<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 March 31, 1997

                                       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 May 12, 1997
             -----                           ---------------------------

     Common Stock, $.01 par value                     20,104,002



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

 
                                                                      PAGE
                                                                      ----

PART  I.  FINANCIAL INFORMATION
 
 
Item 1.   Financial Statements

 
            Consolidated Balance Sheets as of
            December 31, 1996 and March 31, 1997...........             3
 
            Consolidated Statements of Operations for the
            Three Months Ended March 31, 1996 and 1997.....             4
 
            Consolidated Statements of Cash Flows for the
            Three Months Ended March 31, 1996 and 1997.....             5
 
            Notes to Consolidated Financial Statements.....             6
 

Item 2.   Management's Discussion and Analysis of
            Financial Condition and Results of Operations..             8



PART II.  OTHER INFORMATION


Item 1.   Legal Proceedings................................            17
 
Item 2.   Changes in Securities............................            18
 
Item 6.   Exhibits.........................................            19
          
SIGNATURES.................................................            20
 
<PAGE>
 
PART I.    FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS


                            TRANSCEND SERVICES, INC.
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,     MARCH 31,
                                                                 ------------     ---------
                                                                     1996           1997
                                                                     ----           ----
                                                                                 (UNAUDITED)
<S>                                                              <C>            <C>
                 ASSETS
                 ------
 
CURRENT ASSETS:
  Cash and cash equivalents....................................  $  1,660,000   $    625,000
  Accounts receivable, net of allowance for doubtful
    accounts of $147,000 and $90,000 in 1996
    and 1997,  respectively....................................     3,594,000      3,647,000
  Other........................................................       543,000        555,000
                                                                 ------------   ------------
  Total current assets.........................................     5,797,000      4,827,000
                                                                 ------------   ------------
 
NET ASSETS RELATED TO DISCONTINUED
  OPERATIONS...................................................     2,577,000      2,584,000
SECURITIES OF AMHEALTH.........................................       350,000        350,000
EQUIPMENT and LEASEHOLD IMPROVEMENTS, net......................     2,434,000      2,291,000
DEPOSITS AND OTHER ASSETS......................................       158,000        156,000
GOODWILL AND OTHER INTANGIBLE ASSETS, net......................     4,828,000      4,709,000
                                                                 ------------   ------------
  Total assets.................................................  $ 16,144,000   $ 14,917,000
                                                                 ============   ============
 
  LIABILITIES AND SHAREHOLDERS' EQUITY
  ------------------------------------
 
CURRENT LIABILITIES:
  Current maturities of long term debt and note payable........  $  2,226,000   $  2,202,000
  Accounts payable.............................................     1,989,000      1,194,000
  Accrued compensation and employee benefits...................     1,702,000      1,804,000
  Other accrued liabilities....................................     1,318,000        965,000
  Deferred income taxes........................................       113,000        113,000
                                                                 ------------   ------------
  Total current liabilities....................................     7,348,000      6,278,000
                                                                 ------------   ------------
 
CONVERTIBLE DEBENTURES.........................................     2,000,000      2,000,000
                                                                 ------------   ------------
 
LONG TERM DEBT, net of current maturities......................       284,000        258,000
                                                                 ------------   ------------
 
DEFERRED INCOME TAXES..........................................       541,000        541,000
                                                                 ------------   ------------
 
SHAREHOLDERS' EQUITY:
  Preferred stock, $.01 par value; 21,000,000 shares
  authorized; none outstanding.................................            --             --
  Common stock, $.01 par value, 30,000,000 shares
  authorized, 19,469,000 shares and 19,495,000
  shares  issued and outstanding as of December 31, 1996, and
  March 31, 1997, respectively.................................       194,000        195,000
  Additional paid-in capital...................................    19,931,000     19,937,000
  Retained deficit.............................................   (14,154,000)   (14,292,000)
                                                                 ------------   ------------
     Total shareholders' equity................................     5,971,000      5,840,000
                                                                 ------------   ------------
     Total liabilities and shareholders' equity................  $ 16,144,000   $ 14,917,000
                                                                 ============   ============
</TABLE> 

--------------------
 The accompanying notes are an integral part of these consolidated balance 
sheets.

                                       3
<PAGE>
 
                            TRANSCEND SERVICES, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

 
                                            THREE MONTHS ENDED MARCH 31,
                                            ----------------------------

 
                                                 1996          1997
                                                 ----          ----
                                                            (UNAUDITED)
 
NET REVENUE.................................  $ 8,688,000   $ 9,958,000
DIRECT COSTS................................    7,260,000     8,305,000
                                              -----------   -----------
 Gross profit...............................    1,428,000     1,653,000
 
MARKETING AND SALES EXPENSES................      641,000       416,000
GENERAL AND ADMINISTRATIVE EXPENSES.........    1,122,000     1,133,000
AMORTIZATION EXPENSE........................      145,000       119,000
                                              -----------   -----------
 Loss from Operations.......................     (480,000)      (15,000)
 
OTHER INCOME (EXPENSE):
 Interest income............................        9,000         7,000
 Interest expense...........................      (52,000)      (96,000)
 Other......................................           --            --
                                              -----------   -----------
                                                  (43,000)      (89,000)
                                              -----------   -----------
 
LOSS BEFORE PROVISION FOR INCOME TAXES AND
  DISCONTINUED OPERATIONS...................     (523,000)     (104,000)
PROVISION FOR INCOME TAXES..................           --            --
                                              -----------   -----------
LOSS BEFORE DISCONTINUED OPERATIONS.........     (523,000)     (104,000)
LOSS FROM DISCONTINUED OPERATIONS...........     (129,000)      (34,000)
                                              -----------   -----------
NET LOSS....................................  $  (652,000)  $  (138,000)
                                              ===========   ===========
 
NET LOSS PER COMMON SHARE:
BEFORE DISCONTINUED OPERATIONS..............  $     (0.03)  $     (0.01)
DISCONTINUED OPERATIONS.....................        (0.01)        (0.00)
                                              -----------   -----------
NET LOSS....................................  $     (0.04)  $     (0.01)
                                              ===========   ===========
 
Weighted average common shares outstanding..   18,447,000    19,494,000
                                              ===========   ===========
 
-------------------
  The accompanying notes are an integral part of these consolidated statements.

