<PAGE>   1
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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-K
(MARK ONE)

[X]               ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                                       OR

[ ]            TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934
           FOR THE TRANSITION PERIOD FROM ____________ TO ____________


                         COMMISSION FILE NUMBER: 0-21802

                                 --------------

                        N-VIRO INTERNATIONAL CORPORATION
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

               DELAWARE                                  34-1741211
    (STATE OR OTHER JURISDICTION OF         (I.R.S. EMPLOYER IDENTIFICATION NO.)
     INCORPORATION OR ORGANIZATION)

   3450 W. CENTRAL AVENUE, SUITE 328
              TOLEDO, OHIO                                43606
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                (ZIP CODE)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (419) 535-6374


                                 --------------


        SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None

          SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
                     Common Stock, par value $.01 per share

                  Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject
to the filing requirements for at least the past 90 days. Yes  X   No
                                                              ---    ---

                  The aggregate market value of the voting stock held by
non-affiliates of the registrant, based upon the last sale price of registrant's
Common Stock in the National Association of Securities Dealers, Inc. Automated
Quotation System ("Nasdaq") as of April 1, 1998, was approximately $2,953,000.

                  The number of shares of Common Stock of the registrant
outstanding as of April 1, 1998, was 2,755,733.

                       DOCUMENTS INCORPORATED BY REFERENCE

                  None.

                  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. [x]

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<PAGE>   2


                                      INDEX



<TABLE>
<CAPTION>
                                                                     PAGE
                                                                     ----

                                     PART I

<S>              <C>                                                 <C>
    Item 1.      Business                                              1

    Item 2.      Properties                                            9

    Item 3.      Legal Proceedings                                     9

    Item 4.      Submission of Matters to a Vote of Security Holders  10

                                     PART II

    Item 5.      Market for Registrant's Common Equity and Related    10
                 Stockholder Matters

    Item 6.      Selected Financial Data                              10

    Item 7.      Management's Discussion and Analysis of              12
                 Financial Condition and Results of Operations

    Item 8.      Financial Statements and Supplementary Data          20

    Item 9.      Changes in and Disagreements with Accountants        21
                 on Accounting and Financial Disclosure

                                    PART III

    Item 10.     Directors and Executive Officers of the Registrant   21

    Item 11.     Executive Compensation                               22

    Item 12.     Security Ownership of Certain Beneficial Owners      27
                 and Management

    Item 13.     Certain Relationships and Related Transactions       28

                                     PART IV

    Item 14.     Exhibits, Financial Statement Schedules, and         30
                 Reports on Form 8-K
</TABLE>



<PAGE>   3


                                     PART I



ITEM 1.           BUSINESS

GENERAL

         N-Viro International Corporation (the "Company" or "N-Viro"),
incorporated in April, 1993, owns and licenses the N-Viro Process, a patented
technology to treat and recycle wastewater sludges and other bio-organic wastes,
utilizing certain alkaline and mineral by-products produced by the cement, lime,
electric utilities and other industries. See "The N-Viro Process."

         In 1979, Mr. J. Patrick Nicholson and several investors formed N-Viro
Energy Systems, Limited (the "Partnership"). The Partnership's initial strategy
was to license the N-Viro Process to third parties through independent agents.
Each independent agent acted in its respective territory as a marketing and
distribution agent of the Partnership, and the Partnership retained the
marketing and distribution rights to certain other territories. In early 1993,
as a result of the then pending implementation of the Section 503 Sludge
Regulations (as defined below) and the market environment, the Partnership
concluded that a strategy that also included the development and operation, on a
contract management basis, of N-Viro facilities for third parties, and of
Company-owned and/or co-owned N-Viro facilities, would potentially expand the
opportunities to capitalize on the N-Viro Process.

         In order to implement this strategy, the Partnership agreed to combine
with American N-Viro Resources, Inc., National N-Viro Tech, Inc., N-Viro
Midwest, Inc., N-Viro Soil South, Inc. and Tennessee-Carolina N-Viro
(collectively, the "Combined Agents") to form the Company. The Company was
incorporated in April 1993 primarily to expand the opportunities for
capitalizing on the N-Viro Process. The Company assumed the Partnership's
agreements with the remaining agents who are continuing to market the N-Viro
Process in their respective territories.

         The Company became a public company on October 12, 1993 with an initial
public offering (the "IPO") of 2,000,000 shares of Common Stock at $9.50 per
share. On October 19, 1993, the Partnership contributed to the Company all of
its assets (except certain marketable securities and accounts receivable from
certain related parties), subject to all liabilities (except certain retained
liabilities), and the stockholders of the Combined Agents contributed to the
Company all of the outstanding capital stock of such entities in exchange for a
total of 6,000,000 shares of Common Stock of the Company and organization notes
totaling $5,221,709 (including notes of $276,909 which resulted from a partial
exercise of an over-allotment option). The organization notes were repaid out of
the proceeds from the IPO. On November 10, 1993, an additional 112,000 shares
were sold pursuant to the exercise by the Underwriters of their over-allotment
option.

         On October 30, 1995, at a Special Meeting of the Shareholders, the
shareholders approved a one for four reverse stock split which reduced the
number of issued and outstanding shares of the Common Stock. This reverse split
did not affect the Company's retained deficit and the stockholders' equity
remained substantially unchanged. This action was deemed necessary by management
of the Company to remain in compliance with the minimum bid price requirement of
Nasdaq or the alternative net tangible assets requirement and for continued
listing of the Common Stock on Nasdaq. The reverse split reduced the number of
issued and outstanding shares of the Common Stock to approximately 2,037,000
(net of 57,250 treasury shares).

         In late 1995, the Company's business strategy changed from being a low
cost provider of a process to marketing the N-Viro Process that produces an
"exceptional quality" sludge product, as defined in the Section 503 Sludge
Regulations under the Clean Water Act of 1987 (the "Section 503 Sludge
Regulations"), with multiple commercial uses. In this strategy, the primary
focus is to identify allies, public and private, who will build and operate the
N-Viro facility. To date, the Company's revenues primarily have been derived
from the licensing of the N-Viro Process to treat and recycle wastewater sludges
generated by municipal wastewater treatment plants and from the sale to
licensees of the alkaline admixture used in the N-Viro Process. The Company has
also operated N-Viro facilities for third parties on a start-up basis and
currently operates one N-Viro facility on a contract management basis. The
Company has granted 47 licenses to use the N-Viro Process. There are currently
38 N-Viro facilities operating throughout the world using the N-Viro Process.
The Company estimates that these operating N-


                                       1
<PAGE>   4

Viro facilities are treating and recycling sludge at an annualized rate of
approximately 140,000 dry tons per year. The nine licensees not currently
operating include both international and domestic contractors or public
generators who are developing or designing site specific N-Viro facilities.

         Since 1995, the Company has marketed licenses for the use of the N-Viro
Process through its own sales and marketing force in the United States in 30
states and the District of Columbia and internationally throughout the world. In
the remaining states, and in these other parts of the world, the Company
licenses the N-Viro Process through agents (the "Agents"). Typically, the
agreements with the Agents provide for the Company to receive a portion of the
up-front license fees and ongoing royalty fees paid by the licensees and a
portion of the proceeds from the distribution and resale of alkaline admixture
and the sale of N-Viro SoilTM. Agents have total responsibility and control over
the marketing and contracts for N-Viro technology subject only to license models
or minimum agreements with the Company.

         The Company is marketing the use of the N-Viro Process through its own
sales and marketing in house staff and manufacturers representatives. Revenues
are derived from domestic and international licensing of the N-Viro Process, the
sale of alkaline admixtures used in some N-Viro Processes, management fees from
the operation of a treatment facility in Toledo, Ohio, one time sales of the
N-Viro Process technology, and sale of ancillary products and services. The
sales representative network is the key component of the Company's domestic
sales strategy. The manufacturers representatives network was started by the
Company after acquiring eight of eleven domestic agents. These representatives
receive a commission on certain revenue.

         The Toledo, Ohio facility is a "Contract Management Agreement" with the
City of Toledo. Revenue from the Toledo operation accounts for about 35% of the
Company's total revenue. The Company processes Toledo's bio-solids and sells the
N-Viro Soil product. This contract will expire in October of 1999. Currently,
the contract is in its second five-year renewal period, and the Company
reasonably expects to renew this for another term. The relationship between the
City of Toledo and the Company has been satisfactory.

THE N-VIRO PROCESS

         The N-Viro Process is a patented process for the treatment and
recycling of bio-organic wastes, utilizing certain alkaline by-products produced
by the cement, lime, electric utilities and other industries. To date, the
N-Viro Process has been commercially utilized for the recycling of wastewater
sludges from municipal wastewater treatment facilities. N-Viro Soil produced
according to N-Viro Process specifications is an "exceptional quality" sludge
product under the United States Environmental Protection Agency (the "EPA") 40
CFR part 503 Sludge Regulations.

         The N-Viro Process involves mixing the wastewater sludge with an
alkaline admixture and then subjecting the mixture to a controlled period of
storage, mechanical turning and accelerated drying in which a blending of the
sludge and the alkaline admixture occurs. The N-Viro Process stabilizes and
pasteurizes the wastewater sludge, reduces odors to acceptable levels,
neutralizes or immobilizes various toxic components and generates N-Viro Soil, a
product which has a granular appearance similar to soil and has multiple
commercial uses. These uses include agricultural lime, soil enrichment, top soil
blend, landfill cover and filter, and land reclamation.

         The alkaline admixture used in the N-Viro Process consists of
by-product dusts from cement or lime kilns, certain fly ashes and other products
of coal, coke or petroleum combustion and by-product dusts from sulfuric acid
"scrubbers" used in acid rain remediation systems and from fluidized bed coal
fired systems used in electric power generation. The particular admixture that
is used usually depends upon cost and availability in local markets. In certain
cases, commercial lime may also be added to the admixture. Initially, the
Company required licensees to buy all alkaline admixtures from the Company. This
requirement has been eliminated by increasing the royalty or professional
services revenue to offset the lost revenue from alkaline sales.

         The Company and the Agents act as distributors of alkaline admixture
within their respective marketing and distribution territories and are
responsible for quality control of the admixture. The Company also works with
established by-product marketers. The Company generally charges a mark-up over
its cost for alkaline admixture sold directly by the Company, and receives a
royalty fee from the Agents based on a percentage of the Agents' gross profits
from alkaline admixture sales.



                                       2
<PAGE>   5

         N-Viro Soil is sold for agricultural use as a bio-organic and mineral
fertilizer with agricultural liming and nutrient values, as landfill cover
material, as a topsoil blending ingredient and for land reclamation projects.
The Company estimates that approximately five percent of the N-Viro Soil
produced is sold to landfills for cover material, small amounts are sold for
land reclamation and similar projects, and a substantial portion of the
remainder is sold for agricultural use or as a topsoil blend. Although the use
of N-Viro Soil is not subject to any federal regulations or restrictions, each
N-Viro facility is typically required to obtain a state and/or local permit for
the sale of N-Viro Soil. In addition, many states and/or local governments
require site-specific permits for the use of sludge products in bulk amounts.

RESEARCH AND DEVELOPMENT

         Research and development on the N-Viro Process is performed primarily
by BioCheck Laboratories, Inc. ("BioCheck"), formerly a wholly-owned subsidiary
of the Company. In 1997 the Company spent approximately $60,000 on testing of
the process, and considers it's relationship with BioCheck to be satisfactory.

         In 1997 the Company spent approximately $50,000 on research and patent
development. Research and development on N-Viro Soil has been, to date,
performed primarily by Dr. Terry J. Logan and his staff at The Ohio State
University pursuant to a consulting arrangement with the Company. To date, Dr.
Logan has acted as an independent consultant to the Company on a part-time basis
and is a director of the Company.

         All participants on the Company's technology council, including Dr.
Logan and the officers of BioCheck Laboratories, have contracts with the
Company, protecting its rights.

         In addition, the United States Department of Agriculture (the "USDA")
and the Ohio Coal Development Authority (the "OCDA"), have provided substantial
grants to N-Viro International, Rodale Institute, and Compost Council (USDA),
and to BioCheck (OCDA), to demonstrate the effectiveness of compost and
bio-mineral technology on manure (USDA) and ash utilization or bio-mineral
processes (OCDA). Both these grants have funded approximately $100,000 annually
for the past three years. The Company's net revenue after costs from these
grants has been immaterial.

         The Company's initial pasteurization patents have over nine years of
patent life remaining. Newer technologies for accelerated stabilization and use
of carbon dioxide have a longer life cycle. Two patents, including dryer and
"BioBlend" technology are still pending so the patent life has not begun to
expire.

         The Company continues to investigate methods to shorten drying time,
substitute various other materials for use as alkaline admixture and improve the
quality and attractiveness of N-Viro Soil to a variety of end-users. Several new
developments are the subject of issued patents, including the use of carbon
dioxide in the N-Viro Process as a means to (i) reduce by-product carbon dioxide
emissions from industrial processes by fixating carbon dioxide in the N-Viro
Soil and (ii) improve the quality and value of N-Viro Soil. In addition, the
Company has been working with Cemen Tech, an Iowa-based manufacturer of concrete
and sludge processing equipment, to develop a dryer system which will reduce
processing time while continuing to permit the survival of beneficial
microflora. The Company's Phillipsburg, New Jersey and Leamington, Canada
facilities began use of dryers in late 1995. The Company's "BioBlend", which
uses N-Viro Soil as a reagent to accelerate and deodorize yard waste composting,
was fully integrated into Middlesex County operations in 1996.

         In late 1997, N-Viro was awarded a $500,000 grant from USDA to build a
pilot plant at Beltsville, Maryland, to demonstrate the ability of both old and
new N-Viro technology to disinfect animal manure pathogens, fixate their metals,
reduce their odors and most importantly, immobilize soluble nutrients to prevent
water pollution. The Company expects this facility to be "on-line" in the summer
of 1998.

ORGANIZATION

         The Company has continued to streamline its operations in 1997 in an 
effort to provide for an effective, efficient and customer responsive
organization. Domestic Sales and Marketing and Management of the Toledo, Ohio
facility is directed by the Company's Vice-President of Sales and Marketing and
assisted by sales and marketing personnel who coordinate their actions within
the network of manufacturers representatives. Staff personnel are responsible 


                                       3
<PAGE>   6

for the sales and promotions of the N-Viro Process in assigned states.
International Sales and Marketing is directed by the Company's Chief Executive
Officer.

         Prior to late 1995, the marketing and distribution territories were
assigned specifically to divisions of the Company or to its Agents.

<TABLE>
<CAPTION>
--------------------------------------------------------------------------------------------
                                      The Agents
--------------------------------------------------------------------------------------------

<S>                                                           <C>                                                                   
     Synagro Technologies, Inc. (1)...........................Arizona, Arkansas, Louisiana, New Mexico, Oklahoma and Texas
     N-Viro Resources, Inc.                                   Colorado, Iowa, Kansas, Minnesota, Montana, Nebraska, North Dakota,
                                                              South Dakota and Wyoming
     N-Viro Systems Canada, Inc...............................Canada
     Nesher Israel Cement, Ltd................................Israel
     Bio-Recycle Pty. Ltd.....................................Australia, New Zealand and Singapore

<FN>
     (1) Synagro Technologies, Inc. is a public company whose shares are traded on the Nasdaq.
</FN>
</TABLE>

         In 1995, the Company sold the territorial rights of Europe, Africa and
the Middle East and granted an exclusive license for these territories to an
investor group headed by Mr. Robin Millard. This group acquired one of the
Company's wholly owned subsidiaries, N-Viro Worldwide.

         In their respective territories, the Agents market licenses for the
N-Viro Process, serve as distributors of alkaline admixture, oversee quality
control of the N-Viro Process and N-Viro Soil, enforce the terms of the license
agreements with licensees and market N-Viro Soil (or assist licensees in
marketing N-Viro Soil). In general, the Agents have paid one-time, up-front fees
to the Company for the rights to market or use the N-Viro Process in their
respective territories. Typically, the agreements with the Agents provide for
the Company to receive a portion of the up-front license fees and ongoing
royalty fees paid by the licensees and a portion of the proceeds from the
distribution and resale of alkaline admixture and the sale of N-Viro Soil.

INDUSTRY OVERVIEW

         Sludge Management Practices and the 40 CFR part 503 Sludge Regulations.
Historically, sludge management has involved either disposal, principally by
landfilling, incineration, ocean dumping and surface disposal, or land
application for beneficial use. On February 19, 1993, the EPA published the 40
CFR part 503 Sludge Regulations ("part 503 Regs") under the Clean Water Act of
1987 implementing the EPA's "exceptional quality" sludge program. The part 503
Regs establish sludge use and disposal standards applicable to approximately
35,000 publicly and privately-owned wastewater treatment plants in the United
States, including primary publicly-owned treatment works ("POTWs"), secondary
and advanced treatment POTWs, privately-owned treatment works, federally-owned
treatment works and domestic septage haulers. The EPA currently estimates that
the 13,000 to 15,000 POTWs generate 110 to 150 million wet metric tons of sewage
sludge per year. Under the part 503 Regs, sludge may be disposed of in municipal
solid waste landfills approved under Subtitle D of the Resource Conservation and
Recovery Act ("RCRA"), or may be surface disposed, incinerated or land applied
for beneficial use in accordance with the requirements established by the part
503 Regs.

         Disposal. Landfilling, incineration and ocean dumping have
traditionally provided inexpensive, reliable methods of sludge disposal. Ocean
dumping was banned in the United States in December 1992. Under the part 503
Regs, landfilling and incineration remain permissible sludge management
alternatives but have become subject to more stringent regulatory standards. The
vast majority of states have some site restrictions or other management
practices governing the disposal of sludge in landfills. Amendments to the Clean
Air Act governing incineration and disposal of residual ash also impose stricter
air emission standards for incineration in general, and the part 503 Regs impose
additional specific pollutant limits for sludges to be incinerated and for the
resulting air emissions.

                                       4
<PAGE>   7

         Surface disposal of sludge involves the placement of sludge on the land
at a dedicated site for disposal purposes. The part 503 Regs subject surface
disposal to increased regulation by requiring, among other things, run-off and
leachate collection systems, methane monitoring systems and monitoring of, and
limits on, pollutant levels. In addition, sludge placed in a surface disposal
site is required to meet certain standards with respect to pathogen levels
relating to coliform or salmonella bacteria counts ("Class B" pathogen levels),
levels of various pollutants, including metals, and elimination of
attractiveness to pests, such as insects and rodents.

         Land Application for Beneficial Use. Land application for beneficial
use involves the application of sludge or sludge-based products, for
non-disposal purposes, including agricultural, silvicultural and horticultural
uses and for land reclamation. Under the part 503 Regs, sludge products that
meet certain stringent standards with respect to pathogen levels relating to
coliform, salmonella, enteric viruses and viable helminth ova counts ("Class A"
pathogen levels), levels of various pollutants, including metals, and
elimination of attractiveness to pests, such as insects and rodents, are
considered by the EPA to be "exceptional quality" sludge products. The Class A
pathogen levels are significantly more stringent than the Class B levels; for
example, permitted Class B fecal coliform levels are 2,000 times higher than
Class A levels.

