<PAGE>   1
================================================================================
                       SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D. C. 20549
 
                             ---------------------
 
   
                                  FORM 10-K/A1
    
                             ---------------------
 
[X]   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
 
     FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
 
[ ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
 
                           COMMISSION FILE NUMBER: 1-10668
 
                                     ITEQ, INC.
               (Exact name of registrant as specified in its charter)
 
<TABLE>
<C>                                            <C>
                   DELAWARE                                      47-1667001
         (State or other jurisdiction                         (I.R.S. Employer
      of incorporation or organization)                     Identification No.)
</TABLE>
 
              2727 ALLEN PARKWAY, SUITE 760, HOUSTON, TEXAS 77019
              (Address of principal executive offices) (zip code)
 
        REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: 713-285-2700
 
                             ---------------------
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
 
                                      None
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
 
<TABLE>
<CAPTION>
                                                           NAME OF EACH EXCHANGE
             TITLE OF EACH CLASS                            ON WHICH REGISTERED
             -------------------                           ---------------------
<S>                                            <C>
        Common Stock, $.001 par value                      Nasdaq National Market
</TABLE>
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]     No  [ ].
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [ ]
 
     Aggregate market value of the voting stock held by nonaffiliates of the
registrant as of March 6, 1997 was $56,289,031. As of March 6, 1997, there were
11,601,346 shares of the registrant's Common Stock, $.001 par value,
outstanding.
   
================================================================================
    
<PAGE>   2
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
   
     The information required hereunder is included in this report as set forth
in the "Index to Financial Statements" on page F-1.
    
<PAGE>   3
 
     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.
 
                                          ITEQ, INC.
 
                                          By:
                                          --------------------------------------
                                         Lawrance W. McAfee, Executive Vice
                                         President and Chief Financial Officer
 
May 2, 1997
<PAGE>   4
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                         INDEX TO FINANCIAL STATEMENTS
 
   
<TABLE>
<CAPTION>
                                                               PAGE
                                                              ------
<S>                                                           <C>
Reports of Independent Public Accountants...................   F-2,3
Consolidated Balance Sheets -- December 31, 1995 and
  December 31, 1996.........................................     F-4
Consolidated Statements of Operations -- Years ended
  December 31, 1994, 1995 and 1996..........................     F-5
Consolidated Statements of Stockholders' Equity -- Years
  ended December 31, 1994, 1995 and 1996....................     F-6
Consolidated Statements of Cash Flows -- Years ended
  December 31, 1994, 1995 and 1996..........................     F-7
Notes to Consolidated Financial Statements..................     F-8
</TABLE>
    
 
                                       F-1
<PAGE>   5
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
To the Stockholders and Board of Directors of
ITEQ, Inc.:
 
     We have audited the accompanying consolidated balance sheets of ITEQ, Inc.
(a Delaware corporation, formerly Air-Cure Technologies, Inc.) and subsidiaries
as of December 31, 1995 and 1996, and the related consolidated statements of
operations, stockholders' equity and cash flows for each of the three years in
the period ended December 31, 1996. We did not audit the financial statements of
Allied Industries, Inc., a company acquired during 1995 in a transaction
accounted for as a pooling of interests, as discussed in Note 2, for the period
from January 28, 1994 to December 31, 1994. The statement of operations and cash
flows for Allied Industries, Inc. is included in the 1994 consolidated
statements of operations and cash flows of ITEQ, Inc. and reflects total
revenues of 28% of the consolidated total. These statements were audited by
other auditors whose report has been furnished to us, and our opinion, insofar
as it relates to amounts included for Allied Industries, Inc., is based solely
upon the report of other auditors. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements based on our audits.
 
     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of other auditors provide a reasonable
basis for our opinion.
 
     In our opinion, based on our audit and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the financial position of ITEQ, Inc. and subsidiaries as of
December 31, 1995 and 1996, and the results of their operations and their cash
flows for each of the three years in the period ended December 31, 1996 in
conformity with generally accepted accounting principles.
 
     As explained in Note 1 to the consolidated financial statements, the
Company has given retroactive effect to the change in accounting for
percentage-of-completion on long-term contracts.
 
Arthur Andersen LLP
 
Houston, Texas
February 24, 1997
 
                                       F-2
<PAGE>   6
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
 
The Board of Directors
Allied Industries, Inc.:
 
     We have audited the balance sheet of Allied Industries, Inc. (the Company)
as of December 31, 1994, and the related statements of operations, retained
earnings and cash flows for the period from January 28, 1994 (date of inception)
to December 31, 1994 (not presented separately herein). These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
 
     We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
 
     In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Allied Industries, Inc. as
of December 31, 1994, and the results of its operations and its cash flows for
the period from January 28, 1994 (date of inception) to December 31, 1994 in
conformity with generally accepted accounting principles.
 
     As explained in Note 1 to the financial statements, the Company has given
retroactive effect to the change in accounting for percentage of completion on
long-term contracts.
 
KPMG Peat Marwick LLP
 
Houston, Texas
March 31, 1995, except as to Note 1 which
  is as of February 24, 1997
 
                                       F-3
<PAGE>   7
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
                        AS OF DECEMBER 31, 1995 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                                  1995
                                                              AS RESTATED     DECEMBER 31,
                                                                (NOTE 1)          1996
                                                              ------------    ------------
<S>                                                           <C>             <C>
                                          ASSETS
CURRENT ASSETS
Cash and cash equivalents...................................    $ 2,216         $  6,331
Restricted cash.............................................         83              144
Due on contracts and other receivables including retainages
  of $1,279 and $544 at December 31, 1995 and 1996,
  respectively, net.........................................     22,926           34,230
Costs and estimated earnings in excess of billings on
  uncompleted contracts.....................................     18,067           20,690
Inventories.................................................      3,944           10,649
Refundable income taxes.....................................        832               --
Prepaid expenses, deposits and other assets.................        502              881
Deferred tax asset..........................................        240            1,979
                                                                -------         --------
         Total Current Assets...............................     48,810           74,904
PROPERTY AND EQUIPMENT, NET.................................      5,392           13,661
OTHER ASSETS, NET...........................................     16,642           47,823
                                                                -------         --------
         TOTAL ASSETS.......................................    $70,844         $136,388
                                                                =======         ========
 
                           LIABILITIES AND STOCKHOLDERS' EQUITY
 
CURRENT LIABILITIES
Accounts payable............................................    $11,799         $ 14,568
Accrued liabilities
  Job costs.................................................     10,854            8,171
  Warranties................................................        419              353
  Compensation..............................................      2,358            5,067
  Other.....................................................      1,260            4,260
Billings in excess of costs and estimated earnings on
  uncompleted contracts.....................................        815              958
Progress billings...........................................         --            5,137
Current maturities of long-term debt........................      3,347            6,012
Income taxes payable........................................        124              527
                                                                -------         --------
         Total Current Liabilities..........................     30,976           45,053
LONG-TERM LIABILITIES
Borrowings under line of credit.............................     11,499           25,400
Other long-term obligations, less current maturities........      6,709           29,029
Subordinated notes..........................................         --           12,712
Deferred tax liability......................................        257              941
                                                                -------         --------
         Total Liabilities..................................     49,441          113,135
                                                                -------         --------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; 1,000 shares authorized, no
  shares issued or outstanding..............................         --               --
Common stock, $.001 par value; 30,000 shares authorized,
  11,453 and 11,510 shares issued and outstanding at
  December 31, 1995 and 1996, respectively..................         11               11
Additional paid-in capital..................................     20,901           23,161
Retained earnings (deficit).................................         42              (44)
Translation adjustment......................................        449              125
                                                                -------         --------
         Total Stockholders' Equity.........................     21,403           23,253
                                                                -------         --------
         TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.........    $70,844         $136,388
                                                                =======         ========
</TABLE>
 
