/registered trademark/          analgesic
                                           Lortab/registered trademark/
                                        Vicodin/registered trademark/ ES
                                       Lorcet/registered trademark/ Plus

                                       1
<PAGE>
                                                                                                   NUMBER OF
                                                BRAND NAME                      THERAPEUTIC         DOSAGE
PRODUCT NAME                                    EQUIVALENT                         CLASS           STRENGTHS          APPROVAL DATE

6.   Captopril(1)                          Capoten/registered trademark/        Anti-hypertensive      4              February 1996

7.   Hydroxychloroquine Sulfate(2)       Plaquenil/registered trademark/        Anti-rheumatoid        1              November 1995
                                                                                 Arthritis

8.   Piroxicam(1)                          Feldene/registered trademark/        Anti-inflammatory      2              September 1995

9.   Pindolol(1)                            Visken/registered trademark/        Anti-hypertensive      2              February 1995

10.  Acetaminophen and                 Tylenol/registered trademark/ with       Narcotic               3              December 1994
      Codeine Phosphate(3)                  Codeine                              analgesic

11.  Cyclobenzaprine Hydrochloride(1)     Flexeril/registered trademark/        Muscle relaxant        1              November 1994

12.  Hydroxyzine Hydrochloride            Atarax/registered trademark/          Tranquilizer           3              March 1994

13.  Baclofen                             Lioresal/registered trademark/        Muscle relaxant        2              January 1994

14.  Lorazepam                            Ativan/registered trademark/          Tranquilizer           3              October 1991

15.  Perphenazine and Amitriptyline       Triavil/registered trademark/         Anti-depressant        4              October 1991
      Hydrochloride

16.  Amiloride Hydrochloride and          Moduretic/registered trademark/       Anti-hypertensive      1              July 1991
      Hydrochlorothiazide

17.  Doxepin Hydrochloride                Sinequan/registered trademark/        Tranquilizer           3              March 1991

18.  Chlorzoxazone                     Parafon Forte/registered trademark/      Muscle relaxant        1              August 1989

19.  Yohimbine Hydrochloride              Yocon/registered trademark/           Sympathicolytic        1              Not  required
                                                                                 and mydriatic

20.  Quinine Sulfate Capsules(4)                    None                        Anti-malarial          1              Not  required

21.  Quinine Sulfate Tablets(4)                     None                        Anti-malarial          1              Not  required
<FN>
------------------
(1)   Each of these products is subject to a license agreement between the
      Company and Royce Research and Development Limited Partnership (the
      "Partnership"). See "Strategic Relationships."

(2)   This product is subject to a license agreement between the Company and the
      formulator of the drug. See "Strategic Relationships."

(3)   The Company is not marketing this drug at this time, but rather is
      currently evaluating the profit potential for this drug prior to
      manufacturing and marketing it.

(4)   In April 1995, the FDA published a proposed rule stating that Quinine
      Sulfate will become a prescription drug and urging manufacturers to comply
      with the prescription labeling requirements. In July 1995, the Company
      converted labeling for this product to bring it into compliance with the
      proposed FDA rule.
</FN>
</TABLE>

      During 1996, three of the Company's products each individually accounted
for more than 10% of the Company's gross sales (the largest of these products
accounted for approximately 23% of the Company's gross sales) and together,
collectively accounted for approximately 59% of the Company's gross sales.
During 1995, four of the Company's products each individually accounted for more
than 10% of the Company's gross sales (the largest of these products accounted
for approximately 18% of the Company's gross sales) and together collectively
accounted for approximately 58% of the Company's gross sales. During 1994, four
of the Company's products each individually accounted for more than 10% of the
Company's gross sales (the largest of these products accounted for approximately
22% of the Company's gross sales) and together collectively accounted for
approximately 69% of the Company's gross sales.

      The Company believes that as new products are developed and approved,
sales of the Company's largest products relative to total sales and the
Company's dependence thereon may vary from period to period.

         The Company currently has ANDA submissions pending with the FDA for 9
additional products in 15 dosage strengths. Of the products currently pending,
four are narcotic analgesics, one is a tranquilizer, one is

                                       2

<PAGE>

an anti-convulsant,  one is an anti-hypertensive and two are  anti-inflammatory.
Six of  these  products  have  controlled  substances  as one  of  their  active
ingredients.  Patent  protection for all of the products as to which the Company
has an ANDA pending has expired.

         Products with a controlled substance as one of their active ingredients
are subject to extensive regulation and to a quota system which requires
approval of the Drug Enforcement Administration before controlled substance raw
materials can be purchased. Although there can be no assurance, the Company
believes that it will receive a sufficient quota of the controlled substance raw
materials required to manufacture and market its controlled substance products.
See "Government Regulation" and "Raw Materials" below.

PRODUCT DEVELOPMENT STRATEGY

         The Company has been pursuing a strategy of developing a variety of
generic products, focusing primarily on selected niche or overlooked
opportunities, as well as on drugs whose brand-name equivalents have U.S. sales
of over $100 million. Products are chosen for development primarily based on the
patent or marketing exclusivity expiration date, market size and potential,
anticipated competition, availability of active ingredients and manufacturing
requirements.

         The Company has identified a number of products that it believes offer
growth opportunities, such as drugs having a controlled substance as one of
their active ingredients which are used in pain management, certain smaller
products for which patent protection has expired and which are not being
marketed by other generic drug manufacturers and selected drugs with
difficult-to-develop formulations. The Company believes that products such as
these will offer a significant opportunity and generally face less competition
in the marketplace.

         The Company also focuses on developing generic versions of high-volume
drugs whose patent or marketing exclusivity is nearing expiration. The Company
will seek to be among the first to offer such products. While such high-volume
drugs generally face significant competition, even a small market share of a
drug generating in excess of $100 million in revenue would be significant and
would enable the Company to broaden the range of valuable products which it
offers to its customers. Recent changes in U.S. patent terms connected with the
General Agreement on Tariffs and Trade (GATT) have resulted in extensions to the
patent terms for several products which the Company is considering for future
development.

         The Company believes that the time required for the development and
approval of the products which it plans to market should take approximately two
to three years from the time the Company identifies a drug for which it will
seek an ANDA through the date that FDA approval is obtained. This time period
has, in the past, been longer and may be longer in the future. The Company is
presently engaged in research and development with respect to more than 15
generic prescription products. There can be no assurances as to whether products
can be developed or whether ANDAs filed will be approved. See "Government
Regulation" below for a description of the approval process for ANDAs.

SALES AND MARKETING

         The Company markets its products to drug wholesalers, generic drug
distributors, retail buying groups, drug chains, other drug manufacturers,
health care institutions and governmental agencies. The Company markets its
products primarily through direct contact by the Company's regional sales
managers, telemarketing efforts, responding to requests for proposals and bids,
and through independent sales representatives. The Company advertises in trade
journals and uses direct mailing to independent drug stores, among other
promotional activities targeted to the pharmaceutical industry.

         The Company sells its products either under its own label
(approximately 60% of net sales for 1996) or under a customer's private label
(approximately 40% of net sales for 1996). The Company intends to continue
manufacturing products under a customer's private label and believes that its
willingness to offer private label products provides an additional opportunity
for growth, since many of the larger generic drug manufacturers do not
manufacture private label products.

         The Company has over 325 customers, which include various divisions of
large individual wholesalers. Customer service is an integral part of the
Company's focus. Maintaining adequate inventories, making timely 

                                       3
<PAGE>

delivery of its products and providing support services are emphasized by the
Company in order to serve its customers better.

         During 1996, Zenith-Goldline accounted for 21% of the Company's net
sales. During 1995, two of the Company's customers, Qualitest and
Zenith-Goldline, accounted for 13% and 12%, respectively, of the Company's net
sales. During 1994, sales to two of the Company's customers accounted for 14%
and 10%, respectively, of the Company's net sales. No other customer accounted
for more than 10% of net sales in either 1996, 1995 or 1994. The Company's top
ten customers for these years accounted for approximately 58%, 62% and 60%,
respectively, of net sales. The loss of any of these customers may have an
adverse effect on the Company's operations.

STRATEGIC RELATIONSHIPS

         The Company believes that strategic marketing relationships with
customers and drug companies in the U.S. and other countries could contribute to
increased sales and gross profit. The Company has entered into several
agreements with this objective in mind.

         The Company has a license agreement with Wille Laboratories, PTY. Ltd.
("Wille"), a pharmaceutical manufacturer located in Queensland, Australia. The
license permits Wille to develop, manufacture and market the licensed products
in the Pacific Rim markets, including Australia, New Zealand, Japan, Taiwan and
Hong Kong (the "Territory"). The only product licensed to Wille at this time is
Captopril. Under the agreement, the Company will receive a minimal initial fee
and additional minimal fees while Wille is pursuing regulatory approvals to
manufacture and market the licensed products in the Territory. Thereafter, if
Wille is able to obtain such requisite approvals, the Company will receive a
royalty from Wille with respect to any sales of the licensed products by Wille
in the Territory. There can be no assurance that any regulatory applications
filed by Wille with the appropriate governmental authorities in the Territory
will be approved. Although the Company and Wille have agreed that Captopril will
be licensed under the agreement, there can be no assurance that any other
products will be licensed under such agreement. The Company is not obligated
under such agreement to license any products to Wille other than Captopril, and
Wille is not obligated to accept a license for any additional product from the
Company.

         The Company has an agreement with a customer whereby the customer
agreed to engage the Company as its sole supplier of the Company's present and
future products for a five year period, subject to certain exceptions. In
return, the Company granted the customer stock options to purchase up to 50,000
shares of common stock at $6.00 per share, the market price on the date of
grant. Such options vest at the rate of 9,000 per year, with 5,000 options
vesting upon entering into this agreement. In connection with this agreement,
the Company recorded a charge to earnings of approximately $66,000 in 1995 and
$39,000 in 1996.

         The Company has a license agreement with Pharmascience, Inc.
("Pharmascience"), a Canadian pharmaceutical company. Pursuant to the agreement,
Pharmascience licensed the right to manufacture or purchase from the Company at
normal selling prices and distribute eight of the Company's products under the
Pharmascience private label (including one product as to which the Company does
not presently have an approved ANDA). In connection with the agreement,
Pharmascience is obligated to seek regulatory approval of these products for
sale in Canada. Canada has a generic drug approval procedure similar to that of
the United States. The Company will receive a royalty of 5% on Pharmascience's
net sales of the licensed products in Canada for a period of five years starting
from the date of the first commercial sale of each licensed product by
Pharmascience, if and when the products are approved for sale in Canada.

         The Company has an agreement with Duramed Pharmaceuticals, Inc.
("Duramed"), whereby Duramed markets and distributes nine of the Company's
current products (excluding Hydroxychloroquine Sulfate, Captopril and
Hydrocodone Bitartrate) on an exclusive basis to a select group of warehousing
drug chains and to other classes of trade, on a non-exclusive basis, under the
Duramed label. The agreement is for an initial three-year term expiring
September 12, 1998, and is renewable annually thereafter.

         With respect to one of its products, the Company has a perpetual
license agreement with the formulator of the drug whereby the Company has agreed
to pay the formulator a sliding royalty with a maximum of 10%

                                       4
<PAGE>

of net sales of this product for a ten-year period. In 1994, the Company paid
the formulator certain fees (approximately $70,000) when the Company received an
acceptable bioequivalency study for this drug and charged such fees to expense.
In 1995, the Company issued 10,695 shares of unregistered common stock upon the
filing of an ANDA for this drug and accordingly charged $24,000 to expense.
Additionally, the Company expensed royalties of $38,000 for this product in 1995
and $210,000 in 1996.

         Royce Research and Development Limited Partnership I (the
"Partnership") developed five products (the "Licensed Drugs") pursuant to the
terms of a license agreement (the "License Agreement") between the Company and
the Partnership. The Partnership was funded with approximately $1.0 million.
Royce Research Group, Inc., a wholly owned subsidiary of the Company, is the
general partner of the Partnership, for which it earns an administrative fee
based on sales of the Licensed Drugs, and, owns a one percent interest in the
Partnership. Unaffiliated investors own the limited partnership interests.

         Under the terms of the License Agreement, the Company granted to the
Partnership an exclusive irrevocable license to the Licensed Drugs, and received
from the Partnership licensing fees for the Licensed Drugs, third party
out-of-pocket expenses for raw materials and bioequivalency studies relating to
the Licensed Drugs, and $50,000 for a one percent royalty interest in the gross
revenues derived from the commercial sale of Piroxicam for a three-year period
from the time it is first commercially sold. In return for funding the
development of the Licensed Drugs, the Partnership receives a royalty of 10% of
the net revenues generated by sales of the Licensed Drugs over a five-year term
commencing with the first commercial sales of these drugs. After the expiration
of such five year term, all rights to the Licensed Drugs revert back to the
Company. All of the Partnership funds were expended developing the five Licensed
Drugs. As of February 27, 1997, the Company had received approvals for all of
the Licensed Drugs and Piroxicam. During 1996 and 1995, the Company incurred
royalty expenses of $225,000 and $69,000, respectively, related to the sales of
the Licensed Drugs and Piroxicam.

COMPETITION

         The Company competes with generic drug manufacturers, brand name
pharmaceutical companies that manufacture or market generic drugs, the original
manufacturers of brand name drugs that continue to produce such drugs after
their respective patents expire or introduce generic versions of their branded
products, and manufacturers of new drugs that may compete with the Company's
generic drugs. Many competitors have a greater number of products on the market
and have greater financial and other resources than the Company, allowing them
to devote greater resources to research and development and marketing.

         The generic drug industry is highly competitive. Most generic drugs
enjoy relatively short periods of limited competition. The introduction of a new
generic drug typically is followed by the introduction of other competitive
generic products into the marketplace, which results in significant declines in
prices and profit margins. Generic drug manufacturers must frequently introduce
new products in order to retain their profitability and sales volume. Approvals
for new products may have a synergistic effect on a company's entire product
line, since orders for new products are frequently accompanied by, or bring
about, orders for other products available from such company. The Company
believes that price is a significant competitive factor, particularly as the
number of generic manufacturers which produce a particular product increases.
The Company's current product line consists mainly of mature generic
pharmaceutical products. The Company faces competition with respect to these
products. The Company's product development strategy is, in part, to attempt to
market products subject to lower levels of competition.

         The principal competitive factors in the generic pharmaceutical market
are the ability to be one of the first to introduce a product after a patent
expires, product price, product quality, methods of distribution, reputation,
customer service and breadth of product line. The Company believes that its
commitment to service and quality and its willingness to produce private label
products for its customers will enhance its ability to compete with other drug
manufacturers.

         The Company's brand-name competitors may, in the future, attempt to
prevent or discourage the use of generic equivalents through litigation and
negative public relations campaigns. Some brand-name competitors also have
introduced generic versions of their own branded products prior to the
expiration of the patents for 

                                       5
<PAGE>

such drugs, which may result in a retention of a larger portion of the market
share available to generic products by these companies following expiration of
the applicable patents.

GOVERNMENT REGULATION

GENERAL

         The research and development, manufacture and marketing of the
Company's products are subject to regulation by the FDA and the Drug Enforcement
Administration ("DEA") in the United States and by comparable authorities in
other countries. These national authorities and other federal, state and local
entities regulate, among other things, research and development activities and
the testing, manufacture, labeling, storage, record keeping, advertising and
promotion of the Company's products.

         Almost every state and the District of Columbia has drug product
selection legislation that repeals, in part or in whole, previous laws
prohibiting the substitution of generic drugs in prescriptions for their
brand-name counterparts. Drug product selection legislation generally permits or
encourages pharmacists to substitute equivalent generic prescription drug
products for brand-name pharmaceutical products prescribed by physicians,
usually where such substitution has been either authorized or not prohibited by
the prescribing physician.

         The Federal Food, Drug, and Cosmetic ("FDC") Act, the Controlled
Substances Act ("CSA"), and other federal statutes and regulations govern or
influence all aspects of the Company's business. Noncompliance with applicable
requirements can result in fines and other judicially imposed sanctions,
including product seizures, injunction actions and criminal prosecutions. In
addition, administrative remedies can involve the recall of products, as well as
the refusal by the FDA to approve pending applications or supplements to
approved applications. The FDA also has the authority to withdraw approval of
drugs in accordance with statutory due process procedures and has significant
additional authority under the Generic Drug Enforcement Act of 1992.

FOOD AND DRUG ADMINISTRATION

         Except in limited circumstances, FDA approval is required before any
dosage form of any new drug, including generic equivalents of a previously
approved drug, can be marketed. A drug that is not generally recognized by
qualified experts as safe and effective for its intended use, or that is a
generic equivalent of a previously approved prescription drug, is deemed to be a
"new" drug requiring FDA approval. There are two primary types of applications
currently needed to obtain FDA approval of a new drug, a full new drug
application ("NDA") and an ANDA.

         The full NDA typically applies to any drug with active ingredients not
previously approved by the FDA. For the NDA, a prospective manufacturer must
conduct and submit to the FDA complete pre-clinical and clinical studies to
prove that drug's safety and efficacy. The FDA usually requires two adequate and
well-controlled clinical studies to support approval, as well as pre-clinical
animal toxicology studies for supporting safety. An NDA may also be submitted
for a drug with a previously approved active ingredient if the abbreviated
procedure discussed below is not available. If a company obtains approval of a
full NDA for a drug with an active ingredient that has not been previously
approved by the FDA, the company is generally entitled to five years of
marketing exclusivity during which period ANDAs may not be filed for FDA
approval. None of the Company's products currently in development is believed to
require a full NDA.

         An ANDA is similar to an NDA except that the FDA waives the requirement
to conduct complete pre-clinical and clinical studies to prove safety and
efficacy. Instead, for drugs that contain the same active ingredient and are
intended for the same use as drugs already approved for use in the United
States, the FDA ordinarily requires only bioavailability data demonstrating that
the generic drug formulation is, within an acceptable range, bioequivalent to a
previously approved drug. "Bioequivalence" compares the bioavailability of one
oral dosage form of a drug product with another and, when established, indicates
that the rate of absorption and the levels of concentration of the generic drug
in the body are substantially equivalent to those of the previously approved
equivalent drug. "Bioavailability" indicates the rate of absorption and levels
of

                                       6
<PAGE>

concentration of a drug in the bloodstream needed to produce a therapeutic
effect. The FDA review period can last between 12 and 30 months and the outcome
is not certain. The Company's products have been and in the future will likely
be developed pursuant to the ANDA procedure.

