<PAGE>
                    U. S. Securities and Exchange Commission
                              Washington, DC 20549

                                  Form 10-K SB/A

[X]      ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES AND 
         EXCHANGE ACT OF 1934 (FEE REQUIRED)

                     For the fiscal year ended June 30, 1996

                         Commission file number 0-17293

                          DRUG SCREENING SYSTEMS, INC.
                  -------------------------------------------
                 (Name of small business issuer in its charter)

         Pennsylvania                                      22-2795073
         ------------                                      ----------
  (State or other jurisdiction of                        (I.R.S. Employer
  incorporation or organization)                        Identification No.)

 604 VPR Commerce Center, 1001 Lower Landing Road, Blackwood, NJ 08012
 ---------------------------------------------------------------------
(Address of principal executive offices)                    (Zip Code)
 
                    Issuer's telephone number (609) 228-8500

Securities registered under Section 12(b) of the Exchange Act:         None

Securities registered under Section 12(g) of the Exchange Act:

                          Common Stock, $0.01 par value
                          -----------------------------
                                (Title of class)
                 Redeemable Warrants expiring December 31, 1996
                 ----------------------------------------------
                                (Title of class)

         Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 .

         Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B is not contained in this form, and no disclosure will
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-KSB
or any amendment to this Form 10-KSB. [ ]

                            The issuer's revenues for the fiscal year ended June
30, 1996 were $2,172,310.

         The aggregate market value at September 13, 1996 of shares of the
Common Stock held by non-affiliates was $656,052 based upon the bid price of the
Company's Common Stock as reported by the NASD in the OTC Bulletin Board. Solely
for the purpose of this calculation, shares held by certain principal
shareholders named in Item 11 hereof, as well as shares held by directors and
officers of the Registrant, have been excluded. Such exclusion should not be
deemed a determination or an admission by the issuer that such shareholders or
individuals are, in fact, affiliates of the issuer.

         On September 13, 1996, there were 4,246,017 of the issuer's Common
Stock, $0.01 par value, outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE
                       -----------------------------------
                                      None

<PAGE>


                           DRUG SCREENINGSYSTEMS, INC.
                                 FORM 10-K SB/A
                         Fiscal Year Ended June 30, 1996

                                TABLE OF CONTENTS
                                -----------------
<TABLE>
<CAPTION>

                                                                                                Page
                                                                                                ----
                                     PART I

<S>  <C>                                                                                         <C>
Item 1            Description of Business                                                        3

Item 2            Description of Property                                                        11

Item 3            Legal Proceedings                                                              11

Item 4            Submission of Matters to a Vote of Security Holders                            11

                                     PART II

Item 5            Market for Common Equity and Related Stockholder Matters                       12

Item 6            Management's Discussion and Analysis or Plan of Operations                     14

Item 7            Financial Statements                                                           17

Item 8            Changes in and Disagreements with Accountants on Accounting                    27
                  and Financial Disclosures

                                    PART III

Item 9            Directors, Executive Officers, Promoters and Control Persons;                  28
                  Compliance with Section 16(a) of the Exchange Act

Item 10           Executive Compensation                                                         29

Item 11           Security Ownership of Certain Beneficial Owners and Management                 31

Item 12           Certain Relationships and Related Transactions                                 33

                                     PART IV

Item 13           Exhibits, List and Reports on Form 8-K                                         34

Signatures                                                                                       38
</TABLE>


<PAGE>


                                     PART 1

ITEM 1   Description of Business

General

Drug Screening Systems, Inc. (the "Company") was organized under the laws of the
Commonwealth of Pennsylvania on March 17, 1987 under the name of Analytical
Innovations, Inc. On December 29, 1987, the Company adopted its current name of
Drug Screening Systems, Inc. The Company's principal executive offices are
located at 604 VPR Commerce Center, 1001 Lower Landing Road, Blackwood, New
Jersey 08012 and its telephone number is (609) 228-8500.

The Company began the development of its current product line in August 1989. To
date, the Company has developed and markets tests for cocaine, opiates (heroin,
morphine and codeine), methamphetamines, THC (marijuana), barbiturates, PCP
(phencyclidine), amphetamines and benzodiazepines. The Company markets its tests
under the names MACH IV(R) Screen and microLINE(R) Screen (collectively, the
"Products").

The Products are sold for "Medical Uses" (e.g., in vitro diagnostic use by
physicians and hospitals) and "Non-Medical Uses" (e.g., pre-employment screening
and screening by correctional and criminal justice agencies).

The Company's sales for the fiscal year ended June 30, 1996 ("Fiscal 1996") of
$2,172,310 decreased from $2,705,051 in the prior fiscal year ended June 30,
1995 ("Fiscal 1995"). As sales in Fiscal 1996 decreased by $532,741, the net
loss for Fiscal 1996 increased by $156,432 from $295,356 in Fiscal 1995 to
$451,788 in Fiscal 1996. See Items 6 and 7 of this Report.

As a result of the net losses since inception, the Company's cash flows from
operating activities have been negative. Accordingly, the Company has financed
its operations and research and development program primarily through proceeds
received from its initial public offering in May 1988, the exercise of warrants
thereafter and subsequent securities offerings, including the sale of shares of
its Common Stock, $.01 par value (the "Common Stock"), through a rights offering
in June and July, 1993. During Fiscal 1996, the Company raised $450,000 through
a private placement pursuant to Regulation D under the Securities Act of 1933,
as amended (the"Securities Act"). Under this offering, shares of the Common
Stock were issued at $0.25 per share.

The Board of Directors is continuing to explore various financing options,
including a possible sale or merger. However, there are no pending negotiations
for either a sale or a merger.

In view of the losses, there can be, of course, no assurance that management's
actions to increase revenues and to control expenses will result in the Company
achieving profitability for the entire fiscal year ending June 30, 1997 ("Fiscal
1997") or thereafter. See Item 6 to this Report for a more detailed discussion.

UNLESS THE COMPANY CAN (1) OBTAIN CAPITAL CONTRIBUTIONS OR FINANCING AS MAY BE
REQUIRED TO FULFILL ITS DEVELOPMENT AND MARKETING ACTIVITIES, (2) ACHIEVE A
LEVEL OF SALES ADEQUATE TO SUPPORT THE COMPANY'S COST STRUCTURE AND (3)
ULTIMATELY OPERATE PROFITABLY, THE COMPANY WILL BE UNABLE TO CONTINUE AS A GOING
CONCERN. THERE CAN BE, OF COURSE, NO ASSURANCE THAT THE COMPANY WILL ACHIEVE ANY
OR ALL OF THESE OBJECTIVES.

Management of the Company is of the opinion that the Company is, and during its
last three fiscal years has been, engaged in only one industry segment.

                                       3


<PAGE>


During Fiscal 1996, the Company conducted all of its operations within the
continental United States; however, during the past two fiscal years, certain
sales outside the United States have been made directly and by distributors. See
the section "Marketing and Distribution" in this Item 1 to this Report.

The Products

The Products are initial drug screens based upon an immunoassay format designed
to detect the presence of a particular drug or metabolite of a drug being tested
in human urine. The tests are administered on-site as compared with the taking
of a urine or blood sample and delivering it to a laboratory for analysis.

Immunoassay tests generically have been accepted by the National Institute on
Drug Abuse ("NIDA") for initial screening for drugs of abuse. They are designed
to indicate the presence or absence of the substance being screened at or above
the NIDA prescribed minimum quantity for positive responses to initial drug
screening. If conclusive quantitative verification of the presence and the
precise quantity is required, as would be the case in certain medical uses of
the tests, standard industry procedure requires the performance of additional
tests by a quantitative method such as gas chromatography/mass spectrometry
("GC/MS") analysis.

Each of the Products is a self contained cassette, slightly thinner and larger
than a standard audio cassette, in which one or more drug tests is housed. Four
drops of urine are deposited in an opening on the face of each cassette for each
test. No special training is required to perform a test. No reagents, other
substances or additional equipment are required. The Products provide results
within ten minutes at the site of the test. The Products indicate a positive
response by the appearance of one line in the individual test viewing window and
a negative response by the appearance of two lines, which the Company believes
enables the user to clearly and easily understand the indication. The used
cassette can be disposed of without special handling or may be retained as a
permanent record. On-site testing provides an initial drug screen without the
more expensive and time consuming procedure of sending samples to the
laboratory. It also simplifies establishing a chain of custody for the samples.
The Company believes that the use of its Products may be helpful in narrowing
the scope of situations in which laboratory tests are used (by quickly
eliminating negative test results), thereby further reducing costs for the
testing entity.

Each of the Company's tests has a stated "shelf-life" based upon initial and
continuing testing conducted internally by the Company. The shelf-life of a test
is primarily based upon its ability to continue to perform according to its
specifications with no statistically significant evidence of product failure.
Currently, the refrigerated shelf-life of the Company's tests ranges from 12 to
24 months from the date of manufacture. A Product containing multiple tests is
rated for shelf-life on the basis of the shortest remaining shelf-life of the
tests contained therein. The shelf-life of a Product is conspicuously displayed
on the wrapper of the Product. Since the introduction of the first of its
current tests, the Company has had no instance of Product failure traceable to a
shelf-life problem occurring within the stated period. During Fiscal 1996, the
Company received 86 inquiries from its customers concerning Product performance,
none of which related to failures based on shelf-life problems. It is the
Company's policy not to refund the purchase price for expired Products, and it
has not done so in the past.

In developing a drug test, the Company performs evaluations in its own
laboratory on multiple pilot plant small scale pre-production runs using
positive and negative control urine specimens, as well as substances that might
cross-react in the assay being tested. If such a test yields satisfactory
results, a clinical field trial is conducted, including a comparison of results
utilizing the EMIT (e.g., enzyme-multiplied immunoassay technique) procedure,
one of the four principal laboratory drug screening methods currently available.
In addition, GC/MS analysis, which is the procedure by which the drug testing
industry confirms the results of both on-site and in-lab drug tests, is
performed using negative/positive field specimens. To date, the Company has
utilized the laboratories of the Hospital of the University of Pennsylvania in
Philadelphia, Pennsylvania to perform the independent clinical evaluations prior
to submitting pre-market applications to the FDA. 

                                       4

<PAGE>

Upon successful completion of an independent evaluation, the Company submits its
data to the FDA for an equivalency determination for clearance to market the
product as an in vitro diagnostic product under Section 510(k) of the Federal
Food, Drug and Cosmetic Act. See the section "Governmental Regulation" in this
Item 1 to this Report.

Governmental Regulation
-----------------------

Sale of the Products (and any other drug screening test that may be developed by
the Company in the future) for Medical Uses is subject to regulation by the FDA
under Section 510(k) of the Federal Food, Drug and Cosmetic Act. Those
regulations require, among other things, that the tests are substantially
equivalent to devices marketed in interstate commerce, that information relating
to the safety and effectiveness of the products be provided to the FDA and that
the Company demonstrates that its procedures and manufacturing facility conform
to the "Good Manufacturing Practice" standards of the FDA. No test may be sold
for Medical Uses until Cleared for Marketing by the FDA. All such clearances
remain in effect as of the date hereof.

Federal legislation has been proposed that would, among other things, require
the institution of standards for drug testing procedures and the use of
certified laboratories for employee drug testing. If enacted in its current
form, such legislation could have a substantial adverse impact upon certain
market segments of the Company's business. There is can be no assurance that
such legislation will or will not be adopted or, if adopted, the final form the
legislation will take.

In addition, regulations implementing the Clinical Laboratory Improvement
Amendments of 1988 ("CLIA"), promulgated by the United States Department of
Health and Human Services ("HHS") and the Health Care Financing Administration
on February 28, 1992, which were to become effective September 1, 1992, require
that all employment drug testing, including on-site testing, be processed by a
federally approved laboratory. On August 28, 1992, HHS announced that the
application of CLIA to workplace testing would not go into effect on September
1, 1992 because of comments made on the final regulations. The comments raised
questions about, among other things, whether bringing employee drug testing
under CLIA might have an unintended chilling effect on efforts to encourage
drug-free workplace programs. As reported in the January 19, 1993 Federal
Register, the final decision on the regulations will be delayed until further
investigation is completed and has not been made as of the date hereof. The
Company believes that these regulations will not be made effective because (a)
the increased costs and burdensome procedures imposed by CLIA will significantly
reduce the volume of drug tests conducted which is in direct conflict with the
government's long standing war on drugs, (b) work place testing is forensic in
nature (i.e., for the purpose of determining whether an individual is using
illegal drugs) and not for medical purposes (i.e., to make a health assessment
for diagnostic or treatment purposes) as was the original intent of CLIA, and
(c) inclusion of employment drug testing may be a direct violation of the
Federal Administrative Procedures Act under Title 5 of the United States Code
and the United States Constitution. If the regulations are not adopted, on-site
drug testing in the workplace will not be subject to CLIA. The consequences of
adoption of the regulations may have a material adverse impact upon the
Company's business with respect to employment testing in the private sector.

Certain agencies of the United States Government have adopted regulations with
respect to internal employee drug testing and testing of public and private
organization employees they regulate. Most of these regulations require the use
of a certified laboratory. The Company does not believe the exclusion of these
agencies or additional agencies which might adopt such internal regulations in
the future from its potential market has had, or will have, a material adverse
impact upon its potential business. State legislation has been passed or
proposed to allow on-site testing of employees.

Patents
-------

The Company obtained patent protection in the United States for its analytical
test devices and test assemblies for detecting drugs of abuse in biological
fluids using immunochromatographic procedures

                                       5

<PAGE>

from the United States Patent and Trademark Office on August 24, 1993 (U.S.
Patent #5,238,652). Additionally, a patent is pending for the design of a new
modular housing (SN 08/171,109). The term of the patents is 17 years from the
date of issuance, subject to renewal. The Company intends to file additional
patent applications from time to time with respect to its analytical test
devices and test assemblies and additional products. The Company has also filed
patent applications on its analytical test devices and test assemblies in
certain foreign countries. There can be no assurance, however, that any pending
patent application or any patent applied for in the future will be issued.
Moreover, there can be no assurance as to the degree of protection which any
patents issued or to be issued will afford the Company. It is possible that such
patents could be circumvented or invalidated. The cost of patent litigation with
respect to enforcement or defense may be beyond the ability of the Company to
fund. An adversary is likely to possess vastly larger resources than the Company
which may prevent the Company from adequately protecting or defending its
patents in the event of litigation. The Company deems patent protection to be
material to its business. The lack of patent protection or the inability to
prosecute or defend patent litigation could cause the Company to go out of
business.

