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                                 UNITED STATES
                       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   JUNE 30, 1997

[ ]  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 0-13304

                       CHANTAL PHARMACEUTICAL CORPORATION
             (Exact name of registrant as specified in its charter)

                  DELAWARE                           22-2276346
       (State or other jurisdiction of            (I.R.S. Employer
        incorporation or organization)           Identification No.)

12901 W. JEFFERSON BOULEVARD, LOS ANGELES, CALIFORNIA  90066
(Address of principal executive offices)             (Zip Code)

      Registrant's telephone number, including area code:  (310) 574-5588

           Securities registered pursuant to Section 12(b) of the Act
                                      NONE

           Securities registered pursuant to Section 12(g) of the Act
                          COMMON STOCK, $.01 PAR VALUE
                                (Title of Class)

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 twelve (12) months (or for such shorter period that the registrant
was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
 Yes   X      No  
     ------     ------            

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]

The aggregate market value of the voting stock held by non-affiliates of the
registrant was approximately $8,037,000 as of September 26, 1997.

The number of shares of Common Stock, $.01 par value, outstanding as of
September 26, 1997 was 21,120,843.

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SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

Certain statements in this Annual Report on Form 10-K, particularly under Items
1 through 8, constitute "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933 and section 21E of the Securities
Exchange Act of 1934.  Such forward-looking statements involve known and unknown
risks, uncertainties, and other factors which may cause the actual results,
performance, or achievements of the Company to be materially different from any
future results, performance or achievements, expressed or implied by such
forward-looking statements.

Specifically with respect to statements regarding the marketing and distribution
of Chantal Skin Care products, additional risks, uncertainties, and other
factors include, among others, lower than expected consumer acceptance of the
Company's products; introduction of competitive products; market acceptance,
including by retailers, of the Company's advertising campaign and promotional
activities; the availability of sale space within the ultimate retailer; and
negative publicity which reflects on the Company as a whole or its products.

With respect to statements regarding the marketing and distribution of Chantal
Skin Care products in territories other than the United States, additional
risks, uncertainties, and other factors include, among others, executing
agreements with distributors,  implementation by the Company or its distributor
of marketing and distribution programs, compliance with applicable regulatory
requirements of each country, lower than expected consumer acceptance of the
Company's products, and adverse changes in the economic or political conditions
in the respective countries.

With respect to future development of the Company's compounds, such additional
risks, uncertainties, and other factors include, among others, the process of
obtaining FDA or other regulatory approval to market pharmaceutical products,
the regulatory approval process can be lengthy and there is no assurance that
any such approval will ever be obtained, the Company will be competing with
large pharmaceutical companies which have substantially greater research,
development, marketing, financial and personnel resources, and the Company has
been primarily involved in the research and development of its compounds and has
limited marketing experience.

With respect to all statements regarding the Company's future operations,
additional risks, uncertainties, and other factors include, among others, that
the independent certified public accountants have expressed in their opinion on
the Company's financial statements as of and for the year ended June 30, 1997
that the Company has suffered recurring losses from operations and has a working
capital deficiency that raises substantial doubt about its ability to continue
as a going concern.

                                     PART I
                                     ------

ITEM 1.  BUSINESS
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GENERAL
-------

     Chantal Pharmaceutical Corporation and its subsidiaries (the "Company") is
primarily engaged in the research, development and marketing of innovative
compounds for use as dermatological and skin care consumer products.  The
Company's current strategy is to focus, initially through the marketing of its
novel Ethocyn cosmetic ingredient, on becoming an integrated cosmetic and skin
care company.  Ethocyn, one of three principal patented compounds for which the
Company has exclusive manufacturing and distribution rights, is presently being
marketed by the Company as a unique cosmetic product which helps improve the
appearance of aged skin.  The Company operates in one industry segment, the
development and marketing of cosmetic and skin care products.

     Cyoctol and Metcyclor are the Company's two other principal patented
compounds.  Cyoctol is a non-steroidal, anti-androgen which is in various stages
of clinical trials for the treatment of certain androgen mediated disorders,
such as acne, male pattern baldness and keloids (excessive scarring).  Metcyclor
is in final stages of pre-clinical development for the treatment of certain
cancers.  The Company currently intends to continue the development of these
ethical compounds on a limited basis.  The Company expects that future cash
flows from the sale of the Ethocyn-based cosmetic products will contribute to
future funding of the development of these compounds.

     In July 1995, the Company, in conjunction with its U.S. distributor,
launched its nationwide retail marketing program for the Chantal Ethocyn-based
skin care cosmetic products.  Its U.S. Ethocyn product advertising program
consists of thirty- and sixty-second television advertisements that feature
either individuals who have used the products on only one-half of their faces or
celebrity spokespersons who have used the products for at least 60 days.  The
Company also expects to introduce a new television advertisement campaign in the
second half of calendar 1997.  The Company advertises in  national magazines as
well as other print 

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advertising in cooperation with the advertising programs of the Company's U.S.
retailers. The advertising is generally targeted to men and women over 35 years
of age, the portion of the population that the Company believes are most
benefited by use of the Company's products. The Company's products are currently
being sold in pharmacies, chain drug stores and dermatologist offices across the
United States and Canada.
 
     The Company is also currently negotiating with foreign distribution outlets
for Ethocyn-based product marketing and distribution throughout the world,
including Europe and the Pacific Rim.  A special licensing agreement with the
Michilan Company in Taipei, Taiwan allows Chantal Ethocyn Skin Care products to
be available to consumers in China, Hong Kong, Macao and Taiwan.  The first
revenue was realized from a shipment to Michilan in December 1996.  In Europe,
Chantal is currently test marketing for product positioning.

     Unless the context otherwise requires, the term "Company" refers to Chantal
Pharmaceutical Corporation and its subsidiaries, generally, and specifically
with respect to discussions of Ethocyn, Chantal Skin Care Corporation.  The
Company's executive offices are located at 12901 W. Jefferson Boulevard, Los
Angeles, California 90066, and its telephone number is (310) 574-5588.

     For definitions of certain technical terms, see the Glossary which appears
at the end of this Item.

ETHOCYN-BASED CHANTAL SKIN CARE PRODUCTS

     Ethocyn is the Company's proprietary cosmetic ingredient compound for use
in skin care products to help modify certain components of skin aging.  The
Company believes, based on preliminary in vitro and clinical efficacy tests
conducted, that Ethocyn helps to modulate skin tone, texture, resiliency and
elasticity.  The Company currently markets nine skin care products through
direct response marketing and its U.S. distributor to physicians and pharmacies
in North America and Canada.

     The Company has conducted extensive pre-clinical efficacy and safety
testing of Ethocyn in conformance with those standards and requisite for  filing
an IND application with the FDA (see "Government Regulations").  As a means of
obtaining dose response, efficacy and marketing data, the Company in 1985 began
selling, on a limited and controlled basis, a proprietary line of cosmetic
products with Ethocyn as the active ingredient.  Microscopic skin replica
topography analysis efficacy data was obtained from this limited retail store
consumer based population between 1985 and 1988.  In 1988, the Company filed its
Ethocyn IND application and received FDA approval to conduct Phase II clinical
trials to evaluate Ethocyn as a potential skin aging, and elastin fiber
increasing therapeutic treatment product.  The Company believes that its
marketing capabilities with respect to the cosmetic skin care treatment line may
ultimately be enhanced if FDA market approval for Ethocyn is received, since the
Company would then, should FDA approval be granted, be able to make medical
treatment claims in its advertising and promotional campaigns with respect to
the use of these products as a skin anti-aging therapy. The Company has not
conducted any Ethocyn drug studies under the Ethocyn IND and no assurance can be
given that such studies will be undertaken in the future. Double blind placebo
controlled studies which have been undertaken were, and continue to be,
conducted as cosmetic studies.

     The first results of an Ethocyn cosmetic clinical trial were presented on
August 2, 1994 at the 43/rd/ American Academy of Dermatology in San Francisco by
Dr. Richard Strick, Clinical Professor of Dermatology at UCLA Medical Center.
The results presented were of the six month study he conducted on Ethocyn at a
0.5% concentration.  Dr. Strick reported a statistically significant (P=.005)
increase in elastin fiber production at two months in the patients participating
in the study based on a computer analysis of microscopic slides of skin biopsies
of the study's 20 patients before, during and after use of a topical solution
containing Ethocyn.  Dr. Strick reported that, on average, patients' skin
elastin content increased 100%; while patients with initial low skin elastin
fiber content realized increases ranging from 200% to over 500%.

     In January 1995, Dr. Strick completed a second 30-patient trial using the
same 0.5% concentration in the Chantal Ethocyn Essence Vials' formulation
presently for sale to consumers at large.  This study further validated the
results of the first study that patients' skin elastin content increased 100% on
average at 60 days (P=.001) and further showed that patients' skin elastin
increased 50% on average as early as at 30 days. The second study also reported
that patients' elastin levels decreased back to pretreatment use levels if
Ethocyn use was not continued.
 
     Commercially available Chantal Skin Treatment Products include the
Company's feature product, as tested in Dr. Strick's second clinical trial, a
0.46 oz. Two Vial Ethocyn Essence Kit, a 6.7 oz. Gel Cleanser, a 2.0 oz.
Ethocyn Hydrating Complex moisturizer, a 0.5 oz. Ethocyn Eye Cream, a 2.0 oz.
Revitalizing Masque, a 6.7 oz. Ethocyn Hand and Body Moisturizer, a 6.0 oz.
Ethocyn Total Body Satinee, a 6.0 oz. Ethocyn Total Body Mist and a 6.0 oz.
Ethocyn Safe Sun Treatment.  Additionally, numerous other retailers specific
Ethocyn product configurations are available, including an "Introductory
Treatment Collection" consisting of four of the products is available to
consumers for $100.00, which four products if purchased individually would cost
the consumer $180.00.  

                                       3
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The Company markets these products through its direct response telemarketing
operators, The Home Shopping Network and through its U.S. distributor to chain
drug stores and physicians offices. Distribution in foreign countries, to date,
has been through sale of the products to Company's sub-licensee distributors.

     Chantal Skin Care's marketing campaign for its products has included 30
second and 60 second spot television commercials featuring three women, ages 35,
38 and 57 years respectively, who used the product either 30 days, 60 days or
120 days on half their face which began airing in September 1995. Additionally,
the Company's 1995 - 97 Ethocyn marketing campaign included a "1/2 Face
Spokesperson Model Contest" launched nationwide and in Canada; a national
magazine print adver tising campaign and public relations efforts including
editorial interviews. The Company's spokespeople have appeared across the
country in conjunction with product launches and regional half-face contest open
calls in various cities and outlets. Included in the Company's Ethocyn
promotional advertising campaigns during fiscal year 1997 have been public
appearances by a "Baywatch" television series makeup artist and hair stylist
commenting to the product's efficacy and twice a day use by numerous of the
"Baywatch" cast and crew. Television and motion picture celebrity Ethocyn
product users were the subject of several 1997 Ethocyn products advertising and
promotion campaigns, both in the U.S. and foreign markets where the product is
and will be offered for sale.

     The Company entered into a marketing agreement at June 29, 1995 with
Stanson Marketing, Inc. ("Stanson") to distribute the Company's Ethocyn-based
skin care cosmetic products to physicians and pharmacies in North America.  The
agreement calls for Stanson to market the Chantal Ethocyn-based skin care
cosmetic products to various retail and wholesale distribution channels, as well
as to physicians in the United States and Canada.  Physicians, in turn, sell the
product to their patients.  The agreement is for the life of the patents, which
will expire in 2004.  The agreement also provides an option for the Company to
acquire Stanson.  See "Product Development - Distribution Licensing Agreements."

     On June 9, 1997, the Company announced that it had reached an agreement-in-
principle to terminate the Marketing Agreement dated June 29, 1995, as amended,
between the Company and its U.S. distributor, Stanson Marketing, Inc.  Under the
terms of the proposed  termination agreement, among other things, the Company
will be required to issue 1.2 million shares of Common Stock.  The Company is
continuing to negotiate the final terms relating to this termination.  Although
the Company believes that a negotiated termination agreement can be achieved, no
assurance can be given that the agreement in principle will be reduced to a
final agreement.
 
     The Company has expanded Ethocyn distribution to foreign countries both
through the establishment of certain company owned subsidiaries and through
distribution sublicense agreements.  See "Product Development - Distribution
Licensing Agreements."

     In February 1995, the Company entered into a Pacific Rim Territory
distribution agreement with Roger Chang for the distribution and marketing of
Ethocyn based skin care products.  The territory includes Taiwan, The People's
Republic of China, Hong Kong, Macao, Singapore, Malaysia, Indonesia, Vietnam,
Laos, Cambodia, Philippine Islands, Thailand and Korea. Upon the launch in
fiscal 1997, specific performance criteria included minimum quantities of
product purchased by Chang from the Company, and subsequent years' escalating
minimum quantity purchases, some specific advertising and promotional annual
expenditures, and letter of credit payment terms.  In October 1996, a
sublicensing agreement was reached with Michilan International in Taipei, Taiwan
to distribute Ethocyn based skin care products in China, Hong Kong, Macao and
Taiwan.
 
     The Company is also currently negotiating for marketing and distribution
arrangements in other non-U.S. jurisdictions.
 
     In October 1996, the Company reached a product endorsement agreement
with David Hasselhoff, the executive producer and star of the number one
worldwide "Baywatch" and "Baywatch Nights" television series.  David Hasselhoff
is the first celebrity spokesperson for the Company's proprietary Ethocyn-based
Chantal Skin Care cosmetic products.  Mr. Hasselhoff will be featured in Chantal
Skin Care products' television commercials and print advertisements, as well as,
in Pan Asian and Europe calendered promotional tours and appearances.

     In August 1997, the Company reached a second celebrity product endorsement
agreement with Polly Bergen, a Director and Chief Operating Officer of the
Company and a nationally recognized television and Emmy award winning actress.
Ms. Bergen is being featured as the flagship Ethocyn celebrity spokesperson on
The Home Shopping Network.

DRUG DEVELOPMENT

     Historically, the Company's strategy was to conduct chemical research and
development of its proprietary pharmaceutical market compounds, perform pre-
clinical and early clinical tests necessary to establish their respective safety
and efficacy and thereafter enter into strategic alliances with major
pharmaceutical companies that would complete the clinical trials, finalize the
necessary regulatory approvals and ultimately manufacture and market products
containing the compounds. In the future, the Company intends to expand its role
in
                                   4
<PAGE>
 
the development and commercialization of the compounds, including increased
participation in clinical trials, the regulatory approval process, manufacturing
and marketing, subject to the availability of funds for such activities.

     RESEARCH AND DEVELOPMENT STRATEGY

     The FDA and similar regulatory bodies in foreign countries require that a
drug be shown to be safe and effective in adequately controlled clinical trials
before approval is granted to commercially market such drug.  Before clinical
trials may be commenced, extensive and time-consuming basic research and
development information must be produced and submitted to the FDA or similar
foreign regulatory agencies in an IND or similar application to assure the
safety of a drug compound before testing is permitted in humans.

     Given the hormonal toxicity recognized to be associated with anti-androgens
developed prior to Cyoctol, the Company undertook a comprehensive approach in
designing and conducting its pre-clinical safety trials for its compounds.  The
approach was in anticipation of not only obtaining FDA approval for Cyoctol's
topical therapeutic indications such as acne, male pattern baldness, keloids and
hirsutism, but also for building a basis for future development of Cyoctol for
its potential systemic (prostate cancer, benign prostate hypertrophy,
intraperitoneal adhesions) therapeutic markets.  As a result, the Company has
successfully completed the majority of pre-clinical data necessary to apply for
INDs for such systemic indications in addition to those for which INDs have
already been received.

     The Company has expended significant resources on over 40 separate
toxicology, pharmacology and pharmacokinetic studies, including both dermal and
oral group dosage forms.   The  types of  safety pre-clinical tests either
completed  or in  stages of completion include dermal toxicology (six month rat
and monkey), oral toxicology, mutagenicity, phototoxicity, dermal sensitivity,
teratology (Segment I, II in two species), two-year oncogenicity, /14/C-labelled
Cyoctol pharmacokinetic profiles and /3/H-labelled Cyoctol percutaneous
absorption profiles, endocrinology, carcinogenicity and /14/C-labelled Cyoctol
ADME (absorption, distribution, metabolism and excretion) profiles in five
species.  These studies were submitted to the FDA for evaluation before and
subsequent to Cyoctol's various IND approvals.  The data generated from these
many dermal and oral safety studies support the Company's belief that Cyoctol is
a safe compound at the dose levels used in Phase II human clinical trials
conducted to date.
 
     CYOCTOL

     Cyoctol is the principal pharmaceutical compound in the Company's licensed
series of non-toxic, nonsteroidal, anti-androgen compounds known as the X-Andron
Series. In 1986, the Company received INDs to initiate human clinical trials for
Cyoctol's topical use as a treatment for acne and male pattern baldness and in
1987 received an IND to commence human clinical trials using Cyoctol as a
topical keloid scar treatment.

    ACNE INDICATION  Acne Vulgaris is a common dermatological condition of the
    ---------------                                                           
face, chest and back, which affects individuals of all ages, including a high
proportion of the adolescent population.  Cyoctol is a small (molecular weight
252) lipophilic molecule, which penetrates the skin to the dermis sebaceous
ducts and gland, which sebaceous glands sometimes produce excessive sebum oil
and keratin occlusion, the primary causes of acne. Cyoctol blocks the DHT
receptors in the cells of the sebaceous glands. Thereafter, Cyoctol is quickly
and effectively metabolized in the skin to a non-anti-androgen, non-toxic
metabolite.
 
     Biostatisticians have advised the Company that the 6-month treatment of 200
patients in a multicenter acne trial at five U.S. medical centers may be
sufficient for a Cyoctol NDA submission to the FDA. The Company is awaiting
further revenues from the sale of Ethocyn-based cosmetic products to fund Phase
III multi-center clinical trials.

     The Company has several license agreements for certain territories,
pursuant to which the licensees have similar development and regulatory market
approval commitments.  None of these licensees is expected to commence marketing
of Cyoctol for the acne indication until certain Phase III clinical tests are
completed and the results analyzed.

     MALE PATTERN BALDNESS INDICATION   Androgenetic alopecia, or male pattern
     --------------------------------                                         
baldness, is the principal form of baldness, representing approximately 85% of
the baldness incidence.  Since the 1950s, medical science has recognized the
primary cause of this disorder is an individual's genetic pre-disposition to
excessive DHT receptors in his or her scalp hair follicle cells.  Other causes
of baldness include impaired circulation in the scalp.  As in the case of acne,
Cyoctol's potential for treatment of androgenetic alopecia lies in its ability
to block DHT-DHT receptor binding.
 
     A licensee of the Company having certain rights to market Cyoctol in
certain foreign markets has advised the Company that protocol design has been
completed for a Phase II, 120 patient, double blind, placebo controlled Cyoctol
alopecia clinical trial to be conducted at a medical center in the United
States.  Upjohn's NDA approved Rogaine will be used as a positive control in
this study.  

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<PAGE>
 
University investigator review board approval application and patient
recruitment for this licensee-sponsored clinical study is in preparation and
awaits submission to the IRB of validated computer image techniques.
Commencement of the patient treatment phase is awaiting the design and
validation of certain computer image technology software which will enable the
clinical investigator to quantify patients' hair diameter changes during the
course of this one year clinical trial study. This is a desired end point
included in the study design and protocol for supporting a claim for Cyoctol as
a potential "treatment of alopecia" and/or "reversal of hair loss" product.

     Additionally, another nine-month foreign-based 120 patient topical Cyoctol
androgenetic alopecia (male pattern baldness) clinical trial is in preparation
utilizing the same computer image analysis hair count protocol utilized in the
Cyoctol Phase II clinical trial published at the 48th Annual Meeting American
Academy of Dermatology in 1989.  Upjohn's NDA approved Rogaine is a positive
control in this Cyoctol clinical trial.  This study has completed the patient
recruitment phase (males 18-50 years of age)  and patient treatment awaits
finalization of the investigator's computer imaging analysis technology
validation discussed above.

     The Company intends, subject to available funding, to complete the clinical
and other testing as may be necessary to apply to the FDA for an NDA with
respect to the baldness indication and may pursue strategic alliances for such
development.  The Company is unable to predict when the clinical trial would be
completed and when an NDA submission can take place.

     In addition, the Company has several license agreements for other
territories pursuant to which the licensees have undertaken development
commitments with respect to Cyoctol for the male pattern baldness indication.
None of these licensees is expected to commence marketing of Cyoctol for the
acne indication until certain clinical tests are completed and the results are
analyzed.

     KELOIDS INDICATION   Keloids result from the build-up of excessive collagen
     ------------------                                                         
scar tissue which typically occurs in genetically predisposed patients following
certain surgical procedures, such as appendectomies, cesarean deliveries and
plastic surgery.  Keloids typically occur in areas of the body where cells with
DHT receptors exist, such as the face, hands, neck, upper back and groin areas.

     According to the National Institute of Health, there are approximately 5.8
million surgical procedures performed in the United States each year in which
keloid scarring could occur.  Cyoctol represents a potential preventative and
treatment for post-surgical keloids.  Cyoctol also has market applications for
burn patients who frequently experience keloid scarring during the healing
process.

     The Company intends to apply for an IND to conduct human clinical trials in
the United States using Cyoctol as a treatment for keloid scarring by inter-
lesion injection delivery.  Scientific investigators who monitored Phase I
clinical trials believe that scar tissue may have impeded the penetration and
topical drug delivery of Cyoctol to the collagen-producing cells.  The Company
has collaborated with dermatologists in the design of Phase I Cyoctol keloid
treatment by inter-lesion injection delivery protocols and implementation of
subject keloid clinical trials, subject to available funding.

     The Company is currently considering various alternatives, including
license or joint development agreements with pharmaceutical companies which
market wound healing products for the commercial development of the keloids
indication for Cyoctol.
 
     OTHER POTENTIAL INDICATIONS FOR CYOCTOL   In addition to the foregoing
     ---------------------------------------                               
indications, the Company has also conducted research evaluating Cyoctol as a
treatment for certain other androgen-mediated disorders in various therapeutic
fields, including ophthalmology, urology, obstetrics, gynecology and infectious
disease.  Preliminary research indicates that Cyoctol may have other medical,
industrial and agricultural applications.
 
     METCYCLOR

     The Company has developed the Metcyclor family of compounds.  In vitro
                                                                   --------
(biopsied human cancer tumors) and in vivo (animal) tests conducted to date have
                                   -------                                      
shown Metcyclor to be a cancericidal compound with respect to certain cancers,
including renal, colon, breast, ovarian and prostate cancer.  Such tests have
also indicated that Metcyclor effects a reduction in the size of tumors.  Cancer
is a family of related diseases that take many different forms and attack
different parts of the body.  The disease is generally characterized by the
growth and spread of malignant tumors or by the proliferation of cancerous cells
in blood or bone marrow.  Of the three most common methods of treating cancer --
surgery, radiation and chemical therapy -- Metcyclor will constitute a form of
chemical therapy.

     Due to the limited resources, during the third quarter of fiscal 1993, the
Company suspended its efforts to develop Metcyclor.  In keeping with the
Company's strategy of focusing on becoming an integrated cosmetic and skin care
company, the 

                                       6
<PAGE>
 
Company intends to pursue future Metcyclor development via strategic alliances
with other companies, including joint ventures, joint development, license
agreements, or limited partnership financing, or a combination of the foregoing.

     SUPPLIES

     The Company has access, through several trade sources, to the raw
materials, synthetic expertise and contract facilities necessary to produce its
proprietary compounds as well as its formulated products.

     RESEARCH AND DEVELOPMENT ACTIVITIES

     The chemical research and production of the Company's compounds has been
principally performed by the Company's staff.  The laboratory research
activities include synthesis of the Company's compounds, isolation and
identification of these respective compounds' isomers, quality assurance and
quality control testing of all laboratory materials.  The Company's research and
development activities since August 1994 have been primarily focused on the
development of the Company's Ethocyn-based skin care products.  Expenditures for
research and development were approximately $162,000, $1,032,000 and $639,000 in
fiscal 1997, 1996, and 1995, respectively.