                 See Notes to Consolidated Financial Statements
 
                                       F-4
<PAGE>   8
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
              FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
<TABLE>
<CAPTION>
                                                                1994        1995
                                                                 AS          AS
                                                              RESTATED    RESTATED
                                                              (NOTE 1)    (NOTE 1)      1996
                                                              --------    --------    --------
<S>                                                           <C>         <C>         <C>
Revenues....................................................  $61,826     $113,164    $110,804
Cost of revenues............................................   49,135       93,262      88,949
                                                              -------     --------    --------
  Gross profit..............................................   12,691       19,902      21,855
Selling, general and administrative expenses................    8,926       11,645      11,977
Sales commissions...........................................    1,327        2,477       2,755
Depreciation and amortization...............................      845        1,009       1,146
Merger costs, restructuring charges and other nonrecurring
  costs.....................................................       --        1,335       3,704
                                                              -------     --------    --------
  Operating profit..........................................    1,593        3,436       2,273
                                                              -------     --------    --------
Other income (expense):
  Interest expense, net.....................................     (888)      (1,502)     (2,660)
  Other income..............................................      112          326         305
                                                              -------     --------    --------
          Total other expense...............................     (776)      (1,176)     (2,355)
                                                              -------     --------    --------
Earnings (loss) before provision for income taxes...........      817        2,260         (82)
Provision for income taxes..................................      338        1,500           4
                                                              -------     --------    --------
          Net earnings (loss)...............................  $   479     $    760    $    (86)
                                                              =======     ========    ========
Net earnings (loss) per common share........................  $  0.04     $   0.07    $  (0.01)
                                                              =======     ========    ========
Weighted average common and common equivalent shares
  outstanding...............................................   10,891       11,552      11,481
                                                              =======     ========    ========
</TABLE>
 
                 See Notes to Consolidated Financial Statements
 
                                       F-5
<PAGE>   9
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                     COMMON STOCK     ADDITIONAL   RETAINED                      TOTAL
                                                    ---------------    PAID-IN     EARNINGS    TRANSLATION   STOCKHOLDERS'
                                                    SHARES   AMOUNT    CAPITAL     (DEFICIT)   ADJUSTMENT       EQUITY
                                                    ------   ------   ----------   ---------   -----------   -------------
<S>                                                 <C>      <C>      <C>          <C>         <C>           <C>
BALANCE, DECEMBER 31, 1993........................   5,906    $ 6      $14,577      $   236       $(192)        $14,627
Stock issued for business combinations............   1,390      1        5,167           --          --           5,168
Stock issued for the employee stock purchase
  plan............................................       2     --            2           --          --               2
Costs related to issuance of stock................      --     --          (76)          --          --             (76)
Change in foreign currency translation
  adjustment......................................      --     --           --           --         335             335
Equity transactions of pooled company.............   4,140      4          935           --          --             939
Net earnings......................................      --     --           --          479          --             479
                                                    ------    ---      -------      -------       -----         -------
BALANCE, DECEMBER 31, 1994 As Restated (Note 1)...  11,438     11       20,605          715         143          21,474
Stock issued for the employee stock purchase
  plan............................................      15     --           46           --          --              46
Stock issued for the exercise of stock options....      --     --            1           --          --               1
Costs related to issuance of stock................      --     --          (14)          --          --             (14)
Compensation expense in connection with
  non-qualified stock option grants...............      --     --           13           --          --              13
Change in foreign currency translation
  adjustment......................................      --     --           --           --         306             306
Equity transactions of pooled company.............      --     --          250       (1,433)         --          (1,183)
Net earnings......................................      --     --           --          760          --             760
                                                    ------    ---      -------      -------       -----         -------
BALANCE, DECEMBER 31, 1995 As Restated (Note 1)...  11,453     11       20,901           42         449          21,403
Stock issued for the employee stock purchase
  plan............................................      15     --           44           --          --              44
Stock issued for the exercise of stock options....      42     --          134           --          --             134
Warrants issued to Subordinated Lenders, net of
  issuance costs..................................      --     --        2,082           --          --           2,082
Change in foreign currency translation
  adjustment......................................      --     --           --           --        (324)           (324)
Net loss..........................................      --     --           --          (86)         --             (86)
                                                    ------    ---      -------      -------       -----         -------
BALANCE, DECEMBER 31, 1996........................  11,510    $11      $23,161      $   (44)      $ 125         $23,253
                                                    ======    ===      =======      =======       =====         =======
</TABLE>
 
                 See Notes to Consolidated Financial Statements
 
                                       F-6
<PAGE>   10
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
             FOR THE YEARS ENDED DECEMBER 31, 1994, 1995, AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                1994          1995
                                                                 AS            AS
                                                              RESTATED      RESTATED
                                                              (NOTE 1)      (NOTE 1)        1996
                                                              --------      --------      --------
<S>                                                           <C>           <C>           <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net earnings (loss).......................................  $    479       $   760      $    (86)
  Adjustments to reconcile net earnings (loss) to net cash
    provided (used) by operating activities:
    Depreciation and amortization...........................     1,513         1,631         1,865
    Provision (benefit) for deferred income taxes...........      (444)          118          (156)
    Gain on sale of investment in subsidiary................        --            --          (160)
    Non-cash interest.......................................        --            --           302
    Changes in assets and liabilities, net of effects of
      businesses acquired:
      Restricted cash.......................................      (293)          552           (61)
      Due on contracts and other receivables, net...........       (26)       (7,537)        6,944
      Inventories...........................................       616          (664)        2,863
      Costs and estimated earnings in excess of billings on
         uncompleted contracts..............................       153        (9,937)       (3,409)
      Prepaid expenses, deposits and other assets...........       (20)         (122)         (390)
      Accounts payable and accrued liabilities..............       479        11,988        (3,176)
      Billings in excess of costs and estimated earnings on
         uncompleted contracts..............................      (296)       (2,695)          184
      Progress billings.....................................        --            --         4,128
      Income taxes payable..................................       147           (26)           21
      Other.................................................        (6)          (27)         (817)
                                                              --------       -------      --------
         Net cash provided (used) by operating activities...     2,302        (5,959)        8,052
                                                              --------       -------      --------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Cash paid for acquired businesses, net of cash acquired...    (2,087)           --       (52,786)
  Purchases of property and equipment.......................      (657)         (932)         (991)
  Proceeds from sale of investment in subsidiary............        --            --         1,000
                                                              --------       -------      --------
         Net cash used by investing activities..............    (2,744)         (932)      (52,777)
                                                              --------       -------      --------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Proceeds from long-term obligations.......................     3,000        10,000        27,499
  Proceeds from subordinated debt & warrants................        --            --        15,000
  Payments of long-term obligations.........................   (11,247)       (9,279)       (2,499)
  Net borrowings under line of credit.......................     8,906         8,117        11,977
  Debt issuance costs.......................................        --            --        (3,002)
  Capital contributions from (distributions to) shareholders
    of pooled company.......................................       939        (1,433)           --
  Proceeds from exercise of stock options...................         2            47           178
  Costs relating to issuance of warrants and stock..........       (75)           --          (206)
                                                              --------       -------      --------
         Net cash provided by financing activities..........     1,525         7,452        48,947
                                                              --------       -------      --------
EFFECT OF EXCHANGE RATE CHANGES ON CASH.....................        72           114          (107)
                                                              --------       -------      --------
Net increase in cash and cash equivalents...................     1,155           675         4,115
Cash and cash equivalents, beginning of period..............       386         1,541         2,216
                                                              --------       -------      --------
Cash and cash equivalents, end of period....................  $  1,541       $ 2,216      $  6,331
                                                              ========       =======      ========
Supplemental disclosure of cash flow information:
  Cash paid for interest....................................  $    729       $   569      $  1,718
                                                              ========       =======      ========
  Cash paid for income taxes................................  $    546       $ 2,168      $    126
                                                              ========       =======      ========
Supplemental schedule of non-cash investing & financing
  activities:
  Financing of non-compete agreements.......................        --            --      $    500
                                                              ========       =======      ========
  Net business assets disposed through Company financing or
    non-cash consideration..................................        --            --      $    950
                                                              ========       =======      ========
</TABLE>
 