         All applications for FDA approval of drug products must contain
information relating to product formulation, stability, manufacturing process,
packaging, labeling and quality control. The manufacturer must establish that
the methods, facilities, and controls used in connection with the production,
processing, packaging, and storage of the drug meet FDA requirements embodied in
FDA regulations and guidelines, generally referred to as the current good
manufacturing practice ("cGMP") requirements. Compliance with cGMP is required
at all times during the manufacturing and processing of drugs. Such compliance
requires considerable Company time and resources in the area of production and
quality control studies performed to establish that the drug will be safe and
effective for its intended uses. The Company believes that it is in substantial
compliance with cGMP requirements.

         The FDA may not approve an ANDA if applicable regulatory criteria,
including compliance with cGMP requirements, are not satisfied. The FDA may
require additional testing, or manufacturing or quality control changes. Even if
such data are submitted and such changes are made, the FDA may ultimately decide
that the ANDA does not satisfy the criteria for approval. Following approval of
an ANDA, the FDA expects the applicant to conduct extensive in-process and
finished products testing on consecutive batches made in the initial
manufacturing campaign to validate the reliability of all critical processes
during full-scale commercial production. This is commonly referred to in the
industry as the post-approval or pre-shipment validation process. Only after all
processes have been shown through test data to produce consistent results within
quality specifications will the FDA permit commercial distribution. Accordingly,
following the approval of an ANDA, several weeks or months may be required to
complete testing and the FDA pre-shipment validation process. Product approvals
may be withdrawn by the FDA if compliance with regulatory standards is not
maintained or if new evidence demonstrating that the drug is unsafe or lacks
efficacy for its intended uses becomes known after the product reaches the
market.

         In 1988, the House Subcommittee on Oversight and Investigations
launched an investigation into possible wrongdoing by FDA officials and several
generic drug manufacturers pertaining to the ANDA approval process.
Concurrently, the U.S. Department of Justice initiated a similar investigation.
Both investigations revealed instances of criminal activity by certain FDA
employees and by the drug manufacturers and their employees. Five FDA employees
pleaded guilty to fraud and the FDA was accused of being lax in its regulation
of the generic drug industry. Several generic pharmaceutical manufacturers were
charged with giving illegal gratuities to certain FDA officials, substituting
branded products for their own in studies required by the FDA, or engaging in
other fraudulent or unapproved product development practices. As a result of
these investigations, over 200 generic products were recalled, an extensive
investigation of the generic pharmaceutical business was initiated by the FDA,
and there was a dramatic slowing of the ANDA approval process.

         The Generic Drug Enforcement Act of 1992 establishes penalties for
wrongdoing in connection with the development or submission of an ANDA by
authorizing the FDA to permanently or temporarily debar companies or individuals
from submitting or assisting in the submission of an ANDA, and to temporarily
deny approvals and suspend applications to market generic drugs. The FDA must
debar companies or individuals convicted of a federal felony for conduct
relating to the development or approval of an ANDA, and may debar persons
convicted of other misconduct. In addition to debarment, the FDA may refuse to
approve an ANDA if the applicant is under active federal criminal investigation
for (i) bribery or (ii) making material false statements in connection with any
ANDA, or if a significant question has been raised regarding the integrity of
the approval process or the reliability of the data in the ANDA. The FDA also
has authority to withdraw approval of an ANDA under certain circumstances and to
seek civil penalties. The FDA can also significantly delay the approval of any
ANDAs under the Application Integrity Policy. See "Validity Assessment Program"
below.

         All new drugs require FDA premarket approval. However, certain products
may be exempt from such approval if they were marketed in the United States
prior to 1938 and were subject to the Food and Drugs Act of 1906 and whose
labeling has not changed since 1938. On this basis, the Company and certain
other firms currently market Yohimbine Hydrochloride and Quinine Sulfate without
NDA or ANDA approval. However, 

                                       7
<PAGE>

there is no assurance that the FDA will continue to agree with this basis for
marketing and will not require the products to be removed from the market until
such an application is approved.

         Quinine Sulfate is currently the subject of FDA review. In May 1993,
the FDA published a final order removing Quinine Sulfate from the market as an
internal analgesic. In August 1994, the FDA published a final order removing
Quinine Sulfate from the market for treating nocturnal leg muscle cramps.
Quinine Sulfate is still currently available for treating the chills and fever
of malaria. In April 1995, the FDA published a Notice of Proposed Rulemaking to
make Quinine Sulfate available only as a prescription drug. This notice
encouraged voluntary compliance on the part of Quinine Sulfate manufacturers and
the Company is in compliance with this and all other FDA requirements concerning
Quinine Sulfate. It is the Company's understanding that the FDA is working on
proper labeling for Quinine Sulfate and that the FDA will not take any action
which results in the removal of Quinine Sulfate from the marketplace. However,
no assurance can be given in this regard.

         Sales of products are also subject to regulatory requirements governing
human clinical trials, and regulations regarding workplace safety, environmental
protection and hazardous substance controls, among others. The Company believes
that it is in substantial compliance with all such laws which are applicable to
its business.

DRUG ENFORCEMENT ADMINISTRATION

         Certain products are regulated under the CSA, which requires controlled
substance distributors and controlled substance manufacturers to be registered
with the DEA. The DEA has extensive enforcement powers over controlled substance
manufacturers and distributors, including the power to seize products, enjoin
the manufacture or distribution of these products, or criminally prosecute
and/or impose fines against firms and individuals that violate the CSA or DEA
regulations.

         The Company is currently subject to the CSA and DEA regulations for
marketing and distribution of certain of its pending and approved products. The
Company believes that it has complied with all requirements imposed on the
controlled substance products sold or proposed for sale or testing by the
Company relating to the premarket development, research, production, sale and
marketing thereof, pursuant to the federal CSA and applicable state controlled
substances laws. Furthermore, the Company believes that it has complied with all
requirements imposed on implementing regulations promulgated by the DEA
thereunder, and any policies issued by the DEA concerning the development,
production, distribution, sale and marketing of such controlled substances,
including any conditions for approval or acknowledgments, such as issuance of
all registration and licensing applications, and/or any other requirements, such
as physical security, record keeping, reporting and filing requirements, that
are specific to such controlled substances.

VALIDITY ASSESSMENT PROGRAM

         The Application Integrity Policy ("AIP") was established by the Office
of Generic Drugs of the FDA "to investigate wrongful acts by some firms
submitting ANDAs, such as committing fraud, making untrue statements of material
facts, committing bribery, or paying illegal gratuities." Under this policy, if
the agency suspects fraud in any new drug application, it may defer substantive
review of the application until the applicant has taken the appropriate
corrective actions to establish the scientific data's reliability. A company
suspected of fraudulent activity in the submission of an application may be
placed in the Validity Assessment Program.

         The Validity Assessment Program was established by the FDA as part of
its Application Integrity Policy (originally called the Fraud, Untrue Statements
of Material Facts, Bribery and Illegal Gratuities Policy). The Validity
Assessment Program is intended to establish means by which a drug company or
other regulated firm, suspected by the FDA of seeking to subvert the FDA's
review and approval of premarket applications, may seek to restore the FDA's
confidence in the integrity of its applications.

         In order to be removed from the Validity Assessment Program, a company
must have an audit performed by an outside consultant to identify all the
wrongful acts associated with the application submitted to the FDA, and provide
all the reports to the FDA; develop procedures and controls to prevent the
violations from recurring; provide the FDA with a written corrective action plan
to ensure the validity and integrity of

                                       8
<PAGE>

product application data; and remove from authority anyone responsible for any
fraudulent conduct that may have been discovered. If the FDA determines that a
company has satisfied the requirements of the Validity Assessment Program, it
will remove the company from such program and continue its substantive review of
the new drug applications pending before the FDA.

         In February 1992, in connection with an inspection of the Company's
manufacturing facility, the FDA raised questions about the data underlying the
Company's ANDAs for Minoxidil, one of the Company's previously approved
products. After investigating the FDA's concerns with respect to this product,
the Company withdrew this product. The Company also investigated, and in May
1992 withdrew, its ANDAs for a second product, Haloperidol, after similar
questions were raised regarding the data underlying these ANDAs. These products
were developed and these ANDAs were approved in 1986 and 1987, prior to
employment by the Company of the Company's current management and product
development personnel. In the Company's and the FDA's investigations of these
applications, which investigations took place between February 1992 and April
1992, it was determined that there were a number of apparent discrepancies in
the underlying data that support these applications and that there was
insufficient documentation to justify certain of the instances where data was
not included in these applications. Based on these findings, the Company
voluntarily withdrew its ANDAs relating to these two products and initiated a
product recall for these products.

         In early April 1992, the FDA conducted a further examination of the
Company's ANDA for Piroxicam (the Company had received a tentative approval of
its ANDA for Piroxicam in September 1991). On April 21, 1992, the Company was
advised by the FDA that its ANDA for Piroxicam was deficient and, therefore, not
approvable as submitted. The FDA enumerated a number of discrepancies and
inconsistencies contained in the ANDA, which had originally been filed in 1989,
and advised the Company that unless these issues were resolved to their
satisfaction, the Company might have to provide data on new test batches
manufactured in accordance with cGMP, including the results of new
bioequivalency studies, as appropriate, to support approval of the product.

         The Company was placed in the Validity Assessment Program in July 1992.
During the period in which the Company was in the Validity Assessment Program,
the FDA did not review any of the Company's pending ANDAs or accept ANDAs for
new products. Further, during this period, the Company's ANDAs for all of its
pending and approved products were audited by Company personnel under the
supervision of an independent consultant approved by the FDA. The FDA also
conducted an intensive inspection of the Company's facility and all of the
documentation supporting the Company's pending and approved ANDAs. Additionally,
the Company was required to develop procedures and controls to prevent
violations from recurring and provide the FDA with a corrective action plan to
assure the validity and integrity of the Company's product application data. The
Company was released from the Validity Assessment Program on December 16, 1993.
In connection with its release from the Validity Assessment Program, the Company
withdrew its then pending ANDA for Piroxicam. The Company filed a new ANDA for
this product in March 1994, which ANDA was approved in September 1995. Since its
release from the Validity Assessment Program, the Company has received ANDA
approvals for thirteen products.

HEALTH CARE POLICY AND REIMBURSEMENT

         The methods of reimbursement and fixing of reimbursement levels under
Medicare, Medicaid and other reimbursement programs are under active review by
federal, state and local government entities as well as by private third-party
reimbursers and political pressure to contain health care costs at the federal
and state levels is increasing. In addition, Medicaid legislation requires that
all pharmaceutical manufacturers rebate to individual states a percentage of
their revenues arising from Medicaid-reimbursed drug sales. In 1996, the
required rebate for generic drug manufacturers was 11% of the Company's
Medicaid-reimbursed drug sales. The Company incurred $88,000 in Medicaid rebates
in 1996.

         Political, economic and regulatory influences are subjecting the health
care industry in the United States to fundamental change. During 1994, the
Clinton administration proposed comprehensive legislation, known as the Health
Security Act, to reform the health care system (which legislation did not pass).
The Health Security

                                       9
<PAGE>

Act mandated basic health care benefits for all Americans, sought to control
health care expenditures by placing caps on private health insurance premiums
and Medicare and Medicaid spending, and proposed the creation of large insurance
purchasing alliances. Although the proposed Health Security Act did not contain
any provisions which directly regulate generic drug manufacturers, members of
the Clinton administration and Congress have expressed interest in controlling
the prices that pharmaceutical companies charge for their products. The Health
Security Act did contain inducements for patients and providers to use generic
drugs, where available. Members of Congress have introduced other health care
reform proposals whose possible impact on generic drug manufacturers is
uncertain. None of these proposals has been adopted. In addition, several states
in which the Company distributes its products have passed or are considering
their own health care reform legislation. The Company anticipates that Congress
and state legislatures will continue to review and assess alternative health
care delivery systems and payment methodologies and that public debate on these
issues will continue. Because of the uncertainties regarding the ultimate
features of reform initiatives and their enactment and implementation, the
Company cannot predict which, if any, of such reform proposals will be adopted,
when they may be adopted or what impact they may have on the generic drug
industry in general or the Company in particular.

         The Company believes that managed care currently affects and will
continue in the future to affect the Company's business by creating increased
demand for generic drugs as part of the health care cost containment strategy of
managed care.

RAW MATERIALS

         The raw materials essential to the Company's business are purchased
primarily from U.S. distributors of bulk pharmaceutical chemicals manufactured
abroad. The ANDA process requires specification of raw material suppliers, and
only one source has been approved for the active ingredient used in all but
three of the Company's products. The Company has filed supplements with the FDA
to add a second source of supply for five of its products. There can be no
assurance as to if and when the Company's other supplements will be approved. In
the event that raw materials from a specified supplier were to become
unavailable, FDA approval of a new supplier, if available, would be required,
which could cause a delay of between six and twelve months in the manufacture of
the drugs involved and the consequent loss of revenues. The Company experienced
raw material shortages during 1995 and 1996. There can be no assurance that such
shortages will not recur in the future. Additionally, arrangements with foreign
suppliers are subject to certain additional risks, including the availability of
governmental clearances, import/export duties, political instability, currency
fluctuations and restrictions on the transfer of funds. Certain controlled
substances are also subject to a DEA quota system and may not be available in
sufficient quantities for the Company to realize its sales potential of such
products.

         The Company entered into a development agreement with a raw material
supplier to develop two products and to purchase its raw materials requirements
for these products from the supplier. The Company has received FDA approval for
one of the products and currently has an ANDA pending for the other product. So
long as the Company obtains approval of its pending ANDA within a specified time
period and thereafter satisfies certain purchase requirements, the supplier has
agreed that the Company shall be its exclusive customer for this raw material in
the United States, Canada and Mexico. There can be no assurance that the Company
will obtain approval of the ANDA filed for the remaining product.

PRODUCT LIABILITY

         Product liability claims constitute a risk to all pharmaceutical
manufacturers. The Company maintains what it believes to be adequate product
liability insurance, although there can be no assurance that the coverage limit
of such policy will be adequate or that the cost of such insurance will not
increase. The Company's insurance provides coverage on a claims-made basis and
is subject to annual renewal. The insurance may not be available in the future
on acceptable terms or at all.

                                       10
<PAGE>

PATENTS, TRADEMARKS, AND LICENSES

         Since the  Company's  current  business is  manufacturing  products for
which  patents have  expired,  it is not  anticipated  that any of the Company's
products in the near future will be patented.  However,  the Company may develop
new   products   and  obtain   patents  for  them  in  the   future.   The  name
Royce/registered  trademark/  and its design are  registered as a trademark with
the  Department  of State of  Florida  and with the U.S.  Patent  and  Trademark
Office.

EMPLOYEES

         The Company employed 145 persons as of March 14, 1997. No employees are
members of a collective bargaining unit under a union representation contract.
The Company believes that its relationships with its employees is good.

ITEM 2.  PROPERTIES.

         The Company's manufacturing plant is located in a 25,444 square foot
leased facility in Miami, Florida under a lease expiring July 31, 2000. On
January 1, 1997, the Company leased an additional 10,200 square feet of space
attached to the existing premises. The Company also has two five-year renewal
options. Annual rent excluding taxes, insurance and common area maintenance,
after taking possession of such additional space totals $151,000, subject to
annual cost of living increases. Under the lease, the Company has an option to
purchase the entire 35,200 square foot building, and an adjacent building of
approximately 42,000 square feet, throughout the term of the lease, including
renewal periods.

         In October 1994,  the Company  entered into a lease for a 40,000 square
foot facility. The lease is for a period of 10-1/2 years, commencing on November
1, 1994 and ending on April 30, 2005. The Company has two  additional  five year
options.  Included  in the lease are  options to  purchase  the leased  property
during  the first year and the sixth year of the lease term and a right of first
refusal to purchase any buildings  owned by the lessor to the east of the leased
property.  The lease can be  terminated  by the  Company  upon  180-day  written
termination  notice and  payment of a  termination  fee.  Annual rent under this
lease, excluding taxes, insurance and common area maintenance,  totals $195,000.
The Company commenced occupancy of this second facility in May 1995.  Currently,
it houses the Company's administrative, sales and finance departments, warehouse
operations and research and  development  laboratories.  During 1996 the Company
moved its research and development laboratory into the new facility.

         The Company owns significantly all of its manufacturing and laboratory
equipment. The Company has equipment for all stages of manufacturing tablets and
capsules, including machinery for blending and agitating raw materials,
compressing tablets, encapsulation, bottling and packaging, and labeling. The
Company currently contracts for tablet coating with outside vendors and intends
to perform tablet coating at its manufacturing facility in the near future. The
Company's laboratory also includes computerized testing and data analysis
equipment for quality control and is also equipped for in-house research and
development.

ITEM 3.  LEGAL PROCEEDINGS.

COMPANY LEGAL PROCEEDINGS

         In February 1993, the Securities and Exchange Commission (the "SEC")
initiated a formal investigation into possible violations of the federal
securities laws by the Company and certain of its officers and directors. The
SEC's examination focused on the Company's public disclosure during the period
between July 1991 and April 1992 regarding the status of the Company's
abbreviated new drug applications ("ANDAs") for Piroxicam and Minoxidil and on
sales of securities during this period by certain persons, including certain
Company executive officers and/or directors.

                                       11
<PAGE>

         On May 2, 1996, the Company and Patrick J. McEnany, the Company's
Chairman and Chief Executive Officer, entered into a settlement (the
"Settlement") with the SEC resolving the SEC's formal investigation with respect
to the Company and Mr. McEnany, without admitting or denying that a violation of
the securities laws had occurred. As part of the Settlement, the Company and Mr.
McEnany consented to the granting of a civil injunction requiring them to comply
with the federal securities laws in the future. Further, in connection with the
Settlement, Mr. McEnany paid a $25,000 administrative fine, which amount was
reimbursed to Mr. McEnany by the Company under the indemnification provisions of
the Company's Articles of Incorporation and By-Laws. The Company believes that
the Settlement brings to a close the SEC's investigation of the Company and Mr.
McEnany.

         In January 1994, the Company was served with a suit brought by one of
its shareholders who opted out of the Company's settlement of the class action
litigation settled during 1993. The suit, DINESH SHAH V. ROYCE LABORATORIES,
INC. AND CHATFIELD DEAN & CO., INC., 94 CIV 0061 (S.D. N.Y.) which was also
brought against one of the underwriters of the Company's January 1992 public
offering, alleged that the Company's January 9, 1992 prospectus was false and
misleading. In August 1996, the Company settled this matter for $25,000 in cash.

         On August 4, 1995, the Company was sued by Bristol-Myers Squibb
Company, Inc. and E.R. Squibb & Sons, Inc. (collectively, "Bristol-Myers") in
the Southern District of Florida with respect to Captopril (Case No.
95-1682-CIV-Davis). In July 1996, this suit was dismissed without any further
liability to the Company.

OTHER LEGAL PROCEEDINGS

         On September 6, 1996, the Company became aware of the filing of a
complaint for injunctive and other civil relief (the "Complaint") by the SEC
against three Company employees who allegedly traded securities of the Company
while in the possession of material non-public information. The Complaint also
names as defendants three other persons who allegedly traded securities of the
Company based upon material non-public information provided to them by one of
the Company employee defendants.