     The Company intends to focus its near-term, subject to Ethocyn revenues
and/or strategic alliance agreements, future research and development activities
on dermatology and skin care product development and marketing activities,
extending the Company's compounds' patent life and optimizing its compounds'
dose related efficacy profiles through isomer and analog research.  It is
anticipated that Ethocyn, Cyoctol and Metcyclor production, and quality
assurance and quality control of the compounds will continue at the Company's
laboratory in Germany as well as scale up synthetic contract laboratories, on an
as needed basis, and that the safety and efficacy studies have been, and will
continue to be, primarily conducted by independent contract laboratories.  The
extent to which these activities are pursued is subject to available funding, of
which there can be no assurance.
 
PRODUCT DEVELOPMENT - DISTRIBUTION AND LICENSING AGREEMENTS

     Cyto Skin Care (Chantal Skin Care).  On March 15, 1994, the Company entered
     -----------------------------------                                        
into a License agreement (the "License") with Cyto Skin Care Corporation ("Cyto
Skin Care"), an unrelated company, in which the Company sublicensed to Cyto Skin
Care all of the rights to distribute and sell Ethocyn-based cosmetics and skin
care products (i.e. non-pharmaceutical products) in the United States, Canada,
Mexico and the Caribbean.  Cyto Skin Care issued to the Company in consideration
for the License, 10,910,812 shares of its common stock, which shares constituted
approximately 82.7% of Cyto Skin Care's then outstanding shares of common stock
after giving effect to their issuance.  Under the License, Cyto Skin Care was
obligated to use its best efforts to expeditiously launch the marketing and sale
of Ethocyn-based cosmetic skin care products by September 30, 1994, but in no
event later than December 31, 1994.  The launch was effected in August 1994 by
direct response telemarketing.  The License is terminable at the option of the
Company if during the term of the License Cyto Skin Care does not achieve sales
of the Chantal Skin Care product line of at least $5,000,000 in the initial nine
months following execution of the License; $20,000,000 during calendar 1995; and
$50,000,000 in calendar 1996.  In August 1994, Cyto Skin Care changed its name
to Chantal Skin Care Corporation ("Chantal Skin Care").   On June 16, 1995, the
Company accepted for exchange of its common stock, 1,780,000 shares of the
outstanding Chantal Skin Care shares.  Accordingly, the Company now owns
12,690,812 shares of common stock of Chantal Skin Care or 90% of the outstanding
Chantal Skin Care shares.  Although Chantal Skin Care did not achieve the
requisite product sales, the Company does not intend to exercise its termination
rights.

     SIG Corporation.  In August 1989, the Company entered into a research,
     ----------------                                                      
development and distribution agreement with a group of private investors
pursuant to which the investors were granted the exclusive right to manufacture
and distribute products containing Ethocyn and its patent related compounds for
skin anti-aging therapeutic indications, including the Company's line of
cosmetic products, on a worldwide basis, excluding the United States, Canada,
Mexico and the Caribbean.  The investors, in July 1990, assigned their rights
under the agreement to SIG Investment Group Establishment ("SIG"), a newly
formed corporation.  Pursuant to the agreement, SIG paid for certain Ethocyn
pre-clinical and clinical development costs associated with obtaining FDA
approval in the United States, in accordance with a contractually defined
development program and timetable.  The agreement called for SIG to purchase
Ethocyn-containing formulated products from the Company at certain specified
prices which is in excess of anticipated cost and pay to the Company upon
distribution of such products a specified royalty on net sales, should any such
sales occur.

     On January 17, 1994, prior to the transaction between the Company and Cyto
Skin Care, a then unrelated principal stockholder of Cyto Skin Care entered into
an agreement (the "SIG-CSCC Agreement") with SIG, to acquire for Cyto Skin Care
from SIG the worldwide (except for the United States, Canada, Mexico, the
Caribbean, the Middle East, Russia, China and Hong Kong) rights held by SIG to
distribute Chantal Ethocyn skin treatment products.

                                       7
<PAGE>
 
     Pursuant to SIG-CSCC Agreement, Cyto Skin Care was obligated to pay SIG
$1,500,000 as a front-end license fee, 400,000 shares of common stock of Cyto
Skin Care and a royalty of five percent of worldwide sales by Cyto Skin Care of
Ethocyn-based products, such royalty to be payable for three years from the date
of commencement of sales of Ethocyn-based skin treatment products by Cyto Skin
Care with a minimum royalty payment of $350,000 per year and a maximum royalty
of $2,000,000 during such three year period.  Pursuant to the SIG-CSCC
Agreement, Cyto Skin Care was also obligated to issue to SIG an additional
250,000 shares of its common stock if such common stock did not trade at an
average market price of $5.00 per share during the three month period ended
September 30, 1994.  The provisions of the SIG-CSCC Agreement also provided that
a public trading market in Cyto Skin Care's common stock would occur by  no
later than March 31, 1994 and that Cyto Skin Care's common stock would be
qualified for quotation on NASDAQ by April 30, 1994.  On March 15, 1994, as
discussed above, the Company acquired a controlling interest in Cyto Skin Care,
and in August 1994, Cyto Skin Care changed its name to Chantal Skin Care
Corporation.  In August 1994, Chantal Skin Care entered into an agreement with
SIG to issue an additional 300,000 shares of its common stock, in consideration
of SIG's waiver of the various requirements under the SIG-CSCC Agreement and
settlement of a dispute with respect to the per share valuation of the shares of
CSCC initially issued to SIG.  These shares were issued in May 1995.

     CBD Pharmaceutical Corporation.  Pursuant to the terms of a license
     -------------------------------                                    
agreement between the Company and CBD Pharmaceutical Corporation, a corporation
controlled by the Company's Chairman and Chief Executive Officer and certain
members of her family, the Company acquired the manufacturing and distribution
rights to the X-Andron Series compounds (including Ethocyn and Cyoctol) and
Metcyclor compounds, in exchange for which the Company issued to CBD
Pharmaceutical Corporation 2,614,500 shares of the Company's Common Stock and
agreed to pay a royalty of (i) 8% of the wholesale price of all licensed
compounds and products containing licensed compounds manufactured and sold
directly by the Company to wholesale or retail markets; and (ii) 8% of all
revenues derived by the Company from royalty or other sales-based compensation
pursuant to any sublicense, joint venture or other party with respect to the
licensed compounds.  The obligation to make payments to CBD Pharmaceutical
Corporation with respect to Ethocyn-based cosmetics products was assumed by
Chantal Skin Care Corporation in connection with the License Agreement between
the Company and Chantal Skin Care.  In July 1994, and in conjunction with
Ethocyn U.S. and international marketing negotiations then in progress, CBD
Pharmaceutical Corporation agreed with the Company and Chantal Skin Care to
terminate the 8% royalty obligation effective August 1, 1994 and in lieu
thereof, to accept from the Company 300,000 shares of its Common Stock and from
Chantal Skin Care 300,000 shares of its common stock.  Accordingly, no royalty
will be paid by the Company to CBD Pharmaceutical Corporation as a result of the
sale of the Chantal Skin Care product line by Chantal Skin Care.  The term of
the agreement runs for the length of any U.S. patents granted with respect to
the licensed compounds.  See "Patents and Trademarks."

     Stanson Marketing, Inc.   The Company entered into a marketing agreement at
     -----------------------                                                    
June 29, 1995 with Stanson Marketing, Inc. to distribute the Company's Ethocyn-
based skin care cosmetic products to physicians and pharmacies in North America.
This agreement calls for Stanson, subject to certain advertising and promotional
performance criteria of the Company, to market the Ethocyn-based skin care
cosmetic products to more than 25,000 chain and independent drug stores as well
as to approximately 10,000 physicians in the United States which physicians in
turn sell the products to their patients.  The agreement is for the life of the
patents, which will expire in 2004.  Under the terms of the agreement the
Company has the right to direct Stanson to ship to its customers on what is
known in the industry as an "autoship basis" which in accordance with industry
standards requires such customers to purchase higher shelf inventory levels of
product.  In November 1995, the Company exercised its rights to direct autoship
distribution.  Under the agreement, Stanson's payment terms are 90 days for non-
autoship orders prior to December 31, 1995, 60 days for non-autoship orders
after December 31, 1995, and ten days after Stanson receives payment from its
customers for autoship product orders.  Stanson subsequently agreed, subject to
certain performance criteria by the Company, with respect to autoship product
orders, to pay no later than six months from shipment of product to Stanson.
Stanson has advised the Company that it is paying for products within ten days
of receipt of payment from its customers and that due to failure by the Company
to advertise and promote the products as agreed upon in the contract, it has no
obligation to pay within six months.

     Under the Agreement, the Company and Stanson each have certain obligations
with respect to marketing and promotional activities for the Company's products.
As a justification for its policy with respect to payment, Stanson claims that
the Company did not secure appearances on national television talk shows as
contemplated by the Agreement nor perform its advertising contractual
obligations, and by reason thereof Stanson did not sell the amount of product
anticipated.  The Company disagrees with Stanson's position, noting that its
ability to secure such appearances was harmed by a January 1996 Barron's article
primarily questioning the Company's accounting for sales to its distributor and
the resulting litigation and further negative publicity.

     The Company has an option to acquire Stanson, exercisable at any time after
December 31, 1995, for shares of the Company's Common Stock at a purchase price
of three times Stanson's annualized net earnings divided by the lesser of (A)
$10.00 or (B) 80% of the ten day average closing bid price of the Common Stock
prior to the notice of exercise of such option.

                                       8
<PAGE>
 
     On June 9, 1997, the Company announced that it had reached an agreement-in-
principle to terminate the Marketing Agreement dated June 29, 1995, as amended,
between the Company and its U.S. distributor, Stanson Marketing, Inc.  Under the
terms of the proposed  termination agreement, among other things, the Company
will be required to issue 1.2 million shares of Common Stock.  The Company is
continuing to negotiate the final terms relating to this termination.  Although
the Company believes that a negotiated termination agreement can be achieved, no
assurance can be given that the agreement in principle will be reduced to a
final agreement.  If and when the marketing agreement is terminated or
alternatively the Company exercises its option to acquire Stanson, then the
Company will be directly marketing and distributing the Ethocyn-based skin care
products.  

     Roger Chang - In February 1995, the Company entered into a Pacific Rim
     -----------                                                           
distribution agreement with Roger Chang for the distribution and marketing of
Ethocyn based skin care products.  The territory includes Taiwan, The People's
Republic of China, Hong Kong, Macao, Singapore, Malaysia, Indonesia, Vietnam,
Laos, Cambodia, Philippine Islands, Thailand and Korea. Upon the launch in
fiscal 1997, specific performance criteria included minimum quantities of
product purchased by Chang from the Company, and subsequent years' escalating
minimum quantity purchases, some specific advertising and promotional annual
expenditures, and letter of credit payment terms.
 
     Michilan International - In October 1996, a sublicensing agreement with
     ----------------------                                                 
Michilan International as a sublicensee of Roger Chang was reached to distribute
Ethocyn-based Chantal Skin Care products in China, Hong Kong, Macao and Taiwan.
The first shipment was made in December 1996 under this agreement. The sales to
Michilan that the Company has recognized as revenues during fiscal year 1997 is
approximately $876,000.

     The Company is engaged in discussions with other companies which have
expressed interest in entering into license arrangements with the Company.  No
assurance can be given that such discussions will result in license
arrangements.

PATENTS AND TRADEMARKS

     The Company is the licensee from CBD Pharmaceutical Corporation ("CBD") of
a series of compound, composition of matter and method of use patents and patent
applications, both United States and foreign, for its pharmaceutical and
cosmetic compounds.  The license extends for the life of the patents.  From 1978
to 1982, CBD funded chemical structure research and discovery, early acute
toxicology and in vitro and animal efficacy studies, and patent applications.
               --------                                                       
In 1987, method of use patents with respect to Cyoctol and Ethocyn and a
composition of matter patent with respect to Metcyclor were issued in the United
States.  In 1989, compound and composition of matter patents with respect to
Cyoctol and Ethocyn were issued in the United States.  The U.S. patents as
extended and modified currently expire in 2004.  The Company has also pursued a
policy of filing for patent protection in foreign jurisdictions and has been
granted numerous foreign patents.  Although there can be no assurance that any
further patents will be issued or, if issued, will provide meaningful protection
or commercial benefit to the Company, the Company is of the opinion that the
granting of patents substantially enhances its ability to compete in the markets
in which it intends to engage.  In this connection, it is to be noted that the
Company may be obligated to incur substantial expenses in connection with the
defense of, and challenges to, the patents in those countries in which patents
are granted.

     The Company seeks to protect its trademarks, including the marks CHANTAL
and ETHOCYN, its corporate logo, and the names of its compounds, through
registrations under applicable trademark laws in the United States and certain
foreign countries in which the Company anticipates its products may be marketed
or sold.  Although the Company believes that its trademarks are important to its
business, the Company does not believe that any one of its marks is
determinative of the successful marketing of its products.

     The Company intends to actively seek to protect its intellectual property
rights.

GOVERNMENT REGULATION
 
     Cosmetic products sold in the United States have traditionally not required
FDA approval as long as the products are labeled and intended to cleanse,
beautify or provide attractiveness of the body.  However, in response to the
FDA's pronouncement in 1987 (in connection with the issuance of more than 27
regulatory letters to other companies) of its jurisdiction regulating certain
cosmetic treatment claims, the Company filed an IND in August 1988 for Ethocyn
as a skin anti-aging product.  The Company's Ethocyn IND was approved in
September 1988, thereby permitting it to initiate human clinical trials.  If an
NDA is granted, the Company contemplates making medical treatment claims related
to skin anti-aging and other possible age-related skin treatment claims for its
Ethocyn containing skin treatment  products.  There can be no assurance that an
NDA will be submitted or, if submitted, approved.

                                       9
<PAGE>
 
     The Company currently does not make medical treatment claims in its
marketing programs of the Ethocyn-based Chantal Skin Care product line.
However, to the extent the Company's claims with regard to such products are
interpreted by the FDA as relating to treatment of illness or other therapeutic
claims regarding the effect of the compound on the structure or function of the
body, the products may be subject to regulation as a new drug, with all the
requirements described above governing its sale.  There can be no assurance that
the FDA will not seek to subject the Company's Chantal Skin Care product line to
such regulations.

     The Company is also subject to Federal Trade Commission rules and
regulations and applicable state agency rules with respect to the substantiation
and accuracy of the advertising and labeling of its products.

     The Company makes therapeutic claims about certain other compounds being
developed by the Company and therefore such compounds are classified as new
drugs by the FDA.  Before a new drug can be commercially marketed in the United
States, or imported or exported, approval by the FDA is required.

     To initiate human clinical trials, pre-clinical safety and efficacy
research must be conducted and the results submitted to the FDA in an IND
application.  If FDA approval for clinical testing is obtained, the compound is
classified as an IND.  The clinical trial programs generally involve a three-
phase process.  Typically, Phase I trials are conducted in healthy volunteers.
Researchers look for negative side effects, how the drug is metabolized and how
best to administer the drug.  In Phase II, trials are conducted in groups of
volunteers afflicted with the disease or disorder sought to be treated to gather
expanded evidence of safety and to determine preliminary efficacy.  In Phase
III, large-scale comparative trials are conducted in patients with the target
disease or disorder to provide sufficient data for the statistical proof of
safety and efficacy and to determine optimal dosages.  In the case of drugs for
cancer and other life-threatening diseases, the initial human testing is
generally done in patients rather than in healthy volunteers.

     If Phases I through III are successfully completed, the results and data
from these trials are incorporated into an NDA, which is filed with the FDA to
obtain marketing approval.  In general, a more comprehensive NDA and a more
prolonged review process are required for drugs not previously approved for
marketing for another therapeutic use or indication by the FDA.  If a second
indication for an approved product is sought, since many of the components of
the review process are the same, there generally is a shortened review process.
However, the FDA generally gives high priority to novel drugs providing unique
therapeutic benefits and a correspondingly lower priority to drugs similar to or
providing comparable benefits to others already on the market.  The Company's
compounds are novel (patented) chemical entities not previously approved for
marketing for another therapeutic use or indication by the FDA.

     The process of doing the requisite testing, data collection, analysis and
compilation of an IND and an NDA is labor intensive and costly and may take a
protracted time period, particularly if tests must be re-performed or new tests
instituted to comply with FDA requests.  Review by the FDA may also take a
considerable time period and also may involve consideration by an independent
advisory committee which can mandate the generation of additional supporting
data.  There is no guarantee that an NDA will be approved and the Company cannot
estimate how long the approval process may take.  Even if an NDA is approved,
the FDA can make its approval conditional on post-marketing testing or
surveillance programs to monitor the safety and efficacy of the drug in use.
To-date, the FDA has not requested re-performance of any Company-sponsored
studies of its compounds.

     A company that has obtained an NDA can market the new drug, subject to
complying with extensive FDA regulations pertaining to registration, control of
the manufacturing and distribution process, labeling and advertising of the
product and monitoring and reporting of adverse experiences involving use of the
product.  The FDA, as well as state authorities, have the right to conduct
extensive on-site inspections of a company's facilities and its records to
determine compliance with requirements of applicable laws and regulations.
Manufacturers found not to be in compliance may be subject to a number of
regulatory and legal proceedings, including recall, seizure, injunction and
actions for criminal and civil sanctions and penalties.  The Company has been
advised by outside expert GMP and ISO 9000 consultants that its Kaiserslautern,
Germany research and production laboratory meets ISO certification and good
manufacturing procedures ("GMP") standards and procedures.

     Most foreign countries have regulatory requirements comparable in many
respects to those existing in the United States.  Every country has some form of
approval, certification or licensing process which must be satisfied before a
drug can be marketed.  In all instances animal and clinical data must be
submitted for review.  Review times and submission requirements vary widely and
there can be no assurance that approvals will be granted within a reasonable
time frame, if at all.  Once a product is marketed in any of these countries,
the Company will have to comply with requirements involving manufacturing,
labeling, advertising, and distribution and its laboratory production facility
will be subject to potential continued inspection to insure ongoing compliance
with these provisions.

     In addition to the foregoing, the Company's present and future business is
subject to regulation under state and federal laws regarding work place safety,
environmental protection and hazardous substance control and to other present
and possible future local, 

                                       10
<PAGE>
 
State, territorial, federal and foreign regulation. The Company utilizes certain
raw materials in the synthesis of its compounds which would be classified as
hazardous substances under some or all federal and state environmental and other
statutes. Since the Company's compounds are currently manufactured at its German
facility, the Company is not currently subject to such laws. The Company
believes it complies with all applicable German laws. If the Company begins
manufacturing its compounds in the United states, the Company will be required
to comply with all such rules and regulations governing the storage, handling
and disposal of hazardous substances. Failure to so comply could materially
impair the ability of the Company to manufacture its compounds.

COMPETITION

     There are numerous companies, including established pharmaceutical and
cosmetic companies, engaged in the development and sale of new drugs and/or
cosmetics. The Company's Chantal Skin Treatment products containing Ethocyn are
expected to compete in the cosmetics market both in the United States and
internationally. There is strong competition in the cosmetics market which is
characterized by large, well-established cosmetics firms that have greater
financial, marketing and other resources than the Company.  In April 1992,
Johnson & Johnson received a favorable FDA panel recommendation for use of its
Retin A (Tretinoin) containing Renova dermatologic cream to treat wrinkles.
Tretinoin, the active ingredient in Renova, is not an anti-androgen DHT blocker
and accordingly is believed to treat skin aging differently than Ethocyn.
Renova is reported to primarily act upon the dermis in aging skin while Ethocyn
clinical trials report (P=.001) Ethocyn's mechanism to be that of desirably
increasing elastin fiber content in the skin.  The Company is unable to predict
either product's potential and competitive ability to penetrate this market
segment.

     The Company intends to market and compete through other means for market
share of the cosmetic skin treatment market sector by direct marketing,
television commercials, television appearances of Company personnel, certain
celebrity and Company personnel promotional activities and through  marketing to
physicians and pharmacies.

     With respect to the development of its ethical compounds, the Company
competes with many pharmaceutical and biotech companies, many of which have
substantial financial resources, large and highly skilled research and
development staffs, major research facilities and large marketing organizations.
Although the Company is not aware of any organization which has developed or is
developing a  safe and effective nonsteroidal anti-androgen, no representation
can be made that any of its competitors are not engaged in such research or
that, should the Company be successful in the development of its compounds,
other companies will not be successful in producing and selling a non-
proprietary modification of the compounds through the application of their
greater resources.  In this connection, Merck's Proscar/(R)/ (Merck's name for
the compound Finasteride) received market approval from the FDA in mid-1992 as
an anti-androgen treatment for benign prostate hypertrophy, one of the
systematic therapeutic disorders for which Cyoctol is being tested.  Proscar is
a steroidal anti-androgen.  Additionally, Merck has announced that Finasteride,
via oral administration, is in multi-center Phase II clinical trials for the
potential treatment of male pattern baldness, another indication for which
Cyoctol, the Company's non-steroidal anti-androgen.

     The Company anticipates that products containing Cyoctol will be
prescription drug products upon initial FDA approval which will limit their
market until such time as the FDA may grant it over-the-counter status.  The
Company also anticipates it may encounter substantial competition for its
Metcyclor compounds, if ever granted FDA approval, from the existing
pharmaceutical companies in connection with any anti-cancer drug that it
develops.

     Upjohn currently manufactures and markets Cleocin T and Minoxidil
(Rogaine), drugs which respectively treat acne and male pattern baldness.
Neither Cleocin T nor Minoxidil are anti-androgens, and accordingly are thought
to treat acne and male pattern baldness differently than Cyoctol.

EMPLOYEES

     At June 30, 1997 the Company employed 47 full-time employees and considers
its relations with its employees to be good.

                                       11
<PAGE>
 
                                    GLOSSARY

     The following terms used herein have the general meanings set forth below:

1.  ACNE.....................  A skin disorder affecting mainly the face
                               characterized by the development of pimples
                               (papules, pustules, open and closed comedones)
                               which is caused by an infection and inflammation
                               of the sebaceous (wax producing) glands and
                               ducts.

2.  ANDROGEN.................  A hormone which has a masculinizing function,
                               i.e., it produces and maintains the secondary sex
                               characteristics of the male, such as the growth
                               of the beard. Females also possess plasma
                               circulatory androgen hormones such as
                               androstanedione.

3.  ANDROGENETIC ALOPECIA....  A medical disorder involving loss of hair on the
                               scalp of the head classically known as "male
                               pattern baldness," not baldness related to loss
                               of hair induced by chemotherapy or nervous system
                               abnormalities.

4.  ANTI-ANDROGEN...........   A substance which acts against androgen hormones.

5.  CANCERCIDAL.............   Destructive of cancer cells.

6.  CLINICAL TRIALS.........   Human testing of a drug for safety and efficacy.
                               The clinical trial programs generally involve a
                               three-phase process. Typically, Phase I trials
                               are conducted in healthy volunteers. Researchers
                               look for negative side effects, how the drug is
                               metabolized and how best to administer the drug.
                               In Phase II, trials are conducted in groups of
                               volunteers afflicted with the disease or disorder
                               sought to be treated to determine preliminary
                               efficacy and gather expanded evidence of safety.
                               In Phase III, large-scale comparative trials are
                               conducted in patients with the target disease or
                               disorder to provide sufficient data for the
                               statistical proof of safety and efficacy and to
                               determine optimal dosages. In the case of drugs
                               for cancer and other life-threatening diseases,
                               the initial human testing is generally done in
                               patients rather than in healthy volunteers. If
                               Phases I through III are successfully completed,
                               the results and data from these trials are
                               incorporated into an NDA, which is filed with the
                               FDA to obtain marketing approval.

7.  CYOCTOL(TM).............   The name which particularly identifies one
                               chemical entity in the patented (Patent Numbers
                               4,689,345; 4,855,322) X-Andron Series of
                               compounds co-invented by the Company's Chairman
                               and licensed to the Company in 1982. This
                               particular chemical structure is synthesized in
                               the Company's laboratory and is presently in
                               Phase II clinical trials for the topical
                               treatment of acne, male pattern baldness, keloids
                               and hirsutism. Cyoctol pre-clinical safety and
                               efficacy studies have been conducted validating
                               its potential as a possible treatment for certain
                               systemic androgen mediated disorders including
                               benign prostate hypertrophy, and numerous fungal
                               infections.

8.  DHT (DIHYDROTESTOSTERONE)  An intracellular androgen hormone in both males
                               and females which is the by-product of enzyme
                               action on circulating testosterone androgen
                               hormone in males and circulating androstanedione
                               androgen hormone in females. Dihydrotestosterone
                               is found in the cytoplasms of peripheral target
                               cells in males and females (i.e., skin fibroblast
                               cells, skin sebaceous glands and ducts, hair
                               follicle cells, liver, prostate, etc.).