         "Exceptional quality" sludge products are treated by the EPA as
fertilizer material, thereby exempting these products from federal restrictions
on their agricultural use or land application. N-Viro Soil that is produced
according to N-Viro Process specifications meets the pollutant concentration
limits and other standards set forth in the part 503 Regs and, therefore, is an
"exceptional quality" sludge product that exceeds the EPA's standards for
unrestricted agricultural use and land application. Lower quality sludges,
including sludge-based products that meet Class B pathogen levels and certain
pollutant control and pest attraction requirements, may also be applied to the
land for beneficial use but are subject to greater record keeping and reporting
requirements and restrictions governing, among other items, the type and
location of application, the volume of application and limits on cumulative
levels of metals. Sludges applied to the land for agricultural use must meet
Class B pathogen levels and, if applied in bulk, require an EPA permit.

COMPETITION

         The Company is in direct and indirect competition with other
businesses, including disposal and other wastewater sludge treatment businesses,
some of which are larger and more firmly established and may have greater
marketing and development budgets and capital resources than the Company. There
can be no assurance that the Company will be able to maintain a competitive
position in the sludge treatment industry.

         A 1988 EPA survey estimated that sludge generators in the United States
utilized landfilling, incineration, surface disposal and ocean dumping as sludge
management alternatives for approximately two-thirds of wastewater sludges
generated. Although ocean dumping was banned in December 1992, other methods of
sludge disposal remain permissible sludge management alternatives under the part
503 Regs, and in many instances will be less expensive than treatment methods,
including the N-Viro Process.

         Sludge treatment alternatives other than disposal include processes,
such as aerobic and anaerobic digestion and lime stabilization, that typically
produce lower quality sludge products, and other processes, such as
pelletization, composting, high heat lime sterilization and high heat en-vessel
lime pasteurization, that produce "exceptional quality" sludge products. Some of
these processes have established a significant market presence, and the Company
cannot predict whether any of such competing treatment processes will be more or
less successful than the N-Viro Process. In 1997, the primary competition to
N-Viro technology was the dumping of raw sewage sludge in landfills. While such
practices are prohibited in some states, e.g. North Carolina, New Jersey and
Ohio, the practice is accepted by the USEPA.

ENVIRONMENTAL REGULATION

         Various environmental protection laws have been enacted and amended
during recent decades in response to public concern over the environment. The
Company's operations and those of its licensees are subject to these evolving
laws and the implementing regulations. The United States environmental laws
which the Company believes are, or may be, applicable to the N-Viro Process and
the land application of N-Viro Soil include RCRA, as amended by the Hazardous
and Solid Waste Amendments of 1984 ("HSWA"), the Federal Water Pollution Control
Act of 1972 (the "Clean Water Act"), the Clean Air Act of 1970, as amended (the
"Clean Air Act"), CERCLA, the 


                                       5
<PAGE>   8

Pollution Prevention Act of 1990 and the Federal Insecticide, Fungicide and
Rodenticide Act ("FIFRA"). These laws regulate the management and disposal of
wastes, control the discharge of pollutants into the air and water, provide for
the investigation and remediation of contaminated land and groundwater resources
and establish a pollution prevention program. Many of these laws have
international counterparts, particularly in Europe and elsewhere in North
America. In addition, various states have implemented environmental protection
laws that are similar to the applicable federal laws and, in addition, states
may require, among other things, permits to construct N-Viro facilities and to
sell and/or use N-Viro Soil. There can be no assurance that any such permits
will be issued.

         The part 503 Regulations. Sewage sludge and the use and disposal
thereof is regulated under the Clean Water Act. On February 19, 1993, the EPA
published the part 503 Regulations under the Clean Water Act implementing the
EPA's "exceptional quality" sludge program. These regulations establish sludge
use and disposal standards applicable to approximately 35,000 wastewater
treatment plants in the United States, including approximately 12,750 publicly
owned treatment works ("POTWs"). Under the part 503 Regs, sludge products that
meet certain stringent standards are considered to be "exceptional quality"
sludge products and are not subject to any federal restrictions on agricultural
use or land application. N-Viro Soil produced according to N-Viro Process
specifications is an "exceptional quality" sludge product. Lower quality sludges
and sludge products are subject to federal restrictions governing, among other
items, the type and location of application, the volume of application and the
cumulative application levels for certain pollutants. Agricultural application
of these lower quality sludges in bulk amounts also requires an EPA permit.
Agricultural and land applications of all sludges and sludge products, including
N-Viro Soil and other "exceptional quality" sludge products, are typically
subject to state and local regulation and, in most cases, require a permit.

         In order to ensure compliance with the part 503 Regs, the Company
reviews the results of regular testing of sludges required by the EPA to be
conducted by wastewater treatment plants, and itself tests N-Viro Soil produced
at N-Viro facilities on a regular basis. In general, the Company does not
license or permit the ongoing use of the N-Viro Process to treat any sludge that
may not be processed into an "exceptional quality" sludge product. In one N-Viro
facility, however, the Company has permitted the use of the N-Viro Process to
produce a product that is not an "exceptional quality" sludge product due to the
high pollutant levels of the resulting product. This product is not considered
to be N-Viro Soil and is used solely for landfill cover at an adjacent landfill.
In addition, the Company had previously licensed for use at five treatment
facilities an earlier sludge treatment process that is designed to produce a
sludge product that meets only Class B pathogen levels, and therefore does not
produce an "exceptional quality" sludge product.

         Although N-Viro Soil exceeds the current federal standards imposed by
the EPA for unrestricted agricultural use and land application, state and local
authorities are authorized under the Clean Water Act to impose more stringent
requirements than those promulgated by the EPA. Most states require permits for
land application of sludge and sludge based products and several states, such as
Rhode Island, Massachusetts and New Jersey, currently have regulations that
impose more stringent numerical concentration limits for certain pollutants than
the federal rules.

         The Resource Conservation and Recovery Act. RCRA regulates all phases
of hazardous waste generation, management and disposal. A waste is subject to
regulation as a hazardous waste under RCRA if it is a solid waste specifically
listed as a hazardous waste by the EPA or exhibits a defined hazardous
characteristic. Although domestic sewage and mixtures of domestic sewage and
other wastes that pass through a sewer system to a POTW are specifically
exempted from the definition of solid waste, once treated by the POTW, the
sewage sludge is considered a solid waste. However, such sewage sludge is not
considered a hazardous waste unless it exhibits a hazardous characteristic.
While it is possible that sewage sludge could exhibit the toxicity
characteristic, the Company believes that regular tests for hazardous
constituent levels provide assurance that the sewage sludge used in the N-Viro
Process does not exhibit the toxicity characteristic. The alkaline admixtures
used in the N-Viro Process are specifically exempted from RCRA regulation by the
so-called "Bevill Amendments" to RCRA. Although the benefit of the exemption
provided by the "Bevill Amendments" can be lost if the alkaline admixture is
derived from or mixed with a hazardous waste, the Company has adopted and
implemented policies and operational controls, including review of operating
permits held by alkaline admixture suppliers and periodic testing of such
admixtures, to ensure that the alkaline admixtures used in the N-Viro Process by
itself and its licensees are not derived from or mixed with hazardous wastes.



                                       6
<PAGE>   9

         Although neither the alkaline admixture nor wastewater sludges used in
the N-Viro Process are regulated as hazardous waste under RCRA, states may
impose restrictions that are more stringent than federal regulations.
Accordingly, the raw materials used in the N-Viro Process may be regulated under
some state hazardous waste laws as "special wastes," in which case specific
storage and record keeping requirements may apply.

         The Clean Air Act. The Clean Air Act empowers the EPA to establish and
enforce ambient air quality standards and limits of emissions of pollutants from
specific facilities. The Clean Air Act Amendments of 1990 (the "Clean Air Act
Amendments") impose stringent requirements upon owners and operators of
facilities that discharge emissions into the air.

         Existing N-Viro facilities generally have installed "baghouse"
technology for alkaline admixture storage and handling operations in order to
collect airborne dust. At present, the Company does not believe that N-Viro
facilities will be required to undertake any further measures in order to comply
with the Clean Air Act or the existing Clean Air Act Amendments. Ammonia odors
of varying strength typically result from sludge treatment processes, including
the N-Viro Process. A number of N-Viro facilities have installed ammonia
"scrubbers" to reduce ammonia odors produced to varying degrees by the N-Viro
Process. The installation of ammonia "scrubbers" is not required by the Clean
Air Act or the existing Clean Air Amendments. However, the Company or its
licensees may be required under the Occupational Safety and Health Act and state
laws regulating nuisances, odors and air toxic emissions to install odor control
technology to limit ammonia emissions and odors produced during the N-Viro
Process, particularly at N-Viro facilities located near populated residential
areas. The amount of ammonia gas produced is dependent upon the type of sludge
being treated and the amount and type of alkaline admixture being used.

         The Comprehensive Environmental Response, Compensation and Liability
Act of 1980. CERCLA imposes strict, joint and several liability upon owners and
operators of facilities where a release of hazardous substances has occurred,
upon parties who generated hazardous substances into the environment that were
released at such facilities and upon parties who arranged for the transportation
of hazardous substances to such facilities.

         The Company believes that the N-Viro Process poses little risk of
releasing hazardous substances into the environment that presently could result
in liability under CERCLA. Although the sewage sludge and alkaline waste
products could contain hazardous substances (as defined under CERCLA), the
Company has developed plans to manage the risk of CERCLA liability, including
training of operators, regular testing of the sludge and the alkaline admixture
to be used in the N-Viro Process and reviewing incineration and other permits
held by the entities from whom alkaline admixtures are obtained.

         Other Environmental Laws. The Pollution Prevention Act of 1990
establishes pollution prevention as a national objective, naming it a primary
goal wherever feasible. The act states that where pollution cannot be prevented,
materials should be recycled in an environmentally safe manner. The Company
believes that the N-Viro Process contributes to pollution prevention by
providing an alternative to disposal.

         The alkaline admixtures used in the N-Viro Process may be required to
be registered as pesticides under FIFRA because of their effect on pathogens in
sludge. The EPA does not currently regulate commercial lime or any alkaline
by-products under FIFRA and has not attempted to assert such jurisdiction to
date. In the event the alkaline by-products are required to be registered under
FIFRA, the Company would likely be required to submit certain data as part of
the registration process and might be subject to further federal regulation.

         State Regulations. State regulations typically require an N-Viro
facility to obtain a permit for the sale of N-Viro Soil for agricultural use,
and may require a site-specific permit by the user of N-Viro Soil. In addition,
in some jurisdictions, state and/or local authorities have imposed permit
requirements for, or have prohibited, the land application or agricultural use
of sludge products, including "exceptional quality" sludge products. There can
be no assurance that any such permits will be issued or that any further
attempts to require permits for, or to prohibit, the land application or
agricultural use of sludge products will not be successful.

         In addition, many states enforce landfilling restrictions for
non-hazardous sludge. These regulations typically require a permit to sell or
use sludge products as landfill cover material. There can be no assurance that
N-Viro facilities or landfill operators will be able to obtain required permits.



                                       7
<PAGE>   10

         Environmental impact studies may be required in connection with the
development of future N-Viro facilities. Such studies are generally time
consuming and may create delays in the construction process. In addition,
unfavorable conclusions reached in connection with such a study could result in
termination of, or expensive alterations to, the N-Viro facility being
developed.

EMPLOYEES

         As of December 31, 1997, the Company had 19 employees in the following
capacities: 8 engaged in sales and marketing; 6 in finance and administration;
and 5 in operations. The Company considers its relationships with its employees
to be satisfactory.

         The Company is a party to a collective bargaining agreement covering
certain employees of National N-Viro Tech, Inc., a wholly-owned subsidiary of
the Company. The employees that are covered by the collective bargaining
agreement work at the Toledo, Ohio N-Viro facility which is operated by the
Company on a contract management basis for the City of Toledo. These employees
are members of the International Brotherhood of Teamsters, Chauffers,
Warehouseman and Helpers Local Union #20, and the Company considers its
relationships with the organization to be satisfactory. At present, the
agreement expires October 31, 1999.

N-VIRO FACILITIES

         To date, the Company principally has licensed the N-Viro Process to
municipalities for use in municipally-owned wastewater treatment plants. The
Company has also operated, generally on a start-up basis, N-Viro facilities for
municipalities and currently operates one municipally-owned N-Viro facility on a
contract management basis. In most cases, however, municipal licensees have
elected to design, construct and operate N-Viro facilities independently.

         As of December 31, 1997, there were 38 N-Viro facilities operating
throughout the world. The sludge processing capacity of these facilities ranges
from one to 160 dry tons per day. The Company estimates that these N-Viro
facilities are processing wastewater sludge at an annualized rate of
approximately 140,000 dry tons per year. In 1997, four new licenses were
executed by N-Viro; the City of Auburn, Indiana, the City of Fairbanks, Alaska,
the City of Raleigh, North Carolina and the City of Urbana, Ohio.

         The N-Viro Soil produced is typically sold within 100 miles of the
N-Viro facility and used for a variety of purposes, depending upon the needs of
the local market. The chart below summarizes the current annualized sludge
processing volume for each of the ten largest N-Viro facilities.

<TABLE>
<CAPTION>
                                                                          Approximate Sludge
                                                                           Processing Volume
                             Facility Location                              (dry tons/year)
                   ----------------------------------                    --------------------
<S>                <C>                                                         <C>   
                   Middlesex County, New Jersey                                 54,000
                   Wilmington, Delaware                                         12,000
                   Syracuse, New York                                           11,000
                   Phillipsburg, New Jersey                                      8,500
                   Toledo, Ohio                                                  8,000
                   Minneapolis/St. Paul, Minnesota                               5,000
                   Asheville, North Carolina                                     4,000
                   Greenville, South Carolina                                    4,000
                   Riverstone, Australia                                         3,000
                   Ft. Meade, FL                                                 3,000
</TABLE>

         All of the existing N-Viro facilities are owned and operated by third
parties, with the exception of the Toledo, Ohio facility which has been operated
by the Company on a contract management basis since January 1990 and the Fort
Meade, Florida facility which has been owned jointly by the Company and VFL
Technologies, Ltd. since January 1996, after start-up in February 1995.



                                       8
<PAGE>   11

         Design and construction of a facility using the N-Viro Process is
typically undertaken by local independent engineering and construction firms.
Such a facility can be completed in approximately six months, but could take
substantially longer, depending on the size and complexity of the facility. The
N-Viro Process produces ammonia in various concentrations, depending on the
characteristics of the sludge. A number of N-Viro facilities, typically those
located near residential areas, have installed odor control systems in order to
minimize the release of ammonia odors resulting from the N-Viro Process. An odor
control system can significantly increase construction time and cost.
Construction of N-Viro facilities generally requires state and local permits and
approvals and, in certain instances, may require an environmental impact study.

         The Company had previously licensed for use at five treatment
facilities an earlier sludge treatment process that is designed to produce a
sludge product that meets only Class B pathogen levels, and therefore does not
produce an "exceptional quality" sludge product. Royalty payments from sludge
processed at the five facilities using such earlier technology currently account
for less than two percent of total royalty payments to the Company and the
Company does not actively market the use of this process.

ITEM 2.           PROPERTIES

         The Company's executive and administrative offices are located in
Toledo, Ohio, under a lease that expires on December 31, 2002. The Company
believes its relationship with its lessor is satisfactory.

         In early 1994 the Company purchased a site in Fort Meade, Florida to
develop a Company-owned N-Viro processing facility. Construction was started at
the site in late 1994 and the facility became operational in early 1995. In
December 1995, the Company entered in to a Memorandum of Understanding with VFL
Technologies, Inc. to jointly own, through a limited liability partnership named
Florida N-Viro, LLP ("Florida N-Viro"), the Fort Meade, Florida facility,
beginning January 1, 1996. Under this agreement, the Company would contribute
the property, plant and equipment to Florida N-Viro in return for approximately
$1,000,000. Additionally, each partner would contribute $250,000 each to Florida
N-Viro for working capital and property improvements. The employees of Fort
Meade would become employees of the new company, however, the purpose of this
facility would remain essentially unchanged.

         The agreement was amended in 1996 to provide that the Company would
receive $881,000 for the contribution of property, each partner would contribute
$250,000 for working capital, and the Company would receive a 47% interest in
Florida N-Viro.

         On December 31, 1997, the members of Florida N-Viro Management, LLC,
the management company of the Florida entity, approved a Settlement Agreement
that amended certain provisions of existing documents involving the Company.
Among those approved were the recovery of monies due the Company pursuant to the
Manchak settlement in November of 1997 and an increase in the Company's
ownership percentage in Florida N-Viro to 50%. Also contained in the Agreement
was the issuance of a $250,000 Promissory Note to the Company for an existing
trade receivable due the Company from VFL Technologies, the other partner in
Florida N-Viro Management, LLC.

         Because of the joint development of early N-Viro patents with the
Medical College of Ohio ("MCO"), in 1995 the Company and MCO agreed that the
rights of MCO to any intellectual property of value to the Company which
currently may be in development or patentable is equivalent to $31,730 for MCO's
portion of royalties through the year ending December 31, 1997. The Company and
MCO have also agreed that future claims to the N-Viro Soil process is only 1/4
of 1% of technical revenues. MCO rights to BioBlend and other new N-Viro
technologies range from 2% to 4% of technical revenues derived from these newer
technologies.

ITEM 3.           LEGAL PROCEEDINGS.

         Simon Waste Solutions ("Simon Waste") had Agency rights for Mexico and
Puerto Rico. Simon Waste has ceased operations, and in 1996 the Company
terminated their license and called for arbitration as provided in their
contract. Simon Waste has failed to respond and the Company is proceeding with
arbitration to obtain a definitive ruling.



                                       9
<PAGE>   12

ITEM 4.           SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

         None.

                                     PART II

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

MARKET INFORMATION

         The Company's Common Stock is listed in the Nasdaq Small Cap Market
under the symbol "NVIC". The price range of the Common Stock in the Market since
January 1, 1996, was as follows:

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------
                    Quarter                                 High                       Low
-------------------------------------------------------------------------------------------------------
<S>                                                        <C>                       <C> <C>
First 1996                                                    6                      1 & 3/4
-------------------------------------------------------------------------------------------------------
Second 1996                                                   6                         3
-------------------------------------------------------------------------------------------------------
Third 1996                                                    6                      2 & 3/8
-------------------------------------------------------------------------------------------------------
Fourth 1996                                                4 & 1/4                   1 & 7/8
-------------------------------------------------------------------------------------------------------
First 1997                                                    3                         2
-------------------------------------------------------------------------------------------------------
Second 1997                                                2 & 1/8                   1 & 5/16
-------------------------------------------------------------------------------------------------------
Third 1997                                                 3 & 1/4                   1 & 5/8
-------------------------------------------------------------------------------------------------------
Fourth 1997                                                3 & 3/8                   2 & 1/8
-------------------------------------------------------------------------------------------------------
</TABLE>

The Company's stock price closed at $2.625 per share on April 6, 1998.

HOLDERS

         As of April 1, 1998, the number of holders of record of the Company's
Common Stock was 919.

DIVIDENDS

         The Company has never paid dividends with respect to its Common Stock.