                                       4
<PAGE>
 
                            TRANSCEND SERVICES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE> 
<CAPTION> 
                                                                            THREE MONTHS  ENDED MARCH 31,
                                                                            -----------------------------
                                                                                   1996          1997
                                                                                   ----          ----
                                                                                              (UNAUDITED)
<S>                                                                            <C>          <C> 
CASH FLOWS FROM OPERATING ACTIVITIES:                                          $ (652,000)  $  (138,000)
Net Loss.....................................................................
Adjustments to reconcile net loss to net cash used in operating activities:
 Depreciation and amortization...............................................     322,000       380,000
 Loss related to Discontinued Operations.....................................     129,000        34,000
Changes in assets and liabilities, net of acquisitions:
 Accounts receivable.........................................................     217,000       (53,000)
 Prepaid expenses............................................................    (416,000)      (12,000)
 Deposits and other assets...................................................      27,000         2,000
 Accounts payable............................................................     (95,000)     (796,000)
 Accrued liabilities.........................................................     446,000      (250,000)
 Other.......................................................................     (30,000)           --
                                                                               ----------   -----------
Total adjustments............................................................     600,000      (695,000)
Net Cash used in continuing operations.......................................     (52,000)     (833,000)
Net Cash used in discontinued operations.....................................    (122,000)      (40,000)
                                                                               ----------   -----------
Net Cash used in operating activities........................................    (174,000)     (873,000)
                                                                               ----------   -----------
 
CASH FLOWS FROM INVESTING ACTIVITIES:
 Capital expenditures........................................................    (297,000)     (118,000)
                                                                               ----------   -----------
Net Cash used in investing activities........................................    (297,000)     (118,000)
                                                                               ----------   -----------
 
CASH FLOWS FROM FINANCING ACTIVITIES:
 Repayments on short-term debt...............................................    (100,000)           --
 Repayments on line of credit agreement......................................          --       (25,000)
 Principal payments long-term debt...........................................     (24,000)      (26,000)
 Proceeds - Stock options and other issuances................................     157,000         7,000
                                                                               ----------   -----------
Net cash provided by (used in) financing activities..........................      33,000       (44,000)
                                                                               ----------   -----------
 
NET INCREASE IN CASH AND CASH EQUIVALENTS....................................    (438,000)   (1,035,000)
CASH AND CASH EQUIVALENTS, at beginning of period............................   1,117,000     1,660,000
                                                                               ----------   -----------
CASH AND CASH EQUIVALENTS, at end of period..................................  $  679,000   $   625,000
                                                                               ==========   ===========
</TABLE> 

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

                                       5
<PAGE>
 
                    TRANSCEND SERVICES, INC. AND AFFILIATES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                            MARCH 31, 1996 AND 1997



  (1) 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 combined financial statements and footnotes
thereto included in the Company's Form 10-K for the year ended December 31,
1996. Footnote disclosure which would substantially duplicate the disclosure
contained in those documents has been omitted.

  (2) Net loss per common share has been computed based on the weighted number
of the Company's common shares and common share equivalents (dilutive stock
options) outstanding.  The common stock equivalents related to stock options
were not included in the computation due to their antidilutive effect. Fully
diluted net loss per share has not been presented since it is not materially
different from primary net loss per share.

(3) During the first quarter of 1997, the Financial Accounting Standards Board
(FASB) issued Statement 128, Earnings per Share.  This statement sets out new
guidelines for the calculation and presentation of earnings per share.  The
following tables represents a reconciliation of basic and diluted weighted
average shares and a pro forma calculation of earnings per share using the
guidelines of SFAS #128.

<TABLE>
<CAPTION>
                                                                    For the Three Months
                                                                      Ended March 31,
                                                                 --------------------------
                                                                     1996          1997
                                                                     ----          ----
<S>                                                              <C>           <C>
Basic weighted average shares outstanding                         18,447,000    19,494,000
 
Shares of common stock assumed issued upon exercise of
stock options using the "treasury stock" method as it applies
to the computation of diluted earnings per share.                        -0-           -0-
 
Diluted weighted average shares outstanding                       18,447,000    19,494,000
                                                                 -----------   -----------
 
Net earnings used in the computation of basis and
diluted earnings per share                                       $  (652,000)  $  (138,000)
                                                                 ===========   ===========
Earnings per share:
   Basic                                                         $     (0.04)  $     (0.01)
   Diluted                                                       $     (0.04)  $     (0.01)
</TABLE>

                                       6
<PAGE>
 
Subsequent Event

  On April 16, 1997, the Company acquired 100% of the capital stock of DocuMedX,
Inc., a Washington corporation, under the pooling of interests method of
accounting.  The company issued 608,800 shares of Transcend Common Stock at the
time of acquisition and signed Non-Compete Agreements with certain of the former
owners of DocuMedX, Inc.

