<PAGE>
 
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                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                                   FORM 10-K
 
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
   ACT OF 1934 (FEE REQUIRED)
 
                  FOR THE FISCAL YEAR ENDED NOVEMBER 30, 1996
 
                                      OR
 
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
   EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
 
  FOR THE TRANSITION PERIOD FROM                      TO
 
                         COMMISSION FILE NUMBER 1-7008
 
                      TRANSITIONAL HOSPITALS CORPORATION
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 


                  NEVADA                                    94-1599386
      (STATE OR OTHER JURISDICTION OF                    (I.R.S. EMPLOYER
      INCORPORATION OR ORGANIZATION)                  IDENTIFICATION NUMBER)
   5110 W. SAHARA AVENUE, LAS VEGAS, NV                        89102
 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                   (ZIP CODE)

                               AREA CODE (702) 257-3600
                 (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
              SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
<TABLE> 
<CAPTION> 
  TITLE OF EACH CLASS              NAME OF EACH EXCHANGE ON WHICH REGISTERED
  -------------------              -----------------------------------------
<S>                                <C>  
COMMON STOCK, $1.00 PAR VALUE              NEW YORK STOCK EXCHANGE
                                           PACIFIC STOCK EXCHANGE
</TABLE>
 
  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes  X  No
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K (Section 229.405 of this chapter) is not contained
herein, and will not be contained, to the best of Registrant's knowledge, in
definitive proxy or information statements incorporated by reference in Part
III of this Form 10-K or any amendment to this Form 10-K. [X]
 
  The aggregate market value of the voting stock held by non-affiliates of the
Registrant on February 14, 1997, based on the closing price on the New York
Stock Exchange was: $360,351,000
 
         Number of shares outstanding on February 14, 1997: 40,039,000
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<PAGE>
 
ITEM 1. BUSINESS
 
  This Annual Report on Form 10-K contains certain forward looking statements
that are subject to risk and uncertainty. There can be no assurance that these
future results will be achieved. Readers are cautioned that a number of
factors could adversely affect the Company's ability to obtain these results
including: (a) uncertainties in the regulatory environment due to possible
future health care reform legislation, including changes in Medicare and
Medicaid reimbursement programs, (b) uncertainties in the regulatory
environment regarding obtaining approvals to open new operations or expand
current facilities, (c) increased payor pressures in the domestic psychiatric
industry with respect to negotiated rates and other cost-containment measures
that could affect the Company's equity earnings in Behavioral Healthcare
Corporation ("BHC"), (d) increased competition among hospitals, managed care
providers and other health care providers, (e) the possibility of changing
conditions in the securities markets affecting the Company's plans to
repurchase its own stock, and (f) the availability of suitable acquisition
candidates and the Company's success in negotiating favorable terms to
complete acquisitions.
 
  The following discussion should be read in conjunction with the industry
segment information presented in the notes to the financial statements
appearing in Items 7 and 8.
 
GENERAL
 
  On November 30, 1996, Transitional Hospitals Corporation (the "Company" or
"THC" and formerly "Community Psychiatric Centers") consummated the sale of
effectively all of its psychiatric operations in the U.S. and Puerto Rico
(with certain limited exceptions set forth below) to BHC. Prior to such sale,
BHC owned 17 psychiatric hospitals. At the November 30 closing, the Company
transferred title to 22 freestanding psychiatric hospitals, a joint venture
interest in another psychiatric operation, an outpatient psychiatric center,
two closed hospitals and vacant land located at three sites in California. Two
other operating hospitals and a joint venture interest (the "Escrowed Assets")
are to be transferred to BHC upon receipt of necessary regulatory approvals,
which management believes are perfunctory. Additionally, effective November
30, 1996, BHC and the Company entered into a management agreement which grants
BHC, with limited protective rights retained by THC, exclusive and complete
responsibility and discretion in the management and control of the Escrowed
Assets as well as the economic benefit thereof. Accordingly, for accounting
purposes, the sale of the Escrowed Assets has been recorded with an effective
date of November 30, 1996. At the initial closing, the Company received
$60,000,000 in cash, 2,214,400 shares of BHC Common Stock, 5,072,579 shares of
BHC Series A Preferred Stock and 46,902 shares of BHC Series B Preferred
Stock. In general, the Series A Preferred Stock converts into BHC Common Stock
on a share for share basis upon sales and dispositions of the Series A
Preferred Stock by the Company and under certain other limited circumstances.
Upon receipt of the necessary regulatory approvals related to the Escrowed
Assets, the Company will receive an additional 3,785,600 shares of BHC Common
Stock, an additional 578,844 shares of BHC Series A Preferred Stock and 3,350
additional shares of BHC Series B Preferred Stock. Upon distribution of all
shares, the Company will have a common equity interest amounting to 44.2% of
BHC's Common Stock outstanding. An agreement has been entered into between BHC
and the Company requiring THC to vote all shares in excess of 20% of BHC's
outstanding Common Stock as instructed by a majority of BHC's Board of
Directors which includes three members of THC's Board of Directors. THC's
Chairman of the Board and Chief Executive Officer, Richard Conte, will serve
as BHC's Chairman of the Board. THC's common equity interest in future BHC
earnings will be recorded on the equity method of accounting. In determining
the amount of the consideration to be paid to the Company, the parties
compared their respective EBITDA's (Earnings before interest, taxes,
depreciation, and amortization) and used multiples generally accorded to
publicly-traded psychiatric hospitals. Based on this analysis, the total value
of the equity interest in BHC was determined to be approximately $70 million.
 
  In addition to the above, the Company also sold three other closed
psychiatric hospitals in fiscal year 1996. As of November 30, 1996, five
closed psychiatric hospitals with a book of value of $13.4 million remain with
the Company and these assets are being held for sale. The book values of these
facilities represents the estimated fair market value less costs to sell the
properties.
 
                                       1
<PAGE>
 
  On June 21, 1996, the Company sold its United Kingdom psychiatric hospitals
("Priory Hospitals Group" or "PHG") to Foray 911 Limited ("Foray"), a new
corporation formed by Mercury Development Capital, a division of Mercury Asset
Management plc ("Mercury"). PHG operates 15 freestanding acute psychiatric
hospitals and chemical dependency facilities, including one 42 bed hospital
that was 50% owned by the PHG. Based on the number of licensed hospital beds,
PHG is the leading commercial provider of psychiatric services in the United
Kingdom where psychiatric services are generally available to residents
without charge from government-owned NHS hospitals. Approximately 12% of the
British population is covered by private health insurance. The total purchase
price for the PHG facilities was approximately $135 million, which includes a
$4.6 million subordinated note due in 2009 issued by Foray. Excluded from the
sale was PHG's startup secured training centers business, being developed
under the name Youth Services Ltd. ("YSL") which THC and a 20% joint venture
partner intend to develop in the U.K.
 
  The Company used $50 million of the net cash proceeds from the sale of the
U.K. division to repay $50 million of long-term debt. The Company plans to use
the remaining net cash proceeds from the above described sales to accelerate
THC's expansion through acquisitions of both individual hospitals or chains,
and to continue to take advantage of opportunities to buy back the Company's
stock. During fiscal year 1996, the Company's Board of Directors approved the
expenditure of up to $75 million to buy back the Company's stock in the open
market. Through November 30, 1996, the Company expended approximately $36
million to repurchase approximately 4.2 million shares of the Company's stock.
 
  With the above described transactions completed, the Company will now focus
on the development and growth of its core business of operating long-term
acute care hospitals. As of November 30, 1996, THC operated 14 long-term acute
care hospitals and two satellite facilities, with a total of 1,340 licensed
beds, located in 12 states. In December 1996, the Company opened one new THC
facility in San Diego (34 beds) and a satellite facility in Pasadena, Texas
(46 beds). The Company is evaluating numerous other development projects and
potential acquisitions across the country and other alternatives to enhance
shareholder value.
 
  In November 1992, to diversify beyond psychiatric care, the Company began to
offer long-term acute care services in converted, previously underutilized
psychiatric hospitals and newly-acquired freestanding acute care facilities.
THC offers long-term acute care to patients who are stabilized and do not
require the complete spectrum of intensive care services provided by
traditional acute care hospitals, but who are too ill to return home or be
placed in a nursing home. THC provides care to those suffering from pulmonary
diseases, kidney failure and other complex medical problems; such patients
require a variety of intensive services including life-support systems, post-
surgical stabilization, intravenous therapy, subacute rehabilitation and wound
care. THC also provides contract respiratory therapy services to nursing homes
and hospital facilities owned by third parties. THC's strategy is to provide a
comprehensive range of long-term acute care that will enable it to treat most
types of critical care patients, regardless of their diagnosis or medical
condition, with the objective of returning these patients to full activity.
 
  THC offers managed care organizations and indemnity insurance payors a
single source from which to obtain long-term acute care services. The Company
believes THC addresses cost-containment pressures affecting the health care
industry by offering a high quality, cost-effective alternative to traditional
acute care hospitals.
 
HOSPITAL OPERATIONS
 
  THC provides long-term acute care in converted psychiatric facilities,
freestanding acute care facilities and space shared with a BHC psychiatric
facility. In December 1996, the Company opened its first leased unit within an
acute care facility owned by another provider. Although THC's patients range
in age from pediatric to geriatric, a substantial portion of THC's patients
are over 65 years of age. THC's long-term acute care facilities include the
equipment and physician and other professional staff necessary to care for
most types of critically ill patients regardless of their diagnosis or medical
condition. THC's professional staffs work in inter-disciplinary teams to
evaluate patients upon admission to determine a treatment plan with an
appropriate level and intensity of care. Where appropriate, the treatment
programs may involve the services of several disciplines, such as
 
                                       2
<PAGE>
 
pulmonary and rehabilitation therapy. Currently, THC offers a complex medical
care program, ventilator management program, wound care program and low
tolerance rehabilitation program. Patients who successfully complete treatment
programs are discharged to skilled nursing homes, rehabilitation hospitals or
home care settings. During fiscal 1996, the average length of stay for THC
patients was approximately 40 days.
 
  Traditionally, patients suffering from long-term complex medical problems
have stayed in the intensive care unit of general acute care hospitals until
they were sufficiently well to be transferred to less intensive care settings.
Such stays are relatively expensive, reflecting the cost of intensive on-site
equipment and services that, while necessary for hospitals to accomplish their
primary missions, are not required for the ongoing treatment of these
patients.
 
  Over the past several years, hospitals have come under increasing pressure
to reduce the length of patient stays as a means of containing costs. Managed
care organizations have limited hospitalization costs by controlling hospital
utilization and negotiating discounted rates for hospital services.
Traditional third party indemnity insurers have begun to limit reimbursement
to pre-determined amounts of "reasonable charges," regardless of actual costs,
and to increase the co-payments required to be paid by patients. In 1983,
Congress sought to contain Medicare hospital costs by adopting the Prospective
Payment System ("PPS") under which hospitals generally receive a specified
reimbursement rate regardless of how long the patient remains in the hospital
or the volume of ancillary services ordered by the attending physician. The
effect of these various cost-containment measures have provided hospitals with
an incentive to discharge patients more quickly. THC's long-term acute care
hospitals are exempt from PPS and thus receive reimbursement on a more
favorable basis for providing long-term acute care services to Medicare
patients than general acute care hospitals.
 
  THC has primarily targeted larger-population markets which have significant
populations of persons over the age of 65. The aging of the population,
advancements in medical care, the desire of payors and patients for lower cost
and more specialized alternatives to traditional acute care hospitals and the
disincentive for such hospitals to provide long-term care to critically ill
patients has led to a growing demand for long-term acute care services. The
Company believes that providers such as skilled nursing facilities and home
care providers are not in the best position to efficiently provide health care
services to these critically ill patients. Traditional skilled nursing
facilities have generally focused on providing long-term custodial care to
persons eligible for Medicaid. As a result of Medicaid "cost ceilings" on
reimbursement for each patient, nursing homes face an economic disincentive to
treat medically complex patients. Home health care is not a viable alternative
to inpatient care for such patients because of their continued need for (i)
intensive and specialized medical care and equipment, (ii) the availability of
physicians and 24-hour nursing care, and (iii) a comprehensive array of
rehabilitative therapy. The Company believes that its emphasis on long-term
acute care allows it to provide high quality care to critically ill patients
on a cost effective basis.
 
                                       3
<PAGE>
 
HOSPITAL FACILITIES
 
  As of November 30, 1996, THC operated the following 14 long-term acute care
hospitals and two satellite hospitals:
 
<TABLE>
<CAPTION>
                                                         LICENSED
        HOSPITAL                               CITY        BEDS    DATE OPENED
        --------                               ----      --------  -----------
   <S>                                     <C>           <C>      <C>
   CALIFORNIA
     THC Orange County(2)................. Brea              48   May 1995
   FLORIDA
     THC Hollywood........................ Hollywood        124   October 1993
     Transitional Hospital of Tampa....... Tampa            102   March 1993
   ILLINOIS
     Transitional Hospital of
      Chicago(3)(4)....................... Chicago          237   December 1993
   INDIANA
     THC Indianapolis(1).................. Greenwood         38   November 1993
   LOUISIANA
     THC New Orleans(2)................... New Orleans      168   November 1992
   MASSACHUSETTS
     THC Boston........................... Peabody           41   November 1993
   MINNESOTA
     THC Minneapolis...................... Golden Valley    111   November 1994
   NEVADA
     THC Las Vegas........................ Las Vegas         52   December 1993
   NEW MEXICO
     THC Albuquerque...................... Albuquerque       61   December 1993
   TEXAS
     THC Arlington(2)(4).................. Arlington        160   December 1992
     THC Houston(2)....................... Houston           84   December 1993
   WASHINGTON
     THC Seattle.......................... Seattle           80   May 1994
   WISCONSIN
     THC Milwaukee(2)..................... Greenfield        34   February 1994
                                                          -----
       TOTAL THC LICENSED BEDS............                1,340
                                                          =====
</TABLE>
--------
(1) Shared facility with a former CPC psychiatric hospital (now a BHC
    hospital).
(2) Fully converted from a former CPC psychiatric hospital.
(3) Leased facility.
(4) In September of 1995, the Company opened an 80-bed satellite to its
    Arlington facility in Fort Worth, Texas. In October 1996, the Company
    opened a 103-bed satellite to its Chicago facility in Chicago, Illinois.
 
Note: A new facility in San Diego, CA (34 beds) opened in December 1996. A new
      leased satellite facility in Pasadena, Texas (46 beds) also opened in
      December 1996.
 
HOSPITAL PATIENT ADMISSION
 
  Substantially all of the patient admissions to THC's hospitals are transfers
from other health care providers. Patients are referred from general acute
care hospitals, rehabilitation hospitals, skilled nursing facilities and home
care settings. The majority of THC's admissions are directly from the
intensive care units of general acute care hospitals. Referral sources include
discharge planners, case managers of managed care plans, social workers,
physicians, third party administrators, HMOs and insurance companies.
 
                                       4
<PAGE>
 
  THC has directors of patient referrals who educate health care professionals
from traditional acute care hospitals as to the unique nature of the services
provided by THC's hospitals. The directors of patient referrals develop an
annual admission plan for each hospital, with assistance from the hospital's
administrator. The admission plans involve ongoing education of local
physicians and the employees of managed care organizations and acute care
hospitals. THC anticipates that it will direct increased admission efforts
toward insurance company case managers and managed care organizations.
 
PERFORMANCE IMPROVEMENT--TOTAL QUALITY MANAGEMENT
 
  The Company has a program whereby its hospitals are internally reviewed
annually for compliance with the standards of Joint Commission on
Accreditation of Healthcare Organizations ("JCAHO"), Health Care Financing
Administration ("HCFA"), Occupational Safety and Health Administration
("OSHA"), State and other regulatory agencies. The purpose of this internal
review process is to (i) ensure compliance with the standards of all
regulatory agencies, (ii) provide assistance for hospital operations, and
(iii) assist the facilities in identifying opportunities to improve care.
 
  In addition, each hospital has a multi-disciplinary performance improvement
program that includes: performance indicators, utilization review/case
management, infection control and risk management. The objective of this
program is to ensure that patients are appropriately admitted to the Company's
hospitals and that quality healthcare services are provided in a cost-
effective manner.
 
SOURCES OF LONG-TERM ACUTE CARE REVENUES
 
  For long-term acute care services rendered to patients, THC receives payment
from (i) the federal government under Medicare, (ii) certain states under
Medicaid, (iii) commercial insurers and patients and (iv) managed care
organizations. During the first six months of operation, a THC facility is
reimbursed under the Medicare Prospective Payment System ("PPS") which does
not pay the full cost of treating Medicare patients with the severity of
illness treated at THC facilities. As a result, a new facility typically
incurs significant start-up losses in the first six months of operation.
Certification as a long-term acute care hospital typically occurs after the
facility's first six months of operations during which the facility
establishes an average length of stay in excess of 25 days. After
certification as a long-term acute care hospital, the THC facility is no
longer subject to PPS limitations. Payments from Medicare and Medicaid are
generally based upon cost, payments from commercial insurers are generally
based upon actual charges and payments from managed care organizations are
based on negotiated rates. The following table summarizes the approximate
percentages of THC revenues from the specified payor sources indicated:
 
<TABLE>
<CAPTION>
                                                                  FISCAL YEAR
                                                                     ENDED
                                                                  NOVEMBER 30,
                                                                 ----------------
                                                                 1996  1995  1994
                                                                 ----  ----  ----
   <S>                                                           <C>   <C>   <C>
   Medicare.....................................................  78%   72%   69%
   Medicaid.....................................................   3     4     6
   Managed Care and Other.......................................  19    24    25
                                                                 ---   ---   ---
     Total...................................................... 100%  100%  100%
                                                                 ===   ===   ===
</TABLE>
 
                                       5
<PAGE>
 
SELECTED HOSPITAL OPERATING DATA
 
  The following table summarizes certain operating data of the Company's THC
hospitals:
 
<TABLE>
<CAPTION>
                                                         FISCAL YEAR ENDED
                                                           NOVEMBER 30,
                                                      -------------------------
                                                       1996     1995     1994
                                                      -------  -------  -------
   <S>                                                <C>      <C>      <C>
   Hospitals in operation at period end(1)...........      14       14       13
   Licensed beds at period end.......................   1,340    1,154      970
   Patient days...................................... 251,980  197,046  100,485
   Average daily census..............................     688      540      275
   Occupancy percentage..............................    51.3%    46.8%    28.4%
</TABLE>
--------
(1) In September 1995, the Company opened an 80-bed satellite to its Arlington
    facility in Fort Worth, Texas. In October 1996, the Company opened a 103-
    bed satellite to its Chicago facility in Chicago, Illinois.
 