         The Complaint alleges that Abul Bhuiyan, Nilkanth Patel and Hasmukh
Patel violated Section 10(b) of the Securities Exchange Act of 1934 (the
"Exchange Act") by purchasing and, in the case of Messrs. Patel and Patel,
selling shares of the Company's common stock while in the possession of material
non-public information. The alleged improper purchases and sales occurred in
September 1991 and April 1992, respectively. The Complaint also alleges that all
of the defendants except Mr. Bhuiyan violated Section 17(a) of the Securities
Act of 1933, as amended (the "Securities Act"), by reason of their purchase and
sales.

         The suit seeks as to all defendants injunctive relief enjoining the
defendants from future violations of Section 10(b) and 10b-5 under the Exchange
Act and, as to all defendants except Mr. Bhuiyan, enjoining them from future
violations of Section 17(a) under the Securities Act. The suit also seeks
disgorgement from all of the defendants except Mr. Bhuiyan. Finally, the suit
seeks penalties under Section 21A(a) of the Securities Act from each defendant
of up to three times his profits gained and losses avoided as a result of the
violations alleged in the Complaint.

         After reviewing the allegations contained in the Complaint, the Company
took certain corrective actions. These actions were as follows: (i) the Company
removed Mr. Bhuiyan as an executive officer of the Company (although Mr. Bhuiyan
remains an employee of the Company in a product development function); (ii) the
Company terminated Nilkanth Patel as an employee of the Company; and (iii) the
Company reprimanded Hasmukh Patel, but retained him as an employee of the
Company (Mr. Patel is an analytical research and development manager for the
Company).

         On January 9, 1997, Mr. Bhuiyan entered into a settlement with the SEC
resolving the SEC's formal investigation with respect to his activities. As part
of the settlement, without admitting or denying that a violation of the
securities laws had occurred, Mr. Bhuiyan consented to the granting of a civil
injunction

                                       12
<PAGE>

requiring him to comply with the federal securities laws in the future. Further,
in connection with the settlement, Mr. Bhuiyan paid a civil penalty of $1,811.

         The Company does not believe that the outcome of this suit will have a
material adverse impact on the Company, its business, financial position or
results of operations.

ITEM 4.  MATTERS SUBMITTED TO A VOTE OF THE COMPANY'S SECURITIES HOLDERS

         No matters were submitted to a vote of the Company's securities holders
during the fourth quarter of 1996.

                                       13
<PAGE>


                                     PART II

ITEM 5.  MARKET INFORMATION

         The Company's common stock is traded on the Nasdaq SmallCap Market
under the symbol "RLAB." The following are the high and low bid prices per share
reported on the Nasdaq SmallCap Market for the quarterly periods shown.

              YEAR ENDED 1995                                HIGH        LOW
              ---------------                                ----        ---

              First Quarter                                 $8.813      $4.500
              Second Quarter                                 8.063       5.375
              Third Quarter                                  9.625       6.125
              Fourth Quarter                                10.625       7.188

              YEAR ENDED 1996
              ---------------

              First Quarter                                $12.000      $8.500
              Second Quarter                                10.375       4.875
              Third Quarter                                  5.500       3.875
              Fourth Quarter                                 7.063       3.625

              YEAR ENDED 1997
              ---------------

              First Quarter (through March 21, 1997)        $7.125      $6.750

         On March 21, 1997, the closing sales price of the common stock on the
Nasdaq SmallCap Market was $6.75 per share. At March 21, 1997, there were issued
and outstanding 13,565,045 shares of the common stock held, of record, by
approximately 9,100 holders of record (including nominees). The Company believes
that there are over 13,500 beneficial holders of its common stock. Additionally,
as of the same date, there were warrants and options outstanding to purchase an
additional 2,020,392 shares of common stock at prices ranging from $2.64 to
$25.41.

         The market prices for securities of companies engaged primarily in the
development, manufacture and marketing of pharmaceuticals has historically been
volatile. The market price of the Company's common stock has been volatile in
the past and may be volatile in the future. Various factors may influence the
market price of the common stock including fluctuations in the Company's
operating results, the announcement of technological innovations or new
commercial products by the Company or its competitors, governmental regulation,
regulatory approvals, publicity regarding the status of the Company's product
development efforts, political developments or proposed legislation in the
health care industry, and other investment considerations (many of which are
beyond the control of the Company).

DIVIDEND POLICY

         The Company has never paid cash dividends on its common stock and has
no present plans to do so in the foreseeable future. The Company's current
policy is to retain all earnings, if any, for use in the operation of its
business. The payment of future cash dividends, if any, will be at the
discretion of the Board of Directors and will depend upon earnings, financial
requirements of the Company and such other factors as the Board of Directors may
deem relevant.

         The Florida Business Corporations Act restricts the payment of cash or
other dividends and distributions to the extent of a corporation's net worth
(shareholder's equity, excluding liquidation preferences) and prohibits such
dividends and distributions when a corporation is unable to pay debts as they
become due in the usual course of business.

                                       14
<PAGE>


ITEM 6.  SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>

                                                            YEARS ENDED DECEMBER 31,
                                             ------------------------------------------------------
                                               1996      1995       1994       1993          1992
                                             -------   -------    -------    -------       --------
                                                     (In thousands, except per share data)
OPERATING DATA(1)
<S>                                          <C>       <C>        <C>        <C>           <C>     
Net sales ................................   $22,317   $10,391    $ 6,174    $ 3,512       $  2,412
Cost of goods sold .......................    15,060     7,299      4,538      3,017          2,345
                                             -------   -------    -------    -------       --------
Gross profit .............................     7,257     3,092      1,636        495             67
Expenses related to product recalls ......        --        --         --         --            570(2)
Research and development .................     1,715     2,212        960        305            283
Selling, general and admin-
  istrative expenses .....................     4,831     3,366      2,281      2,077          2,274
Write-off of inventory ...................        --        --         --        768(3)          --
                                             -------   -------    -------    -------       --------
Operating income (loss) ..................       711    (2,486)    (1,605)    (2,655)        (3,060)
Other income
  (expense), net .........................       136       150        128     (1,278)(4)        162
                                             -------   -------    -------    -------       --------
Income (loss) before income taxes ........       847    (2,336)    (1,477)    (3,933)        (2,898)
Provision for income taxes ...............        41        --         --         --             --
                                             -------   -------    -------    -------       --------
Net income (loss) ........................   $   806   $(2,336)   $(1,477)   $(3,933)      $ (2,898)
                                             =======   =======    =======    =======       ========
Earnings (loss) per common and
  common equivalent share ................   $   .06   $  (.19)   $  (.14)   $  (.41)      $   (.31)
                                             =======   =======    =======    =======       ========
Weighted average number of
  common and common equivalent
  shares outstanding .....................    13,900    12,352     10,554      9,493          9,321
</TABLE>

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                            --------------------------------------------------------
                                              1996       1995        1994        1993         1992
                                            --------   --------    --------    --------     --------
<S>                                         <C>        <C>         <C>         <C>          <C> 
BALANCE SHEET DATA(1)
Total assets ............................   $ 17,358   $ 12,093    $  8,111    $  4,065     $  6,657
Long term debt ..........................        958        181          33          --            4
Total liabilities .......................      3,996      3,420       1,756         600          726
Stockholders' equity ....................     13,362      8,673       6,355       3,465        5,931

<FN>
--------------
(1)   Certain amounts presented in prior years' financial data have been
      reclassified to conform to the current year's presentation.
(2)   In May 1992, the Company issued a recall of two products for which it
      voluntarily withdrew its ANDAs after investigating FDA questions about the
      data underlying the ANDAs. The expenses related to the product recalls
      consisted of inventory write-downs and credit memos issued to customers as
      a result of products returned to the Company.
(3)   Represents write-off of inventory and related matters.
(4)   Includes a charge against earnings of $1,336 in connection with the
      settlement of certain class action and other litigation.
</FN>
</TABLE>

                                       15
<PAGE>


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS.

THE FINANCIAL INFORMATION INCLUDED HEREIN SHOULD BE READ IN CONJUNCTION WITH THE
ROYCE CONSOLIDATED FINANCIAL STATEMENTS, INCLUDING THE NOTES THERETO. THE YEARS
ENDED DECEMBER 31, 1996, 1995 AND 1994 ARE REFERRED TO HEREIN AS "1996," "1995"
AND "1994." THIS ANNUAL REPORT ON FORM 10-K CONTAINS CERTAIN FORWARD LOOKING
STATEMENTS WHICH INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS
COULD DIFFER FROM THE RESULTS ANTICIPATED HEREIN AS A RESULT OF THE FACTORS SET
FORTH IN THIS REPORT.

GENERAL

            The Company has incurred substantial operating losses in the past
and had an accumulated deficit of approximately $17.0 million at December 31,
1996.

            The Company's future profitability, to a large extent, will depend
upon the Company's ability to successfully commercialize additional generic
pharmaceutical products. Products must be developed and tested, meet strict
regulatory standards, receive requisite regulatory approvals and be manufactured
on a cost-effective basis before successful commercialization can be achieved.
The development and commercialization process is time consuming and costly.
Delays in any part of the process or the inability of the Company to obtain
regulatory approvals for its products could materially adversely affect the
Company's future results of operations. The Company believes that it takes
between 12 and 30 months from the time an ANDA is filed to the time it is
approved, although such time period has been longer in the past and may be
longer in the future. The Company is dependent on the FDA approval process to
introduce new products to the market. There can be no assurance as to when the
Company will have new products to market, or that if products are approved, they
can be successfully commercialized.

            The Company's revenues, gross profit margins and net profitability
may vary significantly from quarter to quarter, as well as in comparison to the
corresponding quarter of the preceding year. Revenue variations may result from,
among other factors, the timing of FDA approvals, the timing of initial
shipments of newly approved drugs and the purchasing practices of the Company's
customers. Additionally, gross profit margins may vary due to, among other
factors, when new products are approved for manufacture and marketing,
competition relating to such products, as well as product mix. Net profits or
losses may also vary due to the foregoing, plus the timing and amounts of
research and development ("R & D") spending. The Company's R & D costs are
expensed as incurred, resulting in charges to earnings prior to the realization
of any revenues from a product.

PENDING MERGER

           On December 24, 1996, the Company and Watson signed a definitive
merger agreement for Watson to acquire the Company in a stock-for-stock merger
transaction to be accounted for as a "pooling-of-interests". Under the terms of
the definitive agreement, the Company will become a wholly-owned subsidiary of
Watson, and Patrick McEnany will become President of the wholly-owned
subsidiary, Royce Laboratories, Inc., as well as Vice President of Corporate
Development for Watson. The proposed transaction is subject to approval by the
Company's stockholders and other customary conditions to closing. The Company's
special meeting of stockholders is scheduled for April 16, 1997 and assuming a
majority of such stockholders vote for the Merger, the transaction will close
immediately thereafter. See Note 1 (II) to the accompanying consolidated
financial statements for a more detailed discussion on the Merger. For further
information about the Merger, see also the Company's proxy statement dated March
17, 1997, which has been sent to the Company's shareholders to solicit proxies
to be voted at the above-referenced special meeting of stockholders at which the
stockholders will vote on the proposed Merger with Watson.

                                       16
<PAGE>

RESULTS OF OPERATIONS

1996 COMPARED TO 1995

            Net sales for 1996 were $22.3 million, representing an increase of
$11.9 million or 115% over net sales of $10.4 million for 1995. Approximately
42% of the increase in net sales was attributable to sales of products which
were introduced by the Company during 1996 ("New Products"), while the remaining
58% of the increase in net sales was attributable to sales of products which
were introduced by the Company during 1995 ("Existing Products"). Most of the
increase in net sales of New Products was the result of the Hydrocodone line of
products. Most of the increase in net sales of Existing Products was
attributable to increased sales of Quinine Sulfate and a full year's inclusion
of sales of Hydroxychloroquine Sulfate. A material portion of Quinine Sulfate
sales for 1996 were to one customer. Three products each accounted for more than
10% of 1996 sales and together, accounted for approximately 59% of such sales.
Total units sold in 1996 increased 48% compared to units sold in 1995.

            Gross profit for 1996 was $7.3 million, or 33% of net sales,
compared to $3.1 million, or 30% of net sales for 1995. Gross profit, as well as
the gross profit margin, increased due to the introduction of New Products and
sales increases of Existing Products, both of which caused an improvement in the
operating leverage on the Company's fixed costs of manufacturing. During the
second half of 1996, the gross profit margin declined due to intensified price
competition and the lack of introduction of new products. The Company believes
that because of current industry dynamics, price competition will continue in
the foreseeable future, which will likely continue to depress prices and gross
margins further. However, the Company also believes that new products launched
in the future will likely have a positive impact on margins, the extent of which
will depend on the level of competition for such new products.

            R&D expenses decreased 22% to $1.7 million in 1996 versus $2.2
million in 1995 due to the Company developing fewer but more technically
demanding products in 1996 and to some delays in R&D activities caused by the
construction during 1996 of the Company's new R&D lab.

            Selling, General & Administrative ("SG&A") expenses increased 44% to
$4.8 million or 22% of net sales in 1996, versus $3.4 million or 32% of net
sales in 1995. Approximately 40% of the increase in SG&A expenses was
attributable to increases in certain variable expenses which increase in
relation to sales. Advertising expenses associated with the launch of new
products accounted for 17% of the increase in SG&A expenses. Payroll and
benefits accounted for 29% of the increase in SG&A expenses and, along with
increases in other SG&A expenses, were due mainly to the growth of the Company's
operations. Offsetting these increases was a decrease in legal fees of $176,000
associated with the Company's litigation over Captopril in 1995.

            The Company recorded $41,000 of income tax expense in 1996, which
was the Company's estimate of alternative minimum taxes incurred for the period,
after utilizing net operating loss carryforwards to offset 90% of taxable
income. As a result of the above factors, the Company's net income for 1996 was
$0.8 million, compared to a net loss of $2.3 million in 1995.

1995 COMPARED TO 1994

            Net sales for 1995 were $10.4 million, representing an increase of
$4.2 million or 68% over net sales of $6.2 million for 1994. Approximately 52%
of the increase in net sales was attributable to sales of products which were
introduced by the Company during 1995 ("1995 New Products"), while the remaining
48% of the increase in net sales was attributable to sales of products in the
Company's product line during 1994 ("1994 Existing Products"). Approximately 64%
of the increase in New Products was attributable to the December 1995 launch of
Hydroxychloroquine Sulfate. The majority of the increase in sales of 1994
Existing Products was attributable to a full year's inclusion of two products
introduced during 1994 and increased sales of Quinine Sulfate. Unit volumes for
1995 increased 51% compared to 1994.

            The gross profit for 1995 was $3.1 million, or 30% of net sales,
compared to $1.6 million, or 26% of net sales for 1994. Gross profit, as well as
the gross profit margin, increased due to the introduction of 1995 New Products
and sales increases of 1994 Existing Products, both of which caused an
improvement in the

                                       17
<PAGE>

operating leverage on the Company's fixed costs of manufacturing.

            The Company increased its R&D expenses to $2.2 million or 21% of net
sales in 1995 versus $1.0 million or 16% of net sales in 1994. In actual
dollars, R&D expense increased 130%. The increase in R&D spending, both in
dollars and percentage of sales, reflects the Company's commitment to increasing
its R&D expenditures as it believes such efforts are vital to the future growth
of the Company.

            SG&A expenses increased 48% to $3.4 million or 32% of net sales in
1995, versus $2.3 million or 37% of net sales in 1994. Approximately 17% of the
increase in SG&A expenses was attributable to legal fees associated with the
Company's litigation over Captopril (see Note 10(IV) of the Notes to
Consolidated Financial Statements for the year ended December 31, 1995). In
addition, the Company's reserve for bad debts was increased by $200,000 as a
result of a substantial increase in trade receivables from 1994 levels. The
remaining increase in SG&A expenses was attributable, in part, to increases in
certain variable expenses which increased in relation to sales. General and
administrative expenses were also impacted by increases in payroll and related
expenses due to pay increases and personnel additions.

            As a result of the above factors, the Company's operating loss for
1995 was $2.5 million, compared to $1.6 million for 1994. After accounting for
other income and interest expense, the net loss was $2.3 million for 1995
compared to a net loss of $1.5 million for 1994.


FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

            To date, the Company has historically financed itself through sales
of its equity securities. In early 1996, the Company received net proceeds of
$3.4 million from the exercise of 581,333 Private Warrants (See Note 8(II)(A) of
the Notes to Consolidated Financial Statements). In addition, during 1996, the
Company received $742,500 in net proceeds from the issuance of long-term debt
and entered into a $559,000 capital lease agreement (see Note 5 of the Notes to
Consolidated Financial Statements) to finance equipment purchases.

            Cash and cash equivalents increased $2.3 million from year end 1995.
This increase represents the $4.2 million received from the above-mentioned
financing activities less $0.1 million used in operating activities and $1.8
million used for property and equipment purchases.

            Inventories at year end 1996 increased by $1.1 million over year end
1995 due to the introduction of new products, increased sales volumes of Quinine
Sulfate, and management's decision to increase inventories to improve service
levels. The Company expects that its inventory level will increase in 1997 as it
introduces several new products.

            Capital expenditures for 1996 were $1.8 million. These purchases
consisted mainly of manufacturing equipment and plant improvements to meet
growing production needs and the construction of a new research and development
laboratory.

            As discussed in Note 1(II) of the Notes to the Consolidated
Financial Statements, the Company and Watson signed a definitive merger
agreement for Watson to acquire the Company in a stock-for-stock merger
transaction. Under such agreement, the Company would become a wholly-owned
subsidiary of Watson. The Company believes its capital needs would be satisfied
following the merger from Watson's capital resources. The Company has incurred
significant costs associated with this merger and the merger agreement is
terminable under certain circumstances. If, pursuant to the agreement, the
merger terminates for reasons other than to accept an alternative offer from
another acquirer, the Company will bear all of its expenses associated with this
merger, which are estimated to total $500,000. If the agreement is terminated
due to the Company accepting an alternative offer, the Company would be
obligated to pay Watson termination fees or Watson's merger expenses, however
the Company would seek to require the alternative acquirer of the Company to
assume such payments.