Trademarks
----------

The Company has been granted registrations in the United States of its MACH
IV(R) Screen and microLINE(R) Screen trademarks used to identify its drug test
kits. The Company has also filed trademark applications in certain foreign
countries. There can be no assurance, however, that any trademark registrations
pending or applied for in the future will be issued. There can be no assurance
as to the degree of protection which the trademarks and their registrations
afford the Company. The Company deems its trademarks and their registrations to
be material to its Products. The lack of trademark protection or the inability
to prosecute or defend trademark litigation could cause the Company to go out of
business.

Research and Development
------------------------

The Company spent $392,698 and $361,978 on Company-sponsored research and
development in Fiscal 1996 and Fiscal 1995, respectively. While the Company has
two products under development, much of the research and development effort is
in manufacturing support, and the Company can not commence any major projects
with its current available resources.

Manufacturing, Assembly and Quality Control
-------------------------------------------

The Company currently assembles its Products on its premises. The Company
believes it has the capacity, for the foreseeable future, to satisfy its
production requirements. See the section "Marketing and Distribution" in this
Item 1 to this Report. During Fiscal 1994, the Company completed the redesign of
the product housing to a modular form and acquired an automated assembly machine
for the new product design. The automation system, as received, failed to meet
the design requirements for performance and underwent significant redesign and
debugging by the manufacturer. During the fourth quarter of Fiscal 1995, the
Equipment passed preliminary acceptance tests. As of June 30, 1996, the Company
has yet to find a market for the new format and has received quotes to re-tool
the machine to produce the current format. The Company is not financially able
to afford the re-tooling at this time. Due to the inability to utilize the
assembly machine the Company has lowered its estimate of the recoverability and
has written the machine down by approximately $212,000.

Immunoassays, like all clinical assays, are susceptible to manufacturing and
in-field performance problems often associated with (1) lot-to-lot, and
within-lot variability of individual assay components (i.e., membranes,
antibodies and conjugates) and (2) variability of individual specimens,
particularly as they relate to pH, proteins and certain other substances
contained therein. The Company's manufacturing performance as measured by
rejection rates has historically been significantly below the norms for
comparable manufacturers. Although this performance has recently improved, there
can be no assurance that the Company will be able to achieve industry norms. To
minimize this variability, the Company 

                                       6

<PAGE>

performs quality control procedures on raw materials, components, in-process
assemblies and finished Products on its premises, utilizing its own personnel,
to ensure conformity to the Company's design specifications and the FDA's
current Good Manufacturing Practices. In addition, samples of each finished
production lot of Products are tested on a random basis at least twice to
establish that the correct response to positive and negative samples is
obtained. Samples of every production lot are retained by the Company's quality
control chemist and are subjected to functional testing on a monthly basis to
insure continued accurate performance throughout the Product's shelf life. The
Company believes that, as a result of its quality control program, in-field
performance is comparable or superior to industry norms.

Raw Materials and Supplies
--------------------------

The Company purchases components, raw materials and supplies for its Products
from numerous unaffiliated vendors. During Fiscal 1996, one vendor, Hoffman
Precision Plastics, Inc., from whom the Company purchased components, accounted
for 12.2% of total purchases. The same vendor accounted for 12.8% of total
purchases during Fiscal 1995. No other single vendor accounted for more than 10%
of such purchases in either Fiscal Year. Although the Company anticipates an
increase in its need for components, raw materials and supplies, it believes
that they will continue to be readily obtainable from various sources at
competitive prices and, accordingly, the Company will not be dependent on any
single source for its components and raw material.

Employees
---------

As of September 13, 1996, the Company employed 40 people, 1 of these employees
was an executive officer, 2 were in distribution support, 10 were laboratory
scientists, technicians and quality control specialists, 6 were accounting and
administrative personnel and 21 were production employees. Of the 40 employees,
17 employees were full-time salaried employees, 23 employees were employed on an
hourly basis. In addition, the Company utilizes an outside personnel agency to
supplement its hourly production staff. As of September 13, 1996, there were 8
individuals utilized by the Company under this program. The Company's employees
are not represented by a labor union. The Company believes that its relations
with its employees are satisfactory.

Competition
-----------

Drugs of abuse screening is a highly competitive industry dominated by major
pharmaceutical companies and characterized by competitors from two types of
companies. The first type of competing companies consists of drug/equipment
manufacturers such as Syntex Corporation, Abbott Laboratories,Inc., Marion
Laboratories, Inc. and Hoffman-LaRoche, Inc. The second type of competing
companies consist of independent testing laboratories. Competitors' tests can
generally be divided into two categories: those performed in the laboratory and
those performed at the test site. Among potential competitive tests, the Company
believes the Products to be unique in that no scientific equipment, special
training, reagents or other substances are required to administer the tests
contained in the MACH IV(R) Screen and microLINE(R) Screen Products. The Company
believes that no other FDA cleared drug screen is as easy to use. However, there
can be no assurance that a competitor of the Company will not develop a drug
screen similar or superior to the Products, particularly if the Products are
successful.

There are currently four principal laboratory (i.e., not on-site) drug screening
methods available: enzyme-multiplied immunoassay technique (EMIT) manufactured
and distributed by Syva (a division of Syntex Corporation); radioimmunoassay
(RIA) manufactured and distributed by Hoffman-LaRoche, Inc. and others; thin
layer chromatography (TLC) manufactured and distributed by Marion Laboratories,
Inc. and a fluorescence polarization immunoassay (FPIA) manufactured by Abbott
Laboratories, Inc. Because these are all laboratory tests, they require a chain
of custody of specimens and scientific or technically trained personnel to
administer the tests and, accordingly, in the opinion of the Company, result in
delay and are not conducive to prompt availability of test results. As a result
of the complexity of these tests, the technical personnel who perform the EMIT,
RIA, TLC, FPIA tests must receive in-depth training, not

                                       7

<PAGE>

only to perform the tests, but also to standardize references, solutions and
protocols. Laboratory tests demand a high initial capital expense, on-going
quality control and skilled personnel.

It is the Company's belief that the Products provide the advantage of immediate
results, which testing to date has proved to be as accurate as the results
offered by conventional laboratory methods. The Company also believes, on the
basis of having compared the Products to conventional laboratory testing, that
the Products provide equivalent results at prices substantially below those of
laboratory tests, without the necessity of specialized training to perform the
tests, or the use of additional equipment or the addition of reagents or other
substances.

There are at least seven immunoassay tests which are currently capable of being
performed on-site (i.e., not in the laboratory): E-Z Screen and Verdict
manufactured and distributed by Editek, Inc.; OnTrak and OnTrak TesTcup,
manufactured and distributed by Hoffman-LaRoche, Inc.; AbuSign, manufactured and
distributed by Princeton Bio Meditech; and Triage manufactured and distributed
by Biosite, Inc. These are products that use either an enzyme immunoassay
colorimetric assay, a latex agglutination or a colloidal gold end point or a
filtration/capture assay. E-Z Screen requires the manipulation and addition of
several reagents for each test and for each different drug of abuse. When
complete, a subjective color end point must be properly interpreted. By the
nature of the subjective end points and the use of multiple reagents, the
determination of whether a specific drug is present is, in the opinion of the
Company, not straightforward. The OnTrak Screen requires the use of three
reagents (which are different for each drug of abuse) and a negative control for
each drug tested. The large number of reagents and controls necessary to screen
for four or five drugs of abuse demands accurate procedures that, in the opinion
of the Company, are similar to a laboratory protocol. In addition, OnTrak relies
on agglutination or mottling of the reagents' small particles which may provide
a cloudy read-out and may render interpretation difficult. The OnTrak TesTcup is
a recently released product which eliminates the handling of urine or reagents.
The Triage screen is a multiple test device that requires three manipulations,
including a ten-minute incubation, followed by additional steps for filtration
and washing. The Verdict and AbuSign tests are similar to the Company's tests
requiring only the addition of the sample with the positive/negative results
determined by the presence or absence of lines on the result window. The Company
has been informed that several other companies are launching an on-site test,
but it is unaware of which or how many companies are involved.

The Company is subject to, and will continue to experience, competition in
connection with both the development and marketing of the Products from at least
the four major pharmaceutical companies mentioned above, as well as from other
major pharmaceutical companies and clinical laboratories. All of such
competitors possess manufacturing facilities and employ a greater number of
scientific and other personnel than the Company. There can be no assurances that
other major pharmaceutical companies or other companies will not enter the
marketplace and present additional competition for the Company and the Products.

If the drug screening market is defined in terms of companies offering both
those tests performed in the laboratory and those performed on site, then
management believes that the Company's revenues in both Fiscal 1996 and Fiscal
1995 constituted an insignificant percentage of the revenues from such market in
each fiscal period. If the drug screening market is defined in terms of
companies offering on-site testing, then management estimates the size of such
market in the United States to be at least $35 million (although management can
only estimate such market because there are no published statistics and not
every competitor is a public company with available financial data), so that the
Company's revenues would constitute approximately 6% and 8% of the revenues in
such market for Fiscal 1996 and Fiscal 1995, respectively.

The technology of drug screening is subject to rapid change. The ability of the
Company to compete successfully will be dependent not only upon its ability to
market successfully its existing and future products, but also upon its ability
to produce state-of-the-art products and patent any new proprietary technology.
No assurance can be given with respect to these matters.

                                       8

<PAGE>

Markets
-------

Currently, drug screening tests, including those sold by the Company, are used
for employment screening and by law enforcement and correctional institutions,
security companies and safety conscious industries, including transportation
(railroads, trucking and airlines), public utilities, insurance companies,
educational systems, governmental agencies, including the United States
Departments of Defense, Energy and Justice, the equine industry and athletic and
drug rehabilitation programs. The Company believes employment screening is the
major portion of the market currently available to the Products. The Company
markets its Products for Medical and Non-Medical Uses to hospitals (emergency
rooms), pre-natal clinics, drug rehabilitation and detoxification clinics, the
criminal justice system (correctional institutions, probation and parole
agencies) and all federal agencies which require the Products to be Cleared for
Marketing by the FDA.

As widespread drug testing is a relatively new phenomenon and the ability to
conduct on-site drug testing is even newer, the Company has been unable to
develop information from which to estimate with reasonable accuracy the scope of
the entire market, nor is it able to estimate the scope of the market for
Medical Uses or any other particular market segment. Even if such estimates were
possible, there can be no assurance that the Products can or will attain any
particular degree of acceptance in the market or market penetration. In
addition, the Company believes that the uncertainties as to proposed
governmental regulations (see the section "Governmental Regulations" in this
Item 1 to this Report) has caused prospective customers to defer entering into
purchase contracts with the Company (see Item 6 to this Report) and,
accordingly, adversely affected the Company's acceptance in the market and its
market penetration.

Marketing and Distribution
--------------------------

The Company is a party to a distribution agreement with Borg Warner
Investigative Services, Inc. (formerly Wells Fargo) ("BWIS"). The agreement was
entered into on May 12, 1989 and was amended on June 5, 1989, July 7, 1989 and
January 29, 1991 (the "Initial BWIS Contract"). On January 15, 1993, the Initial
BWIS Contract was substantially amended and restated (the "Restated BWIS
Contract"). [On May 8, 1995, the Company entered into a new contract (the "BWIS
Contract") which restates the Restated BWIS Contract. Copies of the Initial BWIS
Contract, the Restated BWIS Contract and the BWIS Contract are filed (by
incorporation by reference) as exhibits to this Report and are incorporated
herein by this reference.]

The term of the BWIS Contract is for five years, which commenced May 8, 1995 and
is renewable by BWIS for successive five-year periods. The BWIS Contract is
terminable on 90 days' notice by either party if the other party is in default
and does not cure such default within the 90-day period.

Under the BWIS Contract, BWIS is the exclusive distributor and sole service
agency only for the Products in the United States for customers engaged in
furnishing alarm, armored, courier, patrol or guard related services for the
purpose of transporting property or offering protection to persons or their
property ("Security/Courier Accounts"). The Company reserves the right under the
BWIS Contract to sell, distribute and service the Products to all Commercial
Accounts other than Security/Courier Accounts.

With certain exception, BWIS is entitled to a price per test included in each
Product purchased lower than the lowest price charged by the Company to any
Commercial Non-Security/Courier Account. Pricing is subject to increase by the
Company based upon increases in the Consumer Price Index, with May 1995 as the
base month. Price increases remain in effect for one year and cannot be changed
during such year.

Payment terms under the BWIS Contract are net 30 days and BWIS bears all sales
taxes, freight, freight forwarding, storage, insurance and handling costs,
brokerage fees and all other associated delivery charges.

                                       9

<PAGE>

In April 1994, the Company entered into an exclusive license and distributorship
agreement (the "Exclusive Agreement") with AccuScreen Labs, Inc. ("AccuScreen")
(A copy of the Exclusive Agreement is filed (by incorporation by reference) as
an exhibit to this report and is incorporated herein by this reference.)
AccuScreen was one of the Company's non-exclusive distributors of its Products
in the United States and will continue is such capacity. Under the terms of the
Exclusive Agreement, the Company granted to AccuScreen the license to sell or
distribute the Company's drug screening panel to direct marketing purchasers or
to retailers in the United States and all of its possessions and territories.
This Exclusive Agreement does not modify in any way the aforementioned
agreements with BWIS or Tepnel. The license will be for a term of five years and
six months from the date permission from the FDA to market the tests to direct
marketing purchasers or to retailers is obtained. Such permission has not been
obtained to date and the Company believes the procedures required for such
permission will take an extensive amount of time. At the conclusion of the
initial term, the exclusive license will be automatically renewable for an
additional three-year term, provided that the cumulative purchases during the
initial term total at least $20 million. The Exclusive Agreement provides for
minimum cumulative purchase commitments as follows: $125,000 in the first six
months; $1,125,000, $2,625.000, $5,125,000, $8,125,000 and $11,625,000 in each
of the following five years, respectively. The Company may terminate the
Exclusive Agreement if AccuScreen fails to meet its minimum purchase commitments
or fails to pay for goods ordered, as defined in the Exclusive Agreement.
AccuScreen may terminate the Exclusive Agreement if the Company fails to produce
sufficient volume to meet AccuScreen's demand, the Company's Products become
noncompetitive as a result of the development of less expensive competing
products, or, if the Company's Products are determined by a court of competent
jurisdiction to infringe upon patents held by another.