COMPETITION
 
  THC's hospitals compete with medical/surgical hospitals, certain long-term
care hospitals, sub-acute facilities, rehabilitation hospitals and nursing
homes specializing in providing care to critically ill patients. Many of these
providers are larger and more established than THC. Certain providers that
compete with the Company's hospitals are operated by not-for-profit,
nontaxpaying or governmental agencies, which can finance capital expenditures
on a tax exempt basis, and which receive funds and charitable contributions
unavailable to the Company's hospitals. The Company believes that to offer
programs providing a cost-effective continuum of care, nursing homes and other
companies are converting their facilities and developing programs that will be
competitive with THC's hospitals. This trend is expected to continue due to
cost-containment pressures, lower hospital occupancy rates experienced in
recent years by general acute care hospitals, and the efforts of nursing homes
to expand their existing markets.
 
  The competitive position of a hospital is affected by the ability of its
management to negotiate service contracts with purchasers of group health care
services, including private employers, preferred provider organizations
("PPOs") and health maintenance organizations ("HMOs"). Such organizations
attempt to obtain discounts from established hospital charges. The importance
of obtaining contracts with PPOs, HMOs and other organizations which finance
health care, and its effect on a hospital's competitive position, varies from
market to market, depending on the number and market strength of such
organizations. It is the Company's policy to enter into these contracts
wherever feasible. Generally, hospitals holding major contracts with managed
care organizations are able to attract more doctors to their active medical
staffs than hospitals without such contracts.
 
REGULATION AND REIMBURSEMENT
 
  The health care environment in which the Company operates is highly
regulated and subject to frequent and substantial changes and proposals for
change. There can be no assurance that state or federal regulatory and
legislative bodies will not propose or enact rules or laws that could have a
material adverse effect on the Company.
 
  The Company's hospitals are subject to substantial and continuous federal,
state and local government regulation. Such regulations provide for periodic
inspections and other reviews by state and local agencies and the United
States Department of Health and Human Services ("HHS") to determine compliance
with their respective standards pertaining to medical care, staffing
utilization, safety and equipment necessary for continued licensing or
participation in the Medicare or Medicaid programs.
 
 Accreditation and State Licensing
 
  State licensing of hospitals is a prerequisite to the operation of each
hospital and to participation in all federally-funded programs. Once a
hospital has been licensed, it must continue to comply with federal, state and
 
                                       6
<PAGE>
 
local licensing requirements in addition to local building and life safety
codes. All of the Company's hospitals have obtained the necessary licenses to
conduct business.
 
  Hospitals may seek an accreditation from JCAHO, a nationwide commission
which establishes standards relating to the physical plant, administration,
quality of patient care and operation of medical staffs of hospitals.
Generally, hospitals and certain other health care facilities are required to
have been in operation at least six months in order to be eligible for
accreditation by JCAHO. After conducting on-site surveys, JCAHO awards
accreditation for up to three years to hospitals found to be in substantial
compliance with JCAHO standards. Accredited hospitals are periodically
resurveyed, including, at the option of JCAHO, upon a major change in
facilities or organization and after a merger or consolidation. All of the
Company's hospitals in operation as of November 30, 1996 are accredited by
JCAHO. The Company intends to seek and obtain JCAHO accreditation for any
additional hospitals it may purchase or lease.
 
  Certain states have certificate of need ("CON") laws which generally provide
that prior to the expansion of an existing facility, the construction of a new
facility, the addition of beds, the acquisition of existing facilities or
major items of equipment or certain changes in services, or the undertaking of
a capital expenditure on behalf of a facility, approval must be obtained from
the designated state health planning agency. The stated objective of the CON
process is to promote quality health care at the lowest possible cost and
avoid unnecessary duplication of services, equipment and facilities. If the
Company is unable to obtain the requisite CONs, the growth of its business
could be adversely affected.
 
 Medicare and Medicaid
 
  Medicare is a federal program that provides certain hospital and medical
insurance benefits to persons age 65 and over and certain disabled persons.
Medicaid is a medical assistance program administered by the states and
partially funded by the federal government under which health care benefits
are available to the indigent. Within the Medicare and Medicaid statutory
framework, there are substantial areas subject to administrative rulings,
interpretations and discretion which may affect payments made to providers.
 
  In order to receive Medicare reimbursement, each hospital must meet the
applicable conditions of participation set forth by HHS relating to the type
of hospital, its equipment, personnel and standard of medical care, as well as
comply with state and local laws and regulations. Hospitals undergo periodic
on-site Medicare certification surveys. The Medicare survey is limited if the
hospital is JCAHO accredited. All of THC's operating hospitals are certified
as Medicare providers. All but two of the Company's operating hospitals are
certified by their respective state Medicaid programs. In fiscal 1996,
Medicaid represented only 3% of THC's net operating revenues. A loss of
certification could adversely affect a hospital's ability to receive payments
from Medicare and Medicaid.
 
  Prior to 1983, Medicare reimbursed hospitals for the reasonable direct and
indirect cost of the services provided to beneficiaries. The Social Security
Amendments of 1983 implemented PPS in an effort to reduce and control Medicare
costs. Under PPS, inpatient costs are reimbursed based upon a fixed payment
amount per discharge using diagnosis related groups ("DRGs"). The DRG payment
under PPS is based upon the national average cost of treating Medicare
patients with the same diagnosis.
 
  Although the average length of stay varies for each DRG, the average stay
for all Medicare patients subject to PPS is approximately six days. An
additional outlier payment is made for patients with unusually long lengths of
stay or higher treatment costs. Outlier payments are designed to cover only
marginal costs. Additionally, PPS payments can only be made once every 60 days
for each patient. Thus, PPS creates an economic incentive for general acute
care hospitals to discharge Medicare patients as soon as clinically possible.
 
  The Social Security Amendments of 1983 exempted psychiatric, rehabilitation,
cancer, children's and long-term care hospitals from PPS. A long-term care
hospital is defined as a hospital which has an average length of stay of
greater than 25 days. The Company's experience is that THC's facilities are
able to meet this definition. Under current law, inpatient operating costs for
long-term care and psychiatric hospitals are reimbursed under a cost-based
reimbursement system. The one exception to this rule is that during the
initial six months of
 
                                       7
<PAGE>
 
operations of a long-term care hospital it will be subject to PPS
reimbursement. As a result of the Tax Equity and Fiscal Responsibility Act of
1982 ("TEFRA"), reimbursement under the cost-based system is subject to a
computed target amount per discharge (the "Target") for inpatient operating
costs. A hospital's Target rate is the per discharge (case) limitation,
derived from the hospital's allowable net Medicare inpatient operating costs
in the hospital's base year, and updated for each subsequent hospital cost
reporting period by the appropriate annual rate-of-increase percentage. If
allowable net inpatient operating costs do not exceed the hospital's Target,
payment to the hospital will be determined on the basis of the lower of (i)
net inpatient operating costs plus 50% of the difference between inpatient
operating costs and the Target; or (ii) net inpatient operating costs plus 5%
of the Target. Prior to October 1, 1991, allowable Medicare operating costs
per discharge in excess of the Target were not reimbursed. Effective October
1, 1991, if a hospital's allowable net inpatient operating costs exceed the
Target, Medicare reimburses the lower of (i) the hospital's target amount plus
50% of the allowable Medicare operating costs per discharge in excess of the
Target or (ii) 110% of the Target. With regard to hospitals certified prior to
October 1, 1992, the TEFRA Target provisions do not apply with respect to
hospitals that have been in operation for less than three full years. For
hospitals certified on or after October 1, 1992 (all of THC's hospitals), the
TEFRA Target provisions do not apply with respect to hospitals that have been
in operation for less than two full years. Under the Omnibus Budget
Reconciliation Act of 1993 ("OBRA 1993"), increases in the Target for fiscal
years 1994 through 1997 are generally limited to the hospital market basket
increase minus one percentage point.
 
  On September 1, 1994, HHS published a regulation to establish additional
criteria for certain long-term care hospitals to meet in order to be exempt
from PPS. These regulations address exemption requests by long-term care
hospitals which operate in space leased from another hospital, sometimes
referred to as a "hospital-within-a-hospital" setting. Among other things, the
regulations, as amended, require that the long-term care hospital and the
"host" hospital have separate governing bodies, separate chief executive
officers, separate chief medical officers, and separate medical staffs. In
addition, the long-term care hospital must perform certain hospital functions
through employees or contracts with organizations other than the host
hospital, have 75% or more of its admissions referred from sources other than
the "host" hospital, or hold its purchases of services from the "host"
hospital below certain dollar thresholds. In locations where it is subject to
these rules, the Company believes it is in compliance with the applicable
regulatory criteria.
 
  Medicare and Medicaid reimbursement is generally determined from annual cost
reports filed by the Company. These cost reports are subject to audit by
Medicare and Medicaid. The Company has established reserves for possible
adjustments at levels which management believes to be adequate to cover any
downward adjustments resulting from audits of these cost reports.
 
  Federal regulations provide that admission to and utilization of hospitals
by Medicare and Medicaid patients must be reviewed by peer or utilization
review organizations ("PROs") in order to ensure efficient utilization of
hospitals and services. A PRO may conduct such review either prospectively or
retroactively and may, as appropriate, recommend denial of payments upon
admission or retrospectively for services provided to a patient. Such review
is subject to administrative and judicial appeal.
 
 Health Care Reform
 
  The focus of recent health care legislation in Congress has been on
budgetary and related funding mechanism issues. A number of reports, including
the 1995 Annual Report of the Board of Trustees of the Federal Hospital
Insurance Program (Medicare) have projected that the Medicare "trust fund" is
likely to become insolvent by the year 2002 if the current growth rate of
approximately 10% per year in Medicare expenditures continues. Similarly,
federal and state expenditures under the Medicaid program are projected to
increase significantly during the same seven-year period. In response to these
projected expenditure increases, and as part of an effort to balance the
federal budget, both the Congress and the Clinton Administration have made
proposals to reduce the rate of increase in projected Medicare and Medicaid
expenditures and to change funding mechanisms and other aspects of both
programs. In November 1995, Congress passed legislation that would have
substantially reduced payments to providers and would have made significant
changes in the
 
                                       8
<PAGE>
 
Medicare and the Medicaid programs. While President Clinton vetoed this bill,
the Clinton Administration has proposed and is expected to repropose alternate
measures to reduce, to a lesser extent, projected increases in Medicare and
Medicaid expenditures.
 
  The Medicare legislation that was adopted by Congress would have, among
other things, reduced payments to providers (including the Company), and
created incentives for Medicare beneficiaries to enroll in managed care plans.
Earlier versions of this legislation also contained cost controls affecting
long-term acute care hospitals. The Administration's proposal included a
moratorium on the designation of additional Medicare long-term acute care
hospitals and such a provision may be reintroduced in subsequent budget
legislation. The Company anticipates that federal and state governments will
continue to review and assess alternative health care delivery systems and
payment methodologies. Due to the uncertainties regarding the final details of
reform initiatives, the Company cannot predict which proposals, if any will be
adopted or what impact they may have on the Company. Moreover, there can be no
assurance that the adoption of any reform proposals will not have a material
adverse effect on the Company's business, operating results, or financial
condition.
 
 Reimbursement Limitations and Cost-Containment
 
  Regardless of the outcome of any proposed health care reform bills, there
will likely continue to be ongoing efforts to effect cost savings in the
Medicare program. These efforts could include change in the reimbursement of
the Company's long-term critical care hospitals to the DRG method. In fact,
the conference report accompanying the OBRA 1993 urged prompt completion of a
study of methods to subject hospitals such as THC's to PPS, based on DRGs to
be developed for the subject hospitals, from which they are currently exempt.
Similar language was introduced in 1995 legislation, but not incorporated into
the final bill adopted by Congress. Even if cost-based reimbursement for the
THC facilities continues, additional reimbursement limits may be imposed. Such
cost-containment initiatives may vary substantially from the proposed
structural reforms discussed above and may impact the Company more quickly and
directly.
 
 Relationships With Physicians and Clinicians
 
  The Company is subject to federal and state laws that regulate its
relationships with physicians and other providers of health care services.
These laws include the Medicare and Medicaid anti-kickback statute, under
which criminal penalties can be imposed upon persons who pay or receive any
remuneration in return for referrals of patients for items or services
reimbursed under the Medicare, Medicaid or certain state health care programs.
Violations of this law also result in automatic exclusion from these programs.
The Company is also subject to state and federal laws prohibiting false
claims.
 
  HHS's Office of Inspector General ("OIG") and the courts have broadly
construed the anti-kickback statute. "Safe harbor" regulations promulgated by
the OIG define a narrow range of practices that will be exempt from
prosecution or other enforcement action under this statute. To the extent that
offers to pay or payments made are deemed to be for purposes of inducing
referrals and do not satisfy all the criteria for a safe harbor, the
arrangements could be found to violate the anti-kickback laws. Similarly,
state fraud and abuse laws, which vary from state to state, are often vague
and have infrequently been interpreted by courts or regulatory agencies. Given
the breadth of these laws and the dearth of court rulings dealing with
businesses like the Company's, there can be no assurance that the Company's
arrangements with its providers will not be challenged. However, the Company
has in place a compliance program, whereby all personnel including clinicians
are required to execute Certificates of Understanding of and compliance with
the THC Mission and Standards of Business Conduct. Additionally, the evolving
Compliance Program includes the establishment of a "hotline" which all
employees are encouraged to call if they believe there is any illegal conduct
or wrongdoing.
 
  OBRA 1993 contains provisions ("the Stark Act") prohibiting physicians
having a financial relationship with the provider from making referrals for
"designated health services" rendered by the provider which are paid for by
the Medicare or Medicaid programs. These services include radiation therapy
services; durable medical equipment; parenteral and enteral nutrients,
equipment, and supplies; prosthetics, orthotics, and
 
                                       9
<PAGE>
 
prosthetic devices; home health services; outpatient prescription drugs; and
inpatient and outpatient hospital services. If such a financial relationship
exists, the entity is prohibited from billing for or receiving reimbursement
on account of such referral and is subject to various penalties and sanctions
for noncompliance. These provisions took effect January 1, 1995.
 
  Numerous exceptions are allowed under the Stark Act for financial
arrangements that would otherwise trigger the referral prohibitions. These
provide, under certain conditions, exceptions for relationships involving
rental of office space and equipment, employment relationships, personal
service arrangements, payments unrelated to designated services, physician
recruitment, and certain isolated transactions. While the Department has
issued regulations governing physician self-referrals of Medicare patients for
clinical laboratory services, the Department has not yet issued regulations
pertaining to referrals involving the other designated health services.
 
  The Company has contracts with physicians to provide hospital services and
in some instances patient services. These contracts have been designed to meet
the requirements of the Stark Act. However, until final regulations are
promulgated or the contracts are otherwise tested, there can be no assurance
that the contracts, or other applicable policies of the Company, will be found
to be in compliance with the Stark Act.
 
RESPIRATORY THERAPY SERVICES
 
  In 1995, the Company began providing respiratory therapy services and
supplies to appropriate patients of skilled nursing facilities pursuant to
contracts between THC hospitals and skilled nursing facilities. The services
are provided by respiratory therapists employed at the Company's hospitals.
These respiratory therapists perform a wide variety of procedures, including
oxygen therapy, bronchial hygiene, nebulizer and aerosol treatments,
tracheostomy care, ventilator management and patient respiratory education.
 
  The Company receives payments from the skilled nursing facilities for
services rendered and these facilities in turn, receive payments from the
appropriate payor. Respiratory therapy and supplies are covered under the
Medicare program and reimbursed as an ancillary service when the service is
provided by hospital-based respiratory therapists. Many commercial insurers
and managed care providers are seeking hospital discharge options for lower
acuity respiratory patients. Management believes that the Company's pricing
and successful clinical outcomes make its respiratory therapy program
attractive to commercial insurers and managed care providers.
 
  In 1996, the Company began providing respiratory therapy consulting services
to acute care hospitals which desire to use the Company's program in their own
institution. Under these contractual agreements, Company personnel assist the
hospital to develop and manage a respiratory therapy services program in
skilled nursing facilities. The Company also provides billing services for the
hospital. Each hospital that contracts with the Company provides its own
respiratory therapists who are employed by the hospital to provide services in
the skilled nursing facilities. The Company receives payments from the
hospitals for services rendered. The hospitals, in turn, receive payments from
the skilled nursing facilities.
 
  The primary competitive factors for the respiratory therapy services
business are quality of services, charges for services and responsiveness to
the needs of patients, families and the facilities in which the services are
provided. Certain hospitals have entered into the contract services market
through affiliation agreements and management contracts.
 
DIVESTED PSYCHIATRIC OPERATIONS AND INVESTMENT IN BEHAVIORAL HEALTHCARE
CORPORATION
 
  As noted previously in Item 1, "General", the Company sold its United
States, Puerto Rico, and United Kingdom psychiatric operations during fiscal
year 1996. The United States and Puerto Rico psychiatric operations were sold
to Behavioral Healthcare Corporation which is a private company. THC will have
a 44.2% common equity interest in future BHC earnings. BHC is headquartered in
Nashville, Tennessee, and is now the second largest psychiatric hospital
network in the country, with 38 hospitals and 4 residential treatment centers
 
                                      10
<PAGE>
 
in 18 states and Puerto Rico, comprising approximately 3,500 beds. With the
combination of these hospitals, BHC is a leading provider of
psychiatric/behavioral services for adults, adolescents and children with acute
psychiatric, emotional, substance abuse and behavioral disorders. BHC currently
offers a broad spectrum of inpatient, partial hospitalization, outpatient and
residential treatment programs through its hospitals.
 
  The psychiatric/behavioral care industry in the United States continues to
undergo significant change due to the expanding influence of managed care and
cost-containment measures imposed by governmental and third party payors and
employers. Providers such as BHC continue to experience a significant increase
in the percentage of revenues from payors that reimburse on negotiated per diem
or case rates, episodes of care or length of stay rates, or on a discounted
basis. In addition, this same trend has resulted in higher deductibles and co-
insurance for patients. Negotiated rates with managed care, government and
other third parties have decreased, and the use of less intensive settings of
behavioral care in place of inpatient treatment has increased. The development
of alternative services such as partial programs and intensive outpatient
services have had the impact of significantly decreasing the average length of
a patient's stay. Providers such as BHC have also been affected by the
aggressive privatization of state and county psychiatric/behavioral services
which has generally resulted in lower rates. Payors also have adopted
increasingly stringent admission and length of stay criteria and other
treatment constraints. All of these factors adversely affect utilization and
reimbursement for psychiatric services. As a result, psychiatric care providers
in the U.S. have been forced to adapt their clinical practices, business
practices and operating strategies.
 
  The Company believes that the combination of its former psychiatric hospitals
with the BHC hospitals will provide economies of scale that will allow BHC to
operate more cost-efficiently and better compete in today's cost-conscious
psychiatric industry environment. Strategically, both companies have been
concentrating on building a full continuum of psychiatric and behavioral care
services, and developing and operating fully integrated behavioral health care
delivery systems in selective markets.
 