ITEM 6.           SELECTED FINANCIAL DATA

         The Company was incorporated in April 1993. In September 1993, an
agreement was entered into pursuant to which N-Viro Energy Systems, Ltd., an
Ohio limited partnership contributed to the Company all of its assets (except
certain marketable securities and accounts receivable from certain related
parties) subject to all liabilities (except certain retained liabilities), and
the stockholders of the Combined Agents contributed to the Company all of the
outstanding capital stock of each of such entities, in each case in exchange for
Common Stock and promissory notes (the "Organization"). The Organization was
accounted for as if the Partnership and the Combined Agents (collectively, the
"Company Entities") had always been members of the same operating group.
Accordingly, historical financial statements of each of such entities have been
combined throughout all relevant periods herein. Certain adjustments have been
made to eliminate intercompany transactions between the Company Entities.

         The following selected combined statement of operations data for the
period January 1, 1993 through October 19, 1993, the consolidated statement of
operations data for the period October 20, 1993 through December 31, 1993, the
consolidated statement of operations data for the years ended December 31, 1994,
1995, 1996 and 1997; and the combined and consolidated balance sheet data set
forth below as of December 31, 1993, 1994, 1995, 1996 and 1997 respectively,
have been derived from the financial statements of the Company which


                                      10
<PAGE>   13

have been audited by Ernst & Young LLP, independent auditors for the years
ending December 31, 1994, and the period January 1, 1993 through October 19,
1993 and the period October 20, 1993 through December 31, 1993, and McGladrey &
Pullen, LLP for the years ending December 31, 1995, 1996 and 1997. In the
opinion of management, the financial data presented below reflect all
adjustments (which are of a normal recurring nature) necessary to present fairly
the Company's financial position and results of operations. The data presented
below should be read in conjunction with "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and the Financial Statements
and Supplementary Data appearing elsewhere in this Form 10-K. Prior to the IPO,
the Company Entities operated as separate, independent entities. The financial
data presented below for the period prior to October 20, 1993 is not necessarily
indicative of what the historical financial performance of the Company would
have been, or what the future financial performance of the Company will be, as a
combined entity.

<TABLE>
<CAPTION>
STATEMENT OF OPERATIONS DATA (IN THOUSANDS, EXCEPT PER SHARE DATA):
--------------------------------------------------------------------------------------------------------------------------------
                                                                                                            10/20/93      1/1/93 
                                                                                                              thru         thru 
                                                                                               Total for    12/31/93     10/19/93
                                     12/31/97      12/31/96      12/31/95      12/31/94           1993          (1)         (1)
--------------------------------------------------------------------------------------------------------------------------------
<S>                                   <C>           <C>           <C>           <C>            <C>           <C>          <C>   
Revenues                              $4,053        $4,224        $5,214        $4,552         $4,619        $1,128       $3,491
--------------------------------------------------------------------------------------------------------------------------------
Net income (loss)                        534         (193)       (1,815)       (7,342)        (1,622)         (686)        (936)
--------------------------------------------------------------------------------------------------------------------------------
Net income (loss) per share (2)        $0.23       $(0.09)       $(0.89)       $(3.66)            n/a       $(0.34)          n/a
--------------------------------------------------------------------------------------------------------------------------------
Pro Forma Net loss (3)                   n/a           n/a           n/a           n/a            n/a           n/a        (936)
--------------------------------------------------------------------------------------------------------------------------------

BALANCE SHEET DATA  (IN THOUSANDS):
--------------------------------------------------------------------------------------------------------------------------------
                                     12/31/97      12/31/96      12/31/95      12/31/94      12/31/93
--------------------------------------------------------------------------------------------------------------------------------
<S>                                   <C>           <C>           <C>           <C>            <C>                     
Total assets                           $4,423       $4,167        $5,062        $6,560        $12,860           n/a          n/a
--------------------------------------------------------------------------------------------------------------------------------
Notes payable                            $278       $1,188        $1,540        $1,661           $420           n/a          n/a
--------------------------------------------------------------------------------------------------------------------------------
Shareholder Advance                       n/a         $197           n/a           n/a            n/a           n/a          n/a
--------------------------------------------------------------------------------------------------------------------------------

<FN>
(1)  Amounts represent the total of the combined results of the Company Entities for the period from January 1 through October
     19, 1993 and the consolidated results of the Company for the period from October 20 through December 31, 1993. These
     amounts have been accounted for as if the Partnership and the Combined Agents (collectively, the "Company Entities") had
     always been members of the same operating group.

(2)  Per share amounts have been restated for a one-for-four reverse stock split effective October 31, 1995.

(3)  Certain of the Company Entities operated as subchapter S corporations or, in one case, as a limited partnership, and
     therefore were not subject to federal and state income taxes at the corporate or partnership level; as a result, their
     income or losses were passed through to their respective shareholders or partners. Pro forma net income (loss) reflects a
     provision for pro forma income taxes that would have been recorded had the Company Entities been taxed on a combined basis
     as a C corporation for all periods presented.
</FN>
</TABLE>



                                       11
<PAGE>   14

ITEM 7.           MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                  FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

         The following discussion should be read in conjunction with "Selected
Financial Data" and the Financial Statements and Supplementary Data appearing
elsewhere in this Form 10-K.

         The following table sets forth, as a percentage of total revenues for
the periods presented, revenues related to each of (i) agency, license and
royalty, (ii) facility management and sludge processing, (iii) alkaline
admixture, (iv) N-Viro Soil and (v) miscellaneous revenues:
<TABLE>
<CAPTION>
                                                 FOR THE YEAR ENDED DECEMBER 31,
===================================================================================
                                                       1997       1996       1995
-----------------------------------------------------------------------------------
<S>                                                   <C>        <C>        <C>   
Agency, license and royalty                            28.2%      34.0%      18.8%
-----------------------------------------------------------------------------------
Facility management and sludge processing              33.6%      30.0%      34.9%
-----------------------------------------------------------------------------------
Alkaline admixture                                     33.1%      28.1%      30.6%
-----------------------------------------------------------------------------------
N-Viro Soil                                             1.1%       1.5%       1.2%
-----------------------------------------------------------------------------------
Laboratory                                              1.4%       3.3%       3.2%
-----------------------------------------------------------------------------------
Miscellaneous revenues                                  2.6%       3.1%      11.3%
-----------------------------------------------------------------------------------
                                          Totals      100.0%     100.0%     100.0%
===================================================================================
</TABLE>

         Agency revenues represent non-recurring payments for the right to
market the N-Viro Process in a specified territory. License revenues represent
non-recurring payments for the right to use the N-Viro Process in a specified
geographic area or at a particular N-Viro facility. The Company's policy is to
record fully revenues payable pursuant to agency and license agreements when the
Company has fulfilled substantially all of its obligations under the relevant
contract. Royalty revenues represent ongoing amounts received from licensees for
continued use of the N-Viro Process and are typically based on volumes of sludge
processed. Facility management and sludge processing revenues are recognized
under contracts where the Company itself utilizes the N-Viro Process to treat
sludge, either pursuant to a fixed price contract or based on volumes of sludge
processed. Alkaline admixture revenues represent ongoing payments from licensees
arising from the sale and distribution of alkaline admixture by the Company and
the Agents to N-Viro facilities. N-Viro Soil sales represent revenues derived
from the sale of N-Viro Soil, either through royalties from sales of N-Viro Soil
sold by N-Viro facilities, or through sales of N-Viro Soil sold directly by the
Company. Miscellaneous revenues represent: commissions earned on sales, rental
of equipment to a licensee or agent, or testing income.

         In 1996 the Company redrafted its standard technology license to
include all royalty and alkaline commission income in its on-going professional
services fee. This change allows licensees to directly acquire all alkaline
admixtures, providing such materials meet N-Viro specifications. Moreover, in
1996 the Company offered new and old licensees the opportunity to pre-pay
on-going professional services fees on a one-time up-front basis. A
present-value concept is used to determine the revenue on an up-front basis.

         Cost of goods sold expenses principally reflect sludge processing costs
(principally labor and equipment), costs of acquiring alkaline admixture and
fees paid to outside consultants.



                                        12
<PAGE>   15

RESULTS OF OPERATIONS

         The following tables set forth, for the periods presented, (i) certain
items in the Combined Statement of Operations, (ii) the percentage change of
each such item from period to period and (iii) each such item as a percentage of
total revenues in each period presented.

<TABLE>
<CAPTION>
                                             -------------  ---------------  ------------- ----------------- -------------
      (Dollars in thousands)                  Year Ended         Period to    Year Ended          Period to    Year Ended    
      ----------------------                 December 31,        Period       December 31,        Period      December 31,
                                              31, 1997          Percentage       1996            Percentage       1996     
                                                                  Change                           Change      
                                             -------------  ---------------  ------------- ----------------- -------------
<S>                                          <C>                   <C>       <C>                  <C>        <C>          
COMBINED STATEMENT OF
OPERATIONS DATA:
Revenues                                     $       4,052         (4.1%)    $       4,224        (19.0%)    $       5,214
Cost of revenues                                     1,829          1.7%             1,798        (43.2%)            3,167
                                             -------------                   -------------                   -------------

Gross profit                                         2,223         (8.4%)            2,426         18.5%             2,047

Selling, general & administrative                    1,923        (30.1%)            2,751        (22.6%)            3,552
Other operating expenses                                              0                  0       (100.0%)              372
                                             -------------                   -------------                   -------------

Operating income (loss)                                300            *               (325)           *             (1,877)

Non-operating income (expense)                         (78)           *                132        112.9%                62
                                             -------------                   -------------                   -------------

Income (loss) before income tax (credits)
                                                       222            *               (193)           *             (1,815)
Federal and state income tax (credits)
                                                      (312)           *                  0            *                  0
                                             -------------                   -------------                   -------------

Net income (loss)                            $         534            *      $        (193)           *      $      (1,815)
                                             =============                   =============                   ============= 


PERCENTAGE OF REVENUES:
Revenues                                             100.0%                          100.0%                          100.0%
Cost of revenues                                      45.1                            42.6                            60.7
                                             -------------                   -------------                   -------------

Gross profit                                          54.9                            57.4                            39.3

Selling, general & administrative                     47.5                            65.1                            68.1
Other operating expenses                               0.0                             0.0                             7.2
                                             -------------                   -------------                   -------------

Operating income (loss)                                7.4                            (7.7)                          (36.0)

Non-operating income (expense)                        (1.9)                            3.1                             1.2
                                             -------------                   -------------                   -------------

Income (loss) before income tax 
(credits)                                              5.5                            (4.6)                          (34.8)
Federal and state income tax 
(credits)                                             (7.7)                            0.0                             0.0
                                             -------------                   -------------                   -------------

Net income (loss)                                     13.2%                           (4.6%)                         (34.8%)
                                             =============                   =============                   ============= 

<FN>
* Period to period percentage change comparisons have only been calculated for positive numbers.
</FN>
</TABLE>




                                       13
<PAGE>   16

COMPARISON OF YEAR ENDED DECEMBER 31, 1997 WITH YEAR ENDED DECEMBER 31, 1996

         Revenues decreased $172,000, or 4.1%, to $4,052,000 for the year ended
December 31, 1997 from $4,224,000 for the year ended December 31, 1996. This
decrease was due in part to the sale of one of its wholly-owned subsidiaries,
BioCheck Laboratories, which contributed about $54,000 in revenue in 1996. The
balance in the reduction in revenue of $118,000 was due to the following:
revenues from one-time domestic license or international territory fees
decreased $272,000, to $428,000 for 1997 from $700,000 for 1996; $600,000 of the
1996 revenue was due to a Malaysian license that was fully reserved in bad
debts; revenues from existing on-line facilities, excluding BioCheck, increased
$155,000 to $3,625,000 from $3,470,000 for 1996. In 1997 the Company received
approximately $100,000 in gross royalty revenue from our European licensee,
N-Viro Worldwide. Management is optimistic that activities in 1998 will increase
due to the 1998 ban on ocean dumping of sewerage sludge by European Economic
Community countries.

         Gross Profit decreased $203,000, or 8% to $2,223,000 for the year ended
December 31, 1997 from $2,426,000 for the year ended December 31, 1996. The
gross profit margin decreased to 55% from 57% for the year ended December 31,
1996. This decrease in gross profit margin was primarily due to the decrease in
one-time license fee gross profit of $336,000, The gross profit margin from
existing on-line facilities, excluding BioCheck, increased to 51% from 49% for
1996.

         Selling, General and Administrative expenses decreased 30% to
$1,923,000 for the year ended December 31, 1997 from $2,751,000 for the year
ended December 31, 1996. In 1997, the Company continued streamlining its
operations, primarily through staff reduction. The Company reduced expenditures
for salaries and employee benefits by $282,000, and for bad debts by $452,000.
The Company anticipates that its development of a network of marketing
representatives and regional partnerships will more than offset the Company's
reduced staffing in generating new sales revenue. An additional $49,000 in
expenses for non-personnel costs was reduced by the sale of BioCheck.

         Non-operating income (expense) decreased by $210,000 to a loss of
$78,000 for the year ended December 31, 1997 from income of $132,000 for the
year ended December 31, 1996. The decrease was primarily due to the Company
recognizing legal and settlement income of $254,000 in 1996 relating to the
settlement of the patient infringement litigation with Frank Manchak, Jr. See
"Liquidity and Capital Resources".

         The Company recorded a deferred tax asset (credit) of $312,000 in 1997,
to recognize the future tax benefit of a federal net operating loss carryforward
to offset anticipated net income for years starting in 1998. The effective tax
rate used was 39%. Realization of the asset is dependent on generating
sufficient taxable income prior to expiration of the loss carryforwards.
Although realization is not assured, management believes it is more likely than
not that all of the recorded deferred tax asset will be realized. The amount of
the deferred tax asset considered realizable, however, could be reduced in the
near term if estimates of future taxable income during the carryforward period
are reduced.

         The Company recorded net income of $534,000 for the year ended December
31, 1997 compared to a net loss of $193,000 for the year ended December 31,
1996.

         In early 1996 the Company completed the transfer of its interest in the
Fort Meade, Florida facility. The Company incurred a loss of approximately
$46,000 on its share of Florida N-Viro LLP in 1997, a decrease of $4,000 from
1996. The Company expects to record losses from this investment through at least
1998. The audited financial statements of Florida N-Viro are included in this
document after the Company's financial statements as Item 14(d), Financial
Statements of Subsidiaries not Consolidated.



                                       14
<PAGE>   17

         In June of 1997, the Company reached agreements with three trade
creditors to eliminate, in the aggregate, $259,500 of the Company's short-term
debt in exchange for the Company's issuance and delivery to such creditors, in
the aggregate, 86,500 shares of Common Stock. All three trade creditors are
current members of the Board of Directors of the Company, J. Patrick Nicholson,
Bobby Carroll and Frederick Kurtz. Additionally, Mr. Nicholson is the Chairman
of the Board, Chief Executive Officer and President of the Company. The number
of shares of Common Stock issued to, and the corresponding amount of short-term
debt forgiven by, Mr. Nicholson, Mr. Carroll and Mr. Kurtz is set forth in the
table below:

<TABLE>
<CAPTION>
============================================================================================================
              Creditor                    Amount of Canceled Debt        No. of Shares Issued in Exchange
------------------------------------------------------------------------------------------------------------
<S>                                               <C>                                 <C>   
J. Patrick Nicholson                              $ 48,000                            16,000
------------------------------------------------------------------------------------------------------------
Bobby Carroll                                     $150,000                            50,000
------------------------------------------------------------------------------------------------------------
Frederick Kurtz                                   $ 61,500                            20,500
============================================================================================================
</TABLE>

All such shares of Common Stock were issued and delivered to the Company's
creditors pursuant to appropriate exemptions from registration under federal and
state securities laws. All of the exchanges were evidenced by written Share
Exchange Agreements between the Company and each of the creditors. Copies of
such Share Exchange Agreements were filed as Exhibits to the Company's Form 8-K
filed on July 18, 1997 which has been incorporated herein by reference.

         In addition to the share exchanges described above, the Company, in
June of 1997, also reached agreement with N-Viro Energy Systems, Ltd. an Ohio
limited partnership ("NVESL") and the holder of 45% of the issued and
outstanding share of the Common Stock to cancel $150,000 of the Company's
short-term debt to NVESL in exchange for the Company's issuance and delivery to
NVESL of 50,000 shares of Common Stock. At the time of this agreement, the
Company's total indebtedness to NVESL was $176,500. Such indebtedness was
evidenced by three promissory notes in the aggregate amount of $191,500. In
exchange for the cancellation of the three original promissory notes, the
Company agreed to issue and deliver to NVESL (i) 50,000 shares of Common Stock
and (ii) a promissory note in the amount of $26,500. The shares of Common Stock
issued and delivered to NVESL were issued and delivered pursuant to applicable
exemptions from registration under the Securities Act and state securities laws.
Further, this exchange was evidenced by a written Share Exchange Agreement which
was filed by the Company as an Exhibit to the Company's Form 8-K filed on July
18, 1997.

         In addition to the share exchanges described above, the Company, in
January of 1998, also reached agreement with Morgan Lewis & Bockius, New York,
New York ("ML&B"), to cancel $60,000 of the Company's trade debt to ML&B in
exchange for the Company's issuance and delivery to ML&B of 20,000 shares of
Common Stock. At the time of this agreement, the Company's total indebtedness to
ML&B was $90,272. The shares of Common Stock issued and delivered to ML&B will
be issued and delivered pursuant to applicable exemptions from registration
under the federal and state securities laws. A Form 8-K will be filed upon
delivery of the shares, which is anticipated to be by May of 1998.

         In 1996 the Company agreed to acquire the remaining 50% ownership in
Pan-America N-Viro from Synagro, Inc., a public company headquartered in
Houston, Texas. The Company acquired this interest in September of 1996 and
agreed to issue to Synagro 75,000 unregistered shares of the Company's common
stock for the interest. The share certificates were issued in September of 1997.
Pan-American N-Viro has exclusive licensing rights for all N-Viro technology in
Central and South America. The market value of the stock at the time of issuance
was $2.375 per share.

COMPARISON OF YEAR ENDED DECEMBER 31, 1996 WITH YEAR ENDED DECEMBER 31, 1995

         Revenues decreased $990,000, or 19.0%, to $4,224,000 for the year ended
December 31, 1996 from $5,214,000 for the year ended December 31, 1995. This
decrease was due primarily to the sale of one of its wholly-owned subsidiaries,
N-Viro Worldwide, and the contribution to a joint venture of the Fort Meade,
Florida, facility. In 1995, N-Viro Worldwide was sold to a group of investors,
led by Mr. Robin Millard, and was granted an exclusive license for Europe,
Africa and the Middle East. In December of 1995, the Company entered in to a
Memorandum of Understanding with VFL Technologies, Inc. to form a joint venture
to be known as Florida N-Viro, LLP, in which the Company would contribute the
Fort Meade, Florida facility. Revenue from N-Viro 


                                       15
<PAGE>   18

Worldwide and the Ft. Meade facility provided $605,000 and $609,000
respectively, to 1995 revenue. Revenues from one-time license fees increased
$593,000 to $700,000 for 1996 from $107,000 for 1995. Revenues from existing
on-line facilities, excluding N-Viro Worldwide and Fort Meade, decreased
$356,000 to $3,470,000 from $3,826,000 for 1995. In 1996 the Company received
approximately $100,000 in gross revenue from our European licensee, N-Viro
Worldwide.

