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

                                    FORM 10-K

            [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                    For the Fiscal Year Ended August 31, 1998

                                       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 1-13626

                           HORIZON HEALTH CORPORATION
                           --------------------------
             (Exact name of registrant as specified in its charter)

           Delaware                                     75-2293354
           --------                                     ----------
(State or other jurisdiction of            (I.R.S. Employer Identification No.)
incorporation or organization)

                             1500 Waters Ridge Drive
                           Lewisville, Texas 75057-6011
                           ----------------------------
          (Address of principal executive offices, including zip code)

                                 (972) 420-8200
                                 --------------
              (Registrant's telephone number, including area code)

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

Securities registered pursuant to Section 12(g) of the Act:

                               Title of each class
                               -------------------
                          Common Stock, $.01 par value

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

Yes [X]       No [ ]

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

As of November 23, 1998 there were 6,967,750 shares of the registrant's Common
Stock, $.01 par value, outstanding and the aggregate market value of the shares
of such stock held by non-affiliates of the registrant was $36,859,228. Solely
for purposes of computing such aggregate market value of the outstanding Common
Stock, shares owned by directors and executive officers of the registrant have
been excluded.

                       DOCUMENTS INCORPORATED BY REFERENCE

There is incorporated by reference in Part III of this Annual Report on Form
10-K portions of the information contained in the registrant's proxy statement
for its annual meeting of stockholders to be held on January 28, 1999.



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                                TABLE OF CONTENTS


                           HORIZON HEALTH CORPORATION
<TABLE>
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                                                                                                          PAGE
<S>      <C>              <C>                                                                            <C>
PART I

         Item 1.           Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  3

         Item 2.           Properties  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

         Item 3.           Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

         Item 4.           Submission of Matters to a Vote of Security Holders. . . . . . . .  . . . . . . 21


PART II

         Item 5.           Market for the Company's Common Equity
                           and Related Stockholder Matters . . . . . . . . . . . . . . . . . . . . . . . . 22

         Item 6.           Selected Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

         Item 7.           Management's Discussion and Analysis of Financial
                           Condition and Results of Operations  . . . . . . . . . . . . . . .  . . . . . . 27

         Item 7A.          Quantitative and Qualitative Disclosures 
                           About Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

         Item 8.           Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . 39

         Item 9.           Changes in and Disagreements with Accountants on
                           Accounting and Financial Disclosure . . . . . . . . . . . . . . . . . . . . . . 39


PART III

         Item 10.          Directors and Executive Officers of the Registrant  . . . . . . . . . . . . . . 40

         Item 11.          Executive Compensation  . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

         Item 12.          Security Ownership of Certain Beneficial Owners and Management  . . . . . . . . 40

         Item 13.          Certain Relationships and Related Transactions  . . . . . . . . . . . . . . . . 40


PART IV

         Item 14.          Exhibits, Financial Statement Schedules, and Reports on Form 8-K  . . . . . . . 41


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PART 1


ITEM 1.  BUSINESS

         Unless the context otherwise requires, when used herein the term
"Company" refers to Horizon Health Corporation, formerly known as Horizon Mental
Health Management, Inc., and its subsidiaries.

GENERAL

         The Company is a growing provider of employee assistance plans ("EAP")
and mental health services to business and managed care organizations, as well
as the leading contract manager of clinical programs offered by general acute
care hospitals in the United States. The Company has grown both internally and
through acquisitions, increasing both the variety of its treatment programs and
services and the number of its management contracts. As of August 31, 1998, the
Company had over 200 contracts to provide EAP and mental health services
covering nearly 2.0 million lives. Over the last six years, the Company has
increased its management contracts from 43 to a total of 172 as of August 31,
1998 and currently operates in 37 states. Of those management contracts, 150
relate to mental health programs and 22 relate to physical rehabilitation
programs. The Company has also developed a proprietary mental health outcomes
measurement system known as CQI+ and at August 31, 1998 provided outcome
measurement services at 82 contract locations. The Company was incorporated in
1989 and is the successor to Horizon Health Management Company, which began the
development and management of mental health programs for general acute care
hospitals in 1981.

         The Company's strategy is to enhance its position as the leader in the
contract management of mental health programs and to further expand the range of
services which it offers to its existing and new client hospitals to include
other clinical and related services and programs. A significant challenge in
obtaining clinical management contracts from hospitals is overcoming the initial
reservations that many hospital administrators have with outsourcing key
clinical services. The Company believes its expertise in working with hospital
administrators, its reputation in the industry and its existing contractual
relationships with 172 hospitals nationwide provide it with a significant
advantage in obtaining new contracts. The Company also believes it has
opportunities to cross-sell a range of mental health and physical rehabilitation
services to client hospitals by marketing and selling its mental health services
to client hospitals for which the Company currently manages only physical
rehabilitation programs, and by marketing and selling its physical
rehabilitation services to client hospitals for which the Company currently
manages only mental health programs. The Company is pursuing the development of
such opportunities as a primary part of its business strategy. The Company has
successfully expanded the breadth of services it offers to include the full
continuum of mental health services, including outcome measurement services, and
physical rehabilitation services and its contracts increasingly provide for
multiple services. In addition, the Company capitalizes on its expertise in
managing the delivery of mental health services by directly offering managed
behavioral health care services and employee assistance programs to businesses
and managed care organizations. The Company believes it is strategically-sized
to deliver national programs, while providing local, individualized service to
both employer and health plan clients and their employees or clients.

         General acute care hospitals are increasingly outsourcing key clinical
departments to independent contract management companies for several reasons,
including: (i) the expertise necessary for the development, management and
operation of specialized clinical programs differs from that for traditional
medical/surgical services, (ii) hospitals often lack access to skilled
professionals and the support staff needed to operate specialized clinical
programs, (iii) hospitals often lack expertise in the marketing and development
activities required to support specialized clinical programs, and (iv) hospitals
often lack expertise necessary to design and operate specialized clinical
programs that satisfy regulatory, licensing, accreditation and reimbursement
requirements.


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         MENTAL HEALTH SERVICES

         The Company believes that there continue to be substantial
opportunities to provide mental health contract management services to general
acute care hospitals in the United States. A major shift in the delivery of
mental health services is occurring as payors are increasingly using managed
care methods to review and require pre-approval for mental health treatment and
to evaluate alternatives to inpatient hospitalization in order to ensure that
each patient's treatment regimen utilizes clinical resources effectively. The
Company believes that general acute care hospitals need to be able to offer a
broad array of mental health care services in order to develop or participate in
integrated delivery systems responsive to the demands of managed care companies
and other third-party payors. The Company also believes that it costs general
acute care hospitals less to provide inpatient and partial hospitalization
mental health services than it costs freestanding psychiatric hospitals in part
due to the ability of acute care hospitals to utilize excess capacity. General
acute care hospitals are also able to provide their mental health patients with
needed medical care on-site and in a more cost effective manner than
freestanding psychiatric hospitals. Furthermore, general acute care hospitals
are eligible to receive reimbursement under the Medicaid program for mental
health care provided to Medicaid-eligible adults, unlike freestanding
psychiatric hospitals which are not presently eligible.