PSYCHIATRIC CARE OPERATIONS
 
 Services and Programs
 
  Over the past three years, the former CPC and BHC hospitals have
significantly expanded the scope of their psychiatric treatment programs to
create a continuum of care from which the most appropriate and cost-effective
treatments can be selected to meet the needs of its payors and patients. In
addition to offering traditional inpatient treatment programs, BHC provides
less costly treatment alternatives such as partial hospitalization, residential
treatment and intensive and non-intensive outpatient programs. By offering such
programs through a single organization, the Company believes that patients
receive the most appropriate treatment, and that the transition among differing
intensities of care occurs rapidly and cost effectively from the perspective of
the patient, clinical team (including the medical director, the clinical or
nursing director, the admissions director and the program director) and payor.
BHC's patient programs include inpatient, residential, partial hospitalization,
and outpatient services.
 
 Sources of Psychiatric Hospital Revenues
 
  The psychiatric hospitals receive payment for its services from patients,
private health insurers, managed care organizations, and from the Medicare,
Medicaid and CHAMPUS governmental programs.
 
 Competition--U.S. Psychiatric Hospitals
 
  The BHC psychiatric hospitals compete with other free-standing psychiatric
hospitals and psychiatric units in medical/surgical hospitals as well as with
other specialty psychiatric hospitals. Some competing hospitals are either
owned or supported by government agencies. Others are owned by nonprofit
corporations and supported by endowments and charitable contributions. Such
governmental and nonprofit entities are substantially exempt from income and
property taxation. The competitive position of a hospital is, to a significant
degree, dependent upon the number and quality of physicians practicing at the
hospital and the members of its medical staff. The Company also believes that
the competitive position of a hospital is dependent upon the variety of
services offered by a facility.
 
                                       11
<PAGE>
 
  The competitive position of a hospital is affected by the ability of its
management to negotiate service contracts with purchasers of group health care
services, including private employers, PPOs and HMOs. Such organizations
attempt to obtain discounts from established hospital charges. The importance
of obtaining contracts with PPOs, HMOs and other organizations which finance
health care, and its effect on a hospital's competitive position, varies from
market to market, depending on the number and market strength of such
organizations. Generally, hospitals holding major contracts with managed care
organizations are able to attract more doctors to their active medical staffs
than hospitals without such contracts.
 
EMPLOYEES
 
  As of November 30, 1996, THC had approximately 4,500 employees, of which
approximately 55% were employed full time and 45% were employed part time. The
employees at one hospital are covered by a union agreement. The Company
considers its labor relations to be satisfactory.
 
ITEM 2. PROPERTIES
 
  Information related to the number, location, and ownership of the Company's
hospitals is included in "Hospital Operations". The Company also owns the
corporate office building that is located in Las Vegas, Nevada as well as the
real property related to five closed psychiatric facilities that are being
held for sale. All of the existing hospital buildings meet all state and local
requirements for licensing as hospitals to provide the services indicated.
 
ITEM 3. LEGAL PROCEEDINGS
 
  In July 1995, the Government served a whistleblower suit against the
Company's Subsidiary, CPC Oklahoma, Inc., under the Federal False Claims Act.
CPC Oklahoma, Inc. operated Southwind Hospital, a psychiatric hospital located
in Oklahoma City, Oklahoma. The suit was originally filed by a former employee
and a relative of another employee under the qui tam provisions of the Act.
Invoking its rights under the Act, the United States took over the case. In
November 1996, Southwind and the Government reached an agreement in principle
under which Southwind would pay $750,000 to the Government in exchange for a
release of the Government's civil and administrative claims. The settlement
was paid in February 1997. In a related action, on August 4, 1995, federal and
state authorities executed a search warrant at Southwind and seized various
records. In December 1996, the Government notified Southwind that it had
decided to discontinue any further criminal investigation of this matter.
 
  The Company is subject to ordinary and routine litigation incidental to its
business, including those arising from patient treatment, injuries or death
for which it is covered by liability insurance, and those arising from actions
involving employees. Management believes that the ultimate resolution of such
proceedings will not have a material adverse effect on the Company.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  The following table describes the matters voted upon at the annual meeting
of stockholders held November 8, 1996 and shows the number of votes cast for,
against or withheld as to such matters.
 
<TABLE>
<CAPTION>
                                                      FOR     AGAINST/WITHHELD
                                                   ---------- ----------------
 <C> <S>                                           <C>        <C>
 1.  Election of one director to serve until the
     annual meeting in 1999 and until her
     successor is duly elected and qualified*:
     Wendy Simpson...............................  35,174,115     488,049
 2.  Amend the Company's Articles of
     Incorporation to change the name of the
     Company to Transitional Hospitals
     Corporation.................................  35,360,326     301,838
 3.  Ratify an amendment to the Company's Bylaws
     to generally require that a majority of the
     members of the Board of Directors be
     Independent Directors.......................  30,662,164     569,266
</TABLE>
--------
*  The following directors' term of office continued after the meeting:
   Richard L. Conte, Jack H. Lindheimer, M.D., Nigel Petrie, Dana L. Shires,
   Jr., M.D., Robert L. Thomas and Ralph J. Watts. Carol Burt was appointed to
   the Board of Directors in December 1996.
 
                                      12
<PAGE>
 
                                    PART II
 
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
  (a)Market Information
 
      (1)(i) The Company's Common Stock is traded on the New York and
    Pacific Stock Exchanges. Ticker symbol: THY.
 
      (ii) The information in response to this portion of Item 5 is
    incorporated herein by reference from footnote 15 to the financial
    statements in Item 8.
 
  (b)Holders
 
      (1) As of February 14, 1997, there were approximately 5,842 holders
    of the Company's Common Stock. The number of record holders includes
    banks and brokerage houses which are holding shares of the Company's
    Common Stock for an undetermined number of beneficial owners.
 
  (c)Dividends
 
      (1) The information in response to this portion of Item 5 is
    incorporated by reference from footnote 15 and 16 to the financial
    statements in Item 8.
 
ITEM 6. SELECTED FINANCIAL DATA
 
TRANSITIONAL HOSPITALS CORPORATION (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
AND SUBSIDIARIES
 
<TABLE>
<CAPTION>
                                           YEAR ENDED NOVEMBER 30
                                -----------------------------------------------
                                  1996      1995      1994     1993      1992
                                --------  --------  -------- --------  --------
                                  (IN THOUSANDS, EXCEPT PER SHARE AMOUNT)
<S>                             <C>       <C>       <C>      <C>       <C>
Net operating revenues......... $503,266  $514,991  $423,955 $335,578  $344,274
Net income (loss)*.............   (5,352)  (41,632)   10,220  (24,892)   23,137
Total assets...................  465,947   604,625   600,004  530,340   540,600
Long-term debt, exclusive of
 current maturities............   14,858    84,883    69,090   40,718    26,293
Earnings (loss) per common
 share*........................    (0.12)    (0.95)     0.24    (0.58)     0.52
Dividends per share............      --       0.01      0.01     0.09      0.36
</TABLE>
--------
*  See Item 7 "Management's Discussion and Analysis of Financial Condition and
   Results of Operations"--"Sale of psychiatric divisions and psychiatric
   restructurings" for a discussion of non-recurring transactions related to
   the sales of the Company's psychiatric hospitals.
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
  The following discussion should be read in conjunction with the selected
financial data presented above, the consolidated financial statements and the
notes to the consolidated financial statements appearing in Item 8.
 
 Sale of psychiatric divisions and psychiatric restructurings
 
  On November 30, 1996 the Company sold its U.S. and Puerto Rico psychiatric
operations to BHC for $60 million in cash and BHC stock valued at
approximately $70 million. THC will have a 44.2% common equity interest in
future BHC earnings. BHC is headquartered in Nashville, Tennessee, and is now
the second largest psychiatric hospital network in the country, with 38
hospitals and 4 residential treatment centers in 18 states and Puerto Rico,
comprising approximately 3,500 beds. With the combination of these hospitals,
BHC is a leading provider of psychiatric/behavioral services for adults,
adolescents and children with acute psychiatric, emotional, substance abuse
and behavioral disorder.
 
                                      13
<PAGE>
 
  The Company also announced the closure of Southwind Hospital, a psychiatric
facility in Oklahoma City, Oklahoma in November of 1996 due to poor financial
performance. Net operating revenue and net operating income or (loss) for
Southwind totaled $4.7 million and $(.8) million for fiscal year 1996, $8.1
million and $(.1) million for fiscal year 1995 and $7.1 million and $.8
million for fiscal year 1994. The hospital is being held for sale. The Company
has reached an agreement to settle the whistleblower suit related to Southwind
with the United States Government for $750,000 (see Item 3, Legal
Proceedings).
 
  The effects on income of the above described transactions are classified as
non-recurring transactions for fiscal year 1996 and include the following: i)
$62.0 million loss on the sale of the psychiatric operations to BHC, ii) $14.4
million of expenses related to the transaction that consist of $6.7 million of
severance costs and payments pursuant to employment contracts, $4.0 million of
transaction costs related primarily to legal and investment banking services,
and $3.7 million related to legal expenses and settlement costs for the
Southwind whistleblower suit and one other lawsuit related specifically to the
US Psychiatric Division, iii) $2.1 million for a settlement of a claim from a
former Chairman of Community Psychiatric Centers related to his contract with
the Company (see further discussion in Note 11 to the financial statements
included in Item 8), iv) impairment charges of $6.7 million to writedown the
property value of Southwind and certain other closed hospitals to their
current estimated fair market value, and v) $1.7 million related to
termination benefits and other exit costs related to the closure of Southwind
Hospital. Approximately 150 employees were terminated due to the Southwind
closure and approximately 80 corporate employees were terminated due to the
sale of the U.S. psychiatric division.
 
  During the first three quarters of 1996, the Company recorded net
restructuring charges of $2.1 million for termination benefits and other exits
costs related to the closure of four U.S. psychiatric division hospitals.
Approximately 280 employees were terminated as a result of the closure of
these hospitals. Two of these properties were sold to BHC and two are being
held for sale.
 
  On June 21, 1996, the Company sold its United Kingdom psychiatric hospitals
to Foray. PHG operates 15 freestanding acute psychiatric hospitals and
chemical dependency facilities, including one 42 bed hospital that was 50%
owned by PHG. Based on the number of licensed hospital beds, PHG is the
leading commercial provider of psychiatric services in the United Kingdom
where psychiatric services are generally available to residents without charge
from government-owned NHS hospitals. The total purchase price for the PHG
facilities was approximately $135 million, which includes a $4.6 million
subordinated note due in 2009 issued by Foray. Included in non-recurring
transactions is the net gain of $55.5 million on the sale of these facilities.
Transaction expenses related to legal, investment banking and severance costs
totaled approximately $4.8 million and are reflected in the $55.5 million
gain.
 
  Effective November 30, 1995, the Company recorded a restructuring charge
totaling $4.6 million ($2.8 million after tax), determined in accordance with
the provisions of the January 1995 Financial Accounting Standards Board
Emerging Issues Task Force Consensus No. 94-3 "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs incurred in a Restructuring)", ("EITF 94-3"), in
connection with the decision to close six psychiatric facilities and three
regional offices. EITF 94-3 requires the accrual of certain employee
termination costs and costs resulting from a plan to exit an activity that are
not associated with or that do not benefit activities that will continue and
prohibits accrual of expected future operating losses of the activity exited.
The charge comprised $3.4 million for employee termination benefits related to
hospital operations and overhead personnel and $1.2 million for non-cancelable
operating leases and other exit costs. Approximately 314 hospital employees
and 65 corporate and regional employees were terminated. Amounts charged
against the reserve approximated amounts accrued. Of the six closed hospitals,
three have been sold, two were fully converted to THC hospitals, and one was
exchanged for a similar building held by another health care provider and was
converted into a satellite hospital of a THC facility in October 1996.
 
  Effective May 31, 1995, the Company recorded a restructuring credit totaling
$2.5 million ($1.5 million after tax) from the resolution of previously
restructured psychiatric assets. The restructuring credit resulted from
divesting two restructured properties at higher prices than the 1993 writedown
of the facilities anticipated and the Company's success in collecting accounts
receivable balances that were reserved for as part of the February 28, 1994
restructuring charge.
 
                                      14
<PAGE>
 
  Effective February 28, 1994, the Company recorded a restructuring charge of
$6.3 million ($3.8 million after tax) in connection with the decision to close
three psychiatric facilities. The charge comprised $2.2 million for future
operating losses, $1.5 million for restructuring costs associated with
terminating employees and $2.6 million for additional accounts receivable
allowances and reserves for other assets at the three hospitals. Approximately
225 employees of the restructured hospitals were terminated. Amounts charged
against the reserve for estimated operating losses and termination benefits
paid approximated amounts originally accrued. Of the three closed hospitals,
one was sold in 1996, one was converted into a THC facility after the
restructuring, and one was converted into a satellite hospital of a THC
facility in September 1995.
 
  Effective February 28, 1994, the Company recorded a restructuring credit
totaling $7.2 million ($4.3 million after tax) from the resolution of
previously restructured psychiatric assets. The restructuring credit resulted
from the Company's success in controlling hospital closure costs and in
divesting one of its restructured properties at a higher price than the 1993
writedown of the facility anticipated.
 
 Recent Accounting Pronouncements
 
  In October 1995, the FASB issued Statement of Financial Accounting Standards
No. 123 ("FAS 123"), "Accounting for Stock-Based Compensation", which becomes
effective for fiscal years beginning after December 15, 1995. FAS 123
establishes new financial accounting and reporting standards for stock-based
compensation plans. Entities will be allowed to measure compensation expense
for stock-based compensation under FAS 123 or APB Opinion No. 25, "Accounting
for Stock Issued to Employees". Entities electing to remain with the
accounting in APB Opinion No. 25 will be required to make pro forma
disclosures of net income and earnings per share as if the provisions of FAS
123 had been applied. The Company is in the process of evaluating the
Statement. The potential impact on the Company of adopting the new standard
has not been quantified at this time. The Company must adopt FAS 123 in fiscal
year 1997.
 
 Sources of Revenue
 
  For fiscal years 1996, 1995, and 1994, approximately 47%, 37%, and 28% of
the Company's net revenues were paid by Medicare which based reimbursement on
the Company's costs (except for THC hospitals in their first six months of
operations which are reimbursed based on DRG rates). Medicare reimbursement as
a percentage of total revenues has increased over the past three years as THC
has grown significantly over that period of time. Net Medicare revenue for THC
was 78%, 72%, and 69% of total THC net operating revenue during 1996, 1995,
and 1994, respectively.
 
  For fiscal years 1996, 1995, and 1994, approximately 9%, 11%, and 13% of the
Company's net revenue was derived from Medicaid with varying rates from state
to state. Net revenue totalling 24%, 27%, and 33% for 1996, 1995, and 1994,
respectively, was based upon negotiated rates with payors such as managed care
companies, health maintenance organizations and preferred provider
organizations. The Company expects the number of patients enrolled in managed
care plans to grow in the future. Approximately 17%, 21%, and 22% of the
Company's net revenues for 1996, 1995, and 1994, respectively, were derived
primarily from private sources and insurance companies which based
reimbursement on the Company's price schedule. The Company believes that
revenues from private sources will continue to decline in the future as
purchasers of health care services continue to shift coverage to managed care
plans.
 
  For fiscal years 1996, 1995, and 1994, approximately 3%, 4%, and 4%,
respectively, of the Company's revenues came from CHAMPUS, a federal
government program which bases reimbursement generally on a regional average
rate.
 
 Liquidity and Capital Resources
 
  Net cash provided from operating activities increased $45.1 million in
fiscal year 1996 compared to fiscal year 1995. Excluding the effects from the
sales of domestic and foreign psychiatric operations, net accounts receivable
balances decreased $2.5 million in 1996. Cash flows from third party payors
increased by
 
                                      15
<PAGE>
 
$19.9 million in 1996. The improvement in cash flows from these sources
combined with the $21.3 million of cash paid to settle the securities lawsuit
in fiscal 1995 were the principal causes for the increase in cash flows from
operations in 1996. Excluding fourth quarter revenues generated by the U.S.
psychiatric operations, days revenue in accounts receivable were 72, 82, and
79 at November 30, 1996, 1995, and 1994, respectively. The Company's current
ratio in 1996, 1995 and 1994 was 3.2, 2.4 and 2.4, respectively.
 
  The Company sold its United Kingdom psychiatric operations on June 21, 1996
and its U.S. and Puerto Rico psychiatric operations on November 30, 1996. The
Company also sold three closed psychiatric hospitals in fiscal 1996. The
combined sale of foreign and domestic psychiatric hospitals produced $186.6
million in cash proceeds in addition to non-cash consideration of $10.6
million of notes receivable and BHC stock valued at approximately $70 million.
 
  A portion of the proceeds from the sale of PHG were used for the repayment
of bank credit facilities of $50 million. The Company also repaid an
additional $24.9 million of bank credit facilities and $5.4 million of
subordinated debentures during 1996. Due primarily to the repayment of debt,
the Company's ratio of long-term debt to total equity has been reduced to 3.9%
at November 30, 1996 from 21.3% and 15.7% at November 30, 1995 and 1994,
respectively.
 
  In August 1996, the Company announced that its Board of Directors authorized
spending up to $25 million to buy back company stock from time to time on the
open market. In October 1996, the Board of Directors expanded the buyback
program by authorizing an additional $50 million, bringing the total
authorization for expenditures on company stock to $75 million. In accordance
with this authorization, the Company purchased 4.2 million shares for $35.8
million during 1996. No common stock was repurchased in fiscal years 1995 or
1994.
 
  Purchases of fixed assets totaled $35.4 million in 1996 compared to $40.1
million in 1995. Capital expenditures for 1997 are estimated to be $27 million
for renovation and expansion of existing facilities and equipment additions.
In addition, the Company will pay approximately $5 million for a new computer
system in 1997.
 
  During September 1993, the Company entered into a credit agreement whereby
the Company was able to borrow up to $25 million through November 30, 1995, at
which time the amount outstanding was converted into a term loan payable in
equal quarterly installments through November 30, 1998. As of November 30,
1996, $16.8 million is outstanding under this agreement. The Company believes
that its current cash and cash equivalent balances and its operating cash flow
will be sufficient to fund the Company's operations and capital expenditures
through the end of fiscal 1997.
 
 Operating Results
 
  Following is a summary of net operating revenues by division (dollars in
thousands):
 
<TABLE>
<CAPTION>
                                             1996             1995          1994
                                        ---------------  ---------------  --------
                                                   %                %
                                         AMOUNT  CHANGE   AMOUNT  CHANGE   AMOUNT
                                        -------- ------  -------- ------  --------
<S>                                     <C>      <C>     <C>      <C>     <C>
THC Hospitals.......................... $240,780  24.5   $193,325  91.4   $101,031
Respiratory Therapy Services...........   23,227 133.7      9,939              --
                                        --------         --------         --------
    Total THC Net Operating Revenues...  264,007  29.9    203,264 101.2    101,031
Divisions Sold in Fiscal 1996:
U.S. Psychiatric Division..............  202,069 (18.7)   248,408 (10.2)   276,698
U.K. Psychiatric Division..............   37,190 (41.3)    63,319  37.0     46,226
                                        --------         --------         --------
Net Operating Revenues................. $503,266  (2.3)  $514,991  21.5   $423,955
                                        ========         ========         ========
</TABLE>
 
                                      16
<PAGE>
 
 Fiscal Year 1996 Compared to Fiscal Year 1995
 
  THC hospital net operating revenues increased due to a 27.9% increase in
patient days. Revenue from respiratory therapy services grew by 133.7% in
fiscal year 1996. In 1995, the Company began providing respiratory therapy
services and supplies primarily to skilled nursing facilities. The growth in
revenue related to the respiratory therapy services is due to a 138% increase
in the average number of contracts in effect during the current year compared
to the prior year.
 