         Gross Profit increased $379,000, or 18.5% to $2,426,000 for the year
ended December 31, 1996 from $2,047,000 for the year ended December 31, 1995.
The gross profit margin increased to 57.4% from 39.3% for the year ended
December 31, 1995. This increase in gross profit margin was primarily due to the
increase in one-time license fee income of $593,000, at no cost of revenue, and
the elimination in lower gross profit margins of both the Fort Meade, Florida
and BioCheck Laboratories operations, sold December 31, 1995 and March 31, 1996,
respectively. The gross profit margin from existing on-line facilities,
excluding Fort Meade and BioCheck, increased to 49.4% from 47.3% for 1995.

         Selling, General and Administrative expenses decreased 22.6% to
$2,751,000 for the year ended December 31, 1996 from $3,552,000 for the year
ended December 31, 1995. In 1996, the Company continued streamlining its
operations, primarily through regional sales office closings and staff
reduction. The Company reduced expenditures for salaries and employee benefits
by $701,000, for professional services by $329,000, and for insurance by
$70,000. Offsetting these decreases was a $600,000 charge to bad debts, to fully
reserve the license fee income for the sale of the territory rights to Malaysia.

         Other Operating Expenses declined 100% to $-0- for the year ended
December 31, 1996 from $372,000 for the year ended December 31, 1995. The 1995
expense relate to an extension of the terms of the settlement of an alleged
patent infringement litigation as reported in 1994.

         The Company incurred a loss of $193,000 for the year ended December 31,
1996 compared to a loss of $1,815,000 for the year ended December 31, 1995. This
loss includes $250,000 of other income for the settlement of a legal fee dispute
relating to an alleged patent infringement lawsuit, and $42,000 of the
investment losses in the Florida N-Viro joint venture.

         In early 1996 the Company completed the transfer of its interest in the
Fort Meade, Florida facility. This sale resulted in the Company receiving
$881,000 in 1995 and 1996 from VFL Technologies for a 47% ownership position.
The Company incurred a loss of approximately $108,000 on its share of Florida
N-Viro LLP in 1996, but is confident that this investment will be profitable in
the near future.

         On March 31, 1996, the Company sold its remaining wholly-owned
subsidiary, BioCheck Labs, to their employees for a nominal sum of one dollar.
No gain or loss was recognized on the transaction. The sale was motivated by the
fact that BioCheck produced losses, and would continue to do so. The subsidiary
produced losses in for the first three months of 1996 of $39,000 and $131,000
for the twelve months ended December 31, 1995.

         In August of 1996, the Company signed an exclusive licensing agreement
with Rockland Power (M) Sdn. Bhd. of Kuala Lumpur, Malaysia, for $600,000. In
December of 1996, the Company terminated Rockland for failure to pay this fee.
The entire $600,000 was reserved in allowance for bad debts. The Rockland effort
however, generated substantial interest in Southeast Asia, and increased sales
activity is expected in this area for 1997 and beyond. In September of 1996, the
Company sold exclusive rights to Singapore to its Australian licensee,
Bio-Recycle Pty. Limited, for $100,000.

LIQUIDITY AND CAPITAL RESOURCES

         The Company had working capital of $420,000 at December 31, 1997
compared to ($286,000) at December 31, 1996. Current assets at December 31, 1997
included cash and investments of $33,000, which is a decrease of about $251,000
from December 31, 1996. The increase in working capital was principally due to
the restructuring of certain debt to equity, additional sales of common stock,
and the operating income for the year.




                                       16
<PAGE>   19

         In 1997 the Company's operating cash flow was positive for the first
time in its history. However, the Company continued to have difficulty paying
unsecured vendors on a current basis. The continued demand of cash to settle the
Manchak litigation adversely affected collections of income from one of the
Company's largest licensees. In addition, expenses relating to the continued
progression and negotiation of the Honolulu project were not recovered until
April, 1998. All of the Company's "key" vendors were not affected, and the
Company does not anticipate the jeopardization of future relationships as a
result.

         On September 9, 1997, the Company executed a Subscription Agreement
with Gregory Meyer, to purchase 42,000 unregistered shares of the Company's
Common Stock for $1.75 per share. This subscription agreement was included by
the Company as an exhibit to the Company's Form 8-K filed on October 9, 1997.

         On September 23, 1997, the Company executed a Stock Purchase Agreement
with Heartland Limited Partnership I ("Heartland"), a Wisconsin Limited
Partnership, to purchase 158,000 unregistered shares of the Company's Common
Stock for $1.75 per share. Also on September 23, 1997, the Company executed a
Registration Rights Agreement with Heartland, in connection with the Stock
Purchase Agreement, 120,000 shares of the Company's Common Stock. Both
agreements were included by the Company as exhibits to the Company's Form 8-K
filed on October 9, 1997.

         Much of the Company's cash flow has been used to eliminate its
long-term litigation settlement obligation to Frank Manchak, that originated in
1995 and was paid off in November, 1997. The Company paid Mr. Manchak $750,000
in 1997, which continued the substantial drain on the Company's funds.

         On July 18, 1997, the Company and Mr. Manchak entered into a Second
Amendment to the original Settlement Agreement (the "Second Amendment") between
the parties with respect to that certain lawsuit entitled FRANK MANCHAK, JR. V.
N-VIRO ENERGY SYSTEMS, LTD. that was filed by Mr. Manchak in the United States
District Court for the Central District of California, Case No. CV-93-3042-ABC.

         Pursuant to the terms of the Second Amendment, the Company issued to
Frank Manchak, Jr. 250,000 shares (the "Shares") of the Company's voting common
stock, with par value of $.01 per share (the "Common Stock") as well as an
option (the "Option") to purchase an additional 100,000 shares of Common Stock,
at a purchase price of $2.50 per share. The Second Amendment further provided
that the Company's remaining obligation to Mr. Manchak would be due and payable
in full on November 15, 1997 without interest. The amount of this obligation,
however, was to be reduced if Mr. Manchak sold any of the Shares prior to
November 1, 1997 and would be further reduced by certain payments that might
have been made to Mr. Manchak by or on behalf of the Company prior to November
15, 1997, all as more particularly described in the Second Amendment. The Second
Amendment was filed with the Securities & Exchange Commission as an exhibit to
the Company's Current Report on Form 8-K dated July 18, 1997 which is
incorporated herein by reference.

         Under the terms of the Second Amendment, prior to November 1, 1997, Mr.
Manchak was permitted, but was not required, to sell Shares. Of the 250,000
shares of Common Stock issued to Mr. Manchak under the Second Amendment, 100,000
shares were held in escrow by Shumaker, Loop & Kendrick, LLP, special counsel to
the Company (the "Escrow Agent"). The terms of the escrow are described in the
paragraphs below.

         All sums received by Mr. Manchak as a result of his sale of the Shares,
reduced by any transaction costs, such as broker's fees and commissions incurred
by him in the course of such sales, were to have reduced the aggregate amount of
the Company's remaining obligation to Mr. Manchak on a dollar for dollar basis.

         On or about October 1, 1997, based solely upon information provided by
Mr. Manchak and reviewed by the Company, the Escrow Agent was to have calculated
(i) the amount of the Company's remaining obligation to Mr. Manchak as at the
close of business on September 30, 1997 (the Remaining Obligation") and (ii) the
number of Shares held by Mr. Manchak as at the close of business on September
30, 1997 (the "Remaining Shares"). After determining the amount of the Remaining
Obligation and the number of Remaining Shares, the Escrow Agent was to have
multiplied the number of Remaining Shares by two and subtract such number of
dollars from the amount of the Remaining Obligation to calculate the "Share
Deficit Amount". Finally, the Escrow Agent was to have divided the Share Deficit
Amount by two and delivered to Mr. Manchak such number of shares of Common Stock
from the shares of Common Stock held in escrow. The remaining shares of escrowed
Common Stock, if any, were to be returned to the 


                                       17
<PAGE>   20

Company and retired. None of the shares held in escrow were delivered to Mr.
Manchak or returned to the Company. Instead, such shares remain in escrow with
the Escrow Agent.

         On November 15, 1997, the remaining portion of the Company's obligation
to Mr. Manchak, if any, was to have become due and payable. Under the terms of
the Second Amendment, the Company was to satisfy any remaining portion of the
Company's obligation by redeeming, at a price of $2.00 per share, such number of
the Shares held by Mr. Manchak at such time as was necessary such that the
aggregate amount of funds received by Mr. Manchak as a result of his sales of
the Shares, exclusive of any transaction costs, such as broker's fees and
commissions, plus any cash payments received by him from the Company or the
Escrow Agent pursuant to the terms of the Second Amendment would equal $410,000.

        All of Mr. Manchak's sales of the Shares were to be made under and
pursuant to the terms of an S-3 registration statement to be filed by the
Company with the Securities & Exchange Commission. The Company filed such an S-3
registration statement with the Securities & Exchange Commission on July 21,
1997. However, such registration statement was never made effective, and on
March 24, 1998, such registration statement was withdrawn. Accordingly, Mr.
Manchak did not sell any of the Shares.

        In light of the fact that the S-3 had not been declared effective yet,
the Company, in September of 1997, entered into negotiations with Mr. Manchak
regarding the cash settlement of its remaining obligations to him and the return
to the Company of the Shares and the Option. In early November, 1997, the
Company and Mr. Manchak reached an agreement in principle that (i) the Company
would satisfy its entire remaining obligation to Mr. Manchak in exchange for a
cash payment of $250,000 and (ii) in exchange for such payment, Mr. Manchak
would return the Shares, including the Shares held in escrow, and the Option to
the Company. On November 13, 1997, the Company transferred $250,000 to Mr.
Manchak's counsel to be held in escrow by such counsel until the definitive
agreement is signed. On December 17, 1997, the definitive agreement was signed.

        Effective June 30, 1997, the Company issued 136,500 shares of
unregistered common stock to four individuals in exchange for eliminating
$409,500 in debt. This transaction was reported in the Form 8-K filed by the
Company on July 18, 1997.

        The Company incurred costs through 1997 for engineering work for a
privately operated facility to have been constructed in Honolulu, Hawaii. In
July, 1997, the Company signed Contract Change Order No. 1 with the City of
Honolulu to reimburse the Company "non-transferable" costs of $200,000 by July
30, 1997 and $250,000 by July 15, 1998. An additional $299,651 in "transferable"
costs were to have been included in a new operating contract fee structure with
the City, but on December 30, 1997, the City canceled these negotiations, and
the transferable costs are now due the Company by November 30, 1998. The Company
received the $200,000 in July, 1997. This Contract Change Order No. 1 was
reported in the Form 8-K filed by the Company on July 18, 1997. The Company
billed an additional $121,000 at December 31, 1997, for additional costs
incurred from June through December, 1997.

        In 1997 the Company obtained a working capital line of credit of
$200,000. Borrowings against the line bear interest at prime plus 1.75%, and are
collateralized by accounts receivable, inventories and equipment, and assignment
of the wastewater treatment contract with the City of Toledo, Ohio, and are due
on demand. There was $120,000 owed on the line of credit at December 31, 1997.

        The Company believes that its working capital together with the line of
credit, will provide sufficient cash to meet the Company's cash requirements
through 1998.

         The Company's ability to license its technology during the last four
years has been severely hampered, in part, by three events. These are:

         1. Lack of enforcement of Federal Regulations and failure of states to
            accept delegation of responsibility.

         2. Low cost of landfill disposal and land application of Class B
            (N-Viro is Class A) sludges; this problem is created in part by a
            nearly nationwide lack of governmental enforcement of existing
            regulations.

                                       18
<PAGE>   21

         3. Efforts by competition to induce operators and contractors to
            infringe the Company's intellectual property.

We believe these "roadblocks" of the past are being overcome by:

         a. Enforcement: The entire industry is concerned by "bad practices".
            States are now taking responsibility after convincing USEPA to
            modify 40CFR501, the Administrative requirements for state
            management of Federal regulations.

         b. Cost: While landfill cost and competition are still aggressive, both
            the public and operators are now aware of both the sociological and
            environmental problems of placing raw (as now allowed by USEPA)
            sludge in landfills. Moreover, land application problems, including
            impact on food safety from bad practices, is creating substantial
            generator concern for both public and personal liability.

         c. Infringement: The Company has been gathering evidence to support its
            claims of infringement, and expects to become more aggressive in
            protecting its patent rights in 1998.

         As a result of the market development discussed above and also due to a
significant increase in public and private interest in the safe and responsible
management of animal manure (2.2 billion USA market vs. 40 million USA sewer
sludge market), the Company is optimistic that 1998 and beyond will see an
increase in the sale and use of N-Viro technology. Moreover, public recognition
(e.g., President's Commission on Food Safety) of the dangers of farm-derived
pathogens in our food and water supply, and awareness of the highly negative
impact of currently acceptable organic disposal practices on the ozone and
global warming crisis, is creating renewed awareness of the long term ecological
sustainability of N-Viro type concepts.

         Finally, the Company's decision that it is not a contractor and desires
to sell its patented technology to all public and private sludge or manure
treatment managers in exchange for license and royalty revenues, should help the
Company's financial performance.

         The Company cautions that words used in this document such as
"expects", "anticipates", "believes" and "may" as well as similar words and
expressions used herein identify and refer to statements describing events that
may or may not occur in the future. These forward-looking statements and the
matters to which they refer are subject to considerable uncertainty that may
cause actual results to be materially different from those described herein.
Some, but not all, of the factors that could cause actual results to be
different than those anticipated or predicted by the Company include: (i) a
deterioration in economic conditions in general; (ii) a decrease in demand for
the Company's products or services in particular; (iii) the Company's loss of
key employee or employees; (iv) regulatory changes, including changes in
environmental regulations, that may have an adverse affect on the demand for the
Company's products or services; and (v) increases in the Company's operating
expenses resulting from increased costs of labor and/or consulting services.

INFLATION

         The Company believes that inflation has not had a material impact to
date on the Company's operations.

EFFECT OF YEAR 2000 ISSUE ON THE COMPANY'S MANAGEMENT AND INFORMATION SYSTEMS

         The Company is conducting a review of its computer systems to identify
the systems that could be affected by the Year 2000 Issue, and is developing an
implementation plan to resolve the issue. The issue is whether computer systems
will properly recognize date-sensitive information when the year changes to
2000. Systems that do not properly recognize such information could generate
erroneous data or cause a system to fail. Based on the review of the computer
systems, management does not believe the cost of remediation will be material to
the Company's financial position and results of operations.



                                       19
<PAGE>   22

ITEM 8.           FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                   INDEX TO FINANCIAL STATEMENTS AND SCHEDULE
                   ------------------------------------------

<TABLE>
<CAPTION>
                                                                                                       PAGE
                                                                                                       ----

<S>                                                                                            <C>
Reports of Independent Auditors ..........................................................              F-1

Financial Statements:


          Consolidated Balance Sheets as of December 31, 1997 and 1996 ...................              F-2



          Consolidated Statements of Operations for the years ended December 31, 1997,
              1996 and 1995 ..............................................................              F-3

          Consolidated Statement of Stockholders' Equity for the years ended
              December 31, 1997, 1996 and 1995 ...........................................              F-4

          Consolidated Statements of Cash Flows for the years ended December 31, 1997,
              1996 and 1995 ..............................................................              F-5


          Notes to Financial Statements ..................................................      F-6 to F-14

Financial Statement Schedule:

          Schedule II  Valuation and Qualifying Accounts and Reserves ....................             F-15

          All other schedules are omitted since the required information is not present or
          is not present in amounts sufficient to require submission of the schedule, or
          because the information required is included in the financial statements and
          notes thereto.
</TABLE>



                                       20
<PAGE>   23

                          REPORT OF INDEPENDENT AUDITOR


To the Board of Directors
N-VIRO INTERNATIONAL CORPORATION
Toledo, Ohio

We have audited the accompanying consolidated balance sheets of N-VIRO
INTERNATIONAL CORPORATION as of December 31, 1997 and 1996, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the years in the three-year period ended December 31, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of N-VIRO INTERNATIONAL
CORPORATION as of December 31, 1997 and 1996, and the results of its operations
and its cash flows for each of the years in the three-year period ended December
31, 1997, in conformity with generally accepted accounting principles.



                                     McGLADREY & PULLEN, LLP





Elkhart, Indiana
March 12, 1998




                                      F-1
<PAGE>   24

N-VIRO INTERNATIONAL CORPORATION

CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
=======================================================================================================
                                                                                  December 31,
                                                                       -------------------------------
                                                                            1997               1996
-------------------------------------------------------------------------------------------------------

<S>                                                                    <C>                <C>         
ASSETS

Current Assets
   Cash and cash equivalents                                           $     31,677       $    282,115
   Securities available-for-sale                                              1,401              1,401
   Receivables:
      Trade                                                                 821,906            788,628
      Contract                                                              671,521            -----
      Notes                                                                 394,718            113,544
   Assets held for sale                                                     780,108
   Prepaid expenses and other assets                                         92,060            225,597
                                                                       -------------------------------

              TOTAL CURRENT ASSETS                                        2,013,283          2,191,393

Property and Equipment                                                      561,229            621,558

Investment in Florida N-Viro, L.P.                                          912,620            919,352

Deferred Tax Assets                                                         312,000            -----

Intangible and Other Assets                                                 624,237            434,634
                                                                       -------------------------------
                                                                       $  4,423,369       $  4,166,937
                                                                       ===============================
LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities
   Note payable, bank                                                  $    120,000            -----
   Notes payable, related partnership                                       -----         $    196,920
   Current maturities of long-term debt                                      93,545            714,786
   Accounts payable                                                       1,196,713          1,306,862
   Accrued expenses                                                         183,071            258,779
                                                                       -------------------------------
              TOTAL CURRENT LIABILITIES                                   1,593,329          2,477,347
                                                                       -------------------------------
Long-Term Debt, less current maturities                                      64,702            276,031
                                                                       -------------------------------

Commitments and Contingencies

Stockholders' Equity
   Common stock, $.01 par value; authorized 45,000,000
      shares; issued 1997 2,755,733 shares; 1996 2,094,233 shares            27,558             20,943
   Additional paid-in capital                                            13,359,552         12,048,455
   Retained earnings (deficit)                                           (9,503,795)       (10,037,862)
                                                                       -------------------------------
                                                                          3,883,315          2,031,536
   Less treasury stock, at cost, 1997 307,250
      shares; 1996 57,250 shares                                          1,117,977            617,977
                                                                       -------------------------------
                                                                          2,765,338          1,413,559
                                                                       -------------------------------
                                                                       $  4,423,369       $  4,166,937
                                                                       ===============================
</TABLE>
See Notes to Financial Statements


                                       F-2
<PAGE>   25

N-VIRO INTERNATIONAL CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
============================================================================================================
                                                                         Year Ended December 31,
                                                            ------------------------------------------------
                                                                 1997               1996               1995
------------------------------------------------------------------------------------------------------------

<S>                                                          <C>               <C>               <C>        
Revenues                                                     $ 4,052,648       $ 4,223,873       $ 5,214,113