         The Company believes that, due to the increasing emphasis on
cost-effective treatment, significant demand exists for a complete continuum of
mental health services. In response to this demand, it has expanded the mental
health programs it offers to provide partial hospitalization (or day treatment),
outpatient treatment, short-term crisis intervention and residential treatment
as alternatives and complements to inpatient care. The Company believes it is
uniquely positioned to capitalize on the increased demand for mental health
contract management services as a result of its ability to provide a full
continuum of mental health services, its proprietary quality and outcomes
measurement system and its demonstrated industry expertise. In addition, the
Company believes its position as the leading contract manager of mental health
programs provides the Company with a significant advantage in attracting and
retaining employees and yields several economies of scale such as the ability to
consolidate accounting and administrative functions.

         The Company intends to continue to emphasize the area of mental health
programs for the elderly ("geropsychiatric programs"). At August 31, 1998, 69.2%
of the mental health treatment programs managed by the Company were
geropsychiatric programs. Many elderly patients with short-term mental illness
also have physical problems that make the general acute care hospital
environment the most appropriate site for their care. Subject to certain
recently enacted caps on reimbursement amounts, the Medicare program reimburses
general acute care hospitals for their cost of providing these services, which
includes the Company's management fee as well as allocated overhead costs to the
facility, and allows reimbursement for partial hospitalization and home health
services that permit the patient to be treated in the most cost-effective
environment. The Company has developed particular expertise in developing
specialized psychiatric programs for the elderly, in operating such programs,
and in assisting hospitals to receive approval for inpatient programs as
distinct part units ("DPUs") under Medicare. Approval of an inpatient program as
a DPU is significant to client hospitals because services provided in DPUs are
exempt from predetermined reimbursement rates and are reimbursed by Medicare on
an actual cost basis, subject to certain limitations described below.

         The fees received by the Company for its services under management
contracts are paid directly by its client hospital. The client hospitals receive
reimbursement under either the Medicare or Medicaid programs or payments from
insurers, self-funded benefit plans or other third-party payors for the mental
health and physical rehabilitation services provided to patients of the programs
managed by the Company. As a result, the availability and amount of such
reimbursement impacts the decisions of general acute care hospitals regarding
whether to offer mental health and physical rehabilitation services pursuant to
management contracts with the Company.

         Recent amendments to the Medicare regulations established maximum
reimbursement amounts on a per case basis for both inpatient mental health and
physical rehabilitation services. The new regulations establish a nationwide cap
limiting the reimbursement amount on a per case basis for mental health and
physical rehabilitation services to $10,534 and $19,104, respectively, subject
to adjustments based on market indices. In addition, these amendments
established a new ceiling on the rate of increase in operating costs per case
for mental health and physical rehabilitation services furnished to Medicare
beneficiaries. Prior to these amendments, the reimbursement 



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limits were tied to the hospital's mental health or physical rehabilitation unit
cost during the unit's first year of operations, subject to certain adjustments.
The limitations have resulted, in some cases, in decreased amounts reimbursed to
the Company's client hospitals. This decrease in reimbursement has, in some
cases, led to the renegotiation of a lower contract management fee structure for
the Company and in other cases has resulted in the termination or nonrenewal of
the management contract. The new reimbursement limitations become applicable to
the client hospitals at the beginning of their respective Medicare fiscal years.
The trend of renegotiated fees and canceled or nonrenewed contracts, resulting
in reduced management fees, which the Company first encountered in its fiscal
1998 second quarter, can be expected to continue in the first and second
quarters of fiscal 1999.

         On October 6, 1998, the Company issued a press release (the "October 6 
Release") to provide guidance on earnings expectations as a result of the 
decline in the number and profitability of the Company's mental health 
management contracts due, in part, to the recent decrease in Medicare 
reimbursement amounts to general hospitals for mental health patients. The 
Company stated in the October 6 Release that it believes that such declines 
will be partially offset by internal growth in the physical rehabilitation 
management contract business and improved efficiency in the operation of the 
Company's EAP services and managed behavioral health care services, and as a 
result it believes that earnings for fiscal 1999 should, at a minimum, reach 
$0.90 per share diluted. In addition, the Company announced in the October 6 
Release that the Company's Board of Directors has authorized the repurchase of 
up to 1,000,000 shares of the Company's Common Stock. The stock repurchase plan 
authorizes the Company to make purchases from time to time in the open market 
or through privately negotiated transactions, depending upon market conditions 
and applicable securities regulations. The stock will be repurchased utilizing 
available cash and borrowings under the Company's bank facility. The 
repurchased shares will be added to the treasury shares of the Company and may 
be used for employee stock plans and for other corporate purposes.

         CQI+ OUTCOMES MEASUREMENT SYSTEM

         The Company has developed and markets a proprietary mental health
outcome measurement system, CQI+ Outcomes Measurement System, (the "CQI+
System"), which provides outcome information regarding the effectiveness of a
hospital's mental health programs. The availability of such information enables
a hospital to demonstrate to third-party payors whether patients are improving
as a result of the treatment provided and allows a hospital to refine its
clinical treatment programs and to market such programs to patients and
providers. In addition, it provides the Company with a valuable tool in
demonstrating clinical results of the mental health programs managed by the
Company and in marketing such management services to other hospitals. The
Company provides outcome measurement services not only to client hospitals but
also to other hospitals, health care providers and third-party payors. The Joint
Commission on Accreditation of Healthcare Organizations ("JCAHO"), as part of
its hospital accreditation process, requires each hospital to select at least
one acceptable measurement system and at least two clinical performance
(outcome) measures that together represent at least 20% of the hospital's
patient population. Each year, the requirements for the number of measures and
the percentage of the population will increase. The Company's CQI+ System has
met the initial criteria for inclusion in the future accreditation process and
is included on JCAHO's list of acceptable systems. The Company is committed to
meeting criteria established by JCAHO. Since developing the CQI+ System over
four years ago, the Company has compiled a database containing outcome
measurement data on over 22,000 patients. With the growth of managed care and
the JCAHO accreditation requirement, the Company believes that its CQI+ System
will become an important component of the mental health services it provides.
Effective October 1, 1998, the Company signed an agreement with Eli Lilly and
Company to provide certain research services for an Analysis of Medication
Utilization and Outcomes.

