<PAGE>
 
================================================================================




                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549



                                 FORM 10-Q



( X )  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934



               For the quarterly period ended September 30, 1998



                                      OR



(   )  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934



      For the transition period from ________________ to ________________



                        Commission File Number 0-18217



                           TRANSCEND SERVICES, INC.
            (Exact name of registrant as specified in its charter)



          DELAWARE                             33-0378756

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



        3353 PEACHTREE ROAD, N.E., SUITE 1000, ATLANTA, GEORGIA  30326
             (Address of principal executive offices and zip code)
      Registrant's telephone number, including area code: (404) 364-8000



     Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes   X    No 
                                               -----     -----     



     Indicate the number of shares outstanding of the Registrant's common stock
as of the latest practicable date.



          Class                              Outstanding at November 12, 1998
          -----                              --------------------------------

Common Stock, $.01 par value                            21,516,000

================================================================================
<PAGE>
 
                                 INDEX


<TABLE> 
<CAPTION> 
                                                                            PAGE
                                                                            ----

<S>         <C>                                                          <C>
PART  I.    FINANCIAL INFORMATION



Item 1.     Financial Statements


            Consolidated Balance Sheets as of
            September 30, 1998 and December 31, 1997......................   3

            Consolidated Statements of Operations for the
            Three Months and Nine Months Ended
            September 30, 1998 and 1997...................................   4

            Consolidated Statements of Cash Flows for the
            Nine Months Ended September 30, 1998 and 1997.................   5

            Notes to Consolidated Financial Statements....................   6



Item 2.     Management's Discussion and Analysis of
            Financial Condition and Results of Operations.................   7


PART II.   OTHER INFORMATION

Item 1.    Legal Proceedings..............................................  14

Item 5.    Other Information..............................................  15

Item 6.    Exhibits and Reports on Form 8-K...............................  15

SIGNATURES................................................................  16
</TABLE> 

                                       2
<PAGE>
 
PART I.    FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

                           TRANSCEND SERVICES, INC.
                          CONSOLIDATED BALANCE SHEETS
                                  (UNAUDITED)
<TABLE>
<CAPTION>
                                                       SEPTEMBER 30,   DECEMBER 31,
                                                           1998           1997
                                                       -------------   ------------
<S>                                                    <C>             <C>
                    ASSETS
                    ------
Current assets:
 Cash and cash equivalents...........................      $ 1,838,000   $ 5,541,000
 Accounts receivable, net of allowance for doubtful
  accounts of $158,000 at September 30, 1998 and
  $163,000 at December 31, 1997......................        8,404,000     4,965,000
 Prepaid expenses and other current assets...........        1,372,000       979,000
                                                           -----------   -----------
Total current assets.................................       11,614,000    11,485,000
                                                           -----------   -----------
Property and equipment:
 Property and equipment..............................       10,511,000     6,699,000
 Accumulated depreciation............................       (3,828,000)   (3,277,000)
                                                           -----------   -----------
Property and equipment, net..........................        6,683,000     3,422,000

Deposits and other assets............................          795,000       510,000
Investment...........................................        1,259,000            --
Goodwill and other intangible assets, net............        1,547,000     2,587,000
Net assets from discontinued operations..............        2,702,000     2,646,000
                                                           -----------   -----------
Total assets.........................................      $24,600,000   $20,650,000
                                                           ===========   ===========

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

Current liabilities:
  Current maturities of long term debt..................  $    355,000  $    108,000
  Accounts payable......................................     2,775,000       843,000
  Accrued compensation and benefits.....................     2,281,000     2,399,000
  Other accrued liabilities.............................     2,848,000     1,751,000
  Deferred income taxes.................................       113,000       113,000
                                                          ------------  ------------
Total current liabilities...............................     8,372,000     5,214,000
                                                          ------------  ------------

Long term debt, net of current maturities...............     5,515,000     4,983,000

Deferred income taxes...................................       540,000       540,000

Convertible debentures..................................     2,000,000     2,000,000

Commitments and contingencies

Stockholders' equity:
  Preferred stock, $.01 par value; 21,000,000 shares
      authorized Series A convertible preferred stock,
      212,800 shares issued at September 30, 1998 and
      December 31, 1997.................................         2,000         2,000
  Common stock, $.01 par value, 30,000,000 shares
      authorized, 21,516,000 shares and 20,500,000
      shares issued at September 30, 1998 and
      December 31, 1997 respectively....................       216,000       205,000
  Additional paid-in capital............................    26,210,000    26,208,000

  Retained deficit......................................   (18,255,000)  (18,502,000)
                                                          ------------  ------------
 Total stockholders' equity.............................     8,173,000     7,913,000
                                                          ------------  ------------
 Total liabilities and stockholders' equity.............  $ 24,600,000  $ 20,650,000
                                                          ============  ============
-------------------
</TABLE>
  The accompanying notes are an integral part of these consolidated balance
sheets.