9.  ETHICAL.................   Restricted to sale only by a doctor's
                               prescription.

10. ETHOCYN(R)..............   The name which particularly identifies one
                               chemical entity in the patented (Patent Numbers
                               4,689,345; 4,855,322) X-Andron Series of
                               compounds co-invented by the Company's Chairman
                               and licensed to the Company in 1982. This
                               particular chemical structure is synthesized in
                               the Company's laboratory, which is one of the
                               active ingredients in the "Chantal Elastogenic
                               Skin Treatment Program" line of cosmetics.

11. HIRSUTISM ...............  An androgen mediated disorder which is manifested
                               by the presence of excess body or facial hair,
                               especially in women.

                                       12
<PAGE>
 
12. IND (Investigational 
     New Drug)...............  In order to initiate clinical trials, extensive
                               research and development data must be submitted
                               to the FDA in the form of an IND application.

13. IN VITRO.................  Studies conducted "in glass", or the test tube,
                               or any other experimental medium not involving an
                               animal or human being; tests performed outside
                               the living body.

14. IN VIVO..................  Studies conducted using living organisms,
                               including animals such as rodents and non-rodent
                               species (e.g., monkeys). In vivo may also refer
                               to human testing.

15. KELOIDS..................  Overgrowth of collagenous scar tissue at the site
                               of wound or laceration of the skin; a
                               hypertrophic or excessive type of scarring.
                               Scientific literature sites keloids work in
                               selected generic population (i.e., negroes,
                               certain caucasian sub-population, etc.).

16. MALE PATTERN BALDNESS....  The common term for androgenetic alopecia.

17. METCYCLOR(TM)............  A patented class (Patent Numbers 4,689,349;
                               4,731,458) of synthetic compounds which
                               structures were derived being intermediate
                               synthetic products of the X-Andron Series. The
                               Company believes, based upon preliminary and
                               limited testing to date, that Metcyclor compounds
                               have possible beneficial effects in the treatment
                               of several forms of cancer, specifically, renal,
                               breast, ovarian and prostate cancer.

18. NDA (New Drug 
    Application).............  Before a new drug can be commercially marketed in
                               the United States, or imported or exported, the
                               manufacturer must obtain FDA market approval by
                               filing an NDA. In general, an NDA will include a
                               summary of the components of the IND application,
                               a clinical data section reviewing the studies
                               from Phases I through III, and the proposed
                               description of the benefits, risks and uses of
                               the drug.

19. NON-STEROIDAL............  A chemical compound that is neither a steroid in
                               structure nor a derivative (second generation)
                               steroid.

20. NON-TOXIC................  Non-poisonous chemical structures shown not to
                               cause side effects which would be interpreted by
                               scientists or physicians to be harmful to a
                               living organism.

21. STEROID..................  A large family of chemical compounds which
                               interact with and affect the hormone system,
                               often resulting in adverse side effects when
                               taken into the body and thereby changing the
                               body's normal steroid production and plasma
                               levels.

22. SYNTHETIC................  Artificial structures produced by chemists made
                               with chemical starting materials in the
                               laboratory as contrasted with natural and/or
                               biochemical structures which are chemical
                               structures derived from, or extracted from,
                               living organisms. (i.e., plants, fungi, animals).

23. SYSTEMIC.................  Affecting the body generally, as distinguished
                               from local (topical) affect or application.

24. TARGET TISSUE COMPOUND...  A compound that acts only at certain sites of
                               application.

25. THERAPEUTIC..............  Relating to the treatment of disease or disorder
                               by remedial agents or methods.

26. TOPICAL..................  Local or designed for local application to the
                               surface structures of the body (i.e., skin, hair,
                               nails).

27. X-ANDRON SERIES..........  The numerous chemical synthetic structures
                               referred to in the Company's various sublicensed
                               and issued United States Patent Numbers
                               4,689,345; 4,855,322.

                                      13
<PAGE>
 
ITEM 2.  PROPERTIES
-------  ----------

     The Company leases an aggregate of approximately 39,600 square feet of
office and warehouse space in Los Angeles, California pursuant to a three year
lease expiring in May 1998.  The aggregate monthly rent for these premises is
approximately $25,000.

     The Company leases research and production laboratory facilities in a
government technology center in Kaiserslautern, Germany through December 31,
1997, at a monthly rent of approximately $7,500, with annual options to renew
thereafter.

     The Company believes that its current facilities are adequate to meet its
needs for the immediate future.  If the Company's operations were to expand, the
Company may require additional office and warehouse facilities.
 
ITEM 3.  LEGAL PROCEEDINGS
-------  -----------------

     The Company and Chantal Burnison are defendants in an action titled
Marksman Partners, L.P., on behalf of itself and all others similarly situated
------------------------------------------------------------------------------
vs Chantal Pharmaceutical Corporation and Chantal Burnison, filed on February 7,
----------------------------------------------------------                      
1996 in the United States District Court, Central District of California,
Western Division, Case No. 96-0872.  This action is a securities class action on
behalf of all persons who purchased or otherwise acquired the common stock of
the Company between July 10, 1995 and January 5, 1996, inclusive.

     The Marksman Partners action is based on a contention that the Company's
         -----------------                                                   
accounting for sales revenue, because of the nature of its distribution
agreement with Stanson Marketing, Inc. overstated its revenues for fiscal (June
30) 1995 and for the September 30, 1995 quarter ($3 million and $10 million,
respectively), which , the action claims, violated generally accepted accounting
principles and the Federal securities laws.  The complaint notes that Chantal
Burnison sold 300,000 shares during the class period (the sales were actually
made by CBD Pharmaceutical Corporation from approximate holdings of 1.3 million
shares.  Sales were made after consultation with the Company's legal counsel.)
The complaint appears to rely on details of the contractual relationship with
the distributor to contend that the revenues should not have been booked by the
Company based on shipped orders from the distributor, since among other reasons,
plaintiffs allege that Stanson, during the relevant time period, had the right
to require the Company to purchase Stanson on a formula dependent on its income
from the Company's products' sales, and the Company did not have a substantial
history of selling through the distributor and the distribution system.  The
action seeks monetary damages in an unspecified amount.  An amount sought on
the basis stated in the complaint would be substantially in excess of the
Company's current net worth.

     The Company believes its financial reports were correctly presented under
generally accepted accounting principles. A motion to dismiss the Marksman
                                                                  --------
Partners action was denied, and pre-trial discovery in the Marksman Partners
--------                                                   -----------------
action has commenced.  The Company plans to vigorously defend itself against the
claims asserted in the litigation.

     In addition, a derivative action based on many of the same contentions as
made in Marksman has been filed against the Company and Chantal Burnison.  The
action, entitled Baruch Singer and Dorothea E. Wakefield vs. Chantal Burnison,
                 -------------------------------------------------------------
defendant, and Chantal Pharmaceutical Corporation, nominal defendant, was filed
--------------------------------------------------------------------           
in the Superior Court of the State of California, the County of Los Angeles,
case No. BC 147327.  In June 1997, the plaintiffs amended the complaint to
assert a claim against the Company's former auditors, Coopers & Lybrand LLP, for
negligence and professional malpractice arising out of Coopers & Lybrand's audit
of the Company's fiscal year 1995 financial statements which are the subject of
both the Marksman and Singer actions. Coopers & Lybrand's motion to dismiss the
         --------     ------
case was denied.

     The Company has been a defendant in a lawsuit entitled Amado Institute,
                                                            ----------------
Inc., an Arizona Corporation, Plaintiff, vs. Chantal Pharmaceutical 
-------------------------------------------------------------------
Corporation, Defendants, U.S. Federal District Court, No. CIV 96-154-TUC-RMB, in
-----------------------
a dispute concerning the Company's rescission of an Arizona land transaction.
The Company, in September 1997, won its motion for summary judgment against the
Plaintiff on all counts in the case. Although an appeal is possible by the
Plaintiff, negotiations are in progress to obtain a waiver of the appeal.
                                       
                                      14
<PAGE>
 
     In October, 1996, the Company completed the sale of $5.25 million principal
amount of 8% convertible debentures due December 31, 1998.  The debentures were
sold to investors qualifying as "non U.S. persons" in an offering completed
under Regulation S.  The debentures were convertible into shares of common stock
of the Company as to one-third of the principal amount of each debenture after
forty-five (45) days from the date of issuance, an additional one-third after
seventy-five (75) days from the date of issuance and the balance after ninety
(90) days from the date of issuance.  The conversion price is the lesser of
$3.91 or 80% of the average closing bid price of the Company's common stock for
the five business days immediately preceding the conversion date.  The Company,
in accordance with the terms of the debentures, notified those debenture holders
exercising their conversion option for the first one-third of their debentures,
that the Company intended to exercise its rights under the debenture to pay cash
in lieu of such conversion and notified all debenture holders that it intended
to also redeem the balance of the debentures for a negotiated purchase price.
Such redemption was not completed.  Were all the debentures converted as of the
earliest date in accordance with the terms, the Company would have been required
to issue approximately 3.5 million shares of common stock. Such number is in
excess of the number of authorized but unissued shares available prior to the
amendment of this Company's Certificate of Incorporation on July 18, 1997
following the Annual Meeting of Stockholders increasing the number of authorized
shares of common stock to 50 million.  Were the debentures converted at August
31, 1997, approximately 7.6 million shares would have been issuable based on the
five day average price of approximately $.86 for the five trading days ended on
that date.  The Company is attempting to negotiate toward settlement of subject
1996 Regulation S offering.

     Three actions involving six investors have been commenced against
the Company relating to this offering. Two of these actions which were
consolidated were brought in Delaware - FT Trading v. Chantal Pharmaceutical
                                        ------------------------------------
Corporation, Court of Chancery of the State of Delaware in and for New castle
-----------
County, C.A. No. 15628-NC and Arbinter Omnivalor S.A. v. Chantal Pharmaceutical
                              -------------------------------------------------
Corporation, Court of Chancery of the State of Delaware in and for New Castle,
-----------
C.A. No. 15788-NC -and one was brought in California - UFH Endowment Ltd. 
                                                       ------------------
Ephram-Saghi and Ben Z. Katz v. Chantal Pharmaceutical Corporation and Chantal
------------------------------------------------------------------------------
Burnison, United States District Court, Central District of California, Western
--------
Division, Case No. CV 97-3118LGB (AJW). In each of the actions, the plaintiffs
have sought to have all or a portion of their debentures converted and to
recover damages and attorneys fees as set forth in the debentures.

     On September 9, 1997, FT Trading and Arbinter Omnivalor were granted
partial summary judgement on the claims against the Company.  Pursuant to the
Court's Order entered September 17, 1997, the Company is required to issue to FT
Trading, 48,484 shares of common stock relating to its conversion notice with
respect to one-third of its debenture and to honor the immediate conversion of
the remaining two-thirds, and to pay FT Trading an aggregate of $181,615 for
unpaid interest and damages, and to also reimburse FT Trading for costs and
expenses, including legal fees, relating to the action. The Company has not
yet issued the shares and has not paid the interest and damages in accordance
with the Court Order. 

     Pursuant to the Court Order, the Company is required to issue to Arbinter
Omnivalor 242,424 shares of Common Stock relating to its initial conversion
notice with respect to one-third of each of its two debentures and to honor
future conversions, and to pay Arbinter Omnivalor an aggregate of $396,741 for
unpaid interest and damages, and to also reimburse Arbinter Omnivalor for costs
and expenses, including legal fees relating to this action. The Company, in
compliance with in progress settlement negotiations with Arbinter Omnivalor, has
issued the shares but has not paid the interest and damages in accordance with
the Court Orders. The Company, working with a consultant, is attempting to
negotiate a final settlement with the investors of subject Court Order.
 
     In the UFH Endowment, Ltd., Ephram-Saghi and Ben Z. Katz case, the
plaintiffs, alleged that the defendants violated federal and state law in
connection with the debentures. Plaintiff UFH alleges that it purchased
debentures for $750,000, while plaintiffs Saghi alleges that he purchased
debentures for $100,000, and plaintiff Katz alleges that he purchased debentures
for $50,000. In September 1997, all parties to the UFH matter reached an
                                                   ---
agreement for settlement and resolution of the litigation. An executed
Stipulation for Dismissal with prejudice was filed with the Court in exchange
for the Company issuing shares of the Company's common stock to the plaintiffs
as consideration for the conversion of the plaintiff's debentures and the
simultaneous termination thereof.
 
     With respect to each of the foregoing actions, the likelihood of an
unfavorable outcome and range of possible loss, if any, cannot be determined and
accordingly no amounts are accrued for them at June 30, 1997, with the exception
of FT Trading and Arbinter Omnivalor which have been accrued for at June 30,
1997.

                                       15
<PAGE>
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
-------  ---------------------------------------------------

     None.

                                       16
<PAGE>
 
                                    PART II
                                    -------

ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
------   -----------------------------------------------------------------
         MATTERS
         -------

     The Company's Common Stock, par value $.01 per share, is traded in the
over-the-counter market and is quoted in the automated quotation system of the
National Association of Securities Dealers, Inc. (NASDAQ) under the symbol CHTL.

     The following table sets forth for the periods indicated, the high and low
respective bid prices for the Company's Common Stock as reported by NASDAQ.
These quotations reflect inter-dealer prices without retail mark-up, mark-down
or commissions and may not necessarily represent actual transactions.

<TABLE>
<CAPTION>
 
                                       HIGH        LOW
                                     ---------   --------
<S>                                  <C>         <C>
FISCAL YEAR ENDED JUNE 30, 1996
 
  First Quarter...................      12 1/4     5 3/4
  Second Quarter..................      28 1/8     9
  Third Quarter...................      27 1/4     5
  Fourth Quarter..................       9 3/4     4 3/4
 
FISCAL YEAR ENDED JUNE 30, 1997
 
  First Quarter...................       6 13/16   2 1/8
  Second Quarter..................       5  5/16   1 7/16
  Third Quarter...................       2  3/8     15/16
  Fourth Quarter..................       2  5/32    23/32
</TABLE>

     As of  September 19, 1997  there were 767 holders of record of the
Company's Common Stock.

     No cash dividends have been paid with respect to any of the shares of the
Company's Common Stock since its inception.  The Company presently does not
intend to pay any dividends in the foreseeable future and intends to retain all
earnings, if any, for use in its business operations.

                                       17
<PAGE>
 
ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA
-------                                      

The following selected financial data should be read in conjunction with
Management's Discussion and Analysis of Financial Condition and Results of
Operations included as Item 7 and the audited financial statements included in
Item 8 of this Annual Report on Form 10-K.
 
Consolidated Statements of Operations Data:
<TABLE> 
<CAPTION> 
 
                                                                         Year Ended June 30,
                                                                         ------------------
                                               1997            1996            1995           1994(1)         1993         
                                           ------------    ------------     -----------    -----------      ----------     
<S>                                        <C>             <C>             <C>            <C>            <C>               
Revenues:                                                                                                                  
   Product sales, net                      $  6,560,122    $ 13,053,353     $ 7,094,115    $    89,996      $    5,805     
   License fees and                                                                                                        
      other income                              102,619          95,456         120,823         75,081       1,052,009     
                                           ------------    ------------     -----------    -----------      ----------     
Total revenues                                6,662,741      13,148,809       7,214,938        165,077       1,057,814     
                                           ------------    ------------     -----------    -----------      ----------     
Cost and expenses:                                                                                                         
  Cost of goods sold                          2,343,994       3,803,144       1,497,489         38,499           1,138     
  Marketing and other expenses                                                                                             
    related to cosmetic line                  6,711,801      12,528,263       2,075,061        191,365           3,460     
  General and administrative                  5,600,218       7,434,737       1,965,915        433,863         456,814     
  Amortization of license rights  and                                                                                      
   prepaid royalties                            918,892         918,892         334,996              -               -     
  Writedown of license rights                   563,735               -               -              -               -     
  Research and development                      161,668       1,032,037         638,701      1,277,991       1,421,111     
                                           ------------    ------------     -----------    -----------      ----------     
    Total costs and expenses                 16,300,308      25,717,073       6,512,162      1,941,718       1,882,523     
                                           ------------    ------------     -----------    -----------      ----------     
Income(loss) from operations                 (9,637,567)    (12,568,264)        702,776     (1,776,641)       (824,709)    
                                           ============    ============     ===========    ===========      ==========     
Net income(loss)                           $(10,571,462)   $(12,012,816)    $   406,139    $(1,795,999)       (900,612)    
                                           ============    ============     ===========    ===========      ==========     
Net income(loss) per common share          $       (.58)   $       (.67)    $       .03    $      (.19)     $     (.10)    
                                           ============    ============     ===========    ===========      ==========     
Weighted average shares outstanding          18,190,516      17,817,183      13,375,934      9,429,516       9,001,449     
                                           ============    ============     ===========    ===========      ==========     
 
Consolidated Balance Sheet Data:
<CAPTION> 
                                                                              June 30,
                                                                              --------
                                               1997            1996            1995           1994            1993       
                                           ------------    ------------     -----------    -----------      ----------   
<S>                                       <C>             <C>              <C>            <C>             <C>            
Total assets                               $ 14,952,265    $ 18,745,373     $19,114,137    $ 5,742,137      $2,051,784   
                                                                                                                         
Working capital (deficiency)                 (4,578,196)      1,710,437       7,019,824        273,848          13,219   
                                                                                                                         
Long-term capital lease obligation less                                                                                  
 current portion                                289,014         384,882         489,313        466,727         506,180   
                                                                                                                         
Convertible debentures (3)                    5,250,000               -               -              -               -

Stockholders' equity (deficit)             $   (154,763)   $  9,371,699     $14,401,395    $   698,555      $1,083,508    
-----------------------------
</TABLE>

(1) Includes the results of Chantal Skin Care from March 15, 1994, the date of
    acquisition.

(2) No dividends have been paid for the above five year period.

(3) On September 25 and 26, 1997, the Company issued an aggregate of 2,930,327
    shares of its Common Stock upon conversion of $1,893,333 principal amount,
    an average of $.65 per share, of its 8% convertible debentures (See Note 2).
    Had such conversion been affected at June 30, 1997, the Company would have
    had Stockholder's Equity on a proforma basis of $1,738,570. The proforma
    column appearing on the consolidated balance sheet gives effect at June 30,
    1997 to the referenced conversion.

                                       18
<PAGE>
 
ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS
-------    ------------------------------------
           OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
           ------------------------------------------------

     The discussion in this item contains Statements that may be considered 
forward looking statements. See Special Note Regarding Forward Looking 
Statements at the begining of this Annual Report on Form 10-K.

RESULTS OF OPERATIONS
---------------------

     There are several key considerations which impact the Company's financial
statements for the years ended June 30, 1996 and 1997 and their comparability to
the financial statements for the prior years.

     The Company believes that purchases by retailers during fiscal 1997 were
negatively impacted by activities and negative publicity spread about the
Company by a group of shareholders who in June 1997 filed a Schedule 13D
indicating their dissatisfaction with management of the Company. The Company
immediately following the filing of the 13D filed a lawsuit against the
signatories alleging among other things that certain of the defendants
participated in a plan to disseminate false information concerning the Company
in an effort to drive down the price of its stock both to profit therefrom and
to facilitate the group's takeover of the Company. The Company further alleged
that the widespread confusion and uncertainty created by the defendants' conduct
was causing and would continue to cause serious dislocation in the operations of
the Company's business and the market for its securities, as well as uncertainty
among its customers, employees, distributors and other business relationships.
All but one of the signatories have settled the lawsuit and agreed to support
management at the shareholders meeting held on July 17, 1997.

     The year ended June 30, 1996 was the Company's retail market launch and
first full year of marketing its Ethocyn-based Chantal Skin Care line of
products, having commenced marketing on a limited basis, primarily through
telemarketing in the year ended June 30, 1995. During fiscal 1996, the Company
significantly expanded its operations and began an extensive U.S. and
international marketing campaign. Substantial expenses associated with the
product launch and expected growth in sales of the Company's products were
incurred, especially in increased personnel and other overhead, including the
Company's new warehouse and office facility, the costs of producing advertising
and promotional material and launching the marketing campaign, and producing the
products to meet anticipated needs. As part of the marketing campaign, during
fiscal 1996, the Company began airing television commercials, launched a
national print advertising campaign, and increased its public relations efforts.

     Much of the Company's expenditures during fiscal 1996 anticipated sales of
the Company's products at levels higher than those actually obtained. Those
expenditures were based upon, among other things, the Company's planned
advertising and committed-to-promotional activities, including scheduled
promotional appearances on national and regional talk shows. As a result of a
January 1996 Barron's article primarily questioning the Company's accounting for
sales to its distributor and the resulting litigation and further negative
publicity reported about the Company, the Company's ability to realize such
promotional appearances was harmed. Sales expected to be generated by such
activity accordingly did not materialize in fiscal 1996 and 1997.

     The Company for the year ended June 30, 1996 underwent a complete review of
its method of recording revenue from sales to its U.S. distributor. In the
fiscal year ended June 30, 1995 and in the first quarter ended September 30,
1995, revenue from product sales to the Company's U.S. distributor, Stanson
Marketing, Inc. ("Stanson") was recognized upon shipment of product to Stanson.
In November, 1995 in accordance with its agreement with Stanson, the Company
directed Stanson to commence shipment on an autoship basis to all possible
customers. The Company, in February 1996, sought the advice of its then
independent accountants as to whether its then existing revenue recognition
policy was in compliance with generally accepted accounting principles with
respect to recognizing second quarter autoship sales to Stanson. In connection
with the filing of its two Quarterly reports on Form 10-Q, for the quarters
ended December 31, 1995 and March 31, 1996, the Company adopted a cash basis
revenue recognition policy with respect to products subject to autoship
distribution, upon the advice of its then independent accountants, which advice
was given recognizing that their view may be different upon completion of their
then-in-progress procedures. The then independent accountants subsequently 
resigned as the Company's independent accountants and advised the Company that 
they would not be advising the Company as to whether the then existing revenue 
recognition policy was in compliance with generally accepted accounting 
principles.

     Revenue is recognized upon shipment to Stanson with respect to products
which were not distributed on an autoship basis, and revenue is recognized with
respect to products distributed on an autoship basis upon sale by Stanson to its
customers. On November 21, 1995, the Company, exercising its June 29, 1995
Distribution Agreement contractual right, notified Stanson that all future sales
of Ethocyn products by Stanson were to be "autoship". Accordingly, the Company
considers all products shipped to Stanson after November 21, 1995 as being
subject to distribution on an autoship basis. This revenue recognition policy
complies with FASB 48 "Revenue Recognition when Right of Return Exists".

Fiscal 1997 compared with Fiscal 1996
-------------------------------------

     Revenues.  Revenues decreased 49% to approximately $6,663,000 for the
     ---------                                                            
fiscal year ended June 30, 1997 from approximately $13,149,000 for the fiscal
year ended June 30, 1996 because of a decline related to volume. Volume declined
as a result, among other things, of a decrease in advertising. Revenues are
primarily comprised of telemarketing sales by the

                                       19
<PAGE>
 
Company, sales by Stanson Marketing, the Company's U.S. and Canadian distributor
and Michilan International, the Company's distributor in China, Hong Kong, Macao
and Taiwan based on the revenue recognition policy discussed above. The decrease
in revenue for fiscal 1997 product sales reflects a reduction of approximately
$3.6 million established as a allowance against accounts receivable from Stanson
that are beyond the agreed upon payment terms and correspond to a portion of the
accounts receivable owed to Stanson by its customers. The Company also
considered recent cash receipts collected in estimating the reserve. However,
the amount the Company ultimately collects could differ materially from the
amount estimated.

     The Company's sales terms, for all sales by its own direct response
telemarketing operators and all its distributors, allow the end-user customer
the right to return the product within 75 days for a full refund of the purchase
price.  Distributors, both U.S. and international, can only return (a) product
which does not meet specifically defined product specification (i.e., product
contamination, broken componentry, etc.) or (b) product returned by the end user
customers within the stated 75 day refund period.  Any provision for sales
returns is included as a reduction of product sales.