            If the merger is not completed, the following factors would apply to
the Company's liquidity and capital resources. The Company would continue to
require additional capital. The Company's recent profitability has positively
impacted cash flow, however profits have not yet reached the level where they
can fund all of the Company's capital requirements. Additionally, the Company
believes that continued growth in

                                       18
<PAGE>

sales would be necessary for the Company to generate sufficient cash flow from
operations to be able to internally fund its capital requirements over the next
12 months. The Company expects that once it has established a history of
earnings, revolving credit bank financing on cost effective terms should become
available. The Company may have to sell additional securities to help finance
its business plans and/or strategic alliances or acquisitions in the next year.
There can be no assurance that necessary capital will be available in the future
when and if it is required. If the Company is unable to maintain sufficient
capital, it will likely be forced to reduce the level of its research and
development efforts and to make other necessary changes to its present business
plans until such funding can be secured.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

         The information required by this item is contained in the financial
statements set forth in Item 14(a)(1).

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
          FINANCIAL STATEMENT DISCLOSURE.

         Not applicable.

                                       19

<PAGE>



                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

BOARD OF DIRECTORS

         The Articles of Incorporation and By-laws of the Company presently
provide for a Board of Directors divided into three classes, as nearly equal in
size as possible, with staggered terms of three years. At the date of this
Annual Report on Form 10-K, the members of the Board and the expiration of their
terms as Directors were as follows:
<TABLE>
<CAPTION>

                                                                                    TERM                DIRECTOR
NAME                            AGE          POSITIONS                              EXPIRES             SINCE
----                            ---          ---------                              -------             -----
<S>                             <C>          <C>                                    <C>                 <C>
Patrick J. McEnany(1)            49          Chairman of the Board,
                                             President and
                                             Chief Executive Officer                   1999              1990

Richard W. Gross, Esq(1)(2)      49          Director and Secretary-Treasurer          1997              1985

Gregory Reed, M.D.(3)            49          Director                                  1997              1989

Charles J. Simons(1)(2)(3)       78          Director                                  1998              1993

Rick A. Wilber(3)                49          Director                                  1998              1989

Hubert E. Huckel, M.D.(2)        66          Director                                  1997              1995

Ogden R. Reid(3)                 71          Director                                  1998              1995

Jacqueline Allee(2)              53          Director                                  1999              1996

J. William Grant(3)              53          Director                                  1999              1996
<FN>
-------------
(1)      Member of the Executive Committee.
(2)      Member of the Audit Committee.
(3)      Member of the Compensation Committee.
</FN>
</TABLE>

         Under the terms of the merger agreement with Watson Pharmaceuticals,
Inc., the terms of all of the Company's directors will cease immediately upon
the closing of the Merger. After the closing of the Merger, Mr. McEnany will
remain President of the Company, will become a Vice President of Watson and will
enter into an employment agreement with Watson (see Note 10(III) to the
accompanying consolidated financial statements).

BUSINESS EXPERIENCE

         PATRICK J. MCENANY has been the President of the Company since June
1991 and its Chairman since February 1994. Mr. McEnany was the President, Chief
Executive Officer and Chief Financial Officer of Zenex Synthetic Lubricants,
Inc. ("Zenex"), a company engaged in the distribution of synthetic lubricants
from 1973 until 1985. In February 1985, Zenex merged with Home Intensive Care,
Inc. ("HIC"), a provider of home infusion therapy services, and Mr. McEnany
continued to serve as a director and chairman of the audit committee of the
combined entity. In July 1993, HIC was acquired by W.R. Grace & Co. From
December 1984 through December 1991, Mr. McEnany also served as the President of
Equisource Capital, Inc. ("Equisource"), a consulting company in the areas of
corporate finance and investment banking. He currently serves as a director of
the National Association of Pharmaceutical Manufacturers.

                                       20
<PAGE>

         RICHARD W. GROSS, ESQ., has served as Secretary-Treasurer of the
Company since May 1990 and was the Chairman of the Board between March 1989 and
February 1994. Mr. Gross has been, since June 1990, a partner in the law firm of
Wetzel & Gross. Prior thereto, Mr. Gross was the Deputy City Attorney for the
City of Hialeah, Florida, from 1981 until May 1990, and the Director of
Community Development with the City of Hialeah, Florida, from 1974 to 1981.

         GREGORY REED, M.D., has been a licensed medical doctor with a private
practice in Miami Springs/Miami Lakes, Florida, specializing in internal
medicine, since 1977. He is a member of the American Society of Internal
Medicine and the American Heart Association. Dr. Reed's present hospital
affiliations are with Hialeah Hospital and Palmetto General Hospital.

         CHARLES J. SIMONS is a management and financial consultant. For over 40
years, Mr. Simons was employed by Eastern Airlines and served at various times
during such tenure as Eastern's Vice Chairman, Executive Vice President and a
director. In 1990, at the request of the Board of Directors of General
Development Corporation ("GDC"), a land development company, Mr. Simons became
the Chairman, President and Chief Executive Officer of GDC, at a time when that
corporation was in serious financial trouble and after serious allegations had
been raised about the conduct of its senior management. As CEO, Mr. Simons
guided GDC through a Chapter 11 bankruptcy proceeding, from which it has since
successfully emerged. Mr. Simons left GDC in 1992, immediately prior to its
emergence from bankruptcy. Mr. Simons is presently a director of Renex, Inc.,
Greenwich Air Services, Inc., Bessemer Trust Co. of Florida and Space Industries
International, Inc. Additionally, he is the Chairman of the Board of Directors
of G.W. Plastics, Inc., the Chairman of the Advisory Committee to the University
of Vermont School of Business, a trustee and Treasurer of Dartmouth Hitchcock
Medical Center, and a member of the Board and Treasurer of the Matthew Thornton
HMO. Mr. Simons was a director of HIC before its purchase by W.R. Grace & Co. in
July 1993.

         RICK A. WILBER presently operates a family owned business owning
several Hallmark(R) card stores. In 1974, Mr. Wilber was the co-founder of
Champs Sporting Goods, a retail sporting goods chain. In 1984, Champs, which
then had 62 stores, was sold. Since that time, Mr. Wilber has been a private
investor and a consultant to numerous start-up and second-stage companies
(including the Company, where he served as a consultant from June 1989 until
February 1990). In September 1992, Cash Kingdom Pawn Brokers #2, Inc., a company
in which Mr. Wilber had previously been an officer and director, filed a
petition under Chapter 11 of the United States Bankruptcy Code (which proceeding
has now been converted into a proceeding under Chapter 7 of the United States
Bankruptcy Code). Mr. Wilber resigned as an officer and director of that company
in March 1992, prior to that company filing its Chapter 11 petition.

         HUBERT E. HUCKEL, M.D., has been retired since December 1992. Prior
thereto, for over 29 years Dr. Huckel was employed by Hoechst Celanese
Corporation ("Hoechst"), a Fortune 100 company, and served during such period as
a member of the Executive Committee of the Board of Directors, and as President
of Hoechst's Life Sciences Group of companies. Dr. Huckel also served as a
member of the Board of Directors of the Pharmaceutical Manufacturers Association
from 1978 until 1992, and Celgene Corporation from 1989 until 1992. He currently
is a member of the Executive Committee of The Rockefeller University Council and
a member of the Medical Advisory Committee of the National Society to Prevent
Blindness.

         OGDEN R. REID has been retired for more than the last five years. Mr.
Reid has a distinguished record of service in both the private and government
sector. He was the Editor and Publisher of The New York Herald Tribune and of
its International Edition, the Chairman of the New York State Human Rights
Commission, the U.S. Ambassador to Israel, a six-term member of the United
States Congress and Environmental Commissioner of New York State. Mr. Reid
presently serves as a director of National Patent Development Corporation,
Interfeuron Sciences Corporation and General Physics Corporation and as Vice
Chairman of General Physics Services Technologies, Inc.

         JACQUELINE ALLEE is a private investor. From 1993 to 1995, Ms. Allee
was a professor of law at St. Thomas University School of Law. Prior thereto,
from 1987 until 1993, Ms. Allee was the Vice President, Dean and a Professor of
Law at St. Thomas University School of Law.

                                       21

<PAGE>

         J. WILLIAM GRANT has been the President of Grant & Associates, a
consulting firm, since January 1991. From January 1987 until December 1990, Mr.
Grant served as a United States Congressman. From 1973 until 1986, Mr. Grant was
the President of The Bank of Madison County, Florida. From 1982 until 1986, Mr.
Grant also served as a state senator in the Florida state legislature. Between
1991 and 1995, Mr. Grant served as a director of the Company.

EXECUTIVE OFFICERS

         The following list reflects the Company's executive officers, as of
this date, the capacity in which they serve the Company, and when they assumed
office:
<TABLE>
<CAPTION>


NAME                          AGE           EXECUTIVE POSITIONS                           OFFICER SINCE
----                          ---           -------------------                           -------------
<S>                            <C>          <C>                                           <C>
Patrick J. McEnany             49           President and Chief Executive
                                            and Operating Officer                             1991

John P. Bleau                  60           Vice President, Sales and Marketing               1996

Eugene Sokol                   55           Vice President, Business Development              1992

Loren Gelber, Ph.D.            50           Vice President, Regulatory Compliance             1992

Steven Miller, Ph.D.           35           Vice President, Research and Development          1992

Robert E. Band                 38           Vice President, Finance and                       1994
                                            Chief Financial Officer

Mohammad Rahman                44           Vice President, Plant Operations                  1992

Claude Bertrand                37           Controller                                        1995
</TABLE>

BUSINESS EXPERIENCE

         PATRICK J. MCENANY. See the biographical information contained in
"Board of Directors" above.

         JACK BLEAU joined the Company on April 1, 1996. Prior thereto, for more
than five years, Mr. Bleau was employed by Geneva Pharmaceuticals as Vice
President of Sales.

         EUGENE SOKOL is the Company's Vice President, Business Development. Mr.
Sokol has been employed by the Company since January 1992. During this period he
has served as the Company's Vice President of Sales and Marketing (January 1992
to February 1993), Executive Vice President (February 1993 to March 1996) and
Vice President, Business Development (March 1996 to the present). Prior thereto,
from 1980 to 1992, Mr. Sokol was employed by Barre-National, Inc., a division of
A.L. Laboratories, in various capacities, including as the Director of Field
Sales.

         LOREN GELBER joined the Company in July 1992 as Vice President,
Regulatory Compliance. Dr. Gelber was the Director of Regulatory Affairs and
Compliance for Danbury Pharmacal, Inc. from 1987 until joining the Company. From
August 1985 through September 1987, Dr. Gelber was the Director of Regulatory
Affairs for Barr Laboratories, Inc. Prior thereto, for 11 years, Dr. Gelber was
employed by the United States Food and Drug Administration ("FDA"). On March 10,
1993, Dr. Gelber filed for relief under Chapter 7 of the United States
Bankruptcy Code. Dr. Gelber was discharged from this proceeding in July 1993.

                                       22
<PAGE>


         STEVEN MILLER joined the Company in October 1992 as Director of
Research and Development. Dr. Miller became Vice President, Research and
Development in May 1993. From February 1988 until October 1992, Dr. Miller
headed a research team for Baxter Diagnostics, Inc., a Division of Baxter
International, where he served as a Group Leader and Senior Scientist.

         ROBERT E. BAND, C.P.A., joined the Company in November 1994 as Vice
President, Finance and Chief Financial Officer. Prior to joining the Company,
from July 1990 to November 1994, Mr. Band was Vice President, Finance, Secretary
and Controller of Catalina Lighting, Inc., an AMEX listed distributor and
manufacturer of lighting products. Immediately prior to joining Catalina
Lighting, Mr. Band served as a co-founder and president of Knockouts Publishing,
Inc., a greeting card publisher, from 1989 to 1990. Mr. Band's background prior
to 1989 included over eight years of large-firm public accounting experience.

         MOHAMMAD RAHMAN is the Company's Vice President, Plant Operations.
Prior thereto, he was employed by the Company as Director of Production
(November 1991 until February 1993) and Vice President, Production (February
1993 until May 1995, when he assumed his present position). Prior to joining the
Company, Mr. Rahman was employed, for more than five years, by Superpharm
Corporation, where he was employed in various capacities, including Director of
Production from 1990 until November 1991.

         CLAUDE BERTRAND has been the Company's controller since September 1995.
Prior to joining the Company, from January 1990 to September 1995, Mr. Bertrand
was employed by Ryder System, Inc., where he served in various capacities,
including Manager, Planning and Development. Mr. Bertrand's background prior to
1990 included over seven years of public accounting experience with Deloitte &
Touche.

FAMILY RELATIONSHIPS

         There are no family relationships between or among any of the directors
and executive officers.

COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

         Based solely upon a review of Forms 3 and 4 and amendments thereto
furnished to the Company pursuant to Rule 16a-3(d) under the Securities Exchange
Act of 1934, as amended (the "Exchange Act"), during the Company's fiscal year
ended December 31, 1996 and any Forms 5 and amendments thereto furnished to the
Company with respect to its most recent fiscal year, and any written
representations referred to in subparagraph (b)(2)(i) of Item 405 of Regulation
S-K, except as set forth below, no person who at any time during the fiscal year
ended December 31, 1996 was a Director, officer or, to the knowledge of the
Company, a beneficial owner of more than 10% of any class of equity securities
of the Company registered pursuant to Section 12 of the Exchange Act failed to
file on a timely basis, as disclosed in Forms 3, 4 and 5, reports required by
Section 16(a) of the Exchange Act during the fiscal year ended December 31,
1996. The following Company directors and executive officers were late in the
filing of Form 4s during fiscal 1996: Jacqueline Allee, J. William Grant,
Richard W. Gross; Hubert E. Huckel, Patrick J. McEnany; Gregory Reed; Ogden
Reid, Charles J. Simons; and Rick A. Wilber.

                                       23
<PAGE>

ITEM 11.  EXECUTIVE COMPENSATION

SUMMARY COMPENSATION TABLE

         The following table sets forth information about the compensation paid
or accrued during 1996, 1995 and 1994 to the Company's Chief Executive Officer
and to each of the other most highly compensated executive officers of the
Company whose aggregate direct compensation exceeded $100,000.


<TABLE>
<CAPTION>


                                              SUMMARY COMPENSATION TABLE

                                                                                            LONG-TERM
                                                ANNUAL COMPENSATION                        COMPENSATION
                            -------------------------------------------------------------------------------
                                                                        OTHER
                                                                        ANNUAL                                  ALL OTHER
                                          SALARY       BONUS        COMPENSATION (1)          OPTIONS          COMPENSATION
NAME                           YEAR         ($)         ($)               ($)                   (#)                ($)
----                           ----         ---         ---               ---                   ---                ---
<S>                            <C>          <C>          <C>             <C>                  <C>               <C> 
Patrick J. McEnany             1996         169,250      24,906          44,818                 5,832                   -
                               1995         164,237           -           9,050                 4,166                   -
                               1994         161,977           -           8,685               254,166                   -


John P. Bleau                  1996         109,616      28,125           6,000                80,000                   -
                               1995               -           -               -                     -                   -
                               1994               -           -               -                     -                   -

Loren Gelber                   1996         103,000           -           3,600                     -                   -
                               1995         100,000           -           3,600                     -                   -
                               1994          85,885           -           3,600                30,000                   -

Eugene Sokol                   1996         103,000           -           6,000                     -                   -
                               1995         100,000           -           6,000                     -                   -
                               1994          95,400           -           6,000                30,000                   -
<FN>
--------------
(1)  For Mr. McEnany, represents automobile allowance and life insurance
     benefits and, during 1996, reimbursement of an administrative fine under
     the indemnification provisions of the Company's Articles of Incorporation
     and By-Laws. For all other officers, represents automobile allowance.
</FN>
</TABLE>

                                       24
<PAGE>
OPTION GRANTS DURING LAST FISCAL YEAR

         The following table sets forth information concerning options granted
during the fiscal year ended December 31, 1996 to those persons named in the
preceding Summary Compensation Table.

<TABLE>
<CAPTION>
                                                                                                 POTENTIAL REALIZABLE
                                                                                                   VALUE AT ASSUMED
                                                                                                 ANNUAL RATES OF STOCK
                                                                                                  PRICE APPRECIATION
                                        INDIVIDUAL GRANTS                                          FOR OPTION TERM(1)
                      --------------------------------------------------                           ------------------

                          SHARES           % OF TOTAL
                        UNDERLYING           OPTIONS
                          OPTIONS          GRANTED TO          EXERCISE
                         GRANTED          EMPLOYEES IN           PRICE           EXPIRATION
NAME                        (#)            FISCAL YEAR         ($/SHARE)            DATE          5%($)        10%($)
---------------------------------------------------------------------------------------------------------------------
<S>                        <C>                 <C>                <C>              <C>           <C>         <C>   
Patrick J. McEnany         5,832                4.0               9.31             4/1/2001        5,001      34,146

John P. Bleau             80,000               55.4               8.75             3/31/2002     310,796     738,818
                                                                                     to
                                                                                   3/31/2005
<FN>
-------------
(1)  These amounts represent assumed rates of appreciation in the price of the
     Common Stock during the term of the options in accordance with rates
     specified in applicable federal securities regulations. Actual gains, if
     any, on stock option exercises will depend on the future price of the
     Common Stock and overall stock market conditions. There is no
     representation that the rates of appreciation reflected in the table will
     be achieved.
</FN>
</TABLE>

AGGREGATED OPTIONS EXERCISED DURING LAST FISCAL YEAR AND FISCAL YEAR END OPTION
VALUES

         The following table sets forth information concerning the exercise of
stock options during the 1996 fiscal year and the value of unexercised stock
options at the end of the 1996 fiscal year for the persons named in the Summary
Compensation Table.

<TABLE>
<CAPTION>


                                                                  NUMBER OF UNEXERCISED             VALUE OF UNEXERCISED
                                                                 OPTIONS AT FISCAL YEAR            IN-THE-MONEY OPTIONS AT
                      SHARES ACQUIRED       VALUE REALIZED                 END                       FISCAL YEAR END ($)
NAME                  ON EXERCISE (#)             ($)           EXERCISABLE/UNEXERCISABLE        EXERCISABLE/UNEXERCISABLE*
---------------------------------------------------------------------------------------------------------------------------
<S>                        <C>                  <C>                   <C>                                 <C>
Patrick J. McEnany         16,666               43,498                237,497/100,000                     327,829/21,875

John P. Bleau                --                   --                         0/80,000                              --/--

Loren Gelber               16,500               72,315                  26,500/10,000                      82,732/39,688

Eugene Sokol                 --                   --                    45,000/10,000                      69,375/34,688

<FN>
----------
* Computed based upon the difference between the closing sales price of the
common stock at December 31, 1996 and the exercise price. No value has been
assigned to options which are not in-the-money.
</FN>
</TABLE>

STOCK OPTIONS

         At March 21, 1997, the Company had options to purchase 937,067 shares
of Common Stock outstanding granted to current officers, directors and employees
of the Company. These options consist of 228,089 options granted under the
Company's 1992 Stock Option Plan (the "1992 Plan"), 190,979 options granted
under the Company's 1995 Stock Option Plan (the "1995 Plan"; collectively, the
1992 Plan and the 1995 Plan are hereinafter referred to as the "Plans") and
517,999 options granted outside the Plans ("Non-Qualified Stock Options").