                 See Notes to Consolidated Financial Statements
 
                                       F-7
<PAGE>   11
 
                          ITEQ, INC. AND SUBSIDIARIES
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
NOTE 1 -- ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
     ITEQ, Inc. (formerly Air-Cure Technologies, Inc.) and its subsidiaries (the
"Company") is a provider of manufactured equipment, engineered systems and
services used in the processing, treatment and movement of gases and liquids. It
is a domestic manufacturer of shell and tube heat exchangers, principally for
petrochemical and refining applications, and a producer of baghouses, scrubbers,
fans and other filtration systems and components for environmental and general
industrial applications. ITEQ also manufactures specialized process equipment,
such as reactors, blenders, stacks, towers, columns and pressure vessels,
principally for the refining, petrochemical and plastics industries. The Company
has operations in the United States, Canada, Germany and Singapore.
 
     A summary of the Company's significant accounting policies consistently
applied in the preparation of the accompanying consolidated financial statements
follows.
 
PRINCIPLES OF CONSOLIDATION
 
     The consolidated financial statements include the accounts of ITEQ, Inc.
and its wholly-owned subsidiaries. Significant intercompany balances and
transactions have been eliminated. The consolidated financial statements have
also been restated to reflect the merger with Allied Industries, Inc. ("Allied")
on December 28, 1995, which was accounted for as a pooling-of-interests. (See
Note 2).
 
REVENUE RECOGNITION
 
     The Company records revenues from long-term contracts using the
percentage-of-completion method. Under this method, the Company recognizes as
revenues that portion of the total contract price which the cost of work
completed to date bears to the estimated total cost of the work included in the
contract. Because contracts may extend over more than one fiscal period,
revisions of cost and profit estimates are made periodically and are reflected
in the accounting period in which they are determined. If the estimate of total
costs on a contract indicates a loss, the total anticipated loss is recognized
immediately. Contract costs include all direct material, labor and
subcontracting costs and those indirect costs related to contract performance,
such as supplies, tools and repairs.
 
     The Company recognizes revenue from certain short-term contracts using the
completed contract method. Revenue is recognized when a project is substantially
complete. The contracts under this revenue recognition method are typically less
than three months in duration.
 
     "Costs and estimated earnings in excess of billings on uncompleted
contracts" represents revenues recognized in excess of amounts billed. Such
revenues are expected to be billed and collected within one year. "Billings in
excess of costs and estimated earnings on uncompleted contracts" represents
billings in excess of revenues recognized.
 
                                       F-8
<PAGE>   12
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
     Beginning in 1996, the Company estimated percentage-of-completion for the
materials portion of its long-term contracts at Allied based on when the
material was placed into production, whereas previously such estimates were
based on when the liability for the cost of the material was legally incurred.
The new method of applying the percentage-of-completion accounting principle was
adopted to better reflect the economics of Allied's revenue and profit earnings
process, and financial statements of prior years have been restated to apply the
revised method retroactively. The effect of the accounting change on previously
reported 1994 and 1995 results and net earnings of 1996 is as follows:
 
<TABLE>
<CAPTION>
                                                                INCREASE (DECREASE)
                                                              ------------------------
                                                              1994     1995      1996
                                                              ----    -------    -----
<S>                                                           <C>     <C>        <C>
Net earnings (loss).........................................   $94    $(1,608)   $ 321
Net earnings (loss) per common share........................    --    $  (.14)   $ .03
</TABLE>
 
     The balances of retained earnings at December 31, 1994 and 1995 have been
increased (reduced) by $94 and $(1,514), respectively, for the effect (net of
income taxes) of applying retroactively the revised method of accounting. The
change in method had no effect on periods prior to 1994, since Allied is
included in the Company's historical financial statements beginning January 28,
1994, the date of inception of Allied.
 
CASH AND CASH EQUIVALENTS
 
     The Company considers all highly liquid temporary investments including
those with an original maturity of three months or less to be cash equivalents.
Cash and cash equivalents consist primarily of interest bearing accounts.
 
RESTRICTED CASH
 
     From time to time, the Company pledges cash to financial institutions as
security for bonds.
 
ACCOUNTS RECEIVABLE
 
     The allowance for doubtful accounts totaled $195 and $712 at December 31,
1995 and 1996, respectively. All retainages as of December 31, 1996 are expected
to be collected by December 31, 1997.
 
INVENTORIES
 
     Inventories consist of costs for which no related revenue has been
recognized. Inventories include materials used in the manufacturing process,
purchased parts and equipment held for resale and are valued at the lower of
cost or market. Cost is determined by the average cost method for materials and
the first-in, first-out (FIFO) method for purchased parts. Inventory consists of
the following:
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31,    DECEMBER 31,
                                                                 1995            1996
                                                             ------------    ------------
<S>                                                          <C>             <C>
Raw Materials..............................................     $3,529         $ 3,514
Work in Progress...........................................         --           7,135
Other......................................................        415              --
                                                                ------         -------
          Total............................................     $3,944         $10,649
                                                                ======         =======
</TABLE>
 
                                       F-9
<PAGE>   13
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
PROPERTY AND EQUIPMENT
 
     Property and equipment are stated at cost, including costs to ready assets
for use. Depreciation and amortization of property and equipment are computed on
the straight-line method over the estimated useful lives of the assets as
follows:
 
<TABLE>
<CAPTION>
                                                                USEFUL LIVES
                                                                ------------
<S>                                                           <C>
Furniture and Fixtures......................................  3 to 15 Years
Machinery and Equipment.....................................  7 to 15 Years
Patterns and Molds..........................................  5 Years
Transportation Equipment....................................  3 Years
Buildings and Improvements..................................  7 to 39 Years
Leasehold Improvements......................................  Life of the lease
</TABLE>
 
     At December 31, 1995 and 1996, Property and Equipment was comprised of the
following items:
 
<TABLE>
<CAPTION>
                                            DECEMBER 31,        DECEMBER 31,
                                                1995                1996
                                            ------------        ------------
<S>                                       <C>                 <C>
Land....................................       $    --            $    700
Furniture and fixtures..................           427                 668
Machinery and equipment.................         6,341               9,176
Patterns and molds......................           625                 602
Transportation equipment................           186                 540
Buildings and improvements..............            --               4,382
Leasehold improvements..................           252                 330
                                               -------            --------
                                                 7,831              16,398
  Less accumulated depreciation and
     amortization.......................        (2,439)             (2,737)
                                               -------            --------
          Net property and equipment....       $ 5,392            $ 13,661
                                               =======            ========
</TABLE>
 
     Repair and maintenance costs are expensed as incurred while major renewals
and betterments are capitalized. The cost of assets retired or otherwise
disposed of and the related accumulated depreciation are eliminated from the
accounts in the year of disposal. Gains and losses resulting from property
disposals are included in "Other income."
 