         PHYSICAL REHABILITATION SERVICES

         The Company has successfully expanded the types of programs that it
manages for its client hospitals to include other related clinical services. The
Company's acquisition of Specialty Healthcare Management, Inc. ("Specialty"), in
August 1997, expanded the Company's operations to include the contract
management of physical rehabilitation programs. The Company believes that many
of the same factors driving demand in mental health programs are also driving
significant demand for physical rehabilitation programs. The Company provides
contract management for a full range of physical rehabilitation services. In
addition to acute and sub-acute physical therapy and rehabilitation services,
the Company also provides contract management for a comprehensive outpatient
rehabilitation facility program. Outpatient rehabilitation services are
dominated by the treatment of sports and work related injuries, but also provide
the continuum of rehabilitative care necessary to meet the medical needs of a
post-acute care patient following a disabling illness or traumatic injury.
Pressure from payors to move inpatients to the lowest-cost appropriate treatment
setting has helped fuel growth in these outpatient services.

         Recent amendments to the Medicare statutes also provide for a phase-out
of cost-based reimbursement of physical rehabilitation services over a
three-year period beginning October 1, 2000. The resulting phase-in of
reimbursement for physical rehabilitation services based on the Medicare
prospective payment system utilizing a fixed reimbursement amount for specified
diagnoses could lower Medicare reimbursement levels to hospitals for physical
rehabilitation services. This could adversely affect the ability of the Company
to obtain management contracts for physical rehabilitation services and the
amount of fees paid to the Company under such contracts.


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         MANAGED BEHAVIORAL HEALTH CARE SERVICES AND EMPLOYEE ASSISTANCE 
PROGRAMS

         During fiscal year 1998 the Company combined the three managed care
subsidiaries (Florida Professional Psychological Services, Inc., also known as
Professional Psychological Services, Inc. ("Florida PPS"), Acorn Behavioral
HealthCare Management Corporation ("Acorn"), and FPM Behavioral Health, Inc.
("FPM")) into Horizon Behavioral Services ("HBS") to promote a national
integrated organization. Under the operating structure, there are two divisions,
Managed Care, located in Winter Park, Florida and the EAP/Employer Division
located in the Philadelphia metropolitan area. The Company is a growing provider
of national mental health managed care, utilization management and employee
assistance programs. The Company provides a client employer with quality,
cost-effective programs for administration and management of behavioral health
and substance abuse services. The Company also maintains extensive involvement
on a national level in the at-risk management of corporate mental health
carve-outs and commercial Medicare and Medicaid programs. Beginning with the
acquisition of Florida PPS, in August 1996, the Company expanded its services to
include provision of full risk, capitated managed care mental health services
for health maintenance organizations ("HMOs") and self-insured employers and the
operation of employee assistance programs for employers. The Company further
expanded its services in this area with the acquisitions of Acorn and FPM
effective October 31, 1997 and June 1, 1998, respectively, the FPM acquisition
expanded the companies managed care business to include an additional six clinic
locations in Florida where behavioral health services are provided to some
individuals covered under the managed care plans. In addition, the clinics have
one contract with another managed care vendor to provide services to their
members.

         The mental health care services are provided by mental health care
professionals that are employed by the Company or are under contract with the
Company as independent providers. The clinical staff represents a broad range of
treatment and case management specialties and is qualified to respond to the
complete continuum of behavioral health concerns, pediatric to geriatric. The
staff includes psychiatrists, nurses, psychologists, social workers, and other
related mental health personnel. The Company believes that its existing
relationships with health care providers and its expertise in the provision of
mental health care services provide it with the capability to establish, operate
and manage the network of health care professionals necessary to economically
furnish such services.

         Employee assistance programs, which are usually provided by employers
as a benefit at no cost to employees, give employees the opportunity to have
consultations with a health care provider to identify and discuss problems that
may be affecting the work performance of the employee and a course of action or
treatment to address such problems. The Company believes that an opportunity
exists for the contract management of employee assistance programs offered by
community-based general acute care hospitals. As with its other products, the
Company intends to market such programs as an additional service it can offer
new and existing client hospitals.

SERVICES

         MENTAL HEALTH SERVICES

         The Company has the expertise to manage a broad range of clinical
mental health programs, including geropsychiatric, general adult, substance
abuse and adolescent programs. The programs use a treatment team concept, with
the admitting physician, team psychologist, social workers, nurses, therapists
and counselors coordinating each phase of therapy. The programs include crisis
intervention, individual therapy, group and family therapy, recreational
therapy, occupational therapy, lifestyle education, social services and
substance abuse counseling. Family involvement is encouraged. Each treatment
program is individually tailored as much as practicable to meet the needs of the
patients, the client hospital, physicians and payor groups. Mental health
services represented 150 of the Company's 172 management contracts at August 31,
1998.

         Elements of the Continuum of Care

         The mental health treatment programs managed by the Company are
designed to provide a continuum of mental health services, consisting of
inpatient, partial hospitalization (or day treatment), outpatient and home
health services.





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         Inpatient Services. Inpatient services are generally provided to
patients needing the most intensive mental health treatment and who frequently
have accompanying medical care needs. The patient is admitted to the client
hospital and remains there on a 24-hour per day basis throughout the course of
the inpatient treatment, which is continued until the patient can be stabilized
and moved to another level in the continuum of mental health services.

         Partial Hospitalization. Partial hospitalization services are provided
for limited periods per day at established intervals with the patient returning
home at the conclusion of each day's treatment. Partial hospitalization services
are designed to be both an alternative to inpatient hospitalization services and
a key component of care following inpatient hospitalization.

         Outpatient Services. Outpatient services consist generally of
consultative sessions which can be rendered in a variety of individual or group
settings at various locations, including hospitals, clinics or the offices of
the service provider. Outpatient service providers can also serve as gatekeepers
for persons being evaluated for treatment. Once an individual is assessed for
treatment in an outpatient environment, the individual is provided the
appropriate level of service in relation to the diagnosis.

         Home Health Services. Home health services are provided in the
patient's home. Typically, these services are provided on a periodic basis by an
experienced psychiatric nurse working under the direct supervision of a
psychiatrist. The nurse may provide medication management, vital sign
monitoring, individual and family therapy, and other related clinical services.
Patients utilizing home health services include individuals whose clinical
conditions make it difficult or impossible to leave their homes due to
psychiatric illness or a combination of psychiatric and medical illness. Home
health service patients also include patients without access to transportation.
Patients over the age of 65 often use psychiatric home health services.

         CQI+ Outcomes Measurement System

         The Company began offering its CQI+ Outcomes Measurement System in
1994. The CQI+ System provides a qualitative and quantitative tool for the
clinical staff to evaluate the clinical effectiveness of treatment programs and
to make adjustments in the programs in order to improve quality and
appropriateness of care. In addition, the CQI+ System enables client hospitals
to demonstrate to third-party payors the effectiveness of the treatment programs
and provides a valuable tool to the hospital in marketing to patients and
providers. The CQI+ System also assists the hospitals in complying with the
increasing demands of regulatory and accrediting bodies for quality assessment
of their mental health programs. JCAHO, as part of its accreditation process,
requires each hospital to select at least one acceptable measurement system and
at least two clinical performance (outcome) measures that together represent at
least 20% of the hospital's patient population. Each year, the requirements for
the number of measures and the percentage of the population will increase. The
Company's CQI+ System has met the initial criteria for inclusion in the
accreditation process and is included on JCAHO's list of acceptable systems. The
Company is committed to meeting future criteria established by JCAHO. At August
31, 1998, 82 of the Company's management contracts included the CQI+ System. The
CQI+ System provides the Company with a valuable tool in demonstrating clinical
results of the mental health programs managed by the Company and in marketing
such management services to other hospitals.