                                       7
<PAGE>
 
ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS


  Certain statements contained in this filing are "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995, such
as statements relating to financial results and plans for future business
development 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, economic conditions, competition and other
uncertainties detailed from time to time in the Company's Securities and
Exchange Commission filings.
 

  Transcend Services Inc. (the "Company" or "Transcend") is a healthcare
services company focused on the emerging field of healthcare information
management ("HIM") services to hospitals and other associated healthcare
providers. The Company provides a range of HIM services, including: (i) contract
management ("outsourcing") of the healthcare information or medical records
function, as well as the admissions function; (ii) transcription of physicians'
dictated medical notes; and (iii) consulting services relating to medical
records and reimbursement coding. As of March 31, 1997, the Company operated, on
a contract management basis, the medical records and certain other HIM functions
of 19 general acute care hospitals located in twelve states and the District of
Columbia.  The Company also provides case management and disability  management
services to insurance carriers, third party administrators and self-insured
employers.

  The Company intends to expand the range of its contract management services to
include management of other functional areas of hospitals, such as management of
patient access (admissions), utilization review, quality assurance and the
business office. The Company presently provides full contract management
outsourcing services in the admissions departments for two of the 19 hospitals
it manages. The Company is actively seeking to provide this expanded range of
services to its current and future hospital customers. The Company also
provides, through outsourcing as well as other contracts, medical records
transcription services through computer and telephone links from centralized
facilities to approximately 150 hospital customers.

   Approximately 3,000 hospitals in the United States have more than 100 beds
and constitute the Company's first tier of market opportunity. The Company
currently has contract management contracts covering the medical records
departments of 19 hospitals ranging in bed size from 56 beds to 541 beds, with
the average contract size of approximately $1.3 million. The initial contract
terms of the Company's current contracts range from two to five years and are
generally terminable without cause upon expiration of the initial term or for
cause at any time during the initial term thereof. The Company's existing
contracts currently have remaining terms ranging from approximately one to five
years. Due to its limited operating history in medical records management, the
Company is unable at the present time to assess or predict its contract renewal
rate.

  The Company negotiates its contract management fees on a fixed installment
basis which represents, at contract inception, an immediate savings to the
contracting hospital as compared to its historical costs. In the early term of
such a contract, the Company's expenses in providing the contract services
remain relatively high, as a percentage of contract revenues received, as set-up
and training costs are incurred, 

                                       8
<PAGE>
 
new procedures are implemented and departmental reorganizations are initiated.
Completion of such steps should result in lower operating expenses, which in
turn should increase the profit margin of a constant revenue stream over time.
Due to the Company's limited operating history in the contract management
business, however, there can be no assurances that operating expenses will
sufficiently decrease over the life of such contracts to achieve profitability.

  The Company is experimenting with an alternative volume-based pricing
structure, based upon a hospital's activity levels such as weighted average
number of annual patient discharges, or a "per member per month" ("PMPM")
capitated pricing option similar to current pricing mechanisms used by managed
healthcare groups. As of March 31, 1997, the Company had signed one contract
based on a volume oriented pricing structure tied to weighted annual patient
discharges. There is an opportunity to realize higher margins on an activity-
based pricing structure. The principal advantage of a volume-based pricing
mechanism is that as a hospital's volume of business increases, the Company's
revenues will increase at a faster rate than operating expenses. However, if a
customer's business volume decreases, the Company's revenues will also decrease
at a faster rate than its operating expenses.   The Company is also considering
pricing its contract management contracts, where possible, to provide for more
contingency sharing of either (i) the one-time cash flow savings that the
Company generates for its contract management customers through a reduction in
gross days receivables outstanding by processing bills being delayed in the
medical records department and/or (ii) increased revenues realized by hospital
customers as a result of the Company's favorable impact (through enhanced coder
and physician training) on the hospital's Case Mix Index (a measurement of the
hospital's severity/acuity level for DRG reimbursements under Medicare).  Of its
19 contracts as of March 31, 1997, only one contract was priced under a
contingency sharing arrangement.

  The Company is typically paid for its transcription services on a production
basis at rates determined on a per-line-transcribed basis. Where transcription
services are included as part of the services provided in the Company's
outsourcing contracts, however, the services are provided by the Company as part
of a set contract fee. The Company is paid for its consulting and coding
services on a negotiated fee for services basis. In addition, the Company is
paid for its healthcare case management services primarily on an hourly basis.

  The Company continues to focus on developing its first Data Delivery Center
("DDC"), a centralized, remote center to initially support and at some point
replace entirely some of the critical functions being performed on site in a
medical records department through the off-site, electronic processing of health
information.   Working in partnership with the Brady Group (Austin, Texas),
Network Imaging, Inc. and Health Information Enterprises (Atlanta, Georgia), the
Company is close to completing Phase I of its first DDC which is designed
specifically to allow for the off-site, electronic processing for coding and DRG
optimization applications.  The Company expects to have the DDC completed and
ready for testing by the end of May, 1997, and have two of its contract
management (outsourced) hospitals converted over to the DDC for coding by the
end of this summer.

RESULTS OF OPERATIONS - GENERAL

  The Company's loss from operations for the quarter ended March 31, 1997 was
$15,000.  The Company's major reorganization, initiated in July/August 1996,
resulted in significant cost reductions and helped the Company achieve a near
break-even result from continuing operations.  Management believes that it would
have achieved operating profitability in the first quarter of 1997 if not for
the 

                                       9
<PAGE>
 
continued operating losses being generated by the Company's case management
business operated through its wholly-owned subsidiary, Sullivan Health
Management ("Sullivan").  Sullivan realized a first quarter 1997 operating loss
of $234,000, which marked an improvement over Sullivan's operating loss of
$354,000 in the fourth quarter of 1996.  The Company is focused on improving
Sullivan's operations as well as increasing the Company's revenues from contract
management and other services and effectively managing its costs in order to
achieve profitability.  In addition, the Company's pricing mechanism on most of
its outsourcing contracts requires the Company to increase operating
efficiencies over the life of the contract in order to increase profit margins.
The Company will also be required to procure a critical mass of such contracts
and be able to renew such contracts on favorable terms. There can be no
assurance that the Company will be able to attain the required operating
efficiencies or increase the number of outsourcing contracts to the level needed
to become profitable.