Cost of revenues                                               1,829,309         1,797,796         3,166,922
                                                            ------------------------------------------------

              GROSS PROFIT                                     2,223,339         2,426,077         2,047,191
                                                            ------------------------------------------------

Operating expenses:
   Selling, general, and administrative                        1,920,563         2,708,866         3,522,878
   Research and development                                        2,714            41,784            29,500
   Other                                                         -----             -----             371,525
                                                            ------------------------------------------------
                                                               1,923,277         2,750,650         3,923,903
                                                            ------------------------------------------------

              OPERATING INCOME (LOSS)                            300,062          (324,573)       (1,876,712)
                                                            ------------------------------------------------

Non-operating income (expense):
   Miscellaneous income                                          154,941            71,463
   Interest income (expense), net                                (32,157)           18,215            34,354
   Equity in losses of joint venture                             (45,838)          (41,544)          (44,032)
                                                            ------------------------------------------------
                                                                 (77,995)          131,612            61,785
                                                            ------------------------------------------------

              INCOME (LOSS) BEFORE INCOME TAX (CREDITS)      $   222,067       $  (192,961)      $(1,814,927)

Federal and state income tax (credits)                          (312,000)          -----             -----
                                                            ------------------------------------------------

              NET INCOME (LOSS)                                  534,067          (192,961)       (1,814,927)
                                                            ================================================

Basic and diluted earnings (loss) per share                  $      0.23       $     (0.09)      $     (0.89)
                                                            ================================================

Weighted average common
   shares outstanding                                        $ 2,274,134       $ 2,037,000       $ 2,037,000
                                                            ================================================
</TABLE>

See Notes to Financial Statements


                                      F-3
<PAGE>   26

N-VIRO INTERNATIONAL CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------------------
                                                                                            Unrealized
                                                           Additional         Retained      Losses On
                                             Common         Paid-In           Earnings    Available-For-     Treasury
                                              Stock         Capital          (Deficit)    Sale Securities      Stock      Total
----------------------------------------------------------------------------------------------------------------------------------
<S>                                         <C>          <C>              <C>                             <C>          <C>          
Balance, December 31, 1994                  $ 83,770     $ 11,961,233     $ (8,029,974)      $  (52,090)  $  (617,977) $ 3,344,962  
   Net (loss)                                                               (1,814,927)                                 (1,814,927) 
   Sale of securities                                                                            52,090                     52,090  
   Effect of 1-for-4 reverse stock split     (62,827)          62,827                                                               
                                            --------------------------------------------------------------------------------------  
Balance, December 31, 1995                    20,943       12,024,060       (9,844,901)                      (617,977)   1,582,125  
   Net (loss)                                                                 (192,961)                                   (192,961) 
   Other                                                       24,395                                                       24,395  
                                            --------------------------------------------------------------------------------------  
Balance, December 31, 1996                    20,943       12,048,455      (10,037,862)                      (617,977)   1,413,559  
   Net income                                                                  534,067                                     534,067  
   Issuance of common stock                                                                                                         
      for relief of liabilities                3,865          805,635                                                      809,500  
   Proceeds from sale of common stock,                                                                                              
      net of expenses of $25,414               2,000          322,587                                                      324,587  
   Issuance of common stock for                                                                                                     
      business combination                       750          177,375                                                      178,125  
   Purchase of treasury stock                                                                                (500,000)    (500,000) 
Other                                                           5,500                                                        5,500  
                                            --------------------------------------------------------------------------------------  
Balance, December 31, 1997                  $ 27,558     $ 13,359,552     $ (9,503,795)                   $(1,117,977) $ 2,765,338  
                                            ======================================================================================  
See Notes to Financial Statements                                                            
</TABLE>

                                       F-4
<PAGE>   27

N-VIRO INTERNATIONAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
=======================================================================================================
                                                                       Year Ended December 31,
                                                          ---------------------------------------------
                                                               1997            1996             1995
-------------------------------------------------------------------------------------------------------
<S>                                                       <C>             <C>             <C>        
CASH FLOWS FROM OPERATING ACTIVITIES
   Net income (loss)                                      $   534,067     $  (192,961)    $(1,814,927)
   Adjustments to reconcile net income (loss) to net
      cash provided by (used in) operating activities:
      Depreciation and amortization                           170,588         164,353         209,071
      Provision for bad debts                                 123,490         656,000          70,000
      Deferred income taxes                                  (312,000)        -----           -----
      Loss on contractual obligation                          -----           -----           300,000
      Other                                                    47,316        (360,985)        168,482
      Change in assets and liabilities:
        Decrease (increase) in:
           Receivables                                       (482,939)       (341,773)         (2,094)
           Prepaid expenses and other                         133,537         (35,928)         81,644
        Increase in accounts payable
           and accrued liabilities                             25,643           5,901         513,543
                                                          ---------------------------------------------
              NET CASH PROVIDED BY (USED IN)
                  OPERATING ACTIVITIES                        239,702        (105,393)       (474,281)
                                                          ---------------------------------------------

CASH FLOWS FROM INVESTING ACTIVITIES
   Proceeds from sale of securities                           -----           -----         2,001,710
   Proceeds from sale of property and equipment               -----           945,147         250,000
   Purchase of property and equipment                         (49,943)       (122,434)     (1,398,795)
   Investment in joint venture                                -----           -----           (85,000)
   Expenditures for intangible and other assets               (53,294)       (203,833)       (123,545)
                                                          ---------------------------------------------
              NET CASH PROVIDED BY (USED IN)
                  INVESTING ACTIVITIES                       (103,237)        618,880         644,370
                                                          ---------------------------------------------

CASH FLOWS FROM FINANCING ACTIVITIES
   Borrowings under long-term obligations                     222,296         375,683         -----
   Principal payments on long-term obligations               (433,786)       (855,392)       (420,988)
   Proceeds from sale of common stock                         324,587         -----           -----
   Purchase of treasury stock                                (500,000)        -----           -----
   Other                                                      -----            24,395         -----
                                                          ---------------------------------------------
              NET CASH (USED IN) FINANCING ACTIVITIES        (386,903)       (455,314)       (420,988)
                                                          ---------------------------------------------
              INCREASE (DECREASE) IN CASH
                  AND CASH EQUIVALENTS                       (250,438)         58,173        (250,899)

Cash and cash equivalents, beginning                          282,115         223,942         474,841
                                                          ---------------------------------------------

Cash and cash equivalents, ending                         $    31,677     $   282,115     $   223,942
                                                          =============================================
</TABLE>

See Notes to Financial Statements.



                                      F-5
<PAGE>   28

NOTE 1. NATURE OF BUSINESS, USE OF ESTIMATES, BASIS OF PRESENTATION, AND
SIGNIFICANT ACCOUNTING POLICIES

NATURE OF BUSINESS:

The Company owns and licenses the N-Viro Process, a patented technology to treat
and recycle wastewater sludges and other bio-organic wastes, utilizing certain
alkaline by-products. Revenue and the related accounts receivable are due from
companies acting as independent agents or licensees, principally municipalities.
Credit is generally granted on an unsecured basis. Periodic credit evaluations
of customers are conducted and appropriate allowances are established.

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 as of the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

SIGNIFICANT ACCOUNTING POLICIES:

PRINCIPLES OF CONSOLIDATION:

The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.

The Company accounts for its investments in joint ventures under the equity
method.

CASH AND CASH EQUIVALENTS:

The Company has cash on deposit in one financial institution which, at times,
may be in excess of FDIC insurance limits.

For purposes of the statements of cash flows, the Company considers all highly
liquid debt instruments purchased with a maturity of three months or less to be
cash equivalents.

PROPERTY AND EQUIPMENT:

Depreciation has been computed primarily by the straight-line method over the
estimated useful lives of the assets. Generally, useful lives are thirty-one
years for leasehold improvements and five to fifteen years for equipment and
furniture and fixtures. Management has reviewed property and equipment for
impairment when events and circumstances indicate that the assets might be
impaired and the carrying values of those assets may not be recoverable.
Management believes the carrying amount is not impaired based upon estimated
future cash flows.

INTANGIBLE ASSETS:

Patent costs and territory rights are being amortized by the straight-line
method over 17 and 11 year periods respectively. Management has reviewed
intangible assets for impairment when events and circumstances indicate that the
assets might be impaired and the carrying values of those assets may not be
recoverable. Management believes the carrying amount is not impaired based upon
estimated future cash flows.

REVENUE RECOGNITION:

License and territory fees are generated by selling the right to market or use
the N-Viro Process in a specified territory. The Company's policy is to record
revenue for the license agreements when all material services relating to the
revenue have been substantially performed, conditions related to the contract
have been met, and no material contingencies exist.

                                      F-6
<PAGE>   29

Facility management revenue, sludge processing revenue, and royalty fees are
recognized under contracts where the Company or licensees utilize the N-Viro
Process to treat sludge, either pursuant to a fixed-price contract or based on
volumes of sludge processed. Revenue is recognized as services are performed.

Alkaline admixture sales and N-Viro Soil revenue is recognized upon shipment.

OTHER OPERATING EXPENSES:

Other operating expenses include principally the settlement of alleged patent
infringement litigation and related legal fees.

BASIC AND DILUTED EARNINGS (LOSS) PER SHARE:

The FASB has issued Statement No. 128, Earnings per Share, which supersedes APB
Opinion No. 15. Statement No. 128 requires the presentation of earnings per
share by all entities that have common stock or potential common stock, such as
options, warrants, and convertible securities, outstanding that trade in a
public market. Those entities that have only common stock outstanding are
required to present basic earnings per share amounts. Basic per share amounts
are computed by dividing net income (the numerator) by the weighted-average
number of common shares outstanding (the denominator). All other entities are
required to present basic and diluted per share amounts. Diluted per share
amounts assume the conversion, exercise or issuance of all potential common
stock instruments unless the effect is to reduce the loss or increase the income
per common share from continuing operations.

The Company initially applied Statement No. 128 for the year ended December 31,
1997 and, as required by the Statement, has restated all per share information
for the prior years to conform to the Statement.

The effects of the stock options was to increase the weighted average number of
shares by 6,346 for the year ended December 31, 1997. For the years ended
December 31, 1996 and 1995, the amounts are excluded from the dilutive per share
calculation because they would be antidilutive.

NOTE 2.    BALANCE SHEET DATA

TRADE RECEIVABLES:

Trade receivables in the accompanying balance sheets at December 31, 1997 and
1996 are stated net of an allowance for doubtful accounts of $89,000 and
$625,000 respectively.

CONTRACT RECEIVABLES:

The Company has incurred costs in connection with obtaining a contract and the
design of a processing facility in Hawaii. In 1996, the Company and the
municipality jointly agreed to suspend the building of the facility. In 1997,
the Company reached an agreement for reimbursement of the direct costs incurred
as part of this project. The Company received a down payment of $200,000 with
the balance due under the contract in three installments with the final payment
due November 1998. Costs incurred as of December 31, 1996 were reflected as
assets held for sale as the contract payment terms had not been finalized.


                                      F-7
<PAGE>   30

NOTES RECEIVABLE:

The Company has notes receivable with customers. The amounts in the accompanying
balance sheets at December 31, 1997 and 1996 are stated net of an allowance for
doubtful accounts of $330,980 and $300,980, respectively.

PROPERTY AND EQUIPMENT:
<TABLE>
<CAPTION>
                                                                1997           1996
                                                           ------------------------------

<S>                                                           <C>            <C>        
   Land and leasehold improvements                           $     41,618   $     41,618
   Equipment                                                    1,033,906      1,014,652
   Furniture and fixtures                                         212,464        211,178
                                                           ------------------------------
                                                                1,287,988      1,267,448
   Less accumulated depreciation and amortization                 726,759        645,890
                                                           ------------------------------
                                                              $   561,229    $   621,558
                                                           ==============================
</TABLE>

The Company rents certain equipment to customers under short-term arrangements.

INVESTMENT IN FLORIDA N-VIRO, L.P.:

Florida N-Viro, L.P. was formed in January 1996 pursuant to a joint venture
agreement between the Company and VFL Technology Corporation (VFL). The Company
contributed its Florida operating facility with a carrying value of $1,934,334.
In exchange, the Company received $880,700 in cash and retains a 47% interest in
the facility. During the year ended December 31, 1996, the Company acquired an
additional 3% interest in the subsidiary.

Condensed financial information of the partnership as of December 31, 1997 and
1996 is as follows:

<TABLE>
<CAPTION>

                                                             1997               1996
                                                           -----------------------------------
<S>                                                           <C>                 <C>        
   Current assets                                             $   221,511         $   212,214
   Long-term assets                                             1,853,455           1,946,150
                                                           -----------------------------------
                                                               $2,074,966          $2,158,364
                                                           ===================================

   Current liabilities                                        $   249,726         $   241,449
   Partners' equity                                             1,825,240           1,916,915
                                                           -----------------------------------
                                                               $2,074,966          $2,158,364
                                                           ===================================

   Net sales                                                  $   655,570         $   761,631
   Net (loss)                                                    (91,675)            (83,085)
</TABLE>

The partnership has a major customer which represented 58% and 45% of its
revenue for the years ended December 31, 1997 and 1996 respectively.

<TABLE>
<CAPTION>
INTANGIBLE AND OTHER ASSETS:
                                                                                        1997              1996
                                                                                 --------------------------------
<S>                                                                                    <C>              <C>     
   Patents and other intangibles, less accumulated
      amortization 1997 $181,000; 1996 $151,000                                        $400,876         $378,495
   Territory rights, less accumulated amortization
      1997 $22,600; 1996 none                                                           223,361            -----
   Investment in Pan-American N-Viro, Inc.                                               -----            56,139
                                                                                 --------------------------------
                                                                                       $624,237         $434,634
                                                                                 ================================
</TABLE>



                                      F-8
<PAGE>   31

During the year ended December 31, 1997, the Company purchased the remaining 50%
interest of Pan-American N-Viro, Inc. (Pan-Am) and at that time, consolidated
the entity. The transaction was accounted for as a purchase and the purchase
price was allocated primarily to territory rights. The purpose of Pan-American
is to promote the N-Viro Process in Central and South America and the Caribbean.
Pro forma and condensed financial information has not been presented as the
investment is not significant to the Company's financial position or results of
operations.

<TABLE>
<CAPTION>
ACCRUED LIABILITIES:
                                            1997            1996
                                       -------------------------------

<S>                                         <C>              <C>     
   Employee benefits                        $  37,656        $122,759
   Legal fees                               -----              50,000
   Other                                      145,415          86,020
                                       -------------------------------
                                             $183,071        $258,779
                                       ===============================
</TABLE>

NOTE 3.     PLEDGED ASSETS, LINE OF CREDIT, AND LONG-TERM DEBT

The Company has a $200,000 line of credit with a bank, of which $120,000 was
outstanding at December 31, 1997. Borrowings against the line of credit bear
interest at prime plus 1.75%, are collateralized by accounts receivable,
inventories, equipment, and assignment of certain contracts, and are due on
demand.
This agreement expires July 31, 1998.

Long-term debt at December 31, 1997 and 1996 is as follows:

<TABLE>
<CAPTION>
                                                               1997                1996
                                                          ------------------------------------

<S>                                                             <C>                  <C>     
   Contractual obligation, non-interest bearing               -----                  $700,000
   Term note payable, bank                                    -----                    26,664
   Other notes payable                                           $158,247             264,153
                                                          ------------------------------------
                                                                  158,247             990,817
   Less current maturities                                         93,545             714,786
                                                          ------------------------------------
                                                                $  64,702            $276,031
                                                          ====================================
</TABLE>

The other notes payable are notes signed for amounts owed to vendors. The notes
bear interest at approximately 9% and are due at varying dates through June
2002. Aggregate maturities of long-term debt for the years ending December 31
are as follows: 1999 $48,826; 2000 $7,974; 2001 $5,844; and 2002 $2,058.
Interest expensed and paid was approximately $38,000; $20,000, and $35,000 for
the years ended December 31, 1997, 1996, and 1995 respectively.

During the year ended December 31, 1997, the Company extinguished the
contractual obligation with the payment of $200,000 in cash and the issuance of
250,000 shares of common stock with a fair value of $500,000. Immediately after
the settlement, the Company repurchased the common stock. In addition, the
Company reached agreements with three trade creditors and directors to eliminate
$211,500 of the Company's accounts payable by issuance of 70,500 shares of
common stock. The net gain on extinguishment of these liabilities was
immaterial.

The notes payable, related partnership were extinguished by their conversion
into 66,000 shares of common stock. No gain or loss was recognized on the
transaction as the partnership was controlled by the majority stockholder.


                                      F-9
<PAGE>   32

Note 4.      EQUITY TRANSACTIONS

The Company has authorized 5,000,000 shares of preferred stock, par value of
$.01 per share, of which no shares were outstanding at December 31, 1997 and
1996.

The Company has adopted a stock option plan for directors and key officers under
which 1,000,000 shares of common stock may be issued. The options were 20%
vested on the date of grant, with the balance vesting 20% per year over the next
four years. Options are granted at fair market value.

The following summarizes the number of grants and their respective exercise
prices and grant date fair values per option for the years ended December 31,
1997 and 1996 and the number outstanding and exercisable at those dates:

<TABLE>
<CAPTION>
                                                          1997                      1996
                                              ------------------------------------------------------
                                                              WEIGHTED                    WEIGHTED
                                                               AVERAGE                     AVERAGE
                                                              EXERCISE                    EXERCISE
                                                 SHARES         PRICE        SHARES         PRICE
                                              ------------------------------------------------------

<S>                                             <C>          <C>              <C>         <C>  
    Outstanding, beginning of year               151,525     $    26.45       168,750     $    34.21
       Granted                                   124,850           3.13        37,400           4.35
       Expired during the year                  (112,550)         33.92       (54,625)         35.29
                                              ----------                   ----------
    Outstanding, end of year                     163,825           3.54       151,525          26.45
                                              ==========                   ==========

    Eligible for exercise at end of year          90,850                       78,525
                                              ==========                   ==========

    Weighted average fair value per option
       for options granted during the year                   $     1.83                   $     4.30
                                                             ==========                   ==========
</TABLE>

During 1997, the Company repriced 71,250 shares from $38.00 per option to $4.00
per option. The above schedule reflects the granted and expired shares and
include the shares that have been repriced.

A further summary of stock options is as follows:

<TABLE>
<CAPTION>
                                                                             1997
                                                     Options Outstanding                   Options Exercisable
                                         ------------------------------------------------------------------------------
                                                            Weighted
                                                             Average        Weighted                       Weighted
                                                            Remaining       Average                         Average
                                             Number        Contractual      Exercise        Number         Exercise
                                           Outstanding        Life           Price       Exercisable         Price
                                         ------------------------------------------------------------------------------
   Range of exercise prices,
<S>   <C>                                    <C>               <C>            <C>           <C>             <C>  
      $1.56 to $2.38                         53,200            9.3            $1.69         17,200          $1.62

      $4.00 to $6.00                        110,625           6.29             4.43         73,650           4.29
</TABLE>


As permitted under generally accepted accounting principles, the Company's
present accounting with respect to the recognition and measurement of
stock-based employee compensation costs, primarily related to the Company's
stock option plan, is in accordance with APB Opinion No. 25, which generally
requires that compensation costs be recognized for the difference, if any,
between the quoted market price of the stock and the amount an employee must pay
to acquire the stock. The Company has adopted the provisions of SFAS Statement
No. 123 which prescribes a fair-value based method of measurement that results
in the disclosure of computed compensation costs for essentially all awards of
stock-based compensation to employees. This requirement is to be applied
prospectively to any options granted.