         Since offering CQI+ System, the Company has compiled a database
containing outcome measurement data on over 22,000 patients. Sample data is
collected from randomly selected patients at admission, discharge and 90 to 120
days after discharge. Semi-annual outcome reports include a summary of patient
characteristics and outcome measures. A multidisciplinary committee reviews and
analyzes the data in order to identify specific areas for program improvement. A
regional clinical consultant then prepares an implementation plan. Program
improvements implemented through this process are evaluated for use at other
treatment programs managed by the Company. The Company trains and supervises
on-site personnel to ensure the collection of accurate outcome measurement data.
PricewaterhouseCoopers LLP provides a periodic written examination of the CQI+
System to insure that stated data sampling and analytical procedures are
followed and that the data collection process adheres to the Company's
procedures and patient and client confidentiality policies. Each client is
provided a copy of the attestation report. Effective October 1, 1998, the
Company signed an agreement with Eli Lilly and Company to provide certain
research services for an Analysis of Medication Utilization and Outcomes.



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         PHYSICAL REHABILITATION SERVICES

         The Company provides contract management for a broad range of physical
rehabilitation programs including (i) acute physical medicine and
rehabilitation, (ii) subacute physical therapy and rehabilitation, and (iii)
comprehensive outpatient rehabilitation. Physical rehabilitation services
represented 22 of the Company's 172 management contracts at August 31, 1998.

         Acute Physical Therapy and Rehabilitation. The physical therapy and
rehabilitation program incorporates a variety of treatments and services aimed
at maximizing an individual's capabilities following a disabling illness or
traumatic injury. The treatment program is provided by an interdisciplinary team
of health care professionals including physicians, physical, recreational,
occupational and speech therapists, rehabilitation nurses, social workers and
psychologists. The Company attempts to tailor an acute physical therapy and
rehabilitation program for a health care facility to satisfy unmet community and
medical staff needs, while maximizing utilization of the facility.

         Sub-acute Physical Therapy and Rehabilitation. Rapidly changing
reimbursement issues have challenged health care providers to seek alternative
services to meet the needs of their patient population requiring lower cost and
intensity physical medicine and rehabilitation services. Comprehensive physical
medicine and rehabilitation services at the subacute level offer an attractive
alternative for acute care hospitals and skilled nursing facilities to meet
these needs. The Company evaluates the feasibility of a health care facility
providing rehabilitation services at the sub-acute level by analyzing a
facility's discharge data, conducting a market analysis of services offered in a
facility's community, assessing medical staff needs and evaluating financial
viability.

         Comprehensive Outpatient Rehabilitation. A comprehensive outpatient
rehabilitation facility ("CORF") program serves as an adjunct to inpatient
physical therapy and rehabilitation programs at the acute and/or sub-acute
levels. The program provides the continuum of rehabilitative care necessary to
meet the medical needs of a post-acute care patient following a disabling
illness or traumatic injury. The Company has developed a CORF program in
compliance with Medicare regulations which functions as a non-residential day
facility to provide diagnostic, therapeutic and restorative services to
outpatients at a single fixed location under the supervision of a qualified
physician.

         MANAGED BEHAVIORAL HEALTH CARE SERVICES AND EMPLOYEE ASSISTANCE
PROGRAMS

         The Company began offering mental health care services to HMOs and
employee assistance programs to self-insured employers with the acquisition of
Florida PPS in 1996. During fiscal year 1998, the Company has expanded its
services in this area by acquiring Acorn and FPM on October 31, 1997 and June 1,
1998, respectively. The Company contracts with HMOs to provide the mental health
care component of the general health plans offered by such entities. The
contracts are on a full risk, capitated basis under which the Company is paid a
set fee per month for each member of the respective health plan. The mental
health care services are provided by mental health care professionals that are
employed by the Company or are under contract with the Company as independent
providers. In addition, the Company operates nine clinics within the state of
Florida which perform related services. The Company reimburses the independent
professionals and institutions on a discounted fee-for-service basis. As of
August 31, 1998, the Company provided mental health care services for
approximately 1,874,323 total members of various health plans with which it had
contracted.

         The Company utilizes a specialized network to operate employee
assistance programs for employers. Many of the providers in the managed care
network also participate in the EAP network. Employee assistance programs, which
are usually provided by employers as a benefit at no cost to employees,
generally give employees and their dependents the opportunity to have four to
six consultations annually with a health care provider to discuss problems that
may be affecting their ability to work. Such problems frequently relate to
matters unrelated to mental health care. The purpose of the consultation is to
help the employee identify the problem and to recommend a course of action or
treatment to address the problem. Often the employee is referred by the employer
after observing a change in work performance. The Company frequently provides
training to employer personnel for identifying troubled employees. The Company
believes that such early identification, consultation and treatment can
frequently minimize the likelihood that the problem will develop into a serious
debilitating event requiring extensive treatment. The Company is paid a set fee
per month per employee for its services. As of August 31, 1998, the employee
assistance programs operated by the Company covered approximately 648,709
employees.





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<PAGE>   9

         On October 31, 1997, the Company acquired all the outstanding capital
stock of Acorn for approximately $12.7 million in cash. Acorn offers employee
assistance programs and related services only to self-insured employers. Most of
the contracts are on a capitated basis under which employees and their
dependents are entitled to receive a specified number of consultations per
contract year with behavioral health specialists. Acorn is paid a set fee per
month per employee for such services. Under some contracts, Acorn also provides
certain specified outpatient mental health benefits for the capitated fee. A few
contracts also provide for mental health services on a discounted
fee-for-service basis. Acorn also provides pre-admission certification,
utilization review, case management, hospital bill review, claims adjudication
and related services as requested by the client usually under the capitated fee
but sometimes on a separate fee basis.

         On June 1, 1998 the Company acquired all of the outstanding capital
stock of FPM of Winter Park, Florida, for approximately $20.0 million, subject
to certain post closing adjustments. FPM provides managed behavioral health care
services, employee assistance programs and other related health care services to
health maintenance organizations and self-insured employers. FPM provides its
services both through health care professionals employed by FPM and through
independent health care professionals that have been contracted with FPM on a
fee-for-service basis.

         In addition, on October 5, 1998, the Company acquired all of the
outstanding capital stock of ChoiceHealth, Inc., of Westminster, Colorado
("ChoiceHealth") for approximately $2.0 million in cash. ChoiceHealth provides
managed behavioral health care services, employee assistance programs and other
related behavioral health care services to health maintenance organizations and
self-insured employers.