THREE MONTHS ENDED MARCH 31, 1997 COMPARED TO THREE MONTHS ENDED MARCH 31, 1996

  Total revenues for the Company increased to $9,958,000 for the quarter ended
March 31, 1997 from $8,688,000 for the quarter ended March 31, 1996, an increase
of 14.6%. Contract management revenues were the largest single service class
revenue source for the Company in each of these three month periods,
representing 57.4% of total revenues in the 1997 quarter and 61.0% in the 1996
quarter. Contract management revenues increased to $5,717,000 in the quarter
ended March 31, 1997 from $5,297,000 in the comparable 1996 quarter, an increase
of 7.9%. Medical transcription revenues were the second largest source of
revenues for the Company for the quarters ended March 31, 1997 and 1996,
representing 35.5% of total revenues in the 1997 quarter and 23.0% of total
revenues in the 1996 quarter. Medical transcription revenues grew to $3,539,000
for the quarter ended March 31, 1997 from $2,001,000 for the quarter ended March
31, 1996, an increase of 76.9%. Consulting and coding revenues represented 1.5%
of the Company's total revenues for the period ending March 31, 1997 and 2.5% of
the Company's total revenues for the period ending March 31, 1996.   Consulting
and coding revenues decreased $71,000 or 32.4% to $148,000 for the quarter ended
March 31, 1997 from $219,000 for the quarter ended March 31, 1996.  This is due
primarily to a drop-off in consulting revenues that are recognized as
implementation fees related to the signing of new contract management accounts.
In the first quarter ended March 31, 1997, the Company signed no new contract
management accounts.  Case management revenues represented 5.6% of the Company's
total revenues in the quarter ended March 31, 1997 as compared with 13.5% of
total revenues in the quarter ended March 31, 1996. Case management revenues
decreased to $554,000 in the quarter ended March 31, 1997 from $1,171,000 in the
quarter ended March 31, 1996, a decrease of 52.7% due to the loss of several key
customer accounts at Sullivan.

  The increase in total revenues for the quarter ended March 31, 1997 is
primarily attributable to (i) the increased contract management outsourcing
revenues of approximately $420,000 attributable to a net increase of three
contracts signed since March 31, 1996 and (ii) increased medical transcription
operations revenues of approximately $850,000 resulting from four transcription
contracts signed after March 31, 1996 and increased transcription production for
existing customers.  The increased total revenues were offset by the decrease in
case management revenues generated by Sullivan of approximately $617,000
resulting from the loss of several key accounts over the 1996 fiscal year.  In
August, 1996, the Company hired an experienced sales and operations manager to
serve as President of Sullivan and lead a re-building effort now underway to
increase sales and improve the operations of Sullivan.  Sullivan experienced a
net loss from continuing operations of $234,000 for the three month period ended
March 31, 1997 compared to  net income from continuing operations of $33,000 for
the quarter ended March 31, 1996.

                                       10
<PAGE>
 
  Gross profit as a percentage of revenues increased 15.8% to $1,653,000 for the
quarter ended March 31, 1997 from $1,428,000 in the first quarter of the prior
year. Gross profit as a percentage of revenues increased to 16.6% for the
quarter ended March 31, 1997 from 16.4% for the quarter ended March 31, 1996.
This increase was primarily attributable to the contract management outsourcing
division which expanded its gross margin to 16.9% in the quarter ended March 31,
1997 from 16.6% in the first quarter ended March 31, 1996.  The medical
transcription business expanded its gross margin to 18.5% in the quarter ended
March 31, 1997, from 17.3% in the quarter ended March 31, 1996. The margin
improvement in transcription is a result of increased efficiencies and lower
operating costs following the continued deployment of digital technology and the
improved productivity of the Company's transcriptionists. The Company's overall
gross margin was negatively impacted in the 1997 to 1996 quarter comparison by
the decrease in case management's (Sullivan's) gross margin to 8.8% for the
quarter ended March 31, 1997 from 27.2% for the quarter ended March 31, 1996.
This decline in case management gross margin was the result of a higher case
management operating cost structure in place while revenues declined.
Sullivan's cost structure  has been restructured to more closely match its
revenue stream going forward.

  Marketing and sales expenses decreased 35.1% to $416,000 in the quarter ended
March 31, 1997 from $641,000 in the same prior year period and decreased as a
percentage of revenues to 4.2% for the quarter ended March 31, 1997 from 7.4%
for the quarter ended March 31, 1996.   This decrease is a result of the
restructuring and internal reorganization efforts begun in late 1996.  With much
of the Company's investment in a national sales force, telemarketing and
marketing/advertising programs now in place, the Company anticipates that sales
and marketing expenses, as a percentage of revenues, will stabilize as revenues
increase.

  General and administrative expenses remained relatively constant at $1,133,000
for the quarter ended March 31, 1997, up less than 1% from the $1,122,000
incurred in the same prior year period.  Corporate general and administrative
expenses decreased as a percentage of revenues to 11.4% for the quarter ended
March 31, 1997 from 12.9% in the first quarter of the prior year. General and
administrative expenses declined  as a percentage of revenues due primarily to
the Company's reorganization and restructuring undertaken in July and August,
1996, resulting in a reduction and stabilization in these expenses while
revenues increased.