                                       25
<PAGE>

         The exercise prices of the outstanding Non-Qualified Stock Options
range from $2.64 to $19.50 per share. The terms of each of these options, which
expire between 1997 and 2001, were determined by the Board of Directors, and
were granted either under the Company's former non-qualified stock option plan
or by agreement of the Board of Directors outside of any plan. The exercise
price of all of these options is their fair market value on the date of grant.

         The 1992 Plan provides for the grant of incentive stock options and
non-qualified stock options to employees, officers and directors of the Company.
The Plan is administered by the Compensation Committee. At March 21, 1997,
options to purchase 333,333 shares at exercise prices ranging from $4.50 to
$25.41 per share had been granted under the 1992 Plan, of which 58,998 had been
exercised. At the same date, there were no options available under the 1992
Plan.

         In 1995, the Company adopted the 1995 Plan. The 1995 Plan is
administered by the Compensation Committee and provides for mandatory option
grants to directors. See "Compensation of Directors." Options to purchase up to
550,000 shares are reserved for issuance under the 1995 Plan. At March 21, 1997,
options to purchase 218,465 shares had been granted under the 1995 Plan at
exercise prices ranging from $3.875 to $10.875, of which 4,583 had been
exercised.

COMPENSATION OF DIRECTORS

         Each director who is not an employee of the Company receives a $3,000
annual retainer for serving in such capacity. In addition, each director who is
not an employee of the Company receives $1,000 for each Board meeting attended
($500 for a telephonic meeting), and is reimbursed for expenses incurred in
attending Board and committee meetings. Further, each director who is a member
of a Board committee receives $500 for each committee meeting attended ($250 for
a telephonic meeting). Additionally, the chairman of each committee receives an
additional $250 for each committee meeting attended.

         In addition, directors receive on an annual basis, mandatory stock
option grants under the 1995 Stock Option Plan for serving on the Board during
the prior year. These options are automatically granted on April 1 of each
fiscal year. The option exercise price is the average of the bid and ask prices
of the Common Stock on the first day of April of each year. Under the 1995 Stock
Option Plan, directors are eligible to receive the following option grants on an
annual basis: (i) options to purchase 3,333 shares for serving as a member of
the Board, (ii) options to purchase 833 shares for serving as a member of one or
more committees of the Board, (iii) options to purchase 416 shares for serving
as the chairman of any committee of the Board, and (iv) options to purchase
1,666 shares for serving as the chairman of the Company.

EMPLOYMENT AGREEMENTS

         The Company and Mr. McEnany have a five-year employment agreement which
began January 1, 1994 and expires December 31, 1998. The agreement provides for
an annual base salary of $200,000, plus an annual cost of living adjustment up
to 5% per annum. In 1996, such cost of living adjustment was 3%. In addition,
the Company, at its expense, has agreed to provide Mr. McEnany with $500,000 of
life insurance on Mr. McEnany's life naming the beneficiaries designated by Mr.
McEnany. The agreement provides that Mr. McEnany will devote his full time and
attention to his duties as Chief Executive Officer of the Company. In accordance
with the terms of the agreement, Mr. McEnany was granted an option to purchase
250,000 shares of Common Stock at an exercise price of $6.75 per share (the fair
market value of the Common Stock on the date of grant). Such options become
exercisable at the rate of 50,000 upon the execution of the agreement and 50,000
options per year on each January 1 of the agreement. The options expire on
December 31, 1998.

         Mr. McEnany's employment agreement also provides for bonus compensation
equal to 3% of the Company's pre-tax income during any fiscal year, in an amount
not to exceed three times his base compensation in any one year.
                                       26
<PAGE>

         Mr. McEnany has agreed not to compete with the Company, directly or
indirectly, for a period of eighteen months after termination of his employment
with the Company. In addition, in the event a third party assumes control of the
Company and the assumption of control has not been approved by the Company's
Board of Directors, Mr. McEnany may, within three months from the date of the
assumption of control, terminate his employment with the Company and receive, in
addition to his annual salary through the date of termination, the sum of
$1,000,000 without having to fulfill his obligations or perform his duties
thereunder and, in such event, he will be released from the restrictive
covenants contained in his employment agreement.

         The Company has entered into an employment agreement with Jack Bleau
which began April 1, 1996 and expires March 31, 1998. Under the employment
agreement, Mr. Bleau is entitled to an annual base salary of $150,000, plus a
bonus equal to 25% of base salary based on a performance criteria to be
determined. Mr. Bleau also receives a car allowance and certain life insurance
benefits.

         The Company has entered into an employment agreement with Loren Gelber
which began July 6, 1994 and expires July 5, 1997. Under the employment
agreement, Mrs. Gelber is entitled to an annual base salary of $100,000. Mrs.
Gelber also receives a car allowance.

         The Company has entered into an employment agreement with Eugene Sokol
which began December 1, 1994. The agreement is automatically renewed on December
1 of each subsequent year, unless terminated by the Company. Under the
employment agreement, Mr. Sokol is entitled to an annual base salary of
$100,000. Mr. Sokol also receives a car allowance.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

         During the fiscal year ended December 31, 1996, Mrs. Allee and Messrs.
Reed, Wilber, Simons and Reid served on the Compensation Committee. None of the
members of the Compensation Committee is or was an executive officer of the
Company, nor has any member of the Committee engaged in a related party
transaction with respect to the Company during the past fiscal year. Further,
during the fiscal year ended December 31, 1996, none of the Company's executive
officers served as a member of the compensation committee or similar committee
of another entity, one of whose executive officers served on the Company's
Compensation Committee; served as a director of another entity, one of whose
executive officers served on the Company's Compensation Committee; or served as
a member of the compensation committee or similar committee of any other entity,
one of whose executive officers served as a director of the Company.

BOARD COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION

         The Compensation Committee of the Board of Directors (the "Compensation
Committee") is responsible for making recommendations to the Board of Directors
concerning executive compensation, including base salaries, bonuses and the
bases for their award, stock option plans and health, life insurance and other
benefits. Each of the members of the Compensation Committee is an independent
outside director of the Company.

         In making its recommendations to the Board of Directors, the
Compensation Committee generally considers the overall performance of the
Company during the prior fiscal year, the individual executive officer's
contribution to the achieving of operating goals and business objectives and
levels of compensation of companies in the Nasdaq Pharmaceutical Index used in
the Stock Performance Graph (and other pharmaceutical companies which in the
view of the Compensation Committee are similar in size and development to the
Company). The Compensation Committee has not targeted a specific compensation
level comparable to such Nasdaq Pharmaceutical Index companies, but reviews such
data for assurance that the Company's compensation package is competitive in the
industry.

                                       27
<PAGE>

         It is the Compensation Committee's view that senior executives'
interests should complement those of shareholders. Accordingly, a substantial
portion of senior executive compensation above a base salary is intended to be
provided through bonuses tied to Company performance and through the grant of
stock options, thus creating incentives for executives to achieve long term
Company objectives and increase shareholder value.

                          Gregory Reed, M.D., Chairman
                          Ogden R. Reid
                          Charles J. Simons
                          Rick A. Wilber
                          Jacqueline Allee

                          As members of the Compensation Committee

                                       28

<PAGE>


PERFORMANCE GRAPH

         The following graph compares the total return on the Company's Common
Stock with the cumulative total return on the Nasdaq Stock Market (US Companies)
Index and the Nasdaq Pharmaceutical Index, for the last five fiscal years.


                                [GRAPHIC OMITTED]


* $100 invested on 12/31/91 in stock or index - including reinvestment of
dividends. Fiscal year ending December 31.

<TABLE>
<CAPTION>

                                                                                CUMULATIVE TOTAL RETURN
                                                   ------------------------------------------------------------------------
                                                    12/31/91    12/31/92     12/31/93    12/31/94   12/31/95    12/31/96
                                                    --------    --------     --------    --------   --------    --------
<S>                                                   <C>          <C>          <C>         <C>        <C>        <C>
     Royce Laboratories, Inc.                         $100          52          58           41         90         62
     Nasdaq Stock Market-US Companies Index           $100         116         134          131        185        227
     Nasdaq Pharmaceutical Index                      $100          83          74           56        102        102
</TABLE>


ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

         The following table sets forth, as of February 27, 1997, certain
information regarding the Common Stock, owned of record or beneficially by (i)
each person who owns beneficially more than 5% of the outstanding Common Stock;
(ii) each of the Company's directors and named executive officers; and (iii) all
directors and executive officers as a group. The address for each beneficial
owner is c/o the Company, 5350 Northwest 165th Street, Miami, Florida.

                                       29
<PAGE>



    NAME OF                              SHARES                   APPROXIMATE
BENEFICIAL OWNER                    BENEFICIALLY OWNED            % OF CLASS(1)
----------------                    ------------------            -------------

Patrick J. McEnany(2)                      746,550                     5.3

Rick A. Wilber(3)                          225,329                     1.6

Richard W. Gross, Esq.(4)                   71,229                     *

Gregory Reed, M.D.(5)                       61,015                     *

Charles J. Simons(6)                        46,580                     *

Hubert E. Huckel, M.D.(7)                   33,333                     *

Ogden R. Reid(8)                             3,333                     *

J. William Grant(9)                          4,583                     *

Jacqueline Allee                             2,000                     *

All Directors and Executive Officers
as a Group (16 persons)(10)              1,422,185                    10.1

----------
*  Less than 1%

(1)      Based on 13,525,879 shares of Common Stock outstanding, plus, as to
         each person, the exercise of their currently exercisable options and
         options becoming exercisable within the next 60 days.

(2)      Includes 148,673 shares owned of record by Equisource Capital, Inc., of
         which Mr. McEnany is the sole shareholder. Includes options to acquire
         287,497 shares of Common Stock at exercise prices ranging from $2.64
         per share to $25.41 per share. Excludes unvested options to purchase
         50,000 shares of Common Stock at $6.75 per share. Also excludes 17,333
         shares owned by Mr. McEnany's wife. Mr. McEnany disclaims any
         beneficial interest in the shares owned by his wife.

(3)      Includes options to acquire 28,330 shares of Common Stock at exercise
         prices ranging from $4.00 per share to $25.41 per share.

(4)      Includes options to acquire 34,163 shares of Common Stock at exercise
         prices ranging from $4.00 per share to $25.41 per share.

(5)      Includes options to acquire 33,747 shares of Common Stock at exercise
         prices ranging from $4.00 per share to $25.41 per share.

(6)      Includes options to acquire 22,914 shares of Common Stock at exercise
         prices ranging from $4.00 per share to $9.31 per share.

(7)      Includes options to acquire 3,333 shares of Common Stock at $9.31 per
         share. Excludes 100 shares owned by Dr. Huckel's son. Dr. Huckel
         disclaims any beneficial interest in the shares owned by his son.

(8)      Includes options to acquire 3,333 shares of Common Stock at $9.31 per
         share.

(9)      Includes options to acquire 4,583 shares of Common Stock at $25.41 per
         share.

(10)     Includes vested options and options to vest within the next 60 days to
         purchase an aggregate of 622,233 shares of Common Stock granted to
         directors and executive officers. Excludes unvested options to purchase
         an aggregate of 161,167 shares of Common Stock granted to executive
         officers.

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

         Not applicable.

                                       30

<PAGE>


                                     PART IV

ITEM 14.     EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.

(A) (1) CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Certified Public Accountants........................F-1
Consolidated Balance Sheets at December 31, 1996 and 1995................ F-2
Consolidated Statements of Operations for the Years Ended
  December 31, 1996, 1995 and 1994........................................F-3
Consolidated Statement of Changes in Stockholders' Equity
  for the Three Years Ended December 31, 1996.............................F-4
Consolidated Statements of Cash Flows for the Years Ended
  December 31, 1996, 1995 and 1994........................................F-5
Notes to Consolidated Financial Statements.......................  F-6 - F-21

(A) (2) FINANCIAL STATEMENT SCHEDULES

Schedule II Valuation and Qualifying Accounts and Reserves

(A) (3) EXHIBITS

            2.1     Agreement and Plan of Merger, dated as of December 24, 1996,
                    among Watson Pharmaceuticals, Inc., Dolphins Acquisition
                    Corp. and Royce Laboratories, Inc. as amended effective as
                    of March 4, 1997 (incorporated by reference from Annex A to
                    Watson Pharmaceuticals, Inc.'s Form S-4 dated March 13,
                    1997).

            3.1     Articles of Incorporation, as amended (incorporated by
                    reference from Exhibit 3.1 to the Registrant's Annual Report
                    on Form 10-K for the year ended December 31, 1992 (the "Form
                    10-K").

            3.2     Certificate of Merger between Auntel Capital, Inc. and
                    Auntel Acquisition Corp. (incorporated by reference from
                    Exhibit 3.2 to the Form 10-K).

            3.3     Restated and Amended By-laws (incorporated by reference from
                    the Forms 10-K for the fiscal years ended December 31, 1987
                    and 1989, respectively).

            3.4     Articles of Amendment to Articles of Incorporation
                    (incorporated by reference from Exhibit 3.2 to the Form
                    10-K).

            3.5     Articles of Amendment to Articles of Incorporation
                    (incorporated by reference from Exhibit 3.4 to the Company's
                    Registration Statement on Form S-3, dated October 10, 1995,
                    file no. 33-61917).

            4.1     Specimen Certificate of Common Stock (incorporated by
                    reference from Exhibit 4.1 to the Form 10-K).

            4.2     Specimen Warrant Certificate for the Series F Warrants
                    (incorporated by reference from Exhibit 4.2 to the Company's
                    Registration Statement on Form S-1, SEC file no. 33-72276).

            4.3     Form of Warrant Agreement for the Series F Warrants
                    (incorporated by reference from Exhibit 4.3 to the Company's
                    Registration Statement on Form S-2, SEC file no. 33-72276).

            10.1    Employment Agreement between Abul K. Bhuiyan and Registrant
                    (incorporated by reference from Exhibit 10.3 to the
                    Company's Registration Statement on Form S-2, SEC file no.
                    33-72276).

                                       31
<PAGE>

            10.2    Form of License Agreement between Registrant and Royce
                    Research and Development Limited Partnership I (incorporated
                    by reference from Exhibit 10.6 to the Form 10-K).

            10.3    Form of Partnership Agreement of Royce Research and
                    Development Limited Partnership I (incorporated by reference
                    from Exhibit 10.7 to the Form 10-K).

            10.4    1992 Stock Option Plan (incorporated by reference from
                    Exhibit 10.9 to the Company's Registration Statement on Form
                    S-2, SEC file no. 33-72276).

            10.5    Lease for new facility between the Company and SKA
                    Associates, dated September 20, 1994 (incorporated by
                    reference from Exhibit 10.8 to the Registrant's Annual
                    Report on Form 10-K for the year ended December 31, 1994).

            10.6    Employment Agreement between the Company and Patrick J.
                    McEnany, dated as of January 1, 1994 (incorporated by
                    reference from Exhibit 10.4 to the Registrant's Annual
                    Report on Form 10-K for the year ended December 31, 1994).

            10.7    Lease agreement between the Company and Palmetto Lakes
                    Realty Associates, Ltd dated April 27, 1995 (incorporated by
                    reference from Exhibit 10.7 to the Registrant's Annual
                    Report on Form 10-K for the year ended December 31, 1995).

            10.8    1995 Stock Option Plan (incorporated by reference from the
                    Company's 1995 Proxy Statement dated June 7, 1995).

            10.9    Employment Agreement between the Company and Robert E. Band,
                    effective November 21, 1994 (incorporated by reference from
                    Exhibit 10.9 to the Registrant's Annual Report on Form 10-K
                    for the year ended December 31, 1995).

            10.10   Employment Agreement between the Company and Loren R.
                    Gelber, dated as of March 19, 1993 (incorporated by
                    reference from Exhibit 10.10 to the Company's Registration
                    Statement on Form S-3, SEC file no. 33-84620).

            10.11   Employment Agreement between the Company and Eugene Sokol,
                    effective December 1, 1994 (incorporated by reference from
                    Exhibit 10.12 to the Registrant's Annual Report on Form 10-K
                    for the year ended December 31, 1995).

            10.12   Employment Agreement between the Company and Mohammad N.
                    Rahman, effective May 5, 1995 (incorporated by reference
                    from Exhibit 10.13 to the Registrant's Annual Report on Form
                    10-K for the year ended December 31, 1995).

            10.13   Employment Agreement between the Company and Jack Bleau,
                    effective April 1, 1996 (incorporated by reference from
                    Exhibit 10.14 to the Registrant's Annual Report on Form 10-K
                    for the year ended December 31, 1995).

            10.14   Letter Agreement, Note and Security Agreement between the
                    Company and SunTrust (incorporated by reference from Exhibit
                    10.1 to the Registrant's Quarterly Report on Form 10-Q for
                    the quarter ended June 30, 1996).

            10.15   Master Lease Agreement, Equipment Schedule, Exhibits A, B, X
                    and Indenture and Bill of Sale between the Company and USL
                    Capital (incorporated by reference from Exhibit 10.1 to the
                    Registrant's Quarterly Report on Form 10-Q for the quarter
                    ended September 30, 1996).

            10.16   Form of Employment Agreement between Patrick J. McEnany,
                    Watson Pharmaceuticals, Inc. and Royce Laboratories, Inc.
                    (incorporated by reference from Exhibit 10.1 to the Form 8-K
                    dated January 9, 1997).

                                       32
<PAGE>

            11.0    Schedule of Computation of Earnings (Loss) per Common and
                    Common Equivalent Share.*

            21.1    List of Subsidiaries of Registrant (incorporated by
                    reference from Exhibit 22.1 to the Form 10-K).

            23.0    Consent of Price Waterhouse LLP relating to the Company's
                    Registration Statements on Form S-3 (SEC file nos. 33-84620
                    and 33-61917) and on Form S-8 (SEC file nos. 33-61973,
                    33-61971 and 33-61975).*

            27.0    Financial Data Schedule.*


* Filed herewith

(B)   REPORTS ON FORM 8-K

A Current Report on Form 8-K was filed on January 9, 1997 reporting under Item 5
"Other Events" the Company's entering into the Merger agreement with Watson. No
financial statements were required to be filed.

                                       33
<PAGE>


                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Royce Laboratories, Inc. has duly caused this report to be
signed on its behalf by the undersigned thereunto duly authorized, in the City
of Miami, Florida on the 27th day of March, 1997.

                            ROYCE LABORATORIES, INC.