     Under the provisions of Statement of Financial Accounting Standards (SFAS)
No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of," the Company reviews certain long-lived assets for
impairment whenever events indicate that the carrying amount of an asset may not
be recoverable and recognizes an impairment loss under certain circumstances in
the amount by which the carrying value exceeds the fair value of the asset. The
Company's adoption of SFAS No. 121 had no material effect on the Company's
results of operations or financial position.
 
AMORTIZATION OF INTANGIBLES
 
     The excess of cost over net assets acquired and licenses, trademarks and
tradenames are amortized on a straight-line basis over periods ranging from five
to forty years. The Company maintains separate financial records for each of its
acquired entities and performs periodic strategic and long-range planning for
each entity. This enables the Company to monitor each entity's historical and
expected performance in the context of the value assigned to acquisition
intangibles and to the amortization period applied to each intangible asset. The
Company assesses the recoverability of its goodwill whenever adverse events or
changes in circumstances or business climate indicate that expected future cash
flows (undiscounted and without interest charges) for individual business units
may not be sufficient to support recorded goodwill. The Company modifies the
life and/or the carrying amount of an acquisition intangible if an impairment is
identified. Amortization expense
 
                                      F-10
<PAGE>   14
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
was $0.7 million, $0.8 million and $0.8 million for the years ended December 31,
1994, 1995 and 1996, respectively.
 
     At December 31, 1995 and 1996, other assets was comprised of the following
items:
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,   DECEMBER 31,
                                                                  1995           1996
                                                              ------------   ------------
<S>                                                           <C>            <C>
Excess costs over net assets acquired, net of accumulated
  amortization, of $1,370 and $1,789 at December 31, 1995
  and 1996, respectively....................................    $12,191        $32,941
Licenses, trademarks and tradenames, net of accumulated
  amortization of $600 and $878 at December 31, 1995 and
  1996, respectively........................................      4,400         11,880
Debt issuance costs, net of accumulated amortization of $45
  at December 31, 1996......................................         --          2,957
Other.......................................................         51             45
                                                                -------        -------
          Net Other Assets..................................    $16,642        $47,823
                                                                =======        =======
</TABLE>
 
INCOME TAXES
 
     The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes." SFAS No. 109 requires deferred taxes to be
provided based on temporary differences between the book and tax basis of assets
and liabilities using presently enacted tax rates.
 
NET EARNINGS (LOSS) PER COMMON SHARE
 
     Primary and fully diluted earnings per share are computed based upon the
weighted average number of common and dilutive common equivalent shares
outstanding. The dilutive effect of common equivalent shares is calculated
through the use of the Treasury Stock Method. Common Stock equivalents consist
of stock options and warrants.
 
TRANSLATION ADJUSTMENT
 
     The financial activity of the Company's non-U.S. operations located in
Canada, Germany and Singapore are translated into U.S. dollars in accordance
with SFAS No. 52, "Foreign Currency Translation." Net assets of non-U.S.
operations whose "functional" currencies are other than the U.S. dollar are
translated at year end rates of exchange. Income and expense items are
translated at the average exchange rate for the year.
 
USE OF ESTIMATES
 
     The presentation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
FAIR VALUES
 
     The carrying amounts of cash, accounts receivable, accounts payable and
accrued liabilities are reasonable estimates of their fair values due to the
short maturities of these instruments. The fair value of long-term obligations
is estimated based on ITEQ's current financing agreement and approximates
carrying value.
 
                                      F-11
<PAGE>   15
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
CONCENTRATION OF CREDIT RISK
 
     Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash and accounts
receivable. The Company maintains its cash with various financial institutions.
Accounts receivable at any given time are concentrated in a number of primarily
domestic customers. An allowance for doubtful accounts has been provided for
estimated losses. To mitigate credit risk the Company may require customers to
make advance payments. At December 31, 1996, the Company had collected
approximately $2,018 in such advance payments which are included in progress
billings.
 
RECLASSIFICATIONS
 
     Certain reclassifications have been made to the prior years' consolidated
financial statements to conform with the December 31, 1996 presentation.
 
NOTE 2 -- BUSINESS COMBINATIONS
 
OHMSTEDE
 
     On November 20, 1996 (effective November 1, 1996), the Company purchased
all the outstanding stock (excluding certain assets and liabilities) of
Ohmstede, Inc. ("Ohmstede") for approximately $52.9 million in cash. Assets not
purchased included the majority of receivables due from and a 99 percent equity
investment in C&D Robotics ("C&D"), a partnership formerly consolidated by
Ohmstede; a federal tax deposit made by the owners; and the cash surrender value
of life insurance policies for certain owners. Additionally, the former owners
received approximately $0.6 million in dividends just prior to the transaction,
as set forth in the agreement with the Company. As the Company continues to rent
operating space to C&D, rental fees charged to C&D are included in the financial
statements.
 
     Air-Cure paid $52 million for Ohmstede's stock and $0.9 million for related
acquisition costs. The acquisition has been accounted for using the purchase
method of accounting, and, accordingly, the purchase price has been allocated to
the assets purchased and the liabilities assumed based upon the estimated fair
values at the date of the acquisition, as follows:
 
<TABLE>
<S>                                                           <C>
Working capital.............................................  $14,800
Property and equipment......................................    8,453
Intangibles.................................................    7,500
Excess of costs over net assets acquired....................   21,914
Imputed interest expense....................................      257
                                                              -------
          Total purchase price..............................  $52,924
                                                              =======
</TABLE>
 
     The following unaudited pro forma consolidated results of operations assume
that the purchase occurred on January 1, 1995 and include merger costs,
restructuring charges, and other non-recurring expenses:
 
<TABLE>
<CAPTION>
                                                              YEAR ENDED      YEAR ENDED
                                                             DECEMBER 31,    DECEMBER 31,
                                                                 1995            1996
                                                             ------------    ------------
<S>                                                          <C>             <C>
Revenues...................................................    $201,917        $193,928
Net earnings...............................................    $    699        $  2,253
Net earnings per share.....................................    $    .06        $    .19
</TABLE>
 
                                      F-12
<PAGE>   16
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
ALLIED
 
     On December 28, 1995, the Company issued 4,140 shares of its common stock
in exchange for all of the outstanding common stock of Allied. The merger has
been accounted for as a pooling-of-interests and, accordingly, the Company's
consolidated financial statements have been restated to include the accounts and
operations of Allied effective January 28, 1994, the date of inception of
Allied.
 
     Effective January 1, 1995, Allied was granted S Corporation tax status.
Accordingly, Allied did not pay U.S. Federal income taxes during 1995. Allied
was included in the Company's income tax return effective December 28, 1995,
and, therefore, a deferred tax liability and corresponding charge to income tax
expense of approximately $0.5 million, or $.04 per share, was recorded upon
closing to reflect Allied's net taxable temporary differences.
 
     Revenues, net earnings and related per share amounts of the merged entities
are presented in the following table. The table includes unaudited pro forma net
earnings and per share amounts reflecting the elimination of the nonrecurring
merger costs and pro forma adjustments to present income taxes on the basis on
which they will be reported in future periods.
 