OPERATIONS

         GENERAL

         The Company operates mental health management contracts through a
regional structure with offices in the Chicago, Dallas, Los Angeles and Tampa
metropolitan areas. The structure is designed to keep key operating employees of
the Company in direct contact with clients. Each of the four regional offices is
staffed to have the capacity to supervise up to 40 mental health management
contract locations. Each regional office is under the supervision of a vice
president who in turn supervises regional directors, each of whom has direct
responsibility over eight to ten mental health management contract locations.
Other regional office personnel include clinical and other specialists, who are
available to provide assistance to the local programs and client hospital
personnel. Presently, the Company's physical rehabilitation management contracts
are operated in the same manner out of its Dallas office with plans to develop a
comparable regional structure as it expands that area of its operations.

         The Company develops and operates its outcomes measurement system
primarily out of its Dallas office. Program personnel are responsible for the
completion of the data input forms concerning the various treatment programs.
The data is input into the national database from which reports are developed,
reviewed and analyzed by the CQI+ System staff of 14 employees.

         At August 31, 1998, the Company had approximately 1,056 program
employees at its contract locations and approximately 160 employees at its
regional and national support center offices.

         During fiscal year 1998, the Company combined its three managed care
subsidiaries (Florida PPS, Acorn, and FPM Behavioral Health) into Horizon
Behavioral Services to promote a national integrated organization. Under the new
operating structure, there are two divisions, Managed Care located in Winter
Park, Florida, and the EAP/Employer Division located in the Philadelphia
metropolitan area.





                                     Page 9
<PAGE>   10


         In the EAP/employer division there are 46 employees located in the
Philadelphia office. The EAP network has contracts with approximately 8,000
individual providers located in all 50 states.

         The managed care division has 86 licensed clinicians providing services
in the nine clinic locations in Florida and an additional 120 employees working
in administrative and clinical management positions for the managed care and EAP
business. The managed care division has provider network contracts with
approximately 3,100 providers and facilities.

         ChoiceHealth is headquartered in the Denver metropolitan area and
employs 55 employees, all of which are located in its corporate offices. It
provides the mental health and other services through a network of independent
health care professionals and institutions. ChoiceHealth has contracts with
approximately 1,000 individual providers located throughout the United States.

         MANAGEMENT CONTRACTS

         The Company provides its management services under contracts with its
client hospitals. Each contract is tailored to address the differing needs of
the client hospital and its community. The Company and the client hospital
determine the programs and services to be offered by the hospital and managed by
the Company, which may consist of one or more treatment programs offering
inpatient, partial hospitalization, outpatient or home health services. Under
the contracts, the hospital is the actual provider of the mental health or
physical rehabilitation services and utilizes its own facilities (including beds
for inpatient programs), nursing staff and support services (such as billing,
dietary and housekeeping) in connection with the operation of its programs.

         While each of the Company's management contracts is tailored to the
specific needs of the client hospital, substantially all of the Company's
contracts contain non-compete and confidentiality provisions. In addition, the
Company's management contracts typically prohibit the client hospital from
soliciting the employment of the Company employees during the contract term and
for a specified period thereafter.

         Contracts are frequently renewed prior to or at their stated expiration
dates. Some contracts are terminated prior to their stated expiration dates
pursuant to agreement of the parties or early termination provisions included in
the contracts. As of August 31, 1995, 1996, 1997 and 1998, the Company had
successfully retained 74%, 80%, 78% and 73%, respectively, of the management
contracts in existence at the beginning of such fiscal years. The Company
believes the most frequent reason why the client hospitals do not renew a
contract is that they desire to manage such programs themselves, the economic
viability of the programs have changed resulting in their closing the programs,
or a change in hospital administration results in a change in philosophy
regarding the use of contract managers. 

         Under each contract, the Company receives a fee for its management
services from the client hospital. Management fees may be either a variable fee
related in part to patient census at the program or a fixed fee with
reimbursement for direct program costs. The management fee is frequently subject
to periodic adjustments as a result of changes in the consumer price index or
other economic factors. A significant number of the Company's management
contracts require the Company to refund some or all of its fee if either
Medicare reimbursement for services provided to patients of the programs is
denied or the fee paid to the Company is denied as a reimbursable cost. During
the fiscal year ended August 31, 1998, the Company refunded approximately
$207,801 of its fees in relation to these denials.

         Program Development

         The Company assists in the development of each clinical program as
requested by the client hospital, including such matters as licensing,
accreditation, certificate of need approvals and Medicare certification. The
Company also develops and implements a marketing plan for the clinical programs
to be offered by the hospital. Each program is marketed locally with an emphasis
on the hospital addressing the needs of the local community. The Company markets
the clinical programs in the community in the name of the client hospital. The
Company's name is not used and its role is not publicly emphasized in the
operation of the clinical programs offered by its client hospitals. Each patient
is admitted by the medical staff of the client hospital, and all charges for
clinical services provided to the patient accrue directly to the client hospital
or treating physician.





                                    Page 10
<PAGE>   11


         The Company also develops and maintains standardized policy and
procedure manuals, initial and ongoing staff training and education, and
comprehensive quality assurance procedures. Each local program director receives
ongoing support from the National Support Center and regional support staff in
all areas including recruiting, finance, reimbursement, development, marketing
and quality assurance.

         Each operating region is responsible for training new employees,
including formalized instruction and on-the-job training. Continuing education
programs are also provided to employees. In addition, the Company has a
centralized orientation program for new program directors and an annual
conference for all program directors.

         Program Staffing

         Each mental health program has a psychiatric medical director, a
program director who is usually a psychologist or a social worker, a community
relations coordinator and additional social workers or therapists as needed.
Each physical rehabilitation program has an independent medical director, a
program director, and additional clinical staff tailored to meet the needs of
the program and the client hospital, which may include physical and occupational
therapists, a speech pathologist, a social worker and other appropriate
supporting personnel. Each medical director has a contract with the Company
under which on-site administrative services needed to administer the program are
provided. These contracts generally include nondisclosure, nonsolicitation and
noncompetition covenants pursuant to which the medical director agrees not to
solicit the Company employees for specified periods, disclose confidential
information of the Company or render certain administrative or management
services within specified time periods and geographic areas to any enterprise in
competition with the Company or the programs it manages. Except for the nursing
staff, which is typically provided by the hospital, the other program personnel
are employees of the Company. At August 31, 1998, the Company had an average of
six employees per contract location.

         Program Marketing

         Because the treatment programs managed by the Company are offered by
general acute care hospitals, most patients are referred by the client
hospital's medical staff or result from relationships that the client hospital
has in the community. Each contract location has an outreach coordinator who
works with a referral development committee consisting of Company and hospital
personnel to identify prospective referral sources. The outreach coordinator
informs physicians and other health professionals and nursing homes in the
community of the treatment programs that are available at the client hospital.
The outreach coordinator also designs and offers community educational programs
regarding various health issues.