In March 1996, the Company entered into an exclusive distribution agreement with
the U. S. Distribution Business of Baxter Healthcare Corporation. Under terms of
the agreement Baxter has exclusive distribution rights for DSSI's microLINE
Screen for Drugs of Abuse to clinical testing and diagnostic and research
laboratories in the continental United States, Alaska and Hawaii. The term of
the agreement is for two years, and is automatically renewed for two additional
years unless either party terminates the agreement with 60 days written notice.
The exclusivity provision for the second and subsequent years will be based on
mutually established sales goals agreed to 60 days prior to the end of the first
year.

During Fiscal 1996, sales to BWIS accounted for $1,041,245 or 49% of the gross
revenues of the Company. During Fiscal 1995, sales to BWIS accounted for
$1,641,400 or 61% of the gross revenues of the Company. No other customer
accounted for 10% or more of the Company's gross revenues. A loss of BWIS would
have a materially adverse impact upon the Company's business and financial
condition unless a replacement therefore was obtained or the Company increased
its sales from other sources (as to which there is no assurance).

Seasonality
-----------

The business of the Company is not seasonal.

Backlog
-------

There was no backlog as of June 30, 1995, June 30, 1996 or as of the date of
this Report.

                                       10
<PAGE>

Effect of Environmental Regulations
-----------------------------------

Based upon its experience to date, the Company's expenditures have been minimal
in order for it to comply with federal, state and local provisions which have
been enacted or adopted regulating the discharge of materials into the
environment, or otherwise relating to the protection of the environment.
Compliance therein, accordingly, has not had any material effect upon the
capital expenditures, earnings or competitive position of the Company. There is,
of course, no assurance that environmental laws or regulations adopted in the
future will continue to have no material adverse effect on the Company's capital
expenditures, earnings or competitive position.

Insurance
---------

Although the Company does not believe that the use of the Products entails
potentially significant risks of product liability claims by private parties for
personal injury, the Company carries product liability insurance against such
risks in the amount of $1 million with a $5 million umbrella. While the Company
is not aware of any litigation brought on the ground that action was taken or
not taken (e.g., employment denied, drug treatment program recommended) on the
basis of a drug test yielding a false positive or false negative result which is
not confirmed by a test conducted in a laboratory, a partially or completely
uninsured product liability claim against the Company, if successful and
depending on the amount thereof, would likely cause the Company to go out of
business. Furthermore, the Company may not have the financial ability to fund
the cost of defending product liability litigation. See the section "The
Products" in this Item 1 to this Report.

Government Contracts
--------------------

The Company sells the Products to certain federal, state and local agencies
pursuant to purchase orders. No portion of the business of the Company, however,
derives from government contracts which may be subject to renegotiation of the
profits or termination at the election of the government.


ITEM 2    Description of Property

The Company leases 12,000 square feet at Units 603, 604 and 605 VPR Commerce
Center, 1001 Lower Landing Road, Blackwood, New Jersey 08012, which it utilizes
as administrative, research and development, manufacturing, quality control,
warehousing and shipping facilities. The space allocated for research and
development includes a laboratory with analytical instrumentation. The leases,
with an unaffiliated landlord, expire on April 30, 1997. The aggregate base
monthly rental is $4,712. The Company has the option to renew the term for an
additional 24 months at the monthly base rental of $5,000, provided at least six
months' notice is given prior to April 30, 1997. Management believes the
Company's facilities and equipment are in good repair and suitable for the
purposes for which they are used.


ITEM 3    Legal Proceedings

See note N to the Financial Statements.

ITEM 4   Submission of Matters to a Vote of Security-Holders

None

  
                                     11
<PAGE>


                                     PART II

ITEM 5   Market for the Common Stock and Related Stockholder Matters

Market
------

The Common Stock was traded on the National Association of Securities Dealers,
Inc. ("NASD") Automated Quotation ("NASDAQ") System until July 25, 1994. The
following table sets forth, for the periods indicated, the quarterly range of
the high and low bid prices of the Common Stock as reported by the NASD in the
NASDAQ System through July 25, 1994 and in the OTC Bulletin Board thereafter.

                                   Bid Prices(1)

Fiscal 1996 Quarter Ended                   Low                        High

September 30, 1995                        $ 0.37                      $ 0.81
December 31, 1995                           0.14                         .37
March 31, 1996                              0.19                        1.50
June 30, 1996                                .69                        1.56

Fiscal 1995 Quarter Ended                   Low                        High

September 30, 1994                        $ 0.37                      $ 2.25
December 31, 1994                           0.37                        1.62
March 31, 1995                              0.44                        1.00
June 30, 1995                                .37                        0.87


(1) The foregoing quotations reflect inter-dealers prices, without mark-up,
mark-down or commissions, and may not represent actual transactions.

The high bid and low asked price of the Common Stock as reported by the NASD in
the OTC Bulletin Board on September 13, 1996 were $ 0.50 and $0.25 per share,
respectively.

NASDAQ Status
-------------

On July 25, 1994, the Company's Common Stock was delisted from the NASDAQ System
because the Company failed to meet two of the NASD's maintenance criteria, i.e.,
total assets of $2,000,000 and capital and surplus of $1,000,000. Since July 26,
1994, the Common Stock trades in the over-the-counter market and is reported in
the NASD's OTC Bulletin Board and in the "pink sheets." In order for the Common
Stock to be included again in the NASDAQ System, the Company must comply with
the NASD's stricter entrance criteria, including total assets of $4 million,
capital and surplus of $2 million and a bid price of $3.00 per share. As of the
date of this Report, the Company was not in compliance with any of the foregoing
criteria.

Holders
-------

The number of holders of record of the Common Stock at September 13, 1996 was
289. Management of the Company is of the opinion that, based on the number of
copies of proxy statements requested by brokers, banks and other record holders
for beneficial owners in connection with the November 14, 1995 Annual Meeting of
Shareholders, there are over 3,000 beneficial owners.

                                       12

<PAGE>

Dividends
---------

The Company did not declare or pay cash or stock dividends on the Common Stock
during Fiscal 1996 or 1995. Due to current and anticipated cash requirements, as
well as the Company's history of losses, the Board of Directors does not
anticipate the payment of cash dividends in the foreseeable future.





                                       13

<PAGE>

ITEM 6   Management's Discussion and Analysis or Plan of Operations

The following discussion and analysis for Fiscal 1996 and Fiscal 1995 should be
read in conjunction with the Financial Statements included in Item 7 to this
Report.

Results of Operations
---------------------

Fiscal 1995 versus Fiscal 1996
------------------------------

Revenues - The Company's sales for Fiscal 1996 decreased $532,741 (19.7%) to
$2,172,310 from $2,705,051 in Fiscal 1995. The Company's sales for Fiscal 1996
were in the range of management's expectation. The major reason for the decrease
in sales is because the Company had manufactured the maximum amount under its
arrangement with BWIS during Fiscal 1995. During fiscal 1996, the Company could
no longer build for stock owned by BWIS, but was limited to replacing product as
it was used. This difference accounted for the vast majority of the decline in
sales.

The Company's gross profit of $1,100,348 for Fiscal 1996 amounted to 70.7%
($1,387,502 and 82.2%, respectively, in Fiscal 1995) of its operating expenses.
At the gross profit percentage for Fiscal 1996, the Company would have had to
generate approximately $2,283,000 in sales to cover such operating expenses
($3,291,000 in Fiscal 1995).

Cost of sales and gross profits - The Company's cost of sales for Fiscal 1996
was $1,071,962 and its gross profit percentage was 50.6% ($1,317,549 and 51.3%,
respectively for Fiscal 1995). The slight increase in the gross profit as a
percent of sales resulted from more corporate sales and less government bid
sales.

Research and Development - The Company increased expenditures in the research
and development. In Fiscal 1996, the Company expended $392,698 on research and
development as compared to $361,978 in Fiscal 1995. The increase of $30,720
results principally from the development efforts on the eight panel plate
designed for Baxter's fourth quarter launch of our product in the hospital
market.

Selling, General and Administrative Expenses - Selling, general and
administrative expenses declined $162,572 (12.3%) to $1,163,737 in Fiscal 1996
from $1,326,309 in Fiscal 1995. This decrease resulted primarily because Fiscal
1995 cost reductions were realized for the entire year of Fiscal 1996.

Net Loss - The Fiscal 1996 net loss of $451,788 was $156,432 (53.0%) more than
the net loss of $295,356 in Fiscal 1995. This decrease is attributable to the
reasons cited above.

Fiscal 1994 versus Fiscal 1995
------------------------------

Revenues - The Company's sales for Fiscal 1995 increased $1,138,437 (72.7%) to
$2,705,051 from $1,566,614 in Fiscal 1994. The Company's sales for Fiscal 1995
were in the range of management's expectation. Sales to BWIS increased by 161%,
accounting for most of the increase in sales.

The Company's gross profit of $1,387,502 for Fiscal 1995 amounted to 82.2%
($596,104 and 25.3%, respectively, in Fiscal 1994) of its operating expenses. At
the gross profit percentage for the Fiscal 1995, the Company would have had to
generate approximately $3,291,000 in sales to cover such operating expenses
($6,185,000 in Fiscal 1994).

Cost of sales and gross profits - The Company's cost of sales for Fiscal 1995
was $1,317,549 and its gross profit percentage was 51.3% ($970,510 and 38.1%,
respectively for Fiscal 1994). The increase in the gross profit as a percent of
sales resulted from an increase in the unit sales price across all customers,
combined with an increase in efficiency in the manufacturing area resulting from
improved manufacturing techniques and the economy of scale due to the larger
volume.

                                       14

<PAGE>

Research and Development - The Company continued to reduce expenditures in the
research and development of its Products. In Fiscal 1995, the Company expended
$361,978 on research and development as compared to $511,611 in Fiscal 1994. The
decline of $149,633 results principally from the continued reduction in staff
which commenced during the last quarter of Fiscal 1993 and continued into Fiscal
1995.

Selling, General and Administrative Expenses - Selling, general and
administrative expenses declined $552,053 (28.9%) to $1,326,309 in Fiscal 1995
from $1,848,362 in Fiscal 1994. This decrease resulted primarily from the cost
reduction program initiated by management in July 1994 when it eliminated the
outside sales force and concentrated on in-house sales and its distribution
network.

Net Loss - The Fiscal 1995 net loss of $295,356 was $1,425,198 (82.8%) less than
the net loss of $1,720,554 in Fiscal 1994. This decrease is attributable to the
reasons cited above.


Inflation
---------

Inflation has not had a material impact on the Company's operations during
Fiscal 1995 and 1994.

New Accounting Pronouncements
-----------------------------

The Company adopted Statement of Financial Accounting Standards No. 112,
Employers Accounting for Post Employment Benefits ("SFAS No. 112"), in the first
quarter of the fiscal 1995. SFAS No. 112 establishes accounting standards for
postemployment benefits and requires either the accrual of the obligation or
disclosure, depending on the circumstances, for the cost of benefits provided to
former or inactive employees after employment or before retirement. Such
adoption did not have a material effect on the Company's operations or financial
position.

In October 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards NO. 123, Accounting for Stock-Based Compensation
("SFAS No. 123"). SFAS No. 123 defines a fair value method of accounting for
stock options and other equity instruments. Under the fair value method,
compensation cost is measured at the grant date based on the fair value of the
award and is recognized over the service period, which is usually the vesting
period.

Under SFAS No. 123, The Company is permitted to continue to account for employee
stock-based transactions under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees ("APB No. 25"), but would be required
to disclose in a note to the financial statements pro forma net income and
income per share information as if the Company had applied the new method of
accounting. SFAS No. 123 also requires increased disclosures for stock-based
compensation arrangements regardless of the method chosen to measure and
recognize compensation for employee stock-based arrangements.

The Company has determined that it will continue to account for such
transactions under APB No. 24 and will provide the disclosures required by SFAS
No. 123 during the year ended June 30, 1997.

In March 1995, the Financial Accounting Standards Board issued Statement No.
121, "Accounting for the Impairment of Long Lived Assets and for Long-Lived
Assets to be Disposed Of" (SFAS 121). This statement established accounting
standards for the impairment of long-lived assets, certain identifiable
intangibles and goodwill related to those assets to be held and used and for
long-lived assets and certain identifiable intangibles to be disposed of. SFAS
No. 121 requires that long-lived assets to be held and used by the Company be
reviewed for impairment whenever events or circumstances indicate that the
carrying amount of an asset may not be recoverable. An impairment is recognized
to the extent that the sum of undiscounted estimated future cash flows expected
to result from the assets used is less than the carrying value. the Company
intends to adopt this Standard during the First Quarter of Fiscal Year 1997.

                                       15

<PAGE>

The adoption of this standard is not expected to have a material effect on the
Company's financial position or results of operations. The recognition and
measurement of impairment losses for long-lived assets under the new standard is
consistent with the Company's past practices.

Outlook for Fiscal 1997
-----------------------

If the Company can maintain the level of sales recorded in the fourth quarter of
Fiscal 1996 (approximately $600,000) for the balance of the Fiscal year, sales
for Fiscal 1995 would approximate $2.4 million.

At the current rate, operating expenses are expected to be about $1,600,000 in
Fiscal 1997. At a gross profit rate of 50%, the Company would have to generate
sales of approximately $3.2 million to offset these operating expenses.