     Cost of Goods Sold.  Cost of goods sold as a percentage of revenues from
     -------------------                                                     
product sales during fiscal 1997 was approximately 35% and fiscal 1996 was
approximately 29% of revenues. The cost of Ethocyn-based Chantal Ethocyn-based
products did not change from fiscal 1996 to fiscal 1997. Additional inventory
reserves of approximately $728,000 recorded during fiscal 1997 and sales 
reserves (see Revenues) of approximately $3.6 million negatively effected the
cost of sales as a percentage of revenue. Management established inventory
reserves of approximately one-third of finished goods based on inventory levels
compared to historical sales which except for telemarketing and foreign, were
through the Company's U.S. distributor. Historical, gross profit margins are not
necessarily indicative of future periods.

     Marketing and Other Expenses.  Marketing and other expenses related to
     -----------------------------                                         
cosmetic sales decreased in fiscal 1997 by approximately $5,816,000 or 46% to
approximately $6,712,000 from approximately $12,528,000 for fiscal 1996. These
expenses resulted from the marketing and promoting of the Ethocyn-based skin
care products and decreased from the prior year primarily due to decreased
Ethocyn product advertising media expenditures of approximately $5.0 million and
promotional expenditures as compared to 1996.

     General and Administrative Expenses.  General and administrative expenses
     ------------------------------------                                     
decreased by approximately $1,835,000 or 25% to approximately $5,600,000 for
fiscal 1997 from approximately $7,435,000 for fiscal 1996.  This decrease is
primarily due to a decrease in professional and consulting services of
approximately $1.1 million and a reduction in activities in Germany.   In fiscal
1996 additional professional and consulting services were incurred after an
article in Barron's January 1996 issue.  General & administrative expenses in
fiscal 1997 includes $520,000 for settlement of damages awarded to 8%
convertible debenture holders.   Although the cost of defense of the class
action lawsuit was previously covered by insurance, future expenses, absent
settlement of the class action and derivative lawsuits, are expected to be
incurred beyond insurance coverage.

     Write down of License Rights.   In accordance with a recent independent
     -----------------------------                                          
valuation of the Company's license rights, the license rights have been written
down by $563,735 to reflect the fair value of the asset at June 30, 1997.

     Research and Development Expense.  Research and development expense
     ---------------------------------                                  
decreased by approximately $870,000 or 84% to approximately $162,000 in fiscal
1997 compared with approximately $1,032,000 in fiscal 1996.  Research and
development activities continue to decrease, with the focus by the Company
towards marketing and revenue generation by Chantal Skin Care products.
Research and development expenses primarily represent ongoing stability and
clinical testing of the formulated, consumer targeted Ethocyn-based Chantal skin
care products, continued analysis of data and test results of Cyoctol generated
by the Upjohn Company and Ethocyn scale-up synthesis and isomer resolution
research.

     Interest Expense.  Interest expense increased by approximately $1,303,000
     -----------------                                                        
or 932% to approximately $1,442,000 in fiscal 1997 compared with approximately
$140,000 in fiscal 1996. This is primarily due to the issuance of $5.25 million
of convertible debentures in October 1996. In accordance with an SEC position
taken with respect to debt convertible at a discount to market, the premium
attributable to the discount is to be accounted for as additional interest
expense. Accordingly, the Company has recorded non-cash interest expense of
$1,045,000 to reflect the discount to market of the conversion option in the 8%
convertible debentures due September 30, 1998 and issued in October 1996. The
non-cash interest expense had the effect of increasing the net loss by
$1,045,000 and the net loss per share by $.06.

                                       20
<PAGE>
 
     Income Taxes.  There is no income tax expense for fiscal 1997.  The
     ------------                                                       
deferred tax asset as of June 30, 1997 has a 100% valuation allowance as
management cannot determine if it is more likely than not that the deferred tax
asset will be realized.

Fiscal 1996 compared with Fiscal 1995
-------------------------------------

     Revenues.  Revenues increased 82% to approximately $13,149,000 for the
     --------                                                            
fiscal year ended June 30, 1996 from approximately $7,215,000 for the fiscal
year ended June 30, 1995.  Revenues are primarily comprised of telemarketing
sales by the Company and sales to Stanson Marketing, the Company's  U.S. and
Canadian distributor of Ethocyn-based skin care products based on the revenue
recognition policy discussed above.

     Revenue for 1996 product sales reflects a reduction of approximately $2.0
million for sales returns and allowance. Of this amount, approximately $1.6
million was established as a reserve against accounts receivable at June 30,
1996, including $1.2 million against receivable from Stanson that are beyond the
agreed upon payment terms.

     Cost of Goods Sold. Cost of goods sold as a percentage of revenues from
     ------------------                                                     
product sales during fiscal 1996 was approximately 29% of revenues compared with
21% for fiscal 1995.  The fiscal 1996 cost of goods sold percentage is more than
fiscal 1995 primarily due to the recording of inventory reserves of
approximately $595,000 due to the large quantity of inventory on hand at year
end and an additional provision of approximately $1.2 million recorded as a
reduction to revenue.

     Marketing and Other Expenses.  Marketing and other expenses related to
     ----------------------------                                          
cosmetic sales increased in fiscal 1996 by approximately $10,453,000 or 504% to
approximately $12,528,000 from approximately $2,075,000 in fiscal 1995.  The
increase resulted from the launching, and a full year of marketing and promoting
the sale of Ethocyn based skin care products.  The major expenditures were
approximately $8.2 million of advertising and approximately $2.0 million of
salaries and consulting for fiscal 1996 compared to approximately $400,000 of
advertising and approximately $700,000 of salaries and consulting in fiscal
1995.  The Company expects that although marketing expenses will continue to
increase with further expansion into the international market, such expense as a
percentage of revenues will decrease in time.

     General and Administrative Expenses.  General and administrative expenses
     -----------------------------------
increased by approximately $5,469,000 or 278% to approximately $7,435,000 for
fiscal 1996 from approximately $1,966,000 for fiscal 1995.  The increase in
general and administrative expenses is primarily due to the increase in
personnel with the expansion of operations and an increase in professional
services.

     Research and Development Expenses.  Research and development expenditures
     ---------------------------------                                        
increased by approximately $393,000 or 62% to approximately $1,032,000 in fiscal
1996 as compared with approximately $639,000 in fiscal 1995.  The fiscal 1995
and 1996 research and development represents ongoing clinical testing of Ethocyn
formulation and stability of Ethocyn based Chantal skin care products, continued
analysis of data and test results of Cyoctol generated by a former licensee, and
Ethocyn scale-up synthesis and isomer resolution research.

     Income Taxes.   There is no income tax expense for fiscal 1996 compared to
     ------------
a tax expense of approximately $20,000 in fiscal 1995.   The deferred tax asset
at June 30, 1996 is fully reserved for as management cannot determine if it is
more likely than not that the deferred tax asset will be realized.

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

     The Company used net cash flows from operations of $5,129,120 for the
fiscal year ended June 30, 1997 principally due to the operating loss of
$10,571,462 offset by non-cash interest expense of $1,045,000, depreciation and
amortization of approximately $1,455,000, decreases in accounts receivable of
approximately $1,227,000 and inventory of approximately $1,151,000.

     The Company used net cash flows in operations of approximately $8,375,000
for the fiscal year ended June 30, 1996 principally due to the increase in
inventory of approximately $4,141,000, the net operating loss of approximately
$12,013,000 offset by the increase in accounts payable and accrued expenses of
approximately $5,358,000.  During fiscal 1996, the Company used net cash flows
in investing activities of approximately $805,000 primarily due to the addition
of equipment and leasehold improvements.
 
     During the fiscal year ended June 30, 1997, the Company received
approximately $224,000 in net proceeds from the issuance of short term debt and
notes payable from Stanson Marketing, the Company's U.S. and Canadian
distributor of Ethocyn-based skin care products.  In October, 1996, the Company
completed the sale of $5.25 million principal amount of 8% Convertible

                                       21
<PAGE>
 
Debentures due September 30, 1998.  The Company received net proceeds, after
placement fees and expenses, of $4,882,500 from subject Convertible Debenture
financing.  The debentures were sold to investors qualifying as "non-U.S.
persons" in an offering completed under Regulation S.

     The debentures were convertible into shares of common stock of the Company
as to one-third of the principal amount of each debenture after forty-five (45)
days from the date of issuance, an additional one-third after seventy-five (75)
days from the date of issuance and the balance after ninety (90) days from the
date of issuance.  The conversion price is the lesser of $3.91 or 80% of the
average closing bid price of the Company's common stock for the five business
days immediately preceding the conversion date.  The Company, in accordance with
the terms of the debentures, notified those debenture holders exercising their
conversion option for the first one-third of their debentures, that the Company
intended to exercise its rights under the debenture to pay cash in lieu of such
conversion and notified all debenture holders that it intended to also redeem
the balance of the debentures for a negotiated purchase price.  Such redemption
was not completed.  Were all the debentures converted as of the earliest date in
accordance with the terms, the Company would have been required to issue
approximately 3.5 million shares of common stock, which was in excess of the
number of authorized but unissued shares available prior to the amendment of
this Company's Certificate of Incorporation on July 18, 1997 following the
Annual Meeting of Stockholders increasing the number of authorized shares of
common stock to 50 million.  Were the debentures converted at August 31, 1997,
approximately 7.6 million shares would have been issuable based on the five day
average price of approximately $.86 for the five trading days ended on that
date. The Company is in the process of attempting to negotiate towards
settlement of the 1996 Regulation S Offering, the realization to which there can
be no assurance (For discussion of various actions instituted by some of the
investors in this placement SEC Item 3.)

     In August 1995, pursuant to a private placement under Regulation D of the
Securities Act, the Company sold 1,000,000 shares of common stock and 500,000
shares of Series C Convertible Preferred Stock at $4.90 per share.  The net
proceeds to the Company from such sales, after placement fees, were $6,762,700
and were used for general corporate purposes. The shares of common stock were
registered for sale by investors in a registration statement declared effective
January 5, 1996, subject to the agreement of the investors not to sell pursuant
to such registration statement for 90 days following such effectiveness.  The
registration statement is currently not available for sales by such investors,
pending amendment to reflect current financial information.  Series C Preferred
shares will automatically be converted into shares of Common Stock at the rate
of one (1) share of the Company's Common Stock for each Series C Preferred
share, at the later of (i) the day the Company's Certificate of Incorporation is
amended to increase the number of authorized shares of Common Stock to at least
30,000,000, and (ii) the date a registration statement with respect to the
Common Stock issuable upon such conversion is declared effective by the
Securities and Exchange Commission.  The Series C Preferred shares will also
entitle the holder to dividends and to vote on stockholder matters as if
converted into common shares and will have a liquidation preference of $1.00 per
Series C Preferred share.

     In connection with the ongoing Chantal Skin Care product launch, the
Company has used significant cash flows to increase its inventory in
anticipation of future sales of Ethocyn-based skin care products.  In June 1995
and August 1995, the Company raised an aggregate of $10,302,700 net proceeds:
$3,540,000 from sale of its common stock, and $6,762,700 from sale of a Series C
Convertible Preferred Stock.
 
     On February 24, 1995, the Company announced that it had decided to seek to
acquire the shares of Chantal Skin Care which the Company did not then presently
own.  In furtherance thereof, on March 9, 1995, the Company commenced an
exchange offer seeking to acquire the shares of Chantal Skin Care owned by
shareholders located outside the United States, through the exchange of one (1)
share of Company Common Stock for one share of Chantal Skin Care common stock.
On June 16, 1995, the Company accepted for exchange 1,780,000 shares of Chantal
Skin Care common stock.  Accordingly, the Company now owns 12,690,812 shares of
Chantal Skin Care common stock, or 90% of the outstanding Chantal Skin Care
shares.  The Company presently intends to effect a merger of Chantal Skin Care
with and into a newly formed wholly owned subsidiary of the Company on the same
one share for one share basis as the previously effected exchange with persons
outside the United States.

     The independent certified public accountants have expressed in their
opinion that the Company has suffered recurring losses from operations and a
working capital deficiency that raises substantial doubt about its ability to
continue as a going concern.

     For fiscal 1998, the Company will continue to generate cash through its
telemarketing sales, collection of existing accounts receivable and sales in the
U.S. and foreign markets. Management also plans to continually monitor and make
changes to overhead costs as needed. The Company is also seeking additional
financing to help fund future operations.

     The customer base and distribution outlets have been expanded through the 
recent addition of well known personalities, as Company spokespeople, new 
products and different product pricing.  The Company has reached tentative 
agreement with retail chain operators under which the Company expects its 
product will be distributed into an additional 7,500 locations.  Distribution 
into these new locations is expected to commence as the Company's advertising 
campaign proceeds. Polly Bergen, a director and Chief Operating Officer of the 
Company and a nationally recognized television and Emmy award winning actress is
being featured as the flagship Ethocyn celebrity spokesperson on The Home 
Shopping Network.  The Company is also planning to distribute the Ethocyn-based 
skin care products in department stores, direct response on page and through the
airing of an infomercial which will expand the current distribution channel. If 
and when the marketing agreement with Stanson is terminated or alternatively if
the Company exercises its option to acquire Stanson, then it will directly 
market and distribute the Ethocyn-based skin care products.



                                      22
<PAGE>
 
     In conjunction with the expansion in the retail market, the Company has
begun an advertising campaign which will primarily feature television
advertising with a focus in the geographical regions with the major retail
distribution. These advertisements will feature individuals who used the product
on only one-half of their face in 30 and 60 second spots. The Company is in
negotiations with potential financing which will support this advertising
campaign.

     In the international market, a sublicensing agreement with Michilan
International was reached to distribute the Ethocyn-based skin care products in
China, Hong Kong, Macao and Taiwan. The first shipment under this agreement was
made in December 1996. In addition, the Company in cooperation with its Master
Distributor, is in negotiations for distribution by other potential sublicensees
for other territories in the Pacific Rim. In Europe, the Company is test
marketing for product positioning. The European market launch programs include
television, print and selected direct response in England and physician,
cosmetician directed print and television direct response on the continent.
David Hasselhoff, the executive producer and star of the number one worldwide
"Baywatch" and "Baywatch Nights" television series, is the celebrity
spokesperson for the Company's Ethocyn-based skin care products in the Pacific
Rim and Europe. He will be featured in television and print advertisements as
well as participate in promotional tours and appearances.

     The Company is currently extending its skin care product line with the
addition of the Ethocyn Safe Sun Treatment and plans to include additional sun
care products, super moisterizing night and neck creams and a men's line. The
men's line is planned for initial launch in Europe with an endorsement from
David Hasselhoff.

     The Company believes the collection of existing accounts receivable and
sales in the U.S. and foreign markets (through retail, The Home Shopping
Network, direct response), together with additional funds being negotiated will
enable it to meet its cash requirements through fiscal 1998.  There can be no
assurance that the Company will be successful in securing these additional
funds and generating sufficient cash flows from operations to meet its marketing
and distribution plans.

    In addition, the Company expects to continue to develop certain of its
compounds to pharmaceutical market approvals, both U.S. and foreign.  In this
regard, the Company may be required to obtain additional funds to complete the
research, development and expanded commercialization of such products.  Such
funds are expected to be obtained from one or more of the following sources: (i)
sales of Ethocyn-based cosmetics products  (ii) amounts to be received pursuant
to the Company's license agreements, including royalties from anticipated sales
of Ethocyn-based and Cyoctol-based products; (iii) strategic alliances with
other companies, including joint venture, joint development or license
agreements; and (iv) additional equity or debt offerings.  However, there can be
no assurance that the Company will be successful in obtaining additional funds
from any of the foregoing sources.

     During fiscal 1992, the Company entered into a capital lease to finance the
acquisition of certain improvements and equipment for its laboratory in Germany.
In connection therewith, the Company recorded a $646,000 capital lease
obligation that calls for monthly payments, in German marks, which, at current
exchange rates, approximates $5,800 through December 31, 1997 and a decreasing
balloon payment currently of $332,000 at the end of the lease term which
continues on a yearly basis subject to termination of twelve months notice.  The
Company intends to continue using the laboratory for the foreseeable future and
has not received, nor does it expects to receive a notice of termination from
the lessor.  Accordingly, the balloon payment is classified as a long term
liability.

     The Company, at this time, does not have any material commitments for
capital expenditures.
 
New Accounting Pronouncements
-----------------------------

     The Statement of Financial Accounting Standard Number 128 (SFAS No. 128),
"Earnings Per Share" ("EPS") issued by the Financial Accounting Standards Board
is effective for financial statements issued for the periods ending after
December 15, 1997,including interim periods.  The SFAS No. 128 requires
restatement of all prior period EPS data presented.  The new standard also
requires a reconciliation of the numerator and denominator of the basic EPS
computation to the numerator and denominator of the diluted EPS computation.
The Company does not expect the adoption will have a material effect on its EPS
calculation.

     Statements of Financial Accounting Standards No. 129 "Disclosure of
Information about Capital Structure" (SFAS No. 129) issued by the FASB is
effective for financial statements ending December 15, 1997.  The new standard
reinstates various securities disclosure requirements previously in effect under
Accounting Principles Board Opinion No. 15, which has been superseded by 

                                       23
<PAGE>
 
SFAS No. 128. The Company does not expect adoption of SFAS No. 129 to have a
material effect, if any, on its financial position or results of operations.

     Statements of Financial Accounting Standards No. 130, "reporting
Comprehensive Income" (SFAS No. 130) issued by the FASB is effective for
financial statements with fiscal years beginning after December 15, 1997.
Earlier application is permitted.  SFAS No. 130 establishes standards for
reporting and display of comprehensive income and its components in a full set
of general purpose financial statements.  The Company has not determined the
effect on its financial position or results of operations, if any, from the
adoption of this statement.

     Statements of Financial Accounting Standards No. 131, "Disclosure about
Segments of an Enterprise and Related Information" (SFAS No. 131) issued by the
FASB is effective for financial statements beginning after December 15, 1997.
The new standards requires that public business enterprises report certain
information about operating segments in complete sets of financial statements of
the enterprise and in condensed financial statements of interim periods issued
to shareholders.  It also requires that public business enterprises report
certain information about their products and services, the geographic areas in
which they operate and their major customers.  The Company does not expect
adoption of SFAS No. 131 to have a material effect, if any, on its Results of
Operations.

IMPACT OF INFLATION
-------------------

     To date, the Company has not been significantly affected by inflation.

                                       24
<PAGE>
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
-------  -------------------------------------------
<TABLE>
<CAPTION>

INDEX                                                                                               Page
-----                                                                                               ----
<S>                                                                                                 <C>
Report of Independent Certified Public Accountant............................................         26

Consolidated Balance Sheets at June 30, 1997 and 1996........................................         27

Consolidated Statements of Operations for the years ended June 30, 1997, 1996 and 1995.......         28

Consolidated Statements of Stockholders' Equity (Deficit) for the years ended
  June 30, 1997, 1996 and 1995...............................................................         29

Consolidated Statements of Cash Flows for the years ended June 30, 1997, 1996 and 1995.......         31

Notes to Consolidated Financial Statements...................................................         32

Schedule II  -  Valuation and Qualifying Accounts............................................         58

</TABLE>



                                       25
<PAGE>
 
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANT



To Board of Directors and Stockholders
Chantal Pharmaceutical Corporation

We have audited the accompanying consolidated balance sheets of Chantal
Pharmaceutical Corporation as of June 30, 1997 and 1996, and the related
consolidated statements of operations, stockholders' equity (deficit) and cash
flows for each of the three years ended June 30, 1997.  We have also audited the
schedule listed in the accompanying index.  These consolidated financial
statements and schedule are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these consolidated financial
statements and schedule based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements and
schedule are free of material misstatement.  An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the consolidated
financial statements and schedule.  An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation of the financial
statements and schedule.  We believe our audits provide a reasonable basis for
our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Chantal
Pharmaceutical Corporation as of June 30, 1997 and 1996 and the consolidated
results of its operations and its cash flows for each of the three years ended
June 30, 1997, in conformity with generally accepted accounting principles.

Also, in our opinion, the schedule presents fairly, in all material respects,
the information set forth therein.

The accompanying financial statements and schedule have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 2 to the
consolidated financial statements, the Company has suffered recurring losses
from operations and have a working capital deficiency of $4,578,196 as of June
30, 1997 that raises substantial doubt about its ability to continue as a going
concern. Management's plans in regard to these matters are also described in
Note 2. The financial statements do not include any adjustments that might
result from the outcome of this uncertainty.

BDO SEIDMAN, LLP


Los Angeles, California
September 23, 1997, except for Note 10 and 11 which is as of September 29, 1997.

                                       26
<PAGE>
 
                       CHANTAL PHARMACEUTICAL CORPORATION
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                   Proforma
                                                 June 30,           June 30,     June 30,        
ASSETS                                             1997              1997          1996          
------                                             ----              ----          ----          
<S>                                              <C>              <C>            <C>             
Current assets                                                      (Note 11)                             
Cash and cash equivalents                         $    150,587                     $    305,668  
Short-term investment                                   23,883                           27,926  
Accounts receivable, trade, net of                                                               
 allowance of 5,032,563 and $1,606,908                 796,762                        2,023,911  
Inventory, net of reserve of 988,393                                                             
 and $595,408                                        2,904,723                        6,888,416  
Prepaid expenses and other current assets              203,248                           46,411  
                                                  ------------                     ------------  
  Total current assets                               4,079,203                        9,292,332  
                                                                                                 
Long-term inventory                                  2,832,822                                -  
                                                                                                 
Property and equipment, net of                                                                   
 accumulated depreciation                              783,014                        1,145,924  
                                                                                                 
License rights, net of accumulated                                                               
 amortization of $0 and $1,141,856                   5,800,000                        7,197,689  
Patents and trademarks, net of                                                                   
 accumulated amortization of                                                                     
 $67,194 and $60,298                                    49,920                           56,816  
Prepaid royalties, net of accumulated                                                            
 amortization of                                                                                 
 $196,969 and $112,032                                 652,406                          737,343  
Deposits and other assets                              684,272                          213,251  
Organization costs, net of accumulated                                                           
 amortization of $86,322                                                                         
 and $54,932                                            70,628                          102,018  
                                                  ------------                     ------------  
  TOTAL ASSETS                                    $ 14,952,265                     $ 18,745,373  
                                                  ============                     ============  
                                                                                                 
LIABILITIES AND STOCKHOLDERS' EQUITY                                                             
 (DEFICIT)                                                                                       
----------------------------------------                                                         
Current liabilities                                                                              
Accounts payable                                  $  5,438,600                     $  5,422,239  
Accrued liabilities                                  2,294,013                        1,447,291  
Royalties payable                                      652,668                          652,668  
Current portion of long-term capital                                                             
 lease obligation                                       47,653                           59,697  
Short-term note payable to distributor                 183,000                                -  
Short-term borrowings                                   41,465                                -  
                                                  ------------                     ------------  
 Total current liabilities                           8,657,399                        7,581,895  
                                                                                                 
Long Term Liabilities                                                                            
Capital lease obligations, less current                                                          
 portion                                               289,014                          384,882  
Convertible Debentures                               5,250,000        3,356,667               -  
                                                  ------------     ------------    ------------  
 Total liabilities                                  14,196,413       12,303,080       7,966,777  
Commitments and contingencies                                                                    
Minority interest                                      910,615                        1,406,897  
                                                                                                 
Stockholders' equity (deficit)                                                                   
Preferred stock, $.10 par value;                                                                 
 1,000,000 shares authorized;  500,000                                                           
 Preferred Series C shares issued and                                                            
 outstanding                                            50,000                           50,000  
                                                                                                 
 Liquidation preference of $500,000                                                              
Common stock, $.01 par value;                                                                    
 20,000,000 shares authorized;                                                                   
 18,190,516 shares issued and                                                                    
 outstanding                                           181,905          211,208         181,905  
                                                                                         
                                                                                                 
Additional paid-in capital-preferred                                                             
 stock                                               2,204,000                        2,204,000  
Additional paid-in capital - common                                                              
 stock                                              52,204,860       54,068,890      51,159,860  
Accumulated deficit                                (54,795,528)                     (44,224,066) 
                                                  ------------     ------------    ------------  
 Total stockholders' equity (deficit)                 (154,763)       1,738,590       9,371,699  
                                                  ------------     ------------    ------------  
      TOTAL LIABILITIES AND                                                                      
       STOCKHOLDERS' EQUITY (DEFICIT)             $ 14,952,265     $ 14,952,265    $ 18,745,373  
                                                  ============     ============    ============  
</TABLE>
          See accompanying notes to consolidated financial statements.
                                                                      