         Internal Clinical Audits

         The Company has established a comprehensive internal clinical audit
process for its mental health programs. The Company's regional mental health
clinical specialists review the services and clinical documentation of the
treatment programs to ensure compliance with client hospital, federal and state
standards. The Company also has an internal clinical auditor who makes
unannounced visits to contract locations on a periodic basis. The auditor
reviews medical records and marketing programs, and conducts interviews with
physicians, referral sources and client hospital staff members. Results of the
audits are reported directly to the senior management of the Company, rather
than through the normal operating organization.




                                    Page 11
<PAGE>   12




         Contract Locations

         At August 31, 1998, the Company had a total of 172 management contracts
with general acute care hospitals located in 37 states, as shown below:

<TABLE>
<CAPTION>

           STATE                      NUMBER OF              STATE                             NUMBER OF
                                      CONTRACTS                                                CONTRACTS
<S>                                       <C>                <C>                               <C>
           Alabama......................  2                  Nebraska............................  1
           Arizona......................  4                  Nevada..............................  2
           Arkansas..................... 11                  New Hampshire.......................  1
           California................... 19                  New Jersey..........................  5
           Colorado.....................  1                  New Mexico..........................  1
           Connecticut..................  1                  New York............................  5
           Florida......................  9                  North Carolina......................  5
           Georgia......................  6                  Ohio................................  8
           Illinois.....................  6                  Oklahoma............................  4
           Indiana......................  2                  Oregon..............................  3
           Iowa.........................  3                  Pennsylvania........................ 12
           Kansas.......................  1                  South Carolina......................  2
           Kentucky.....................  3                  Tennessee........................... 12
           Louisiana....................  2                  Texas............................... 10
           Maryland.....................  1                  Vermont.............................  1
           Massachusetts................  7                  Virginia............................  1
           Michigan.....................  5                  Washington..........................  4
           Mississippi..................  4                  Wisconsin...........................  3
           Missouri.....................  5
</TABLE>


         Client Hospitals

         The Company's clients are primarily small to medium sized hospitals and
include some large tertiary care hospitals. At August 31, 1998, 40.7% of the
Company's management contracts were with proprietary hospitals. The remainder
are with primarily community not-for-profit hospitals.

         At August 31, 1998, the Company had management contracts with 27
hospitals directly or indirectly owned by Columbia/HCA Healthcare Corporation
("Columbia/HCA"). These 27 contracts accounted for 12.5% of the Company's
revenues for the year ended August 31, 1998. In the aggregate, including both
contracts in effect on August 31, 1998 and contracts that terminated during the
fiscal year ended August 31, 1998, revenues generated by hospitals directly or
indirectly owned by Columbia/HCA accounted for 15.4% of the Company's revenues
for the year ended August 31, 1998. Of the 27 Columbia/HCA contracts at August
31, 1998, 9 contracts contain a provision limiting the number of contracts which
Columbia/HCA can cancel without cause to 33.3% during any calendar year. The
termination or non-renewal of all or a substantial part of the management
contracts with hospitals owned by Columbia/HCA could have a material adverse
effect on the Company's business, financial condition or results of operations.

MANAGED CARE AND EMPLOYEE ASSISTANCE CONTRACTS

         The Company delivers its EAP and managed care services through a 
provider network as well as through employees and clinics in the Jacksonville,
Orlando and Tampa/St. Petersburg areas.  Claims processing is currently done at
the Philadelphia, Winter Park and Denver locations. The Company intends to
consolidate all claims processing to the Winter Park location during fiscal year
1999.

SALES AND MARKETING

         At August 31, 1998, the Company's subsidiary Horizon Mental Health
Management employed seven full-time Vice Presidents of Development for mental
health management and physical rehabilitation management contracts. The Company
compiles information from numerous databases to identify prospective clients.
The Company has developed profiles of over 6,500 hospitals in the United States,
with numerous financial and operating characteristics for each hospital.
Potential clients include hospitals without existing mental health, physical
rehabilitation, employee assistance programs or other programs as well as
hospitals with existing programs of which the Company could assume management. A
select list of candidates is systematically and regularly updated based on
criteria indicating which hospitals are the most likely potential clients. A
vice president of development, who 

 

                                    Page 12
<PAGE>   13


typically acts as the point person on the sales team for such region, directly
contacts the prospective clients and, where appropriate, presents a detailed
proposal to key decision-makers. The proposal often contains detailed financial
projections of the proposed programs. The Company works with the potential
client to develop contract terms responsive to the client's specific needs. The
typical sales cycle for a management contract is approximately nine months,
during which time the Company's Vice President of Sales will assist the Vice
President of Development and will sometimes assume the role of point person for
the sales effort. In addition, the Company's Executive Vice President of Sales
and Development will generally become involved at the end of the sales process
and negotiate the final terms of the management contract. The Company believes
it can increase sales of rehabilitation management contracts by applying its
expertise in winning mental health management contracts to the solicitation of
rehabilitation management contracts. In addition, the Company believes it has
substantial opportunity to cross-sell a broad range of services to client
hospitals and is pursuing the development of such opportunities as a primary
part of its business strategy.

         The subsidiary Mental Health Outcomes ("MHO") markets the CQI+ Outcomes
Measurement System to 1,700 medical/surgical hospitals with psychiatric
inpatient units and 300 free-standing psychiatric hospitals nationwide. MHO
employs a full-time Vice President of Market Development and a Director of
Market Development who market the CQI+ System to hospitals through understanding
psychiatric unit outcomes measurement needs and application of the most
compatible CQI+ System module. MHO also contracts for telemarketing assistance
to support initial "cold" calling to prospective customers. In addition, CQI+ is
marketed as an "add-on" service to the contract managed psychiatric programs
provided by Horizon Mental Health Management through efforts of the seven Vice
Presidents of Development.

         The subsidiary Horizon Behavioral Services markets employee assistance
programs and managed behavioral health programs to employers and HMOs
nationwide. HBS employs a full-time Vice President of Sales and four Regional
Directors of Sales and Development to market both the EAP and managed behavioral
health services. The HBS sales staff markets the EAP to employers by assessing
the individualized behavioral health benefit needs of their employees and
providing the appropriate EAP model. In addition, the EAP is marketed by the
seven Horizon Mental Health Management Vice Presidents of Development to
hospitals as a benefit for their employees. The HBS sales staff markets the
managed behavioral health care services to HMOs who wish to outsource management
of the behavioral health benefit to an experienced provider.

COMPETITION

         The health care industry is highly competitive and subject to continual
changes in the method in which services are provided and the types of companies
providing such services. The Company competes with several national competitors
and many regional and local competitors, some of which have greater resources
than the Company. In addition, hospitals could elect to manage their own mental
health and physical rehabilitation programs.