                                      F-10
<PAGE>   33

Had compensation cost been determined based upon the fair value method
prescribed in SFAS Statement No. 123, reported net income (loss) would have been
$386,564, $(263,833), and $(1,825,751) and basic earnings (loss) per share would
have been $.18, $(.13), and $(.90) for the years ended December 31, 1997, 1996,
and 1995 respectively.

In determining the pro forma amounts above, the value of each grant is estimated
at the grant date using the fair value method prescribed in Statement No. 123,
with the following weighted-average assumptions for grants in 1995, 1996, and
1997 respectively: no assumed dividend rates for all years; risk-free interest
rates of 5.25%, 5.25%, and 5.5%; on expected lives of 10 years for all years;
and expected price volatility of 99%, 99%, and 118%.

NOTE 5.     REVENUE AND MAJOR CUSTOMERS

Revenues for the years ended December 31, 1997, 1996, and 1995 consist of the
following:

<TABLE>
<CAPTION>
                                                                 1997                 1996                 1995
                                                         ------------------------------------------------------------

<S>                                                            <C>                  <C>                   <C>       
Facility management and sludge processing                      $1,360,572           $1,267,161            $1,819,725
Royalty fees                                                      707,694              696,117               848,378
License and territory fees                                        428,050              700,000               131,875
Alkaline admixture sales                                        1,393,526            1,186,908             1,595,519
Other                                                             162,806              373,687               818,616
                                                         ------------------------------------------------------------
                                                               $4,052,648           $4,223,873            $5,214,113
                                                         ============================================================
</TABLE>

Revenues for the years ended December 31, 1997, 1996, and 1995 include revenues
from one major customer which represented approximately 35%, 30%, and 26%
respectively of total revenues. In addition, the Company had another major
customer of approximately 11% for the year ended December 31, 1997. The accounts
receivable balances due from these customers at December 31, 1997 and 1996 were
approximately $189,000 and $114,000 respectively.

NOTE 6.     RELATED PARTY TRANSACTIONS

The Company paid a consulting fee to the former stockholder of one of the
Company agents of $120,000, $150,000, and $80,000 for the years ended December
31, 1997, 1996, and 1995 respectively. On January 1, 1994, the Company granted
this individual a security interest in all present and future receivables and
contract rights from licenses in the states of Tennessee, North Carolina, and
South Carolina. The secured receivables amounted to approximately $100,000 and
$154,000 at December 31, 1997 and 1996 respectively.

NOTE 7.     COMMITMENTS AND CONTINGENCIES

The Company leases office space under an agreement which requires monthly
payments of approximately $4,800. The lease expires in December 2002. The
Company also leases various other equipment on a month-to-month basis. The total
minimum rental commitment at December 31, 1997 is $289,000. The total rental
expense included in the statements of operations for the years ended December
31, 1997, 1996, and 1995 is approximately $78,000, $110,000 and $110,000
respectively.

During 1994, the Company reacquired territory rights from a former agent and
issued 66,250 shares of unregistered common stock with a designated value of $6
per share. In the event the former agent elects to sell all these shares, the
Company has guaranteed the former agent $6 per share. This guarantee expires
December 30, 1999.

The Company pays a consultant $10,000 per month (see Note 6). The Company's
minimum commitment under this agreement at December 31, 1997 is $240,000.

The Company is conducting a review of its computer systems to identify the
systems that could be affected by the Year 2000 Issue, and is developing an
implementation plan to resolve the issue. The issue is whether computer 


                                      F-11
<PAGE>   34

systems will properly recognize date-sensitive information when the year changes
to 2000. Systems that do not properly recognize such information could generate
erroneous data or cause a system to fail. Based on the review of the computer
systems, management does not believe the cost of remediation will be material to
the Company's financial position and results of operations.

The Company is involved in legal proceedings and subject to claims which have
arisen in the ordinary course of business. These actions, when concluded and
determined, will not, in the opinion of management, have a material adverse
effect upon the financial position of the Company.

NOTE 8.     INCOME TAX MATTERS

Deferred income tax assets and liabilities are computed annually for differences
between the financial statement and tax bases of assets and liabilities that
will result in taxable or deductible amounts in the future based on enacted tax
laws and rates applicable to the periods in which the differences are expected
to affect taxable income. Valuation allowances are established when necessary to
reduce deferred tax assets to the amount expected to be realized. Income tax
expense is the tax payable or refundable for the current period plus or minus
the change during the period in deferred tax assets and liabilities.

The composition of the deferred tax assets and liabilities at December 31, 1997
and 1996 is as follows:

<TABLE>
<CAPTION>
                                                                   1997                1996
                                                              -----------------------------------
<S>                                                             <C>                 <C>         
   Gross deferred tax liability,
      accelerated depreciation                                  $    (12,000)       $    (2,000)
                                                              -----------------------------------
   Gross deferred tax assets:
      Loss carryforwards                                            3,490,000          3,187,000
      Patent costs                                                    666,000            743,000
      Allowance for doubtful accounts                                 156,000            370,000
      Property and equipment basis difference                          21,000             24,000
      Other                                                            15,000             69,000
                                                              -----------------------------------
                                                                    4,348,000          4,393,000
                                                              -----------------------------------
   Less valuation allowance                                       (4,036,000)        (4,391,000)
                                                              -----------------------------------
                                                                $     312,000        -----

                                                              ===================================
</TABLE>

The income tax provisions differ from the amount of income tax determined by
applying the U.S. Federal income tax rate to pre-tax income from continuing
operations for the years ended December 31, 1997 and 1996, as follows:

<TABLE>
<CAPTION>
                                                              1997               1996             1995
                                                         --------------------------------------------------

<S>                                                       <C>                  <C>              <C>       
   Computed "expected" tax (credits)                      $     76,000         $(66,000)        $(617,000)
   State taxes, net of federal tax benefit                       8,000           (7,000)          (66,000)
   Increase in income taxes resulting from:
      Change in valuation allowance                          (355,000)           103,000           672,000
      Other                                                   (41,000)          (30,000)            11,000
                                                         --------------------------------------------------
                                                            $(312,000)         -----            -----
                                                         ==================================================
</TABLE>

The net operating losses available at December 31, 1997 to offset future taxable
income total approximately $8,600,000 which expire as follows: 2008 $300,000;
2009 $6,200,000; 2010 $1,500,000; and 2011 $600,000.

The Company has recorded a deferred tax asset and a corresponding income tax
benefit of $312,000 to recognize the benefit of $800,000 in loss carryforwards
expected to be realized. The Company believes that the taxable income will be
generated in the next three years and realization of the loss carryforwards
beyond that period are 


                                      F-12
<PAGE>   35

uncertain. Realization of that asset is dependent on generating sufficient
taxable income prior to expiration of the loss carryforwards. Although
realization is not assured, management believes it is more likely than not that
all of the recorded deferred tax asset will be realized. However, the amount of
the deferred tax asset considered realizable could be reduced in the near term
if estimates of future taxable income during the carryforward period are
reduced.

NOTE 9.     DISCONTINUED AND TRANSFERRED DIVISIONS

At the beginning of the year ended December 31, 1996, the Company transferred
its Florida operating facility to a joint venture which is being accounted for
under the equity method, and sold its wholly-owned subsidiary, Biocheck
Laboratories. In addition, during 1995, the Company sold its wholly-owned
subsidiary, N-Viro Worldwide.

Unaudited pro forma consolidated net sales, net (loss) and basic (loss) per
share for the year ended December 31, 1995, if the Company had sold these
entities as of January 1, 1995 would have been $3,811,146, $(1,514,986), and
$(.75) respectively.

NOTE 10.    CASH FLOWS INFORMATION

Supplemental information relative to the statements of cash flows for the years
ended December 31, 1997, 1996, and 1995 is as follows:

<TABLE>
<CAPTION>
                                                         1997        1996        1995
                                                     ----------------------------------
<S>                                                    <C>          <C>         <C>     
    Supplemental schedule of non-cash investing and
       financial activities:
       Common stock issued for relief of
         liabilities                                   $809,500     -----       -----
                                                     ==================================

       Common stock issued in exchange
         for 50% interest of Pan-Am                    $178,125     -----       -----
                                                     ==================================
</TABLE>

NOTE 11.    NEW ACCOUNTING PRONOUNCEMENTS

Effective for the years beginning after December 15, 1997, the Company will be
required to adopt Financial Accounting Standards Board (FASB) Statement No. 130,
"Reporting Comprehensive Income," and Statement No. 131, "Disclosures about
Segments of an Enterprise and Related Information." The Company is currently
evaluating the impact, if any, these Statements will have on its financial
statement disclosures.


                                      F-13
<PAGE>   36

                         INDEPENDENT AUDITOR'S REPORT ON
                            THE SUPPLEMENTAL SCHEDULE


To the Board of Directors
N-VIRO INTERNATIONAL CORPORATION
Elkhart, Indiana


Our audits of the consolidated financial statements of N-VIRO INTERNATIONAL
CORPORATION included Schedule II, contained herein, for the years ended December
31, 1995, 1996, and 1997. Such schedule is presented for purposes of complying
with the Securities and Exchange Commission's rule and is not a required part of
the basic consolidated financial statements. In our opinion, such schedule
presents fairly the information set forth therein, in conformity with generally
accepted accounting principles.








                                       McGLADREY & PULLEN, LLP



Elkhart, Indiana
March 12, 1998



                                      F-14
<PAGE>   37

N-VIRO INTERNATIONAL CORPORATION

SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
DECEMBER 31, 1995, 1996, AND 1997

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------------------
                                                Balance At                                  Deductions           Balance At
                                                 Beginning              Charged To             From                 Close
                                                 Of Period              Operations           Reserves             Of Period
-----------------------------------------------------------------------------------------------------------------------------
Allowance for doubtful accounts -
     deducted from trade receivables and
     long-term receivables in the
     balance sheets:
<S>                                             <C>                    <C>                 <C>                   <C>     
   1995                                         $ 20,000               $ 88,877            $ 18,877              $270,000
                                           ==================================================================================

   1996                                         $270,000               $656,000                -----             $926,000
                                           ==================================================================================

   1997                                         $926,000               $204,000            $710,000              $420,000
                                           ==================================================================================
</TABLE>



                                      F-15
<PAGE>   38

ITEM 9.           CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
                              ACCOUNTING AND FINANCIAL DISCLOSURES

         None


                                    PART III


ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

                            DIRECTORS OF THE COMPANY

TERRY J. LOGAN, PH.D., AGE 55. Dr. Logan is a professor of Agronomy at The Ohio
State University. Dr. Logan served as President of Pan-American N-Viro Inc.
(affiliate of the Company) from 1994 through 1995 and is the President of Logan
Environmental, Inc. (environmental consulting firm). Dr. Logan also acts as a
consultant to the Company with respect to various matters. Dr. Logan has been a
member of the Board since May 1993 and is a member of the Board's Audit and
Finance Committees.

JAMES D. O'NEIL, P.E., AGE 67. Mr. O'Neil has served as the Vice-President of
Engineering and Operations since May, 1993. Prior to that date, Mr. O'Neil was
Vice-President and General Manager of Leon Boulton + Son, Inc., for 14 years,
and subsequently self-employed as an engineering consultant. Mr. O'Neil has been
a member of the Board since August, 1997 and is a member of the Board's
Nominating Committee.

MICHAEL G. NICHOLSON, AGE 31. Mr. Nicholson has served as the Vice-President of
Sales and Marketing of the Company since December, 1996. Prior to that date, Mr.
Nicholson served the Company and the Partnership in various management positions
in sales. Mr. Nicholson is the son of J. Patrick Nicholson, Chairman, Chief
Executive Officer and President of the Company. Mr. Nicholson has been a member
of the Board since February, 1998.

WALLACE G. IRMSCHER, AGE 75. Mr. Irmscher has been self-employed as a consultant
in the construction and construction materials industry since 1995. Prior to the
time, Mr. Irmscher was an officer and Director of Newfoundland Resources and
Mining Limited (quarry operation), an entity that was the subject of bankruptcy
proceedings in 1995. Mr. Irmscher is a Director of United States Lime and
Minerals (publicly traded company), has served as a Director of the Company
since May 1995 and is a member of the Board's Audit and Finance Committees.

CHARLES B. KAISER, JR., AGE 74. From 1957 until his retirement in 1990, Mr.
Kaiser was general counsel to the St. Louis Metropolitan Sewer District. Mr.
Kaiser is also a former President of both the Water Environment Federation and
the Association of Metropolitan Sewerage Agencies. Mr. Kaiser has served as a
Director of the Company since May 1993 and is a member of the Board's Audit
Committee.

FREDERICK H. KURTZ, AGE 63. Mr. Kurtz is President of PARCOR Incorporated
(consulting firm). From May 1993 to June 1995, Mr. Kurtz was the Chief Operating
Officer of the Company and was the Executive Director of the Middlesex County
Utility Authority from 1986 to 1993. Mr. Kurtz has served as Director of the
Company since May 1993, is currently Vice Chairman of the Board and is a member
of the Board's Compensation and Nominating Committees.

BOBBY B. CARROLL, AGE 64. Mr. Carroll is the President and Chief Executive
Officer of Pozzolanic Contracting & Supply Co., a supplier of roadway
construction materials in the Southeast U.S.. Mr. Carroll also acts as a
consultant to the Company with respect to various matters. Mr. Carroll has
served as a Director of the Company since May 1997 and is a member of the
Board's Finance Committee.



                                       21
<PAGE>   39

J. PATRICK NICHOLSON, AGE 61. Mr. Nicholson became Chairman, Chief Executive
Officer of the Company in May 1993. In 1979, he founded the Partnership, one of
the predecessor entities that combined to form the Company in October 1993. From
the Partnership's inception to present, Mr. Nicholson has served as one of its
general partners and is the controlling stockholder of N-Viro Energy Systems,
Inc., the corporate general partner of the Partnership. Mr. Nicholson has served
as a Director of the Company since May 1993.

B.K. WESLEY COPELAND, AGE 64. Mr. Copeland, a physical chemist, was the Founder
of the International Science and Technology Institute, Inc., as well as Founder
and CEO of the Foundation for Economic Development. Mr. Copeland has served as a
Director of the Company since May 1997 and is a member of the Board's
Compensation and Nominating Committees.

                              BOARD AND COMMITTEES

         Pursuant to Delaware law, under which the Company is organized, the
Company's business, property and affairs are managed under the direction of the
Board of Directors. The Board met five times during the year ended December 31,
1997. The Board has appointed standing Audit, Compensation, Finance and
Nominating Committees. In 1997, each incumbent Director attended at least 75% of
the aggregate meetings of the Board and the Committees on which they served.

         The Audit Committee of the Board of Directors currently consists of
three members and met five times during the year ended December 31, 1997. The
Audit Committee recommends the appointment of auditors and oversees the
accounting and internal audit functions of the Company.

         The Compensation Committee of the Board of Directors currently consists
of three members and met twice during the year ended December 31, 1997. The
Compensation Committee determines officers' salaries and bonuses and administers
the grant of stock options pursuant to the Company's Stock Option Plan.

         The Finance Committee of the Board of Directors currently consists of
three members and met once during the year ended December 31, 1997. The Finance
Committee assists in monitoring cash flow requirements of the Company and
approves any internal or external financing or leasing arrangements.

         The Nominating Committee of the Board of Directors currently consists
of three members and met twice during year ended December 31, 1997. The
Nominating Committee considers and recommends to the Board of Directors nominees
for election to the Board of Directors.

                        EXECUTIVE OFFICERS OF THE COMPANY

         The following information is furnished as to the Executive Officers of
the Company:

J. PATRICK NICHOLSON, AGE 61. Mr. Nicholson has served as Chairman, Chief
Executive Officer and President of the Company since its inception in May 1993.
As described above, Mr. Nicholson served in a similar capacity to the
Partnership prior to that date.

JAMES K. MCHUGH, AGE 39. Mr. McHugh has served as Chief Financial Officer,
Secretary and Treasurer of the Company since January 1997. Prior to that date,
Mr. McHugh served the Company and the Partnership in various capacities
including Controller and Director of Accounting and Taxation.

ITEM 11. EXECUTIVE COMPENSATION

                                  REMUNERATION

COMPENSATION OF EXECUTIVE OFFICERS

         The following table presents the total compensation awarded to, earned
by, or paid to, the Chief Executive Officer of the Company during 1996 and 1997.
There were no other Executive Officers of the Company who were serving at the
end of 1997 and whose total annual salary and bonus, if any, exceeded $100,000.

                                       22
<PAGE>   40

                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                 Year                  Annual Compensation                Long-Term                             
                                                       -------------------               Compensation              All Other        
   Name and Principal Position                    Salary ($)             Bonus ($)        Options (#)(2)        Compensation ($)(1)
-----------------------------------------------------------------------------------------------------------------------------------
<S>                              <C>              <C>                       <C>            <C>                         <C>
J. Patrick Nicholson             1997             $ 125,600                -0-             5,000                      -0-
 Chairman, Chief                 1996             $ 147,500                -0-              -0-                       -0-
 Executive Officer               1995             $ 149,167                -0-              -0-                     $ 1,575
 and President

-------------------

<FN>
         (1)      Amounts shown consist of term life insurance premiums paid by the Company for the benefit of Mr. Nicholson.

         (2)      The numbers shown represent the number of shares of common stock for which options were granted to the named
                  Executive Officer in 1995 and 1997.
</FN>
</TABLE>

EMPLOYMENT AGREEMENTS

         On July 1, 1993, Mr. Nicholson entered into a three-year employment
agreement with the Company providing for automatic one-year renewals and minimum
annual salary of $250,000. Such agreement also provides that Mr. Nicholson shall
be entitled to (i) bonuses to be payable at the discretion of the Board of
Directors, and (ii) such medical and other benefits, including insurance and
pension plan, as are provided to other Executive Officers of the Company.
Effective March 1, 1998, Mr. Nicholson has voluntarily agreed to reduce his
minimum annual salary to $131,250 for the year ended December 31, 1998.

<TABLE>
<CAPTION>
                                             OPTION GRANTS IN LAST FISCAL YEAR
---------------------------------------------------------------------------------------------------------------------------------
                                                 % of Total 
                                                    Options 
                                 Number of         Granted to                                      Potential Realizable Value 
                                Securities         Employees                                       at Assumed Annual Rates of
                                Underlying         in Fiscal        Exercise or                   Stock Price Appreciation for  
                                 Options             Year            Base Price      Expiration          Option Term(1)
           Name                  Granted(2)                           ($/share)         Date           5% ($)           10% ($) 
---------------------------------------------------------------------------------------------------------------------------------
<S>                               <C>               <C>              <C>             <C>              <C>           <C>    
    J. Patrick Nicholson           5,000             5.2%            $1.5625         11/9/2007        $4,938          $12,438
---------------------------------------------------------------------------------------------------------------------------------
                                  25,000            26.1%            $ 4.00          11/3/2003          $0            $10,723
---------------------------------------------------------------------------------------------------------------------------------

<FN>
         (1)      The potential realizable value through the expiration date of each option has been determined on the basis of
                  the closing price on May 9, 1997, compounded annually over the term of the option, net of the exercise price.
                  These values have been determined based upon assumed rates of appreciation and are not intended to forecast the
                  possible future appreciation, if any, of the price or value of the Company's common stock.