                                       27
<PAGE>
 
                      CHANTAL PHARMACEUTICAL CORPORATION

                     CONSOLIDATED STATEMENTS OF OPERATIONS

               For the Years Ended June 30, 1997, 1996 and 1995

<TABLE>
<CAPTION>
                                               1997            1996            1995
                                        ----------------------------------------------
<S>                                        <C>             <C>             <C>
Revenues:
  Product sales, net                       $  6,560,122    $ 13,053,353    $ 7,094,115
  License fees and other income                 102,619          95,456        120,823
                                           ------------    ------------    -----------
     Total revenues                           6,662,741      13,148,809      7,214,938
 
  Cost of goods sold                          2,343,994       3,803,144      1,497,489
                                           ------------    ------------    -----------
Gross profit                                  4,318,747       9,345,665      5,717,449
 
  Marketing and other expenses related to
   cosmetic line                              6,711,801      12,528,263      2,075,061
                                        
  General and administrative                  5,600,218       7,434,737      1,965,915
 
  Amortization of license rights and  
   prepaid royalties                            918,892         918,892        334,996
 
  Write down of license rights                  563,735               -              -
 
  Research and development                      161,668       1,032,037        638,701
                                           ------------    ------------    -----------
 Income (loss) from operations               (9,637,567)    (12,568,264)       702,776
 
Other income (expense):
  Interest income                                12,128          99,051         15,730
  Interest expense                             (397,305)       (139,758)      (111,965)
  Non-cash interest expense on
    convertible debentures                   (1,045,000)
    Other                                             -               -        (24,245)
                                           ------------    ------------    -----------
Income (loss) before income taxes and
      minority interest                     (11,067,744)    (12,608,971)       582,296
 
     Income taxes                                                     -        (20,425)
     Minority interest                          496,282         596,155       (155,732)
                                           ------------    ------------    -----------
Net income (loss)                          $(10,571,462)   $(12,012,816)   $   406,139
                                           ============    ============    ===========
Net income (loss) per share                $       (.58)   $       (.67)   $       .03
                                           ============    ============    ===========
Weighted average shares outstanding          18,190,516      17,817,183     13,375,934
                                           ============    ============    ===========
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       28
<PAGE>
 
                      CHANTAL PHARMACEUTICAL CORPORATION
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
               For the years ended June 30, 1997, 1996 and 1995

<TABLE> 
<CAPTION> 

                                            PREFERRED     COMMON       COMMON                            COMMON                 
                                             SHARES       SHARES       SHARES    PREFERRED    COMMON      STOCK                 
                                             ISSUED       ISSUED     SUBSCRIBED    STOCK       STOCK    SUBSCRIBED              
                                            ----------------------------------------------------------------------              
<S>                                         <C>          <C>         <C>         <C>         <C>        <C>                     
Balances, June 30, 1994                      124,000     10,195,516    160,000    $12,400    $101,955   $ 320,000               
Common shares issued in July                                                                                                    
 1994                                              -        140,000   (140,000)         -       1,400    (280,000)              
                                                                                                                                
Common shares issued in                                                                                                         
 August 1994                                       -         20,000    (20,000)         -         200     (40,000)              
                                                                                                                                
Common shares issued for                                                                                                        
 compound in August 1994                           -         15,000          -          -         150           -               
                                                                                                                                
Preferred shares conversion                                                                                                     
 in August 1994                              (24,000)       120,000          -     (2,400)      1,200           -               
                                                                                                                                
Common shares issued at $.50                                                                                                    
 per share for cash in                                                                                                          
 private placement in August                                                                                                    
 1994                                              -      1,200,000          -          -      12,000           -               
                                                                                                                                
Preferred shares conversion                                                                                                     
 in September 1994                           (60,000)       300,000          -     (6,000)      3,000           -               
                                                                                                                                
Preferred shares conversion                                                                                                     
 in December 1994                            (10,000)        50,000          -     (1,000)        500           -               
                                                                                                                                
Common shares issued at                                                                                                         
 $1.86 per share for cash                                                                                                       
 less expenses of $427,175                                                                                                      
 in private placement in Dec                                                                                                    
 1994                                              -      1,450,000          -          -      14,500           -               
                                                                                                                                
Common shares issued for                                                                                                        
 license rights in China and                                                                                                    
 Hong Kong in January 1995                         -         50,000          -          -         500           -               
                                                                                                                                
Common shares issued for                                                                                                        
 termination of royalty                                                                                                         
 obligation to CBD in Jan                                                                                                       
 1995                                              -        300,000          -          -       3,000           -               
                                                                                                                                
Common shares issued at                                                                                                         
 $3.06 per share for cash                                                                                                       
 less expense of $138,000 in                                                                                                    
 private placement in June                                                                                                      
 1995                                              -      1,200,000          -          -      12,000           -               
<CAPTION> 
                                  PREFERRED      COMMON
                                    STOCK         STOCK
                                  ADDITIONAL    ADDITIONAL
                                   PAID-IN       PAID-IN       ACCUMULATED
                                   CAPITAL       CAPITAL         DEFICIT           TOTAL
                                  ------------------------------------------------------
<S>                               <C>          <C>           <C>               <C>
Balances, June 30, 1994           $ 572,823    $32,308,766    $(32,617,389)     $  698,555
Common shares issued in July      
 1994                                     -        278,600               -               -
                                                
Common shares issued in                         
 August 1994                              -         39,800               -               -
                                                
Common shares issued for                        
 compound in August 1994                  -         22,913               -          23,063
                                                
Preferred shares conversion                     
 in August 1994                     (112,823)      114,023               -               -
                                                
Common shares issued at $.50                    
 per share for cash in                          
 private placement in August                    
 1994                                      -       588,000               -         600,000
                                                
Preferred shares conversion                     
 in September 1994                  (264,000)      267,000               -               -
                                                
Preferred shares conversion                     
 in December 1994                    (49,000)       49,500               -               -
                                                
Common shares issued at                         
 $1.86 per share for cash                       
 less expenses of $427,175                      
 in private placement in Dec                    
 1994                                      -     2,258,325               -       2,272,825
                                                
Common shares issued for                        
 license rights in China and                    
 Hong Kong in January 1995                 -        64,188               -          64,688
                                                
Common shares issued for                        
 termination of royalty                         
 obligation to CBD in Jan                       
 1995                                      -       385,125               -         388,125
                                                
Common shares issued at                         
 $3.06 per share for cash                       
 less expense of $138,000 in                    
 private placement in June                      
 1995                                      -     3,528,000               -       3,540,000
</TABLE> 
         See accompanying notes to consolidated financial statements.

                                      29
<PAGE>
 
                      CHANTAL PHARMACEUTICAL CORPORATION
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
               For the years ended June 30, 1997, 1996 and 1995
                                  (continued)
<TABLE> 
<CAPTION> 
                                                                                                                                
                                                                                COMMON                                          
                                                        PREFERRED    COMMON     SHARES                                          
                                                         SHARES      SHARES       SUB-  PREFERRED                               
                                                         ISSUED      ISSUED     SCRIBED   STOCK                                 
                                                        -----------------------------------------                
<S>                                                     <C>          <C>        <C>     <C>                    
Common shares issued in                                                                                        
exchange for 1,780,000 shares of                                                                               
Chantal Skin Care in June 1995                               -      1,780,000         -         -                    
                                                                                                               
Net income                                                   -              -         -         -              
                                                        ------     ----------      ---- ---------                         
Balances, June 30, 1995                                 30,000     16,820,516         -     3,000                   
                                                                                                               
Common shares issued for                                                                                       
consulting fee in July 1995                                  -         30,000         -         -                       
                                                                                                               
Common shares issued at $4.90                                                                                  
per share for cash less expenses                                                                               
of $391,300 in private                                                                                         
placement in August 1995                                     -      1,000,000         -         -                    
                                                                                                               
Preferred shares issued at $4.90                                                                               
per share for cash less expense                                                                                
of $196,000 in private                                                                                         
placement in August 1995                               500,000              -         -    50,000                         
                                                                                                               
Stock options of 100,000 shares                                                                                
exercised at $1.00 per share                                                                                   
in February 1996                                             -        100,000         -         -                     
                                                                                                               
Preferred shares conversion in                                                                                 
June 1996                                              (30,000)       240,000         -    (3,000)                    
                                                                                                               
Net loss                                                     -              -         -         -              
                                                       -------     ----------      ---- ---------                         
Balance, June 30, 1996                                 500,000     18,190,516         -    50,000                   
                                                                                                               
Non- cash interest expense on                                                                                  
convertible debentures                                       -              -         -         -                         
                                                                                                               
Net loss                                                     -              -         -         -              
                                                       -------     ----------      ---- ---------              
Balance, June 30, 1997                                 500,000     18,190,516         - $  50,000                  
                                                       =======     ==========      ==== =========              
<CAPTION> 
                                                                PREFERRED       COMMON                             
                                                                  STOCK         STOCK                              
                                                       COMMON   ADDITIONAL    ADDITIONAL       ACCUMU-                 
                                             COMMON     STOCK     PAID-IN       PAID-IN         LATED                  
                                              STOCK   SUBSCRIBED  CAPITAL       CAPITAL        DEFICIT        TOTAL       
                                             -------------------------------------------------------------------------    
<S>                                         <C>       <C>        <C>         <C>           <C>             <C> 
Common shares issued in                                                                                                    
exchange for 1,780,000 shares of                                                                                           
Chantal Skin Care in June 1995               17,800           -         -      6,390,200              -      6,408,000     
                                                                                                                           
Net income                                        -           -         -              -        406,139        406,139     
                                           --------        ---- ----------   -----------   ------------   ------------
Balances, June 30, 1995                     168,205           -    147,000    46,294,440    (32,211,250)    14,401,395     
                                                                                                                           
Common shares issued for                                                                                                   
consulting fee in July 1995                     300           -          -       120,120              -        120,420     
                                                                                                                           
Common shares issued at $4.90                                                                                              
per share for cash less expenses                                                                                           
of $391,300 in private                                                                                                      
placement in August 1995                     10,000           -          -     4,498,700              -      4,508,700     
                                  
Preferred shares issued at $4.90  
per share for cash less expense   
of $196,000 in private            
placement in August 1995                          -           -  2,204,000             -              -      2,254,000     
                                  
Stock options of 100,000 shares   
exercised at $1.00 per share      
in February 1996                              1,000           -          -        99,000              -        100,000     
                                  
Preferred shares conversion in    
June 1996                                     2,400           -   (147,000)      147,600              -              -     
                                  
Net loss                                          -           -          -             -    (12,012,816)   (12,012,816)    
                                           --------        ---- ----------   -----------   ------------   ------------
Balance, June 30, 1996                      181,905           -  2,204,000    51,159,860    (44,224,066)     9,371,699     
                                  
Non- cash interest expense on     
convertible debentures                            -           -          -     1,045,000              -      1,045,000     
                                  
Net loss                                          -           -          -             -    (10,571,462)   (10,571,462)    
                                           --------        ---- ----------   -----------   ------------   ------------
Balance, June 30, 1997                     $181,905           - $2,204,000   $52,204,860   $(54,795,528)  $   (154,763)     
                                           ========        ==== ==========   ===========   ============   ============
</TABLE> 

         See accompanying notes to consolidated financial statements.

                                       30



<PAGE>
 
                      CHANTAL PHARMACEUTICAL CORPORATION
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
               For the Years ended June 30, 1997, 1996 and 1995
<TABLE> 
<CAPTION>  
                                                                           
                                                          1997            1996           1995        
                                                          ----            ----           ----        
<S>                                                   <C>             <C>             <C>            
Increase (decrease) in cash and cash
  equivalents                                                                                                     

Cash flows from operating activities:                                                                

Net (loss) income                                     $(10,571,462)   $(12,012,816)   $   406,139    
Adjustments to reconcile net income                                                                  
 (loss) to net cash used in operating                                                                
 activities:                                                                                         
      Write down of license rights                         563,735               -              -    
      Inventory reserve                                    392,985         595,408              -    
      Depreciation and amortization                      1,455,331       1,286,781        621,873    
      Allowance for sales returns                        3,425,655       1,516,692         90,216    
      Minority interest                                   (496,282)       (386,155)       155,732    
      Loss on disposition of assets                         36,667               -         24,245    
      Common stock issued in satisfaction of                                                           
        consulting and legal fees                                -         120,420              -      
      Non-cash interest expense on                       1,045,000               -              -    
       convertible debentures                                                                        
      Changes in operating assets and                                                                
       liabilities:                                                                                  
         Accounts receivable and other                  (2,198,506)       (566,732)    (2,974,051)   
         Inventory                                         757,886      (4,736,774)    (1,830,527)   
         Prepaid expenses                                 (156,837)        307,685       (281,564)   
         Other assets                                     (246,375)        161,389       (197,712)   
         Income taxes payable                                    -         (18,500)        17,225    
         Accounts payable and accrued liabilities          863,083       5,357,629        344,345    
                                                       -----------     -----------    -----------    
Net cash used in operating activities                   (5,129,120)     (8,374,973)    (3,624,079)   
                                                       -----------     -----------    -----------    
Cash flows from investing activities:                                                                
  Sale (purchase) of short-term                                  -          72,074       (100,000)   
   certificate of deposit                                                                            
  Additions to property and equipment                      (25,014)       (876,950)      (315,669)   
                                                       -----------     -----------    -----------    
Net cash provided used in investing activities             (25,014)       (804,876)      (415,669)   
                                                       -----------     -----------    -----------    
Cash flows from financing activities:                                                                
  Proceeds from issuance of short-term                                                               
   debt/notes payable from distributor                   1,174,726               -         51,490    
  Payments on short-term debt/notes                                                                  
   payable to distributor                                 (950,261)        (94,332)             -    
  Payments on capital lease obligation                    (107,912)       (107,494)       (57,353)   
  Proceeds from issuance of convertible           
   debentures                                            4,882,500               -              -    
  Proceeds from issuance of common stock                         -       4,608,700      6,732,825    
  Proceeds from issuance of preferred stock                      -       2,254,000              -    
                                                       -----------     -----------    -----------    
Net cash provided by financing activities                4,999,053       6,660,874      6,726,962    
                                                       -----------     -----------    -----------    
Net increase (decrease) in cash and                                                                  
  cash equivalents                                        (155,081)     (2,518,975)     2,687,214    
Cash and cash equivalents:                                                                           
  At beginning of period                                   305,668       2,824,644        137,430    
                                                       -----------     -----------    -----------    
  At end of period                                     $   150,587     $   305,668    $ 2,824,644    
                                                       ===========     ===========    ===========     
</TABLE>

          See accompanying notes to consolidated financial statements.

                                       31
<PAGE>
 
                       CHANTAL PHARMACEUTICAL CORPORATION


                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1.   Organization and development activities
     ---------------------------------------

     Chantal Pharmaceutical Corporation and its subsidiaries is primarily
     engaged in the research, development and marketing of innovative compounds
     for use as dermatological and skin care consumer products.  The Company's
     current strategy is to focus initially through the marketing of its novel
     Ethocyn cosmetic ingredient on becoming an integrated cosmetic and skin
     care company.  Ethocyn, one of three principal patented compounds for which
     the Company has exclusive manufacturing and distribution rights, is
     presently being marketed by the Company as a unique cosmetic product which
     improves the appearance of skin aging.  The Company operates in one
     industry segment, the development and marketing of cosmetic and skin care
     products.  The Company's products are currently being sold in pharmacies,
     chain drug stores and dermatologists offices across the United States and
     Canada and through a licensing agreement with Michilan in Taiwan.


     Prior to October 1, 1994, the Company was considered to be in the
     development stage as defined by Statement of Financial Accounting Standards
     No. 7, "Accounting and Reporting By Development Stage Enterprises" ("SFAS
     No. 7"). Due to the launch of the Company's Ethocyn-based cosmetic line
     during the first quarter of fiscal year 1995, the Company began realizing
     revenues associated with its planned principal operations. Accordingly,
     beginning October 1, 1994, the Company emerged from the development stage
     and began amortizing license rights and organization costs which were
     previously unamortized in accordance with SFAS No. 7.

2    Significant accounting policies
     -------------------------------

     Principles of consolidation
     ---------------------------

     The consolidated financial statements include the accounts of the Company,
     its wholly-owned subsidiaries and its 90% owned subsidiary, Chantal Skin
     Care Corporation ("Chantal Skin Care").  All significant intercompany
     accounts and transactions have been eliminated.

     Basis of presentation
     ---------------------

     The financial statements have been prepared on a going concern basis which
     contemplates the realization of assets and the settlement of liabilities
     and commitments in the normal course of business. The Company has suffered
     recurring losses from operations and a working capital deficiency of
     $4,578,196 at June 30, 1997 which raises substantial doubt about the
     Company's ability to continue as a going concern. The financial statements
     do not include any adjustments that might result from the outcome of this
     uncertainty.

     For fiscal 1998, the Company will continue to generate cash through its
     telemarketing sales, collection of existing accounts receivable and sales
     in the U.S. and foreign markets. Management also plans to continually
     monitor and make changes to overhead costs as needed. The Company is also
     seeking additional financing to help fund future operations.

     The customer base and distribution outlets have been expanded through the
     recent addition of well known personalities, as company spokespeople, new
     products and different product pricing. The Company has reached tentative
     agreement with retail chain operators under which the Company expects its
     product will be distributed into an additional 7,500 locations.
     Distribution into these new locations is expected to commence as the
     Company's advertising campaign proceeds. Polly Bergen, a director and Chief
     Operating Officer of the Company and a nationally recognized television and
     Emmy award winning actress is being featured as the flagship Ethocyn
     celebrity spokesperson on The Home Shopping Network. The Company is also
     planning to distribute the Ethocyn-based skin care products in department
     stores, direct response on page and through the airing of an infomercial
     which will expand the current distribution channel. If and when the
     marketing agreement with Stanson is terminated or alternatively if the
     Company exercises its option to acquire Stanson, then it will directly
     market and distribute the Ethocyn-based skin care products.
     
     
                                       32
<PAGE>
 
     In conjunction with the expansion in the retail market, the Company has
     begun an advertising campaign which will primarily feature television
     advertising with a focus in the geographical regions with the major retail
     distribution.  These advertisments will feature individuals who used the
     product on only one-half of their face in 30 and 60 second spots.  The
     Company is in negotiations with potential financing which will support this
     advertising campaign.

     In the international market, a sublicensing agreement with Michilan
     International was reached to distribute the Ethocyn-based skin care
     products in China, Hong Kong, Macao and Taiwan. The first shipment under
     this agreement was made in December 1996. In addition, the Company, in
     cooperation with its Master Distributor, is in negotiations for
     distribution by other potential sublicenses for other territories in the
     Pacific Rim.  In Europe, the Company is test marketing for product market
     positioning.  The European market launch programs include television, print
     and selected direct response in England and physician, cosmetician directed
     print and television direct response on the continent.  David Hasselhoff,
     the executive producer and star of the number one worldwide "Baywatch" and
     "Baywatch Nights" television series, is the celebrity spokesperson for the
     Company's Ethocyn-based skin care products in the Pacific Rim and Europe.
     He will be featured in television and print advertisements as well as
     participate in promotional tours and appearances.

     The Company is currently extending its skin care product line with the
     addition of the Ethocyn Safe Sun Treatment and plans to include additional
     sun care products, super moisterizing night and neck creams and a men's
     line.  The men's line is planned for initial launch in Europe with an
     endorsement from David Hasselhoff.

     The Company believes the collection of existing accounts receivable and
     sales in the U.S. and foreign markets (through retail, The Home Shopping
     Network, direct response), together with additional funds being negotiated
     will enable it to meet its cash requirements through fiscal 1998. There can
     be no assurance that the Company will be successful in securing these
     additional funds and generating sufficient cash flows from operations to
     meet its marketing and distribution plans.

     Revenue Recognition
     -------------------

     The Company's sales terms, for all sales by its own direct response
     telemarketing operators and all its distributors, allow the end-user
     customer the right to return the product within 75 days for a full refund
     of the purchase price. Distributors, both U.S. and international, can only
     return (a) product which does not meet specifically defined product
     specification (i.e., product contamination, broken componentry, etc.) or
     (b) product returned within the 75 days from purchase by the end user
     customers. A provision for sales returns is included as a reduction of
     product sales.

     The Company, for the year ended June 30, 1996, underwent a complete review
     of its method of recording revenue from sales to its U.S. distributor.  In
     the fiscal year ended June 30, 1995 and in the first quarter ended
     September 30, 1995, revenue from product sales to the Company's U.S.
     distributor, Stanson Marketing, Inc. ("Stanson") was recognized upon
     shipment of product to Stanson.  In November 1995, in accordance with its
     agreement with Stanson, the Company directed Stanson to commence shipment
     on an autoship basis to all possible customers.  The Company, in February
     1996, sought the advice of its then independent accountants as to whether
     its then existing revenue recognition policy was in compliance with
     generally accepted accounting principles with respect to recognizing second
     quarter  autoship sales to Stanson.  In connection with the filing of its
     Quarterly reports on Form 10-Q for the quarters ended December 31, 1995 and
     March 31, 1996, the Company adopted a cash basis revenue recognition policy
     with respect to products subject to autoship distribution, upon the advice
     of its then independent accountants, which advice was given recognizing
     that their view may be different upon completion of their then in progress
     procedures.  The then independent accountants subsequently resigned as the
     Company's independent accountants and advised the Company that they would
     not be advising the Company as to whether the then existing revenue
     recognition policy was in compliance with generally accepted accounting
     principles.

                                       33
<PAGE>
 
     Revenue is recognized upon shipment to Stanson with respect to products
     which were not distributed on an autoship basis, and revenue is recognized
     with respect to products distributed on an autoship basis upon sale by
     Stanson to its customers. On November 21, 1995, the Company, exercising its
     June 29, 1995 Distribution Agreement contractual right, notified Stanson
     that all future sales of Ethocyn products by Stanson were to be "autoship".
     Accordingly, the Company considers all products shipped to Stanson after
     November 21, 1995 as being subject to distribution on an autoship basis.
     This revenue recognition policy complies with FASB 48 "Revenue Recognition
     when Right of Return Exists".


     At June 30, 1997, the Company has an allowance of approximately $3.6
     million against accounts receivable. This allowance were established as a
     reserve against accounts receivable from Stanson that are beyond the agreed
     upon payment terms and correspond to a portion of the accounts receivable
     owed to Stanson by its customers. The Company also considered recent cash
     receipts collection in estimating the allowance. The amount the Company
     could ultimately realize could differ materially from the amount estimated
     at arriving at the reserves.

     Inventory
     ---------

     Inventory is stated at the lower of cost (first-in, first-out) or market.
     Inventory consisted of the following:

<TABLE>
<CAPTION>
                                    June 30,      June 30,
                                      1997          1996
                                ---------------------------
 
<S>                                <C>           <C>
Finished goods                     $2,965,178    $4,067,510
Compound                                    -       855,761
Work in progress                      844,796     1,380,017
Raw materials and componentry          83,142     1,180,536
                                   ----------    ----------
                                    3,893,116     7,483,824
Inventory reserve                    (988,393)     (595,408)
                                   ----------    ----------
                                   $2,904,723    $6,888,416
                                   ==========    ==========
</TABLE>

     Included in inventory are products held by the Company's U.S. distributor
     which in accordance with the revenue recognition policy discussed above are
     not being recognized as revenue for accounting purposes.

     At June 30, 1997 the inventory balance of approximately $2.9 million
     includes an inventory reserve of approximately $988,000. Management
     estimates reserves based on the relationship of inventory levels to
     historical and known future sales. The amount the Company could ultimately
     realize could differ materially from the amount estimated at arriving at
     the reserves.

     Long-term inventory
     -------------------

     Long-term inventory is stated at the lower of cost (first-in, first-out) or
     market. Long-term inventory is comprised of the Ethocyn compound of
     approximately $1.6 million and componentry of approximately $1.3 million.
     Long-term inventory may not be sold within one year, since the finished
     goods on hand is estimated to support Company sales in the near future.

     Property and equipment
     ----------------------

     Property and equipment is stated at cost and depreciated on the straight-
     line method over the assets' estimated useful lives ranging from three to
     ten years. Leasehold improvements are amortized over the shorter of the
     asset's life or remaining lease term. Depreciation and amortization expense
     related to property and equipment for the years ended June 30, 1997, 1996
     and 1995 was $351,259, $320,521 and $246,403, respectively. Maintenance,
     repairs and minor renewals are charged to operations as incurred. Major
     renewals and betterments which substantially extend the useful life of the
     property are capitalized. Upon sale or other disposition of assets, the
     cost and related accumulated depreciation and amortization are removed from
     the accounts and the resulting gain or loss, if any, is reflected in the
     statement of operations.