However, there is no assurance that current levels of sales will be maintained
or whether increased sales will materialize or whether operating expenses can be
maintained at the expected level.

Liquidity and Capital Resources
-------------------------------

The Company had working capital at June 30, 1996 of $348,185 compared to $99,456
as of June 30, 1995. At June 30, 1996, the Company had the availability of
$91,807 of cash as compared to $305,108 at June 30, 1995. Both changes were
primarily attributable to net losses from operations offset by the net proceeds
received from the private placement.

Net accounts receivable increased from $124,975 at June 30, 1995 to $222,262 at
June 30, 1996. The increase was substantially due to a large sale made at the
end of Fiscal 1996 and the reduction in the reserve for bad debts due to better
than expected collections of old receivables.

Inventory increased by $65,893 to $445,229 at June 30, 1996 from $379,336 at
June 30, 1995. The major portion of this increase results from a build up in
work-in-process inventory relating to preparing for Baxter sales. Management
believes that no material amount of obsolete inventory is included in the
balance at June 30, 1996.

Equipment and improvements, net, decreased by $278,474 to $283,726 at June 30,
1996 from $562,200 at June 30, 1995. This decrease is due to depreciation, the
impairment writedown of approximately $212,000 and sale of certain equipment,
offset by only minor capital additions. The Company has no current commitments
to purchase additional equipment and improvements. During Fiscal 1994, the
Company completed the redesign of the product housing to a modular form and
acquired an automated assembly machine for the new product design. The
automation system, as received, failed to meet the design requirements for
performance and underwent significant redesign and debugging by the
manufacturer. During the fourth quarter of Fiscal 1995, the Equipment passed
preliminary acceptance tests. As of June 30, 1996 the Company has yet to find a
market for the new format and has received quotes to re-tool the machine to
produce the current format. The Company is not financially able to afford the
re-tooling at this time. Due to the inability to utilize the assembly maching
the Company has lowered its estimate of the recoverability and has written the
machine down by approximately $212,000. To determine the fair value of the
automation system, the Company projected the present value of projected future
cash flows using a 12% discount rate. Included in the line item "Machinery and
equipment" on the Balance Sheet at June 30, 1996, is the idle automated assembly
machine which has been written down to a book value of approximately $206,000.

Accounts payable and accrued expenses of $348,116 at June 30, 1996 have
decreased by $197,709 from $545,825 at June 30, 1995. This decrease resulted
primarily from releasing a reserve established in prior years to offset certain
contingencies which did not materialize.

                                       16

<PAGE>

As of June 30, 1996, the Company had stockholders' equity of $669,807 as
compared to $671,595 at June 30, 1995. Continuation of operational losses at the
same monthly rate of the Fiscal 1996 loss will result by the fiscal year ending
June 30, 1998 in the Company having a stockholders' deficit. During Fiscal 1996,
the Company was able to offset the net loss of $451,788 by net capital
contributions of $450,000 from the net proceeds of a private placement. The
Company's net loss in Fiscal 1996 increased by $156,432 from that in Fiscal 1995
and the net cash used in operating activities increased by $267,340 from
$504,848 to $772,188. The principal other reason for this increase was the
increase in accounts receivable and inventory described above. Net cash from
investing activities was $190,447 in Fiscal 1996 as compared to net cash used in
investing activities of $3,249 in Fiscal 1995. Net cash provided by financing
activities was $368,440 in Fiscal 1996, a decrease of $163,990 over the $532,430
in Fiscal 1995, primarily due to increase in principal payments made and the
reduction in proceeds from non-bank financing.

SUBSEQUENT TO YEAR END, THE BOARD ORDERED ANOTHER REDUCTION IN HEADCOUNT TO
REDUCE THE CASH BURN. THIS REDUCTION DID NOT GET THE COMPANY TO BREAK-EVEN. IN
ADDITION, THE BOARD IS KEEPING THE COMPANY SOLVENT IN THE FORM OF LOANS WHILE
PURSUING ACQUISITION DISCUSSIONS WITH A NUMBER OF POTENTIAL CANDIDATES. THE
COMPANY CAN STILL NOT SURVIVE WITHOUT THE CONTINUED FUNDING FROM CERTAIN MEMBERS
OF THE BOARD. SHOULD THE ACQUISITION DISCUSSIONS NOT BE SUCCESSFUL IN THE NEAR
FUTURE, THE COMPANY WILL UNDERGO ANOTHER CUT WHICH WOULD MAKE IT TEMPORARILY
BREAK-EVEN ON A CASH FLOW BASIS. A MEMBER OF THE BOARD HAS COMMITTED TO FUND ANY
SHORTFALLS IN THE REDUCED COMPANY FOR THE REMAINDER OF THE TWELVE MONTHS PERIOD
FOLLOWING OUR LATEST ANNUAL REPORT DATE.

UNLESS THE COMPANY CAN (1) OBTAIN CAPITAL CONTRIBUTIONS OR FINANCING AS MAY BE
REQUIRED TO FULFILL ITS DEVELOPMENT AND MARKETING ACTIVITIES, (2) ACHIEVE A
LEVEL OF SALES ADEQUATE TO SUPPORT THE COMPANY'S COST STRUCTURE AND (3)
ULTIMATELY OPERATE PROFITABLY, THE COMPANY WILL BE UNABLE TO CONTINUE AS A GOING
CONCERN. THERE IS NO GUARANTEE THAT THE COMPANY CAN ACHIEVE ANY OF THESE THREE
OBJECTIVES DURING FISCAL 1998.

Commitments
-----------

There were no material commitments for capital expenditures at June 30, 1996.


Governmental Regulation
-----------------------

The Company's Products (and any other drug screening tests that may be developed
by the Company in the future) are subject to governmental regulations. See the
section "Governmental Regulation" in Item 1 to this Report. Federal legislation
has been proposed that would, among other things, require the institution of
standards for drug testing procedures and the use of certified laboratories for
employee drug testing. If enacted in its current form, such legislation could
have a substantial adverse impact upon certain market segments of the Company's
business. There can be no assurance that such legislation will or will not be
adopted or, if adopted, the final form the legislation will take.

In addition, other proposed regulations would require that all employment drug
testing, including on-site testing, be processed by a federally approved
laboratory; however, these have not yet become effective. If such regulations
become effective, the consequences of adoption of the regulations may have a
material adverse impact upon the Company's business with respect to employment
testing in the private sector.

Certain agencies of the United States Government have adopted internal
regulations with respect to employee drug testing. Most of these regulations
require the use of a certified laboratory. The Company does not believe the
exclusion of these agencies or additional agencies which might adopt such
internal regulations in the future from its potential market has had, or will
have, a material adverse impact upon its potential business.

                                       17

<PAGE>
<TABLE>
<CAPTION>



ITEM 7   Financial Statements

Index to Financial Statements
-----------------------------
                                                                                                 Page
                                                                                                 ----
<S>                                                                                               <C>
Independent Auditors' Report                                                                      19

Balance Sheets as of June 30, 1996 and 1995                                                       20

Statements of Operations for the years ended June 30, 1996 and 1995                               21

Statements of Changes in Stockholders' Equity for the
         years ended June 30, 1996 and1995                                                        22

Statements of Cash Flows for the years ended June 30, 1996 and 1995                               23

Notes to Financial Statements                                                                     24
</TABLE>

                                       18


<PAGE>


Independent Auditors' Report

To the Stockholders and Board of Directors
Drug Screening Systems, Inc.
Blackwood, New Jersey

We have audited the accompanying balance sheets of Drug Screening Systems, Inc.
as of June 30, 1996 and 1995, and the related statements of operations, changes
in stockholders' equity (deficiency) and cash flows for the years then ended.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on the 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 provide a reasonable basis for our opinion.

In our opinion, such financial statements presented fairly, in all material
respects, the financial position of Drug Screening Systems, Inc. as of June 30,
1996 and 1995, and the results of its operations and its cash flows for the
years then ended in conformity with generally accepted accounting principles.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As described in Note A to the
financial statements, the Company has suffered recurring losses from operations
which raises substantial doubt about the Company's ability to continue as a
going concern. The future of the Company as an operating business will depend on
(1) the availability of such additional financing as may be required to fulfill
its development and marketing activities, (2) achieving a level of sales
adequate to support the Company's cost structure and (3) ultimately, its ability
to operate profitably. Management's plans in regard to these matters are also
described in Note A. The financial statements do not include any adjustments
that might result from the outcome of this uncertainty.


/s/ DELOITTE & TOUCHE LLP
   -----------------------  

DELOITTE & TOUCHE LLP
Philadelphia, Pennsylvania
July 31, 1996

                                       19
<PAGE>


DRUG SCREENING SYSTEMS, INC.
 Balance Sheets, June 30, 1996 and 1995

<TABLE>
<CAPTION>

                                                                                       1996              1995
                                                                                       ----              ----
 Assets
<S>                                                                            <C>                <C>
 Current Assets:
   Cash                                                                         $                  $
                                                                                      91,807           305,108
   Accounts receivable, net of allowance of $50,000 at June 30, 1996
    and $100,000 at June 30, 1995
                                                                                     222,262           124,975
   Inventory
                                                                                     445,229           379,336
   Prepaid expenses and other
                                                                                      63,120            63,312
                                                                                ------------       -----------
 Total Current Assets
                                                                                     822,418           872,731

 Equipment and improvements, net
                                                                                     283,726           562,200

 Other Assets:
   Deposits
                                                                                      12,104             9,397
   Patents
                                                                                      25,792            27,292
                                                                                ------------       -----------
 Total Assets                                                                   $                  $
                                                                                   1,144,040         1,471,620
                                                                                ============       ===========



 Liabilities and Stockholders' Equity
 Current Liabilities:
   Current maturities of long-term debt and capital leases                      $                  $
                                                                                     109,117           163,927
   Accounts payable and accrued expenses
                                                                                     348,116           545,825
   Customer advances and prepayments
                                                                                      17,000            63,523
                                                                                ------------       -----------
      Total Current  Liabilities
                                                                                     474,233           773,275

   Long term debt
                                                                                           -            26,750

 Commitments and contingencies

 Stockholders' Equity
   Class "A" preferred stock, $0,01 par value; 2,000
      shares authorized; none issued
                                                                                           -                 -
   Common stock, $0.01 par value; 20,000,000 shares authorized; 4,246,017 shares
      at June 30, 1996 and
       2,446,017shares at June 30, 1995 issued and outstanding
                                                                                      42,460            24,460
   Additional paid-in-capital
                                                                                  15,070,555        14,638,555
   Accumulated deficit
                                                                                 (14,443,208)      (13,991,420
                                                                                ------------       -----------
      Total Stockholders' Equity
                                                                                     669,807           671,595
                                                                                ------------       -----------

 Total Liabilities and Stockholders' Equity                                     $                  $
                                                                                   1,144,040         1,471,620
                                                                                ============       ===========

</TABLE>

 See notes to financial statements

                                       20

<PAGE>



 DRUG SCREENING SYSTEMS, INC.
 Statements of Operations for the Years Ended June 30, 1996 and 1995
<TABLE>
<CAPTION>



                                                      1996             1995
                                                      ----             ----

<S>                                               <C>              <C>       
 Revenues                                         $2,172,310       $2,705,051
 Cost of sales                                     1,071,962        1,317,549
                                                  ----------       ----------

 Gross profit                                      1,100,348        1,387,502

 Operating expenses:
   Research and development                          392,698          361,978
   Selling, general and administrative             1,163,737        1,326,309
                                                  ----------       ----------
                                                   1,556,435        1,688,287
                                                  ----------       ----------
 Loss from operations                              (456,087)         (300,785)

 Interest income
                                                       4,299            5,429
                                                  ----------       ----------

 Net loss                                         $ (451,788)      $ (295,356)
                                                  ==========       ==========

 Net loss per share                               $                $
                                                       (0.15)           (0.14)
                                                  ==========       ==========

 Weighted average number of shares
   outstanding                                     3,096,000        2,168,000
                                                  ==========       ==========

</TABLE>


 See notes to financial statements

                                       21

<PAGE>



DRUG SCREENING SYSTEMS, INC.
Statements of Changes in Stockholders' Equity (Deficiency)
For the Years Ended June 30, 1996 and 1995
<TABLE>
<CAPTION>
                                                              Additional
                                          Common Stock         Paid-in     Accumulated     Receivable
                                       Shares      Amount      Capital       Deficit      from Director     Total
                                       ------      ------      -------       -------      -------------     -----
<S>                                  <C>        <C>          <C>          <C>              <C>          <C>            
Balance, June 30, 1994                1,696,017  $ 16,960     $14,271,055  $(13,696,064)    $(70,456)    $ 521,495      
                                       

Sale of common stock through a
  private offering
                                        750,000     7,500         367,500                                  375,000
Elimination of receivable from
director                                                                                      70,456        70,456
Net loss
                                                                               (295,356)                  (295,356)
                                     ------------------------------------------------------------------------------

 Balance, June 30, 1995
                                      2,446,017    24,460      14,638,555   (13,991,420)             -     671,595

Sale of common stock through a
  private offering                    1,800,000    18,000         432,000                                $ 450,000         

Net loss                                                                   $   (451,788)                 $(451,788) 
                                                                               
                                     ------------------------------------------------------------------------------

 Balance, June 30, 1996               4,246,017  $ 42,460     $15,070,555  $(14,443,208)    $        -   $ 669,807 
                                     ==============================================================================
</TABLE>


See notes to financial  statements

                                       22

<PAGE>

DRUG SCREENING SYSTEMS, INC.
Statements of Cash Flows for the Years Ended June 30, 1996 and 1995
<TABLE>
<CAPTION>