                                       3
<PAGE>
 
                           TRANSCEND SERVICES, INC.
                                        
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (UNAUDITED)
<TABLE>
<CAPTION>
                                                                 THREE MONTHS                NINE MONTHS
                                                              ENDED SEPTEMBER 30,         ENDED SEPTEMBER 30,
                                                           -------------------------   -------------------------
                                                              1998          1997          1998          1997
                                                           -----------   -----------   -----------   -----------
<S>                                                        <C>           <C>           <C>           <C>
Net revenues.............................................. $14,030,000   $10,844,000   $39,235,000   $31,949,000
Direct costs..............................................  11,685,000     9,157,000    32,627,000    27,133,000
                                                           -----------   -----------   -----------   -----------
   Gross profit...........................................   2,345,000     1,687,000     6,608,000     4,816,000
Marketing and sales expenses..............................     585,000       543,000     1,566,000     1,462,000
General and administrative expenses.......................   1,187,000     1,411,000     3,352,000     3,703,000
Amortization expenses.....................................      45,000       110,000       167,000       343,000
Research and development expenses.........................     105,000            --       134,000            --
                                                           -----------   -----------   -----------   -----------
 Income (loss)  from operations...........................     423,000      (377,000)    1,389,000      (692,000)

Other income (expense):
   Interest expense, net..................................    (170,000)     (110,000)     (375,000)     (323,000)
   Other..................................................          --            --       (60,000)           --
                                                           -----------   -----------   -----------   -----------
                                                              (170,000)     (110,000)     (435,000)     (323,000)

Income (loss) before taxes and discontinued operations....     253,000      (487,000)      954,000    (1,015,000)
Income taxes..............................................          --            --            --            --
                                                           -----------   -----------   -----------   -----------
Income (loss) before discontinued operations..............     253,000      (487,000)      954,000    (1,015,000)
Loss from discontinued operations.........................     (22,000)      (15,000)      (54,000)     (124,000)
                                                            ----------   -----------   -----------   -----------
Net income (loss)......................................... $   231,000   $  (502,000)  $   900,000   $(1,139,000)
                                                           ===========   ===========   ===========   ===========

Dividends on preferred stock..............................    (120,000)           --      (359,000)           --

Net income (loss) to common stockholders.................. $   111,000   $  (502,000)  $   541,000   $(1,139,000)
                                                           ===========   ===========   ===========   ===========
Basic income (loss) per share:
  From continuing operations..............................     $  0.01        $(0.02)       $ 0.03        $(0.05)
  From discontinued operations............................     $ (0.00)       $(0.00)       $(0.00)       $(0.01)
                                                           -----------   -----------   -----------   -----------
Net income (loss).........................................     $  0.01        $(0.02)       $(0.03)       $(0.06)
                                                           ===========   ===========   ===========   ===========

Weighted average common shares outstanding................  21,514,000    20,442,000    20,882,000    20,219,000
                                                           ===========   ===========   ===========   ===========
Diluted income (loss) per share:
  From continuing operations..............................     $  0.01        $(0.02)       $ 0.03        $(0.05)
  From discontinued operations............................     $ (0.00)       $(0.00)       $(0.00)       $(0.01)
                                                           -----------   -----------   -----------   -----------
Net income (loss).........................................     $  0.01        $(0.02)       $ 0.03        $(0.06)
                                                           ===========   ===========   ===========   ===========
Weighted average common shares outstanding................  21,643,000    20,442,000    20,978,000    20,219,000
                                                           ===========   ===========   ===========   ===========
</TABLE> 
--------------------
The accompanying notes are an integral part of these consolidated statements.