                                       34
<PAGE>
 
     License rights and prepaid royalties
     ------------------------------------

     License rights from SIG Investment Group Establishment ("SIG") and in
     connection with the acquisition of 1,780,000 common shares of Chantal Skin
     Care Corporation, and prepaid royalties to CBD Pharmaceutical Corporation
     ("CBD"), a related party are recorded at cost. Amortization of such costs
     HAS BEEN provided by use of the straight-line method over ten years, their
     --------
     estimated useful lives. The Company began amortization of license rights
     and prepaid royalties upon the launch of the Ethocyn-based product line in
     fiscal year 1995. Amortization expense for the year ended June 30, 1997 was
     $833,954 and $84,937 for license rights and prepaid royalties,
     respectively. Amortization expense for the year ended June 30, 1996 was
     $833,954 and $84,938 for license rights and prepaid royalties,
     respectively. Amortization expense for the year ended June 30, 1995 was
     $269,580 and $27,094 for license rights and prepaid royalties,
     respectively. If events indicate that identifiable intangible assets may be
     impaired, management evaluates such potential impairment based on future
     undiscounted cash flows. If impairment is deemed to have occurred, an
     impairment loss is recognized for the amount by which the carrying amount
     exceeds the fair value. After an impairment is recognized, the reduced
     carrying amount of the asset shall be accounted for as its new cost which
     shall be depreciated over the assets remaining useful life. Due to the
     lower than expected sales of Ethocyn skin care product after the conclusion
     of its first full year of sales subsequent to its launch, the Company
     engaged an independent valuation firm to determine the fair value of the
     license rights.  In accordance with the recent independent valuation, the
     license rights have been written down by approximately $564,000 to fair
     value at June 30, 1997. The new cost will be depreciated over the assets
     remaining useful life of approximately seven years. The amount the Company
     could ultimately realize could differ materially from the carrying value of
     the assets.

     Patents and trademarks
     ----------------------

     Patent and trademark costs consist primarily of legal costs incurred by the
     Company in its efforts to obtain domestic and foreign patents on its
     products. Patent and trademark costs are amortized on a straight-line basis
     over the life of the related patent or trademark. Amortization expense for
     the years ended June 30, 1997, 1996 and 1995 was $6,896, $6,895 and $6,896,
     respectively.

     Organization costs
     ------------------

     Organization costs represent cost incurred related to the organization of
     Chantal Skin Care Corporation and are amortized on a straight-line method
     over five years. Amortization expense for the years ended June 30, 1997,
     1996 and 1995 was $31,390, $31,389 and $23,543, respectively.

     Short-term notes payable to distributor
     ---------------------------------------

     Short-term notes payable to Stanson Marketing, the Company's U.S. and
     Canadian distributor, represent amounts collateralized by inventory and
     equipment extended to the Company with an interest rate of 8.5% and a
     maturity date of less than one year from the date of issuance. 

     Royalties payable
     -----------------

     Royalties payable represent royalties payable to SIG for a period of three
     years ending fiscal 1997, a contractual obligation of the Company in
     connection with the acquisition of Cyto Skin Care subsidiary (subsequent
     name change to Chantal Skin Care).  The royalty is calculated at 5% of
     revenues, with a minimum amount of $350,000 per year and a cap of
     $2,000,000. No payment to SIG has been made since October 1995.

     Convertible debentures
     ----------------------

     In October, 1996, the Company completed the sale of $5.25 million principal
     amount of 8% Convertible Debentures due September 30, 1998. The Company
     received net proceeds of $4,882,500 after payment of

                                       35
<PAGE>
 
     placement fees and expenses. The debentures were sold to investors
     qualifying as "non-U.S. persons" in an offering completed under Regulation
     S. The fair value of the debentures are determined using the market
     interest rates at which similar loans would be made to borrowers with
     similar credit risks for the remaining maturities. At June 30, 1997, the
     carrying value appproximates the fair value.

     The debentures were convertible into shares of common stock of the Company
     as to one-third of the principal amount of each debenture after forty five
     (45) days from the date of issuance, an additional one-third after seventy-
     five (75) days from the date of issuance and the balance after ninety (90)
     days from the date of issuance. The conversion price is the lesser of $3.91
     or 80% of the average closing bid price of the Company's common stock for
     the five business days immediately preceding the conversion date. The
     Company, in accordance with the terms of the debentures, notified those
     debenture holders exercising their conversion option for the first one-
     third of their debentures, that the Company intended to exercise its rights
     under the debenture to pay cash in lieu of such conversion and notified all
     debenture holders that it intended to also redeem the balance of the
     debentures for a negotiated purchase price. Such redemption was not
     completed. Were all the debentures converted as of the earliest date in
     accordance with the terms, the Company would have been required to issue
     approximately 3.5 million shares of common stock, which was in excess of
     the number of authorized but unissued shares available prior to the
     amendment of this Company's Certificate of Incorporation on July 18, 1997
     following the Annual Meeting of Stockholders increasing the number of
     authorized shares of common stock to 50 million. Were the debentures
     converted at August 31, 1997, approximately 7.6 million shares would have
     been issuable based on the five day average price of approximately $.86 for
     the five trading days ended on that date. The Company is in the process of
     attempting to negotiate towards settlement of the 1996 Regulation S
     offering, the realization to which there can be no assurance. (For
     discussion of various actions instituted by some of the investors in this
     placement see Note 10.)

     Stock-based compensation
     ------------------------

     Statement of Financial Accounting Standards No. 123, "Accounting for Stock-
     Based Compensation" (SFAS 123) establishes a fair value method of
     accounting for stock-based compensation plans and for transactions in which
     a company acquires goods or services from nonemployees in exchange for
     equity instruments.  The Company adopted this accounting standard on
     January 1, 1996.  SFAS 123 also gives the option to account for stock-based
     employee compensation in accordance with Accounting Principles Board
     Opinion No. 25 (APB 25), "Accounting for Stock Issued to Employees" or SFAS
     123.  The Company has chosen to continue to account for stock-based
     compensation utilizing the intrinsic value method prescribed in APB 25.
     Accordingly, compensation cost for stock options is measured as the excess,
     if any, of the fair market price of the Company's stock at the date of
     grant over the amount an employee must pay to acquire the stock.

     If SFAS 123 is not adopted related to stock-based employee compensation,
     SFAS 123 for footnote purposes requires that companies measure the cost of
     stock-based employee compensation at the grant date on the value of the
     award and recognize this cost over the service period.  The value of the
     stock based award if determined using a pricing model whereby compensation
     cost is in excess of the fair value of the stock as determined by the model
     at grant date or other measurement date over the amount an employee must
     pay to acquire the stock.

     Foreign currency translation
     ----------------------------

     The Company's foreign subsidiaries use the U.S. dollar as the functional
     currency and translate monetary assets and liabilities at the year end
     exchange rate.  Property and non-monetary assets and liabilities are
     translated at historical rates.  Income and expense accounts are translated
     at the average rates in effect during the year. The effect of foreign
     currency translation is not material.

     Research and development costs
     ------------------------------

     A significant portion of the Company's activities relates to developing
     drug and cosmetic products derived from its licensed family of synthetic
     chemical compounds. Research and development costs are expensed as
     incurred.

                                       36
<PAGE>
 
     Advertising and promotion costs
     -------------------------------

     Broadcast and print advertising costs are expensed when the advertising
     schedule is first broadcast or circulated.  All other advertising and
     promotion costs are expensed as incurred.  The Company has prepaid
     advertising of approximately 272,000 at June 30, 1997.  There was no
     prepaid advertising at June 30, 1996.

     Net income (loss) per share
     ---------------------------

     The computation of net income (loss) per share is based on the weighted
     average number of common shares outstanding.  When dilutive, stock options,
     warrants and convertible Preferred Stock are included as common share
     equivalents using the treasury stock method. Primary and fully diluted
     earnings per share are the same for the years presented.

     Statement of cash flows
     -----------------------

     The Company considers investments that are short-term, highly liquid,
     readily convertible to cash and purchased with an original maturity of
     three months or less to be cash equivalents.

<TABLE>
<CAPTION>
                                              1997        1996         1995
                                        --------------------------------------
<S>                                        <C>          <C>         <C> 
Supplemental cash flow information:
 Interest paid                             $   25,249    $139,758     $111,965
Non-cash financing activities:
 Non-cash interest expense                  1,045,000
 Common shares issued for consulting                      
  service                                                 120,420
 Common shares of subsidiary issued for
 consulting service                                       210,000
 Common shares of subsidiary issued
    to acquire license rights                                          845,625
 Common shares issued for termination
    of royalty payment obligation                                      388,125
 Common shares of subsidiary issued for
    termination of royalty payment                                     
     obligation                                                        461,250
     Common shares issued for compound                                  23,063
     Common shares issued for license                                   
      rights                                                            64,688
 Common shares issued in exchange for
  1,780,000 common shares of  Chantal                                
  Skin Care                                                          6,048,000
</TABLE>

     Use of Estimates
     ----------------

     The preparation of financial statements in conformity with generally
     accepted accounting principles requires management to make estimates and
     assumptions that affect the reported amounts of assets and liabilities and
     disclosure of contingent assets and liabilities at the date of the
     financial statements and the reported amounts of revenues and expenses
     during the year.  Actual results could differ from those estimates.

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

     The Statement of Financial Accounting Standard Number 128 (SFAS No. 128),
     "Earnings Per Share" ("EPS") issued by the Financial Accounting Standards
     Board is effective for financial statements issued for the periods ending
     after December 15, 1997, including interim periods. The SFAS No. 128
     requires restatement of all prior period EPS data presented. The new
     standard also requires a reconciliation of the numerator and denominator of
     the basic EPS computation to the numerator and denominator of the diluted
     EPS computation. The Company does not expect the adoption will have a
     material effect on its EPS calculation.

                                       37
<PAGE>
 
     Statements of Financial Accounting Standards No. 129 "Disclosure of
     Information about Capital Structure" (SFAS No. 129) issued by the FASB is
     effective for financial statements ending December 15, 1997.  The new
     standard reinstates various securities disclosure requirements previously
     in effect under Accounting Principles Board Opinion No. 15, which has been
     superseded by SFAS No. 128.  The Company does not expect adoption of SFAS
     No. 129 to have a material effect, if any, on its financial position or
     results of operations.

     Statements of Financial Accounting Standards No. 130, "reporting
     Comprehensive Income" (SFAS No. 130) issued by the FASB is effective for
     financial statements with fiscal years beginning after December 15, 1997.
     Earlier application is permitted.  SFAS No. 130 establishes standards for
     reporting and display of comprehensive income and its components in a full
     set of general purpose financial statements.  The Company has not
     determined the effect on its financial position or results of operations,
     if any, from the adoption of this statement.

     Statements of Financial Accounting Standards No. 131, "Disclosure about
     Segments of an Enterprise and Related Information" (SFAS No. 131) issued by
     the FASB is effective for financial statements beginning after December 15,
     1997.  The new standards requires that public business enterprises report
     certain information about operating segments in complete sets of financial
     statements of the enterprise and in condensed financial statements of
     interim periods issued to shareholders.  It also requires that public
     business enterprises report certain information about their products and
     services, the geographic areas in which they operate and their major
     customers.  The Company does not expect adoption of SFAS No. 131 to have a
     material effect, if any, on its Results of Operations.

3.   Off balance sheet risk and concentration of credit risk
     -------------------------------------------------------

     At June 30, 1997, the Company has uncollateralized accounts receivable
     from its distributor representing the majority of total accounts
     receivable.  Subsequently, cash receipts have been received from accounts
     receivable from its distributor for the majority of the balance.  At June
     30, 1997, approximately $940,000 of the ending net inventory balance of
     approximately $2.9 million was comprised of inventory held by the Company's
     U.S. distributor.
     
     The Company earned net revenues from two significant customers of
     approximately $2.6 million (39%) and approximately 876,000 (13%) in fiscal
     year 1997, one significant customer of approximately $8.6 million (65%) in
     fiscal year 1996 and $4.4 million (62%) in fiscal year 1995.

     The Company manufactures its Ethocyn, Cyoctol and Metcyclor patented
     compounds, as concentrated oils,  in Germany.  Total foreign assets at June
     30, 1997 and 1996 were $883,262 and $1,763,162.

4.   Manufacturing and distribution licenses
     -----------------------------------------

     In 1982 the Company acquired from CBD Pharmaceutical Corporation ("CBD"), a
     corporation majority controlled by the Company's Chairman of the Board and
     Chief Executive Officer and certain members of her family, a license for
     the exclusive worldwide manufacturing and distribution rights to all
     products derived from the X-Andron family of synthetic chemical compounds
     which were developed by CBD. The license agreement is effective for the
     life of all patents obtained for these products and required royalty
     payments of 8% of the Company's net revenue from such products and
     derivative products and 8% of revenues derived by the Company from royalty
     or other sales-based compensation pursuant to any sub-license, joint
     venture or other marketing or development agreement between the Company and
     any other party with respect to the licensed compounds. The obligation to
     make payments to CBD with respect to Ethocyn-based cosmetic products

                                       38
<PAGE>
 
     was assumed by Chantal Skin Care in connection with the License Agreement
     between the Company and Chantal Skin Care. Effective August 1, 1994, CBD,
     the Company and Chantal Skin Care agreed to terminate the 8% royalty
     obligation and in lieu thereof CBD agreed to accept from the Company
     300,000 shares of its common stock and 300,000 shares of Chantal Skin Care
     Corporation's common stock. These transactions, in fiscal 1995, resulted in
     prepaid royalties for the Company and Chantal Skin Care valued at $388,125
     and $461,250, respectively.

5.   Lease obligations
     -----------------

     Included in property and equipment are certain laboratory equipment and
     improvements subject to capital leases having an aggregate original cost of
     $598,111 at June 30, 1997 and 1996.  The related accumulated amortization
     for such laboratory equipment and improvements was $498,327 and $421,661 at
     June 30, 1997 and 1996.

     The aggregate annual minimum lease commitments under all non-cancelable
     leases as of June 30, 1997 are as follows:

<TABLE>
<CAPTION>
                     Capital    Operating
Fiscal Year           leases     leases
-----------------    --------   ---------
<S>                  <C>        <C>
1998                 $ 74,352   $ 394,242
1999                   68,977      94,648
2000                   68,977       3,068
2001                   68,977           -
2002                   68,977           -
Thereafter            123,583           -
                     --------   ---------
                      473,843   $ 491,958
                                =========
Less: interest        137,176
                     --------
                     $336,667
                     ========
</TABLE>

     For the years ended June 30, 1997, 1996 and 1995, rental expense amounted
     to $633,451 and $636,332 and $278,386.  Due to the terms of the leases, the
     book value approximates the fair value.

6.   Income taxes
     --------------

     The Company is subject to income tax in the United States, Germany and
     Switzerland.  The provision for income tax has been made in accordance with
     applicable tax law and practice in these jurisdictions.

     In the United States, the Company files on a consolidated basis, including
     itself and all United States subsidiaries.  The Company also considers the
     United States tax liability of any earnings by foreign subsidiaries.

     For the year ended June 30, 1997 and 1996, the Company had no current or
     deferred income tax expense.  For the year ended June 30, 1995, income tax
     expense consisted of current federal and state taxes of $15,130 and $5,295.

     The effective federal rate differed from the expected statutory rate for
     income taxes in the consolidated statements of operations as follows:

<TABLE>
<CAPTION>
                                               1997            1996           1995
                                            -----------     -----------     --------
<S>                                         <C>             <C>             <C>
Expected tax expense (benefit) at
  federal statutory rate                    $(3,763,033)    $(4,287,050)    $203,804
State taxes, net of federal tax
  benefit and before utilization of 
  net operating loss carry-forwards            (417,083)        280,085        3,442  
Effect of foreign income taxes                  167,447               -       (3,888)
Utilization of net operating loss
</TABLE> 

                                       39
<PAGE>
 
<TABLE> 
<S>                                        <C>               <C>            <C> 
           carry-forwards                             -               -     (264,774)
       Non-cash interest expense                355,300
       Goodwill                                 330,377         138,694            -
       Federal alternative minimum tax                -               -       15,130
       Change in deferred tax asset
        valuation allowance                   3,277,239       3,868,271       54,899
       Other, net                                49,753               -       11,812
                                           ------------    ------------    ---------
       Total tax expenses at actual rate   $          -    $          -    $  20,425
                                           ============    ============    =========
<CAPTION> 
 
   Significant components of deferred tax balances are as follows:
 
                                               Years ended June 30,
                                               -------------------
<S>                                          <C>               <C>  
Deferred tax assets:
 Allowance on accounts receivable             2,013,026         166,883
 State taxes                                          -               -
 Inventory                                      395,357         238,163
 Net operating loss carry-forward            14,797,444      13,573,552
 Amortization                                    99,153          38,739
 Other                                                -          10,404
                                           ------------    ------------
Total deferred tax assets                    17,304,980      14,027,741
Valuation allowance                         (17,304,980)    (14,027,741)
                                           ------------    ------------
Net deferred tax assets                    $          -    $          -
                                           ============    ============
</TABLE>
     
     The deferred tax asset is fully reserved for as Management cannot determine
     if it is more likely than not that the deferred tax asset will be realized.

     At June 30, 1997, the Company has Federal and California net operating loss
     carryforwards for tax purposes of approximately $41,635,000 and $6,899,000
     which expire beginning fiscal year 1998 to 2012.  The Company's ability to
     utilize the net operating loss carryforwards is dependent upon the ability
     to generate taxable income in future periods which may be limited due to
     future ownership changes as defined under Section 382 of the Internal
     Revenue Code of 1986.  Utilization of  Federal and California net operating
     losses may also be limited in any one year by alternative minimum tax
     rules.

7.   Stockholders' equity
     --------------------

     During the fiscal year ended June 30, 1995, 94,000 shares of the Company's
     Preferred Stock  were converted into an aggregate of 470,000 shares of the
     Company's common stock in accordance with the terms of the Preferred Stock
     Agreements.

     In March and April 1994, the Company received notice of exercises with
     respect to certain outstanding warrants.  With respect to the exercise of
     such warrants, the Company recorded at March 31, 1994, 185,000 shares as
     common stock subscribed and at June 30, 1994, the Company recorded an
     additional 135,000 shares as common stock subscribed.  The Company received
     payment for 160,000 of the initial 185,000 shares in June 1994, at which
     time it recorded such shares as issued, leaving at June 30, 1994, 160,000
     shares as common stock subscribed.  Payment of $320,000 for all outstanding
     common stock subscribed was received by the Company in July and August
     1994.

     In August 1994, pursuant to a private placement, the Company received
     $600,000 for the sale of 1,200,000 shares of the Company's common stock and
     1,200,000 warrants, each to purchase a share of common stock at an exercise
     price of $2.00, exercisable through September 29, 1994.  The warrants
     expired unexercised.

     In August 1994, the Company issued to The Upjohn Company 15,000 shares of
     the Company's common stock pursuant to an agreement reached between the
     Company and The Upjohn Company for purchase by the Company of The Upjohn
     Company's 38.5 kilograms of synthesized Cyoctol inventory.

                                       40
<PAGE>
 
     In December 1994, the Company completed the sale of 1,450,000 shares of its
     common stock in a private placement offering, for an aggregate $2,700,000
     and received $2,272,825, net of sales commissions and other expenses
     associated with the sale.

     In July 1994 and in conjunction with Ethocyn U.S. and international
     marketing negotiations then in progress, CBD Pharmaceutical Corporation, a
     related party, agreed with the Company and Cyto Skin Care Corporation  (in
     August 1994 name changed to Chantal Skin Care) to terminate the 8% royalty
     obligation, effective August 1, 1994, and in lieu thereof, to accept from
     the Company 300,000 shares of its common stock and from Chantal Skin Care
     Corporation 300,000 shares of its common stock.  In January 1995, 300,000
     shares of the Company's common stock were issued per the agreement and
     300,000 shares of common stock of Chantal Skin Care were issued in May
     1995.

     In January 1995, the Company issued 50,000 shares of its common stock to a
     sublicensee of SIG for returning the license rights for the territory of
     China and Hong Kong back to the Company, pursuant to the agreement between
     the Company and the sublicensee.

     On February 24, 1995, the Company announced that it had decided to seek to
     acquire the shares of Chantal Skin Care which the Company did not then
     presently own.  In furtherance thereof, on March 9, 1995, the Company
     commenced an exchange offer seeking to acquire the shares of Chantal Skin
     Care owned by stockholders located outside the United States, through the
     exchange of one share of Common Stock of the Company for one share of
     Chantal Skin Care.  On June 16, 1995, the Company accepted for exchange
     1,780,000 shares of  Chantal Skin Care.  Accordingly, the Company now owns
     12,690,812 shares of Chantal Skin Care or 90% of the outstanding  Chantal
     Skin Care shares.

     In June 1995, the Company concluded a private placement of 1,200,000 shares
     of common stock for an aggregate $3,678,000 with net proceeds to the
     Company of $3,540,000 after placement fees.

     In July 1995 the Company issued 30,000 shares of  common stock to a
     consultant for consulting services.

     In August 1995, pursuant to a private placement under Regulation D of the
     Securities Act, the Company sold 1,000,000 shares of common stock and
     500,000 shares of Series C Convertible Preferred Stock at $4.90 per share.
     The net proceeds to the Company from such sales, after placement fees, were
     $6,762,700 and were used for general corporate purposes. The shares of
     common stock were registered for sale by investors in a registration
     statement declared effective January 5, 1996, subject to the agreement of
     the investors not to sell pursuant to such registration statement for 90
     days following such effectiveness.  The registration statement is currently
     not available for sales by such investors, pending amendment to reflect
     current financial information.  Series C Preferred shares will
     automatically be converted into shares of Common Stock at the rate of one
     (1) share of the Company's Common Stock for each Series C Preferred share,
     at the later of (i) the day the Company's Certificate of Incorporation is
     amended to increase the number of authorized shares of Common Stock to at
     least 30,000,000, and (ii) the date a registration statement with respect
     to the Common Stock issuable upon such conversion is declared effective by
     the Securities and Exchange Commission.  The Series C Preferred shares will
     also entitle the holder to dividends and to vote on stockholder matters as
     if converted into common shares and will have a liquidation preference of
     $1.00 per Series C Preferred share.


     Options
     -------

     In May 1984, the Company adopted an incentive stock option plan which
     provides for the granting of incentive stock options for up to 175,000
     shares of the Company's common stock.  Options were granted at not less
     than the fair market value of the shares at the date of grant.  The plan
     terminated on April 30, 1994 by its terms.

     In September 1982, the Company's shareholders approved a non-qualified
     stock option plan for the members of the Board of Directors (except the
     Company's president), independent contractors and key employees, whereby
     the eligible persons may be granted an option to purchase shares of the
     Company's common stock at less than the fair market value of the shares at
     the date of grant.  A total of 250,000 shares 

                                       41
<PAGE>
 
     are authorized under the plan. Under the Company's non-qualified stock
     option plan, certain options were granted at significantly less than the
     fair market value of the shares at the date of grant. In these instances,
     upon granting of the stock options, the difference between the option price
     and the fair market value of the shares granted was charged to deferred
     costs and subsequently amortized over the vesting period of the related
     options. There were no charges to compensation expense relating to non-
     qualified stock options for the years ended June 30, 1997, 1996 and 1995.
     The plan terminated by its terms on January 27, 1994.

     In February 1994, the Company granted a consultant options exercisable over
     a term of three years for the purchase of 100,000 shares at an exercise
     price of $1.00 per share.  The right to exercise these options vested in
     equal quarterly installments of 25,000 shares, on May 1, 1994, August 1,
     1994, November 1, 1994 and February 1, 1995.  These options were exercised
     in the fiscal year ended June 30, 1996.

     In March 1995, the Company granted a then executive officer (who has since
     resigned from the Company) options for the purchase of 100,000 shares at an
     exercise price of $2.44 per share.  Pursuant to an agreement with the
     former officer, options to purchase 75,000 shares became exercisable in
     September 1995 and the balance became exercisable on December 31, 1995.
     The options are exercisable for three years.

     In July 1995, an officer of the Company was granted options to purchase an
     aggregate of 500,000 shares of common stock of the Company at a purchase
     price of $5.00 per share that vest upon certain performances by the
     Company.  Under the option agreement, 300,000 of the options granted to him
     terminated by fiscal 1997.