<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                              --------------------------
                                                                 1994           1995
                                                              AS RESTATED    AS RESTATED
                                                               (NOTE 1)       (NOTE 1)
                                                              -----------    -----------
<S>                                                           <C>            <C>
Net revenues:
  ITEQ......................................................    $44,713       $ 74,457
  Allied....................................................     17,113         38,707
                                                                -------       --------
          Total.............................................    $61,826       $113,164
                                                                =======       ========
Net earnings:
  ITEQ......................................................    $  (298)      $  1,557
  Allied....................................................        777           (797)
                                                                -------       --------
          Net earnings, as reported.........................        479            760
Pro forma adjustments:
  Allied merger costs, net of tax...........................         --            973
  Allied Subchapter S status................................         --           (321)
  Allied deferred tax liability.............................         --            491
  Interest on convertible debt..............................         --             12
                                                                -------       --------
          Pro forma net earnings............................    $   479       $  1,915
                                                                =======       ========
Net earnings per common share:
  As reported...............................................    $   .04       $    .07
  Pro forma.................................................    $   .04       $    .17
</TABLE>
 
     The "Allied merger costs, net of tax" balance of $973 related to $1.1
million in nonrecurring merger costs, the majority of which was non-deductible.
 
AMEREX
 
     On May 25, 1994, Amerex, Inc. and Amerex Industries, Inc. (collectively
"Amerex") were merged into a subsidiary of the Company. In the merger, the
stockholders of Amerex received $4 million and 1,256 shares of Common Stock with
a fair market value of $3.69 per share at the acquisition date. The excess of
the total acquisition costs over the fair value of the net assets acquired in
the amount of $5.9 million is being amortized
 
                                      F-13
<PAGE>   17
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
on a straight-line basis over 25 years. Amerex produces and markets filtration,
gas cleaning and heat recovery equipment.
 
     The accounts of Amerex have been included in the accompanying financial
statements for the period from the date of acquisition through December 31,
1996. This acquisition has been accounted for as a purchase with the purchase
price allocated to the assets acquired and liabilities assumed based upon their
estimated fair market values.
 
NOTE 3 -- MERGER COSTS, RESTRUCTURING CHARGES AND OTHER NONRECURRING COSTS
 
     During 1996, the Company incurred a restructuring charge of $4.4 million,
of which $3.7 million and $0.7 million were recorded as restructuring charges
and cost of revenues, respectively. The charge included (i) a provision for the
contractually required severance obligations to the former president and chief
executive officer who was replaced in March 1996, and (ii) the cost of
implementing new management's plan to reduce the Company's overall cost
structure including employee severance, lease and other contract buyouts,
inventory and other asset impairments, losses related to termination of
unprofitable product lines, excess machinery disposal and other related costs.
 
     The following table summarizes the major components of the restructuring
charge:
 
<TABLE>
<S>                                                   <C>
Termination pay and benefits........................  $1,300
Discontinued product lines..........................   1,656
Office relocation and consolidation.................     564
Legal...............................................     242
Other...............................................     642
                                                      ------
                                                      $4,404
                                                      ======
</TABLE>
 
     When the Company committed to its restructuring plan during the first
quarter, it made the decision to terminate 15 employees, including the former
president and chief executive officer. By December 31, 1996, all 15 employees
had been terminated. Approximately $0.9 million in severance pay and benefits,
unpaid as of December 31, 1996, was paid during the first quarter of fiscal
1997. Substantially all of the terminated employees were either in management
positions or were professionals including engineers and accountants.
 
     During the fourth quarter of fiscal 1995, the Interel and VIC subsidiaries
were reorganized and combined. The reorganization of these operations and costs
of settling a lawsuit resulted in a one-time charge of approximately $0.2
million. In the fourth quarter of 1995, the Company recorded a nonrecurring
charge of approximately $1.1 million for acquisition costs related to the Allied
merger, which is more fully described in Note 2 to the financial statements.
 
NOTE 4 -- CONTRACTS IN PROGRESS
 
     The Company obtains substantially all of its contracts through competitive
bids. The Company's prerequisites for billing on contracts vary with individual
contract terms. The Company sometimes has bonds or letters of credit as
collateral on accounts receivable, and generally all amounts are due in the
month following performance under contract except for retainages that are
collected upon completion of the contract. The Company has lien rights on
certain contracts.
 
                                      F-14
<PAGE>   18
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
     Costs incurred to date, estimated earnings and the related progress
billings to date on contracts in progress are as follows:
 
<TABLE>
<CAPTION>
                                                                 1995
                                                              AS RESTATED
                                                               (NOTE 1)        1996
                                                              -----------    --------
<S>                                                           <C>            <C>
Costs incurred to date......................................   $ 49,137      $ 53,037
Estimated earnings..........................................     14,801        17,701
                                                               --------      --------
Revenue recognized..........................................     63,938        70,738
Progress billings to date...................................    (48,867)      (51,961)
Costs incurred for which no revenues were recognized to
  date......................................................      2,181           955
                                                               --------      --------
                                                               $ 17,252      $ 19,732
                                                               ========      ========
</TABLE>
 
     The preceding is included in the accompanying consolidated balance sheets
as follows:
 
<TABLE>
<CAPTION>
                                                                 1995
                                                              AS RESTATED
                                                               (NOTE 1)       1996
                                                              -----------    -------
<S>                                                           <C>            <C>
Costs and estimated earnings in excess of billings on
  uncompleted contracts.....................................    $18,067      $20,690
Billings in excess of costs and estimated earnings on
  uncompleted contracts.....................................       (815)        (958)
                                                                -------      -------
                                                                $17,252      $19,732
                                                                =======      =======
</TABLE>
 
NOTE 5 -- LONG-TERM OBLIGATIONS
 
     Long-term obligations include the following:
 
<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              ------------------
                                                               1995       1996
                                                              -------    -------
<S>                                                           <C>        <C>
Secured term loan note ("term loan"), maturing October 31,
  2001; due in quarterly installments of $1,500 commencing
  January 31, 1997 and increasing to $1,813 after the first
  four payments, with interest (December 31, 1996 -- 8.6%)
  fluctuating with the Offshore Rate or Base Rate defined
  below.....................................................  $10,000    $35,000
Secured note maturing November 18, 2001, under a revolving
  credit facility ("line of credit") totaling $38,000 with
  interest (December 31, 1996 -- 8.9%) fluctuating with the
  Offshore Rate or Base Rate defined below..................   11,499     25,400
Unsecured senior subordinated notes maturing November 18,
  2003, bearing interest at 12% through 1997 increasing 0.5%
  per year through maturity.................................       --     15,000
Less debt discount related to issuance of detachable
  warrants in conjunction with senior subordinated notes....       --     (2,288)
Other.......................................................       56         41
                                                              -------    -------
                                                               21,555     73,153
Less current maturities.....................................   (3,347)    (6,012)
                                                              -------    -------
Long-term obligations, net of current maturities............  $18,208    $67,141
                                                              =======    =======
</TABLE>
 
                                      F-15
<PAGE>   19
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
     Scheduled maturities of long-term obligations are as follows:
 
<TABLE>
<S>                                                           <C>
1997........................................................  $ 6,012
1998........................................................    7,262
1999........................................................    7,262
2000........................................................    7,255
2001........................................................   32,650
Thereafter..................................................   12,712
                                                              -------
                                                              $73,153
                                                              =======
</TABLE>
 
     On November 18, 1996, the Company revised its financing agreement to, among
other things, increase its credit facilities with participating financial
institutions ("Lenders"), including Bank of America National Trust and Savings
Association ("BoA"), as agent for the Lenders. The financing consists of a $35
million term loan and a $38 million revolving line of credit facility. The term
loan currently bears interest at the BoA Offshore Rate ("Offshore Rate"), as
defined by BoA, plus a spread, and the line of credit bears interest at the
Offshore Rate or the Base Rate plus spreads. The spread can range from 2% to 3%
above the Offshore Rate and from 0.25% to 1.25% above the Base Rate. The spread
increases or decreases based on the Company's leverage ratio. Substantially all
of the assets of the Company serve as collateral.
 