                                                                                    1996                       1995
                                                                                    ----                       ----
Cash flows from operating activities:
<S>                                                                              <C>                        <C>       
      Net loss                                                                   $(451,788)                 $(295,356)
      Adjustments to reconcile net loss to net cash used
           Depreciation and amortization                                                                      
                                                                                    89,620                    126,400
           Impairment of capital equipment                                         212,050
           Gain on sale of equipment                                                (2,800)                    (5,861)
           Decrease (increase) in assets:                                                                           -
                Accounts receivable                                                (97,287)                    72,576
                Inventory                                                          (65,893)                  (112,213)
                Prepaid expenses and other                                             192                    (41,998)
           Increase (decrease) in liabilities:
                Accounts payable and accrued expenses                             (197,709)                   (58,919)
                Customer prepayments and advances                                  (46,523)                  (189,477)
                                                                                 ---------                  ---------
Net cash used in operating activities                                             (560,138)                  (504,848)

Cash flows from investing activities:
      Proceeds from sale of equipment net of expenses                                2,800                     33,723   
      Expenditures for equipment and improvements                                  (21,696)                   (36,709) 
      Recovery of deposits                                                          (2,707)                      (263)
                                                                                 ---------                  ---------
Net cash used in investing activities                                              (21,603)                    (3,249)
Cash flows from financing activities:
      Net proceeds from issuance of common stock                                   450,000                    375,000
      Proceeds from non-bank financing                                              95,150                    227,994   
      Principal payments on debt and capital leases                               (176,710)                   (70,564)
                                                                                 ---------                  ---------
Net cash provided by financing activities                                          368,440                    532,430
                                                                                 ---------                  ---------
Net increase (decrease) in cash and cash equivalents                              (213,301)                    24,333

Cash and cash equivalents:
      Beginning of period                                                          305,108                    280,775
                                                                                 ---------                  ---------
      End of period                                                              $  91,807                  $ 305,108
                                                                                 =========                  =========

Supplemental disclosure of cash flow information:
      Cash paid during the period for interest                                   $   2,058                  $   1,435
                                                                                 =========                  =========
</TABLE>

See notes to financial statements

                                       23



<PAGE>



DRUG SCREENING SYSTEMS, INC.
Notes to Financial Statements
Years Ended June 30, 1996 and 1995

A        BUSINESS, FINANCING AND BASIS OF FINANCIAL STATEMENT PREPARATION

Drug Screening Systems, Inc. (the "Company") was incorporated in the
Commonwealth of Pennsylvania on March 17, 1987. The Company has also received a
certificate of authority to do business in the States of New York and New
Jersey. The Company develops, manufactures and markets on-site drug screening
tests for the detection of the following drugs of abuse: cocaine, opiates
(heroin, morphine and codeine), methamphetamines, THC (marijuana), barbiturates,
amphetamines, benzodiazepines. and PCP (phencyclidine) in human urine. The
Company markets its tests under the names MACH IV(R) Screen and microLINE(R)
Screen (collectively, the "Products"). The Products are initial drug screens
based upon an immunoassay format, designed to give positive and negative
responses to the presence in human urine of a particular drug or metabolite of a
drug being screened.

Since its inception, the Company has sustained recurring losses from operations
except for the last two quarters of Fiscal 1995. The Company has financed its
operations and research and development program primarily through proceeds
received from its initial public offering in May 1988 and subsequent securities
offerings. During the quarter ended December 31, 1994 the Company raised
$375,000 through a private placement pursuant to Regulation D under the
Securities Act of 1993, as amended. Under this offering 750,000 shares of the
Common Stock were issued at $0.50 a share During the quarter ended March 31,
1996, the Company raised $450,000 through a private placement pursuant to
Regulation D under the Securities Act of 1933, as amended. Under this offering,
1,800,000 shares of the Common Stock were issued at $0.25 a share.

The Board of Directors is exploring various financing options, including a
possible sale or merger of the Company.

There can be, of course, no assurance that management's actions will result in
the Company achieving profitability in Fiscal 1997 or thereafter.

SUBSEQUENT TO YEAR END, THE BOARD ORDERED ANOTHER REDUCTION IN HEADCOUNT TO
REDUCE THE CASH BURN. THIS REDUCTION DID NOT GET THE COMPANY TO BREAK-EVEN. IN
ADDITION, THE BOARD IS KEEPING THE COMPANY SOLVENT IN THE FORM OF LOANS WHILE
PURSUING ACQUISITION DISCUSSIONS WITH A NUMBER OF POTENTIAL CANDIDATES. THE
COMPANY CAN STILL NOT SURVIVE WITHOUT THE CONTINUED FUNDING FROM CERTAIN MEMBERS
OF THE BOARD. SHOULD THE ACQUISITION DISCUSSIONS NOT BE SUCCESSFUL IN THE NEAR
FUTURE, THE COMPANY WILL UNDERGO ANOTHER CUT WHICH WOULD MAKE IT TEMPORARILY
BREAK-EVEN ON A CASH FLOW BASIS. A MEMBER OF THE BOARD HAS COMMITTED TO FUND ANY
SHORTFALLS IN THE REDUCED COMPANY FOR THE REMAINDER OF THE TWELVE MONTHS PERIOD
FOLLOWING OUR LATEST ANNUAL REPORT DATE.

UNLESS THE COMPANY CAN (1) OBTAIN CAPITAL CONTRIBUTIONS OR FINANCING AS MAY BE
REQUIRED TO FULFILL ITS DEVELOPMENT AND MARKETING ACTIVITIES, (2) ACHIEVE A
LEVEL OF SALES ADEQUATE TO SUPPORT THE COMPANY'S COST STRUCTURE AND (3)
ULTIMATELY OPERATE PROFITABLY, THE COMPANY WILL BE UNABLE TO CONTINUE AS A GOING
CONCERN. THERE IS NO GUARANTEE THAT THE COMPANY CAN ACHIEVE ANY OF THESE THREE
OBJECTIVES DURING FISCAL 1998.


B        SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Inventory - Inventories are stated at the lower of cost (first-in, first-out
method) or market.

                                       24

<PAGE>

Revenue Recognition - The Company recognizes revenues at the time Product is
shipped. The Company has an arrangement with a customer whereby title and risk
of loss transfers to the customers upon transfer of Product from the Company's
finished goods inventory into a segregated refrigeration unit on the Company's
premises, and, accordingly, the Company recognizes revenue at the time such
Product is transferred. Sales under these arrangements totaled $1,041,245 during
Fiscal 1996 and $1,616,119 during Fiscal 1995, of which $660,000 was in the
refrigerated storage unit at June 30, 1996 and 1995, respectively.

Depreciation and Amortization - Depreciation and amortization are computed by
the straight-line method over the estimated useful lives of the respective
assets or the term of the related lease. Estimated useful lives and lease terms
range from two to seven years. Depreciation and amortization of property was 
$89,620 and $126,400 in Fiscal 1996 and 1995, respectively.

Income taxes - Deferred income taxes reflect the net tax effects of (a)
temporary differences between the carrying amounts of assets and liabilities for
financial reporting purposes and the amounts used for income tax purposes and
(b) operating loss and tax credit carryforwards. See Note I.

Patents - Patents are amortized over the life of the patent beginning at the
time the patent is obtained. Amortization of patents for Fiscal 1996 and 1995
was $1,500.

Research and Development Costs - Research and development costs consist mainly
of salaries and related employee benefits, purchased materials and services.
These costs are charged to operations as incurred.

Restricted Stock Incentive Plan - Shares issued to employees under the plan are
recorded at fair market value at the date of the grant and are amortized to
compensation expense over a two-year vesting period.

Net Loss Per Share - Net loss per share has been computed based on the weighted
average number of shares outstanding during the year. Stock options and warrants
are considered anti-dilutive and have not been considered in the computation.

Employers Accounting for Postemployment Benefits - Statement of Financial
Accounting Standards No. 112, Employers Accounting for Post Employment Benefits
("SFAS No. 112"), establishes accounting standards for postemployment benefits
and requires either the accrual of the obligation or disclosure, depending on
the circumstances, for the cost of benefits provided to former or inactive
employees after employment or before retirement. The Company adopted SFAS No.
112 in the first quarter of Fiscal 1995. Such adoption did not have a material
effect on the Company's operations or financial position.

Stock-Based Compensation - In October 1995, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards NO. 123, Accounting for
Stock-Based Compensation ("SFAS No. 123"). SFAS No. 123 defines a fair value
method of accounting for stock options and other equity instruments. Under the
fair value method, compensation cost is measured at the grant date based on the
fair value of the award and is recognized over the service period, which is
usually the vesting period.

Under SFAS No. 123, The Company is permitted to continue to account for employee
stock-based transactions under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees ("APB No. 25"), but would be required
to disclose in a note to the financial statements pro forma net income and
income per share information as if the Company had applied the new method of
accounting. SFAS No. 123 also requires increased disclosures for stock-based
compensation arrangements regardless of the method chosen to measure and
recognize compensation for employee stock-based arrangements.

The Company has determined that it will continue to account for such
transactions under APB No. 25 and will provide the disclosures required by SFAS
No. 123 during the year ended June 30, 1997.

                                       25

<PAGE>


Use of Estimates - The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results may differ from those
estimates and assumptions.

Fair Value of Financial Instruments - The amounts reported in the balance sheets
for cash and accounts receivables and accounts payable approximate fair value.

Concentration of Credit Risk - The Company is subject to credit risk through
receivables. Credit risk with respect to receivables is minimized due to the
credit worthiness of its major customer and the large number of smaller
customers which spreads the risk.

Asset Impairment - In March 1995, the Financial Accounting Standards Board
issued Statement No. 121, "Accounting for the Impairment of Long Lived Assets
and for Long-Lived Assets to be Disposed Of" (SFAS 121). This statement
established accounting standards for the impairment of long-lived assets,
certain identifiable intangibles and goodwill related to those assets to be held
and used and for long-lived assets and certain identifiable intangibles to be
disposed of. SFAS No. 121 requires that long-lived assets to be held and used by
the Company be reviewed for impairment whenever events or circumstances indicate
that the carrying amount of an asset may not be recoverable. An impairment is
recognized to the extent that the sum of undiscounted estimated future cash
flows expected to result from the assets used is less than the carrying value.
the Company intends to adopt this Standard during the First Quarter of Fiscal
Year 1997. The adoption of this standard is not expected to have a material
effect on the Company's financial position or results of operations. The
recognition and measurement of impairment losses for long-lived assets under the
new standard is consistent with the Company's past practices.

Assets are reviewed for impairment when a specific event indicates that the
carrying value of an asset may not be recoverable and on an annual basis in
conjunction with the preparation of the annual report. Recoverability is
assessed based on estimates of future cash flows expected to result from the use
and eventual disposition of the asset. If the sum of expected undiscounted cash
flows is less than the carrying value of the asset, an impairment loss is
recognized. The impairment loss is measured as the amount by which the carrying
amount of the asset exceeds its estimated fair value.

C        INVENTORY

Inventory at June 30, 1996 and 1995 consisted of the following:
<TABLE>
<CAPTION>
                                                                              1996                   1995
                                                                              ----                   ----

<S>                                                                          <C>                    <C>      
                Raw Materials                                                $ 262,858              $ 207,031
                Work-in-process                                                134,911                132,739
                Finished goods                                                  47,460                 39,566
                                                                          =============          =============
                                         Total                               $ 445,229              $ 379,336
                                                                          =============          =============
</TABLE>

                                       26

<PAGE>

D        EQUIPMENT AND IMPROVEMENTS

Equipment and improvements at June 30, 1996 and 1995, which are recorded at
cost, consisted of the following:
<TABLE>
<CAPTION>


                                                                 1996                1995
                                                                 ----                ----

<S>                                                          <C>                <C>        
Furniture and fixtures                                       $     59,746       $    59,746
Leasehold improvements                                            176,299           176,299
Machinery and equipment                                           666,259           466,763
Construction in process                                                 -           418,958
                                                             ------------      ------------
                                                                  902,304         1,121,766
Less accumulated depreciation
     and amortization                                             618,578           559,566
                                                             ------------      ------------
                                                             $    283,726       $   562,200
                                                             ============      ============
</TABLE>


During Fiscal 1994, the Company completed the redesign of the product housing to
a modular form and acquired an automated assembly machine for the new product
design. The automation system, as received, failed to meet the design
requirements for performance and underwent significant redesign and debugging by
the manufacturer. During the fourth quarter of Fiscal 1995, the Equipment passed
preliminary acceptance tests. As of June 30, 1996 the Company has yet to find a
market for the new format and has received quotes to re-tool the machine to
produce the current format. The Company is not financially able to afford the
re-tooling at this time. Due to the inability to utilize the assembly maching
the Company has lowered its estimate of the recoverability and has written the
machine down by approximately $212,000. To determine the fair value of the
automation system, the Company projected the present value of projected future
cash flows using a 12% discount rate. Included in the "Machinery and equipment
"at June 30, 1996, is the idle automated assembly machine which has been written
down to a book value of approximately $206,000.

                                       27


<PAGE>


 E       ACCOUNTS PAYABLE AND ACCRUED EXPENSES

Accounts payable and accrued expenses at June 30, 1996 and 1995 consisted of the
following:
<TABLE>
<CAPTION>

                                                               1996           1995
                                                            ---------      ---------
<S>                                                         <C>            <C>      
Accounts payable - trade                                    $ 257,878      $ 268,759
Accrued payroll and related expenses                           46,728         51,212
Other                                                          43,510        225,854
                                                            ==========     ==========
                                                            $ 348,116      $ 545,825
                                                            ==========     ==========
</TABLE>


Based upon the favorable outcome of certain matters reserved for in prior years
the Company revised a previous estimate and reduced its accrual by approximately
$200,000.

F        RELATED PARTY TRANSACTIONS

On April 30, 1991, the Company issued to John Pappajohn (a director of the
Company) a warrant expiring September 30, 1996 to purchase 50,000 shares of the
Common Stock at an initial exercise price of $12.50 a share, subject to
adjustment in certain specified circumstances. The warrant first became
exercisable on October 1, 1991. The warrant was granted to Mr. Pappajohn in
consideration of his advising management of the Company on various matters and
not in connection with the sale or distribution of any of the Company's
securities. As a result of the anti-dilution provisions of this warrant, Mr.
Pappajohn may, as of June 30,1996 purchase 171,184 shares at an exercise price
of $3.65 a share.