     In August 1996, an officer of the Company was granted options to purchase
     an aggregate of 150,000 shares of common stock of the Company at a purchase
     price of $4.625 per share, which exercise price was reduced to 1 5/16 in
     April, 1997.  Of the 150,000 shares, 75,000 shares vest upon certain
     performances by the Company.  Under the option agreement, 40,000 of the
     options granted terminated in fiscal 1997.

     In April 1997, the Company granted a board member options for the purchase
     of 45,000 shares, at an exercise price of $1 5/16 per share, of which
     25,000 are immediately exercisable and the remaining 20,000 become
     exercisable upon re-election to the Board at the Annual Meeting following
     the first anniversary of service as a director.  These options replaced
     options previously granted in June 1996.

     In June 1996, the Company granted a board member options for the purchase
     of 40,000 shares at an exercise price of $7.00 per share, which exercise
     price was reduced to 1 5/16 in April, 1997, of which 20,000 are immediately
     exercisable and the remaining 20,000 become exercisable upon re-election to
     the Board at the Annual Meeting following the first anniversary of service
     as a director.

     In April 1997, the Company granted a board member options for the purchase
     of 40,000 shares at an exercise price of $1 5/16, of which 20,000 are
     immediately exercisable and the remaining 20,000 become exercisable upon
     re-election to the Board at the Annual Meeting following the first
     anniversary of grant.

     In June 1997, the Company granted to two board members options for the
     purchase of 40,000 shares at an exercise price of $1.00 per share, of which
     20,000 are immediately exercisable and the remaining 20,000 become
     exercisable upon re-election to the Board at the Annual Meeting following
     the first anniversary of service as a director.

     In June 1997, the Company granted to an officer options for the purchase of
     100,000 shares at an exercise price of $1.00 per share.  The Company also
     granted options for the purchase of 200,000 shares that vest upon certain
     performance goals being obtained by the Company at an exercise price
     determined at the time of vesting.

     In June 1997, an officer of the Company was granted options to purchase
     100,000 shares of common stock of the Company at $1.00 per share.  The
     Company also granted options for the purchase of 400,000 shares that vest
     upon certain performances by the Company at exercise prices ranging from
     $2.00 to $5.00.

                                       42
<PAGE>
 
     FASB Statement 123 Accounting for Stock-Based Compensation, requires the
     Company to provide pro forma information regarding net income and earnings
     per share as if compensation cost for the Company's stock option plans had
     been determined in accordance with the fair value based method prescribed
     in FASB Statement 123.  The Company estimates the fair value of each stock
     option at the grant date by using the Black-Scholes option-pricing model
     with the following weighted average assumption used for grants in 1996 and
     1997: dividend yield of 0%; expected volatility of 30.7 percent; risk-free
     interest rates ranging from 5.8% to 6.5%; and expected lives ranging from
     3 to 6 years.  The weighted fair value of options granted in 1996 and 1997
     was $2.06 and $.33.


     Under the accounting provisions of FASB Statement 123,  the Company's net
     loss and losses per share is not materially different.
<TABLE>
<CAPTION>
 
<S>                                     <C>          <C>                  <C>        <C>           
                                               June 30, 1997                  June 30, 1996        
                                         Shares        Weighted Ave.       Shares     Weighted Ave.
                                          (000)       Exercise Price        (000)    Exercise Price
                                        ---------    ----------------     -------    --------------
                                                                                                   
Outstanding at beginning of year          485,000                4.87     200,000              1.72
Granted                                 1,115,000                1.86     585,000              5.33
Exercised                                                                 100,000              1.00
Forfeited                                 185,000                6.04     200,000              5.00
                                        ---------                         -------                  
Outstanding at end of year              1,415,000                2.74     485,000              4.87
                                        =========                         =======                  
                                                                                                   
Options exercisable at year end           410,000                1.44     130,000              3.53 
 
 
 
                         Options        Outstanding              Number of                      
                         Number        Weighted Ave.        Options exercisable               
                       Outstanding       Remaining              Exercisable                   
Exercise Prices        at 6/30/97     Contractual Life          at 6/30/97                    
---------------        -----------    ----------------      -------------------                
 
    $1.00                330,000             3                    190,000      
     1.31                235,000             3                    120,000      
     2.00                250,000             3                          -      
     2.44                100,000             3                    100,000      
     5.00                500,000             3                          -      
                      ----------                                  -------
                                                                           
                       1,415,000             3                    410,000      
</TABLE>

8.   Transactions with related parties
     ---------------------------------


     In addition to the transactions described elsewhere, the Company recognized
     in 1997, 1996 and 1995 legal expenses of approximately $42,000, $42,000 and
     $85,000, respectively, for services provided by a law firm in which a
     former director (until March 1995) and officer (until February 1993) of the
     Company is a partner.  This firm has served as European legal and
     regulatory counsel to the Company since 1984.


     The Company also recognized in 1997, 1996 and 1995 legal expenses of
     approximately $528,000, $641,925 and $85,911, respectively for services
     provided by a law firm in which a current director of the Company is a
     partner.


     At June 30, 1997, the Company has short-term notes payable of $183,000 to
     its U.S distributor.(see Note 2)

                                       43
<PAGE>
 
9.   Fourth Quarter Adjustments
     --------------------------

     In the fourth quarter of fiscal 1997, the Company recorded an additional
     allowance of approximately $2.1 million against the June 30, 1997 accounts
     receivable balance. In conjunction with the planned termination of the
     distribution agreement with Stanson, the Company reevaluated the adequacy
     of the accounts receivable allowance and due to the recent cash receipts
     from Stanson, recorded the additional allowance. The Company recorded this
     allowance as a reduction of revenue for income statement purposes. The
     Company also recorded inventory reserves of approximately $441,000 due to
     the large quantity of inventory on hand at year end. In accordance with a
     recent independent valuation, the license rights have been written down by
     approximately $564,000 to fair value at June 30, 1997.

     In the fourth quarter of fiscal 1996, the Company recorded an additional
     provision of approximately $1.2 million against the June 30, 1996 accounts
     receivable balance from Stanson which are beyond the agreed upon payment
     terms.  The Company recorded this provision as a reduction of revenues for
     income statement purposes.  The Company also recorded inventory reserves of
     approximately $595,000 due to the large quantity of inventory on hand at
     year end.

10.  Litigation
     ----------

     The Company and Chantal Burnison are defendants in an action titled
     Marksman Partners, L.P., on behalf of itself and all others similarly
     ---------------------------------------------------------------------
     situated vs Chantal Pharmaceutical Corporation and Chantal Burnison, filed
     -------------------------------------------------------------------       
     on February 7, 1996 in the United States District Court, Central District
     of California, Western Division, Case No. 96-0872. This action is a
     securities class action on behalf of all persons who purchased or otherwise
     acquired the common stock of the Company between July 10, 1995 and January
     5, 1996, inclusive.

     The Marksman Partners action is based on a contention that the Company's
         -----------------                                                   
     accounting for sales revenue, because of the nature of its distribution
     agreement with Stanson Marketing, Inc. overstated its revenues for fiscal
     (June 30) 1995 and for the September 30, 1995 quarter ($3 million and $10
     million, respectively), which, the action claims, violated generally
     accepted accounting principles and the Federal securities laws. The
     complaint notes that Chantal Burnison sold 300,000 shares during the class
     period (the sales were actually made by CBD Pharmaceutical Corporation from
     approximate holdings of 1.3 million shares. Sales were made after
     consultation with the Company's legal counsel.) The complaint appears to
     rely on details of the contractual relationship with the distributor to
     contend that the revenues should not have been booked by the Company based
     on shipped orders from the distributor, since among other reasons,
     plaintiffs allege that Stanson, during the relevant time period, had the
     right to require the Company to purchase Stanson on a formula dependent on
     its income from the Company's products' sales, and the Company did not have
     a substantial history of selling through the distributor and the
     distribution system. The action seeks monetary damages in an unspecified
     amount. An amount sought on the basis stated in the complaint would be
     substantially in excess of the Company's current net worth.

     The Company believes its financial reports were correctly presented under
     generally accepted accounting principles. A motion to dismiss the Marksman
                                                                       --------
     Partners action was denied, and pre-trial discovery in the Marksman
     --------                                                   --------
     Partners action has commenced. The Company plans to vigorously defend
     --------
     itself against the claims asserted in the litigation.

     In addition, a derivative action based on many of the same contentions as
     made in Marksman has been filed against the Company and Chantal Burnison.
     The action, entitled Baruch Singer and Dorothea E. Wakefield vs. Chantal
                          ---------------------------------------------------
     Burnison, defendant, and Chantal Pharmaceutical Corporation, nominal
     --------------------------------------------------------------------
     defendant, was filed in the Superior Court of the State of California, the
     ---------                                                                 
     County of Los Angeles, case No. BC 147327. In June 1997, the plaintiffs
     amended the complaint to assert a claim against the Company's former
     auditors, Coopers & Lybrand LLP, for negligence and professional
     malpractice arising out of Coopers & Lybrand's audit of the Company's
     fiscal year 1995 financial statements which are the subject of both the
     Marksman and Singer actions. Coopers & Lybrand's motion to dismiss the case
     --------     ------
     was denied.

                                       44
<PAGE>
 
     The Company has been a defendent in a lawsuit entitled Amado Institute,
                                                            ---------------
     Inc., an Arizona Corporation, Plaintiff, vs. Chantal Pharmaceutical
     -------------------------------------------------------------------
     Corporation, Defendants, U.S. Federal District Court, No. CIV 96-154-TUC-
     ----------------------- 
     RMB, in a dispute concerning the Company's rescission of an Arizona land
     transition. The Company, in September 1997, won its motion for summary
     judgment against the Plaintiff on all counts in this case. Although an
     appeal is possible by the Plaintiff, negotiations are in progress to obtain
     a waiver of the appeal.

     In October, 1996, the Company completed the sale of $5.25 million principal
     amount of 8% convertible debentures due December 31, 1998.  The debentures
     were sold to investors qualifying as "non U.S. persons" in an offering
     completed under Regulation S.  The debentures were convertible into shares
     of common stock of the Company as to one-third of the principal amount of
     each debenture after forty five (45) days from the date of issuance, an
     additional one-third after seventy-five (75) days from the date of issuance
     and the balance after ninety (90) days from the date of issuance.  The
     conversion price is the lesser of $3.91 or 80% of the average closing bid
     price of the Company's common stock for the five business days immediately
     preceding the conversion date.  The Company, in accordance with the terms
     of the debentures, notified those debenture holders exercising their
     conversion option for the first one-third of their debentures, that the
     Company intended to exercise its rights under the debenture to pay cash in
     lieu of such conversion and notified all debenture holders that it intended
     to also redeem the balance of the debentures for a negotiated purchase
     price.  Such redemption was not completed.  Were all the debentures
     converted as of the earliest date in accordance with the terms, the Company
     would have been required to issue approximately 3.5 million shares of
     common stock.  Such number is in excess of the number of authorized but
     unissued shares available prior to the amendment of this Company's
     Certificate of Incorporation on July 18, 1997 following the Annual Meeting
     of Stockholders increasing the number of authorized shares of common stock
     to 50 million.  Were the debentures converted at August 31, 1997,
     approximately 7.6 million shares would have been issuable based on the five
     day average price of approximately $.86 for the five trading days ended on
     that date.  The Company is attempting to negotiate towards settlement of
     subject 1996 Regulation S offering.


     Three actions involving six investors have been commenced against
     the Company relating to this offering. Two of these actions which were
     consolidated were brought in Delaware - FT Trading v. Chantal 
                                             ---------------------
     Pharmaceutical Corporation, Court of Chancery of the State of Delaware
     ---------------------------
     in and for New castle County, C.A. No. 15628-NC and Arbinter Omnivalor S.A.
                                                         -----------------------
     v. Chantal Pharmaceutical Corporation, Court of Chancery of the State of
     -------------------------------------
     Delaware in and for New Castle, C.A. No. 15788-NC - and one was brought in
     California - UFH Endowment Ltd. Ephram-Saghi and Ben Z. Katz v. Chantal
                  ----------------------------------------------------------
     Pharmaceutical Corporation and Chantal Burnison, United States District
     -----------------------------------------------
     Court, Central District of California, Western Division, Case No. CV 97-
     3118LGB (AJW). In each of the actions, the plaintiffs have sought to have
     all or a portion of their debentures converted and to recover damages and
     attorneys fees as set forth in the debentures.


     On September 9, 1997, FT Trading and Arbinter Omnivalor were granted
     partial summary judgement on the claims against the Company.  Pursuant to
     the Court's Order entered September 17, 1997, the Company is required to
     issue to FT Trading, 48,484 shares of common stock relating to its
     conversion notice with respect to one-third of its debenture and to honor
     the immediate conversion of the remaining two-thirds, and to pay FT Trading
     an aggregate of $181,615 for unpaid interest and damages, and to also
     reimburse FT Trading for costs and expenses, including legal fees, relating
     to the action.  The Company has not yet issued the shares and has not paid
     the interest and damages in accordance with the Court Order.  

     Pursuant to the Court Order, the Company is required to issue to Arbinter
     Omnivalor 242,424 shares of Common Stock relating to its initial conversion
     notice with respect to one-third of each of its two 

                                       45
<PAGE>
 
     debentures and to honor future conversions, and to pay Arbinter Omnivalor
     an aggregate of $396,741 for unpaid interest and damages, and to also
     reimburse Arbinter Omnivalor for costs and expenses, including legal fees
     relating to this action. The Company in compliance with in progress
     settlement negotiations with Arbinter Omnivalor, has issued the shares but
     has not paid the interest and damages in accordance with the Court Order.
     The Company, working with a consultant, is attempting to negotiate a final
     settlement with the investors of subject Court Orders.

     In the UFH Endowment, Ltd., Ephram-Saghi and Ben Z. Katz final case, the
     plaintiffs, alleged that the defendants violated federal and state
     law in connection with the debentures. Plaintiff UFH alleges that it
                                                      ---
     purchased debentures for $750,000, while plaintiffs Saghi alleges that he
     purchased debentures for $100,000, and plaintiff Katz alleges that he
     purchased debentures for $50,000. In September 1997, all parties to the UFH
     matter reached an agreement for settlement and resolution of the
     litigation. An executed Stipulation for Dismissal with prejudice was filed
     with the Court in exchange for the Company's issuing shares of the
     Company's common stock to the plaintiffs as consideration for the
     conversion of the plaintiffs' debentures and the simultaneous termination
     thereof.

     With respect to each of the foregoing actions, the likelihood of an
     unfavorable outcome and range of possible loss, if any, cannot be
     determined and accordingly no amounts are accrued for them at June 30,
     1997, with the exception of FT Trading and Arbinter Omnivalor which have
     been accrued for at June 30, 1997.

11.  Subsequent Events
     -----------------

     On September 25 and 26, 1997, the Company issued an aggregate of 2,930,327
     shares of its Common Stock upon conversion of $1,893,333 principal amount,
     an average of $.65 per share, of its 8% convertible debentures (See Note
     2). Had such conversion been affected at June 30, 1997, the Company would
     have had Stockholder's Equity on a proforma basis of $1,738,570. The
     proforma column appearing on the consolidated balance sheet gives effect at
     June 30, 1997 to the referenced conversion.

                                       46
<PAGE>
 
                                   PART  III
                                   ---------

ITEM 9.  CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS
-------  ---------------------------------------------
ON ACCOUNTING AND FINANCIAL DISCLOSURE
--------------------------------------


     Not applicable.



ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
--------  --------------------------------------------------


The names, ages and positions of the directors and executive officers of the
Company are as follows:

<TABLE>
<CAPTION>
       NAME                      AGE                  POSITION
--------------------             ---   ---------------------------------------
<S>                              <C>   <C>
Chantal Burnison                  46   Chairman of the Board and Chief 
                                       Executive Officer(1)
 
Marc Dworkin                      51   President
 
Dr. Jeannie Wu                    35   Vice President and Director of Clinical
                                       Trial Development
 
Polly Bergen                      66   Director and Chief Operating Office
 
Joseph Dekama                     57   Executive Vice President
 
Yvette Lamprecht                  29   Chief Financial Officer                           
                                                                                         
Joseph Daly                       79   Director                                          
                                                                                         
Dr. Norman Estrin                 58   Director                                          
                                                                                         
Dr. George Goldstein              64   Director                                          
                                                                                         
Robert Pinco                      53   Director                                          
                                                                                         
Gilbert D. Raker                  53   Director                                          
                                                                                         
Charles D. Strang                 76   Director                                           
</TABLE>



_________________

     All Directors are serving a current term which expires at the next annual
meeting of stockholders, and until their successors are electe majority and
qualified. All officers serve at the discretion of the board.


     Chantal Burnison is Chief Executive Officer and Chairman of the Board of
Directors of the Company and Chantal Skin Care Corporation.  She has served as
Chief Executive Officer and Chairman of the Board of the Company since May 21,
1982, at which date the Company acquired from her family majority held company
the licensing rights to the patents and safety and efficacy test data conducted
to such date for the X-Andron synthetic anti-androgen compounds (including
Cyoctol and Ethocyn) and the Metcyclor Family of cancercidal compounds. In May
1994, she
                                       47
<PAGE>
 
became Chairman of the Board and Chief Executive Officer of the Company's 90%
owned Chantal Skin Care Corporation subsidiary. In addition to being a corporate
executive, Chantal Burnison is a chemist, biologist and attorney. She is co-
inventor on the patents and patent applications and has co-authored numerous
scientific medical publications. Prior to joining the Company, her employment
experience included serving as a vice president and general legal counsel to a
steel company, a partner in a Los Angeles based law firm specializing in
corporate and commercial property law and as a chemist in plastics in private
industry. She has, and continues to, serve as a director on the boards of
several privately held corporations. Since 1980, Ms. Burnison has served as
president of CBD Pharmaceutical Corporation, a company controlled by her and her
family which is engaged in the development and marketing of products unrelated
and not in competition with the business of the Company. See "Item 1, Business
and Distribution Licensing Agreement" and "Item 13 - Certain Relationships and
Related Transactions". She spends substantially all of her business time on the
business of the Company.

     Mr. Marc Dworkin joined the Company in July 1995 and was elected President
in August 1995.  Mr. Dworkin has spent his business career in retail marketing,
primarily in the chain drug industry.  From 1988 until joining the Company, he
was president of Sid's Get It For Less of Houston, Ohio.  Between 1985 - 1987,
Mr. Dworkin was the Senior Operating Executive of Carls Drug Company, Rome, New
York.  Between 1969-1985, Mr. Dworkin held numerous management positions at
Revco Drug Store Incorporated, a NYSE public company based in Cleveland, Ohio.
Mr. Dworkin's education and professional affiliations include a bachelors of
arts in marketing from Michigan State University, and membership in Young
Presidents Organization, American Marketing Association and American Management
Association.

     Dr. Jeannie Wu joined the Company in February 1994 and was elected as Vice
President and Director of Clinical Trial Development, a newly created position
in July 1994. Dr. Wu is a medical physician trained in China where she practiced
medicine from 1985 to 1992.  After coming to the U.S. in 1992, she worked as an
assistant to the president of Xing Hwa Corporation, a trading company in Los
Angeles from 1992 to 1993 and at the Beverly Hills Pain Center from 1993 to 1994
until joining the Company.

     Ms. Bergen became a director and Chief Operating Officer in June, 1997.
From November 1996 to June 1997, she was a consultant to the Company, primarily
with respect to product development and prospective marketing to department
stores in North America.  Ms. Bergen is an Emmy Award winning actress having won
the Emmy for best actress for CBS-TV's "The Helen Morgan Story" and been twice
nominated for best actress in the ABC mini-series "Winds of War" and "War and
Remembrance."  From 1965 to 1973, Ms. Bergen was President and Chief Executive
Officer of Polly Bergen Cosmetics, which marketed a full line of skin care,
make-up and fragrance products.  Ms. Bergen served as the first woman director
on Singer Corporation's Board of Directors.  She is founder and former President
of the National Business Council for Women, and a noted lecturer, author and
recording artist.  Ms. Bergen currently serves as a director or trustee of a
number of charitable organizations, including The Martha Graham Dance Center and
Cancer Care, Inc.

     Mr. DeKama joined the Company in June 1997 and serves as Executive Vice
President of the Company and President of Chantal Skin Care, the Company's 90%
owned subsidiary.  Mr. DeKama has been a leader in the cosmetic and fragrance
industry for more than 35 years.  Mr. DeKama has held senior executive positions
at several major health and beauty corporations, such as Faberge, and since 1979
has independently marketed and distributed nationally recognized cosmetic and
fragrance brands in the U.S. and Canada.

     Ms. Yvette Lamprecht joined the Company in August 1996 and serves as Chief
Financial Officer.  Between September 1993 and when she joined the Company, she
held various accounting and financial positions at Iwerks Entertainment, Inc., a
public company.  Between September 1990 and September 1993, she was a senior
auditor at Ernst & Young, serving clients in numerous business sectors,
including the retail and manufacturing industries.  Ms. Lamprecht is a certified
public accountant.

     Mr. Daly became a director in June, 1997.  He is the former Chairman of DDB
Needham Worldwide, Inc., the international advertising agency ("DDB"), and the
present Chairman Emeritus of DDB.  Mr. Daly has served as Chairman of the Board
of DDB from 1974 to 1986, and thereafter as Chairman of the Executive Committee
of the Board.

                                       48
<PAGE>
 
     Norman F. Estrin, Ph.D., became a director in June 1996.  Dr. Estrin is a
30 year veteran of the cosmetic industry.  Dr. Estrin is President of Estrin
Consulting Group, Inc., President and Chief Operating Officer of J&R Total Skin
Care, Inc. and Senior Vice President of Discovery Pharmaceuticals Inc.  He
serves on the Board of Directors of these development stage companies .  He is
also a member of the Board of Trustees of the National Museum of Helath &
Medicine Foundation.  Dr. Estrin was senior Vice President - Science of the
Cosmetic, Toiletry and Fragrance Association, where he served from 1968 to 1985.
He joined the Health Industry Manufacturers Association in 1985 as Vice
President - Science and Technology, a position he held until 1990.

     Dr. George Goldstein became a director in June 1996. Dr. Goldstein has
served as a consultant to major pharmaceutical companies that include Aprex
Corporation, Church and Dwight, Inc., Johnson and Johnson, Sterling Drug, Inc.,
Proctor and Gamble, Glaxo, Fisens, Smith Kline Beecham, and others. Dr.
Goldstein presently is Executive Vice-President, Clinical Development, for
Medeva Pharmaceuticals. For five years prior to joining Medeva, he was
President, Director and Co-founder of a drug delivery firm, Pharmaceutical
Discovery Corporation. From 1975 to 1990, he held several positions, including
Corporate Vice President , Worldwide Medical and Regulatory Affairs, at Sterling
Drug Inc., of New York, New York.

     Mr. Robert Pinco became a director in April 1992.  Mr. Pinco is an attorney
and licensed pharmacist.  He is a partner and the Head of the Food and Drug
Group of the Washington, D.C. law offices of Akin, Gump, Strauss, Hauer & Feld.
Additionally, Mr. Pinco serves as an Adjunct Professor of Pharmacy Practice and
Administrative Sciences and a member of the Board of Advisors at the University
of Maryland.  Between 1974-1977, Mr. Pinco was Director of the Over-the-Counter
Drug Evaluation Division at the United States Food and Drug Administration
(FDA).  Prior thereto, from 1972-1974, Mr. Pinco was an Assistant General
Counsel with the White House Special Action Office for Drug Abuse Prevention and
between 1969-1972 served as an Attorney with the Office of Chief Counsel, Bureau
of Narcotics and Dangerous Drugs (now the Drug Enforcement Administration) of
the Department of Justice and Assistant United States attorney for the District
of Columbia.  Akin, Gump, Strauss, Hauer & Feld serves as FDA legal counsel  to
the Company.

     Mr. Raker became a director in July, 1997.  Since 1990, Mr. Raker has been
the Chairman, President and Chief Executive Officer of Semiconductor Packaging
Materials Co., Inc., a publicly held provider of materials and services for the
microelectronic and semiconductor industries.  From 1987 to 1990, he was
Managing Director of the buy out firm Ditri Associates, Inc.  Prior thereto, Mr.
Raker held senior executive positions, including as chief executive officer and
chief financial officer, with various public and non-public companies.