                                       4
<PAGE>
 
                            TRANSCEND SERVICES, INC.
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (UNAUDITED)
<TABLE>
<CAPTION>
                                                                                                   NINE MONTHS
                                                                                                ENDED SEPTEMBER 30,
                                                                                            --------------------------
                                                                                                1998          1997
                                                                                                ----          ----
<S>                                                                                         <C>            <C>
Cash flows from operating activities:
Net income (loss).....................................................................      $   541,000    $(1,139,000)
Adjustments to reconcile net income (loss) to net cash used in operating activities:   
   Depreciation and amortization......................................................        1,254,000      1,220,000
   Loss related to discontinued operations............................................           54,000        124,000
Changes in assets and liabilities:                                                     
   Accounts receivable, net...........................................................       (3,375,000)      (706,000)
   Prepaid expenses and other current assets..........................................         (402,000)      (192,000)
   Deposits and other assets..........................................................         (286,000)      (373,000)
   Accounts payable...................................................................        1,839,000        430,000
   Accrued liabilities................................................................          384,000         26,000
                                                                                            -----------    -----------
Total adjustments.....................................................................         (532,000)       529,000
                                                                                            -----------    -----------
Net cash provided by (used in) continuing operations..................................            9,000       (610,000)
Net cash used in discontinued operations..............................................         (111,000)      (154,000)
                                                                                            -----------    -----------
Net cash provided by (used in) operating activities...................................         (102,000)      (764,000)
                                                                                            -----------    -----------
Cash flows from investing activities:                                                    
   Capital expenditures...............................................................       (4,327,000)    (1,631,000)
   Cash acquired from acquisitions....................................................           31,000             -- 
   Distribution to former stockholder/owners..........................................               --       (282,000)
                                                                                            -----------    -----------
Net cash used in investing activities.................................................       (4,296,000)    (1,913,000)
                                                                                            -----------    -----------
Cash flows from financing activities:                                                                                 
   Borrowings under line of credit agreements.........................................          (60,000)     1,756,000 
   Borrowings from long term debt.....................................................          917,000        189,000
   Principal payments long-term debt..................................................         (188,000)      (262,000)
   Proceeds from  stock options and other issuances...................................           26,000        723,000
                                                                                            -----------    -----------
Net cash provided by financing activities.............................................          695,000      2,406,000
                                                                                            -----------    -----------
                                                                                                                      
Net change in cash and cash equivalents...............................................       (3,703,000)      (271,000)
Cash and cash equivalents, at beginning of period.....................................        5,541,000      1,663,000
                                                                                            -----------    -----------
Cash and cash equivalents, at end of period...........................................      $ 1,838,000    $ 1,392,000
                                                                                            ===========    ===========     
Supplemental cash flow information:

Cash paid for interest expense........................................................      $   439,000    $   377,000
</TABLE>

---------------------------

 The accompanying notes are an integral part of these consolidated statements.

                                       5
<PAGE>
 
                           TRANSCEND SERVICES, INC.
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                          SEPTEMBER 30, 1998 AND 1997

                                  (UNAUDITED)
                                        



(1) The accompanying consolidated financial statements are unaudited and have
been prepared by management of Transcend Services, Inc. ("The Company") in
accordance with the rules and regulations of the Securities and Exchange
Commission.  The unaudited financial information furnished herein in the opinion
of management reflects all adjustments which are necessary to fairly state the
Company's financial position, the results of its operations and its cash flows.
For further information refer to the consolidated financial statements and
footnotes thereto included in the Company's Form 10-K for the year ended
December 31, 1997.  Footnote disclosure which would substantially duplicate the
disclosure contained in those documents has been omitted.


(2) In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
"Reporting Comprehensive Income," which establishes standards for reporting and
display of comprehensive income that includes all changes in equity during a
period from transactions and events from nonowner sources. The Company has no
components of comprehensive income other than net income for the nine month
periods ended September 30, 1998 and 1997.


   In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information" which
establishes accounting standards for reporting information about operating
segments in annual financial statements.   SFAS No. 131 is effective for fiscal
years beginning after December 15, 1997 and has not yet been adopted by the
Company.


(3)   In March 1998, the Company completed the sale of the net assets of its
wholly owned subsidiary, Transcend Case Management, Inc. ("TCM") to CORE, Inc
("CORE").  Transcend will receive CORE stock with the value based on the future
annual revenues from CORE's operation of TCM as of a date to be determined at
the Company's discretion between April 1, 1999 and February 28, 2001.  The
carrying amount of the Company's future interest in CORE is recorded on the
balance sheet based on the net book value of TCM on March 16, 1998.

(4)   On June 1, 1998, the Company acquired 100% of the capital stock of  Health
Care Information Systems, Inc. ("HCIS") for 920,000 shares of unregistered
common stock of the Company.  The consolidated financial statements reflect the
acquisition of  HCIS under the pooling of interests method of accounting,
however, the financial statements were not restated for the pre-acquisition
results of HCIS, as the amounts are immaterial.

                                       6
<PAGE>
 
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS


  Certain information included in this Quarterly Report on Form 10-Q contains,
and other reports or materials filed or to be filed by the Company with the
Securities and Exchange Commission (as well as information included in oral
statements or other written statements made or to be made by the Company or its
management) contain or will contain, "forward-looking statements" within the
meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
Section 27A of the Securities Act of 1933, as amended and pursuant to the
Private Securities Litigation Reform Act of 1995.  Such forward-looking
statements may relate to financial results and plans for future business
activities, and are thus prospective.  Such forward-looking statements are
subject to risks, uncertainties and other factors which could cause actual
results to differ materially from future results expressed or implied by such
forward-looking statements.  Potential risks and uncertainties include, but are
not limited to, general economic conditions, competition and other uncertainties
detailed in this report and detailed from time to time in other filings by the
Company with the Securities and Exchange Commission (as well as information
included in oral statements or other written statements made or to be made by
the Company or its management).  Any forward-looking statements are made
pursuant to the Private Securities Litigation Reform Act of 1995 and, as such
speak only as of the date made.