     In addition to the bank financing, on November 18, 1996, the Company
entered into two Senior Subordinated Notes ("Subordinated Notes") with
International Mezzanine Capital, B.V. and First Commerce Capital, (collectively,
the "Subordinated Note Holders"), for $13 million and $2 million, respectively.
The Subordinated Notes, which mature November 18, 2003, bear interest at 12%
through December 31, 1997 and increase by 0.5% per year for each year they
remain unpaid. As further consideration, the Subordinated Note Holders received
warrants to purchase an aggregate of 1,760 shares of the Company's Common Stock
at $5.10 per share, subject to adjustment. The warrants may be exercised at any
time or from time to time until they expire on November 18, 2003. The warrants
were valued at approximately $2.3 million, which was reflected as equity and as
a debt discount at the date of their issuance, and will be amortized as
additional interest expense over the seven-year life of the Subordinated Notes.
 
     The debt obligations require the Company to maintain certain levels of
working capital and stockholders' equity and contain other provisions, some of
which restrict expenditures for the purchase of the Company's stock, for capital
expenditures and for payment of dividends. Such agreements also limit, subject
to the Lenders' and Subordinated Note Holders' consent, the creation, incurrence
or assumption of indebtedness (as defined by the agreements) and acquisitions
and investments. At December 31, 1996, the Company was in compliance with the
provisions of its debt agreements.
 
                                      F-16
<PAGE>   20
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
NOTE 6 -- LEASE COMMITMENTS
 
     The Company and its subsidiaries are obligated under various leases for
office and manufacturing facilities and certain machinery, equipment and
fixtures. Certain leases have renewal or escalation clauses or both. The
following is a schedule of minimum rental commitments under all non-cancellable
leases which expire at various dates:
 
<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31,
------------------------
<S>                      <C>                                                <C>
        1997..............................................................  $  924
        1998..............................................................     795
        1999..............................................................     667
        2000..............................................................     599
        2001..............................................................     571
        Thereafter........................................................   1,579
                                                                            ------
                                                                            $5,135
                                                                            ======
</TABLE>
 
     The leases provide for payment of maintenance and other expenses by the
Company. Rent expense was $1.1 million, $1.2 million, and $1.2 million for the
years ended December 31, 1994, 1995 and 1996, respectively.
 
NOTE 7 -- INCOME TAXES
 
     Provision for income taxes consists of the following:
 
<TABLE>
<CAPTION>
                                               YEAR ENDED DECEMBER 31,
                                          ---------------------------------
                                           1994         1995         1996
                                          -------      -------      -------
<S>                                       <C>          <C>          <C>
Current:
  Federal...............................  $   644      $ 1,069      $    --
  State.................................      105          201           --
  Foreign...............................       33          112          160
                                          -------      -------      -------
                                              782        1,382          160
                                          -------      -------      -------
Deferred:
  Federal...............................      119           99         (419)
  State.................................        6           19          (74)
  Foreign...............................     (569)          --          337
                                          -------      -------      -------
                                             (444)         118         (156)
                                          -------      -------      -------
Provision for income taxes..............  $   338      $ 1,500      $     4
                                          =======      =======      =======
</TABLE>
 
     The earnings before taxes relating to foreign operations totaled
approximately $0.1 million and $1.4 million for the years ended December 31,
1995 and 1996, respectively. The loss before taxes relating to foreign
operations totaled approximately $1.3 million for the year ended December 31,
1994.
 
                                      F-17
<PAGE>   21
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
     The tax effects of the financial reporting and income tax reporting basis
differences which give rise to the deferred income tax asset and liability are
as follows:
 
<TABLE>
<CAPTION>
                                              DECEMBER 31,
                                          --------------------
                                           1995         1996
                                          -------      -------
<S>                                       <C>          <C>
Net current deferred income tax assets:
  Compensation recognition..............  $    --      $   382
  Accruals and reserves.................      439        1,056
  Tax benefit carryforwards.............       --          825
  Contract accounting...................     (213)        (316)
  Other.................................       14           32
                                          -------      -------
                                          $   240      $ 1,979
                                          =======      =======
Net non-current deferred income tax
  liabilities:
  Tax benefit carryforwards.............  $   524      $   208
  Property and equipment................     (444)        (692)
  Intangible assets.....................     (197)        (313)
  Other.................................        6            2
  Valuation allowance...................     (146)        (146)
                                          -------      -------
                                          $  (257)     $  (941)
                                          =======      =======
</TABLE>
 
     The valuation allowance relates to deferred tax assets established under
SFAS No. 109 for losses incurred in foreign subsidiaries. These losses will be
carried forward to future years for utilization and are not expected to expire.
 
     As of December 31, 1995 and 1996, the Company had regular U.S. and foreign
net operating loss carryforwards for tax reporting purposes totaling
approximately $1.3 million and $2.6 million, respectively. The majority of the
foreign net operating loss carryforwards do not have an expiration date.
 
     Differences between the Company's effective income tax rate and the
statutory federal income tax rate are as follows:
 
<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                              -------------------------
                                                              1994      1995      1996
                                                              -----    -------    -----
<S>                                                           <C>      <C>        <C>
Tax provision at the federal statutory income tax rate......   $277     $  768     $(28)
Differences in foreign versus U.S. tax rates................    (79)         7        9
State income taxes, net of federal benefit..................     46        178      (74)
Amortization of intangible assets...........................     70        104       84
Non-deductible acquisition costs............................     --        234       --
S Corporation income........................................     --       (202)      --
Conversion from S-Corporation...............................     --        491       --
Valuation allowance.........................................     --       (137)      --
Other.......................................................     24         57       13
                                                               ----     ------     ----
          Total Tax Provision...............................   $338     $1,500     $  4
                                                               ====     ======     ====
</TABLE>
 
     During 1995, the valuation allowance was reduced by $137 in order to
properly recognize the portion of the Company's deferred tax asset which was
more likely than not to be realized.
 
                                      F-18
<PAGE>   22
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
NOTE 8 -- STOCK WARRANTS AND OPTIONS
 
STOCK WARRANTS
 
     Following is a summary of the warrants outstanding at December 31, 1996:
 
<TABLE>
<CAPTION>
                                                              STOCK      EXERCISE
                                              OUTSTANDING    ISSUABLE     PRICE
                                     DATE         AND          UPON        PER       EXPIRATION
           DESCRIPTION              ISSUED    EXERCISABLE    EXERCISE     SHARE         DATE
           -----------              ------    -----------    --------    --------    ----------
<S>                                 <C>       <C>            <C>         <C>         <C>
Financial advisor:
  Warrants........................   6/92          100          140       $4.42         6/97
  Warrants........................   4/96           34           34       $4.72         4/98
Underwriter warrants..............  12/92           50           50       $4.80        12/97
Subordinated debt warrants........  11/96        1,760        1,760       $5.10        11/03
                                                 -----        -----
          Total...................               1,944        1,984
                                                 =====        =====
</TABLE>
 
     No warrants have been exercised. The exercise price of the subordinated
debt warrants and the financial advisor warrants issued in June of 1992 are
subject to adjustment.
 