  Net operating revenues from the United States psychiatric hospitals
decreased by 18.7% or $46.3 million. Approximately $42.0 million of the
decline is related to the fact that the Company closed six hospitals in
November of 1995, one hospital in January 1996, and two hospitals in the
second quarter of 1996. The remaining portion of the decrease in net operating
revenues was due to a decrease in same store patient days of 2.8%.
 
  The Company closed one additional psychiatric hospital in December 1996 and
sold the remaining operating psychiatric hospitals to Behavioral Healthcare
Corporation on November 30, 1996. The Company received as partial
consideration for the sale of its U.S. and Puerto Rico psychiatric operations
a common equity interest in BHC of approximately 44.2%.
 
  Net operating revenues from the Company's United Kingdom psychiatric
operations declined substantially as the division was sold on June 21, 1996.
 
  Operating expenses as a percentage of net operating revenues increased from
76.3% in fiscal year 1995 to 80.0% in fiscal year 1996. The increase related
to several factors including an increase in personnel costs at the U.S.
psychiatric division as the Company made an effort to upgrade the quality of
its operating and financial personnel in these hospitals as well as expand the
psychiatric and behavioral health services offered. The increase in operating
expenses as a percentage of net operating revenues was also impacted by
approximately $4.0 million of post-closing operating expenses and holding
costs related to the ten U.S. psychiatric division hospitals that have been
closed since November of 1995. These costs were prohibited from being accrued
for in any of the related restructuring charges as they did not qualify as
exit costs as defined by EITF 94-3 (see "Sale of psychiatric divisions and
psychiatric restructurings" for a description of EITF 94-3 and the
restructuring charges taken).
 
  General and administrative expenses decreased $6.4 million and decreased as
a percentage of net operating revenues to 6.6% in 1996 from 7.7% in 1995.
Beginning in November of 1995, the Company closed three psychiatric division
regional offices, consolidated certain positions at the Corporate office, and
continued with further reductions in corporate overhead in January of 1996.
General and administrative expenses also decreased due to the sale of the
United Kingdom psychiatric division in June 1996.
 
  Bad debt expense decreased from 5.6% of net operating revenues in 1995 to
4.0% in 1996. Bad debt expense was higher in 1995 due to the fact that the
Company experienced a slow down in billing and collections as it converted
several U.S. psychiatric hospitals to a centralized billing office as well as
a new computer system. In addition, collections were adversely impacted in the
prior year as certain State Medicaid programs converted to managed care
initiatives in 1995.
 
  Non-recurring transactions related primarily to the sales of the U.S. and
United Kingdom psychiatric divisions in fiscal year 1996 as described above in
"Sale of psychiatric divisions and psychiatric restructurings". Non-recurring
transactions in 1995 related primarily to the settlement of shareholder
litigation from 1991 in the amount of $46.0 million and impairment losses of
$46.0 million related primarily to the U.S. psychiatric division. The
impairment losses were taken upon adoption of Financial Accounting Standard
No. 121 ("FAS 121"), "Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to Be Disposed Of", in the fourth quarter of 1995.
 
  Investment income increased $1.4 million due to higher cash and short-term
investment balances that resulted from the sale of the United Kingdom
psychiatric division in June of 1996.
 
 
                                      17
<PAGE>
 
  Interest expense decreased as the Company repaid $80.3 million of long-term
debt in fiscal year 1996.
 
  See Note 7 to the financial statements for a reconciliation of effective
income tax rates to statutory rates.
 
 Fiscal Year 1995 Compared to Fiscal Year 1994
 
  Net operating revenues increased by 21.5% from $422.4 million for the year
ended November 30, 1994 to $515.0 million for the year ended November 30,
1995. The largest portion of this increase was a $93.9 million increase in THC
revenue from $101.0 million in fiscal year 1994 to $194.9 million in fiscal
year 1995. THC's same-store admissions and patient days increased 62.3% and
82.6%, respectively. In addition, the Company began providing respiratory
therapy services and supplies primarily to skilled nursing facilities in
fiscal year 1995. $9.9 million of revenue was generated from this line of
business in fiscal year 1995.
 
  Net operating revenues from the United States psychiatric operations
decreased by 10.2% or approximately $28.3 million as a result of a 12.0%
decrease in adjusted patient days offset by a 2.0% increase in net revenue per
patient day. Net revenue per patient day increased as favorable Medicare and
Medicaid cost report settlements exceeded prior year amounts by approximately
$2 million in fiscal 1995. Adjusted patient days declined primarily due to the
continuing decline in the average length of a patient's stay.
 
  Net operating revenues from the Company's United Kingdom operations
increased by 37.0% or approximately $17.1 million as a result of an increase
in same-store patient days of 15.6% and a 5.6% increase in average net revenue
per patient day. The remaining portion of the increase in net operating
revenue related to additional patient days generated by three new facilities
that started operations subsequent to the third quarter of 1994.
 
  Operating expenses decreased as a percentage of net operating revenues to
76.3% in the year ended November 30, 1995 from 77.5% in the year ended
November 30, 1994. A higher percentage of THC's total costs were being
reimbursed in 1995 because an increased number of THC hospitals received
certification for cost-based reimbursement under Medicare during fiscal year
1995 compared to fiscal year 1994. THC hospitals incur significant start up
losses because they are not entitled to cost based reimbursement for Medicare
patients until they are certified as long-term care hospitals. Pending such
certification, these start up hospitals are reimbursed under the Medicare
Prospective Payment System which does not pay the full cost of treating
Medicare patients with the severity of illness treated at THC facilities. Of
the 14 hospitals in operation during fiscal year 1995, 13 were certified as
long-term care hospitals and therefore received cost-based reimbursement under
Medicare, whereas at the same time in 1994, 13 facilities were in operation
and 11 had been open long enough to receive their long-term care hospital
certification. In addition, 11 facilities completed their TEFRA rate setting
period during fiscal 1995 and were eligible for an additional incentive
payment if their costs were less than the targeted rate per discharge.
 
  General and administrative expenses increased $5.7 million and decreased as
a percentage of net operating revenues to 7.7% in 1995 from 8.0% in 1994. The
increase in general and administrative expenses related primarily to the fact
that the Company centralized functions at the corporate office such as billing
offices for some hospitals in the U.S. psychiatric division and THC as well as
added increased reimbursement support. The Company also completed the
installation of its new computer system in early 1995 and began incurring
costs to support the new system beginning in the second quarter of 1995. All
of these functions supported the daily operations of the Company's hospitals.
Also, additional Corporate administrative functions were added to specifically
support the expanded THC and United Kingdom operations.
 
  Bad debt expense as a percentage of net operating revenue was 5.6% for the
year ended November 30, 1995 compared to 6.4% for the year ended November 30,
1994. Bad debt expense as a percentage of net operating revenues for THC
decreased from 5.6% in fiscal 1994 to 1.3% in fiscal 1995. Beginning in the
middle of fiscal year 1994, the Company strengthened controls over admissions,
insurance verification, and billing for THC revenues. The implementation of
these controls resulted in a decrease in uncollectible accounts and bad debt
expense.
 
                                      18
<PAGE>
 
  Bad debt expense as a percentage of net operating revenues for the U.S.
psychiatric division increased from 7.3% in 1994 to 10.3% in 1995. A portion
of the increase relates to the fact that collections had slowed from certain
State Medicaid programs that converted to managed care initiatives in 1995. In
addition the Company moved 11 psychiatric hospitals to a central billing
office late in the fourth quarter of 1994 and in the first quarter of 1995
which also contributed to the slowdown in billings and collections and higher
bad debt expense.
 
  Depreciation and amortization expense increased from 4.4% of net operating
revenue in 1994 to 4.6% of net operating revenue in 1995 primarily due to an
increased number of facilities at THC and in the United Kingdom.
 
  Other income decreased primarily due to the fact that the prior year
included $2.0 million of gains on the sale of land that did not occur in the
current year.
 
  Interest expense, net of capitalized interest, increased due to an increase
in borrowings during fiscal year 1995.
 
  See Note 7 to the financial statements for a reconciliation of effective
income tax rates to statutory rates.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The information in response to this item is incorporated by reference from
Exhibit 1 in Item 14.
 
ITEM 9. CHANGE IN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
  The Board of Directors of the Company approved on September 28, 1995 the
dismissal of Ernst & Young LLP and the engagement of Price Waterhouse LLP as
the independent accountants of the Company for the fiscal year ending November
30, 1995, effective September 29, 1995, based on the recommendation of the
Company's Audit Committee.
 
  The reports of Ernst & Young for the fiscal years ended November 30, 1993
and 1994 contained no adverse opinion, disclaimer of opinion or qualification
or modification as to uncertainty, audit scope or accounting principles.
 
  During the fiscal years ended November 30, 1993 and 1994 and the interim
period from December 1, 1994 through September 29, 1995, the date of
dismissal, there were no disagreements between the Company and Ernst & Young
on any matter of accounting principles or practices, financial statement
disclosure or auditing scope or procedure, which, if not resolved to the
satisfaction of Ernst & Young would have caused it to make reference to the
subject matter of the disagreement in connection with its report. No event
described in paragraph (a)(1)(v) of Item 304 of Regulation S-K occurred during
the Company's fiscal years ended November 30, 1993 or 1994, or the period from
December 1, 1994 through September 29, 1995, except that Ernst & Young advised
management and the Board of Directors in a letter dated January 28, 1994,
that, in connection with the audit of the Company's 1993 fiscal year its
representatives had identified certain matters involving the internal control
structure of the Company's subsidiary, Transitional Hospital Corporation and
its operations which Ernst & Young considered to be material weaknesses as
defined under standards established by the American Institute of Certified
Public Accountants. Ernst & Young further stated in that letter that these
conditions were considered in determining the nature, timing, and extent of
the procedures performed in their audit for the Company's 1993 fiscal year.
Ernst & Young's letter to the Board of Directors dated January 27, 1995 issued
in conjunction with the audit of the Company's 1994 fiscal year stated that
they noted no matters involving the internal control structure and its
operations that they considered to be material weaknesses as defined under
standards established by the American Institute of Certified Public
Accountants.
 
                                      19
<PAGE>
 
                                   PART III
 
  Information under the following items required by Part III of Form 10-K is
incorporated by reference from Registrant's definitive Proxy Statement
applicable to Registrant's 1997 Annual Meeting of Shareholders, or will be
provided by Amendment to Form 10-K on Form 10-K/A, to be filed with the
Commission by Registrant no later than 120 days subsequent to the end of its
fiscal year.
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
ITEM 11. EXECUTIVE COMPENSATION
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
 
(a)1.Financial Statements. The Financial Statements listed in response to Item
   8 are filed herewith.
 
  2.The following Financial Statement Schedule is filed herewith:
 
   Valuation and Qualifying Accounts
 
  3.Exhibits:
 
    (3)Articles of Incorporation and By-laws
 
     3.1  Restated Articles of Incorporation as adopted by vote of
          shareholders on May 20, 1993 and as amended by vote of
          shareholders on November 8, 1996.
 
     3.2  Amended and Restated By-Laws of the Company.
 
   (10)Material Contracts
 
     10.1 Employment Contract Number Four between Registrant and Richard L.
          Conte, dated as of May 1, 1992 (filed as Exhibit 10.1 to
          Registrant's Annual Report on Form 10-K for its fiscal year ended
          November 30, 1993 and incorporated in full herein by reference).*
 
     10.2 Amendment Number One dated as of July 29, 1994, to Employment
          Contract Number Four between Registrant and Richard L. Conte
          (filed as Exhibit 10.2 to Registrant's Annual Report on Form 10-K
          for its fiscal year ended November 30, 1994 and incorporated in
          full herein by reference).*
 
     10.2.1 Employment Contract between Registrant and Richard L. Conte
            dated as of December 1, 1995 (filed as Exhibit 10.2.1 to
            Registrant's Annual Report on Form 10-K for its fiscal year
            ended November 30, 1995 and incorporated in full herein by
            reference).*
 
     10.3 Supplemental Retirement Contract between Registrant and Richard
          L. Conte, dated as of September 1, 1988 (filed as Exhibit 10.4 to
          Registrant's Annual Report on Form 10-K for its fiscal year ended
          November 30, 1988 and incorporated in full herein by this
          reference).*
 
     10.4 Restated and Amended Employment Contract between Registrant and
          Robert L. Green, dated June 1, 1988 (filed as Exhibit 10.1 to
          Registrant's Annual Report on Form 10-K for its fiscal year ended
          November 30, 1988, and incorporated in full herein by this
          reference).
 
                                      20
<PAGE>
 
     10.5 Amendment Number One dated as of August 1, 1989, and Amendment
          Number Two dated as of December 1, 1989 to Restated and Amended
          Employment Contract between Registrant and Robert L. Green (filed
          as Exhibit 10.5 to Registrant's Annual Report on Form 10-K for
          its fiscal year ended November 30, 1994 and incorporated in full
          herein by reference).
 
     10.6 Employment Contract between Registrant and Julia Kopta dated as
          of June 6, 1996.*
 
     10.7 Employment Contract between Registrant and Wendy Simpson dated as
          of June 6, 1996.*
 
     10.8 Employment Contract between Registrant and Ronald L. Ooley dated
          as of June 6, 1996.*
 
     10.9 Employment Contract between Registrant and J. Rodney Laughlin
          dated as of June 6, 1996.*
 
     10.10 Termination Agreement between Registrant and Steven S. Weis
           dated as of December 30, 1994 (filed as Exhibit 10.8 to
           Registrant's Annual Report on Form 10-K for its fiscal year
           ended November 30, 1994 and incorporated in full herein by
           reference).
 
     10.11 Settlement Agreement between Registrant, Kay Seim, Richard Seim
           and Continuum Healthcare, Inc. dated as of February 19, 1996
           (filed as Exhibit 10.9.1 to Registrants' Annual Report on Form
           10-K for its fiscal year ended November 30, 1995 and
           incorporated in full herein by reference).
 
     10.12 Form of Indemnification Agreements between Registrant and its
           Directors and Executive Officers (filed as Exhibit C to
           Registrant's Proxy Statement, dated April 24, 1987, relating to
           the annual meeting of its shareholders on June 1, 1987, and
           incorporated in full herein by this reference).
 
     10.13 Registrant's 1989 Stock Incentive Plan (filed as Exhibit A to
           Registrant's Proxy Statement, dated July 12, 1989, and
           incorporated in full herein by this reference).*
 
     10.14 Form of Stock Option Agreement (filed as Exhibit 10.6.1 to
           Registrant's Report onForm 10-K for its fiscal year ended
           November 30, 1990 and incorporated in full herein by this
           reference).*
 
     10.15 Form of Nonstatutory Stock Option Agreement with Director (filed
           as Exhibit 10.6.2 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1990 and incorporated in full
           herein by this reference).*
 
     10.16 Registrant's Combined Stock Option Plan for Key Employees and
           Amendment Numbers One, Two, Three, Four and Five thereto (filed
           as Exhibit 10.7 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1989 and incorporated in full
           herein by this reference).*
 
     10.17 Form of Stock Option Agreement--General Stock Option (filed as
           Exhibit 10.7.1 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1989 and incorporated in full
           herein by this reference).*
 
     10.18 Form of Stock Option Agreement--Incentive Stock Option (filed as
           Exhibit 10.7.2 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1989 and incorporated in full
           herein by this reference).*
 
     10.19 Agreement and Promissory Note between Registrant and Richard
           Conte dated as of June 7, 1995 (filed as Exhibit 10 to
           Registrant's report on 10-Q for its quarter ended August 31,
           1995, and incorporated herein by this reference).
 
     10.20 Agreement and Promissory Note between Registrant and J. Rodney
           Laughlin dated as of November 9, 1995 (filed as Exhibit 10.20 to
           Registrant's Annual Report on Form 10-K for its fiscal year
           ended November 30, 1995 and incorporated in full herein by
           reference).*
 
                                      21
<PAGE>
 
     10.21 Agreement and Promissory Note between Registrant and Ronald L.
           Ooley dated as of June 2, 1995 (filed as Exhibit 10.21 to
           Registrant's Annual Report on Form 10-K for its fiscal year
           ended November 30, 1995 and incorporated in full herein by
           reference).*
 
     10.22 Agreement between Community Psychiatric Centers and Foray 911
           Limited, dated as of June 21, 1996, related to the sale of the
           entire issued share capital of CPC (Londinium) Limited. The
           Agreement contains certain attachments designated as "Approved
           Form Documents" which were not included in this filing. The
           Company will furnish supplementally a copy of any omitted
           attachment to the Commission upon request (filed as Exhibit 1 to
           Registrant's July 5, 1996 filing on Form 8-K and incorporated in
           full herein by reference).
 
     10.23 The Series A Loan Note dated June 21, 1996, made by Foray 911
           Limited and payable to Community Psychiatric Centers in the
           amount of 3 million British Pounds (filed as Exhibit 2 to
           Registrant's July 5, 1996 filing on Form 8-K and incorporated in
           full herein by reference).
 
     10.24 Inter-Creditor Agreement between the Royal Bank of Scotland,
           Mercury Asset Management PLC, Foray 911 Limited and Community
           Psychiatric Centers (filed as Exhibit 3 to Registrant's July 5,
           1996 filing on Form 8-K and incorporated in full herein by
           reference).
 
     10.25 Rights Agreement, dated as of June 21, 1996 between Community
           Psychiatric Centers and Chase Mellon Shareholder Services (filed
           as Exhibit 4 to Registrant's July 5, 1996 filing on Form 8-K and
           incorporated in full herein by reference).
 
     10.26 Form of Letter to the holders of Community Psychiatric Centers
           Common Stock (filed as Exhibit 5 to Registrant's July 5, 1996
           filing on Form 8-K and incorporated in full herein by
           reference).
 
     10.27 Asset Purchase Agreement, between the Company and BHC, dated
           October 22, 1996 (filed as Exhibit 99.1 to Registrant's October
           22, 1996 filing on Form 8-K and incorporated in full herein by
           reference). **
 
     10.28 Agreement and Plan of Merger between the Company and BHC, dated
           October 22, 1996 (filed as Exhibit 99.2 to Registrant's October
           22, 1996 filing on Form 8-K and incorporated in full herein by
           reference). **
 
     10.29 Schedule 3.10 to the Asset Purchase Agreement, consisting of the
           Audited Consolidated Financial Statements of BHC, for fiscal
           years ended June 30, 1996, 1995 and 1994 (filed as Exhibit 99.3
           to Registrant's October 22, 1996 filing on Form 8-K and
           incorporated in full herein by reference).
 