OVERVIEW
--------



  Transcend Services, Inc.  ("Transcend" or the "Company") provides healthcare
information management ("HIM") solutions to hospitals and other associated
healthcare providers. The Company's range of HIM services includes (i) contract
management, or "Co-Sourcing", of medical records and other HIM functions; (ii)
transcription of physicians' dictated medical notes; (iii) consulting services
relating to medical records and reimbursement coding; and (iv) software
solutions for the collection, abstraction, effective medical coding and
reporting of clinical data. The Company currently operates the medical records
and certain other HIM functions of 20 general acute care hospitals located in 12
states and the District of Columbia.


RESULTS OF OPERATIONS


  Results of operations include the results from Transcend Case Management
("TCM") during 1997.  TCM was sold in March 1998 and therefore affects the
comparability of 1998 results to 1997.  On June 1, 1998, the Company acquired
100% of the capital stock of Health Care Information Systems, Inc. and formed a
wholly owned subsidiary of the Company hereinafter referred to as "Cascade".
Cascade provides information management software and related services to
approximately 65 hospitals concentrated in eight western states.  Cascade has
recently released a new set of Windows based products, a state of the art set of
tools for the management and reporting of health care information.  Transcend
plans to implement these tools in each of its hospitals and will utilize them in
its Information Delivery Center ("IDC") operations.  The IDC will provide for 
the off-site medical coding from electronic records over a private network.

                                       7
<PAGE>
 
THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 1997



  Net revenues for the Company increased to $14,030,000 for the three months
ended September 30, 1998 from $10,844,000 for the three months ended September
30, 1997, an increase of 29.4%.  The increase in net revenues results from new
sales and the acquisition of Cascade in June, 1998.

  Excluding TCM, net revenues for the Company increased from $10,402,000 for the
three months ended September 30, 1997 to $14,030,000 for the three months ended
September 30, 1998, an increase of 34.9%.

  Gross profit increased 39.0% to $2,345,000 for the three months ended
September 30, 1998 from $1,687,000 in the same prior year period. The increase
in gross profit was attributable to the increase in net revenues from new sales
and improvements in gross profit margins from existing contracts. Gross profit
margins (as a percentage of net revenues) expanded to 16.7% for the three months
ended September 30, 1998 from 15.6% for the three months ended September 30,
1997 period.


  Excluding TCM, gross profits were $2,345,000 for the quarter ended September
30, 1998, an increase of 42.4% over the same prior year period in 1997.  Gross
margins, excluding TCM, were 16.7% for the three months ended September 30, 1998
compared to 15.8% for the same prior year period.


  Marketing and sales expenses increased to $585,000 for the three months ended
September 30, 1998 from $543,000 in the same prior year period but decreased as
a percentage of net revenues to 4.2%.  The decrease is due to the sale of TCM in
March 1998.  Excluding TCM, marketing and sales expenses increased $165,000 or
39.3% reflecting the acquisition of Cascade on June 1, 1998 and the hiring of
five new sales executives.


  General and administrative expenses decreased 15.9% to $1,187,000 for the
three months ended September 30, 1998, from the $1,411,000 incurred in the same
prior year period. General and administrative expenses decreased as a percentage
of net revenues to 8.5% for the three months ended September 30, 1998 from 13.0%
for the prior year quarter.  This decrease is also attributable to the sale of
TCM in March.

  Research and development expenses increased to $105,000 for the three months
ended September 30, 1998 due to the acquisition of Cascade.

  Amortization expenses decreased to $45,000 for the three months ended
September 30, 1998 from $110,000 for the three months ended September 30, 1997,
reflecting the impact of the 1993 acquisition of dataLogix, Inc. being fully
amortized and the write down of intangible assets related to TCM in December
1997  and its sale in March 1998.

  The Company's income from operations increased to $423,000 for the three
months ended September 30, 1998 from a loss of $377,000 for the same prior year
period due to increased gross profits from revenue growth and from the sale of
TCM which produced an operating loss of $276,000 in 1997.


  Other expense, net increased to $170,000 for the three months ended September
30, 1998 as compared to $110,000 for the same prior year period, primarily due
to the impact of interest expense incurred in connection with the Company's
increased borrowings and loan fees associated with the credit facility.

   The Company's income before discontinued operations increased to $253,000 for
the three months ended September 30, 1998 from a loss of $487,000 for the three
months ended September 30, 1997.

                                       8
<PAGE>
 
  The Company's loss from discontinued operations increased to $22,000 from
$15,000 for the three months ended September 30, 1998 and September 30, 1997,
respectively, representing legal expenses incurred in connection with the
Lawsuit (hereinafter defined).  See Part II, Item 1.  Legal Proceedings.