In February 1993, the Company obtained a non-revolving, multiple drawdown line
of credit from a bank in the amount of $500,000. To enable the Company to obtain
such line of credit, Mr. Pappajohn became a guarantor of the Company's
borrowings under the demand note and pledged a money market account owned by
him, in the amount of $500,000, as collateral security for his performance under
the guaranty. The Company had granted to Mr. Pappajohn a security interest in
its tangible and intangible assets (excluding certain equipment which it is
attempting to lease) as collateral in the event the bank called his guarantee.
In consideration of his action as such guarantor and pledging his money market
account as aforesaid, the Company granted Mr. Pappajohn a warrant expiring
February 17, 1998 to purchase 10,000 shares of the Common Stock at $10.00 a
share. The Company also agreed to grant him a warrant to purchase up to 8,000
shares of the Common Stock for each $100,000 as and when drawn by the Company
under the line of credit. Each of these warrants would be exercisable for a
period of five years from its respective date of grant at $10.00 a share. Mr.
Pappajohn was also granted registration rights with respect to the shares of the
Common Stock issuable upon exercise of these warrants. Subsequently, the Company
borrowed the $500,000. As a result of this borrowing, the Company issued to Mr.
Pappajohn additional warrants to purchase 40,000 shares of the Common Stock.
After giving effect to the anti-dilution provisions of these warrants, Mr.
Pappajohn had received, as consideration for his guaranty and pledge, warrants
to purchase, as of June 30, 1996, an aggregate of 141,830 shares of the Common
Stock at an exercise price of $3.53 a share. Such warrants expire in February
and March 1998.

Sales to Tepnel Diagnostics, PLC, a United Kingdom company which owns 62,500
shares of the Company's Common Stock, was $56,175 and $40,900 in Fiscal years
ended June 30, 1996 and 1995 respectively.

 G       STOCKHOLDERS' EQUITY

During Fiscal 1993, the Company granted to the holders of record on May 13, 1993
(the "Record Date") of all of its outstanding shares of the Common Stock the
nontransferable right (the "Rights") to subscribe for Units at $5.00 per Unit
(the "Subscription Price") on the basis of one Unit for every 1.36 shares of the
Common Stock owned on the Record Date. Each Unit consisted of one share of the
Common Stock and a Redeemable Common Stock Purchase Warrant expiring June 30,
1006 (subsequently extended to 

                                       28

<PAGE>


December 31, 1996) to purchase one share of the Common Stock at $5.50 per share.
Between June 4 and June 30, 1993, 96,996 shares of the Common Stock were issued
upon the exercise of Rights, from which the Company received proceeds of
$484,980. Between July 1 and July 9, 1993, 603,004 shares of the Common Stock
were issued upon the exercise of Rights, from which the Company received
proceeds of $3,015,020, including 541,078 Rights purchased by the Underwriter
pursuant to a Standby Agreement. Costs of the rights offering of $864,946 were
charged to additional paid-in capital in Fiscal 1994. As a portion of the
consideration for the Standby Agreement, the Underwriter received an
Underwriter's Unit Purchase Warrant, exercisable at any time during the
four-year period which commenced June 4, 1994, at a purchase price of $0.00001
per warrant, to purchase 70,000 units, exercisable at $6.00 per unit, each unit
consisting of one share of the Common Stock and one Underwriter's Warrant. The
Underwriter's Warrant enables the Underwriter to purchase one share of the
Common Stock for $4.77 after giving effect to the anti-dilution provisions of
these warrants.

The Company has a Key Employees and Key Personnel Stock Option Plan with respect
to 30,000 shares of the Common Stock. All stock options will be exercisable at a
price to be determined by the Board of Directors which may not be less than the
fair market value of the Common Stock at the time of grant (110% of fair market
value for employees owning more than 10% of the voting power of all classes of
the Common Stock). See the table following for status of options. At June 30,
1996, there were 19,654 shares of the Common Stock reserved for future grants.

The Company has issued options and warrants to directors, officers, employees
and others as additional incentives for prior and future services.

On September 22, 1994, the Board of Directors ratified the adoption of the Drug
Screening Systems, Inc. Stock Option Plan of 1994 (the "1994 Option Plan") which
provides for the granting of non-qualified stock options to purchase up to
500,000 shares of the Common Stock, subject to possible adjustment in the event
of stock dividends, stock splits and similar transactions. Pursuant to the 1994
Option Plan, options may be granted to key employees, officers, directors,
consultants and advisers of the Company and, if later incorporated,
subsidiaries; the options may become exercisable in installments; the exercise
price of an option may not necessarily be at the fair market value of the Common
Stock at its date of grant; the expiration date of an option may be five to ten
years after its date of grant; and there is a provision permitting exercise if
there is a "change in control" (which definition does not include a transaction
approved by the then current directors). Pursuant to this Plan, options to
purchase an aggregate of 270,000 shares of the Common Stock at $0.625 a share
were granted on July 29, 1994 and an option to purchase 25,000 shares at $1.375
a share was granted on September 22, 1994 (the prices per share were the fair
market values at the dates of respective grants). The exercise price of the
option issued on September 22, 1994 was subsequently reduced to $0.625 to
reflect a drop in the market price. During its December, 1995 meeting, the Board
further reduced the exercise price for options granted to active officers and
its consultant to $0.25 to reflect an additional drop in the market price. These
options are exercisable immediately on the respective date of grant and expire
five years from the respective date of grant regardless of the current status
with the Company.

All options and warrants have been issued with exercise prices equivalent to the
market value of the Common Stock at the date of grant. As of June 30, 1996,
options and warrants to purchase 2,998,204 shares of the Common Stock were
currently exercisable. A summary of the Company's option and warrant activity
for the years ended June 30, 1996 and 1995 follows. The following table reflects
the anti-dilutive provisions of the options and warrants through August 31, 1996
and excludes the contingent warrants to purchase 225,000 shares of the Common
Stock (see Note J).

                                       29

<PAGE>
<TABLE>
<CAPTION>



                                 Warrants Issued    Warrants Issued                                                 Options
                                   in connection       to Directors          Warrants     Key Employees           issued to
                                            with       Officers and          issued to            Stock        Officers and
                                 Rights Offering          Employees       Other Parties     Option Plan           Employees
                                 ---------------          ---------       -------------     -----------           ---------

<S>                                <C>                    <C>                <C>             <C>                   <C>    
Outstanding July 1, 1994           1,921,993              317,613            851,137         10,346                324,646

Warrants granted                                                                                                   295,000
Warrants expired                                                            (466,734)                             (141,865)
---------------------------------------------------------------------------------------------------------------------------
Outstanding June 30, 1995          1,921,993              317,613            384,403         10,346                495,781

Options granted
Options expired                                                             (120,192)                             (189,008)
---------------------------------------------------------------------------------------------------------------------------
Outstanding June 30, 1996          1,921,993              218,441            264,211         10,346                306,773
===========================================================================================================================
Exercise price of
outstanding
options and warrants             $2.28-$2.46          $3.53-$7.80       $2.18-$12.50  $31.25-$70.63            $0.62-$8.61

</TABLE>


The Company's Board of Directors is expressly  authorized,  without  shareholder
approval,  to determine with respect to the Preferred  Stock,  the  preferences,
privileges, voting rights and other characteristics set forth in the articles of
incorporation. There are no shares of Preferred Stock issued and outstanding.

H        COMMITMENTS AND CONTINGENCIES

The Company leases facilities which it utilizes as its administrative, research
and developmentmanufacturing, quality control, warehousing and shipping
facilities. The leases, as amended, with an unaffiliated landlord, expire on
April 30, 1997. The monthly base rental is $4,712. Provided the Company is not
in default of any of the terms of its leases, the Company has the right to renew
the term of the leases for an additional five years. The Company has other
operating leases for certain equipment with various terms. Rental expense under
these leases was $78,963 and $90,325 in Fiscal 1996 and 1995, respectively.
Future commitments are not considered material.

I        INCOME TAXES AND NET OPERATING LOSS CARRYFORWARDS

The tax effects of significant items comprising the Company's net deferred taxes
as of June 30, 1996 and 1995 were as follows:
<TABLE>
<CAPTION>

                                                                        1996               1995
                                                                        ----               ----
Deferred tax assets:
<S>                                                                  <C>                <C>         
  Property                                                           $     44,000       $     44,000
  Allowance for doubtful accounts                                          20,000             40,000
  Vacation  accrual                                                         4,000              8,000
Operating loss carryforwards                                            6,100,000          5,800,000
Valuation allowance                                                    (6,168,000)        (5,892,000)
                                                                    =============      =============
                                                                         -                  -
                                                                    =============      =============
</TABLE>

                                       30
<PAGE>


The change in the valuation allowance for Fiscal 1996 was an increase of
approximately $276,000 as a result of the operating loss generated during the
year ended June 30, 1996, offset by small deductions in the allowance for
doubtful accounts and the vacation accrual.

There was no provision for current income taxes for either Fiscal 1996 or 1995.

The federal and state net operating loss carryforwards of approximately
$14,200,000, respectively, expire in varying amounts through 2011 and 2010,
respectively.

The Company has had numerous transactions in its Common Stock. Such transactions
may have resulted in a change in the Company's ownership, as defined in the
Internal Revenue Code Section 382. Such change may result in an annual
limitation on the amount of the Company's taxable income which may be offset
with its net operating loss carryforwards. The Company has not evaluated the
impact of Section 382, if any, on its ability to utilize its net operation loss
carryforwards in future years.

J        MAJOR CUSTOMERS, ETC.

In September 1993, the Company entered into an exclusive distributorship
agreement with Triangle Healthcare Systems, Lt. ("Triangle"), under which
Triangle had the right to distribute the Products in the Kingdom of Saudi
Arabia, Jordan, Kuwait, Bahrain, United Arab Emirates, Egypt, Qatar and Muscat
Oman. Upon signing the Triangle Agreement, the Company received a $500,000
purchase order from Triangle for Product to be delivered and paid for before
December 31, 1993. In return for granting the purchase order and other
consideration provided in the Triangle Agreement, the Company granted to
Triangle a warrant to purchase 50,000 shares of the Common Stock at $7.75 a
share (the then market price). The warrant, which was exercisable for five
years, was to be held by the Company as collateral until payment in full was
received for the $500,000 purchase order. Because Triangle failed to meet its
sales targets, the Company deems this warrant to have expired.

Triangle has not authorized the Company to ship under the purchase order and has
not met its sales target. By letter dated August 24, 1995, the Company notified
Triangle that, unless Triangle corrected its defaults by making payment and
placing minimum orders, the Triangle Agreement would terminate effective
November 24, 1995 per the termination paragraph of the agreement. Triangle did
not correct the defaults and the agreement terminated.

The finder of the Triangle opportunity was granted by the Company, on July 15,
1993, a warrant, exercisable for five years, to purchase 175,000 shares of the
Common Stock at an exercise price of $6.00 a share (the then market price). Per
a separate agreement, the finder would receive these warrants ratably upon
receipt of the funds for the $500,000 initial purchase order. In addition, the
Company granted to the finder warrants to purchase up to an additional 225,000
shares of the Common Stock, contingent upon Triangle meeting certain sales
targets through March 22, 1995; the exercise price of such warrants would have
been equal to the fair market value of the Common Stock at each date of
issuance. However, the sales targets were not met and the warrant expired.
Because the sales targets were not met and only $100,000 was received, the
Company deems the warrant to be outstanding for 35,000 shares (included in table
of Note G) and deems the right to the additional 140,000 shares under the
warrant, as well as the contingent warrant for 225,000 shares to have expired.

During Fiscal 1996, sales to BWIS was $1,041,245 (49%) of gross revenues, During
Fiscal 1995, sales to BWIS accounted for $1,616,119 (61%) of the gross revenues
of the Company. No other customer accounted for 10% or more of the Company's
gross revenues. A loss of BWIS would have a materially adverse impact upon the
Company's business and financial condition unless a replacement therefor was
obtained or the Company increased its sales through its own efforts (as to which
there is no assurance).

                                       31


<PAGE>

K        RESTRICTIVE STOCK INCENTIVE PLAN

In February 1990, the Company adopted a Restrictive Stock Incentive Plan which
allows for issuance of up to 75,000 shares of the Common Stock to certain key
employees. Provisions of the plan require continued employment and prohibit the
sale or transfer of shares issued for two years from the date of the grant.

As of June 30, 1996, the Company had issued an aggregate of 41,800 shares of the
Common Stock under such agreement; none were issued in Fiscal 1996 or 1995.
These shares were recorded at the fair market value at the date of the stock
grant. The Company records compensation expense for a period of 24 months from
the date of the stock grant. No compensation expense was recognized in Fiscal
1996 or Fiscal 1995.

As of June 30, 1996, 33,200 shares of the Common Stock were reserved for future
issuances under the Restrictive Stock Incentive Plan.

N        LITIGATION

On September 27, 1993, an action was initiated in the United States District
Court for the Eastern District of Pennsylvania by Gary and Carol Pache, joint
tenants, allegedly the owners of 30 shares of the Common Stock, against the
Company, Robert G. Wallace, the then Chairman of the Board and a director of the
Company (the President and Chief Executive Officer during the period alleged in
the complaint); Gary Nacht, the then Senior Vice President, Secretary and Chief
Financial Officer of the Company; and Jesse Greenfield, formerly a director of
the Company. The plaintiffs, in their complaint, were seeking to have a class
certified pursuant to Rule 23 of the Federal Rules of Civil Procedure consisting
of any shareholders who purchased shares of the Common Stock during the period
January 27, 1992 and September 28, 1992 (the "Class Period"), but excluding the
named individual defendants and any other officer or director of the Company.
The complaint alleges that the defendants issued affirmative statements in press
releases and other documents (including quarterly reports under the Securities
Exchange Act of 1934, as amended (the "Exchange Act") during the Class Period as
to the prospects of the Company for which there was no reasonable basis, with
the intention of inflating the market price of the Common Stock, and that these
allegedly false statements constituted a violation of Section 10(b) of the
Securities Act and Rule 10b-5 promulgated thereunder and "negligent
misrepresentation." The complaint sought damages for the class in an amount to
be determined at trial. The defendants moved to dismiss the complaint on the
ground that it failed to state an actionable claim within the judicial opinions
interpreting Section 10(b) of the Exchange Act and Rule 10b-5 promulgated
thereunder or for negligent misrepresentation. On March 20, 1995, the Court on
defendants' motion, dismissed the complaint for failure by the plaintiffs to
state a claim. On April 18, 1995, the plaintiffs appealed the dismissal to the
United States Court of Appeals for the Third Circuit. On November 14, 1995, this
Court affirmed the decision by the District Court for the Eastern District of
Pennsylvania dismissing the complaint.The period for further appeal has expired
and accordingly the action is terminated.