                            By: /s/PATRICK J. MCENANY
                                ---------------------
                                Patrick J. McEnany, President

     Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons in the
capacities and on the dates indicated.
<TABLE>
<CAPTION>

             SIGNATURE                                       TITLE                                DATE
             ---------                                       -----                                ----


<S>                                             <C>                                          <C> 
   /s/PATRICK J. MCENANY                            Chairman, President, Chief               March 27, 1997
-----------------------------                         Executive and Operations
        Patrick J. McEnany                            Officer and Director (Principal
                                                      Executive Officer)

                                                    Director and                             March 27, 1997
-----------------------------                       Secretary-Treasurer
        Richard W. Gross                                               

      /s/GREGORY REED                               Director                                 March 27, 1997
-----------------------------
        Gregory Reed


    /s/RICK A. WILBER                               Director                                 March 27, 1997
-----------------------------
        Rick A. Wilber


    /s/CHARLES J. SIMONS                            Director                                 March 27, 1997
-----------------------------
        Charles J. Simons


    /s/HUBERT HUCKEL                                Director                                 March 27, 1997
-----------------------------
          Hubert Huckel

      /s/OGDEN R. REID
-----------------------------                       Director                                 March 27, 1997
         Ogden R. Reid


    /s/JACQUELINE ALLEE                             Director                                 March 27, 1997
-----------------------------
         Jacqueline Allee


    /s/J. WILLIAM GRANT                             Director                                 March 27, 1997
-----------------------------
        J. William Grant


    /s/ROBERT E. BAND                               Vice President, Finance and              March 27, 1997
-----------------------------                         Chief Financial Officer (Principal
        Robert E. Band                                Financial Officer)


    /s/CLAUDE BERTRAND                              Controller                               March 27, 1997
-----------------------------
         Claude Bertrand
</TABLE>
                                       34

<PAGE>


               REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS


To the Board of Directors and Stockholders
of Royce Laboratories, Inc.



In our opinion, the consolidated financial statements listed in the index
appearing under Item 14(a)(1) on page 31 present fairly, in all material
respects, the financial position of Royce Laboratories, Inc. and its subsidiary
(the "Company") at December 31, 1996 and 1995, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1996 in conformity with generally accepted accounting principles.
These financial statements are the responsibility of the Company's management;
our responsibility is to express an opinion on these financial statements based
on our audits. We conducted our audits of these statements in accordance with
generally accepted auditing standards which require that we plan and perform the
audit to obtain reasonable assurance about whether the financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for the opinion expressed
above.

As discussed in Note 1(II), the Company and Watson Pharmaceuticals, Inc.
("Watson") signed a definitive merger agreement for Watson to acquire the
Company in a stock-for-stock merger transaction to be accounted for as a
pooling-of-interests.




PRICE WATERHOUSE LLP
Miami, Florida
February 19, 1997

                                      F-1
<PAGE>


                            ROYCE LABORATORIES, INC.
                           CONSOLIDATED BALANCE SHEETS
                          (IN THOUSANDS EXCEPT SHARES)



                                                         DECEMBER 31,
ASSETS                                                 1996       1995
------                                                -------   -------

Current assets:
   Cash and cash equivalents                          $ 4,596   $ 2,291
   Accounts receivable, net of allowances
       of $1,877 and $909, respectively                 3,209     3,466
   Inventories                                          5,287     4,212
   Prepaid expenses and other current assets              691       315
                                                      -------   -------
       Total current assets                            13,783    10,284

Property and equipment, net                             3,512     1,732
Other assets                                               63        77
                                                      -------   -------

                                                      $17,358   $12,093
                                                      =======   =======

LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------

Current liabilities:
   Accounts payable and accrued liabilities           $ 2,687   $ 3,149
   Current maturities of long-term debt                   351        90
                                                      -------   -------
       Total current liabilities                        3,038     3,239

Long-term debt                                            958       181
                                                      -------   -------

       Total liabilities                                3,996     3,420
                                                      -------   -------

Commitments and contingencies                            --        --
                                                      -------   -------

Stockholders' equity:
   Common stock, $.005 par value, 35,000,000 shares
     authorized; 13,519,213 and 12,838,466
     shares issued, respectively                           67        64
   Additional paid-in capital                          30,351    26,471
   Accumulated deficit                                (17,045)  (17,851)
   Treasury stock (2,500 shares, at cost)             (    11)  (    11)
                                                      -------   -------
       Total stockholders' equity                      13,362     8,673
                                                      -------   -------

                                                      $17,358   $12,093
                                                      =======   =======

   THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
                                      F-2
<PAGE>
<TABLE>
<CAPTION>


                            ROYCE LABORATORIES, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                      (IN THOUSANDS EXCEPT PER SHARE DATA)


                                                         YEARS ENDED DECEMBER 31,
                                               --------------------------------------------
                                                   1996            1995            1994
                                               ------------    ------------    ------------


<S>                                            <C>             <C>             <C>         
Net sales                                      $     22,317    $     10,391    $      6,174

Cost of goods sold                                   15,060           7,299           4,538
                                               ------------    ------------    ------------

Gross profit                                          7,257           3,092           1,636

Operating expenses:
  Research and development                            1,715           2,212             960
  Selling, general and administrative                 4,831           3,366           2,281
                                               ------------    ------------    ------------

Operating income (loss)                                 711          (2,486)         (1,605)
                                               ------------    ------------    ------------


Other income (expense):
  Interest income                                       189             161              64
  Interest expense                                     (101)            (36)            (10)
  Miscellaneous income                                   48              25              74
                                                -----------    ------------    ------------

                                                        136             150             128
                                                ------------    ------------   ------------

Income (loss) before income taxes                       847          (2,336)         (1,477)

Provision for income taxes                               41            --              --
                                                ------------    ------------    ------------

Net income (loss)                               $       806     $    (2,336)    $    (1,477)
                                                ============    ============    ============

Per share data:

   Earnings (loss) per common and
   common equivalent share                      $       .06    $       (.19)    $      (.14)
                                                ============   ============    ============

Weighted average number of common and common
    equivalent shares outstanding                13,899,593      12,352,235      10,554,228
                                                ============    ============    ============
</TABLE>

   THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.

                                   F-3
<PAGE>
<TABLE>
<CAPTION>

                            ROYCE LABORATORIES, INC.
            CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
                       THREE YEARS ENDED DECEMBER 31, 1996
                          (IN THOUSANDS EXCEPT SHARES)
                                                                       
                                               COMMON STOCK         ADDITIONAL                                  TOTAL 
                                               ------------           PAID IN    ACCUMULATED    TREASURY    STOCKHOLDERS'
                                            SHARES      AMOUNT       CAPITAL       DEFICIT        STOCK        EQUITY
                                          ---------   ----------   -----------   -----------   ----------   -------------
<S>                                       <C>         <C>          <C>           <C>           <C>           <C>
BALANCE AT DECEMBER 31, 1993              9,798,627   $       49   $   17,465    $  (14,038)   $      (11)   $    3,465

Issuance of common stock to employees         3,254         --             26          --            --              26

Payment of debt by a director                  --           --             38          --            --              38

Issuance of common stock - exercise of
 warrants and options                       152,570            1          200          --            --             201

Issuance of common stock -
 private placement                        2,000,000           10        4,116          --            --           4,126

Reclassification of loan to director           --           --            (24)         --            --             (24)

Net loss                                       --           --           --          (1,477)         --          (1,477)
                                         ----------   ----------   ----------    ----------    ----------    ----------
BALANCE AT DECEMBER 31, 1994             11,954,451           60       21,821       (15,515)          (11)        6,355

Issuance of common stock in payment of
  Company obligations                        12,017         --             32          --            --              32

Issuance of common stock -
 exercise of options                         38,665         --            131          --            --             131

Stock options                                  --           --             57          --            --              57

Collection of loan from officer                --           --             27          --            --              27

Adjustment related to 1994
 private placement                             --           --            (15)         --            --             (15)

Issuance of common stock -
 private placement                          833,333            4        4,418          --            --           4,422

Net loss                                       --           --           --          (2,336)         --          (2,336)
                                         ----------   ----------   ----------    ----------    ----------    ----------

BALANCE AT DECEMBER 31, 1995             12,838,466           64       26,471       (17,851)          (11)        8,673

Issuance of common stock -
 exercise of warrants and options           680,747            3        3,766          --            --           3,769

Stock options                                  --           --            106          --            --             106

Tax benefit related to stock options           --           --              8          --            --               8

Net income                                     --           --           --             806          --             806
                                         ----------   ----------   ----------    ----------    ----------    ----------

BALANCE AT DECEMBER 31, 1996             13,519,213   $       67   $   30,351    $  (17,045)   $      (11)   $   13,362
                                         ==========   ==========   ==========    ==========    ==========    ==========
</TABLE>

   THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.

                                      F-4
<PAGE>
<TABLE>
<CAPTION>


                            ROYCE LABORATORIES, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                (IN THOUSANDS EXCEPT IN SUPPLEMENTAL DISCLOSURES)

                                                                                       YEARS ENDED DECEMBER 31,
                                                                           ----------------------------------------------
                                                                               1996               1995               1994
                                                                           -----------         ---------          -------

<S>                                                                        <C>                 <C>                <C>
   Cash flows from operating activities:
     Net income (loss)                                                     $      806           $  (2,336)        $  (1,477)
     Adjustments to reconcile net income (loss)
     to net cash used in operating activities:
        Depreciation                                                              582                 301               211
        Option grant                                                               40                   -                 -
     Change in operating assets and liabilities:
        Decrease (increase) in accounts receivable                                257              (2,013)             (650)
        Increase in inventories                                                (1,075)             (2,163)             (821)
        Increase in prepaid expenses and
         other current assets                                                    (368)                (92)              (75)
        Decrease (increase) in other assets                                        14                   9               (60)
        (Decrease) increase in accounts payable and accrued liabilities          (396)              1,540             1,127
                                                                           ----------          ----------        ----------

          Net cash used in operating activities                                  (140)             (4,754)           (1,745)
                                                                           ----------          -----------       -----------

   Cash flows from investing activities:
     Acquisition of property and equipment                                     (1,803)               (955)             (548)
                                                                           ----------          -----------       -----------
          Net cash used in investing activities                                (1,803)               (955)             (548)
                                                                           ----------          -----------       -----------

   Cash flows from financing activities:
     Proceeds from issuance of long-term debt                                     743                 171                75
     Repayments of long-term debt                                                (264)                (59)              (20)
     Net proceeds from issuance of stock                                        3,769               4,538             4,299
     Collection of loan receivable                                                  -                  27                38
                                                                           ----------          ----------        ----------
          Net cash provided by financing activities                             4,248               4,677             4,392
                                                                           ----------          ----------        ----------

   Net increase (decrease) in cash and cash
     equivalents                                                                2,305              (1,032)            2,099

   Cash and cash equivalents, beginning of year                                 2,291               3,323             1,224
                                                                           ----------          ----------        ----------

   Cash and cash equivalents, end of year                                  $    4,596          $    2,291        $    3,323
                                                                           ==========          ==========        ==========
</TABLE>

   SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

   During 1996, 1995, and 1994, the Company made cash payments for interest of
   approximately $104,000, $26,000 and $10,000, respectively.

   During 1996, the Company made cash payments for income taxes of approximately
   $44,000.

   SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITIES:

   During 1996 and 1995, the Company incurred $559,000 and $101,000,
   respectively, in capital lease obligations for new equipment.

   In 1995, the Company issued 12,017 shares of unregistered common stock in
   satisfaction of contract obligations.

   In 1994, the Company issued 30,600 shares of common stock to Paradise Valley
   Securities, Inc. ("PVS") (See Note 8 (III)(G)).

   THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE FINANCIAL STATEMENTS.
   
                                   F-5
<PAGE>



                            ROYCE LABORATORIES, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994


NOTE 1.  DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES

   I. Description of business

   Royce Laboratories, Inc. (the "Company") is a Florida corporation engaged in
   developing, manufacturing and marketing generic prescription and
   non-prescription drugs in solid dosage form (tablets and capsules). The
   Company sells its products primarily to U.S. based drug wholesalers, generic
   drug distributors, retail buying groups, managed care organizations and drug
   chains.

   In October 1991, the Company formed a wholly-owned subsidiary, Royce Research
   Group, Inc. ("RRGI") to engage, through a licensing agreement with the
   Company, in the development and marketing of five generic prescription drugs
   (See Note 9).

   II.  Pending Merger

   On December 24, 1996, the Company and Watson Pharmaceuticals, Inc.
   ("Watson"), a pharmaceutical company, signed a definitive merger agreement
   for Watson to acquire the Company in a stock-for-stock merger transaction to
   be accounted for as a "pooling-of-interests" ("Merger"). Under the terms of
   the definitive agreement, the Company will become a wholly-owned subsidiary
   of Watson, and Patrick McEnany will become President of the wholly-owned
   subsidiary, Royce Laboratories, Inc., as well as Vice President of Corporate
   Development for Watson. The proposed transaction is subject to approval by
   the Company's stockholders and other customary conditions to closing. The
   Company's special meeting of stockholders is scheduled for April 16, 1997 and
   assuming a majority of such stockholders vote for the Merger, the transaction
   will close immediately thereafter.

   Under the merger agreement, Watson will issue to the holders of each share of
   the Company's common stock, the number of shares of Watson's common stock
   equal to $7.25 divided by the average closing stock price of a share of
   Watson's common stock for the ten consecutive trading days ending on the day
   immediately preceding the effective date of the merger ("Exchange Ratio"),
   subject to a $38.00 and $47.00 collar. If the average closing price (i)
   exceeds $47.00, the average closing price will be deemed to be $47.00 for
   purposes of calculating the Exchange Ratio and (ii) is less than $38.00, the
   average closing price shall be deemed to be $38.00 for purposes of
   calculating the Exchange Ratio. All options and warrants to acquire the
   Company's common stock which are outstanding when the merger is completed
   will be assumed by Watson and shall be exercisable upon the same terms and
   conditions as under the applicable Company stock option plan, except that the
   number of shares subject to such Company option shall be multiplied by the
   Exchange Ratio and the option exercise price shall be divided by the Exchange
   Ratio.

   The merger agreement may be terminated under various circumstances. If,
   however, the Company terminates this agreement in order to accept an
   alternative offer and consummates such alternative transaction, the Company
   would be liable to Watson for a termination fee of $3,000,000 or payment of
   Watson's merger related expenses. However the Company would seek to require
   the alternative acquirer of the Company to assume such payments. If the
   merger terminates for reasons other than to accept an alternative offer from
   another acquirer, pursuant to the agreement, the Company will bear all of its
   costs associated with this merger, which are estimated to total $500,000. The
   Company will expense the merger costs when the Merger is consummated or
   terminated, whichever is earliest.

                                      F-6
<PAGE>



                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 1.  DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


   III. Significant accounting policies

   A summary of the significant accounting policies followed by the Company in
   the preparation of the accompanying financial statements is presented below.

   (A) Principles of consolidation

   The accompanying consolidated financial statements include the accounts of
   the Company and its wholly owned subsidiary. All significant intercompany
   balances and transactions have been eliminated.

   (B) Fair value of financial instruments

   The financial instruments included in the Company's balance sheets are cash
   and cash equivalents and long-term debt. These instruments were carried at
   amounts approximating fair value at December 31, 1996 and 1995. The fair
   value of long-term debt was estimated based on future cash flows discounted
   at current interest rates available to the Company for instruments with
   similar maturities and characteristics.

   (C) Concentration of credit risk

   The Company is subject to a concentration of credit risk consisting of its
   accounts receivable, the entire balance of which is due from generic drug
   distributors, wholesalers, retail buying groups, managed care organizations
   and drug chains. The Company assesses the financial strength of its customers
   and does not require collateral. The Company maintains reserves for potential
   losses from uncollectible accounts.

   (D) Cash and cash equivalents

   Cash on hand, deposits in banks, and money market funds, and other highly
   liquid investments with an original maturity of three months or less, are
   considered cash and cash equivalents.

   (E) Inventory

   Inventory is stated at the lower of cost or market. Cost is determined
   principally by the first-in, first-out method. Components of inventory
   include materials, labor and manufacturing overhead.

   (F) Property and equipment

   Property and equipment is stated at cost, less accumulated depreciation and
   amortization. Depreciation, which includes depreciation of assets under
   capital leases, is computed using the straight-line method over the estimated
   useful lives of the assets. Amortization of leasehold improvements is
   computed using the straight-line method over the shorter of the lease term or
   estimated useful lives of the related assets. Expenditures for repairs and
   maintenance are charged to expense as incurred, while expenditures which
   extend the useful lives of assets are capitalized.

   (G) Income taxes

   The Company records income taxes using the liability method. Under this
   method, deferred tax assets and liabilities are determined based upon
   differences between financial reporting and tax bases of assets and
   liabilities and are measured using the enacted income tax rates that will be
   in effect when the differences are expected to reverse. An allowance is
   recorded when it is more likely than not that any or all of a deferred tax
  

                                      F-7
<PAGE>

                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 1.  DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)


   asset will not be realized. The provision for income taxes includes taxes
   currently payable plus the net change during the year in deferred tax assets
   and liabilities recorded by the Company.

   (H) Revenue recognition

   Sales are recorded at the time goods are shipped.

   (I) Research and development costs

   All research and development costs are expensed as incurred.

   (J) Earnings (loss) per common and common equivalent share

   Earnings (loss) per common and common equivalent share amounts are computed
   by dividing net income (loss) by the weighted average number of shares of
   common stock and common stock equivalents outstanding during each of the
   periods. Warrants, options and other common stock equivalents have not been
   included in the calculation of loss per share for the years ended December
   31, 1995 and December 31, 1994 because their effect was anti-dilutive.
   Primary and fully diluted earnings per share were the same for the year ended
   December 31, 1996.

   (K) Reclassifications

   Certain amounts in the 1994 and 1995 financial statements have been
   reclassified to conform to the 1996 presentation. These reclassifications had
   no effect on net loss or accumulated deficit.

   (L) Stock-based compensation

   Effective January 1, 1996, the Company adopted Statement of Financial
   Accounting Standards No. 123, "Accounting For Stock Based Compensation ("SFAS
   123")". SFAS 123 establishes a fair value based method of accounting for
   stock-based compensation plans, the effect of which can either be disclosed
   or recorded. Upon adoption, the Company has chosen to continue to account for
   stock-based compensation using the intrinsic value method of accounting
   prescribed in Accounting Principles Board Opinion No. 25, "Accounting for
   Stock Issued to Employees," and is providing pro forma disclosures of net
   income and earnings per share as if the fair value-based method prescribed by
   SFAS 123 had been applied in measuring compensation expense.

   (M) Management estimates

   The preparation of financial statements in conformity with generally accepted
   accounting principles requires management to make estimates and assumptions
   that affect the reported amounts of assets and liabilities and disclosure of
   contingent assets and liabilities at the date of the financial statements and
   the reported amounts of revenues and expenses during the reporting period.
   The most significant estimates made by management in the accompanying
   financial statements relate to accounts receivable allowances. Actual results
   could differ from those estimates.