  The following charts reflect the results of operations for the three months
ended September 30, 1998 and 1997 excluding TCM, which was sold by the Company
in March 1998.

<TABLE>
<CAPTION>
                                                 THREE MONTHS ENDED SEPTEMBER 30
--------------------------------------------------------------------------------------------------------------------------------
                                             1998         1997        CHANGE     % CHANGE
--------------------------------------------------------------------------------------------------------------------------------
<S>                                        <C>          <C>           <C>          <C>
Net revenues                               $14,030      $10,402       $3,628       34.9%
--------------------------------------------------------------------------------------------------------------------------------
Gross profit                                 2,345        1,647          698       42.4%
--------------------------------------------------------------------------------------------------------------------------------
Gross margin                                  16.7%        15.8%          --         .9%
--------------------------------------------------------------------------------------------------------------------------------
Marketing and sales expenses                   585          420          165       39.3%
--------------------------------------------------------------------------------------------------------------------------------
General and administrative expenses          1,187        1,257          (70)      (5.6%)
--------------------------------------------------------------------------------------------------------------------------------
Amortization expenses                           45           71          (26)     (36.6%)
--------------------------------------------------------------------------------------------------------------------------------
Research and development expenses              105           --          105        N/A
--------------------------------------------------------------------------------------------------------------------------------
Income (loss) from operations                  423         (101)         524      518.8%
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>

<TABLE>
<CAPTION>
                                                 THREE MONTHS ENDED SEPTEMBER 30
--------------------------------------------------------------------------------------------------------------------------------
                                            1998                1997               CHANGE
--------------------------------------------------------------------------------------------------------------------------------
<S>                                        <C>                <C>                   <C>
Net revenues                               100.0%              100.0%                -- 
--------------------------------------------------------------------------------------------------------------------------------
Direct costs                                83.3%               84.2%               (.9%)
--------------------------------------------------------------------------------------------------------------------------------
Gross profit                                16.7%               15.8%                .9%
--------------------------------------------------------------------------------------------------------------------------------
Marketing and sales expenses                 4.2%                4.0%               0.2%
--------------------------------------------------------------------------------------------------------------------------------
General and administrative expenses          8.5%               12.1%              (3.6%)
--------------------------------------------------------------------------------------------------------------------------------
Research and development                     0.7%                 --                0.7%
--------------------------------------------------------------------------------------------------------------------------------
Amortization expense                         0.3%                0.7%              (0.4%)
--------------------------------------------------------------------------------------------------------------------------------
Income  (loss) from operations               3.0%               (1.0%)              4.0%
--------------------------------------------------------------------------------------------------------------------------------
</TABLE>

                                       9
<PAGE>
 
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
1997

  Net revenues increased to $39,235,000 for the nine months ended September
30,1998 from $31,949,000 for the nine months ended September 30,1997, an
increase of 22.8%.  The increase in net revenues results from new sales and the
acquisition of Cascade.
 

  Gross profit increased to $6,608,000 for the nine month period ended September
30, 1998 from $4,816,000 in the same prior year period. The increase in gross
profit was attributable to the increase in net revenues, improvements in gross
profit margins from existing contracts and the addition of Cascade which yields
significant higher profit margins than the other service lines of business.
Gross profit as a percentage of net revenues increased to 16.8% for the nine
months ended September 30, 1998 from 15.1% in the same prior year period.


  Marketing and sales expenses increased 7.1% to $1,566,000 in the nine month
period ended September 30,1998 from $1,462,000 in the same prior year period but
decreased as a percentage of net revenues to 4.0% for the nine month period
ended September 30, 1998 from 4.6% for the nine month period ended September 30,
1997.

  General and administrative expenses decreased 9.5% to $3,352,000 for the nine
months ended September 30, 1998 from the $3,703,000 incurred in the same prior
year period.   General and administrative expenses decreased as a percentage of
net revenues to 8.5% for the nine months ended September 30, 1998 from 11.6% in
the same prior year period.

  Research and development expenses increased to $134,000 for the nine months
ended September 30, 1998 as a result of the acquisition of Cascade.

  Amortization expenses decreased to $167,000 for the nine months ended
September 30, 1998 from $343,000 for the nine months ended September 30, 1997,
reflecting the impact of the 1993 acquisition of dataLogix, Inc. being fully
amortized and the write down of intangible assets related to TCM in December
1997 and its sale in March 1998.

  The Company's income from operations increased to $1,389,000 for the nine
months ended September 30, 1998, a $2,081,000 improvement from a loss of
$692,000 in the same prior year period.


   Other expenses, net increased to $435,000 for the nine months ended September
30,1998 as compared to $323,000 for the nine months ended September 30, 1997,
primarily due to legal expenses incurred in connection with the acquisition of
Cascade and the impact of interest expense incurred in connection with the
Company's increased borrowings associated with the credit facility.