STOCK OPTIONS
 
     On October 1, 1990, the Company's Board of Directors approved an Employee
Stock Option Plan (the "Plan") which was subsequently amended and which provides
for the issuance of up to 10% of the Company's outstanding shares of Common
Stock shares but initially not less than 1,250 shares of Common Stock (subject
to anti-dilution provisions). Options granted expire in five to ten years, and
the option price, which must be at least the fair market value of the Company's
stock at the date of grant can be paid in cash or in shares of the Company's
Common Stock. Options may not be transferred by the optionee other than by will
or the laws of descent and distribution.
 
     The Company's Board of Directors approved the Directors' Stock Option Plan
on May 19, 1993, which provides for the issuance of up to 200 shares of Common
Stock (subject to anti-dilution provisions). The plan currently provides that
each outside director will be granted an option to purchase 10 shares of Common
Stock at the fair market value of the Common Stock at the date of grant at each
time the director is elected, re-elected or appointed to the Board of Directors.
Options granted under this plan expire after ten years, and the option price
must be paid in cash. Options may not be transferred by the optionee other than
by will or the laws of descent and distribution.
 
     The Company accounts for these plans under APB Opinion No. 25, under which
no compensation cost has been recognized. Had compensation cost for these plans
been determined consistent with SFAS No. 123 "Accounting for Stock-Based
Compensation", the Company's net earnings (loss) and net earnings (loss) per
common share would have been reduced to the following pro forma amounts:
 
<TABLE>
<CAPTION>
                                                               YEAR ENDED
                                                              DECEMBER 31,
                                                              -------------
                                                              1995     1996
                                                              -----    ----
<S>                                                           <C>      <C>
Net earnings (loss):
  As reported...............................................  $ 760    $(86)
  Pro forma.................................................    730    (199)
Net earnings (loss) per common share:.......................
  As reported...............................................    .07    (.01)
  Pro forma.................................................    .06    (.02)
</TABLE>
 
                                      F-19
<PAGE>   23
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
     Because the SFAS 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the resulting pro forma compensation cost may
not be representative of the pro forma cost to be expected in future years. The
fair value of each option grant is estimated on the date of the grant using the
Black-Scholes option-pricing model with the following assumptions:
 
<TABLE>
<CAPTION>
                                                     1995 GRANTS         1996 GRANTS
                                                   ---------------    -----------------
<S>                                                <C>                <C>
Expected dividend yield..........................        0%                  0%
Expected stock price volatility..................  39.74% - 45.09%     42.88% - 44.85%
Risk free interest rate..........................   5.43% - 6.48%       5.38% - 6.93%
Expected life of options.........................   5 to 10 years      4.25 - 10 years
</TABLE>
 
     A summary of the status of the Company's two stock option plans at December
31, 1995 and 1996 and changes during the years then ended is presented in the
table below.
 
<TABLE>
<CAPTION>
                                                       1995                   1996
                                                -------------------    -------------------
                                                           WTD AVG                WTD AVG
                                                SHARES    EX PRICE     SHARES    EX PRICE
                                                ------    ---------    ------    ---------
<S>                                             <C>       <C>          <C>       <C>
Outstanding at beginning of year..............    751      $ 4.00        953      $ 3.63
Granted.......................................    249        2.50        385        3.66
Exercised.....................................     --       (3.38)       (42)      (3.15)
Forfeited.....................................    (47)      (3.52)      (201)      (3.42)
Expired.......................................     --          --         --          --
                                                -----      ------      -----      ------
Outstanding at end of year....................    953      $ 3.63      1,095      $ 3.70
                                                =====      ======      =====      ======
Exercisable at end of year....................    474      $ 3.96        681      $ 3.88
                                                =====      ======      =====      ======
Weighted average fair value of options
  granted.....................................  $1.19                  $1.78
                                                =====                  =====
</TABLE>
 
     The options outstanding at December 31, 1996 have exercise prices between
$2.44 and $4.75 and a weighted average remaining contractual life of 4.44 years.
 
     The Company maintains an Employee Stock Purchase Plan whereby all employees
are eligible for participation after ninety days of service. Under this plan,
employees may purchase stock at 90% of the current market price of the stock.
During the years ended December 31, 1995 and December 31, 1996, 15 and 15
shares, respectively, were issued under the plan.
 
NOTE 9 -- COMMITMENTS AND CONTINGENCIES
 
     The Company is party to certain legal proceedings which are considered by
management to be customary and incidental to its business. In the opinion of
management, after consulting with legal counsel, the ultimate disposition of
these lawsuits will not have a material adverse effect on the Company's
financial position or results of operations.
 
                                      F-20
<PAGE>   24
 
                          ITEQ, INC. AND SUBSIDIARIES
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
 
NOTE 10 -- MAJOR CUSTOMERS AND FOREIGN OPERATIONS
 
     Due to the nature of the Company's business, contracts are generally
nonrecurring. For the year ended December 31, 1996, no single customer accounted
for 10% of revenues. For the years ended December 31, 1994 and 1995, a single
customer accounted for revenues of 11% and 10%, respectively.
 
     Financial data by geographical area is as follows:
 
<TABLE>
<CAPTION>
                                                            YEAR ENDED DECEMBER 31,
                                                     --------------------------------------
                                                                      1995
                                                         1994          AS
                                                     AS RESTATED    RESTATED
                                                       (NOTE 1)     (NOTE 1)       1996
                                                     ------------   --------    -----------
<S>                                                  <C>            <C>         <C>
Revenue:
  North America....................................    $56,764      $101,546     $ 96,024
  Europe...........................................      1,913         6,974        8,866
  Asia.............................................      3,149         4,644        5,914
                                                       -------      --------     --------
          Total....................................    $61,826      $113,164     $110,804
                                                       =======      ========     ========
Operating profit (loss):
  North America....................................    $ 2,558      $  2,640        1,237
  Europe...........................................     (1,140)          404          620
  Asia.............................................        175           392          416
                                                       -------      --------     --------
          Total....................................    $ 1,593      $  3,436     $  2,273
                                                       =======      ========     ========
Identifiable assets:
  North America....................................    $47,916      $ 63,983     $128,915
  Europe...........................................      3,214         4,276        5,633
  Asia.............................................      1,670         2,585        1,840
                                                       -------      --------     --------
          Total....................................    $52,800      $ 70,844     $136,388
                                                       =======      ========     ========
</TABLE>
 
     Including exports, international sales accounted for approximately 23% of
total revenues in 1996.
 
NOTE 11 -- SUBSEQUENT EVENT (UNAUDITED)
 
     The Company is in the process of filing a registration statement on Form
S-2 to register for sale 5.1 million shares of common stock (4.3 million from
the Company and 0.8 million from certain selling stockholders). The primary use
of the offering proceeds to the Company will be to reduce debt incurred in the
aforementioned acquisitions and for potential future acquisitions.
 