                                      F-8

<PAGE>


                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



NOTE 2.  INVENTORIES

   Inventories consisted of the following (in thousands):

                                                            DECEMBER 31,
                                                         -------------------
                                                          1996         1995
                                                         ------       ------

Raw materials                                            $2,321       $2,439
Work-in-process                                           1,275          783
Finished goods                                            1,691          990
                                                         ------       ------

                                                         $5,287       $4,212
                                                         ======       ======

NOTE 3.  PROPERTY AND EQUIPMENT

   Property and equipment consisted of the following (in thousands):
                                                                     ESTIMATED
                                                 DECEMBER 31,      USEFUL LIVES
                                              1996         1995       (YEARS)
                                            -------      -------    ----------

Leasehold improvements                      $ 1,182      $   529       5 - 10
Machinery and equipment                       2,966        1,948       3 - 7
Research and laboratory equipment               495           40       4 - 7
Furniture and equipment                         631          395       3 - 7
Transportation equipment                         17           17           3
                                            -------      -------
                                              5,291        2,929
Less accumulated depreciation
and amortization                             (1,779)      (1,197)
                                            -------      -------

                                            $ 3,512      $ 1,732
                                            =======      =======


NOTE 4.  ACCOUNTS PAYABLE AND ACCRUED LIABILITIES

  Accounts payable and accrued liabilities consisted of the following (in
thousands):

                                                             DECEMBER 31,
                                                         -------------------
                                                          1996         1995
                                                         ------       ------

Trade accounts payable                                   $2,089       $2,521
Accrued payroll and benefits                                316          165
Accrued royalties                                           112          108
Other accrued expenses                                      170          355
                                                         ------       ------
                                                         $2,687       $3,149
                                                         ======       ======

                                      F-9
<PAGE>



                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
<TABLE>
<CAPTION>


NOTE 5.  LONG-TERM DEBT

     Long-term debt consisted of the following (in thousands):
                                                                                           DECEMBER 31,
                                                                                    -------------------------
                                                                                     1996                1995
                                                                                    -----                ----
          <S>                                                                       <C>                 <C>
           Bank term loan, payable in 48 monthly installments of $19 consisting
           of principal and interest with an effective rate of 10.5%,
           collateralized by a first priority security interest in all of the
           equipment and fixtures owned by the Company, except equipment
           financed  under capital leases                                          $   692                $  -

           Notes payable to banks, payable in monthly installments, including
           interest at rates ranging from 9.6% to 10.5% per annum for terms
           expiring at various dates through March 2000, secured by furniture 
           and equipment.                                                              124                 186

           Capital lease obligations, net of imputed interest of $89, payable in
           monthly installments including interest at imputed rates ranging from
           10.4% to 13.0% per annum for terms expiring at various dates
           through August 1999, secured by equipment.                                  493                  85
                                                                                   -------             -------
                                                                                     1,309                 271

           Less current maturities                                                    (351)                (90)
                                                                                   -------             --------

                                                                                   $   958             $   181
                                                                                   =======             =======
</TABLE>

     Annual maturities of long-term debt, including capital lease obligations,
     at December 31, 1996 were as follows (in thousands):

                                      1997              $   351
                                      1998                  354
                                      1999                  449
                                      2000                  155
                                                        -------
                                                        $ 1,309
                                                        =======

     In connection with the bank term loan, the Company is required to comply
     with various covenants, including capital expenditures restrictions, debt
     to equity and interest coverage ratios.

NOTE 6.  MAJOR CUSTOMERS

     The table below reflects the percentage of the Company's net sales that
major customers accounted for:

                                             YEARS ENDED DECEMBER 31,
                                   -------------------------------------------
                                   1996                 1995              1994
                                   ----                 ----              ----

           Customer  A               -                   13%              14%
           Customer  B               -                    -               10%
           Customer  C              21%                  12%               -


                                      F-10
<PAGE>


                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 7.  INCOME TAXES

     There was no income tax provision or benefit recorded in 1994 or 1995. In
     the year ended December 31, 1996, the provision for income taxes consisted
     of the Company's estimate of alternative minimum taxes incurred for the
     period, after utilizing net operating loss carryforwards to offset 90% of
     taxable income and was comprised of the following (in thousands):

                                                                      1996
                                                                     -----
     Taxes currently payable:
              Federal                                                $  25
              State                                                      8
                                                                     -----
                                                                        33

     Exercise of stock options not treated
     as a reduction of income tax expense
     for financial reporting purposes                                    8
                                                                     -----
                                                                     $  41
                                                                    ======

     For tax purposes, the exercises of stock options under certain
     circumstances result in deductible compensation expense which reduces taxes
     currently payable. However, such deduction must be recorded as an increase
     in additional paid-in capital for financial reporting purposes, and thus,
     income tax expense for financial reporting purposes exceeds taxes currently
     payable.

     The provision for income taxes differs from the amount computed by applying
     the federal income tax rate to income as follows:
<TABLE>
<CAPTION>

                                                                                            DECEMBER 31,
                                                                              -------------------------------------
                                                                               1996             1995         1994
                                                                              ------         ---------    ---------

          <S>                                                                 <C>            <C>          <C>    
          Federal statutory rate                                                34.0%           (34.0%)       (34.0%)
          State income tax, net of federal income tax benefit                    3.6%            (3.6%)        (3.6%)
          (Utilization) generation of net operating loss carryforwards         (33.8%)           37.6%         37.6%
          Other                                                                  1.0%             0.0%          0.0%
                                                                              -------        ---------     ---------
                                                                                 4.8%             0.0%          0.0%
                                                                              =======        =========     =========

     Deferred tax assets are measured based on the difference between the
     financial statement and tax bases of assets and liabilities at the
     applicable enacted tax rates. Deferred tax assets resulted from the
     following (in thousands):


                                                                                              DECEMBER 31,
                                                                                       ------------------------
                                                                                          1996            1995
                                                                                       ----------      --------

         Benefits from net operating loss carryforwards                                $    4,102      $  4,511
         Difference in accounting for accounts receivable and inventory                       454           233
         Difference in depreciation for book and tax purposes                                 106            47
         Other, net                                                                            46            26
                                                                                       ----------      --------
                                                                                            4,708         4,817

         Valuation allowance                                                               (4,708)       (4,817)
                                                                                       ----------      --------

         Net deferred tax assets                                                       $        -      $      -
                                                                                       ==========      ========
</TABLE>

                                      F-11
<PAGE>


                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)



NOTE 7.  INCOME TAXES (CONTINUED)

     As of December 31, 1996, the Company had net operating loss of
     approximately $12.1 million carryforwards that could be used to offset
     future taxable income. These operating loss carryforwards expire between
     the years 2000 and 2010. This amount is net of pre-1991 operating loss
     carryforwards which will expire before being used due to limitation on
     their use imposed as a result of certain changes in the Company's ownership
     during 1991. Future changes in the Company's ownership, if any, may have
     the effect of further limiting the annual utilization of loss carryforwards
     (see Note 1(II)).

NOTE 8.  CAPITAL STOCK

     I.   Capital stock - authorized and issued

     At December 31, 1996, the Company had authorized 200,000 shares of
     preferred stock, $.005 par value (the "Preferred Stock"), none of which was
     issued and outstanding.

     In addition to its 13,519,213 common shares issued, the Company had a total
     of 2,185,667 warrants and options outstanding at December 31, 1996.

     II.  Stock offerings

     A)    1995 Private Placement

     During July 1995, the Company completed a $5 million private placement
     ("1995 Private Placement") of 833,333 units at a price of $6.00 per unit.
     Each unit consisted of one share of common stock, $.005 par value, and a
     twelve month warrant (the "Private Warrants") to purchase one share of
     common stock at an exercise price of $6.50 per share. The price of the
     shares was determined in arms-length negotiations between the Company and
     the placement agent, Gruntal & Co., Incorporated ("Gruntal"). The Company
     received aggregate net proceeds of approximately $4.4 million from this
     offering. In addition to fees for serving as the placement agent, Gruntal
     received three-year warrants (See Note 8(III)(C)) to purchase 83,333 shares
     of common stock at an exercise price of $6.00 per share.

     In August 1995, the Company filed a registration statement relating to the
     shares of common stock sold in the 1995 Private Placement and the shares of
     common stock underlying the warrants sold in the private placement. Such
     registration statement was declared effective under the Securities Act of
     1933, as amended, during October 1995. The Company has also agreed to use
     its best efforts to maintain the effectiveness of the registration
     statement until July 1997.

     B)   1994 Private Placement

     During September 1994, the Company completed a private placement ("1994
     Private Placement") in which the Company sold an aggregate of 2,000,000
     shares of its common stock at a price of $2.50 per share. The price of the
     shares was determined in arms-length negotiations between the Company and
     Gruntal, which acted as the placement agent of this offering. In addition
     to fees for serving as the placement agent, Gruntal also received 200,000
     warrants (See Note 8(III)(D)). The Company received aggregate net proceeds
     of approximately $4.1 million from this offering. A registration statement
     relating to the shares sold in the 1994 Private Placement is effective as
     of the date of these financial statements.

                                      F-12
<PAGE>

                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 8.  CAPITAL STOCK (CONTINUED)


     III. Stock options, warrants and rights

     A)   Stock options

     (1)  Description of employee and director stock option plans

     In 1992 and 1995, the Company adopted stock option plans which provide for
     the granting at or above the fair market value of the underlying shares at
     the date of grant, of incentive options for its employees, officers and
     directors (referred to individually as the "1992 Plan" and the "1995 Plan",
     respectively, and collectively as "the Plans"). The 1992 Plan and 1995 Plan
     provide for the grant of up to 333,333 and 550,000 shares, respectively, of
     common stock. The Plans provide for mandatory grants to directors for
     serving on the Board of Directors, committees of the Board of Directors, as
     chairman of committees and as Chairman of the Board of Directors. Options
     granted pursuant to the Plans generally expire five years from the date
     they become vested. Options issued to directors vest on grant date while
     options issued to employees and officers generally vest over a two to four
     year period beginning with the grant date. The Plans are administered by
     the Compensation Committee of the Board of Directors. All employee and
     director options expire at various times between 1997 and 2005.

     (2)  Employee and director stock option activity in 1996

     In April 1996, the Board of Directors granted a total of 38,326 stock
     options under its 1995 Plan to the President and the outside directors for
     their services on the Board and its committees. These options vest on grant
     date, are exercisable at a price of $9.31 per share and expire five years
     from their vesting dates. During 1996, the Company also granted 138,500
     stock options to certain employees of the Company. These options vest
     generally over two to four years, are exercisable at prices between $3.88
     and $10.88 per share and expire five years from their vesting dates.

     3)   Customer and consultant options

     In February 1996, the Company entered into an option agreement with a
     consultant. Under the agreement, the consultant was granted stock options
     to purchase up to 40,000 shares of common stock at $10.50 per share, the
     market price on the date of grant. Such options vest at the rate of 20,000
     on January 1, 1997 and 20,000 on January 1, 1998 upon the consultant
     meeting certain minimum net sales targets in 1996 and 1997, respectively.
     For the year ended December 31, 1996, the consultant did not meet the
     minimum net sales target in 1996 and as a result did not earn the 20,000
     options available for that year.

     In February 1995, the Company entered into an agreement with a customer
     whereby the customer agreed to engage the Company as its sole supplier of
     the Company's present and future products for a five year period subject to
     certain exceptions. In return, the Company granted the customer stock
     options to purchase up to 50,000 shares of common stock at $6.00 per share,
     the market price on the date of grant. Such options vest at the rate of
     9,000 per year, with 5,000 options vesting upon entering into this
     agreement and expire seven years from the date of the agreement. In
     connection with this agreement, the Company recorded a charge to earnings
     of approximately $66,000 in 1995 and $39,000 in 1996.

                                      F-13

<PAGE>


                           ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 8.  CAPITAL STOCK (CONTINUED)

     Below is a table summarizing transactions and other relevant data
pertaining to stock options:
<TABLE>
<CAPTION>

                                                                                    WEIGHTED
                                                                 NUMBER OF        AVERAGE PRICE
                                                                  OPTIONS           PER SHARE
                                                                  -------         -------------
   1992 PLAN
   ---------
<S>                                                              <C>               <C>
   Options outstanding at December 31, 1993                        210,823         $13.09

   Options granted                                                  85,829         $ 5.10
                                                                 ---------

   Options outstanding at December 31, 1994                        296,652         $10.77

   Options granted                                                 103,761         $ 7.12
   Options exercised                                               ( 9,166)        $ 6.16
   Options canceled                                                (67,080)        $19.54
                                                               ------------

   Options outstanding at December 31, 1995                        324,167         $ 7.92

   Options granted                                                     428         $10.75
   Options exercised                                               (16,500)        $ 5.64
   Options canceled                                                (21,261)        $ 7.03
                                                               -----------

   Options outstanding at December 31, 1996                        286,834         $ 8.12
                                                               ===========
   Options exercisable at December 31, 1996                        221,904         $ 8.45
                                                               ===========

   1995 PLAN
   ---------

   Options outstanding at December 31, 1994                              -              -
   Options granted                                                  42,067         $ 8.52
                                                               -----------

   Options outstanding at December 31, 1995                         42,067         $ 8.52

   Options granted                                                 176,398         $ 7.77
   Options exercised                                                (4,583)        $ 8.44
   Options canceled                                                 (6,239)        $ 9.00
                                                               -----------

   Options outstanding at December 31, 1996                        207,643         $ 7.87
                                                               ===========
   Options exercisable at December 31, 1996                         77,071         $ 8.51
                                                               ===========

   NON-PLAN STOCK OPTIONS
   ----------------------

   Options outstanding at December 31, 1993                        502,641         $ 2.79

   Options granted                                                 462,500         $ 5.29
   Options exercised                                              (105,665)        $ 0.75
   Options canceled                                               (  3,334)        $ 0.75
                                                               -----------

   Options outstanding at December 31, 1994                        856,142         $ 4.40
</TABLE>

                                      F-14
<PAGE>

                           ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 8.  CAPITAL STOCK (CONTINUED)

<TABLE>
<CAPTION>


<S>                                                            <C>                 <C>
   Options granted                                               50,000         $    6.00
   Options exercised                                            (29,499)        $    2.51
   Options canceled                                             (70,733)        $    1.88
                                                               --------

   Options outstanding at December 31, 1995                     805,910         $    4.79

   Options granted                                               40,000         $   10.50
   Options exercised                                            (78,331)        $    2.67
   Options canceled                                            (137,498)        $    3.96
                                                               --------

   Options outstanding at December 31, 1996                     630,081         $    5.60
                                                               ========
   Options exercisable at December 31, 1996                     424,080         $    5.32
                                                               ========
</TABLE>

   The weighted average fair value at date of grant for options granted during
   1996 and 1995 was $4.26 and $3.65 per option, respectively. The weighted
   average fair value of each option is estimated on the date of grant using the
   Black-Scholes option-pricing model with the following weighted average
   assumptions used for grants in 1996 and 1995, respectively: no dividend
   yield; expected volatility of 60%; risk-free interest rates of 6.4 and 6.6%;
   expected lives of 5.8 and 5.9 years.

   The following table summarizes information about stock options outstanding at
December 31, 1996:
<TABLE>
<CAPTION>

                                                   OPTIONS OUTSTANDING                                   OPTIONS EXERCISABLE
                               ----------------------------------------------------------------    --------------------------------
                                                                                WEIGHTED                                WEIGHTED
                                                      WEIGHTED-AVERAGE           AVERAGE                                AVERAGE
  RANGE OF EXERCISE                SHARES                REMAINING              EXERCISE              SHARES            EXERCISE
        PRICES                  OUTSTANDING           CONTRACTUAL LIFE           PRICE             EXERCISABLE           PRICE
---------------------------    -------------------    ---------------------    ----------------    -----------------    -----------

<S>                            <C>                    <C>                      <C>                         <C>               <C>
    $2.64 - $3.94                   237,167                     3.5               $  3.23                169,666          $  3.11
    $4.00 - $5.91                   204,246                     3.6               $  4.79                167,244          $  4.73
    $6.00 - $9.00                   554,990                     3.6               $  7.11                286,990          $  6.90
    $9.31 - $10.88                   92,326                     3.6               $  9.78                 63,326          $  9.41
   $19.50 - $25.41                   35,829                     0.3               $ 25.00                 35,829          $ 25.00
                               ------------                                                        -------------
    $2.64 - $25.41                1,124,558                     3.4               $  6.66                723,055          $  6.62
</TABLE>

   The following table summarizes pro forma net income (loss) and earnings
   (loss) per share as if the Company would have applied the fair value-based
   method prescribed by SFAS 123 in measuring stock-based compensation expense
   related to options issued in 1995 and 1996 (in thousands except per share
   amounts):

                                                             DECEMBER 31,
                                                     -------------------------
                                                       1996            1995
                                                     ---------      ----------
        Net income (loss) - as reported              $  806         $  (2,336)
        Net income (loss) - pro forma                $  306         $  (2,629)

        Earnings (loss) per share - as reported      $  .06         $    (.19)
        Earnings (loss) per share - pro forma        $  .02         $    (.21)

                                      F-15
<PAGE>

                           ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


NOTE 8.  CAPITAL STOCK (CONTINUED)

   B)   1995 private placement warrants

   As part of the Company's 1995 Private Placement, the Company issued 833,333
   Private Warrants. Each Private Warrant entitled the holder to purchase one
   share of common stock at an exercise price of $6.50 per share. The exercise
   price was subject to increase or decrease upon the happening of certain
   corporate events including, but not limited to the payment of any stock
   dividend, stock split, stock combination or similar transaction.

   On December 12, 1995, the Company reduced the exercise price of the Private
   Warrants from $6.50 to $6.00 for a 60 day period as an incentive for warrant
   holders to exercise their Private Warrants. During 1996, the Company issued
   581,333 shares of its common stock as a result of the exercise of Private
   Warrants. Net proceeds from the exercise of these warrants amounted to
   approximately $3.4 million. The remaining 252,000 Private Warrants expired on
   July 20, 1996.

   C)   1995 Gruntal warrant

   As part of its compensation for acting as the placement agent in connection
   with the 1995 Private Placement, Gruntal received the 1995 Gruntal warrant
   which allows them to purchase 83,333 shares of common stock at an exercise
   price equal to $6.00 per share, exercisable until July 21, 1998. The holder
   of the 1995 Gruntal warrant may pay the exercise price in cash or use a
   cashless exercise. In a cashless exercise, the holder of the 1995 Gruntal
   warrant has the right at any time to exercise the warrant in whole or in part
   by surrendering the warrant certificate in exchange for the number of shares
   of common stock equal to (x) the number of shares as to which the 1995
   Gruntal warrant is being exercised multiplied by (y) a fraction, the
   numerator of which is the market price (as defined in the 1995 Gruntal
   warrant) of the common stock at the date of exercise less the exercise price
   and the denominator of which is such market price. The 1995 Gruntal warrant
   provides for an adjustment of the exercise price and the number and type of
   securities issuable upon the exercise thereof upon the occurrence of certain
   events, including the payment of any stock dividend stock split, stock
   combination or similar transaction.