  The Company's income before discontinued operations increased to $954,000 for
the nine months ended September 30, 1998 from a loss of $1,015,000 for the nine
months ended September 30, 1997.  This improvement is due to the increase in
gross profit for existing customers, new business and the sale of TCM in March,
1998.

  The Company's loss from discontinued operations of $54,000 and $124,000 for
the nine months ended September 30, 1998 and September 30, 1997, respectively,
is due to legal expenses incurred in connection with the Lawsuit (hereinafter
defined).   See Part II, Item 1.  Legal Proceedings.

                                       10
<PAGE>
 
  The following charts reflect the results of operations for the nine months
ended September 30, 1998 and 1997 excluding TCM, which was sold by the Company
in March 1998.



<TABLE>
<CAPTION>
                                                    NINE MONTHS ENDED SEPTEMBER 30
---------------------------------------------------------------------------------------------------
                                                   1998      1997    CHANGE    % CHANGE
---------------------------------------------------------------------------------------------------
<S>                                                <C>      <C>      <C>       <C>
Net revenues                                       $38,889  $30,530  $8,359    27.4% 
---------------------------------------------------------------------------------------------------
Gross profit                                         6,525    4,660   1,865    40.0% 
---------------------------------------------------------------------------------------------------
Gross margin                                          16.8%    15.3%     --     1.5%
---------------------------------------------------------------------------------------------------
Marketing and sales expense                          1,507    1,061     446    42.0%
---------------------------------------------------------------------------------------------------
General and administrative expense                   3,352    3,267      85     2.6%
---------------------------------------------------------------------------------------------------
Amortization expense                                   167      304    (137)  (45.1%)
---------------------------------------------------------------------------------------------------
Research and development expense                       134       --     134      --
---------------------------------------------------------------------------------------------------
Income from operations                               1,365       28   1,337 4,775.0%
---------------------------------------------------------------------------------------------------
</TABLE> 
 
<TABLE>
<CAPTION>
                                                      NINE MONTHS ENDED SEPTEMBER 30
---------------------------------------------------------------------------------------------------
                                                       1998        1997      CHANGE
---------------------------------------------------------------------------------------------------
<S>                                                   <C>         <C>         <C>
Net revenue                                           100.0%      100.0%
---------------------------------------------------------------------------------------------------
Direct costs                                           83.2%       84.7%       (1.5%)
---------------------------------------------------------------------------------------------------
Gross profit                                           16.8%       15.3%        1.5%
---------------------------------------------------------------------------------------------------
Marketing and sales expense                             3.9%        3.5%        0.4%
---------------------------------------------------------------------------------------------------
General and administrative expenses                     8.6%       10.7%       (2.1%)
---------------------------------------------------------------------------------------------------
Research and development                                0.4%         --         0.4%
---------------------------------------------------------------------------------------------------
Amortization expenses                                   0.4%        1.0%       (0.6%)
---------------------------------------------------------------------------------------------------
Income from operations                                  3.5%        0.1%        3.4%
---------------------------------------------------------------------------------------------------
</TABLE>

                                       11
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES


   For the nine months ended September 30, 1998, continuing operations provided
$409,000 of cash. Cash has been used to fund the investment in capital assets
and to fund changes in the Company's assets and liabilities.   See also Part I,
Item 1. Financial Statements.  Consolidated Statements of Cash Flows.

  For the nine months ended September 30, 1998, the Company's principal use of
cash of $4,296,000 for investing purposes was for capital expenditures in
association with the implementation of dictation, transcription, and electronic
document management systems to support new contracts and for the development and
deployment of its new transcription system, T2K, (see year 2000 compliance), and
IDC solutions.

  For the nine months ended September 30, 1998, financing activities provided
cash of $695,000 due to the proceeds received from the credit facility with DVI
Financial Services, Inc. for the financing of electronic medical record systems.

  The Company had net working capital of $3,242,000 at September 30, 1998,
compared to $6,271,000 at December 31, 1997.  The decrease in working capital of
$3,429,000 is primarily attributable to capital expenditures.

  The Company has a $5.0 million  revolving credit agreement with Coast Business
Credit ("Coast"), an asset based lender (and a division of Southern Pacific
Thrift and Loan Association) which matures May 31, 2000.  The agreement provides
the Company with a $4.7 million working capital facility and a $300,000 capital
expenditure facility secured by substantially all of the Company's assets.  The
Coast facilities do not contain any financial covenants but contain restrictions
from paying dividends and entering into financing arrangements without consent.
As of September 30, 1998 the capacity of the credit line based on the funding
formula was $5.0 million.