  The Company's loss from operations decreased to $15,000 for the quarter ended
March 31, 1997 from $480,000 in the first quarter of the prior year period.
This $15,000 quarterly loss compares to an operating loss of $229,000 for the
quarter ended December 31, 1996 and an operating loss of $3,758,000 for the
quarter ended September 30, 1996.

  Amortization expenses decreased to $119,000 for the quarter ended March 31,
1997 from $145,000 in March 31, 1996, reflecting the impact of the 1993
acquisition of dataLogix, Inc. being fully amortized.

   Other expenses increased to $89,000 for the quarter ended March 31, 1997 as
compared to $43,000 for the quarter ended March 31, 1996, primarily due to the
impact of interest expense incurred in connection with the Company's borrowings
against its working capital line of credit established April 30, 1996, totaling
$2,094,000 as of March 31, 1997.

  The Company's loss before discontinued operations decreased to $104,000 for
the quarter ended 

                                       11
<PAGE>
 
March 31, 1997 from $523,000 for the quarter ended March 31, 1996. The Company's
reorganization has resulted in a more streamlined management, sales and
implementation effort and has lowered the Company's overall selling, general,
administrative and operating costs.

  The Company's loss from discontinued operations of $34,000 and $129,000 for
the quarters ended March 31, 1997 and March 31, 1996, respectively, is due to
legal expenses incurred in connection with the Lawsuit (hereinafter defined).
See Part II, Item 1.  Legal Proceedings.

DISCONTINUED OPERATIONS

  At March 31, 1997, the net assets related to the discontinued operations of
the Company's healthcare subsidiaries, First Western Health Corporation ("First
Western") and Veritas Healthcare Management ("Veritas"), both of which ceased
operations as of April 30, 1993, totaled $2,584,000, consisting of $5,912,000 of
gross accounts receivable offset by $3,328,000 in collection liabilities.  In
October 1995, the Company sold approximately 38% of the gross accounts
receivable to a third party with which the Company has also contracted with to
service and manage the remaining accounts receivable balance for a set fee. The
net assets from the discontinued operations represent reimbursements that are
owed the Company by certain insurance companies for applicant medical/legal
evaluation services provided by FWHC Medical Group, Inc. and Veritas Medical
Group, Inc., two managed medical groups associated with the Company's former
subsidiaries, First Western and Veritas.   The  applicant/legal evaluation
services were provided to injured California workers who, under Section 4620 of
the California Labor Code (the "California Code"), are entitled to
"medical/legal" testimony from a physician of his or her choosing in order to
provide medical evidence that he or she is entitled to benefits under
California's workers' compensation system.  Under section 4621 of the California
Code, employers are responsible for paying the employees' costs of such
medical/legal expenses that are reasonably, actually and necessarily incurred
and payment for such costs must be made or objected to within 60 days of receipt
of the billing from the provider.  Notwithstanding the requirement for prompt
payment and objection, many insurance companies fail to pay promptly.

  In the event of non-payment, a lien is filed with the California Workers'
Compensation Appeals Board ("WCAB"), after which the medical/legal provider is
known as a "lien claimant." In connection with the accounts receivable owed the
Company, liens have been filed with the WCAB for all $5,912,000 of the gross
accounts receivable outstanding as of March 31, 1997. While liens are supposed
to be paid immediately, lien claimants are not entitled to a determination as to
the collectibility on the lien until there has been an administrative court
hearing on the employee's underlying case. Accordingly, if an insurer fails to
pay a medical/legal provider's bill as required and continues to dispute payment
after the filing of a lien, the provider may have to wait years until the
injured worker's health status reaches the point that entitlement to benefits
may be determined.  In addition, even after an employee's entitlement to
benefits has been determined, backlogs in the system often create delays of
several years before an order for payment can be obtained. The situation is
analogous to the several years or longer that it often takes in the civil court
system to obtain judgement after filing an action. Although it may take a number
of years, the Company does not believe that there is any dispute as to the
Company's ability to attempt collection on the liens and expects to collect the
accounts receivable from discontinued operations over the next several years
under the provisions of the sale and service agreement that the Company has
entered into with the third party for servicing and managing the remaining
accounts receivable balance. During the three months ended March 31, 1997, the
Company collected approximately $30,000 on the receivables and wrote off
approximately $51,000.  As a further 

                                       12
<PAGE>
 
delay to the Company obtaining an order of payment, four insurers that are
defendants in the Lawsuit (see "Item 1. Legal Proceedings.") have obtained stays
of the proceedings before the WCAB, pending resolution of the Lawsuit. Such
stays relate to the collection of $5,519,000 of the total gross receivables.
Although over 93% of the accounts receivable are subject to the stays of
proceedings, the Company believes that it will be able to collect such accounts
as the stays of proceedings only impact the timing of the Company's collection,
not the insurance companies' legal obligation to pay for the services rendered.
In estimating net accounts receivable, the Company believes that it has made
adequate provisions as to the estimated amount of gross receivables that the
Company can expect to collect upon resolution by the California WCAB of the
collectibility of the disputed receivables. The Company will continue to re-
evaluate the net realizability of the net assets related to discontinued
operations on an ongoing basis. Any such re-evaluation could result in an
adjustment that may potentially be material to the carrying value of the asset.