         (2)      All options have been granted pursuant to the N-Viro International Stock Option Plan. Options granted are
                  exercisable on the date of grant and on each succeeding anniversary thereof as to 20% of the shares of common
                  stock issuable with respect to such options.
</FN>
</TABLE>

<TABLE>
<CAPTION>
                                   AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
                                          AND FISCAL YEAR END OPTION VALUES
------------------------------------------------------------------------------------------------------------------------------

                                Shares          Value           Number of Unexercised            Value of Unexercised In-The-
                               Acquired        Realized       Options at Fiscal Year End(2)           Money Options at Fiscal
       Name                       On            ($)(1)                                                Year End ($)(3)
                              Exercise(1)
------------------------------------------------------------------------------------------------------------------------------
<S>                              <C>              <C>        <C>             <C>                 <C>            <C>          
                                                             Exercisable     Unexercisable       Exercisable    Unexercisable
------------------------------------------------------------------------------------------------------------------------------
J. Patrick Nicholson             -0-              $0           26,000          4,000                $0            $12,500
------------------------------------------------------------------------------------------------------------------------------
</TABLE>

                                       23
<PAGE>   41

         (1)      No options were exercised by the named Executive Officers in
                  1997.

         (2)      All options have been adjusted to reflect a one-for-four
                  reverse stock split effective October 31, 1995.

         (3)      Options are "in-the-money" only if the closing market price of
                  the common stock on December 31, 1997 exceeded the exercise
                  price of the options. There were 8,000 "in-the-money" options
                  held by Executive Officers of the Company on December 31, 1997
                  at $2.50 per share closing price.

         On November 14, 1997, the Board adopted a proposal conditionally
granting options to purchase Common Stock of the Company under the Company's
1993 Stock Option Plan (the "Plan") to certain employees and consultants of the
Company who hold existing options granted on November 3, 1993 under the Plan to
purchase Common Stock at a price in excess of $15.00 per share (such existing
options are referred to as "Outstanding Options" and the employees and
consultants holding them are referred to as "Eligible Option Holders"). The
Board has conditionally granted to each Eligible Option Holder one new Option
("A New Option") corresponding to each Outstanding Option held by the Eligible
Option Holder. Each New Option is an option to purchase that number of shares of
Common Stock which is equal to the number of shares subject to the Eligible
Option Holder's corresponding Outstanding Option at a price of $4.00 per share.
Except for the change in the exercise price, each New Option is otherwise on the
same terms and conditions as the corresponding Outstanding Option; that is, all
of the other terms and conditions of the corresponding Outstanding Option, such
as the date or dates upon which the option holder may exercise the Option and
the date upon which the Option terminates, are the same for the New Option as
they were for the corresponding Outstanding Option. The grant of each New Option
to each Eligible Option Holder was conditioned upon the surrender and
termination of the corresponding Outstanding Option of the Eligible Option
Holder. If an Outstanding Option is not surrendered and terminated, the
corresponding New Option terminates automatically. The names of the Eligible
Option Holders and the New Options granted to each are set forth in the table
below.

<TABLE>
<CAPTION>
         ------------------------------------------------------------------
                                                 NUMBER OF NEW OPTIONS 
                  NAMES           EXERCISE PRICE       GRANTED
         ------------------------------------------------------------------
<S>                                    <C>             <C>     
         J. Patrick Nicholson          $ 4.00          25,000  
         ------------------------------------------------------------------
         Frederick Kurtz               $ 4.00          25,000  
         ------------------------------------------------------------------
         Dr. Terry Logan               $ 4.00           6,250  
         ------------------------------------------------------------------
         Michael Nicholson             $ 4.00           6,250  
         ------------------------------------------------------------------
         James McHugh                  $ 4.00           3,125  
         ------------------------------------------------------------------
         James D. O'Neil               $ 4.00           3,125  
         ------------------------------------------------------------------
         June Taylor                   $ 4.00           2,500  
         ------------------------------------------------------------------
</TABLE>

         The New Options were granted to certain employees and consultants to
the Company in order to more adequately fulfill the purpose of the Plan. The
stated purpose of the Plan is "to enable (the Company) to attract and retain
qualified officers, key employees and non-employee directors and to provide an
incentive for such employees and directors to expand and improve the profits and
prosperity of (the Company)." The Board granted the New Options because it
believed that most of the Outstanding Options which had exercise prices in
excess of $15.00 per share did not provide a practical incentive to the Eligible
Option Holders. The Board granted the New Options in order to provide what it
believes is a better incentive to current employees.

COMPENSATION OF DIRECTORS

         Directors who are employees of the Company do not receive additional
compensation for serving as Directors. Effective April 1, 1994, non-employee
Directors no longer receive cash compensation, but receive stock options
pursuant to the Company's Stock Option Plan. Each Director currently receives a
grant of 500 shares of Common Stock of the Company per each meeting attended, as
approved by the Compensation Committee on May 9, 1997. Directors of the Company
are reimbursed for out-of-pocket expenses incurred in attending meetings of the
Board of Directors or any committees thereof.

COMPENSATION COMMITTEE INTERLOCKS

         During 1997, the members of the Compensation Committee consisted of Mr.
Copeland, Mr. Carroll and Mr. Kaiser, each of whom is a non-employee Director of
the Company.

                                       24
<PAGE>   42

COMPENSATION COMMITTEE REPORT ON EXECUTIVE COMPENSATION

         The compensation of the Company's Executive Officers is determined by
the Compensation Committee of the Board of Directors.

         The Committee's compensation philosophy is to provide competitive forms
and levels of compensation compared to industrial companies of similar size and
business area. This philosophy is intended to assist the Company in attracting,
retaining and motivating executives with superior leadership and management
abilities. Consistent with this philosophy, the Committee determines a total
compensation structure for each officer, consisting primarily of salary, bonus
and stock options. The proportions of the various elements of compensation vary
among the officers depending upon their levels of responsibility.

         The Committee establishes salaries at a level intended to be
competitive with the average salaries of Executive Officers in comparable
companies with adjustments made to reflect the financial health of the Company.
Bonuses are intended to provide executives with an opportunity to receive
additional cash compensation, but only if they earn it through Company and
individual performance.

         Long-term incentives are provided through stock options granted under
the Company's Stock Option Plan. The stock options represent an additional
vehicle for aligning management's and stockholders' interest, specifically
motivating executives to remain focused on the market value of the Common Stock
in addition to earnings per share and return on equity goals.

         The Committee, subject to any employment agreement in effect with its
Executive Officers reviews and recommends to the Board of Directors for approval
the salaries, bonuses and long-term incentives of the Company's officers,
including its most highly compensated Executive Officers. In addition, the
Committee grants stock options under the Company's Stock Option Plan to
Executive Officers and other selected employees, Directors and to consultants,
and otherwise administers the Company's Stock Option Plan.

         The Committee has not yet formulated any policy regarding qualifying
compensation paid to the Company's Executive Officers for deductibility under
the limits of Section 162(m) of the Internal Revenue Code of 1986, as amended.

         With respect to Chief Executive Officer Compensation, Mr. Nicholson's
base salary for 1997 was $125,000. Mr. Nicholson's base salary is determined by
his Employment Agreement which entitles him to a minimum annual base salary of
$250,000. See "Employment Agreements." However, Mr. Nicholson has reduced his
base salary in each of the four preceding years, but will be paid an annual
minimum base salary of $131,250 for 1998. Mr. Nicholson will continue to accept
a reduced base salary until such time as the Company's profitability permits
payment of the $250,000 annual minimum base salary provided for in his
Employment Agreement.

         The Committee is also responsible for recommending to the Board of
Directors bonus amounts payable to Mr. Nicholson, the Chief Executive Officer.
Any bonuses payable will be determined by the Committee, based on the same
elements and factors relating to the other Executive Officers of the Company. No
bonuses were paid to Mr. Nicholson or any other Executive Officer in 1997. As
the founder and the largest beneficial owner (42.74% of total shares of common
stock outstanding) of the Company, Mr. Nicholson has a significant portion of
his wealth invested in the Company's stock. Mr. Nicholson's level of stock
ownership continues to provide a strong link between Company performance and the
resulting rewards.

         Compensation Committee of the Board of Directors
         N-Viro International Corporation
                  Bobby B. Carroll
                  B.K. Wesley Copeland
                  Frederick H. Kurtz

                                       25
<PAGE>   43

STOCKHOLDER RETURN PERFORMANCE PRESENTATION

         Set forth below is a line graph comparing the yearly percentage change
and the cumulative total shareholder return on the Company's shares against the
cumulative total return of the NASDAQ Stock Market (U.S. Companies) Index and an
index comprised of Peer Group companies selected by the Company. The Peer Group
consists of six companies considered to be either competitors or similar to the
Company. Upon written request to the Secretary/Treasurer, N-Viro International
Corporation, 3450 West Central Avenue, Suite 328, Toledo, Ohio 43606, the
Company shall provide stockholders with the names of the component issuers. The
data is for the period beginning October 12, 1993, the date of the Company's
initial public offering, and ending December 31, 1997. The calculation assumes
that $100 was invested at the close of business on October 12, 1993 and all
dividends are assumed to be reinvested.


<TABLE>
<CAPTION>
============================================================================================
                           10/12/93   12/31/93   12/31/94   12/31/95   12/31/96    12/31/97
--------------------------------------------------------------------------------------------
<S>                         <C>        <C>         <C>       <C>        <C>          <C>    
     NASDAQ Index           100.00     100.7       98.4      139.2      171.2        210.2  
--------------------------------------------------------------------------------------------
     Company                100.00      65.8       18.4        5.3        5.9          6.6  
--------------------------------------------------------------------------------------------
     Peer Group             100.00      94.2       57.7       84.3       50.8         53.9  
--------------------------------------------------------------------------------------------
</TABLE>

                                                            
         Except to the extent the Company specifically incorporates this
information by reference, the foregoing Report of the Compensation Committee and
Stock Price Performance Graph shall not be deemed incorporated by reference by
any general statement incorporating by reference this Proxy Statement into any
filing under the Securities Act of 1933 or under the Securities Exchange Act of
1934. This information shall not otherwise be deemed filed under such Acts.

SECTION 16(a) COMPLIANCE

         Section 16(a) of the Securities and Exchange Act of 1934 requires the
Company's Directors and Executive Officers, and persons who own beneficially
more than ten percent (10%) of the shares of common stock of the Company, to
file reports of ownership and changes of ownership with the Securities and
Exchange Commission. Copies of all filed reports are required to be furnished to
the Company pursuant to Section 16(a). Based solely on the reports received by
the Company and on written representations from reporting persons, the Company
believes that the Directors and Executive Officers complied with all applicable
filing requirements during the fiscal year ended December 31, 1997.

                                       26
<PAGE>   44

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The Company had outstanding 2,755,733 shares of common stock, $.01 par
value per share (the "shares of common stock"), on April 1, 1998. These shares
of common stock constitute the only class of outstanding voting securities of
the Company. Stockholders of record at the close of business on April 1, 1998
are entitled to notice of, and to vote at, the Annual Meeting and any
adjournments thereof. Each share of common stock is entitled to one vote on all
matters to come before the Annual Meeting. Stockholders are not permitted to
cumulate votes for the purpose of electing directors or otherwise.

         At April 1, 1998, the following were the only persons known to the
Company to own beneficially more than 5% of the outstanding shares of common
stock:

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------------
                                                       Shares of Common Stock      Percentage of Outstanding Shares of  
     Name and Address of Beneficial Owner                Beneficially Owned            Common Stock as of April 1, 1998
-------------------------------------------------------------------------------------------------------------------------
<S>                                                         <C>                                 <C>   
N-Viro Energy Systems, Ltd.(1)                              1,018,357(2)                        36.95%
3450 West Central Avenue, Suite 328
Toledo, Ohio  43606
-------------------------------------------------------------------------------------------------------------------------
Heartland Advisors, Inc.                                      250,000(3)                         9.07%
790 North Milwaukee Street
Milwaukee, Wisconsin  53202
-------------------------------------------------------------------------------------------------------------------------
</TABLE>

                 SECURITY OWNERSHIP OF DIRECTORS AND MANAGEMENT

         The following table sets forth as of April 1, 1998, unless otherwise
specified, certain information with respect to the beneficial ownership of the
Company's shares of common stock by each person who is a Director of the
Company, a nominee for the Board, each of the named Executive Officers, and by
the Directors and Executive Officers of the Company as a group.

<TABLE>
<CAPTION>
         ----------------------------------------------------------------------------------------
                                                   Beneficial Ownership of 
                 Name of Beneficial Owner         Common Stock as of April 1,   Percent of Class
                                                            1998
         ----------------------------------------------------------------------------------------
<S>                                                   <C>                           <C>    
         Bobby B. Carroll                                96,100(1)(2)                 3.48% 
         ----------------------------------------------------------------------------------------
         B.K. Wesley Copeland                             6,000(2)                     .22% 
         ----------------------------------------------------------------------------------------
         Wallace G. Irmscher                              7,525(2)                     .27% 
         ----------------------------------------------------------------------------------------
         Charles B. Kaiser, Jr                            7,650(2)                     .28% 
         ----------------------------------------------------------------------------------------
         Frederick H. Kurtz                              80,200(2)                    2.91% 
         ----------------------------------------------------------------------------------------

-----------------------------
<FN>
         (1)      Includes 44,600 Shares actually owned by Pozzolanic Contracting & Supply Co., a
                  company of which Mr. Carroll is the controlling shareholder.

         (2)      Includes shares not actually owned by such individuals as of April 1, 1998, but
                  of which beneficial ownership could be acquired currently by such individuals
                  upon the exercise of outstanding options.

         (3)      Includes shares vested January 1, 1997 to be received from the Partnership as
                  part of the Company's Stock Bonus Plan dated October 1, 1993.
</FN>
</TABLE>


                                       27
<PAGE>   45

<TABLE>
<CAPTION>
         ----------------------------------------------------------------------------------------
                                                   Beneficial Ownership of 
                 Name of Beneficial Owner         Common Stock as of April 1,   Percent of Class
                                                            1998
         ----------------------------------------------------------------------------------------
<S>                                                   <C>                           <C>    
         Terry L. Logan                                  21,987(2)(3)                  .80% 
         ----------------------------------------------------------------------------------------
         James K. McHugh                                  9,351(2)(3)                  .34% 
         ----------------------------------------------------------------------------------------
         J. Patrick Nicholson                         1,177,737(2)(4)                42.74% 
         ----------------------------------------------------------------------------------------
         Michael G. Nicholson                            15,942(2)(3)                  .58% 
         ----------------------------------------------------------------------------------------
         James D. O'Neil                                  9,425(2)                     .34% 
         ----------------------------------------------------------------------------------------
         All Directors and Executive Officers as a    1,431,917(5)(6)                51.96% 
         group (10 persons)                                                          
         ----------------------------------------------------------------------------------------

-----------------------------
<FN>

         (1)      Includes 44,600 Shares actually owned by Pozzolanic
                  Contracting & Supply Co., a company of which Mr. Carroll is
                  the controlling shareholder.

         (2)      Includes shares not actually owned by such individuals as of
                  April 1, 1998, but of which beneficial ownership could be
                  acquired curently by such individuals upon the exercise of
                  outstanding options.

         (3)      Includes shares vested January 1, 1997 to be received from the
                  Partnership as part of the Company's Stock Bonus Plan dated
                  October 1, 1993.

         (4)      Includes 1,018,357 shares owned by the Partnership, of which Mr. Nicholson is a
                  general partner, and 69,748 shares owned by N-Viro Energy Systems, Inc., a
                  corporation of which Mr. Nicholson is the controlling shareholder.

         (5)      Includes an aggregate of 131,325 shares not actually owned by such Directors and
                  Executive Officers as of April 1, 1998, but of which beneficial ownership could
                  be acquired currently by such Directors and Executive Officers upon the exercise
                  of outstanding options.

         (6)      Includes an aggregate of 780 shares vested in January 1, 1997 to be received
                  from the Partnership by such Directors and Executive Officers as part of the
                  Company's Stock Bonus Plan dated October 1, 1993.
</FN>
</TABLE>

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Bobby B. Carroll, a consultant to and Director of the Company, is
currently under a consulting contract with the Company that will pay him
$120,000 per year through 1999. In addition, Pozzolanic Contracting & Supply
Co., a company of which Mr. Carroll is the controlling shareholder, sells
materials to the Company in the ordinary course of business, the aggregate
amount of which exceeded $31,000 in 1997.

         In June of 1997, the Company reached agreements with three trade
creditors to eliminate, in the aggregate, $259,500 of the Company's short-term
debt in exchange for the Company's issuance and delivery to such creditors, in
the aggregate, 86,500 shares of common sock. All three trade creditors are
current members of the Board of Directors of the Company, J. Patrick Nicholson,
Bobby Carroll and Frederick Kurtz. Additionally, Mr. Nicholson is the Chairman
of the Board, Chief Executive Officer and President of the Company. The number
of shares of common stock issued to, and the corresponding amount of short-term
debt forgiven by, Mr. Nicholson, Mr. Carroll and Mr. Kurtz is set forth in the
table below:

<TABLE>
<CAPTION>

=====================================================================================================
            Creditor                 Amount of Canceled Debt        No. of Shares Issued in Exchange
-----------------------------------------------------------------------------------------------------
<S>                                       <C>                                 <C>   
J. Patrick Nicholson                      $ 48,000                            16,000
-----------------------------------------------------------------------------------------------------
Bobby Carroll                             $150,000                            50,000
-----------------------------------------------------------------------------------------------------
Frederick Kurtz                           $ 61,500                            20,500
=====================================================================================================
</TABLE>


                                       28
<PAGE>   46

All such shares of common stock were issued and delivered to the Company's
creditors pursuant to appropriate exemptions from registration under federal and
state securities laws. All of the exchanges were evidenced by written Share
Exchange Agreements between the Company and each of the creditors. Copies of
such Share Exchange Agreements were filed as Exhibits to the Company's Form 8-K
filed on July 18, 1997 which has been incorporated herein by reference.

         In addition to the share exchanges described above, the Company, in
June of 1997, also reached agreement with the Partnership (the holder of 45% of
the issued and outstanding shares of the common stock of the Company) to cancel
$150,000 of the Company's short-term debt to the Partnership in exchange for the
Company's issuance and delivery to the Partnership of 50,000 shares of common
stock. At the time of this agreement, the Company's total indebtedness to the
Partnership was $176,500. Such indebtedness was evidenced by three promissory
notes in the aggregate amount of $191,500. In exchange for the cancellation of
the three original promissory notes, the Company agreed to issue and deliver to
the Partnership (i) 50,000 shares of common stock and (ii) a promissory note in
the amount of $26,500. The shares of common stock issued and delivered to the
Partnership were issued and delivered pursuant to applicable exemptions from
registration under the Securities Act and state securities laws. Further, this
exchange was evidenced by a written Share Exchange Agreement which was filed by
the Company as an Exhibit to the Company's Form 8-K filed on July 18, 1997.