  These facilities bear interest at prime plus 2.25% declining to prime plus
1.75% upon two consecutive quarters of achievement and ongoing maintenance of a
debt service coverage ratio of not less than 1.5 measured on an earnings before
interest, taxes, and amortization (EBITDA) basis minus the unfinanced portion of
capital expenditures.  EBITDA is used by Coast as an indicator of a company's
ability to incur and service debt.  EBITDA should not be considered an
alternative to operating income, net income, cashflows, or any other measure of
performance as determined in accordance with generally accepted accounting
principles, as an indicator of operating performance, or as a measure of
liquidity.  These facilities are secured by a first security interest on all
Company assets.

   On February 19, 1998, the Company signed a master lease agreement
providing up to $5.0 million in lease financing with Information Leasing
Corporation, a subsidiary of Provident Bank, Cincinnati, Ohio at interest rates
equal to Provident Bank prime rate plus two percent.  Subject to a review of the
underlying customer contract, the master lease agreement calls for equal monthly
payments over the term of the lease, typically the life of the underlying
contract, not to exceed five years.  The facility is intended to provide
financing for new electronic document management systems and transcription
systems required for new contracts.  There were no borrowings outstanding as of
September 30, 1998.

                                       12
<PAGE>
 
  On April 13, 1998 the Company signed a new $10.0 million equipment loan
facility with DVI  Financial Services Inc.  This facility provides additional
financing for electronic document management systems and transcription systems
required for new contracts.  The master loan agreement calls for monthly
payments which fully amortize the cost of the equipment over the life of the
customer contract, not to exceed 60 months, at a current interest rate of 10.2%.
The total borrowings outstanding at September 30, 1998 was approximately
$500,000.

  The Company anticipates that cash on hand, together with internally generated
funds, expected reductions in accounts receivable and cash available under its
credit facilities will be sufficient to finance continuing operations, make
capital investments in the normal and ordinary course of its business, and fund
the out-of-pocket expenses and certain legal fees of its civil litigation action
against certain insurance carriers for the next year. Additional capital
resources will be required to fund year 2000 compliance and T2k investments (see
below). The Company is working to procure such additional capital resources over
the next six months.


YEAR 2000 COMPLIANCE


  The Company has performed an assessment on the year 2000 readiness of its
operations and the corporate financial systems and has begun to implement its
plan to become year 2000 compliant.

  The Company is currently in the process of converting or upgrading its
transcription systems to become year 2000 compliant.  The Company expects to
invest $1.5 million in new year 2000 compliant dictation and transcription
systems over the next 15 months.

  In July 1998, the first of the Company's transcription operations went live on
the Company's new national transcription platform, Transcription 2000, or "T2K".
The Company plans to install T2K to service substantially all of the Company's
new contracts and is assessing a plan to convert its existing operations to T2K.
T2K utilizes Windows NT and allows for the digital movement of dictated voice
files significantly reducing the cost of remote processing.
 
   The Company's Co-Sourcing operations and software systems are dependant upon
the hospital's systems. The Company is in the process in making written
inquiries to its existing customers to determine  their readiness and their
plans to become year 2000 compliant. The majority of the Company's Co-Sourcing
contracts require that the hospital provide certain services, including access
to electronic information,  in order for Transcend to provide the services that
the Company is contractually obligated to supply.  If such services are not
provided by the hospital, the Company has the contractual ability to receive
reimbursement from the hospital for any additional expenses incurred due to the
inability of the hospital to provide a functional software system.

  Cascade's new software product is year 2000 compliant.  The software for
existing customers has been modified to be year 2000 compliant.  Cascade plans
to upgrade or convert all of its customers to be year 2000 compliant by October
1998.  The cost to be incurred for the upgrade is immaterial.

  The Company plans to upgrade its corporate financial systems by the end of
1998 to be year 2000 compliant.  The cost to be incurred for the upgrade is
estimated at $50,000.

                                       13
<PAGE>
 
PART II.    OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS


  The Company is subject to certain claims in the ordinary course of business
which are not material.

  On September 17, 1993, the Company and its former subsidiaries, First Western
Health Corporation and Veritas Healthcare Management, and the physician-owned
medical groups, FWHC Medical Group, Inc. and Veritas Medical Group, Inc., which
had contracts with the healthcare subsidiaries, initiated a lawsuit in the
Superior Court of the State of California, County of Los Angeles, against 22 of
the largest California workers' compensation insurance carriers (the "Lawsuit".)
The Lawsuit was subsequently amended to name 13 defendant insurance groups
including State Compensation Insurance Fund, Continental Casualty Company,
California Compensation Insurance Company, Zenith National Insurance Corporation
and Pacific Rim Assurance Company. The action seeks $115 million in compensatory
damages plus punitive damages. The plaintiffs claim abuse of process,
intentional interference with contractual and prospective business relations,
negligent interference and unlawful or unfair business practices which led to
the discontinuation in April 1993 of the former business of the Company's
subsidiaries and their contracting associated medical groups.  Nine defendants
in the Lawsuit have filed cross complaints against the plaintiffs seeking
restitution, accounting from the plaintiffs for monies previously paid by the
defendants, disgorgement of profits, injunctive relief, attorneys' fees and
punitive damages, based upon allegations of illegal corporate practice of
medicine, illegal referral arrangements, specific statutory violations and
related improper conduct.  The Company and its counsel do not believe that it is
likely that the Company will be held liable on any of the cross complaints;
however, there can be no assurance that the Company will be successful in the
defense of the cross complaints. In addition, there can be no assurance as to
the recovery by the Company of the damages sought in its complaint against the
defendants.