     10.30 First Amendment to Asset Purchase Agreement between the Company
           and BHC, dated November 30, 1996 (filed as Exhibit 99.1 to
           Registrant's December 16, 1996 filing on Form 8-K and
           incorporated in full herein by reference). **
 
     10.31 Amendment to Agreement and Plan of Merger, between the Company
           and BHC, dated November 30, 1996 (filed as Exhibit 99.2 to
           Registrant's December 16, 1996 filing on Form 8-K and
           incorporated in full herein by reference). **
 
     10.32 Debt Instruments--Copies of debt instruments for which the
           related debt is less than 10% of total assets will be furnished
           to the Commission upon request.
 
  11 Statement re computation of earnings per share
 
  21 Subsidiaries of the Registrant
 
  23 Consent of Independent Accountants--Price Waterhouse LLP
 
  23.1 Consent of Independent Auditors--Ernst & Young LLP
 
  27 Financial Data Schedule
 
                                      22
<PAGE>
 
  (b) Reports on Form 8-K:
 
    Report dated October 22, 1996 reporting the execution of an Asset
  Purchase Agreement related to the sale of substantially all of the
  psychiatric hospital and residential treatment center operations of the
  Company in the United States and Puerto Rico to Behavioral Healthcare
  Corporation.
 
    Report dated October 24, 1996 reporting the issuance of a press release
  dated October 22, 1996 regarding the sale of the U.S. and Puerto Rico
  psychiatric assets to Behavioral Healthcare Corporation.
 
    Report dated December 16, 1996 reporting the completion of the sale of
  the U.S. and Puerto Rico psychiatric assets to Behavioral Healthcare
  Corporation on November 30, 1996 and related unaudited pro forma financial
  information.
--------
*Required to be filed as an exhibit pursuant to item 14 (c) of this Form.
** The Agreements contain certain schedules and exhibits which were not
   included in this filing. The Company will furnish supplementally a copy of
   any omitted schedule or exhibit to the Commission upon request.
 
                                      23
<PAGE>
 
                                  SIGNATURES
 
  Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
 
                                          TRANSITIONAL HOSPITALS CORPORATION
 
Date: February 26, 1997                   By:      /s/ Richard L. Conte
                                            ___________________________________
                                                       Richard L. Conte
                                                   Chairman of the Board of
                                                        Directors and
                                                   Chief Executive Officer
                                                (Principal Executive Officer)
 
  Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
             SIGNATURE                           TITLE                    DATE
             ---------                           -----                    ----
 
<S>                                  <C>                           <C>
      /s/ Richard L. Conte           Chairman of the Board of      February 26, 1997
____________________________________  Directors and Chief
          Richard L. Conte            Executive Officer
                                      (Principal Executive
                                      Officer)
 
       /s/ Wendy L. Simpson          Director and Executive        February 26, 1997
____________________________________  Vice President of the
          Wendy L. Simpson            Company, Chief Operating
                                      Officer and Chief Financial
                                      Officer (Principal
                                      Financial Officer)
 
   /s/ Jack H. Lindheimer, M.D.      Director                      February 26, 1997
____________________________________
      Jack H. Lindheimer, M.D.
 
          /s/ Carol Burt             Director                      February 26, 1997
____________________________________
             Carol Burt
 
         /s/ Nigel Petrie            Director                      February 26, 1997
____________________________________
            Nigel Petrie
 
  /s/ Dana L. Shires, Jr., M.D.      Director                      February 26, 1997
____________________________________
     Dana L. Shires, Jr., M.D.
 
       /s/ Robert L. Thomas          Director                      February 26, 1997
____________________________________
          Robert L. Thomas
 
        /s/ Ralph J. Watts           Director                      February 26, 1997
____________________________________
           Ralph J. Watts
 
        /s/ Steven M. Gray           Senior Vice President and     February 26, 1997
____________________________________  Corporate Controller
           Steven M. Gray             (Principal Accounting
                                      Officer)
</TABLE>
 
                                      24
<PAGE>
 
 
 
                            ANNUAL REPORT FORM 10-K
 
                   ITEM 8, ITEM 14(a)(1) AND (2), (c) AND (d)
                  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
         LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
                                CERTAIN EXHIBITS
 
                          FINANCIAL STATEMENT SCHEDULE
 
              TRANSITIONAL HOSPITALS CORPORATION AND SUBSIDIARIES
                    (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
                               LAS VEGAS, NEVADA
 
                          YEAR ENDED NOVEMBER 30, 1996
 
 
                                       25
<PAGE>
 
 
 
 
                      (THIS PAGE INTENTIONALLY LEFT BLANK)
 
                                       26
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
                        FORM 10-K ITEM 14(a)(1) AND (2)
 
         LIST OF FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE
 
  The following consolidated financial statements of Transitional Hospitals
Corporation and Subsidiaries are included in Item 8:
 
  Report of Independent Accountants--Years ended November 30, 1996 and 1995--
Price Waterhouse LLP
 
  Report of Independent Auditors--Year ended November 30, 1994--Ernst & Young
LLP
 
  Consolidated balance sheets--November 30, 1996 and 1995
 
  Consolidated statements of operations--Years ended November 30, 1996, 1995
and 1994
 
  Consolidated statements of stockholders' equity--Years ended November 30,
1996, 1995 and 1994
 
  Consolidated statements of cash flows--Years ended November 30, 1996, 1995
and 1994
 
  Notes to consolidated financial statements--November 30, 1996
 
  The following consolidated financial statement schedule of Transitional
Hospitals Corporation and Subsidiaries is included in Item 14(d):
 
  Report of Independent Accountants on Financial Statement Schedule--Year
ended November 30, 1996
 
  Schedule II--Valuation and Qualifying Accounts
 
  All other schedules for which provision is made in the applicable accounting
regulation of the Securities and Exchange Commission are not required under
the related instructions or are inapplicable, and therefore have been omitted.
 
                                      27
<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS
 
To The Board of Directors and Shareholders of
Transitional Hospitals Corporation
 
  In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations and stockholders' equity and of cash
flows present fairly, in all material respects, the financial position of
Transitional Hospitals Corporation (formerly Community Psychiatric Centers)
and its subsidiaries at November 30, 1996 and 1995 and the results of their
operations and their cash flows for the years then ended in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for the opinion expressed above.
 
  As discussed in Note 4 to the consolidated financial statements, the Company
adopted Statement of Financial Accounting Standard No. 121 "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of"
in 1995.
 
PRICE WATERHOUSE LLP
Los Angeles, California
January 24, 1997
 
                                      28
<PAGE>
 
                        REPORT OF INDEPENDENT AUDITORS
 
Board of Directors
Transitional Hospitals Corporation
 
  We have audited the accompanying consolidated statements of operations,
stockholders' equity, and cash flows of Transitional Hospitals Corporation
(formerly Community Psychiatric Centers) for the year ended November 30, 1994.
Our audit also included the financial statement schedule listed in the index
at Item 14(a) as it relates to the year ended November 30, 1994. These
financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements and schedule based on our audit.
 
  We conducted our audit in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.
 
  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated results of
Transitional Hospitals Corporation's (formerly Community Psychiatric Centers)
operations and their cash flows for the year ended November 30, 1994, in
conformity with generally accepted accounting principles. Also, in our
opinion, the related financial statement schedule as it relates to the year
ended November 30, 1994, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
 
                                          /s/ ERNST & YOUNG LLP
 
Los Angeles, California
January 27, 1995
 
                                      29
<PAGE>
 
              TRANSITIONAL HOSPITALS CORPORATION AND SUBSIDIARIES
                    (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                                 NOVEMBER 30
                                                              -----------------
                                                                1996     1995
                                                              -------- --------
                                                               (IN THOUSANDS)
<S>                                                           <C>      <C>
                           ASSETS
                           ------
Current assets:
  Cash and cash equivalents.................................. $ 84,313 $ 17,263
  Short-term investments.....................................   16,777    7,601
  Accounts receivable, less allowance for doubtful accounts
   (1996--$21,448 and 1995--$24,682).........................   55,557  113,686
  Receivable from third parties under reimbursement
   contracts.................................................      --     4,550
  Prepaid expenses and other current assets..................   14,784   14,756
  Property held for sale.....................................   13,393   15,512
  Refundable income taxes....................................   15,722   21,028
  Deferred income taxes......................................    5,697      951
                                                              -------- --------
Total current assets.........................................  206,243  195,347
Property, buildings and equipment, at cost, less allowances
for depreciation.............................................  153,933  354,192
Other assets:
  Investment in affiliate....................................   69,859      --
  Refundable income taxes....................................    9,275      --
  Deferred income taxes......................................    6,691   21,334
  Other assets...............................................   19,889   24,862
                                                              -------- --------
                                                               105,714   46,196
Excess of investment in subsidiaries over net assets
 acquired, less accumulated amortization (1996--$62 and
 1995--$2,351)...............................................       57    8,890
                                                              -------- --------
                                                              $465,947 $604,625
                                                              ======== ========
</TABLE>
 
 
 
                See notes to consolidated financial statements.
 
                                       30
<PAGE>
 
              TRANSITIONAL HOSPITALS CORPORATION AND SUBSIDIARIES
                    (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
                    CONSOLIDATED BALANCE SHEETS--(CONTINUED)
 
<TABLE>
<CAPTION>
                                                                NOVEMBER 30
                                                             ------------------
                                                               1996      1995
                                                             --------  --------
                                                              (IN THOUSANDS,
                                                                  EXCEPT
                                                              PAR VALUE DATA)
<S>                                                          <C>       <C>
           LIABILITIES AND STOCKHOLDERS' EQUITY
           ------------------------------------
Current liabilities:
  Accounts payable.........................................  $  9,136  $ 18,194
  Accrued payroll and other expenses.......................    15,549    34,949
  Income taxes payable.....................................       131     4,425
  Payable to third parties under reimbursement contracts...    13,954       --
  Other accrued liabilities................................    17,796     3,693
  Current maturities on long-term debt.....................     8,467    18,764
                                                             --------  --------
  Total current liabilities................................    65,033    80,025
Long-term debt, exclusive of current maturities............    14,858    84,883
Deferred credits:
  Deferred income taxes and other liabilities..............     3,857    19,678
Commitments and contingencies
Obligation to be settled in common stock...................       --     21,250
Stockholders' equity:
  Preferred stock, par value $1 a share; authorized 2,000
   shares; none issued.....................................       --        --
  Common stock, par value $1 a share; authorized 100,000
   shares; issued 46,856 in 1996 and 1995..................    46,856    46,856
  Additional paid-in capital...............................    56,657    62,096
  Unrealized gains on investments in debt securities.......       163       --
  Retained earnings........................................   321,710   327,062
  Foreign currency translation adjustment..................       --     (2,943)
                                                             --------  --------
                                                              425,386   433,071
Less cost of treasury stock--4,988 shares in 1996 and 3,166
 shares in 1995............................................   (43,187)  (34,282)
                                                             --------  --------
                                                              382,199   398,789
                                                             --------  --------
                                                             $465,947  $604,625
                                                             ========  ========
</TABLE>
 
 
                See notes to consolidated financial statements.
 
                                       31
<PAGE>
 
              TRANSITIONAL HOSPITALS CORPORATION AND SUBSIDIARIES
                    (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                             YEAR ENDED NOVEMBER 30,
                                    -------------------------------------------
                                        1996           1995           1994
                                    -------------  -------------  -------------
                                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                 <C>            <C>            <C>
Revenues:
  Net operating revenues..........  $     503,266  $     514,991  $     423,955
  Investment and other income.....          3,928          2,513          3,785
                                    -------------  -------------  -------------
                                          507,194        517,504        427,740
Costs and expenses:
  Operating expense...............        402,686        393,146        328,508
  General and administrative
   expense........................         33,029         39,444         33,775
  Bad debt expense................         20,101         28,732         26,966
  Depreciation and amortization...         22,364         23,344         18,649
  Interest expense................          3,889          5,256          3,545
  Non-recurring transactions, net.         33,524         94,116           (875)
                                    -------------  -------------  -------------
                                          515,593        584,038        410,568
                                    -------------  -------------  -------------
Income (loss) before income taxes.         (8,399)       (66,534)        17,172
Income taxes (benefit)............         (3,047)       (24,902)         6,952
                                    -------------  -------------  -------------
Net income (loss).................  $      (5,352) $     (41,632) $      10,220
                                    =============  =============  =============
Net income (loss) per common
 share............................  $       (0.12) $       (0.95) $        0.24
                                    =============  =============  =============
Average number of common shares...         43,942         43,642         43,465
                                    =============  =============  =============
</TABLE>
 
 
 
                See notes to consolidated financial statements.
 
                                       32
<PAGE>
 
              TRANSITIONAL HOSPITALS CORPORATION AND SUBSIDIARIES
                    (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                              AMOUNTS DUE                          FOREIGN
                                 ADDITIONAL FROM EMPLOYEES                        CURRENCY
                         COMMON   PAID-IN   FOR EXERCISE OF UNREALIZED RETAINED  TRANSLATION TREASURY  STOCK
                          STOCK   CAPITAL    STOCK OPTIONS    GAINS    EARNINGS  ADJUSTMENT   SHARES   AMOUNT
                         ------  ---------- --------------- ---------- --------  ----------- --------  ------
                                                 (IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<S>                      <C>     <C>        <C>             <C>        <C>       <C>         <C>      <C>
Balance at November 30,
 1993................... $46,856  $65,341        $(35)         $  0    $359,345    $(3,815)   (3,763) $(45,200)
  Exercise of employees'
   stock options........           (4,052)                                                       498     9,735
  Income tax benefits
   derived from employee
   stock option
   transactions.........               68
  Net income for the
   year.................                                                 10,220
  Dividends paid, $.01
   per common share.....                                                   (434)
  Foreign currency
   translation
   adjustment...........                                                             2,010
                         -------  -------        ----          ----    --------    -------    ------  --------
Balance at November 30,
 1994...................  46,856   61,357         (35)            0     369,131     (1,805)   (3,265)  (35,465)
  Exercise of employees'
   stock options........             (206)                                                       102     1,235
  Expiration of employee
   stock options........               17          35                                             (3)      (52)
  Income tax benefits
   derived from employee
   stock option
   transactions.........              928
  Net loss for the year.                                                (41,632)
  Dividends paid, $.01
   per common share.....                                                   (437)
  Foreign currency
   translation
   adjustment...........                                                            (1,138)
                         -------  -------        ----          ----    --------    -------    ------  --------
Balance at November 30,
 1995...................  46,856   62,096           0             0     327,062     (2,943)   (3,166)  (34,282)
  Exercise of employees'
   stock options........              (36)                                                        16       186
  Issuance of shares
   related to settlement
   of shareholder
   litigation...........           (5,482)                                                     2,342    26,732
  Stock repurchased.....                                                                      (4,180)  (35,823)
  Income tax benefits
   derived from employee
   stock option
   transactions.........               79
  Net loss for the year.                                                 (5,352)
  Foreign currency
   translation
   adjustment...........                                                             2,943
  Unrealized gains from
   changes in market
   value of investments
   in debt securities,
   net of income taxes..                                        163
                         -------  -------        ----          ----    --------    -------    ------  --------
Balance at November 30,
 1996................... $46,856  $56,657        $  0          $163    $321,710    $     0    (4,988) $(43,187)
                         =======  =======        ====          ====    ========    =======    ======  ========
</TABLE>
 
                See notes to consolidated financial statements.
 
                                       33
<PAGE>
 
              TRANSITIONAL HOSPITALS CORPORATION AND SUBSIDIARIES
                    (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                   YEAR ENDED NOVEMBER 30
                                                 -----------------------------
                                                   1996       1995      1994
                                                 ---------  --------  --------
                                                       (IN THOUSANDS)
<S>                                              <C>        <C>       <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)..............................  $  (5,352) $(41,632) $ 10,220
Adjustments to reconcile net income (loss) to
 net cash provided by operating activities:
     Depreciation and amortization.............     22,364    23,344    18,649
     Provision for uncollectible accounts......     20,101    28,732    26,966
     Nonrecurring transactions.................     33,378    70,446    (2,845)
     Other.....................................       (821)   (3,033)   (1,800)
Changes in assets and liabilities, exclusive of
 business acquisitions and disposals:
   Accounts receivable.........................    (17,570)  (39,290)  (50,070)
   Receivable/payable to third parties under
    reimbursement contracts....................      9,529   (10,352)      812
   Prepaid expenses and other current assets...     (6,259)    1,615    (1,837)
   Accounts payable and accrued expenses.......     (1,506)    4,340    10,438
   Other accrued liabilities...................     (5,626)      154      (942)
   Dividends payable...........................        --        --       (111)
   Income taxes................................     (3,252)  (34,435)    9,709
                                                 ---------  --------  --------
Net cash provided from (used for) operations...     44,986     ( 111)   19,189
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from revolving credit facilities......        --     39,195    41,982
Dividends paid.................................        --       (437)     (434)
Purchase of treasury shares....................    (35,823)      --        --
Payments of deferred compensation..............       (162)     (634)     (162)
Net proceeds from exercise of stock options....        150     1,029     5,683
Payments on long-term debt.....................    (80,341)  (18,859)   (1,402)
                                                 ---------  --------  --------
Net cash provided from (used for) financing
 activities....................................   (116,176)   20,294    45,667
CASH FLOWS FROM INVESTING ACTIVITIES:
Proceeds from sales of short-term investments..      7,601    16,884     1,934
Purchases of short-term investments............    (16,614)  (10,729)   (4,758)
Payment received on notes......................      2,151     4,591     3,437
Purchase of property, buildings and equipment..    (35,419)  (40,139)  (48,760)
Investment in pre-opening costs................     (3,177)   (2,899)   (4,225)
Proceeds from sale of psychiatric hospitals....    186,643     5,289     7,393
Loans made to officers.........................       (825)   (4,055)   (1,242)
Payment for business acquisitions:
   Property, buildings and equipment...........       (320)   (8,604)   (4,787)
   Excess of purchase price over fair value of
    assets acquired............................     (1,800)     (521)   (1,225)
                                                 ---------  --------  --------
Net cash provided from (used for) investing
 activities....................................    138,240   (40,183)  (52,233)
                                                 ---------  --------  --------
Net increase (decrease) in cash and cash
 equivalents...................................     67,050   (20,000)   12,623
Beginning cash and cash equivalents............     17,263    37,263    24,640
                                                 ---------  --------  --------
Ending cash and cash equivalents...............  $  84,313  $ 17,263  $ 37,263
                                                 =========  ========  ========
</TABLE>
 
                 See Notes to consolidated financial statements
 
                                       34
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1--SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
PRINCIPLES OF CONSOLIDATION
 
  The consolidated financial statements include the accounts of Transitional
Hospitals Corporation (formerly Community Psychiatric Centers) and its
subsidiaries (THC or the Company). All material intercompany transactions have
been eliminated in the accompanying consolidated financial statements.
 