ITEM 8            Changes in and Disagreements with Accountants on Accounting
                  and Financial Disclosure

There were none.

                                       32


<PAGE>


                                    PART III

ITEM 9            Directors, Executive Officers, Promoters and Control Persons;
                  Compliance with Section 16(a) of the Exchange Act

Directors

As of September 13, 1996, the directors of the Company were:
<TABLE>
<CAPTION>

                                                                                        Year First
                                                                                        Became a
                                                                                        Director
Name                                Age     Principal Occupation                        or Officer
----                                ---     --------------------                        ----------

<S>                                 <C>                                                 <C> 
John Pappajohn                      68      President of Equity Dynamics, Inc., a       1991
                                            financial consulting and venturecapital
                                            firm

Stephen C. Turner                   51      Chief Executive Officer of Oncor, Inc.,     1991
                                            a manufacturer of genetic medical
                                            diagnostics

Jeff  Davidowitz                    40      Private Investor                            1994
</TABLE>

All directors hold office until the next Annual Meeting of Shareholders of the
Company or until their successors have been duly elected and qualified. Each of
the current directors was elected at the Annual Meeting of Shareholders on
November 14, 1995.

Executive Officers
------------------

As of September 13, 1995, the executive officer of the Company was:
<TABLE>
<CAPTION>

                                                                                        Year First
                                            Position with                               Became an
Name                                Age     the Company                                 Officer
----                                ---     -----------                                 -------

<S>                                 <C>                                                    
Joseph R. Shaya                     56      Acting President & CEO                        *

Patrick J. Brennan, CPA             52      Vice President, Chief Financial
                                            Officer and Secretary                       1994

Kenneth S. Carmenter                51      Vice President                              1991
</TABLE>


* Joseph R. Shaya, a consultant to the Company since June 1, 1994, was hired by
the Board to fulfill the duties of President and Chief Executive Officer,
reporting directly to the Board, an officer is engaged to perform such duties as
an employee.

Kenneth S. Carpenter served as a Vice President and was in charge of
manufacturing throughout Fiscal 1995. Mr. Carpenter left the Company in July
1996 to pursue interests in the Southwestern United States.

Each executive officer of the Company will serve until the first meeting of the
Board of Directors following the next Annual Meeting of Shareholders or until
the Board otherwise directs.


                                       33


<PAGE>

Family Relationships
--------------------

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

Business History
----------------

John Pappajohn, a director of the Company since December 1991, has been the
President of Equity Dynamics, Inc., a financial consulting and venture capital
firm, and the sole owner of Pappajohn Capital Resources, a venture capital firm,
since 1969. Mr. Pappajohn is a member of the Board of Directors of the following
public companies: Pace Health Systems, Inc., Core Management, Inc. United
Systems Technology, Inc., BioCryst Pharmaceuticals, Inc; and, OncorMed, Inc.,
which is a genetic based cancer screening service.

Stephen C. Turner, a director of the Company since December 1991, has been,
since August 1983, the Chairman of the Board and Chief Executive Officer of
Oncor, Inc., a public company which manufactures genetic medical diagnostics,
and OncorMed, Inc., a public company which is a genetic based cancer screening
service.

Anthony Ian Newman, a director of the Company since May 1993, resigned in
December 1995. He is a technology transfer and licensing specialist, resident in
England. Mr. Newman also sits on a number of boards including public companies
in the United Kingdom.

Jeff Davidowitz, a director of the Company since June 22, 1994, has been
President of Penn Footwear, a private company which manufactures shoes, since
January 1, 1991. Prior to that, he was Vice President of Penn Footwear.

Joseph R. Shaya was engaged as a consultant on June 1, 1994 to perform the role
of Acting President and CEO. Mr. Shaya has had his own consulting business for
the past seventeen years, and has served such clients as the Gallop
Organization, Nynex Mobil, Century Telephone Enterprises, World Data, Nokea and
others.

Patrick J. Brennan, CPA joined the Company on September 27, 1994 as Vice
President, Chief Financial Officer, Chief Accounting Officer and Secretary.
Prior to that, Mr. Brennan was Chief Financial Officer of Enzymatics, Inc. from
June 1993 until March 1994. Prior to that, he served as Chief Financial Officer
for American Film Technologies, Inc. (AFT) from August 1988 until December 1992.
In February 1991, Mr. Brennan was elected to the Board of Directors of AFT. Mr.
Brennan continued to serve on the Board after his resignation as Chief Financial
Officer. In October 1993, AFT filed for bankruptcy under Chapter 11 of the
Federal Bankruptcy Code. Mr. Brennan, as well as most directors, resigned upon
the acquisition by a new investor. From December 1992 to June 1993 and from
March 1994 to September 1994, Mr. Brennan was an independent consultant.

Messrs. Pappajohn and Turner (as indicated above) are the only directors to
serve as a director of another company which has a security registered under
Section 12(b) or (g) of the Exchange Act. No director serves as a director of
another company which is registered as an investment company under the
Investment Company Act of 1940, as amended.

Compliance with Section 16(a) of the Exchange Act
-------------------------------------------------

Based solely on a review of Forms 3 and 4 furnished to the Company under Rule
16a-3(e) promulgated under the Exchange Act with respect to Fiscal 1996, the
Company is not aware of any director or officer of the Company who failed to
file on a timely basis, as disclosed in such forms, reports required by Section
16(a) of the Exchange Act during Fiscal 1996 or prior years. The Company is not
aware of any beneficial owner of 10% or more of the outstanding shares of the
Common Stock, which is the only security of the 

                                       34


<PAGE>

Company registered under Section 12 of the Exchange Act, other than John
Pappajohn who is a director of the Company. See Item 11 to this Report.

ITEM 10  Executive Compensation

The following table sets forth summary compensation information awarded to,
earned by or paid to each highly paid executive officer whose total annual
salary and bonuses exceeded $100,000 during Fiscal 1996, 1995 and 1994 by the
Company. There was no person designated as chief executive officer as of June
30, 1995 or June 30, 1996; the duties were performed by a consultant. During
Fiscal 1995, no officer received a combined salary and bonus in excess of
$100,000.
<TABLE>
<CAPTION>


Summary Compensation Table
--------------------------
                                                                           Long-term
                                       Annual         Compensation        Compensation
      Name and                                            Other         Awards/Options        All Other
      Principal                                          Annual             SARS(4)         Compensation
      Position           Year         Salary          Compensation                                $
         (a)             (b)            (c)                (d)                (e)            Long-term
---------------------- --------- ------------------ ------------------ ------------------ ------------------
<S>                     <C>       <C>                 <C>               <C>               <C> 
Patrick Byrne ,  (1)     1994              106,000               none               none               none
---------------------- --------- ------------------ ------------------ ------------------ ------------------
COO, VP  of
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Sales & Mkt.
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Gary Nacht, (2)          1994              121,600              2,590               none               none
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Sr. VP, CFO  &
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Secretary
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Francis Pfeiffer, (3)    1994               92,508                554               none             13,500
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Vice President
---------------------- --------- ------------------ ------------------ ------------------ ------------------
R & D
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Joseph R. Shaya,         1994               15,000               none               none               none
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Acting President
---------------------- --------- ------------------ ------------------ ------------------ ------------------
& CEO                    1995              180,000               none            125,000               none
---------------------- --------- ------------------ ------------------ ------------------ ------------------

---------------------- --------- ------------------ ------------------ ------------------ ------------------
                         1996              180,000               none               none               none
---------------------- --------- ------------------ ------------------ ------------------ ------------------

---------------------- --------- ------------------ ------------------ ------------------ ------------------
Patrick J. Brennan       1995               77,600               none             25,000               none
---------------------- --------- ------------------ ------------------ ------------------ ------------------
VP, CFO &
---------------------- --------- ------------------ ------------------ ------------------ ------------------
Secretary                1996              106,917               none               none               none
---------------------- --------- ------------------ ------------------ ------------------ ------------------
</TABLE>


(1)      Mr. Byrne joined the Company in March 1992 and was terminated on July
         21, 1994.Under an agreement with Mr. Byrne, he received severance of
         approximately $52,000 paid bi-weekfrom the date of termination through
         April 28, 1995.

(2)      Mr. Nacht was terminated in July 1994.

(3)      Dr. Pfeiffer resigned in March 1994.

(4)      Amounts reflect anti-dilution provisions of options.

There were no Option/SAR grants or long-term incentive plan awards in Fiscal
1996. There are no other plans pursuant to which cash or non-cash compensation
was paid or distributed during Fiscal 1995 or 1996 or pursuant to which cash or
non-cash compensation is proposed to be paid or distributed in the future to the
executive officers of the Company in respect to Fiscal 1995 or 1996.

                                       35
<PAGE>


Aggregated Option/SAR Exercises during Fiscal 1996 and
------------------------------------------------------
Option/SAR Values at June 30, 1996
----------------------------------
<TABLE>
<CAPTION>

                                                                                           Value ($) of
                                                                    Number (#) of          Unexercised
                                                                     Unexercised           in-the-Money
                               Shares                                Options/SARs          Options/SARs
                              Acquired              Value          at June 30,1996       at June 30,1996
                                 on               Realized           Exercisable/          Exercisable/
         Name                 Exercise               ($)          Unexerciseable (4)      Unexerciseable
          (a)                    (b)                 (c)                 (d)                   (e)
------------------------ -------------------- ------------------ --------------------- ---------------------
<S>                            <C>                 <C>                <C>                      <C>                  
Joseph R. Shaya                 None                None              125,000/0                None
Acting President
& CEO (1)
------------------------ -------------------- ------------------ --------------------- ---------------------
Patrick J. Brennan,             None                None               25,000/0                None
VP, CFO &
Secretary (2)
------------------------ -------------------- ------------------ --------------------- ---------------------
Kenneth S. Carpenter            None                None               28,840/0                None
Vice President (3)
------------------------ -------------------- ------------------ --------------------- ---------------------
</TABLE>

(1)      Mr.  Shaya joined the Company as a consultant on June 1, 1994

(2)      Mr. Brennan joined the Company on September 27, 1994.

(3)      Mr. Carpenter joined the Company on February 20, 1991.

(4)      These amounts reflect anti-dilution provisions of options.

Other Compensation
------------------

None.

Compensation of Directors
-------------------------

Directors of the Company receive no compensation for their services as
directors.

Stock Option Plan of 1994
-------------------------

On September 22, 1994, the Board of Directors ratified the adoption of the Drug
Screening Systems, Inc. Stock Option Plan of 1994 (the "1994 Option Plan") which
provides for the granting of non-qualified stock options to purchase up to
500,000 shares of the Common Stock, subject to possible adjustment in the event
of stock dividends, stock splits and similar transactions. Pursuant to the 1994
Option Plan, options may be granted to key employees, officers, directors,
consultants and advisers of the Company and, if later incorporated,
subsidiaries; the options may become exercisable in installments; the exercise
price of an option may not necessarily be at the fair market value of the Common
Stock at its date of grant; the expiration date of an option may be five to ten
years after its date of grant; and there is a provision permitting exercise if
there is a "change of control" (which definition does not include a transaction
approved by the then current directors).

Pursuant to this Plan, options to purchase an aggregate of 270,000 shares of the
Common Stock at $0.625 a share (the fair market value at the date of grant) were
granted on July 29, 1994 and an option to purchase 25,000 shares at $1.375 a
share (the fair market value at the date of grant) on September 22, 1994
(subsequently reduced to $.0625 to reflect current market) as follows. During
its December, 1995 meeting, the Board further reduced the exercise price for
options granted to active officers and its

                                       36

<PAGE>

consultant to $0.25 to reflect an additional drop in the market price. These
options are exercisable on the respective date of grant and expire five years
from the respective date of grant.
<TABLE>
<CAPTION>

  Name of Optionee                  Position with Company                         Number  of Shares
  ----------------                  ---------------------                         ------  ---------

<S>                                <C>                                                  <C> 
Granted July 29, 1994
Joseph Shaya                        Consultant                                          125,000
Robert G. Wallace                   Sales Consultant                                     50,000
Stephen C. Turner                   Director                                             25,000
Anthony Ian Newman                  Director                                             25,000
Jeff Davidowitz                     Director                                             25,000
Kenneth S. Carpenter                Vice President (resigned 7/26/96)                    10,000
Jeffrey M. Bachrach                 Consultant                                           10,000

Granted September 22, 1994
Patrick J. Brennan                  Vice President,Chief Financial
                                           Officer and Secretary                         25,000
</TABLE>


ITEM 11  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS

(a)      Security Ownership of Certain Beneficial Owners and Management
         --------------------------------------------------------------

The following table sets forth information at August 31, 1996, based upon
information obtained from the persons named below or, in the case of Mr. Gordon,
based on his filings under the Exchange Act, with respect to the beneficial
ownership of shares of the Common Stock, which is the sole voting security of
the Company, by each person known by the Company to be the owner of more than 5%
of the outstanding shares of the Common Stock:

                                    Number of Shares of
Name and Address of                     CommonStock                 Percent of
Beneficial Owner                    Beneficially Owned              Class(1)
----------------                    ------------------              --------

JohnPappajohn(2)                       1,719,342(3)                   35.3%
c/o Pappajohn Capital Resources
2116 Financial Center
Des Moines, Iowa 50309

James A. Gordon                          882,317(4)                   20.3
Edgewater Private Equity Fund L.P.
666 Grand Avenue, Suite 200
Des Moines, Iowa 50309

Jeff Davidowitz(2)                       410,000(5)                   9.6%
c/o JIBS Equities
Line and Grove Streets
PO Box 87  Nanticoke, PA  18634

William Davidowitz                       260,000                      6.1%
PO Box 87
Nanticoke, PA  18634

(1) The percentages are based upon 4,246,017 shares of the Common Stock being
outstanding on September 13, 1996 and, where appropriate, effect is given to the
exercise of warrants or options as required by Rule 13d-3(d)(1)(i) under the
Exchange Act.