  On March 21, 1997, the Los Angeles County Superior Court sustained the
defendant insurance companies' demurrer to the Third Amended and Supplemental
Complaint of the Company and certain of its subsidiaries, without leave to
further amend the complaint.  The Court determined in such ruling that exclusive
jurisdiction with respect to the claims contained in the Lawsuit resides with
the California Workers' Compensation Appeals Board and that the Superior Court
of the State of California is an improper forum.  The Company has been advised
by counsel that there is no remedy for the damages claimed in the Lawsuit from
the California Workers' Compensation Appeals Board.  A final order dismissing
the Lawsuit was issued by the Court on June 18, 1997.  The Company appealed the
ruling in the California Court of Appeals on June 25, 1997.

  On June 25, 1998 the California Court of Appeals affirmed the Superior Court
of the State of California's decision dismissing its lawsuit against 22 of the
largest California worker's compensation insurance carriers.  The lawsuit had
sought damages for abuse of process, intentional interference with contractual
and prospective business relationships, negligent interference and unlawful or
unfair business practices which led to the discontinuation in April 1993 of the
former business of the Company's subsidiaries and their contracting associated
medical groups.  The Superior Court of  the State of California had dismissed
the lawsuit in June 1997 holding that exclusive jurisdiction of these claims
reside with the California Workers' Compensation Appeals Board.  Notwithstanding
the Court of Appeals ruling, the Company continues to believe the lawsuit should

                                       14
<PAGE>
 
be heard in the Superior Court and the Company filed Petition for Review with
the California Supreme Court on July 28, 1998.

  On October 2, 1998, the Supreme Court of the State of California agreed to
review the decision of the California Court of Appeals affirming the Superior
Court of the State of California's dismissal of the lawsuit.

  For the nine months ended September 30, 1998, the Company expensed
approximately $54,000 of legal expenses connected with the Lawsuit.   Under the
original agreement with the Company's counsel of record in the Lawsuit, there
was a cap on legal expenses and after December 1996, with respect to expenses
incurred at the trial court level, the Company would only be responsible for
out-of-pocket expenses and the payment to counsel of a percentage of any
recovery of damages by the Company.  However, in May 1997, the Company was
notified that the partner principally responsible for the case was leaving the
firm with which the Company contracted to handle the case.  The Company has
moved the representation to new counsel, which resulted in negotiation of a new
fee arrangement requiring the Company to pay additional legal expenses incurred
in connection with the appeal and the cross complaints.

ITEM 5.  OTHER INFORMATION.

  As stated in the Company's 1998 Proxy Statement, proposals by stockholders
intended to be presented at the 1999 Annual Meeting must be received at the
offices of the Company no later than December 1, 1998 for consideration for
inclusion in the Company's Proxy Statement for the 1999 Annual Meeting.

  In connection with the Company's Annual Meeting of Shareholders to be held in
1999, if the Company does not receive notice of a matter or proposal to be
considered by February 10, 1999, then the persons appointed by the Board of
Directors to act as the proxies for such Annual Meeting (named in the form of
proxy) will be allowed to use their discretionary voting authority with respect
to any such matter or proposal at the Annual Meeting, if such matter or proposal
is raised at the Annual Meeting.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K.

 The following exhibits are filed herewith:

               11    Computation of Per Share Earnings
               27.1  Financial Data Schedule 1998  (for SEC use only)



          Reports on Form 8-K:   There were no filings on Form 8-K during the
          -------------------                                                
          quarter ended September 30, 1998.

                                       15
<PAGE>
 
                                 SIGNATURES


Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.



                                    TRANSCEND SERVICES, INC.



November 13, 1998                   By: /s/ Larry G. Gerdes
                                        ----------------------------------------
                                       Larry G. Gerdes,
                                       President and Chief Executive Officer
                                      (Principal Executive Officer)



November 13, 1998                   By: /s/ Doug Shamon
                                        ----------------------------------------
                                        Doug Shamon
                                        Executive Vice President,
                                        Chief Financial Officer (Principal
                                        Financial and Accounting Officer)

                                       16