  The Company provides long-term acute care services to patients suffering
from long-term complex medical problems in the United States. As of November
30, 1996, THC operated 14 long-term care hospitals and two satellite
facilities with a total of 1,340 beds, located in 12 states. THC also provides
respiratory therapy services to other healthcare providers.
 
  In June of 1996, the Company sold its United Kingdom psychiatric operations
(see Note 2). In November 1996, the company sold its U.S. psychiatric
operations to Behavioral Healthcare Corporation ("BHC") for $60 million in
cash and stock valued at approximately $70 million (see Note 3).
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amount of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the
reporting period. Actual results could differ from those estimates.
 
CASH EQUIVALENTS
 
  The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Those highly liquid
assets with a maturity of more than three months are classified as short-term
investments.
 
SHORT-TERM INVESTMENTS
 
  The Company has investments in debt securities which are classified as
available for sale. These investments consist primarily of U.S. corporate
securities and have various maturity dates which do not exceed one year.
Securities classified as available-for-sale are carried at fair value with
unrealized gains, net of tax, reported in a separate component of
stockholders' equity. There were no unrealized losses on any investments held
at November 30, 1996. Realized gains and losses are included in investment
income and are immaterial for all years presented.
 
PROPERTY, BUILDINGS AND EQUIPMENT
 
  Depreciation is computed on the straight-line method based on the estimated
useful lives of fixed assets of 31.5 to 40 years for buildings and three to
ten years for furniture and equipment.
 
PREOPENING COSTS
 
  Costs incurred prior to the opening of new facilities are deferred and
amortized on a straight-line basis over a five-year period.
 
CAPITALIZATION OF INTEREST
 
  Interest incurred in connection with development and construction of
hospitals is capitalized as part of the related property.
 
                                      35
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NET OPERATING REVENUES
 
  Net operating revenues include amounts for hospital services estimated by
management to be reimbursable by federal and state government programs
(Medicare, Medicaid and CHAMPUS); managed care programs (managed care
companies, health maintenance organizations and preferred provider
organizations) and private pay payors (private sources and insurance companies
which base reimbursement on the Company's price schedule).
 
  The following table summarizes the percent of net operating revenue
generated from all payors.
 
<TABLE>
<CAPTION>
                                                                 1996  1995  1994
                                                                 ----  ----  ----
      <S>                                                        <C>   <C>   <C>
      Medicare..................................................  47%   37%   28%
      Medicaid..................................................   9    11    13
      CHAMPUS...................................................   3     4     4
                                                                 ---   ---   ---
        Total Government........................................  59    52    45
      Managed Care..............................................  24    27    33
      Private pay and other.....................................  17    21    22
                                                                 ---   ---   ---
        Total................................................... 100%  100%  100%
                                                                 ===   ===   ===
</TABLE>
 
  Amounts received are generally less than the established billing rates of
the Company and the difference is reported as a contractual allowance and
deducted from operating revenues. Final determination of amounts earned for
hospital services is subject to audit by the payors. In the opinion of
management, adequate provision has been made for any adjustments that may
result from such audits. Differences between estimated provisions and final
settlement are reflected as charges and credits to operating revenues in the
year the audit reports are finalized. In the current year, the Company
received approximately $5.6 million in excess of recorded amounts related to
prior year Medicare settlements. These amounts are included in operating
revenue.
 
CONCENTRATION OF CREDIT RISK
 
  Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash and short-term
investments and receivables from government programs.
 
  The Company maintains cash equivalents and short-term investments with
various financial institutions. The Company's policy is designed to limit
exposure to any one institution. The Company performs periodic evaluations of
the relative credit standing to those financial institutions that are
considered in the Company's investment strategy. The Company and management do
not believe that there are any significant credit risks associated with
receivables from governmental programs. Negotiated and private receivables
consist of receivables from various payors, including individuals involved in
diverse activities, subject to differing economic conditions, and do not
represent any concentrated credit risks to the Company. Furthermore,
management continually monitors and adjusts its reserves and allowances
associated with these receivables.
 
STOCK OPTIONS
 
  Proceeds from the exercise of stock options are credited to common stock, to
the extent of par value, and the balance to additional paid-in capital, except
when shares held in the treasury are issued. The difference between the cost
of the treasury stock and the option price is charged or credited to
additional paid-in capital. No charges or credits are made to earnings with
respect to options granted or exercised. Income tax benefits derived from
exercise of non-incentive stock options and from sales of stock obtained from
incentive stock options before the minimum holding period are credited to
additional paid-in capital.
 
                                      36
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
EARNINGS (LOSS) PER SHARE
 
  Earnings (loss) per share have been computed based upon the weighted average
number of shares of common stock outstanding during the year. Dilutive common
stock equivalents have not been included in the computation of earnings per
share because the aggregate potential dilution resulting therefrom is less
than 3%.
 
TRANSLATION OF FOREIGN CURRENCIES
 
  The Company sold its United Kingdom psychiatric hospitals in June of 1996.
For periods prior to the sale, the financial statements of the Company's
foreign subsidiaries have been translated into U.S. dollars in accordance with
FASB Statement No. 52. All balance sheet accounts were translated at year-end
exchange rates. Statements of earnings amounts have been translated at the
average exchange rate for the applicable years. The resulting currency
translation adjustments were made directly to a separate component of
Stockholders' Equity. The effect on the statement of earnings of translation
gains and losses is insignificant for all years presented.
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
  In October 1995, the FASB issued Statement of Financial Accounting Standards
No. 123 ("FAS 123"), "Accounting for Stock-Based Compensation", which becomes
effective for fiscal years beginning after December 15, 1995. FAS 123
establishes new financial accounting and reporting standards for stock-based
compensation plans. Entities will be allowed to measure compensation expense
for stock-based compensation under FAS 123 or APB Opinion No. 25, "Accounting
for Stock Issued to Employees". Entities electing to remain with the
accounting in APB Opinion No. 25 will be required to make pro forma
disclosures of net income and earnings per share as if the provisions of FAS
123 had been applied. The Company is in the process of evaluating the
Statement. The potential impact on the Company of adopting the new standard
has not been quantified at this time. The Company must adopt FAS 123 in fiscal
year 1997.
 
RECLASSIFICATIONS
 
  Certain amounts have been reclassified to conform with 1996 presentations.
 
NOTE 2--NON-RECURRING TRANSACTIONS
 
  On November 30, 1996 the company sold its U.S. psychiatric operations to BHC
for $60 million in cash and stock valued at approximately $70 million. THC
will have a 44.2% common equity interest in future BHC earnings. BHC is
headquartered in Nashville, Tennessee, and is now the second largest
psychiatric hospital network in the country, with 38 hospitals and 4
residential treatment centers in 18 states and Puerto Rico, comprising
approximately 3,500 beds. With the combination of these hospitals, BHC is a
leading provider of psychiatric/behavioral services for adults, adolescents
and children with acute psychiatric, emotional, substance abuse and behavioral
disorder.
 
  The Company also announced the closure of Southwind Hospital, a psychiatric
facility in Oklahoma City, Oklahoma in November of 1996 due to poor financial
performance. Net operating revenue and net operating income or (loss) for
Southwind totaled $4.7 million and $(.8) million for fiscal year 1996, $8.1
million and $(.1) million for fiscal year 1995 and $7.1 million and $.8
million for fiscal year 1994. The hospital is being held for sale. The Company
has reached an agreement to settle the whistleblower suit related to Southwind
with the United States Government for $750,000 (see Note 14).
 
 
                                      37
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The effects on income of the above described transactions are classified as
non-recurring transactions for fiscal year 1996 and include the following: i)
$62.0 million loss on the sale of the psychiatric operations to BHC, ii) $14.4
million of expenses related to the transaction that consist of $6.7 million of
severance costs and payments pursuant to employment contracts, $4.0 million of
transaction costs related primarily to legal and investment banking services,
and $3.7 million related to legal expenses and settlement costs for the
Southwind whistleblower suit (see Note 14) and one other lawsuit related
specifically to the US psychiatric division, iii) $2.1 million for a
settlement of a claim from a former Chairman of Community Psychiatric Centers
related to his contract with the Company (see further discussion in Note 11),
iv) impairment charges of $6.7 million to writedown the property value of
Southwind and certain other closed hospitals to their current estimated fair
market value, and v) $1.7 million related to termination benefits and other
exit costs related to the closure of Southwind. Approximately 150 employees
were terminated due to the Southwind closure and approximately 80 corporate
employees were terminated due to the sale of the U.S. psychiatric division. As
of November 30, 1996, approximately $7.8 million is included in other accrued
liabilities for severance and other exit costs related to the corporate office
and Southwind hospital.
 
  During the first three quarters of 1996, the Company recorded net
restructuring charges of $2.1 million for termination benefits and other exit
costs related to the closure of four U.S. psychiatric division hospitals.
Approximately 280 employees were terminated as a result of the closure of
these hospitals. Two of these properties were sold to BHC and two are being
held for sale.
 
  On June 21, 1996, the Company sold its United Kingdom psychiatric hospitals
("Priory Hospitals Group" or "PHG") to Foray 911 Limited ("Foray"), a new
corporation formed by Mercury Development Capital, a division of Mercury Asset
Management plc ("Mercury"). PHG operates 15 freestanding acute psychiatric
hospitals and chemical dependency facilities, including one 42 bed hospital
that was 50% owned by PHG. Based on the number of licensed hospital beds, PHG
is the leading commercial provider of psychiatric services in the United
Kingdom where psychiatric services are generally available to residents
without charge from government-owned NHS hospitals. The total purchase price
for the PHG facilities was approximately $135 million, which includes a $4.6
million subordinated note due in 2009 issued by Foray. Included in non-
recurring transactions is the net gain on the sale of these facilities of
$55.5 million. Transaction expenses related to legal, investment banking and
severance costs totaled approximately $4.8 million and are reflected in the
$55.5 million gain.
 
  During fiscal year 1995, the Company recorded impairment charges related to
the adoption of FASB statement 121 (see Note 4) and settlements costs related
to shareholder lawsuits filed in 1991 (See Note 14). Each matter resulted in
charges of $46.0 million, for a total of $92.0 million.
 
  Effective November 30, 1995, the Company recorded a restructuring charge
totaling $4.6 million ($2.8 million after tax), determined in accordance with
the provisions of the January 1995 Financial Accounting Standards Board
Emerging Issues Task Force Consensus No. 94-3 "Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs incurred in a Restructuring)", ("EITF 94-3"), in
connection with the decision to close six psychiatric facilities and three
regional offices. EITF 94-3 requires the accrual of certain employee
termination costs and costs resulting from a plan to exit an activity that are
not associated with or that do not benefit activities that will continue and
prohibits accrual of expected future operating losses of the activity exited.
The charge comprised $3.4 million for employee termination benefits related to
hospital operations and overhead personnel and $1.2 million for non-cancelable
operating leases and other exit costs. Approximately 314 hospital employees
and 65 corporate and regional employees were terminated. Amounts charged
against the reserve approximated amounts accrued. Of the six closed hospitals,
three have been sold, two were fully converted to THC hospitals, and one was
exchanged for a similar building held by another health care provider and was
converted into a satellite hospital of a THC facility in October 1996.
 
                                      38
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Effective May 31, 1995, the Company recorded a restructuring credit totaling
$2.5 million ($1.5 million after tax) from the resolution of previously
restructured psychiatric assets. The restructuring credit resulted from
divesting two restructured properties at higher prices than the 1993 writedown
of the facilities anticipated and the Company's success in collecting accounts
receivable balances that were reserved for as part of the February 28, 1994
restructuring charge.
 
NOTE 3--INVESTMENT IN AFFILIATE
 
  On November 30, 1996, THC consummated the sale of effectively all of its
psychiatric operations in the U.S. and Puerto Rico (with certain limited
exceptions set forth below) to BHC. Prior to such sale, BHC owned 17
psychiatric hospitals. At the November 30 closing, the Company transferred
title to 22 freestanding psychiatric hospitals, a joint venture interest in
another psychiatric operation, an outpatient psychiatric center, two closed
hospitals and vacant land located at three sites in California. Two other
operating hospitals and a joint venture interest (the "Escrowed Assets") are
to be transferred to BHC upon receipt of necessary regulatory approvals, which
management believes are perfunctory. Additionally, effective November 30,
1996, BHC and the Company entered into a management agreement which grants
BHC, with limited protective rights retained by THC, exclusive and complete
responsibility and discretion in the management and control of the Escrowed
Assets as well as the economic benefit thereof. Accordingly, for accounting
purposes, the sale of the Escrowed Assets has been recorded with an effective
date of November 30, 1996. At the initial closing, the Company received
$60,000,000 in cash, 2,214,400 shares of BHC Common Stock, 5,072,579 shares of
BHC Series A Preferred Stock and 46,902 shares of BHC Series B Preferred
Stock. In general, the Series A Preferred Stock converts into BHC Common Stock
on a share for share basis upon sales and dispositions of the Series A
Preferred Stock by the Company and under certain other limited circumstances.
Upon receipt of the necessary regulatory approvals related to the Escrowed
Assets, the Company will receive an additional 3,785,600 shares of BHC Common
Stock, an additional 578,844 shares of BHC Series A Preferred Stock and 3,350
additional shares of BHC Series B Preferred Stock. Upon distribution of all
shares, the Company will have a common equity interest amounting to 44.2% of
BHC's Common Stock outstanding. An agreement has been entered into between BHC
and the Company requiring THC to vote all shares in excess of 20% of BHC's
outstanding Common Stock as instructed by a majority of BHC's Board of
Directors which includes three members of THC's Board of Directors. THC's
Chairman of the Board and Chief Executive Officer, Richard Conte, will serve
as BHC's Chairman of the Board. THC's common equity interest in future BHC
earnings will be recorded on the equity method of accounting. In determining
the amount of the consideration to be paid to the Company, the parties
compared their respective EBITDAs (Earnings before interest, taxes,
depreciation, and amortization) and used multiples generally accorded to
publicly-traded psychiatric hospitals. Based on this analysis, the total value
of the equity interest in BHC was determined to be approximately $70 million.
 
NOTE 4--IMPAIRMENT OF ASSETS
 
  In the fourth quarter of fiscal year 1995, the Company adopted the
provisions of FASB Statement 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of ("FAS 121")". The statement
requires impairment losses to be recognized for long-lived assets used in
operations when indicators of impairment are present and the undiscounted cash
flows are not sufficient to recover the assets' carrying amount. The
impairment loss is measured by comparing the fair value of the asset to its
carrying amount. FAS 121 also requires that assets to be disposed of be
written down to fair value less selling costs. Based on a comparison of the
recorded values of long-lived assets (defined as land, buildings, fixed assets
and goodwill) to the expected future cash flows to be generated by the assets
of three U.S. Psychiatric facilities that were closed in November 1995 as well
as three U.S. Psychiatric facilities which experienced declines in operating
performance in fiscal 1995, and after applying the principles of measurement
contained in FAS 121, the Company recorded an asset impairment charge of
approximately $26.5 million in fiscal 1995.
 
                                      39
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  Using the same principles as described above, the Company recorded an asset
impairment charge of approximately $5.3 million on land that was being held
for sale. The closed facilities as well as the land held for sale were
classified as assets held for sale with a carrying value of $13.7 million
after the impairment writedown as of November 30, 1995. All assets held for
sale pertain to the U.S. Psychiatric Division. All of these assets, with the
exception of three closed hospitals, were sold in fiscal 1996.
 
  The Company completed an installation of a new computer system in the first
quarter of 1995. As several of the promised applications did not function as
specified, an impairment loss of approximately $8.1 million ($6.8 million
related to the U.S. Psychiatric Division and $1.3 million related to THC) was
recorded in the fourth quarter of 1995 to write down a portion of the total
cost of the system. The Company also shortened the estimated useful life of
the system to two years in anticipation of implementing an alternative system.
 
  In November of 1995, the Company closed Harvard Medical Limited, a patient
liaison business in West Germany due to declines in operating performance in
fiscal 1995. Based on these factors, the Company recorded an impairment loss
of $4.1 million to write off the goodwill related to this Company.
 
  In the fourth quarter of 1996, the Company recorded impairment charges
totaling $6.7 million related to the writedown of Southwind psychiatric
hospital, which was closed in December 1996 and two other closed hospitals,
one of which was sold in November 1996.
 
NOTE 5--ACQUISITIONS
 
  During 1996, the Company exchanged a closed psychiatric hospital with a book
value of $7.3 million for a closed acute care hospital and $.9 million. The
hospital acquired was converted into a THC satellite hospital which opened in
October 1996. No gain or loss was recorded on the exchange.
 
  During 1995, the Company purchased for $5.8 million, the land, building, and
fixed assets for a THC facility that had been managed by THC since May of
1994. All other acquisitions in 1994 to 1996 consisted of psychiatric entities
which were sold in fiscal year 1996.
 
NOTE 6--PROPERTY, BUILDINGS AND EQUIPMENT
 
  Property, buildings and equipment are summarized as follows:
<TABLE>
<CAPTION>
                                                              NOVEMBER 30
                                                           -------------------
                                                             1996      1995
                                                           --------  ---------
                                                             (IN THOUSANDS)
      <S>                                                  <C>       <C>
      Land................................................ $ 18,585  $  51,598
      Buildings and improvements..........................  102,092    300,388
      Furniture, fixtures and equipment...................   61,914     92,933
      Construction in progress (estimated additional cost
       to complete at November 30, 1996--$12.0 million)...    2,496     12,599
                                                           --------  ---------
                                                            185,087    457,518
      Less accumulated depreciation.......................  (31,154)  (103,326)
                                                           --------  ---------
                                                           $153,933  $ 354,192
                                                           ========  =========
</TABLE>
 
  The Company incurred interest expense of $4.9 million, $7.2 million, and
$4.8 million in 1996, 1995, and 1994, respectively, including $1.0 million,
$1.9 million, and $1.3 million which was capitalized in 1996, 1995, and 1994,
respectively.
 
  Interest paid was $5.8 million, $7.3 million and $4.1 million during 1996,
1995, and 1994, respectively.
 