                                       37

<PAGE>

(2)      A director of the Company.

(3)      Includes 171,256 shares, after giving effect to anti-dilution
provisions, issuable upon the exercise of a warrant expiring September 30, 1996
which is currently exercisable and 17,741 shares, after giving effect to
anti-dilution provisions, issuable upon exercise of a warrant expiring December
31, 1996 held by an affiliate of his wife as to which he disclaims beneficial
ownership. Also includes an aggregate of 141,731 shares, after giving effect to
anti-dilution provisions, subject to warrants expiring February 17, 1998,
February 18, 1998. March 11, 1998 and March 30, 1998 granted to Mr. Pappajohn in
connection with a loan guaranty and pledge. Also includes 296,887 shares, after
giving effect to anti-dilution provisions, issuable upon exercise of warrants
expiring December 31, 1996 which are currently exercisable.

 (4)     Includes 97,244 shares, after giving effect to anti-dilution
provisions, issuable upon the exercise of a warrant expiring December 31, 1996
which is currently exercisable.

(5)      Reflects 25,000 shares issuable upon exercise of an option expiring
August 9, 1999.


(b)      Security Ownership of Management
         --------------------------------

Set forth below is information with respect to shares of the Common
Stockbeneficially owned as of August 31, 1996, based upon information obtained
from the personsnamed below, by each director of the Company, by the sole
executive officer whose compensation exceeded $100,000 in Fiscal 1996 and by all
current directors and executive officers as a group:

Name and Address of                  Amount of Beneficial       Percent of
Beneficial Owner                           Ownership             Class(1)
-------------------                  --------------------       ----------

John Pappajohn(2)                        1,719,342(3)               35.3%
 c/oPappajohn Capital Resources
2116 Financial Center
Des Moines, Iowa  50309

Stephen C. Turner(2)                        26,000(4)                0.6%
c/o Oncor, Inc.
 209 Perry Parkway
Gaithersburg, MD  20877

Jeff Davidowitz(2)                         410,000(5)                9.6%
c/o JIBS Equities
Line and Grove Streets
PO Box 87
Nanticoke, PA  18634

Joseph R. Shaya                            125,000(6)                2.9%
c/o Drug Screening Systems, Inc.
P. O. Box 579
Blackwood, NJ 08012

Patrick J. Brennan, CPA                     25,000(5)                0.6%
c/o Drug Screening Systems, Inc.
P. O. Box 579
Blackwood, NJ 08012

All Executive Officers and
Directors as a Group (5 persons)           2,350,052                41.0%

                                       38

<PAGE>


(1)     See Note (1) to the first table in this Item 11 to this Report.

(2)     See Note (2) to the firsttable in this Item 11 to this Report.

(3)     See Note (3) to the first table in this Item 11 to thisReport.

(4)     See Note (4) to the first table in this Item 11 to this Report.

(5)     Reflects 25,000 shares issuable upon exercise of an option expiring
        August 9, 1999.

(6)     Reflects 125,000 shares issuable upon exercise of an option expiring
        August 9, 1999.




ITEM 12  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Mr. Pappajohn is the major shareholder and a Member of the Board of Directors of
Drug Screening Systems, Inc. Mr. Pappajohn has purchased stock in the private
placements and has recently loaned funds to the Company to keep the Company
solvent. Mr. Pappajohn has no other dealings with the Company.

Mr. Shaya was hired as a consultant to the Company to perform the duties of
Acting President and CEO. Mr. Shaya's compensation for these services are
described elsewhere in this document. Mr. Shaya has no other dealings with the
Company.

                                       39

<PAGE>

                                     PART IV

ITEM 13  Exhibits, List and Reports on Form 8-K

(a)      Exhibits
         --------

The exhibits listed below which are marked with a footnote reference were filed
with a prior registration statement filed under the Securities Act or in a
periodic report filed under the Exchange Act and are incorporated herein by this
reference. The exhibits listed below which are not marked with a footnote
reference are filed with this Form 10-KSB.

<TABLE>
<CAPTION>

Number            Exhibit
------            -------

<C>               <C>
3(a)              Copy of Articles of Incorporation of the small business issuer.  (1)

3(a)(1)           Copy of Certificate of Amendment to Articles of Incorporation of the Company filed on
                  December 29, 1987. (1)

3(a)(2)           Copy of Certificate of Amendment to Articles of Incorporation of the Company filed on
                  December 24, 1991. (1)

3(a)(3)           Copy of Certificate of Amendment to Articles of Incorporation of the Company filed on
                  May 5, 1993.  (2)

3(b)              Copy of By-Laws of the Company.   (1)

4(a)              Specimen Certificate of Common Stock, $0.001 par value, of the Company.  (1)

4(a)(1)           Specimen Certificate of Common Stock, $0.01, par value, of the Company.  (3)

10(a)             Copy of Warrant Agency Agreement dated as of June 4, 1993 between the Company and
                  Continental Stock Transfer & Trust Company, as Warrant Agent.  (4)

10(a)(1)          Proof of Redeemable Warrant expiring June 3, 1996 of the Company.  (4)

10(b)             Copy of form of Underwriter's Unit Purchase Warrant of the Company.  (5)

10(b)(1)          Copy of form of Underwriter's Warrant of the Company.  (5)

10(c)             Copy of the 1988 Stock Option Plan of the Company.  (1)

10(c)(1)          Copy of the 1994 Stock Option Plan of the Company.

10(d)             Copy of Employee Restricted Stock Plan of the Company.  (6)

10(e)             Copy of Warrant expiring September 30, 1996 of the Company issued to John
                  Pappajohn.  (3)

10(e)(1)          Copy of Investor's Rights Agreement dated April 30, 1991 between the Company and
                  John Pappajohn. (3)

</TABLE>

                                       40

<PAGE>
<TABLE>
<CAPTION>

<C>               <C>
10(e)(2)          Copy of Warrant  expiring February 17, 1998 of the Company issued to John Pappajohn. (3)

10(e)(3)          Copy of Warrant expiring February 18, 1998 of the Company issued to John Pappajohn.  (3)

10(e)(4)          Copy of Warrant expiring March 11, 1998 of the Company issued to John Pappajohn.  (3)

10(e)(5)          Copy of Warrant expiring March 30, 1998 of the Company issued to John Pappajohn.  (3)

10(e)(6)          Copy of Investor's Rights Agreement dated February 18, 1993 between  the Company
                  and John Pappajohn.  (3)

10(f)             Copy of Warrant expiring February 28, 1997 issued by the Company to Gold & Wachtel.  (3)

10(g)             Copy of Lease dated May 9, 1988 between the Company, as tenant, and VPR Commerce
                  Center, as landlord.  (6)

10(g)(1)          Copy of Lease dated December 31, 1989 between the Company, as tenant, and VPR
                  Commerce Center, as landlord.  (6)

10(g)(2)          Copy of Lease dated February 19, 1992 between the Company, as tenant, and VPR
                  Commerce Center, as landlord.  (3)

10(g)(3)          Copy of Lease dated March 4, 1993 between the Company, as tenant, and VPR
                  Commerce Center, as landlord.  (3)

10(h)             Copies of Independent Laboratory Results and Supplements thereto.  (6)

10(i)             Copy of Exclusive Distributorship, Sale and Service Agency Agreement dated May 12,
                  1989 between the Company and B.P.S. Guard Services, Inc. ("BPS").  (6)

10(i)(1)          Copies of Amendments dated June 5, 1989, July 7, 1989, December 19, 1989 and
                  January 29, 1991 to the foregoing Agreement.  (6)

10(I)(2)          Copy of Exclusive Distributorship, Sale and Service Agency Agreement dated January
                  15, 1993 among the Company, BPS and Wells Fargo Investigative Services, Inc. (now
                  Borg Warner Investigative Services, Inc.) restating and amending the Agreement, as
                  previously amended, filed as Exhibits 10(i) and 10(i)(1).  (3)

10(I)(3)          Copy of  Distributorship, Sale and Service Agency Agreement dated May 8, 1995
                  between the Company amd Borg Warmer Information Services, Inc.  restating and
                  amending the Agreement as previously amended, filed as Exhibits 10(I), 10(I)(1) and
                  10(I)(3).

10(I)(4)          Copy of the Exclusive Distribution Agreement dated March 5, 1996 between the
                  Company and U. S. Distribution, a division of Baxter healthcare Corporation. (8)

10(j)             Copy of Distribution Agreement dated July 22, 1991 between the Company and
                  Marketing & Trade International, Ltd. (now Intertec, Inc.).  (6)
</TABLE>

                                       41
<PAGE>
<TABLE>
<CAPTION>

<C>               <C>
10(k)(1)          Copy of security agreement dated January 18, 1993 between the Company and John
                  Pappajohn.  (3)

10(k)(2)          Copy of security letter agreement dated January 18, 1993 between the Company and
                  John Pappajohn.  (3)

10(l)             Copy of Promissory Note dated August 18, 1988 of Robert G. Wallace to the Company.  (3)

10(l)(1)          Copy of Pledge Agreement dated August 18, 1989 by Robert G. Wallace to the
                  Company.  (6)

10(l)(2)          Copy of Extension Notes dated November 18, 1988 and July 1, 1991 relating to Exhibit
                  10(k) hereto.  (6)

10(l)(3)          Copy of Extension Note dated April 8, 1983 relating to Exhibit 10(k) hereto.  (3)  10(m)
                  Copy of Employment Agreement dated as of February 1, 1990 between the Company
                  and Ming Sun.  (3)

10(n)             Copy of Employment Agreement dated as of February 1, 1990 between the Company
                  and Francis R. Pfeiffer.  (3)

10(o)             Copy of Standby Agreement dated as of June 4, 1993 between the Company and Royce
                  Investment Group, Inc. ("Royce"). (5)

10(o)(1)          Copy of Financial Consulting Agreement between the Company and Royce is an exhibit
                  to Exhibit 10(o) hereto.

10(p)             Copy of  Agreement  dated as of April  30,  1993 by and among
                  Tepnel  Diagnostics  PLC  ("Tepnel"),  the  Company,  Gold  &
                  Wachtel, as escrow agent, and Milberg Weiss
                  Bershad Specthrie & Lerach.  (2)

10(p)(1)          Copy of letter dated April 30, 1993 from John Pappajohn and Mary Pappajohn to
                  Tepnel.  (3)

10(q)             Copy of Exclusive Distribution Agreement dated May 21, 1993 between the Company
                  and Tepnel Diagnostics PLC.  (3)

10(r)             Copy of the Joint Research and Development Agreement dated May 21, 1993 between
                  the Company and Tepnel Diagnostics PLC.  (3)

10(s)             Copy of the Exclusive Distribution Agreement dated September 15, 1993 between
                  the Company and Triangle Healthcare Systems, Ltd.  (7)

10(t)             Copy of Financial Consulting and Employment Agreement dated July 15, 1993 between
                  the Company and Charles Levy.  (7)

10(u)             Copy of Exclusive License and Distributorship Agreement dated April 21, 1994 between
                  the Company and AccuScreen Labs, Inc.

10(u)(1)          Copy of Non-Exclusive Distribution Agreement dated November 11, 1993 between the
                  Company and AccuScreen Labs, Inc.

10(v)             Copy of Exclusive Distribution Agreement dated May 3, 1994 between the Company
                  and Rimstar Trading Company.

</TABLE>

                                       42
<PAGE>
<TABLE>
<CAPTION>

<C>               <C>
(1)      Filed as an exhibit to the Company's Registration Statement on Form S-18, File 
         No. 33-19770-NY.

(2)      Filed as an exhibit to the Company's Quarterly Report on Form 10-Q for the quarter ended March
         31, 1993.

(3)      Filed as an exhibit to the Company's Registration Statement on Form SB-2, File No. 33- 60176.

(4)      Filed as an exhibit to the Company's Form 8-A dated dune 28, 1993.

(5)      Filed as an exhibit to the Company's Current Report on Form 8-K filed on July 12, 1993.

(6)      Filed as an exhibit to a Post-Effective Amendment to the Company's Registration Statement on
         Form S- 18, File No. 33-19770-NY.

(7)      Filed as an exhibit to the Company's Annual Report on Form 10- KSB for the year ended June
         30, 1993.

(8)      Files as an exhibit to the  Company's  Quarterly  Report on Form 10-QSB
         for the quarter ended March 31, 1996.

(b)      Reports on Form 8-K
         -------------------
None
</TABLE>
                                       43


<PAGE>


                                   SIGNATURES

In accordance with Sections 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

                          DRUG SCREENING SYSTEMS, INC.

                                By:     /s/ Joseph R. Shaya
                                        ----------------------
                                        Acting President & CEO

                                        /s/ Patrick J. Brennan
                                        --------------------------------------
                                        Vice President, Chief Financial Officer

Dated: September  26 ,1996

In  accordance  with the Exchange  Act, this report has been signed below by the
following  persons on behalf of the  registrant and in the capacities and on the
dates indicated.

Signature                           Title                   Date
---------                           -----                   ----

/s/ John Pappajohn                  Director                September  26, 1996
-----------------------
John Pappajohn

/s/ Stephen C. Turner               Director                September  26, 1996
-----------------------
Stephen C. Turner

/s/ Jeff Davidowitz                 Director               September  26 , 1996
-----------------------
Jeff Davidowitz

/s/ Patrick J. Brennan             Vice President,Chief     September  26, 1996
-----------------------
Patrick J. Brennan                 Financial Officer and Secretary
                                   (Principal Financial and
                                   Accounting Officer)