  In September 1994, the Company sold substantially all the assets and
liabilities of its wholly-owned subsidiary, Occu-Care, Inc., which operated
industrial medical clinics, to AmHealth, Inc. ("AmHealth") for a price of
$4,000,000. The purchase price included $1,500,000 in cash paid at closing and
the issuance of two promissory notes bearing interest at 8% per annum. AmHealth
defaulted on the first interest payments on the two notes. The Company initially
recorded these notes as one note due for $2,050,000, which was the Company's
estimate of fair market value (using a discounted cash flow approach). AmHealth
defaulted on a December 1, 1995 mandatory redemption of a portion this
obligation.

  For the first six to nine months of 1996, AmHealth tried repeatedly to sell
its operating facilities to several third parties with no success.  Throughout
this time period, AmHealth's northern California clinics continued to lose money
from operations while its southern California clinics were profitable and cash
flow positive.  It was only after AmHealth's failed attempt to sell all of its
operations to CORE Inc., a public company, in July, 1996, that the Company
decided to write-down its debt due from AmHealth by $1.7 million (in September,
1996) as the CORE transaction would have resulted in the Company realizing the
full value of its receivable due from AmHealth ($2.9 million inclusive of
accrued interest).

  In November, 1996, AmHealth had its four Northern California operating
entities (three clinics and its Employee Services Division) foreclosed on by the
senior secured creditors.  The operations were turned over to the senior secured
creditors and the outstanding receivables for the four entities are now being
collected by the creditor who had the first lien position on all of the
outstanding accounts receivable.  There remain five clinics under AmHealth
ownership in Southern California, all of which are generating operating profits
according to AmHealth officials.  AmHealth is in the process of trying to sell
the remaining clinics and use the proceeds from the sale to negotiate a final
payout - at a substantially lower level than the current principal amount of
debt outstanding -  to all of AmHealth's creditors.  As of March 31, 1997, with
all of the information the Company has received from AmHealth regarding the
likelihood of a final payment and the potential amount of that payment, the
Company believes the carrying value of the AmHealth receivable is valued
correctly as it is stated on the Company's March 31, 1997 balance sheet.
 
LIQUIDITY AND CAPITAL RESOURCES

  The Company's cash flows from continuing operations required the use of cash
of $1,396,000 in 1996.   For the quarter ended March 31, 1997, cash flows from
continuing operations used $833,000, 

                                       13
<PAGE>
 
primarily to pay down accounts payable balances and other accrued liabilities.
Cash has been used to fund the Company's operating losses and make necessary
capital investments. See "Consolidated Statements of Cash Flows."

  Discontinued operations used cash of $1,745,000 in 1996 and used cash of
$40,000 in the first quarter of 1997.   This is a net cash total that includes
cash contributed from discontinued operations (through the collection of
accounts receivable) of $30,000 and cash expenditures of $36,000 for collection
costs and other discontinued operations liabilities and  $34,000 for legal fees
and expenses incurred in connection with the Company's civil lawsuit filed
against certain insurance carriers in the Superior Court in California.   "See
Part II, Item 1.  Legal Proceedings."   The accounts receivable from the
discontinued operations represent reimbursements that are owed the Company by
certain insurance companies for applicant medical/legal evaluation services
provided by FWHC Medical Group, Inc. and Veritas Medical Group, Inc., two
managed medical groups associated with the Company's former subsidiaries, First
Western and Veritas.   The gross receivables, however, are subject to liens
before the WCAB, an administrative body charged with determining an insurance
company's liability for the payment of medical-legal evaluation services.   The
Company expects to collect the accounts receivable from discontinued operations
over the next several years under the provisions of the sale and service
agreement that the Company has entered into with a third party for servicing and
managing the remaining accounts receivable balance.   In estimating net accounts
receivable, the Company believes that it has made adequate provisions as to the
estimated amount of gross receivables that the Company can expect to collect
upon resolution by the California WCAB of the collectibility of the disputed
portion of the receivables. The Company will continue to re-evaluate the net
realizability of the net assets related to discontinued operations on an ongoing
basis. Any such re-evaluation could result in an adjustment that may potentially
be material to the carrying value of the assets.

  The Company's working capital position improved during the quarter ended March
31, 1997, from a deficit position of $1,551,000 at December 31, 1996 to a
deficit position of $1,451,000 at March 31, 1997.  The Company's negative
working capital position is primarily the result of the Company having to
increase its short-term debt in 1996 (i.e., working capital credit facility
provided by Silicon Valley Bank) by $2.1 million to help finance the Company's
losses from continuing and discontinued (i.e., lawsuit fees and expenses)
operations.  Although the Company has historically realized a negative cash
flow, the Company's accounts receivables turn faster than related payables,
allowing the Company to operate and grow its business.  Under the terms of its
contract management fixed-fee pricing schedules, the Company receives the annual
fee in monthly payments in advance (due on the first day of the month), prior to
actually incurring any of the month's fixed and/or variable operating expenses.
This results in accounts receivables for contract management turning in
approximately seven days.   The Company also receives an up-front implementation
fee prior to incurring any costs associated with the actual start-up of a
contract management site.

  The Company's cash flows from investing activities used cash of $1,411,000 in
1996.   For the quarter ended March 31, 1997, the Company's principal use of
cash for investing purposes was for capital expenditures in the amount of
$118,000.  In 1996, the Company invested $1,338,000 in capital expenditures,
primarily in its medical transcription division for digital dictation equipment
and related technology investments.  In early 1997, the Company made a
commitment to fund its first Data Delivery Center ("DDC").  The total capital
expenditure of approximately $400,000 that the Company anticipates it will incur
in connection with its first DDC is expected to be financed through either the
working capital and capital expenditure facilities with Coast Business Credit
described below or another third 

                                       14
<PAGE>
 
party financing relationship.