     Mr. Strang became a director in July, 1997.  From November 1995 to the
present, Mr. Strang has been retired.  From January 1993 to January 1996, he was
a director and Chairman of the Management Committee of Outboard Marine
Corporation ("Outboard"), a marine products manufacturing company, and a
consultant to Volvo-Panta, a subsidiary of Volvo, from November 1993 to November
1995.  From January 1990 to January 1993, Mr. Strang was the Chairman of the
Board of Outboard and served as Chairman of the Board and Chief Executive
Officer from January 1982 to January 1990.  From June 1966 to January 1982, he
held a variety of positions at Outboard, as manager and executive officer.

                                       49
<PAGE>
 
ITEM 405 DISCLOSURE


     No directors, officers or beneficial owners of more than ten percent of the
Company's Common Stock failed to file on a timely basis reports required by
Section 16(a) of the Securities Exchange Act of 1934.

                                       50
<PAGE>
 
ITEM 11.  EXECUTIVE COMPENSATION
--------  ----------------------


SUMMARY COMPENSATION TABLE


     The following table shows, as to the Chief Executive Officer and as to each
of the other two most highly compensated executive officers whose salary plus
bonus exceeded $100,000 during the last fiscal year, information concerning all
compensation paid for services to the Company in all capacities during the last
three fiscal years.

<TABLE>
<CAPTION>
 
                                                                                         Long Term
                                                Annual Compensation                    Compensation
                                     --------------------------------------------   ---------------------
                                                                     Other Annual   Securities Underlying
Name and Principal Position          Year   Salary          Bonus    Compensation      Options/SARS (1)
---------------------------          ----   -------         ------   ------------   ---------------------
 
<S>                                  <C>    <C>       <C>   <C>      <C>            <C>
Chantal Burnison                     1997   290,000(2)   
  Chief Executive Officer            1996   266,997(2)       5,000
                                     1995   200,769(2)   
 
Marc Dworkin (3)                     1997   180,000
  President                          1996   153,946         25,000         18,000          500,000 shares
                                     1995
 
Yvette Lamprecht (4)                 1997   100,615                                        150,000 shares
  Chief Financial Officer
</TABLE>
 
(1) All numbers reflect the number of shares of Common Stock subject to options
    granted during the fiscal year.
(2) Includes $200,000, $107,692 and $90,000 received as compensation from
    Chantal Skin Care Corporation.
(3) Mr. Dworkin provided consulting services in early fiscal 1996 and then
    joined the Company as an officer in August 1995.
(4) Ms. Lamprecht joined the Company in fiscal 1997.

          The amount of compensation paid or distributed during the last fiscal
year and not described above with respect to any individual named in the Summary
Compensation Table did not exceed the lesser of $25,000 or 10% of the
compensation table for such person.


OPTIONS GRANTS IN LAST FISCAL YEAR


          The following table sets forth certain information regarding grants of
stock options made during the fiscal year ended June 30, 1997 to the executive
officers  named in the Summary Compensation Table.


                       OPTION GRANTS IN LAST FISCAL YEAR

<TABLE>
<CAPTION>
                                     Percent of
                                   Total Options
                     Number of       Granted to     Exercise or
                      Options       Employees in    Base Price    Expiration
     Name             Granted       Fiscal Year      Per Share       Date
----------------     ----------    -------------    -----------   ----------
 
<S>                  <C>           <C>              <C>           <C>
Yvette Lamprecht     (1) 150,000        16%             1.31        6/30/01
</TABLE>

(1)    In August 1996, the Company granted Yvette Lamprecht options to purchase
an aggregate of 150,000 shares of common stock of the Company at a purchase
price of 4.625 per share, which exercise price was reduced to 1 5/16 in April,
1997 of which 55,000 are vested and 75,000 of these options vest upon certain
performance goals being obtained by the Company. Under the option agreement,
40,000 of the options granted terminated in fiscal 1997.

                                       51
<PAGE>
 
                AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
                     AND FISCAL YEAR-END OPTION VALUES (1)

<TABLE>
<CAPTION>
 
                                                     Number of           Value of All Unexercised
                                                 Unexercised Options        In-the-Money Options
                        Shares                   at Fiscal Year-End        at Fiscal Year End (1)
                       Acquired      Value     -------------------------   -------------------------
       Name           on Exercise   Realized   Exercisable/Unexercisable   Exercisable/Unexercisable
-------------------   -----------   --------   -------------------------   -------------------------
 
<S>                   <C>           <C>        <C>                         <C>
Yvette Lamprecht            -          -             55,000/55,000                  $0/$0
</TABLE>

(1) Based upon the last reported sale price of the Common Stock on NASDAQ
    National Market System on June 30, 1997.


COMPENSATION OF DIRECTORS


     In June 1996, the Company granted Dr. Goldstein options for the purchase of
40,000 shares at an exercise price of $7.00 per share, which exercise price was
reduced to 1 5/16 in April, 1997, of which 20,000 are immediately exercisable
and the remaining 20,000 become exercisable upon re-election to the Board at the
Annual Meeting following the first anniversary of service as a director.


     In April 1997, the Company granted Dr. Estrin options for the purchase of
45,000 shares, at an exercise price of $1 5/16 per share, of which 25,000 are
immediately exercisable and the remaining 20,000 become exercisable upon re-
election to the Board at the Annual Meeting following the first anniversary of
service as a director.  These options replaced options previously granted to Dr.
Estrin in June 1996.


     In April 1997, the Company granted Mr. Pinco options for the purchase of
40,000 shares at an exercise price of $1 5/16, of which 20,000 are immediately
exercisable and the remaining 20,000 become exercisable upon re-election to the
Board at the Annual Meeting following the first anniversary of grant.


     In June 1997, the Company granted Joseph Daly options for the purchase of
40,000 shares at an exercise price of $1.00 per share, of which 20,000 are
immediately exercisable and the remaining 20,000 become exercisable upon re-
election to the Board at the Annual Meeting following the first anniversary of
service as a director.


     In June 1997, the Company granted to Polly Bergen options for the purchase
of 100,000 shares at an exercise price of $1.00 per share.  The Company also
granted options to Polly Bergen for the purchase of 200,000 shares that vest
upon certain performances by the Company at an exercise price determined at the
time of vesting.


     In July 1997, the Company granted to each of Gil Raker and Charles Strang
options for the purchase of 40,000 shares at an exercise price of $1.1875 per
share, of which 20,000 are immediately exercisable and the remaining 20,000
become exercisable upon re-election to the Board at the Annual Meeting following
the first anniversary of service as a director.

                                       52
<PAGE>
 
ITEM 12.  PRINCIPAL STOCKHOLDERS
--------  ----------------------


     The following table sets forth certain information regarding the beneficial
ownership of the Company's Common Stock, as of August 31, 1997, based on
18,190,516 shares outstanding, (i) by each of the Company's directors, (ii) all
directors and officers of the Company as a group and (iii) by each person
believed by the Company to own beneficially more than 5% of its outstanding
shares of Common Stock:

<TABLE>
<CAPTION>
 
        Name and Address            Number of Shares Owned    Percentage of Class
        ----------------            ----------------------    -------------------
<S>                                 <C>                       <C>
Chantal Burnison*                      1,312,103 (1)                   7.2
                                  
Polly Bergen *                           100,000 (2)                    (3)
                                  
Joseph Daly *                             20,000 (2)                    (3)
                                  
Robert Pinco*                             40,000 (2)                    (3)
                                  
Norman Estrin*                            45,000 (2)                    (3)
                                  
George Goldstein *                        42,000 (2)                    (3)
                                  
Gilbert Raker *                           26,000 (2) (4)                (3)
                                  
Charles Strang *                          37,500 (2)                    (3)
                                  
CBD Pharmaceutical Corporation    
  147 E. Liberty Street           
  Reno, NV  89501                      1,209,503 (1)                   6.6
                                  
Buchanan Fund Limited/Buchanan    
Partners Limited                       2,898,551 (5)                  13.7
                                  
All Directors and Officers             1,728,603 (1)                   9.3
as a group (11 persons)
 
</TABLE>
------------------
* The address of each director is c/o Chantal Pharmaceutical Corporation, 12901
  West Jefferson Boulevard, Los Angeles, California 90066.

(1)  Includes 1,209,503 shares beneficially owned by CBD, which is controlled by
     Ms. Burnison and certain members of her family.


(2)  Includes shares issuable upon exercise of currently exercisable options.

(3)  Less than one percent.


(4)  Includes 1,000 shares owned by Mr. Raker's wife and 1,000 shares owned by
     Mr. Raker's daughter as to which he disclaims beneficial ownership.


(5)  Buchanan Fund Limited/Buchanan Partners Limited ("Buchanan") is the holder
     of $2 million principal of the Company's 8% convertible debentures which
     are currently convertible into common stock of the Company. Buchanan has
     filed a schedule 13D dated July 11, 1997 stating that if the entire amount
     of the principal of the debenture was converted it would own more than 5%
     of the outstanding common stock of the Company. The shares listed as number
     of shares owned, assumes a conversion of the entire principal amount based
     on a market price at August 31, 1997. As of September 26, 1997, $660,000 of
     the debentures have been converted at $.80 per share. See Management's
     Discussion & Analysis and Note 2 to the financial statements.

                                       53
<PAGE>
 
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------  ----------------------------------------------


     In May 1982, the Company acquired a license for the exclusive manufacturing
and marketing rights to the X-Andron family of compounds (including Cyoctol and
Ethocyn) and Metcyclor compounds and all derivatives and isometric families
thereof from CBD Pharmaceutical Corporation, which is controlled by Chantal
Burnison and her family, in exchange for 2,614,500 shares of the Company's
Common Stock and an agreement to pay an aggregate royalty of (i) 8% of the
wholesale price of all licensed compounds manufactured and sold directly by the
Company to the wholesale or retail markets; and (ii) 8% of all revenues derived
by the Company from royalty or other sales-based compensation pursuant to any
sub-license, joint venture or other marketing or development agreement between
the Company and any other party with respect to the licensed compounds.  The
term of the Company's license from CBD Pharmaceutical Corporation is equal to
the period during which any of such compounds are protected under any patent
rights which may issue from the United States Patent Office.  Total royalty
expense under such royalty arrangement with CBD was $414 for the year ended June
30, 1993.  No royalty expense was recorded for the years ended June 30, 1994 and
1995.  As of June 30, 1993, the Company had accrued liabilities of  $19,159 for
unpaid royalties pursuant to this agreement.  The obligation to make payments to
CBD Pharmaceutical Corporation with respect to Ethocyn-based cosmetics products
was assumed by Chantal Skin Care in connection with the License Agreement
between the Company and Chantal Skin Care.  In July 1994 and in conjunction with
Ethocyn U.S. and international marketing negotiations then in progress, CBD
Pharmaceutical Corporation agreed with the Company and Chantal Skin Care to
terminate the 8% royalty obligation, effective August 1, 1994, and in lieu
thereof, to accept from the Company 300,000 shares of its common stock and from
Chantal Skin Care 300,000 shares of its common stock.


     Since May 1984, the law firm of Staubach Teich & Partner, of which Dr.
Rainer Staubach is a partner, has served as European legal and regulatory
counsel to the Company.  Dr. Staubach, a former director and officer of the
Company, is the husband of Chantal Burnison, Chairman of Board and Chief
Executive Officer of the Company.


     In June 1993, CBD Pharmaceutical Corporation agreed to invest $150,000 of
royalties owed it by acquiring Units, each Unit consisting of one share of the
Company's Series B Convertible Preferred Stock and five Common Stock purchase
warrants, for $5.00 per Unit, all on the same terms and conditions as other
unrelated investors in the Company's June 1993 private placement.  The warrants
expired in April 1994 unexercised.  At June 30, 1996, the 30,000 shares of
Series B Convertible Preferred Stock were automatically converted in accordance
with the terms thereof into 240,000 shares of common stock of the Company.


     On March 15, 1994, the Company entered into a License agreement (the
"License") with Cyto Skin Care Corporation ("Cyto Skin Care") pursuant to which
the Company licensed to Cyto Skin Care the rights to distribute and sell
Ethocyn-based cosmetics and skin care products (i.e. non-pharmaceutical
products) in United States, Canada, Mexico and the Caribbean.  Cyto Skin Care
issued to the Company in consideration of the License, 10,910,812 shares of its
common stock.  Under the License, Cyto Skin Care was obliged to use its best
efforts to expeditiously launch the marketing and sale of Ethocyn-based cosmetic
skin care products (the "Chantal Line") by September 30, 1994, but in no event
later than December 31, 1994.  In August of 1994, Cyto Skin Care changed its
name to Chantal Skin Care Corporation ("Chantal Skin Care").  The License is
terminable at the option of the Company if during the term of the License
Chantal Skin Care does not achieve sales of the Chantal Line of at least
$5,000,000 in the initial nine months following execution of the License;
$20,000,000 during calendar 1995; and $50,000,000 in calendar 1996.  Although
Chantal Skin Care did not achieve the requisite product sales, the Company does
not intend to exercise its termination rights.


     On February 24, 1995, the Company announced that it had decided to seek to
acquire the shares of Chantal Skin Care which the Company did not then own.  In
furtherance thereof, on March 9, 1995, the Company commenced an exchange offer
seeking to acquire the shares of Chantal Skin Care owned by shareholders located
outside the United States, through the exchange of one (1) share of Common Stock
of the Company for one share of common stock of Chantal Skin Care.  On June 16,
1995, the Company accepted for exchange 1,780,000 shares of Chantal Skin Care
common stock.  Accordingly, the Company now owns 12,690,812 shares of Chantal
Skin Care or 90% of the outstanding Chantal Skin Care shares.  The Company
intends to effect a merger of Chantal Skin Care with and into a newly formed
wholly owned subsidiary of the Company on the same basis as the exchange for the
shares owned by persons outside the United States.


     At various times during July 1, 1997 to September 29, 1997, Ms. Burnison
loaned an aggregate of $310,104 to the Company.  The loans bear interest at
prime + 1 percent per annum.  The loans are payable upon demand.

                                       54
<PAGE>
 
                                    PART IV
                                    -------



ITEM 14.  EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES,
--------  ------------------------------------------
          AND REPORTS ON FORM 8-K
          -----------------------

 

     A.  EXHIBITS: See Exhibit List attached to this Annual Report on Form 10-K.


     B.  FINANCIAL STATEMENTS:
 

         Reports of Independent Certified Public Accountants
       
       
         Consolidated Balance Sheets
         June 30, 1997 and 1996
       
       
         Consolidated Statements of Operations
         Years Ended June 30, 1997, 1996 and 1995
       
       
         Consolidated Statements of Stockholders' Equity
         Years Ended June 30, 1997, 1996 and 1995
       
       
         Consolidated Statements of Cash Flows
         Years Ended June 30, 1997, 1996 and 1995
       
       
         Notes to Consolidated Financial Statements
       
       
     C.  FINANCIAL STATEMENT SCHEDULE:
       
       
         Schedule II - Valuation and Qualifying Accounts for the years ended
         June 30, 1997, 1996 and 1995.
       
       
         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.
       
       
     D.  REPORTS ON 8-K:
       
       
         None.

                                       55
<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.

Date: September 29, 1997



                              CHANTAL PHARMACEUTICAL CORPORATION
                                        (Registrant)



                                By /s/ Chantal Burnison
                                  ---------------------
                                  Chantal Burnison
                                  Chairman of the Board
                                  and Chief 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 indicated.


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



     /s/ Chantal Burnison                   September 29, 1997
     --------------------------          
     Chantal Burnison              
     Chairman of the Board         
     and Chief Executive Officer   
     (Principal Executive Officer) 



     /s/ Yvette Lamprecht                   September 29, 1997
     --------------------------      
     Yvette Lamprecht              
     Chief Financial Officer       
     (Principal Financial Officer) 
                                   


     /s/ Polly Bergen                        September 29, 1997
     --------------------------          
     Polly Bergen                         
     Director and Chief Operating Officer 
                                          
 

                                             September   , 1997
     --------------------------          
     Joseph Daly
     Director
 


     /s/ Robert Pinco                        September 29, 1997
     --------------------------               
     Robert Pinco               
     Director                   

                                       56
<PAGE>
 
     /s/ Norman Estrin                       September 29, 1997
     --------------------------               
     Norman Estrin          
     Director               
                            
                            
     /s/ George Goldstein                    September 29, 1997
     --------------------------               
     George Goldstein       
     Director               
                            
                            
     /s/ Gilbert Raker                       September 29, 1997
     --------------------------               
     Gilbert Raker          
     Director               
                            
                            
     /s/ Charles Strang                      September 29, 1997
     --------------------------               
     Charles Strang         
     Director               

                                       57
<PAGE>
 
                                                                     SCHEDULE II



                       CHANTAL PHARMACEUTICAL CORPORATION

                       VALUATION AND QUALIFYING ACCOUNTS

                FOR THE YEARS ENDED JUNE 30, 1995, 1996 AND 1997

<TABLE>
<CAPTION>
                                      Balance at
                                      beginning                              Balance at
Classification                         of year     Additions    Deductions   end of year
--------------                        ----------   ----------   ----------   -----------
<S>                                   <C>          <C>          <C>          <C>
 
FOR THE YEAR ENDED JUNE 30, 1995
                                 
 Allowance for sales returns                   -   $   90,216            -    $   90,216
                                 
FOR THE YEAR ENDED JUNE 30, 1996 
 
 Allowance for sales returns              90,216    1,516,692            -     1,606,908
 
 Inventory obsolescence reserve                -      595,408            -       595,408
 
FOR THE YEAR ENDED JUNE 30, 1997
 
 Allowance for sales returns           1,606,908    3,425,655            -     5,032,563
 
 Inventory obsolescence reserve          595,408      392,985            -       988,393
 
</TABLE>

                                       58
<PAGE>
 
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
 
Incorporated by        Exhibit
Reference to:          Number                                  Exhibits                           Page
--------- ---          -------                                 -------                            -----
<S>                   <C>                 <C>                                                     <C>
(1)-Exhibit 3.1A      3.1                 Certificate of Incorporation                              --
                                                                                                 
(12)   *              3.2                 By-laws                                                   --
                                                                                                 
(4)-Exhibit 3.2A      3.3                 Amendment to the Certificate of Incorporation          
                                          dated March 24, 1987                                      --
                                                                                                 
(7)-Exhibit 3.4       3.4                 Amendment to the Certificate of Incorporation          
                                          dated April 30, 1992                                      --
                                                                                                 
   *                  3.4.1               Amendment to Certificate of Incorporation                 
                                          dated July 18, 1997                                       --
                                                                                                 
(8)-Exhibit 3.5       3.5                 Certificate of Designation, Preferences and Rights     
                                          of Series B Voting Convertible Preferred Stock         
                                          Dated July 28, 1993                                       --
                                                                                                 
(10)Exhibit 3.6       3.6                 Amended Certificate of Designation, Preferences and    
                                          Rights of Series B Voting Convertible Preferred Stock  
                                          Dated November 22, 1993                                   --
                                                                                                 
(12)Exhibit 3.7       3.7                 Certificate of Designations Preferences and Rights of  
                                          Series C Voting Convertible Preferred Stock dated      
                                          August 2, 1995                                            --
                                                                                                 
(1)-Exhibit 10.4      10.1                Amended and Restated License Agreement between         
                                          CBD Pharmaceutical Corporation and CBD, Inc.              --
                                                                                                 
(1)-Exhibit 10.5      10.2                Amended and Restated License Agreement between         
                                          CBD Pharmaceutical Corporation and the Registrant         --
                                                                                                 
(1)-Exhibit 10.9      10.3                Registrant's Incentive Stock Option Plan                  --
                                                                                                 
(1)-Exhibit 10.10     10.4                Registrant's Non-Qualified Stock Option Plan              --
                                                                                                 
(2)-Exhibit 10.12     10.5                Copy of lease between Registrant and Search            
                                          Wilshire Brentwood Plaza Limited Partnership.             --
                                                                                                 
(3)-Exhibit 10.16     10.6                Agreement with National Cancer                         
                                          Institute dated October 19, 1986                          --
                                                                                                 
(4)-Exhibit 10.21     10.7                Distribution Agreement with Leca,                      
                                          S.A., dated as of October 5, 1987.                        --
                                                                                                 
(5)-Exhibit 10.24     10.8                Copy of sub-lease between the Registrant               
                                          and Phoenix Marketing Group, Inc.                         --
                                                                                                 
(6)-Exhibit 10.26     10.9                Research, Development and Distribution                 
                                          Agreement with Investors, represented                  
                                          by Trustee, Dr. Urs Wehinger dated                     
                                          as of August 10, 1989                                     --
                                                                                                 
(6)-Exhibit 10.27     10.10               License agreement with Chi Fu Trading                  
                                          Company dated as of January 11, 1989                      --
                                                                                                 
(6)-Exhibit 10.28     10.11               License agreement with Kolon Industries,               
                                          Incorporated dated as of June 12, 1989                    --
</TABLE>

                                       59
<PAGE>
 
                                 EXHIBIT INDEX

                                  (Continued)


<TABLE>
<CAPTION>
Incorporated by        Exhibit
Reference to:          Number                                  Exhibits                           Page
--------- ---          -------                                 -------                            -----
<S>                   <C>                 <C>                                                     <C> 
 
(7)-Exhibit 10.17      10.13              Amendment to the License Agreement between the  
                                          Registrant and CBD Pharmaceutical Corporation             --
 
(9)-Exhibit 10.1       10.14              Agreement for Issuance/Stock by and between
                                          the Registrant and Cyto Skin Care Corporation
                                          (name changed in August 1994 to Chantal 
                                          Skin Care Corporation) dated
                                          March 15, 1994                                            --
 
(9)-Exhibit 10.2       10.15              License Agreement by and between the Registrant
                                          and Cyto Skin Care Corporation (name changed in
                                          August 1994 to Chantal Skin Care Corporation) dated
                                          March 15, 1994                                            --
 
(10)-Exhibit 10.21     10.16              Second Amendment to License Agreement between
                                          the Registrant, CBD Pharmaceutical Corporation and
                                          Chantal Skin Care Corporation dated October 17, 1994      --
                                        
(11)Exhibit 10.22      10.17              Employment Agreement between the Registrant
                                          and Lawrence J. Brady, dated as of March 7, 1995          --
 
(11)Exhibit 10.23      10.18              Lease dated May 1, 1995 between the Registrant
                                          and A.D. Clark, Inc.                                      --
 
(12)Exhibit 10.19      10.19              Agreement dated June 29, 1995 between the
                                          Registrant and Stanson Marketing, Inc.                    --
 
(13)Exhibit 10.20      10.20              Amendment to agreement dated June 29, 1995 between the
                                          Registrant and Stanson Marketing, Inc.                    --

          *            10.21              Employment Agreement between the Registrant and Yvette 
                                          Lamprecht, dated August 15, 1996.                          +
  
          *            10.22              Employment Agreement between the Registrant and Joseph 
                                          DeKama, dated June 6, 1997.                                +

          *            10.23              Employment Agreement between the Registrant and Polly 
                                          Bergen, dated June 17, 1997.                               +
 
          *            21                 Listing of Subsidiaries                                   --

          *            27                 Financial Data Schedule                                   --
 
</TABLE>
---------------------
*    Filed herewith.

+    Compensation Agreement.

(1)  Registrant's Registration Statement on Form S-18, File No. 2-94956-NY.

(2)  Registrant's Annual Report on Form 10-K for the year ended June 30, 1985.

(3)  Registrant's Registration Statement on Form S-1, File No. 33-10724.

(4)  Registrant's Registration Statement on Form S-1, File No. 33-19079.

(5)  Registrant's Registration Statement on Form S-1, File No. 33-25521.

(6)  Registrant's Registration Statement on Form S-1, File No. 33-31846.

(7)  Registrant's Registration Statement on Form S-3, File No. 33-40352.

                                       60
<PAGE>
 
(8)  Registrant's Annual Report on Form 10-K for the year ended June 30, 1993.
(9)  Registrant's Report on Form 10-Q for the quarter ended December 31, 1993.
(10) Registrant's Annual Report on Form 10-K for the year ended June 30, 1994.
(11) Registrant's Registration Statement on Form S-1, File No. 33-89180.
(12) Registrant's Registration Statement on Form 10-K for the year ended June
     30, 1995.
(13) Registrant's Quarterly Report on Form 10Q for the three and six months
     ended December 31, 1995.

                                       61