                                      40
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 7--INCOME TAXES
 
  The Company accounts for income taxes under the liability method required by
FASB Statement No. 109, "Accounting for Income Taxes". Deferred income taxes
reflect the net tax effects of temporary differences between the carrying
amounts of assets and liabilities for financial reporting purposes and the
amounts used for income tax purposes. Significant components of the Company's
deferred tax liabilities and assets as of November 30, 1996 and November 30,
1995, are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                1996     1995
                                                               -------  -------
   <S>                                                         <C>      <C>
   Deferred tax liabilities:
     Excess tax depreciation.................................. $ 5,389  $23,425
     Disposition of subsidiary................................   4,337      --
     Other....................................................   1,543    2,018
     Sale of hospitals........................................  (4,612)     --
     Restructuring charge.....................................  (3,059)  (7,784)
                                                               -------  -------
         Total deferred tax liabilities....................... $ 3,598  $17,659
                                                               =======  =======
   Deferred tax assets:
     Current:
       Excess of book over tax bad debt provision............. $ 3,485  $   701
       Insurance..............................................   2,057      --
       Other..................................................     155      250
                                                               =======  =======
         Total current deferred tax assets.................... $ 5,697  $   951
                                                               =======  =======
   Non-current:
     Impairment loss.......................................... $ 2,996  $18,108
     Net operating loss.......................................   9,833    5,952
     Sale of hospitals........................................     701      --
     Restructuring charge.....................................     452    1,094
     Disposition of subsidiary................................    (487)     --
     Excess tax depreciation..................................    (522)  (1,649)
     Other....................................................      19       (9)
     Net operating loss valuation reserve.....................  (6,301)  (2,162)
                                                               -------  -------
         Total non-current deferred tax assets................ $ 6,691  $21,334
                                                               =======  =======
</TABLE>
 
  Deferred tax liabilities and assets by tax jurisdictions are as follows as
of November 30, 1996 (in thousands):
 
<TABLE>
<CAPTION>
                                                   DEFERRED        DEFERRED
                                                  TAX ASSETS    TAX LIABILITIES
                                                --------------- ---------------
                                                         NON-            NON-
                                                CURRENT CURRENT CURRENT CURRENT
                                                ------- ------- ------- -------
   <S>                                          <C>     <C>     <C>     <C>
   U.S. Federal Income Taxes (consolidated).... $4,932  $2,533   $ --   $3,598
   State.......................................    765   4,158     --      --
                                                ------  ------   -----  ------
                                                $5,697  $6,691   $ --   $3,598
                                                ======  ======   =====  ======
</TABLE>
 
                                      41
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  Income before income taxes includes the following components:
<TABLE>
<CAPTION>
                                                      1996      1995     1994
                                                    --------  --------  -------
                                                         (IN THOUSANDS)
<S>                                                 <C>       <C>       <C>
Pretax income (loss):
  United States.................................... $(15,100) $(79,772) $ 7,846
  Foreign..........................................    6,701    13,238    9,326
                                                    --------  --------  -------
                                                    $ (8,399) $(66,534) $17,172
                                                    ========  ========  =======
 
  Provision for income taxes consists of the following:
<CAPTION>
                                                      1996      1995     1994
                                                    --------  --------  -------
                                                         (IN THOUSANDS)
<S>                                                 <C>       <C>       <C>
Current:
  Federal.......................................... $ (3,409) $(14,931) $ 1,497
  Foreign..........................................    2,418     4,580    1,996
  State............................................     (223)   (1,507)   1,614
                                                    --------  --------  -------
    Total current.................................. $ (1,214) $(11,858) $ 5,107
Deferred:
  Federal.......................................... $ (2,558) $ (9,992) $ 1,295
  Foreign..........................................        4       331    1,364
  State............................................      721    (3,383)    (814)
                                                    --------  --------  -------
    Total deferred.................................   (1,833)  (13,044)   1,845
                                                    --------  --------  -------
                                                    $ (3,047) $(24,902) $ 6,952
                                                    ========  ========  =======
</TABLE>
  Reconciliation of federal statutory rate to effective income tax rate
follows:
 
<TABLE>
<CAPTION>
                                   1996              1995             1994
                              ---------------- ----------------- --------------
                              AMOUNT   PERCENT  AMOUNT   PERCENT AMOUNT PERCENT
                              -------  ------- --------  ------- ------ -------
                                           (AMOUNT IN THOUSANDS)
<S>                           <C>      <C>     <C>       <C>     <C>    <C>
Tax at U.S. statutory rates.. $(2,855)   (34)% $(22,622)   (34)% $5,838    34%
State income taxes, net of
 federal taxes benefit
 (charge)....................     329      4     (3,227)    (5)     528     3
Goodwill.....................  (2,428)   (29)       --     --       --    --
Non-deductible expenses......   1,170     14        --     --       --    --
Other........................     737      9        947      2      586     4
                              -------    ---   --------    ---   ------   ---
                              $(3,047)   (36)% $(24,902)   (37)% $6,952    41%
                              =======    ===   ========    ===   ======   ===
</TABLE>
 
  The Company received income tax refunds (net of income taxes paid of $5.7
million) of $1.3 million in 1996. The Company made income tax payments of $8.0
million in 1995. The Company received income tax refunds (net of income taxes
paid of $4.5 million) of $2.3 million in 1994.
 
  At November 30, 1996, the Company has deferred tax assets totalling $9.8
million related to State net operating loss carryforwards which expire in 1997
through 2012. Deferred tax assets related to State net operating loss
carryforwards increased $3.9 million in the current year primarily due to the
loss recorded on the sale of the U.S. psychiatric hospitals. The valuation
reserve was increased in fiscal 1996 to reserve for these losses as it is
likely, at this time, that the Company will not receive future tax benefits
therefrom. In fiscal year 1995, the Company decreased the valuation reserve by
$.2 million for THC State net operating loss carryforwards that were realized
in fiscal 1995 and for those that are expected to be realized in future years.
 
                                      42
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 8--LONG TERM DEBT
 
  Long term debt is summarized as follows:
<TABLE>
<CAPTION>
                                                                1996     1995
                                                               ------- --------
                                                                (IN THOUSANDS)
<S>                                                            <C>     <C>
Borrowings under revolving credit agreements.................. $16,800 $ 90,326
5 3/4% Convertible Subordinated Debentures due 2012,
 convertible into Common Stock of the Company at $35.89 per
 share, may be redeemed at 103.75% of face value as of October
 15, 1992 declining annually to 100% of face value on or after
 October 15, 1999.............................................   6,511    6,885
8 3/4% Subordinated Guaranteed Debentures due 1996............     --     4,980
Other.........................................................      14    1,456
                                                               ------- --------
                                                                23,325  103,647
Less current portion..........................................   8,467   18,764
                                                               ------- --------
                                                               $14,858 $ 84,883
                                                               ======= ========
</TABLE>
 
  During May 1994, the Company and Bank of America National Trust and Savings
Association entered into a credit agreement whereby THC was able to borrow,
repay and reborrow up to $50 million through February 28, 1997. The Company
repaid $50 million which was outstanding through June 21, 1996 under this
agreement.
 
  During September 1993, the Company entered into a credit agreement with Bank
of America National Trust and Savings Association whereby the Company was able
to borrow up to $25 million through November 30, 1995 (the revolving loan
period), at which time the amount outstanding was converted into a term loan
payable in equal quarterly installments through November 30, 1998. As of
November 30, 1996, interest was payable at LIBOR plus 1.0%. As of November 30,
1996, $16.8 million was outstanding under this agreement.
 
  The credit agreement contains provisions which, among other things, place
restrictions on borrowing, capital expenditures and the payment of dividends,
and requires the maintenance of certain financial ratios including tangible
net worth, fixed charge coverage and funded debt. The Company is currently in
compliance with or has received a waiver for all material covenants and
restrictions contained in the agreement. Borrowings are unsecured and are
guaranteed by the Company's domestic subsidiaries.
 
  The conversion price of the convertible debentures is subject to
antidilutive provisions.
 
  The annual maturities of debt for five years ending November 30, 2001 and
thereafter are as follows (in thousands):
 
<TABLE>
      <S>                                                                 <C>
      1997............................................................... $8,467
      1998...............................................................  8,347
      1999...............................................................    -0-
      2000...............................................................    -0-
      2001...............................................................    -0-
      Thereafter.........................................................  6,511
</TABLE>
 
 
                                      43
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 9--CAPITAL STOCK AND STOCK OPTIONS
 
  The Company has stock option plans whereby options may be granted at not
less than 100% of fair market value at the date of grant and are exercisable
at any time thereafter for a period of ten years, or five years for options
granted prior to November 8, 1990. Options granted on and after November 8,
1990, are exercisable 20% at date of grant with the remaining 80% becoming
exercisable at the rate of 20% each December 1 thereafter. At the time of
exercise, at least one-third is payable in cash and the balance, if any, with
a five-year note bearing interest at 8%. Stock options may also be exercised
by the return of previously acquired shares of common stock. Shares obtained
by such exercises are included in treasury stock and valued at the market
value at date of exercise.
 
  On May 20, 1993, the Company issued 860,000 of non-qualified options to
several key executives. The option price was $20 above the closing price of
the Company's stock on the date of grant, or $29.50 per share. During fiscal
year 1994, 146,000 shares of converging options were issued at an option price
of $24.50 per share. For each year during which the Company meets specified
performance targets, the option price will decrease by $5.00 until the option
price and market price converge. The option price will be fixed at the market
price on the date of convergence and the options will vest.
 
  If convergence does not occur during the first five years after grant of the
options, the options will be canceled and the shares will revert to the 1989
Stock Incentive Plan and be available for reissuance. The Company met these
targets for fiscal 1993. The Company did not meet these targets in fiscal
years 1994-1996.
 
  A summary of activity under the plans during 1996, 1995 and 1994 is as
follows:
 
<TABLE>
<CAPTION>
                                         NUMBER OF       PRICE      AGGREGATE
                                           SHARES      PER SHARE   OPTION PRICE
                                         ----------  ------------- ------------
                                            (IN THOUSANDS, EXCEPT PER SHARE
                                                       AMOUNTS)
   <S>                                   <C>         <C>           <C>
   Options outstanding at November 30,
    1993...............................   3,578,000   $ 9.50-33.00   $ 61,399
     Options granted...................   1,264,000    12.38-24.50     18,591
     Options cancelled and expired.....    (498,000)    9.50-33.00     (5,673)
     Treasury stock issued on exercise.    (355,000)    9.50-33.00     (5,295)
     Options converged.................         --           24.50     (4,300)
                                         ----------  -------------   --------
   Options outstanding at November 30,
    1994...............................   3,989,000     9.50-28.88     64,722
     Options granted...................   1,676,000     9.88-12.88     18,243
     Options cancelled and expired.....    (758,000)    9.50-24.50    (10,839)
     Treasury stock issued on exercise.    (102,000)    9.50-12.88     (1,029)
                                         ----------  -------------   --------
   Options outstanding at November 30,
    1995...............................   4,805,000     9.50-28.88     71,097
     Options granted...................   1,311,000     8.00-12.00     12,721
     Treasury stock issued on exercise.     (16,000)    9.50-9.875       (150)
     Options cancelled and expired.....  (1,735,000)    8.00-28.88    (29,016)
                                         ----------  -------------   --------
   Options outstanding at November 30,
    1996...............................   4,365,000  $ 8.00-28.875   $ 54,652
                                         ==========  =============   ========
</TABLE>
 
  The market value of the Company's common stock at the date the options were
exercised was $10.875- $12.00, $10.88-$13.63, $11.88-$18.75 for 1996, 1995,
and 1994, respectively.
 
  At November 30, 1996, 2.4 million options were exercisable and 1.2 million
(.7 million and 1.7 million at November 30, 1995 and 1994) were available for
grant under the plans.
 
                                      44
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 10--PROFIT SHARING PLAN
 
  The Company has a noncontributory, trusteed profit sharing plan which is
qualified under Section 401 of the Internal Revenue Code. All regular non-
union employees in the United States (union employees are eligible if the
collective bargaining agreement so specifies) with at least 1,000 hours of
service per annum, over 21 years of age, and employed at year-end are eligible
for participation in the plan after one year of employment. The Company's
contribution to the plan for any fiscal year, as determined by the Board of
Directors, is discretionary, but is limited to an amount which is deductible
for federal income tax purposes. Contributions to the plan are allocated among
eligible participants in the proportion of their salaries to the total
salaries of all participants. There were no contributions made by the Company
in 1996, 1995 and 1994. During 1993, a 401(k) segment was added to the plan
which allows employees to defer a portion of their salary on a pre-tax basis.
The Company may match a portion of the amount deferred. The Company's matching
contribution is determined by the Board of Directors each year. During 1996,
1995, and 1994 no matching contribution was made.
 
NOTE 11--DEFERRED COMPENSATION
 
  Effective November 30, 1989, a former Chairman of the Board of Directors of
Community Psychiatric Centers terminated his employment with the Company and
began receiving deferred compensation benefits. Approximately $162,000 of the
annual payment of $323,000 was charged to expense as consideration for
services rendered over the term of the consulting and noncompetition
agreements which was to extend to November 30, 2000. In 1995, such former
Chairman notified the Company of his position that certain provisions in the
contract that accelerate the payment of certain deferred compensation were
triggered and that up to $4.5 million was due from the Company thereunder.
 
  In January 1997, the Company settled this claim for $3.9 million. Of the
amount to be paid, $1.8 million had been previously accrued and, as described
in Note 2, $2.1 million of the settlement was accrued in November 1996. The
settlement amount was paid in February 1997.
 
                                      45
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 12--BUSINESS SEGMENT INFORMATION
 
  With the sales of the Company's U.S., Puerto Rico and United Kingdom
psychiatric divisions in fiscal 1996, the Company is now primarily a provider
of long-term acute care services in the United States. The following tables
have been prepared in accordance with the requirements of FASB Statement No.
14. This information has been derived from the Company's accounting records.
 
<TABLE>
<CAPTION>
                                                   YEAR ENDED NOVEMBER 30
                                                 ----------------------------
                                                   1996      1995      1994
                                                 --------  --------  --------
                                                       (IN THOUSANDS)
   <S>                                           <C>       <C>       <C>
   Net operating revenues:
     U.S. psychiatric division.................. $202,069  $248,408  $276,698
     U.K. psychiatric division..................   37,190    63,319    46,226
     Long-term acute care division..............  264,007   203,264   101,031
                                                 --------  --------  --------
                                                 $503,266  $514,991  $423,955
   Operating profit:
     U.S. psychiatric division.................. $  7,584  $ 14,345  $ 29,778
     U.K. psychiatric division..................    9,442    17,880    12,558
     Long-term acute care division..............   30,424    21,444    (7,630)
                                                 --------  --------  --------
                                                 $ 47,450  $ 53,669  $ 34,706
   Other income and expense:
     Other income............................... $  3,928  $  2,513  $  3,785
     Depreciation and amortization..............  (22,364)  (23,344)  (18,649)
     Interest expense...........................   (3,889)   (5,256)   (3,545)
     Non-recurring transactions, net............  (33,524)  (94,116)      875
                                                 --------  --------  --------
       Earnings (loss) before income taxes...... $ (8,399) $(66,534) $ 17,172
   Identifiable assets:
     U.S. psychiatric division(1)............... $ 69,859  $343,082  $396,377
     U.K. psychiatric division..................      --     78,248    68,640
     Long-term acute care division..............  396,088   183,295   134,987
                                                 --------  --------  --------
                                                 $465,947  $604,625  $600,004
   Depreciation and amortization expense:
     U.S. psychiatric division.................. $ 10,267  $ 12,318  $ 11,197
     U.K. psychiatric division..................    1,954     3,214     2,514
     Long-term acute care division..............   10,143     7,812     4,938
                                                 --------  --------  --------
                                                 $ 22,364  $ 23,344  $ 18,649
   Capitalized expenditures for property,
    building, and equipment:(2)
     U.S. psychiatric division.................. $ 10,096  $ 13,276  $ 11,194
     U.K. psychiatric division..................    5,973     7,962     6,209
     Long-term acute care division..............   19,350    18,901    31,357
                                                 --------  --------  --------
                                                 $ 35,419  $ 40,139  $ 48,760
</TABLE>
--------
(1) The U.S. psychiatric division was sold to Behavioral Healthcare
    Corporation on November 30, 1996. Amount represents the equity interest
    received as partial compensation for the sale of the division.
(2) Excludes assets acquired in business acquisitions of $2.1 million, $8.6
    million and $4.8 million in 1996, 1995 and 1994, respectively.
 
                                      46
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 13--FAIR VALUE OF FINANCIAL INSTRUMENTS
 
  The following methods and assumptions were used by the Company in estimating
its fair value disclosures for financial instruments:
 
    Cash and Cash Equivalents: The carrying amount reported in the balance
  sheet for cash and cash equivalents approximates its fair value.
 
    Short-Term Investments: The fair values for investment in debt securities
  are based on quoted market prices with unrealized gains, or losses, net of
  tax, reported in a separate component of stockholders' equity.
 
    Long-Term and Short-Term Debt: The carrying amounts of the Company's
  long-term and short-term debt approximates its fair value.
 
NOTE 14--COMMITMENTS AND CONTINGENCIES
 
  On September 28, 1995, the Company reached an agreement to settle certain
consolidated securities class action lawsuits and a related shareholder
derivative action. Although management of the Company believed that the claims
asserted in such suits lacked merit, the Company believed that it was prudent
to settle these cases due to the continuing substantial costs of defense, the
distraction of management's attention and the risks associated with
litigation. During the third and fourth quarter of 1995, the Company recorded
charges totaling $46.0 million ($28.9 million after tax) relating to
settlement of the lawsuits and associated legal fees and expenses. The suits,
filed in late 1991, alleged violations of the federal securities laws by the
Company and certain individuals between September 1990 and November 1991
arising from the activities of the U.S. Psychiatric Division. The principal
terms of the agreement called for a settlement amount of $42.5 million
consisting of a cash settlement fund of $21.25 million and shares of the
Company's common stock with a value of $21.25 million. The cash amount, plus
interest, was paid in November 1995. The shares issued to the plaintiff class
were previously repurchased by the Company pursuant to a stock buyback program
during late 1991 through early 1993. On March 4, 1996 the Company issued
689,189 of common shares to the plaintiffs' attorney which represented a
portion of the settlement to be made in common stock. The remaining portion of
the settlement in common stock totaled 1,652,778 shares which were issued on
August 21, 1996. Upon issuance, these shares had a dilutive effect on the
Company's earnings per share. As a result of the stock issued upon the
settlement of this lawsuit, a large number of shareholders became holders of
less than 100 shares of the Company's stock. To reduce administrative costs
related to servicing these small shareholders, on January 21, 1997, the
Company implemented a small shareholder selling program offering shareholders
who own less than 100 shares a convenient method for selling their shares.
 
  In July 1995, the Government served a whistleblower suit against the
Company's Subsidiary, CPC Oklahoma, Inc., under the Federal False Claims Act.
CPC Oklahoma, Inc. operated Southwind Hospital, a psychiatric hospital located
in Oklahoma City, Oklahoma. The suit was originally filed by a former employee
and a relative of another employee under the qui tam provisions of the Act.
Invoking its rights under the Act, the United States took over the case. In
November 1996, Southwind and the Government reached an agreement in principle
under which Southwind would pay $750,000 to the Government in exchange for a
release of the Government's civil and administrative claims. The settlement
was paid in February 1997. In a related action, on August 4, 1995, federal and
state authorities executed a search warrant at Southwind and seized various
records. In December 1996, the Government notified Southwind that it had
decided to discontinue any further criminal investigation of this matter.
 