  In 1995 the Company expended $1,232,000 in cash to acquire the medical
transcription businesses of International Dictating Services, Inc. and Medical
Transcription of Atlanta, Inc.   In connection with these acquisitions, on
August 15, 1995, the Company raised $2 million in cash through the private
placement of 8% Subordinated Convertible Debentures. The Debentures are
unsecured and subordinated to all other debt of the Company. The interest rate
on the Debentures is 8%, payable semi-annually, and the principal amount is due
in full on August 15, 2000. The Debentures are convertible into Common Stock by
the holder at any time prior to August 15, 2000 at a rate of 286 shares of
Common Stock for each $1,000 in principal amount and are convertible by the
Company at any time when the Common Stock trades at $10.50 per share for 30
consecutive trading days. The Company may redeem the Debentures at any time upon
30 to 60 days notice to the holder of a Debenture.

  Cash flows from financing activities provided cash of $5,095,000 in 1996.
For the quarter ended March 31, 1997, financing activities used cash of $44,000.
For the quarter, the Company's principal uses of cash for financing have been
payments under the line of credit and long-term debt.  The Company's primary
sources of cash over the past several years have been (i) proceeds from
borrowings under a line of credit facility (April, 1996); (ii) proceeds from the
issuance of convertible debentures (August, 1995); (iii) proceeds from the
issuance of common stock and warrants through a private placement in September,
1996 and (iv) proceeds from the exercise of incentive stock options.

  On April 30, 1996, the Company established two separate credit-facilities with
Silicon Valley East (Wellesley, Massachusetts) a division of Silicon Valley
Bank, a California-chartered bank (Santa Clara, California). The aggregate
credit available (under both facilities) was $5.75 million. The banking
facilities were secured by all of the Company's assets. One of the facilities
was a $5.0 million working capital credit line under which the Company could
borrow a certain percentage of its accounts receivable balance, subject to an
initial cap of $3.0 million that was to be removed if the Company realized net
income of at least $50,000 in the quarter ended September 30, 1996. Because the
Company recognized a loss in the third quarter as well as the fourth quarter of
1996, this facility remained capped at $3.0 million. The second facility was a
$750,000 term facility set up to help the Company meet any of its capital
investment requirements which included the purchase of computers and
transcription related equipment. This term note was subject to an initial cap of
$250,000, with the cap being removed during such periods that the Company
maintained a minimum debt service ratio of 1.5 to 1.0, where debt service was
defined as earnings before interest and taxes plus depreciation and
amortization, divided by total interest plus the current portion of long-term
debt. As of March 31, 1997 the Company was not maintaining the required debt
service ratio, therefore, the cap of $250,000 remained in place on this term
facility. As of March 31, 1997 total borrowings under both facilities totaled
$2,094,000. The stated interest rate on the working capital facility was prime
plus 0.5% (or 9.0%) and the stated interest rate on the term loan was prime plus
1.0% (or 9.5%). Both of these facilities were due to mature on April 30, 1997.
Due to the Company's financial losses, the Company's borrowing capacity was
capped at the $2,094,000 level of debt throughout the first quarter of 1997.
The Company had been in negotiations with Silicon Valley to re-define all of its
major financial covenants and establish new borrowing capabilities with Silicon
Valley East as a result of its third and fourth quarter losses (inclusive of all
one-time, non-recurring balance sheet adjustments).

  On April 3, 1997, the Company closed on a new credit facility with Coast
Business Credit, a California-based asset based lender (and a division of
Southern Pacific Thrift and Loan Association) to 

                                       15
<PAGE>
 
provide the Company a $4.7 million working capital facility and a $300,000
capital expenditure facility to be effective (funding capability) immediately.
The working capital facility has been used to pay off Silicon Valley in full.
These new Coast facilities do not contain any financial covenants and are based
on a funding formula (for determining funding limits) as follows: 1.5 times
monthly contractual contract management revenues, plus 80% of all medical
transcription receivables under 90 days (aging) under the working capital
facility; up to $300,000 on new capital expenditures under the capital
expenditure facility. Based on current monthly contractual contract management
revenues and 80% of all medical transcription receivables under 90 days as of
March 31, 1997, this would provide the Company with a current funding capacity
of approximately $3.5 million. These facilities have a term of two years and are
priced at prime plus 2.25% declining to prime plus 1.75% upon two consecutive
quarters of achievement and ongoing maintenance of debt service coverage of not
less than 1.5 times measured on an EBITA basis including all principal and
interest (excluding depreciation). These facilities are secured by a first
security interest on all Company assets.

  The Company anticipates that cash on hand, together with internally generated
funds,  cash collected from discontinued operations and cash available under its
new credit facilities with Coast Business Credit, should 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
1997.  The Company will continue to pursue various alternatives to allow for the
effective use of cash (i.e., leasing for capital asset funding). This should
help the Company to (i) continue its growth, (ii) achieve operating
profitability and positive cash flow from operations during 1997, and (iii)
continue to fund the out-of-pocket expenses and certain legal fees to be
incurred in connection with its civil litigation against certain insurance
carriers.


IMPACT OF INFLATION

  Inflation has not had a material effect on the Company to date. However, the
effects of inflation on future operating results will depend in part, on the
Company's ability to increase prices and/or lower expenses in amounts offsetting
inflationary cost increases.