                                      F-21
<PAGE>   25
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                                DESCRIPTION
-------                               -----------
<C>      <S>  <C>
    3.1  --   Certificate of Incorporation of Registrant, as amended
              (Filed as an exhibit to Form 10-Q for the quarter ended June
              30, 1995 and incorporated herein by reference).
    3.2  --   Certificate of Amendment to Certificate of Incorporation of
              Registrant (Filed as an exhibit to Form 8-K dated March 7,
              1997 and incorporated herein by reference).
    3.3  --   Bylaws of the Registrant, as amended (Filed as an exhibit to
              Form 10-Q for the quarter ended September 30, 1995 and
              incorporated herein by reference).
    4.1  --   See Exhibits 3.1 and 3.3 for provisions of the Certificate
              of Incorporation and Bylaws of the Registrant defining the
              rights of holders of Common Stock.
    4.2  --   Amended and Restated Credit Agreement dated November 18,
              1996, among the Registrant, Bank of America National Trust
              and Savings Association, as Agent, The First National Bank
              of Boston, as Co-Agent and certain other financial
              institutions. (Filed as an exhibit to Form 8-K dated
              December 5, 1996 and incorporated herein by reference).
    4.3  --   Subordination Agreement among the Registrant and various
              financial institutions (the "Senior Lenders"), including
              Bank of America National Trust and Savings Association, as
              Agent, and The First National Bank of Boston, as Co-Agent.
              (Filed as an exhibit to Form 8-K dated December 5, 1996 and
              incorporated herein by reference).
    4.4  --   Subordinated Note and Purchase Agreement dated November 18,
              1996, among the Registrant, International Mezzanine Capital,
              B.V. ("Mezzanine") and First Commerce Corporation ("First
              Commerce"). (Filed as an exhibit to Form 8-K dated December
              5, 1996 and incorporated herein by reference).
    4.5  --   Senior Subordinated Note due November 18, 2003, between the
              Registrant and Mezzanine, dated November 18, 1996. (Filed as
              an exhibit to Form 8-K dated December 5, 1996 and
              incorporated herein by reference).
    4.6  --   Senior Subordinated Note due November 18, 2003, between the
              Registrant and First Commerce, dated November 18, 1996.
              (Filed as an exhibit to Form 8-K dated December 5, 1996 and
              incorporated herein by reference).
    4.7  --   Guaranty dated November 18, 1996, executed by the Registrant
              in favor of Mezzanine and First Commerce. (Filed as an
              exhibit to Form 8-K dated December 5, 1996 and incorporated
              herein by reference).
    4.8  --   Warrant Agreement, dated November 18, 1996, between the
              Registrant and Mezzanine. (Filed as an exhibit to Form 8-K
              dated December 5, 1996 and incorporated herein by
              reference).
    4.9  --   Warrant Agreement dated November 18, 1996, between the
              Registrant and First Commerce. (Filed as an exhibit to Form
              8-K dated December 5, 1996 and incorporated herein by
              reference).
   4.10  --   Registration Rights Agreement dated November 18, 1996, among
              the Registrant, Mezzanine, and First Commerce. (Filed as an
              exhibit to Form 8-K dated December 5, 1996 and incorporated
              herein by reference).
   4.11  --   Warrant Agreement, dated April 24, 1996, between the
              Registrant and Sanders Morris Mundy, Inc. (Filed as an
              exhibit to Form 10-Q for the quarter ended September 30,
              1996 and incorporated herein by reference).
   4.12  --   Warrant Agreement, dated December 1992, between Registrant
              and Pennsylvania Merchant Group, Ltd. (Filed as an exhibit
              to Form 10-K for fiscal year ending March 31, 1993 and
              incorporated herein by reference).
   10.1  --   Agreement and Plan of Merger dated September 19, 1996, among
              the Registrant, Air-Cure Acquisition, Inc. and Ohmstede,
              Inc. (Filed as an exhibit to Form 10-Q for the quarter ended
              September 30, 1996 and incorporated herein by reference).
</TABLE>
<PAGE>   26
   
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                                DESCRIPTION
-------                               -----------
<C>      <S>  <C>
   10.2  --   Agreement and Plan of Merger dated October 13, 1995, among
              the Registrant, Air-Cure Acquisition Corporation, Allied
              Industries, Inc., Mark E. Johnson and Pierre S. Melcher.
              (Filed as an exhibit to Post-Effective Amendment No. 1 to
              Form S-4 Registration Statement (No. 33-92308) and
              incorporated herein by reference).
   10.3  --   Agreement and Plan of Merger dated April 28, 1994, among the
              Registrant., VIC Acquisition Corporation, VIC Environmental
              Systems, Inc. and Ronald E. Lewis. (Filed as an exhibit to
              Post-Effective Amendment No. 1 to Form S-1 Registration
              Statement (No. 33-69524) and incorporated herein by
              reference).
   10.4  --   Agreement and Plan of Merger dated April 5, 1994, among the
              Registrant, Air-Cure Acquisition Corporation, Amerex, Inc.,
              Amerex Industries, Inc. and certain other parties. (Filed as
              an exhibit to Post-Effective Amendment No. 1 to Form S-1
              Registration Statement (No. 33-69524) and incorporated
              herein by reference).
   10.5  --   Employment Agreement dated March 1, 1996, between the
              Registrant and Lawrance W. McAfee. (Filed as an exhibit to
              Form 10-Q for the quarter ended September 30, 1996 and
              incorporated herein by reference).
   10.6  --   Employment Agreement dated December 29, 1995, between the
              Registrant and Mark E. Johnson. (Filed as an exhibit to Form
              10-K for the year ended December 31, 1995 and incorporated
              herein by reference).
   10.7  --   Employment Agreement dated December 29, 1995, between the
              Registrant and Pierre S. Melcher. (Filed as an exhibit to
              Form 10-K for the year ended December 31, 1995 and
              incorporated herein by reference).
   10.8  --   Employment Agreement dated March 1, 1995, between the
              Registrant and John P. Fitzpatrick. (Filed as an exhibit to
              Form 10-K for the year ended December 31, 1994 and
              incorporated herein by reference).
   10.9  --   Employment Agreement dated December 17, 1992, between the
              Registrant and Michael P. Lawlor. (Filed as an exhibit to
              Form 10-K for the fiscal year ended March 31, 1993 and
              incorporated herein by reference).
  10.10  --   Employees Stock Purchase Plan, as amended, dated December
              15, 1994. (Filed as an exhibit to Form 10-K for year ended
              December 31, 1994 and incorporated herein by reference).
  10.11  --   Director Stock Option Plan, as amended. (Plan filed as an
              exhibit to Proxy Statement for Annual Meeting of
              Stockholders hold on June 29, 1995, and amendment filed as
              an exhibit to Form 10-Q for the quarter ended June 30, 1996
              both of which are incorporated herein by reference).
  10.12  --   Amended and Restated 1990 Stock Option Plan, as amended,
              dated June 29, 1995. (Filed as an exhibit to Proxy Statement
              for Annual Meeting of Stockholders held on June 29, 1995 and
              incorporated herein by reference).
  10.13  --   Form of Stock Option Agreement. (Filed as an exhibit to Form
              10-K for the fiscal year ended March 31, 1993 and
              incorporated herein by reference).
  10.14  --   Lease Agreement dated May 25, 1994, between Halligan and
              Labbe Enterprises, L.L.C. and Amerex Industries, Inc. (Filed
              as an exhibit to Form 10-K for the year ended December 31,
              1994 and incorporated herein by reference).
  10.15  --   License and Technical Assistance Agreement dated August 28,
              1991, between Interel Environmental Technologies, Inc. and
              Heinrich Luhr Staubtechnik GmbH & Co. (Filed as an exhibit
              to Form S-1 (No. 33-44205) and incorporated herein by
              reference).
  *23.1  --   Consent of Arthur Andersen LLP.
  *23.2  --   Consent of KPMG Peat Marwick LLP.
   23.3  --   Letter of Arthur Andersen LLP regarding change in
              accounting.
</TABLE>
    
 
---------------
* Filed herewith.