         Dr. Terry J. Logan, Ph.D., a consultant to and Director of the Company,
received consulting fees in the amounts of $41,333 in 1997 and $35,127 in 1996.
Dr. Logan is also the controlling shareholder of Logan Environmental, Inc., an
environmental consulting firm which performs consulting services for the Company
from time to time.

         Charles Kaiser, a consultant to and Director of the Company, received
consulting fees in the amounts of $3,500 in 1997 and $-0- in 1996.

         James D. O'Neil, a Director of the Company, has been employed as
Vice-President of Engineering and Operations of the Company since March, 1993.
Prior to that date, Mr. O'Neil was Vice-President and General Manager of Leon
Boulton + Son, Inc. for 14 years, and subsequently self-employed as an
engineering consultant. For the year ended 1997 and 1996, Mr. O'Neil earned
$76,100 and $65,000, respectively, from the Company.

         Michael Nicholson, a Director of the Company, has been employed as
Vice-President of Sales and Marketing of the Company since December, 1996. Prior
to that date, Mr. Nicholson served the Company and the Partnership in various
management positions in sales. For the year ended 1997 and 1996, Mr. Nicholson
earned $73,400 and $67,200, respectively, from the Company. Mr. Nicholson is the
son of J. Patrick Nicholson, Chairman, Chief Executive Officer and President of
the Company.


                                       29
<PAGE>   47

                                     PART IV

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

(a) 1. AND (a) 2.   FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE

                           See "Index to Financial Statements and Schedule" set
                    forth in Item 8 at page 20 of this Form 10-K.


(a) 3.              EXHIBITS

                           The exhibits designated by an asterisk are management
                    contracts and compensatory plans and arrangements required
                    to be filed as exhibits to this Form 10-K.

<TABLE>
<CAPTION>
                    Exhibit
                    Number     Description
                    ------     -----------
<S>                   <C>      <C>       
                      3.1      Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1 to the
                               Registration Statement of the Registrant on Form S-1 (Reg. No. 33-62766) (the "Registration
                               Statement")).

                      3.2      By-Laws of the Company (incorporated by reference to Exhibit 3.2 to the Registration Statement).

                      *10.1    The Amended and Restated N-Viro International Corporation Stock Option Plan (incorporated by
                               reference to Exhibit 10.1 to the 1993 Form 10-K).

                      *10.2    Employment Agreement, dated May 10, 1993, between N-Viro International Corporation and J.
                               Patrick Nicholson (incorporated by reference to Exhibit 10.2 to the Registration Statement).

                      *10.3    Transitional Consulting and Sales Representative Agreement, dated September 2, 1993, and amended
                               January 1, 1994 between N-Viro International Corporation and Bobby B. Carroll (incorporated by
                               reference to Exhibit 10.102 to Amendment No. 1 to the Registration Statement).

                      *10.4    Letter Agreement, dated November 22, 1993, from Jeffrey C. Burnham, Ph.D. on behalf of BioCheck
                               Laboratories, Incorporated to Terry J. Logan, Ph.D. relating to research at The Ohio State
                               University (incorporated by reference to Exhibit 10.110 to the 1993 Form 10-K).

</TABLE>

                                       30
<PAGE>   48

<TABLE>
<S>                   <C>      <C>       
                      21.1     List of subsidiaries of the Company.
                      24.1     Powers of Attorney
                      27.1     Financial Data Schedule
</TABLE>


(b)                        REPORTS ON FORM 8-K
                           The Company filed a report on Form 8-K dated October
                           9, 1997, Item 5., Other Items, to disclose agreements
                           for sales of Common Stock, with attached exhibits of
                           the three agreements.

                           The Company filed on report on Form 8-K dated
                           December 10, 1997, Item 5., Other Items, to disclose
                           a press release on the final settlement agreement
                           with Frank Manchak, Jr., with an attached exhibit of
                           the press release of the Company.


(c)                        None



                                       31
<PAGE>   49

(d)                        Financial Statements of Subsidiaries not Consolidated

                              FLORIDA N-VIRO, L.P.
                              --------------------

                                Table of Contents
                                -----------------



<TABLE>
<CAPTION>
                                                                                                    PAGE
                                                                                                    ----
<S>                                                                                              <C>
Independent Auditor's Report                                                                            E-1

Balance Sheets                                                                                   E-2 to E-3

Statement of Income (Loss) and Partners' Capital                                                        E-4

Statement of Cash Flows                                                                                 E-5

Notes to Financial Statements                                                                    E-6-to E-8
</TABLE>


                                       32
<PAGE>   50

                                                               February 10, 1998



                          INDEPENDENT AUDITOR'S REPORT


To the Partners 
of Florida N-VIRO, L.P.
West Chester, Pennsylvania 19382


I have audited the accompanying balance sheets of Florida N-VIRO, L.P., (a
Limited Partnership), as of December 31, 1997 and 1996, and the related
statements of income (loss) and partners' capital, and cash flows for the years
then ended. These financial statements are the responsibility of the
Partnership's management. My responsibility is to express an opinion on these
financial statements based on my audit.

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

In my opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Florida N-VIRO, L.P. as of December
31, 1997 and 1996, and the results of its operations and its cash flows for the
years then ended in conformity with generally accepted accounting principles.




/s/ Joseph M. Cahill
--------------------
Joseph M. Cahill, Ltd.,
Certified Public Accountants

JMC/rb


                                      E-1
<PAGE>   51

                              FLORIDA N-VIRO, L.P.
                              --------------------

                                 Balance Sheets
                                 --------------

                           December 31, 1997 and 1996
                           --------------------------



<TABLE>
<CAPTION>
                                                      1997          1996
                                                   ------------------------
Assets

<S>                                                <C>           <C>       
               Current Assets
                 Cash                              $   26,820    $    3,817
                 Receivables:
                      Trade                            60,616        90,177
                      Partners                        124,696       105,704
                 Costs in Excess of Billings          -----             976
                 Prepaid Expenses                       9,379        11,540
                                                   ------------------------
                 Total Current Assets                 221,511       212,214

               Property and Equipment
                 Land                                 147,163       147,163
                 Site improvements                     45,965        45,965
                 Building                           1,383,169     1,383,169
                 Operating equipment                  459,345       459,345
                 Office furniture and equipment         3,199         3,199
                                                   ------------------------
                                                    2,038,841     2,038,841

                 Less Accumulated Depreciation        185,386        92,691
                                                   ------------------------

                 Total Property and Equipment       1,853,455     1,946,150
                                                   ------------------------

Total Assets                                       $2,074,966    $2,158,364
                                                   ========================
</TABLE>

    The accompanying notes are an integral part of these financial statements



                                      E-2
<PAGE>   52

                              FLORIDA N-VIRO, L.P.
                              --------------------

                                 Balance Sheets
                                 --------------

                           December 31, 1997 and 1996
                           --------------------------





<TABLE>
<CAPTION>
                                                           1997          1996
                                                       ------------------------
<S>                                                    <C>           <C>       
Liabilities and Partners' Capital

         Current Liabilities

                Payables:
                      Trade                            $  128,684    $  141,948
                      Partners                             21,523        48,549
                      Current portion capital lease       -----          10,013
                      Accrued expenses                     99,519        40,939
                                                       ------------------------

         Total Current Liabilities                        249,726       241,449

         Partners' Capital                              1,825,240     1,916,915
                                                       ------------------------

Total Liabilities and Partners' Capital                $2,074,966    $2,158,364
                                                       ========================
</TABLE>

   The accompanying notes are an integral part of these financial statements.



                                      E-3
<PAGE>   53

                              FLORIDA N-VIRO, L.P.
                              --------------------

                Statements of Income (Loss) and Partners' Capital
                -------------------------------------------------

                 For the Years Ended December 31, 1997 and 1996
                 ----------------------------------------------

<TABLE>
<CAPTION>
                                                 1997          1996
                                              -----------------------
<S>                                           <C>           <C>      
Revenues                                      $ 655,570     $ 761,631

Costs and Expenses (Income)

        Costs of Operations                     696,978       697,658
        Selling General and Administrative       51,062       148,151
        Interest Income                            (795)       (1,093)
                                              -----------------------

Net Income (Loss)                             $ (91,675)    $ (83,085)
                                              =======================
</TABLE>





Statement of Partners' Capital
<TABLE>
<CAPTION>
                               General Partner  Limited Partners    Total
                               ---------------------------------------------

                                                    1996
                               ---------------------------------------------
<S>                              <C>             <C>             <C>        
Contributions                    $    10,000     $ 1,990,000     $ 2,000,000
  Net (Loss)                          (1,661)        (81,424)        (83,085)
                               ---------------------------------------------
Ending Balance,
December 31, 1996                $     8,339     $ 1,908,576     $ 1,916,915
                               =============================================


                                                    1997
                               ---------------------------------------------
Beginning Balance                $     8,339     $ 1,908,576     $ 1,916,915

  Net Loss                            (1,833)        (89,842)        (91,675)
                               ---------------------------------------------

                                 $     6,506     $ 1,818,734     $ 1,825,240
                               =============================================
</TABLE>







   The accompanying notes are an integral part of these financial statements.




                                      E-4
<PAGE>   54

                              FLORIDA N-VIRO, L.P.
                              --------------------

                            Statements of Cash Flows
                            ------------------------

                 For the Years Ended December 31, 1997 and 1996
                 ----------------------------------------------

<TABLE>
<CAPTION>
                                                   1997            1996
                                                 ------------------------
<S>                                              <C>          <C>         
Cash Flow from Operating Activities
      Net Income (Loss)                          $(91,675)    $   (83,085)
      Adjustment to Reconcile Net Earnings
          (loss) to Cash Provided (used) by
          Operating Activities
      Depreciation                                 92,691          92,691
      Decrease in Accounts Receivable              10,569        (195,881)
      (Decrease) in Prepaid Expenses                2,165         (11,540)
      Decrease in Costs in Excess of Billings         976            (976)
      (Decrease) in Accounts Payable              (40,290)        190,497
      (Decrease) in Accrued Expenses               58,580          40,939
                                                 ------------------------

      Net Cash Provided (Used) by
          Operating Activities                     33,016          32,645

Cash Flows from Investing Activities
      Acquisition of Property and Equipment       -----          (995,073)
                                                 ------------------------

      Net Cash Provided (Used) by
          Investing Activities                    -----          (995,073)

Cash Flows from Financing Activities
      Contributions from Partners                     -         1,000,000
      Principal Payments on Capital Lease         (10,013)        (33,755)
                                                 ------------------------

Net Cash Provided (Used) by
          Financing Activities                    (10,013)        966,245
                                                 ------------------------

Net Increase in Cash                               23,003           3,817

Cash, Beginning of Year                             3,817         -----
                                                 ------------------------

Cash, End of Year                                $ 26,820     $     3,817
                                                 ========================
</TABLE>




   The accompanying notes are an integral part of these financial statements.






                                      E-5
<PAGE>   55

                              FLORIDA N-VIRO, L.P.
                              --------------------

                          Notes to Financial Statements
                          -----------------------------

Note A - Background
-------------------

         BUSINESS ACTIVITIES - Florida N-Viro, L.P., was formed January 1, 1996
         as a Delaware Limited Partnership under the Delaware Revised Limited
         Partnership Act. The Partnership has entered into a patent and
         technology agreement with N-Viro International Corporation for the
         exclusive, royalty free, use in Florida of certain systems/processes
         for the treatment and remediation of waste water sludge. The
         Partnership operates from its Ft. Meade, Florida facility.

         The Partnership consists of one general partner, Florida N-Viro Limited
         Liability Corporation, a Delaware limited liability corporation, and
         two limited partners: VFL Technology Corporation and N-Viro
         International Corporation. The general partner, which is a limited
         liability corporation having limited resources, is responsible for the
         liabilities of the partnership beyond the capital contributed by the
         limited partners.

         The Partnership agreement terminates on December 31, 2026.

Note B - Summary of Accounting Principles
-----------------------------------------

1.       METHOD OF ACCOUNTING AND USE OF ESTIMATES - The financial statements
         are prepared using the accrual basis of accounting. Generally accepted
         accounting principles requires management to make estimates and
         assumptions that affect the reported amounts of assets and liabilities
         at the date of the financial statements, and the reported amounts or
         revenues and expenses during the reporting period. Actual results could
         defer from the estimates.

2.       CASH AND CASH EQUIVALENTS - The Partnership considers all short-term
         investments with an original maturity of three months or less to be
         cash equivalents.

3.       PROPERTY AND EQUIPMENT - Property and equipment, carried at cost, is
         depreciated over the estimated useful life of the related assets.
         Depreciation is computed principally by the straight-line method. The
         estimated useful lives used in computing depreciation are summarized as
         follows:

<TABLE>
<CAPTION>
                                                      Years of Useful Life
                                                -------------------------------------

<S>                                                           <C> 
             Operating equipment                              7-10
             Office equipment                                  5-7
             Land improvements                                 15
             Buildings                                         39
</TABLE>

         Depreciation amounted to $92,691 for 1997 and 1996.

         Maintenance, repairs and expenditures for renewals and betterments not
         determined to extend the useful life or to increase materially the
         productivity of the properties to which they are applied are charged to
         income as incurred. Other renewals and betterments are capitalized.

         It is the policy of the Partnership generally to eliminate from the
         accounts the cost and related allowances for depreciation applicable to
         assets retired or otherwise disposed of, charging or crediting to
         income the differences between depreciation cost and the proceeds of
         sale or salvage.

4.       INCOME TAXES - No provision for income taxes is required since the
         partners report their proportionate share of partnership taxable income
         or loss on their respective income tax returns. Such income or losses
         are proportionately allocated to the partners based upon their
         ownership interests.

5.       ADVERTISING - The Partnership follows the policy of charging the costs
         of advertising to expense as incurred.

                                      E-6
<PAGE>   56

         There was no advertising expense for 1997 or 1996.

6.       FINANCIAL INSTRUMENTS - The following methods and assumptions were used
         by the Partnership to estimate the fair values of financial instruments
         as disclosed herein:
            Cash and Cash Equivalents - The carrying amount approximates fair
         value because of the short period to maturity of the instruments.
            Capital Lease obligation - The carrying amount approximates fair
         value since fair value of long-term debt is estimated based on interest
         rates for the same or similar debt offered to the Partnership having
         the same or similar remaining maturities and collateral requirements.


Note C - Supplemental Disclosures for Statement of Cash Flows
-------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                   1997                    1996
                                                            -------------------------------------------
<S>                                                               <C>                     <C>    
Cash paid for:
      Interest                                                    $5,197                  $ 4,640

Non-Cash Investing and
      Financing Activities:
          Contribution of Property and
               Equipment by Partner                                -----                $1,000,000
                                                            ===========================================
</TABLE>




                                      E-7
<PAGE>   57

Rote D - Related Parties
------------------------

         VFL Technology Corporation provides the Partnership with certain
         management, accounting, and engineering services without charge.

         The Partnership has a fee sharing arrangement with N-Viro International
         Corporation for services provided to several customers. The
         Partnership's share of these fees was approximately $25,500 for 1997.

         The Partnership had the following receivable balances due at December
         31, from its partners:

<TABLE>
<CAPTION>
                                                    1997                   1996
                                             -------------------------------------------
<S>                                               <C>                    <C>     
                General Partner                   $ 10,000               $ 10,000
                Limited Partner                    114,696                 95,704
                                             ===========================================
                                                  $124,696               $105,704
                                             ===========================================
</TABLE>

         The Partnership had payable balances due the other limited partner at
         December 31, 1997 and 1996 of $21,523 and $48,549 respectively.

Note E - Capital Lease
----------------------

         The Partnership assumed responsibility for the balance of a capital
         lease on equipment that was part of the initial capital contribution of
         one of the partners. Accordingly, the asset was capitalized and has the
         following book value at December 31, 1997 and 1996:

<TABLE>
<CAPTION>
                                                           1997                  1996
                                                    --------------------------------------------
<S>                                                      <C>                   <C>     
                  Capitalized Cost                       $120,000              $120,000
                  Accumulated Depreciation                 34,286                17,143
                                                    ============================================
                  Net Book Value                         $ 85,714              $102,857
                                                    ============================================
</TABLE>

Note F - Concentration of Credit Risk
-------------------------------------

         In the normal course of business, the Partnership extends credit to
         customers principally in the State of Florida. The Partnership expects
         to collect all of its accounts receivable and, accordingly, no
         allowance for doubtful accounts is provided.

         The Partnership conducts a major portion of its business with one
         customer. For the years ended December 31, 1997 and 1996, this customer
         accounted for 58% and 45% of total revenue respectively. For 1997, the
         Partnership had a second major customer who accounted for 15% of
         revenue.

         The Partnership maintains its operating checking account at a bank
         located in Southeastern Pennsylvania. The balance in this account may
         at times exceed the federally insured limit of $100,000.

Note G - Operating Leases
-------------------------

         The Partnership leases a piece of heavy equipment that is accounted for
         as an operating lease. The future lease payments are:

<TABLE>
<S>                                              <C>            <C>    
                                                 1998           $28,788
                                                 1999            28,788
                                                 2000            11,995
                                                       --------------------------

                                                                $69,571
                                                       ==========================
</TABLE>




                                      E-8
<PAGE>   58

                                   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.

<TABLE>
<S>                                       <C>
                                          N-VIRO INTERNATIONAL CORPORATION

Dated: April 13, 1998

                                          By: /s/  J. Patrick Nicholson*
                                              ---------------------------------------------
                                              J. Patrick Nicholson, President, Chairman and
                                              Chief Executive Officer
                                              (Principal Executive Officer)
</TABLE>


         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.

Dated: April 13, 1998

<TABLE>
<S>                                                       <C>
/s/  J. Patrick Nicholson*                                /s/ James D. O'Neil*
----------------------------------------------            --------------------------------
J. Patrick Nicholson, President, Chairman,                James D. O'Neil, Director
Chief Executive Officer and Director
(Principal Executive Officer)


/s/  Frederick H. Kurtz*                                  /s/  Charles B. Kaiser, Jr.*
----------------------------------------------            --------------------------------
Frederick H. Kurtz, Vice-Chairman and Director            Charles B. Kaiser, Jr., Director


/s/ James K. McHugh                                       /s/  Terry J. Logan, Ph.D.*
----------------------------------------------            --------------------------------
James K. McHugh                                           Terry J. Logan, Ph.D., Director
Chief Financial Officer, Secretary and Treasurer
(Principal Financial and Accounting Officer)


/s/ Wallace G. Irmscher*                                  /s/ Michael G. Nicholson*
----------------------------------------------            --------------------------------
Wallace G. Irmscher, Director                             Michael G. Nicholson, Director


/s/ B.K. Wesley Copeland*                                 /s/ Bobby B. Carroll*
----------------------------------------------            --------------------------------
B.K. Wesley Copeland, Director                            Bobby B. Carroll, Director


                                                           /s/ James K. McHugh          
                                                          --------------------------
                                                          By: James K. McHugh           
                                                          Attorney-in-fact
                                                     

</TABLE>


                                       33