                                       16
<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 healthcare 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,
which  was subsequently amended to name 16 defendants (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
healthcare subsidiaries and their contracting associated medical groups (the
"Lawsuit"). The claims arise out of the Company's former business, which prior
to the merger with Transcend Services, Inc., included providing medical/legal
evaluations and medical treatment services (in association with managed medical
groups) in the workers' compensation industry in California. Seven 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. The costs associated with the conduct of the Lawsuit cannot be
ascertained with certainty but are expected to be substantial.   Based upon
facts and circumstances known to date, in the opinion of management, final
resolution of the Lawsuit will not have a material adverse effect on the
Company's financial condition or results of operations.

  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 will be entered by the Court, and the Company will appeal the ruling
in the California Court of Appeals.  There can be no assurance that the Company
will be successful 

                                       17
<PAGE>
 
appealing such dismissal. By stipulation, the carriers' cross-complaints against
the plaintiffs were stayed pending resolution of the plaintiffs' appeal. The
Company believes that the trial court's ruling, if upheld by the appellate
court, also would result in dismissal of the cross-complaints. There can be no
assurance, however, that such cross complaints would be dismissed. The cross
complaints expose the Company to risk of liability which, if the Company is
unsuccessful in the defense of such cross complaints, could have a materially
adverse impact on the Company's results of operations for a particular period.
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 1996, the Company expensed approximately $1,582,000 of legal expenses
incurred in connection with the Lawsuit.  For the quarter ended March 31, 1997,
the Company expensed approximately $34,000 of legal expenses connected with the
lawsuit.  Pursuant to an agreement with its legal counsel retained in connection
with the lawsuit, with respect to any future expenses related to the lawsuit
incurred at the trial court level, commencing in December 1996, the company is
only responsible for out-of-pocket expenses and the payment to its legal counsel
of a percentage of any recovery awarded in the lawsuit.  With respect to the
appeal of the Superior Court's March 21, 1997 ruling in the lawsuit, the Company
is only responsible for out-of-pocket expenses and, pursuant to an agreement
with its counsel, an immaterial amount of legal fees to be incurred in
connection with the appeal.

  On June 22, 1995, an action was filed by Timothy S. Priest in his capacity as
administrator of the estate of Robert V. Taylor against Carol Brown, Debbie
Ostwald, the Company's subsidiary Sullivan, and Fireman's Fund Insurance
Company, in the Circuit Court of Franklin County, Tennessee, alleging breach of
the duty to provide reasonably competent nursing care to an injured individual.
The plaintiff demands compensatory damages in the amount of $1 million and
punitive damages in the amount of $2 million, plus costs. Management of the
Company believes that the Company has meritorious defenses to the allegations
and intends to vigorously contest liability in this matter. At the present time,
management of the Company cannot predict the outcome of this litigation, but
does not believe that the resolution of the litigation will have a material
adverse effect on the Company's financial condition or results of operations.

ITEM 2. CHANGES IN SECURITIES

  On April 3, 1997, the Company issued a warrant to purchase shares of its
Common Stock to Coast Business Credit ("Coast"), a California-based asset-based
lender (and a division of Southern Pacific Thrift and Loan Association), in
connection with the credit facilities the Company established with Coast. The
Warrant entitles the holder to purchase an aggregate of 15,000 shares of the
Company's Common Stock subject to certain adjustments, at an exercise price of
$4.625 per share. The Warrant is presently exercisable and expires not later
than April 3, 1999. In connection with the Company's borrowings under the credit
facilities, on April 3, 1997 the Company also issued a promissory note to Coast
in the principle amount of $300,000.

  In connection with a merger with DocuMedX, Inc. ("DocuMedX"), a medical
transcription service company with offices in Seattle, Washington and Portland,
Oregon, on April 16, 1996 the Company issued an aggregate of 608,800 shares of
Common Stock to four shareholders of DocuMedX in exchange for their shares of
the common stock of DocuMedX.

                                       18
<PAGE>
 
  The issuance of the Securities described above was made in reliance on the
exemption from registration provided by Section 4(2) and Regulation D of the
Securities Act of 1933 as transactions by an issuer not involving a public
offering. Offers and sales were made without any public solicitation and the
Securities bear a restrictive legend. No underwriter was involved in the
transaction and no commissions were paid.

ITEM 6.   EXHIBITS.  The following exhibits are filed herewith:

          (a)  2.6    Agreement and Plan of Merger among Transcend Services,
                      Inc., DocuMedX, Inc. and Terri Kaminski, John Kaminski,
                      Amie Clark, Nancy Gartner, Greg Hammock, and Barbara
                      Shelman dated April 16, 1997.

               10.12  Loan and Security Agreement dated April 3, 1997 between
                      the Company and Coast Business Credit.

               10.13  Schedule to Loan and Security Agreement dated April 3,
                      1997 between the Company and Coast Business Credit.

               10.14  First Amendment dated April 15, 1997 to Loan and Security
                      Agreement dated April 3, 1997 between the Company and
                      Coast Business Credit.

               10.15  Secured Promissory Note to Coast Business Credit dated
                      April 3, 1997 in the principal amount of $300,000.

               11     Computation of Per Share Earnings

               27.1   Financial Data Schedule

          (b)     Reports on Form 8-K:

            The following report on Form 8-K was filed during the quarter ended
  March 31, 1997: Form 8-K dated January 28, 1997 (reporting developments in the
  Lawsuit).

                                       19
<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.

 

May 14, 1997                           By: /s/ Larry G. Gerdes
                                           -------------------------------------
                                           Larry G. Gerdes,
                                           President and Chief Executive Officer



May 14, 1997                           By: /s/ David W. Murphy
                                           -------------------------------------
                                           David W. Murphy
                                           Executive Vice President, Finance and
                                           Chief Financial Officer (Principal
                                           Financial and Accounting Officer)

                                       20