         Competition among contract managers for hospital-based mental health
and physical rehabilitation programs is generally based upon reputation for
quality, price, the ability to provide financial and other benefits for the
hospital, and the management expertise necessary to enable the hospital to offer
mental health and physical rehabilitation programs that provide the full
continuum of mental health and physical rehabilitation services in a quality and
cost-effective manner. The pressure to reduce health care expenditures has
emphasized the need to manage the appropriateness of mental health and physical
rehabilitation services provided to patients. As a result, competitors without
management experience covering the various levels of the continuum of mental
health and physical rehabilitation services may not be able to compete
successfully. The Company believes that its reputation and management expertise
will enable it to compete successfully in this rapidly changing market.

         In addition, general acute care hospitals offering mental health and
physical rehabilitation programs managed by the Company compete for patients
with other providers of mental health care services, including other general
acute care hospitals, freestanding psychiatric hospitals, independent
psychiatrists and psychologists, and with other providers of physical
rehabilitation services, including other general acute care hospitals,
freestanding rehabilitation facilities and outpatient facilities.




                                    Page 13
<PAGE>   14


         The Company also competes with hospitals, nursing homes, clinics,
physicians' offices and contract therapy companies for the services of physical,
occupational and speech therapists. These specialists are in short supply and
there can be no assurance that the Company will be able to attract a sufficient
number of therapists for its growing needs.

         The behavioral health care marketplace includes two large national
providers (Magellan Health Services and Value Options) who control approximately
sixty-six percent of the market. The rest of the market consists of other
organizations from medium size regional operations to very small local providers
in the EAP business. The Company currently maintains a market share of
approximately nine percent. The primary factor affecting competition in the EAP
business is the range of services provided. In addition, quality of service and
price are also of importance to EAP customers. Price is the primary factor in
obtaining additional managed care customers. All companies involved in
behavioral health care must plan to overcome obstacles related to increased
customer and government scrutiny. Customers require sophisticated data that
provides information regarding clinical outcomes, patient and provider
satisfaction, and administrative performance information. National Committee for
Quality Assurance accreditation is also becoming a necessary element for any
behavioral health care company and is essential in competing with large national
businesses.

GOVERNMENT REGULATION

         The Company's business is affected by federal, state and local laws and
regulations concerning, among other matters, mental health and physical
rehabilitation facilities and reimbursement for mental health and physical
rehabilitation services. These regulations impact the development and operation
of mental health and physical rehabilitation programs managed by the Company for
its client hospitals. Licensing, certification, reimbursement and other
applicable government regulations vary by jurisdiction and are subject to
periodic revision. The Company is not able to predict the content or impact of
future changes in laws or regulations affecting the mental health or physical
rehabilitation industries.

         FACILITY USE AND CERTIFICATION

         Hospital facilities are subject to various federal, state and local
regulations, including facilities use, licensure and inspection requirements,
and licensing or certification requirements of federal, state and local health
agencies. Many states also have certificate of need laws intended to avoid the
proliferation of unnecessary or under-utilized health care services and
facilities. The mental health and physical rehabilitation programs which the
Company manages are also subject to licensure and certification requirements.
The Company assists its client hospitals in obtaining required approvals for new
programs. Some approval processes may lengthen the time required for programs to
commence operations. In granting and renewing a facility's licenses,
governmental agencies generally consider, among other factors, the physical
condition of the facility, the qualifications of administrative and professional
staff, the quality of professional and other services, and the continuing
compliance of such facility with the laws and regulations applicable to its
operations. The Company believes that the mental health and physical
rehabilitation programs it manages and the facilities of the client hospitals
used in the operation of such programs comply in all material respects with
applicable licensing and certification requirements.

         MEDICARE AND MEDICAID; REIMBURSEMENT FOR SERVICES

         Most of the Company's client hospitals receive reimbursement under one
or more of the Medicare or Medicaid programs for mental health and physical
rehabilitation services provided in programs managed by the Company. The Company
is paid directly by its client hospitals for the management services it
provides. While fees paid to the Company by its client hospitals are not subject
to or based upon reimbursement under the Medicare or Medicaid programs or from
any other third-party payor, under many of its management contracts the Company
is obligated to refund a portion of its fee if Medicare denies reimbursement for
an individual patient treatment or all of its fee if the fee paid to the Company
is denied by Medicare as a reimbursable cost. Since a substantial portion of the
patients of the programs managed by the Company are covered by Medicare, any
changes which limit or reduce Medicare reimbursement levels could have a
material adverse effect on the Company's client hospitals and, in turn, on the
Company.

         The Company is not a provider reimbursed by Medicare or Medicaid but
provides contract management services to such providers. As such, the Company
could be considered subject to such federal and state laws. While the Company
believes that its relationships with its client hospitals, medical directors and
other providers and the fee 





                                    Page 14
<PAGE>   15


arrangements with its client hospitals are consistent with Medicare and Medicaid
criteria, those criteria are often vague and subject to interpretation. The
federal government has been actively investigating health care providers for
potential abuses. There can be no assurance that aggressive anti-fraud
enforcement actions will not adversely affect the business of the Company.

         The Medicare program was enacted in 1965 to provide a nationwide,
federally funded health insurance program for the elderly. The program is
divided in Part A and Part B, each of which has separate rules and requirements
and separate funding sources. Medicare Part A, the Hospital Insurance Program
(42 U.S.C. (delta) 1395c et seq.) is financed primarily through mandatory taxes
on workers' wages. Part A pays for hospital, skilled nursing, home health
agency, hospice, and dialysis services determined to be medically necessary for
the individual patient. Medicare Part B, the Supplementary Medical Insurance
program (42 U.S.C. (delta) 1395j et seq.), is a voluntary medical benefits plan
in which eligible individuals can enroll to receive benefits in addition to
those available under Part A. Under Part B, each beneficiary must pay a monthly
premium, meet a deductible towards the cost of covered items and services
determined to be medically necessary, and pay 20 percent of the Medicare
allowable charge as coinsurance on most covered items. Non-institutional
services, including physician services, outpatient hospital services, durable
medical equipment, and laboratory services, among others, are paid under
Medicare Part B. In addition, the Balanced Budget Act adds a new Medicare Part
C, which provides Medicare beneficiaries with additional health plan choices,
such as managed care plans and medical savings accounts.

         The Medicare program is administered by the Health Care Financing
Administration ("HCFA") of the U.S. Department of Health and Human Services
("HHS"). HCFA adopts regulations and issues interpretive memoranda and program
manuals providing detailed explanation of the Medicare program. The payment
operations of the Medicare program are handled by intermediaries (under Part A)
and carriers (under Part B) who are insurance companies and Blue Cross/ Blue
Shield plans which contract with the Secretary of HHS (the "Secretary") to make
Medicare payments to providers in a particular geographic region. Individual
intermediaries and carriers issue transmittals, bulletins, notices, and general
instructions to providers and suppliers in their respective areas to facilitate
the administration of the Medicare program, but are required to follow the
Medicare statute, HCFA regulations, HCFA transmittals, and the program manuals.
Within these requirements, intermediaries and carriers are granted broad
discretion to establish particular guidelines and procedures for making Medicare
coverage determinations and payments, including prior approval, utilization
limits, and specific documentation.