   D)   1994 Gruntal warrant

   As part of its compensation for acting as the placement agent in connection
   with the 1994 Private Placement, Gruntal received warrants which allow them
   to purchase 200,000 shares of common stock at an exercise price equal to
   $3.50 per share, exercisable until August 12, 1999. The holder of the 1994
   Gruntal warrant may pay the exercise price in cash or use a cashless
   exercise. The provisions for a cashless exercise and adjustments to the
   exercise price are similar to those described above for the 1995 Gruntal
   warrant.

   E)   Class action settlement warrants

    In  accordance  with the  settlement  in 1993 of the class  action  lawsuit,
    during the first quarter of 1995,  the Company  issued  warrants to purchase
    658,333  shares of  common  stock.  Each of these  warrants  (the  "Series F
    Warrants")  entitles  the holder to purchase one share of common stock at an
    exercise  price of $15.00 per share.  The Series F Warrants are  exercisable
    through  December 1999,  unless such period is extended by the Company.  The
    exercise price and the number of shares of common stock to be purchased upon
    the  exercise  of each  Series F Warrant are subject to increase or decrease
    upon the happening of certain corporate events, including but not limited to
    the payment of any stock dividend, stock split, stock combination or similar
    transactions.  The Series F Warrants may be called at the sole option of the
    Company  upon thirty days prior  written  notice to the  registered  holders
    thereof so long as the common  stock  trades  above  $18.00 per share for 20
    consecutive trading days ending not more than 10 days prior to the date that
    the notice of  redemption  is given.  Any such  redemption  shall be for all
    outstanding Series F Warrants. If the Company elects to redeem

                                      F-16

<PAGE>


                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 8.  CAPITAL STOCK (CONTINUED)

    the Series F  Warrants,  then the Warrant  holders  shall have the rights to
    exercise their Series F Warrants until the redemption  date, and thereafter,
    the holder shall only be entitled to receive the redemption price therefor.

   F)   1992 underwriters warrants

   The Company had outstanding underwriters' warrants relating to its 1992
   public offering ("the 1992 Underwriters Warrants"). Paradise Valley
   Securities, Inc. ("PVS"), the managing underwriter of the Company's January
   1992 public offering and designees of Chatfield Dean and Co., Inc., one of
   the underwriters of such offering, owned an aggregate of 33,333 1992
   Underwriters Warrants to purchase units of the Company's securities at an
   exercise price of $21.60 per unit. Each unit consisted of two shares of
   common stock and a warrant to purchase 1/2 of a share of common stock at an
   exercise price of $30 per share. The exercise price and the number of shares
   of common stock and warrants which can be purchased upon the exercise of the
   1992 Underwriters' Warrants were subject to increase or decrease upon the
   happening of certain events, and in the event that the Company issued shares
   of common stock at less than $9.00 per share. Issuances of securities
   subsequent to the date of issuance of the 1992 Underwriters Warrants reduced
   the exercise price of the units to approximately $15.07 per unit and
   increased the number of units available for purchase to approximately 47,777
   units. On January 9, 1997, all such warrants expired unexercised.

   G)   1991 public offering warrants

   In August 1993, PVS exercised an "Underwriter's Warrant" issued in connection
   with the Company's February 1991 public offering. The Underwriter's warrant
   entitled PVS to purchase 15,300 Units of the Company's securities. Each unit
   consisted of eight shares of common stock, $.005 par value, and two common
   stock purchase warrants, at an exercise price of $7.68 per Unit. In
   connection with the exercise of this Underwriter's Warrant, the Company
   issued 122,400 shares of its common stock and a warrant to purchase 30,600
   shares and received $117,504 from the Underwriter.

   On May 2, 1994, PVS exercised their warrant to purchase 30,600 shares of the
   Company's common stock. The exercise price of the warrant was $3.00 per
   share, representing an aggregate exercise price of $91,800. PVS paid the
   Company $45,225, which represents the difference between the aggregate
   exercise price and a credit of $46,575, which the Company granted to PVS in
   return for PVS agreeing to waive its right of first refusal contained in the
   underwriting agreement relating to the Company's 1992 public offering. In
   connection with this agreement, the Company and PVS executed mutual releases
   with respect to all matters arising under the 1992 underwriting agreement and
   with respect to the class action litigation.

   H)   Anti-takeover right

   Certain provisions of the Articles and Bylaws of the Company may be deemed to
   have an anti-takeover effect and may delay, defer or prevent a tender offer
   or takeover attempt, including an attempt that might result in a premium
   being bid over the market price for the shares held by shareholders. Several
   provisions may not be amended in the Company's Articles and Bylaws without
   the affirmative votes of the shareholders holding 80% of the outstanding
   shares of common stock.

   A supermajority (80%) vote of the shareholders is required to approve certain
   transactions with an entity of which 10% or more is beneficially owned by a
   10% or more shareholder of the company, unless such transaction is approved
   by a majority of the continuing directors.

   The Company has a classified Board of Directors divided into three classes
   serving staggered terms. At each annual meeting, approximately one-third of
   the director's terms of office expire for which elections are held. Directors
   may be removed from office only for cause and only by supermajority vote of
   the shareholders.

                                      F-17
<PAGE>

                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 8.  CAPITAL STOCK (CONTINUED)

   In addition, shareholder action must be effected at a duly called annual or
   special meeting of the shareholders and may not be effected by written
   consent. Special meetings are called by the Board of Directors pursuant to a
   resolution approved by a majority of the entire Board of Directors.

NOTE 9.  R&D LIMITED PARTNERSHIP

   In 1991, the Company, through its subsidiary RRGI, completed the funding of a
   research and development limited partnership (the "Partnership"). The
   Partnership received net proceeds of $1,035,000 from its partners to develop
   five generic prescription drugs ("Licensed Drugs"). The Partnership's funds
   were paid, in part, to the Company for its services in developing the
   Licensed Drugs and to obtain a one percent royalty interest in the gross
   revenue derived from the commercial sale of Piroxicam for a three-year
   period, with the remainder paid to third party vendors used in the
   development of the products. As remuneration for developing the Licensed
   Drugs, the Company received $40,000 and $52,000 in 1994 and 1993,
   respectively, from the Partnership. In return for funding the development of
   the Licensed Drugs, the Partnership receives a royalty of 10% of the net
   revenues generated by sales of the Licensed Drugs over a five-year period.

   As of February 14, 1997, the Company had received FDA approvals for all the
   Licensed Drugs and Piroxicam. During 1996 and 1995, the Company incurred
   royalty expenses of $225,000 and $69,000, respectively, related to the sales
   of the Licensed Drugs and Piroxicam.


NOTE 10.  COMMITMENTS AND CONTINGENCIES

   I.   Operating and capital leases

   The Company leases its 25,444 square foot production facility under an
   operating lease that expires on July 31, 2000 and has two five-year renewal
   options. Additionally, on January 1, 1997, the Company leased an additional
   10,228 square foot space contiguous to its existing premises. Annual rent,
   excluding taxes, insurance and common area maintenance, after taking
   possession of such additional space is approximately $151,000, subject to
   annual cost of living increases. Pursuant to the lease agreement, the Company
   also has an option throughout the term of the lease, including renewal
   periods, to purchase the entire building and an adjacent building of
   approximately 42,000 square feet at a specified price.

   The Company also leases under an operating lease another nearby 40,000 square
   foot facility which houses its administrative, sales and finance departments,
   warehouse operations and research and development laboratory. The lease is
   for a 10-1/2 year term, with two five-year renewal options. Annual rent,
   excluding taxes, insurance and common area maintenance totals approximately
   $195,000. The Company also has an option to purchase the leased facility
   during the sixth year of the lease at a specified price.

   Total rental expense for operating leases was $336,000, $322,000 and $176,000
   for 1996, 1995 and 1994, respectively. The terms of the operating leases for
   the Company's facilities require the Company to maintain minimum insurance
   coverage and to pay property taxes, repairs and maintenance.

   The company leases certain furniture, machinery and research and development
   equipment under capital leases. All capital leases have purchase options at
   the end o the original lease term. 

                                      F-18
<PAGE>

                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 10.  COMMITMENTS AND CONTINGENCIES (CONTINUED)


   Leased capital assets included in property and equipment were as follows (in
thousands):

                                                          DECEMBER 31,
                                                   --------------------------
                                                    1996                1995
                                                   ------             -------
     Machinery and equipment                       $  199             $     -
     Research and laboratory equipment                382                  38
     Furniture and equipment                           76                  63
                                                   ------             -------
                                                      657                 101
     Less accumulated depreciation                    (88)                (15)
                                                   ------             -------
                                                   $  569             $    86
                                                   ======             =======

   At December 31, 1996, future minimum lease payments under all non-cancelable
   operating and capital leases were as follows (in thousands):

                                              CAPITAL LEASES   OPERATING LEASES
                                              --------------   ----------------
          1997                                   $  184            $     304
          1998                                      165                  311
          1999                                      233                  317
          2000                                       --                  236
          2001                                       --                  173
          Thereafter                                 --                  577
                                                  -----            --------- 
          Total minimum lease payments              582            $   1,918
                                                                   =========
          Imputed interest                           89
                                                  -----
          Present value of minimum                     
             lease payments                       $ 493
                                                  =====

   II.  Other commitments

   A)   Purchase commitments

   Pursuant to a development agreement with a raw material supplier, the Company
   shall develop two products and purchase its raw material requirements for
   these products from the supplier. So long as the Company files ANDAs within a
   specified time period and thereafter satisfies certain purchase requirements,
   the supplier has agreed that the Company shall be its only customer for this
   raw material in the United States, Canada and Mexico. As of February 14,
   1997, the Company has received FDA approval for one of the products and has
   an ANDA pending for the other.

   B)   Product license agreement

   Pursuant to a perpetual license agreement with the formulator of a drug, the
   Company pays the formulator a sliding royalty with a maximum of 10% of net
   sales of this product for a ten-year period. In 1994, the Company paid the
   formulator certain fees ($70,000 in cash) when the Company received an
   acceptable bioequivalency study for this drug and charged such fees to
   expense. In 1995, the Company issued the formulator 10,695 shares in
   unregistered common stock upon the filing of an ANDA for this drug and
   accordingly charged $24,000 to expense. During 1996 and 1995, the royalty
   expense incurred for this product were $210,000 and $38,000, respectively.

                                      F-19
<PAGE>

                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 10.  COMMITMENTS AND CONTINGENCIES (CONTINUED)

   C)   Foreign distribution agreements

   On July 31, 1994 the Company entered into a license agreement with an
   Australian pharmaceutical manufacturer with respect to the licensing of one
   or more products developed by the Company. The license permits the Australian
   manufacturer to develop, manufacture and market the licensed products in the
   Pacific Rim markets, including Australia, New Zealand, Japan, Taiwan and Hong
   Kong (the "Territory").

   Although the Company and the Australian manufacturer have agreed on the first
   product to be licensed under the agreement, there can be no assurance that
   any other products will be licensed under such agreement. The Company is not
   obligated under such agreement to license any products to the Australian
   manufacturer other than the first product, and the Australian manufacturer is
   not obligated to accept and license any additional product from the Company.
   Under the agreement, the Company will receive a royalty from the Australian
   manufacturer with respect to any sales of the licensed products by such
   manufacturer in the Territory.

   In November 1994, the Company entered into a license agreement with a
   Canadian pharmaceutical company. Pursuant to the agreement, the Canadian
   company licensed the right to manufacture or purchase from the company at
   normal selling prices and distribute eight of the Company's products under
   its private label. Under the agreement, the Company will receive a royalty on
   the Canadian company's sales of the licensed products in Canada.

   III. Employment Contracts

   The Company has entered into employment contracts with certain officers, the
   most significant of which is with the Company's President. The President's
   contract, dated January 1, 1994, provides for an annual base salary, plus
   cost of living increases, plus a bonus equal to three percent of pre-tax
   income, the total not to exceed three times the President's base salary.
   Additionally, the President was granted options to purchase up to 250,000
   shares of common stock at a price of $6.75 per share. Such options become
   exercisable at the rate of 50,000 each January 1st, beginning January 1,
   1994. The agreement and these options expire December 31, 1998. The President
   has agreed not to compete with the Company for a period of eighteen months
   after termination of his employment.

   Upon the effective date of the Merger with Watson (see Note 1(II)), Patrick
   J. McEnany will execute a new three-year employment agreement with Watson and
   the Company whereby Mr. McEnany will remain as the President of Royce after
   the Merger and will also become a Vice President of Watson in charge of
   Corporate Development. The new employment agreement will replace the existing
   employment agreement between the Company and Mr. McEnany.

   Under the terms of the new employment agreement, Mr. McEnany will receive:
   (i) a base salary of $200,000 per annum (adjusted annually for increases in
   the cost of living); (ii) the right to receive a bonus of up to $150,000
   during the first year of the agreement by meeting certain targets, and
   discretionary bonuses in future years; (iii) customary benefits consistent
   with the other officers of Watson; (iv) an option (vesting over five years)
   to purchase 100,000 shares of Watson Common Stock at an exercise price equal
   to the last closing price of shares of Watson Common Stock on the effective
   date of the Merger.

   Each contract with the Company's other officers provides for a minimum base
   salary, bonuses and stock options, which generally vest over a three-year
   period. These contracts expire at various dates between 1995 and 1998.

   IV.  Contingencies

   In February 1993, the Securities and Exchange Commission (the "SEC")
   initiated a formal investigation into possible violations of the federal
   securities laws by the Company and certain of its officers and directors. The
   SEC's examination focused on the Company's public disclosure during the
   period between July 1991 and

                                      F-20
<PAGE>
                            ROYCE LABORATORIES, INC.
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 10.  COMMITMENTS AND CONTINGENCIES (CONTINUED)

   April 1992 regarding the status of the Company's abbreviated new drug
   applications ("ANDAs") for Piroxicam and Minoxidil and on sales of securities
   during this period by certain persons, including certain Company executive
   officers and/or directors.

   On May 2, 1996, the Company and Patrick J. McEnany, the Company's Chairman
   and Chief Executive Officer, entered into a settlement (the "Settlement")
   with the SEC resolving the SEC's formal investigation with respect to the
   Company and Mr. McEnany, without admitting or denying that a violation of the
   securities laws had occurred. As part of the Settlement, the Company and Mr.
   McEnany consented to the granting of a civil injunction requiring them to
   comply with the federal securities laws in the future. Further, in connection
   with the Settlement, Mr. McEnany paid a $25,000 administrative fine, which
   amount was reimbursed to Mr. McEnany by the Company under the indemnification
   provisions of the Company's Articles of Incorporation and By-Laws. The
   Company believes that the Settlement brings to a close the SEC's
   investigation of the Company and Mr. McEnany.

   In January 1994, the Company was served with a suit brought by one of its
   shareholders who opted out of the Company's settlement of the class action
   litigation settled during 1993. The suit, Dinesh Shah v. Royce Laboratories,
   Inc. and Chatfield Dean & Co., Inc., 94 CIV 0061 (S.D. N.Y.) which was also
   brought against one of the underwriters of the Company's January 1992 public
   offering, alleged that the Company's January 9, 1992 prospectus was false and
   misleading. In August 1996, the Company settled this matter for $25,000 in
   cash.

   On August 4, 1995, the Company was sued by Bristol-Myers Squibb Company, Inc.
   and E.R. Squibb & Sons, Inc. (collectively, "Bristol-Myers") in the Southern
   District of Florida with respect to Captopril (Case No. 95-1682-CIV-Davis).
   In July 1996, this suit was dismissed without any further liability to the
   Company.

   An agreement in which one of the Company's customers could earn options to
   purchase shares of the Company's common stock by meeting certain purchase
   targets expired during the second quarter of 1996. The Company believes, and
   has been so advised by its legal counsel, that based upon the terms and its
   interpretation of the written agreement, the customer did not satisfy the
   purchase requirement under the agreement and, thus, did not earn the options.
   Accordingly, the Company has not recorded any sales allowance relating to
   these options. Notwithstanding, the customer may disagree with this
   interpretation and no assurance can be given as to the ultimate outcome of
   any dispute with respect to this issue. The future resolution of this matter
   in a manner inconsistent with the Company's interpretation would result in a
   charge to earnings at the time of any such resolution.

   In the ordinary course of business, the Company is at times involved in other
   legal actions and proceedings. Presently, there are no such actions which are
   expected to have a significant effect on the Company's operations.

                                      F-21

<PAGE>
<TABLE>
<CAPTION>



                            ROYCE LABORATORIES, INC.

          SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
              FOR THE YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
                                 (IN THOUSANDS)


                                                   BALANCE AT     CHARGED TO        CHARGED TO                  BALANCE
                                                   BEGINNING      COSTS AND           OTHER                     AT END
CLASSIFICATION                                      OF YEAR       EXPENSES          ACCOUNTS     DEDUCTIONS     OF YEAR
--------------                                     -------       --------           --------      ----------    -------

YEAR ENDED DECEMBER 31, 1996
----------------------------

<S>                                               <C>              <C>                 <C>           <C>        <C>  
Allowance for Doubtful Accounts:                  $ 252            $  170           $   -          $   -        $   422

Allowance for Sales Returns and Incentives:       $ 657            $1,455           $   -          $ 657        $ 1,455


YEAR ENDED DECEMBER 31, 1995
----------------------------

Allowance for Doubtful Accounts:                  $  52            $ 200            $  -           $   -         $ 252

Allowance for Sales Returns and Incentives:       $ 333            $ 611            $  -           $ 287         $ 657


YEAR ENDED DECEMBER 31, 1994
----------------------------

Allowance for Doubtful Accounts:                  $  35            $  30            $  -           $  13         $  52

Allowance for Sales Returns and Incentives:       $  63            $ 333            $  -           $  63         $ 333
</TABLE>

                                      F-22

<PAGE>


          As required under Item 14, Exhibits, Financial Statement Schedules and
     Reports on Form 8-K, the exhibits filed as a part of this report are
     provided in this separate section. The exhibits included in this section
     are as follows:



          EXHIBIT
          NUMBER         DESCRIPTION
          -------        -----------

          11.0           Schedule of Computation of Earnings (Loss) per Common
                         and Common Stock Equivalent Share.

          23.0           Consent of Price Waterhouse LLP.

          27.0           Financial Data Schedule.