  The Company is subject to ordinary and routine litigation incidental to its
business, including those arising from patient treatment, injuries or death
for which it is covered by liability insurance, and those arising from actions
involving employees. Management believes that the ultimate resolution of such
proceedings will not have a material adverse effect on the Company.
 
                                      47
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
NOTE 15--QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
 
  The following is a tabulation of the unaudited quarterly data for the two
years ended November 30, 1996:
 
<TABLE>
<CAPTION>
                                                THREE MONTHS ENDED
                                     ------------------------------------------
                                                           AUGUST
                                     FEBRUARY 28  MAY 31     31     NOVEMBER 30
                                     ----------- -------- --------  -----------
                                       (IN THOUSANDS, EXCEPT PER SHARE DATA)
   <S>                               <C>         <C>      <C>       <C>
   1996
   Total revenues...................  $127,975   $142,282 $120,001   $116,936
   Net income (loss)................     3,723      6,226   39,108    (54,409)
   Earnings (loss) per common
    share*..........................      0.09       0.14      .88      (1.26)
   Per common share:
   Dividend declared................       --         --       --         --
     Stock prices:
       High.........................    12 1/4         10    9 3/4      9 1/2
       Low..........................     8 5/8          8    7 3/4          8
   1995
   Total revenues...................  $121,609   $138,479 $130,909   $126,507
   Net income (loss)................     5,930      9,178  (24,332)   (32,408)
   Earnings (loss) per common
    share**.........................      0.14       0.21    (0.56)      (.74)
   Per common share:
   Dividend declared................       --         .01      --         --
     Stock prices:
       High.........................    12 1/2     13 3/4   13 1/2     12 1/2
       Low..........................     9 5/8     11 1/2   10 1/2     10 1/4
</TABLE>
--------
*  Included in earnings per share for the first, second and third quarter of
   1996 are restructuring charges of $.01, $.01 and $.01 per share,
   respectively, related to employee termination benefits and other exit costs
   resulting from the closure of four psychiatric hospitals in fiscal year
   1996. Included in earnings per share for the third quarter of 1996 is a net
   gain of $.81 per share on the sale of the Company's United Kingdom
   psychiatric hospitals. Included in earnings per share for the fourth
   quarter is a loss of $(1.28) per share related primarily to the sale of the
   Company's U.S. psychiatric hospitals.
 
** Included in earnings per share for the second quarter of 1995 is a
   restructuring credit $(.03) totaling $2.5 million ($1.5 million after tax)
   from the resolution of previously restructured psychiatric assets. Earnings
   per share in the third quarter of 1995 include $(.65) for a pre-tax charge
   of $45.0 million ($28.4 million after tax) relating to the settlement of
   shareholder litigation. Earnings per share in the fourth quarter of 1995
   include a charge of $(.01) related to legal expenses associated with the
   legal settlement and $(.65) for a pre-tax charge of $46.0 million ($28.4
   million after tax) related to impairment of assets. Also included in the
   fourth quarter of 1995 is a pre-tax restructuring charge of $4.6 million
   ($2.8 million after tax) or $.07 per share related to employee termination
   benefits and other costs in connection with the decision to close six
   psychiatric hospitals and three regional offices.
 
NOTE 16--PREFERRED STOCK PURCHASE RIGHTS AND PREFERRED STOCK
 
  On June 21, 1996 the Board of Directors of the Company declared a dividend
of one preferred stock purchase right (the "Rights") on each outstanding share
of common stock, payable to stockholders of record on July 16, 1996. Each
Right will entitle the holder thereof after the Rights become exercisable and
until June 20, 2006 (or the earlier redemption, exchange or termination of the
Rights), to buy one one-hundredth of a share of
 
                                      48
<PAGE>
 
                      TRANSITIONAL HOSPITALS CORPORATION
                   (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
Series B Junior Participating Preferred Stock (the "Preferred Stock") at an
exercise price of $45.00, subject to certain antidilution adjustments (the
"Purchase Price"). The Rights will be represented by the Common Stock
certificates and will not be exercisable or transferable apart from the Common
Stock until the earlier of (i) the tenth day after the public announcement
that a Person or group has become an Acquiring Person (a Person who has
acquired, or obtained the right to acquire, beneficial ownership of 15% or
more of the Common Stock), or (ii) the tenth day after a Person or group
commences, or announces an intention to commence, a tender or exchange offer,
the consummation of which would result in the beneficial ownership by a Person
or group of 15% or more of the Common Stock (the earlier of (i) and (ii) being
called herein the "Distribution Date"). Prior to the Distribution Date, the
Board of Directors has the power, under certain circumstances, to postpone the
Distribution Date. The Rights will first become exercisable on the
Distribution Date, unless earlier redeemed or exchanged, and may then begin
trading separately from the Common Stock. The Rights will at no time have any
voting rights.
 
  With certain exceptions, in the event that (i) the Company were acquired in
a merger or other business combination transaction in which the Company is not
the surviving corporation or its Common Stock is changed or exchanged (other
than a merger which follows certain cash offers for all outstanding Common
Stock approved by the Board) or (ii) more than 50% of the Company's assets or
earning power were sold, proper provision shall be made so that each holder of
a Right (except Rights which previously have been voided as set forth above)
shall thereafter have the right to receive, upon exercise thereof, that number
of share of common stock of the acquiring company which at the time of such
transaction would have a market value of two times the then-current exercise
price of one Right.
 
  At any time after a Person has become an Acquiring Person and prior to the
acquisition of 50% or more of the then-outstanding Common Stock by such
Acquiring Person, the Board of Directors may cause the Company to acquire the
Rights (other than Rights owned by an Acquiring person which have become
void), in whole or in part, in exchange for that number of shares of Common
Stock having an aggregate value equal to the excess of the value of the Common
Stock issuable upon exercise of a Right after a Person becomes an Acquiring
Person over the Purchase Price.
 
  The Rights are redeemable at $0.01 per Right prior to the first date of
public announcement that a Person or group has become an Acquiring Person.
Prior to the expiration of the period during which the Rights may be redeemed,
the Board of Directors has the power, under certain circumstances, to extend
the redemption period. The Rights will expire on June 20, 2006 (unless earlier
redeemed or exchanged).
 
  The Purchase Price payable, and the number of shares of Preferred Stock or
other securities or property issuable upon exercise of the Rights are subject
to adjustment from time to time to prevent dilution.
 
                                      49
<PAGE>
 
       REPORT OF INDEPENDENT ACCOUNTANTS ON FINANCIAL STATEMENT SCHEDULE
 
To The Board of Directors
of Transitional Hospitals Corporation
 
  Our audits of the consolidated financial statements of Transitional
Hospitals Corporation (formerly Community Psychiatric Centers) and its
subsidiaries referred to in our report dated January 24, 1997 with respect to
the consolidated financial statements included in this Annual Report on Form
10-K also included an audit of Financial Statement Schedule II of Transitional
Hospitals Corporation and its subsidiaries for the years ended November 30,
1996 and 1995. In our opinion, this Financial Statement Schedule of
Transitional Hospitals Corporation and its subsidiaries for the years ended
November 30, 1996 and 1995 presents fairly, in all material respects, the
information set forth therein when read in conjunction with the related
consolidated financial statements for the years ended November 30, 1996 and
1995.
 
Price Waterhouse LLP
Los Angeles, California
January 24, 1997
 
                                      50
<PAGE>
 
                 SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
 
              TRANSITIONAL HOSPITALS CORPORATION AND SUBSIDIARIES
                    (FORMERLY COMMUNITY PSYCHIATRIC CENTERS)
 
<TABLE>
<CAPTION>
       COLUMN A           COLUMN B           COLUMN C            COLUMN D    COLUMN E
       --------          ----------- ------------------------  ------------ -----------
                                            ADDITIONS
                                     ------------------------
                                                  CHARGED TO
                         BALANCE AT  CHARGED TO     OTHER                   BALANCE AT
                          BEGINNING   COSTS AND   ACCOUNTS--   DEDUCTIONS--   END OF
    DESCRIPTION           OF PERIOD   EXPENSES     DESCRIBE      DESCRIBE     PERIOD
    -----------          ----------- ----------- ------------  ------------ -----------
<S>                      <C>         <C>         <C>           <C>          <C>
Year ended November 30,
 1994................... $22,658,000 $26,966,000 $(20,325,000)     (1)      $29,381,000
                                                       82,000      (2)
Year ended November 30,
 1995...................  29,381,000  28,732,000  (33,383,000)     (1)       24,682,000
                                                      (48,000)     (2)
Year ended November 30,
 1996...................  24,682,000  20,101,000   (3,586,000)     (1)       21,448,000
                                                  (17,317,000)     (3)
                                                   (2,432,000)     (4)
</TABLE>
--------
(1) Write-offs, net of recoveries.
(2) Foreign currency translation adjustment.
(3) Represent allowance for bad debts for the U.S. psychiatric hospitals that
    were sold on November 30, 1996.
(4) Represent allowance for bad debts for the U.K. psychiatric hospitals that
    were sold on June 21, 1996.
 
                                       51
<PAGE>
 
                                EXHIBIT INDEXES
 
  EXHIBIT NO.                       DOCUMENT
 
  (3)Articles of Incorporation and By-laws
 
      3.1 Restated Articles of Incorporation as adopted by vote of
          shareholders on May 20, 1993 and as amended by vote of
          shareholders on November 8, 1996.
 
      3.2 Amended and Restated By-Laws of the Company.
 
 (10)Material Contracts
 
     10.1 Employment Contract Number Four between Registrant and Richard L.
          Conte, dated as of May 1, 1992 (filed as Exhibit 10.1 to
          Registrant's Annual Report on Form 10-K for its fiscal year ended
          November 30, 1993 and incorporated in full herein by reference).*
 
     10.2 Amendment Number One dated as of July 29, 1994, to Employment
          Contract Number Four between Registrant and Richard L. Conte
          (filed as Exhibit 10.2 to Registrant's Annual Report on Form 10-K
          for its fiscal year ended November 30, 1994 and incorporated in
          full herein by reference).*
 
     10.2.1 Employment Contract between Registrant and Richard L. Conte
            dated as of December 1, 1995 (filed as Exhibit 10.2.1 to
            Registrant's Annual Report on Form 10-K for its fiscal year
            ended November 30, 1995 and incorporated in full herein by
            reference).*
 
     10.3 Supplemental Retirement Contract between Registrant and Richard
          L. Conte, dated as of September 1, 1988 (filed as Exhibit 10.4 to
          Registrant's Annual Report on Form 10-K for its fiscal year ended
          November 30, 1988 and incorporated in full herein by this
          reference).*
 
     10.4 Restated and Amended Employment Contract between Registrant and
          Robert L. Green, dated June 1, 1988 (filed as Exhibit 10.1 to
          Registrant's Annual Report on Form 10-K for its fiscal year ended
          November 30, 1988, and incorporated in full herein by this
          reference).
 
     10.5 Amendment Number One dated as of August 1, 1989, and Amendment
          Number Two dated as of December 1, 1989 to Restated and Amended
          Employment Contract between Registrant and Robert L. Green (filed
          as Exhibit 10.5 to Registrant's Annual Report on Form 10-K for
          its fiscal year ended November 30, 1994 and incorporated in full
          herein by reference).
 
     10.6 Employment Contract between Registrant and Julia Kopta dated as
          of June 6, 1996.*
 
     10.7 Employment Contract between Registrant and Wendy Simpson dated as
          of June 6, 1996.*
 
     10.8 Employment Contract between Registrant and Ronald L. Ooley dated
          as of June 6, 1996.*
 
     10.9 Employment Contract between Registrant and J. Rodney Laughlin
          dated as of June 6, 1996.*
 
     10.10 Termination Agreement between Registrant and Steven S. Weis
           dated as of December 30, 1994 (filed as Exhibit 10.8 to
           Registrant's Annual Report on Form 10-K for its fiscal year
           ended November 30, 1994 and incorporated in full herein by
           reference).
 
     10.11 Settlement Agreement between Registrant, Kay Seim, Richard Seim
           and Continuum Healthcare, Inc. dated as of February 19, 1996
           (filed as Exhibit 10.9.1 to Registrants' Annual Report on Form
           10-K for its fiscal year ended November 30, 1995 and
           incorporated in full herein by reference).
 
     10.12 Form of Indemnification Agreements between Registrant and its
           Directors and Executive Officers (filed as Exhibit C to
           Registrant's Proxy Statement, dated April 24, 1987, relating to
           the annual meeting of its shareholders on June 1, 1987, and
           incorporated in full herein by this reference).
<PAGE>
 
  EXHIBIT NO.                       DOCUMENT
 
     10.13 Registrant's 1989 Stock Incentive Plan (filed as Exhibit A to
           Registrant's Proxy Statement, dated July 12, 1989, and
           incorporated in full herein by this reference).*
 
     10.14 Form of Stock Option Agreement (filed as Exhibit 10.6.1 to
           Registrant's Report on Form 10-K for its fiscal year ended
           November 30, 1990 and incorporated in full herein by this
           reference).*
 
     10.15 Form of Nonstatutory Stock Option Agreement with Director (filed
           as Exhibit 10.6.2 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1990 and incorporated in full
           herein by this reference).*
 
     10.16 Registrant's Combined Stock Option Plan for Key Employees and
           Amendment Numbers One, Two, Three, Four and Five thereto (filed
           as Exhibit 10.7 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1989 and incorporated in full
           herein by this reference).*
 
     10.17 Form of Stock Option Agreement--General Stock Option (filed as
           Exhibit 10.7.1 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1989 and incorporated in full
           herein by this reference).*
 
     10.18 Form of Stock Option Agreement--Incentive Stock Option (filed as
           Exhibit 10.7.2 to Registrant's Report on Form 10-K for its
           fiscal year ended November 30, 1989 and incorporated in full
           herein by this reference).*
 
     10.19 Agreement and Promissory Note between Registrant and Richard
           Conte dated as of June 7, 1995 (filed as Exhibit 10 to
           Registrant's report on 10-Q for its quarter ended August 31,
           1995, and incorporated herein by this reference).
 
     10.20 Agreement and Promissory Note between Registrant and J. Rodney
           Laughlin dated as of November 9, 1995 (filed as Exhibit 10.20 to
           Registrant's Annual Report on Form 10-K for its fiscal year
           ended November 30, 1995 and incorporated in full herein by
           reference).*
 
     10.21 Agreement and Promissory Note between Registrant and Ronald L.
           Ooley dated as of June 2, 1995 (filed as Exhibit 10.21 to
           Registrant's Annual Report on Form 10-K for its fiscal year
           ended November 30, 1995 and incorporated in full herein by
           reference).*
 
     10.22 Agreement between Community Psychiatric Centers and Foray 911
           Limited, dated as of June 21, 1996, related to the sale of the
           entire issued share capital of CPC (Londinium) Limited. The
           Agreement contains certain attachments designated as "Approved
           Form Documents" which were not included in this filing. The
           Company will furnish supplementally a copy of any omitted
           attachment to the Commission upon request (filed as Exhibit 1 to
           Registrant's July 5, 1996 filing on Form 8-K and incorporated in
           full herein by reference).
 
     10.23 The Series A Loan Note dated June 21, 1996, made by Foray 911
           Limited and payable to Community Psychiatric Centers in the
           amount of 3 million British Pounds (filed as Exhibit 2 to
           Registrant's July 5, 1996 filing on Form 8-K and incorporated in
           full herein by reference).
 
     10.24 Inter-Creditor Agreement between the Royal Bank of Scotland,
           Mercury Asset Management PLC, Foray 911 Limited and Community
           Psychiatric Centers (filed as Exhibit 3 to Registrant's July 5,
           1996 filing on Form 8-K and incorporated in full herein by
           reference).
 
     10.25 Rights Agreement, dated as of June 21, 1996 between Community
           Psychiatric Centers and Chase Mellon Shareholder Services (filed
           as Exhibit 4 to Registrant's July 5, 1996 filing on Form 8-K and
           incorporated in full herein by reference).
<PAGE>
 
  EXHIBIT NO.                       DOCUMENT
 
 
     10.26 Form of Letter to the holders of Community Psychiatric Centers
           Common Stock (filed as Exhibit 5 to Registrant's July 5, 1996
           filing on Form 8-K and incorporated in full herein by
           reference).
 
     10.27 Asset Purchase Agreement, between the Company and BHC, dated
           October 22, 1996 (filed as Exhibit 99.1 to Registrant's October
           22, 1996 filing on Form 8-K and incorporated in full herein by
           reference).**
 
     10.28 Agreement and Plan of Merger between the Company and BHC, dated
           October 22, 1996 (filed as Exhibit 99.2 to Registrant's October
           22, 1996 filing on Form 8-K and incorporated in full herein by
           reference).**
 
     10.29 Schedule 3.10 to the Asset Purchase Agreement, consisting of the
           Audited Consolidated Financial Statements of BHC, for fiscal
           years ended June 30, 1996, 1995 and 1994 (filed as Exhibit 99.3
           to Registrant's October 22, 1996 filing on Form 8-K and
           incorporated in full herein by reference).
 
     10.30 First Amendment to Asset Purchase Agreement between the Company
           and BHC, dated November 30, 1996 (filed as Exhibit 99.1 to
           Registrant's December 16, 1996 filing on Form 8-K and
           incorporated in full herein by reference).**
 
     10.31 Amendment to Agreement and Plan of Merger, between the Company
           and BHC, dated November 30, 1996 (filed as Exhibit 99.2 to
           Registrant's December 16, 1996 filing on Form 8-K and
           incorporated in full herein by reference).**
 
     10.32 Debt Instruments--Copies of debt instruments for which the
           related debt is less than 10% of total assets will be furnished
           to the Commission upon request.
 
 11   Statement re computation of earnings per share
 
 21   Subsidiaries of the Registrant
 
 23   Consent of Independent Accountants--Price Waterhouse LLP
 
 23.1 Consent of Independent Auditors--Ernst & Young LLP
 
 27   Financial Data Schedule
 
  (b) Reports on Form 8-K:
 
    Report dated October 22, 1996 reporting the execution of an Asset
  Purchase Agreement related to the sale of substantially all of the
  psychiatric hospital and residential treatment center operations of the
  Company in the United States and Puerto Rico to Behavioral Healthcare
  Corporation.
 
    Report dated October 24, 1996 reporting the issuance of a press release
  dated October 22, 1996 regarding the sale of the U.S. and Puerto Rico
  psychiatric assets to Behavioral Healthcare Corporation.
 
    Report dated December 16, 1996 reporting the completion of the sale of
  the U.S. and Puerto Rico psychiatric assets to Behavioral Healthcare
  Corporation on November 30, 1996 and related unaudited pro forma financial
  information.
--------
*Required to be filed as an exhibit pursuant to item 14 (c) of this Form.
** The Agreements contain certain schedules and exhibits which were not
   included in this filing. The Company will furnish supplementally a copy of
   any omitted schedule or exhibit to the Commission upon request.