         The Medicaid program is a joint federal-state cooperative arrangement
established for the purpose of enabling states to furnish medical assistance on
behalf of aged, blind, or disabled individuals, or members of families with
dependent children, whose income and resources are insufficient to meet the
costs of necessary medical services. The federal and state governments share the
costs of such aid pursuant to statutory formulae. The Secretary has primary
federal responsibility for administering the Medicaid program. The
responsibility has been delegated to HCFA, whose Medicaid Bureau carries out
this delegation. States are not required to participate in the Medicaid program.
States which choose to participate, however, must administer their Medicaid
programs in accordance with federal law, the implementing regulations and
policies of the Secretary and their approved state plans. A state becomes
eligible to receive federal funds by submitting to the Secretary a state plan
for medical assistance. The federal Medicaid statute establishes minimum
standards for state plans in such area as administration, eligibility, coverage
of services, quality and provision of services, and payment for services. States
have significant latitude, within these standards, to determine the mix of
services and structure of their state Medicaid programs. The state plan must be
amended by appropriate submission to the Secretary whenever necessary to reflect
changes in federal statutes, regulations, policies, court decisions, or material
changes in any phase of state law, policy, or operations.

         In order to receive reimbursement under the Medicare or Medicaid
programs, each client hospital or facility must meet applicable requirements
promulgated by HHS relating to the type of facility, personnel, standards of
patient care and compliance with all state and local laws, rules and
regulations. The Company believes that the programs it manages comply in all
material respects with applicable Medicare and Medicaid requirements.

         In the mid-1980's, changes in reimbursement rates and procedures
included the creation of the Prospective Payment System using predetermined 
reimbursement rates for diagnosis related groups ("DRGs"). The DRG system
established fixed payment amounts per discharge for diagnoses generally provided
by acute care hospitals. Mental health services provided by acute care hospitals
which qualify for an exemption are deemed to be DPUs and are not included in the




                                    Page 15
<PAGE>   16


DRG system. Services provided by DPUs are reimbursed on an actual cost basis,
subject to certain limitations. The mental health programs managed by the
Company which are eligible for reimbursement by the Medicare program currently
meet the applicable requirements for designation as DPUs and are exempt from the
DRG system. In the future, however, it is possible that Medicare reimbursement
for mental health services, including those provided by programs managed by the
Company, could be under the DRG system or otherwise altered. At August 31, 1998,
of the 273 mental health treatment programs managed by the Company, 189 were
geropsychiatric programs for which a substantial majority of the patients are
covered by Medicare. Recent amendments to the Medicare regulations established
maximum reimbursement amounts on a per case basis for both inpatient mental
health and physical rehabilitation services. Effective as of October 1, 1997,
regulations promulgated pursuant to these amendments establish a ceiling on the
rate of increase in operating costs per case for mental health and physical
rehabilitation services furnished to Medicare beneficiaries. Prior to these
amendments, the reimbursement amounts were tied to each hospital's mental health
or physical rehabilitation unit cost during such unit's first year of
operations, subject to adjustment. The new regulations establish a nationwide
cap limiting the reimbursement target amount on a per case basis for mental
health and physical rehabilitation services to $10,534 and $19,104,
respectively, subject to adjustments based on market indices and on costs for
other similar units. The limitations have resulted, in some cases, in decreased
amounts reimbursed to the Company's client hospitals. This decrease in
reimbursement has, in some cases, led to the renegotiation of a lower contract
management fee structure for the Company and in other cases has resulted in
termination or nonrenewal of the management contract. The new reimbursement
limitations become applicable to the client hospitals at the beginning of their
respective Medicare fiscal years. The trend of renegotiated fees and canceled or
nonrenewed contracts, resulting in reduced management fees, which the Company
first encountered in its fiscal 1998 second quarter, can be expected to continue
in the first and second quarters of fiscal 1999.

         Qualified outpatient rehabilitation services are exempt from the 
Prospective Payment System. Acute rehabilitation units within acute-care
hospitals are eligible to obtain an exemption from the Prospective Payment
System, generally after the first year of operation, upon satisfaction of
specified federal criteria. Such criteria include the operation for a full 12
months under the Prospective Payment System and the completion of an initial
exemption survey. The exemption survey measures compliance with certain criteria
applicable to exempt units generally, including approval to participate as a
Medicare provider, admission standards, record keeping, compliance with state
licensure laws, segregation of beds, accounting standards and certain specific
standards applicable to rehabilitation units, including staffing, medical care
and patient mix. Upon successful completion of the survey, Medicare payments for
rehabilitation services provided in inpatient units are made under a cost-based
reimbursement system. As of August 31, 1998, 17 of the Company's managed
physical rehabilitation programs were exempt from the Prospective Payment
System. The remaining five programs will apply for exemption as soon as they are
eligible. A recently enacted amendment to the Medicare statutes provides for a
gradual phase-out of cost-based reimbursement for physical rehabilitation
services over a three-year period commencing on October 1, 2000. The resulting
phase-in of reimbursement for physical rehabilitation services based on the
Prospective Payment System could significantly lower Medicare reimbursements to
hospitals and thus have a material adverse effect on the business, operations
and financial results of the Company.

         The Medicare and Medicaid programs are subject to statutory and
regulatory changes, retroactive and prospective rate adjustments, administrative
rulings and funding restrictions, any of which could have the effect of limiting
or reducing reimbursement levels to general acute care hospitals for mental
health and physical rehabilitation services provided by programs managed by the
Company. The Company cannot predict whether any changes to such government
programs will be adopted or, if adopted, the effect, if any, such changes will
have on the Company. In addition, a significant number of the Company's
management contracts require the Company to refund a portion of its fee if
Medicare reimbursement to the client hospital is disallowed for a patient
treated in a program managed by the Company or all of its fee if the fee paid to
the Company is disallowed as a reimbursable cost. During the fiscal year ended
August 31, 1998, the Company refunded approximately $207,801 of its fees in
relation to these denials. Also, Medicare retrospectively audits cost reports of
client hospitals upon which Medicare reimbursement for services rendered in the
programs managed by the Company is based. Accordingly, at any time, the Company
could be subject to refund obligations to client hospitals for prior year cost
reports that have not been audited and settled at the date hereof. Any
significant decrease in Medicare reimbursement levels, the imposition of
significant restrictions on participation in the Medicare program, or the
disallowance by Medicare of any significant portion of the client hospital's
costs, including the fee to the Company, where the Company has a reimbursement
denial repayment obligation could adversely affect the Company. 



                                       16

<PAGE>   17
In addition, there can be no assurance that hospitals which offer mental health
or physical rehabilitation programs now or hereafter managed by the Company will
satisfy the requirements for participation in the Medicare or Medicaid programs.

         Payors, including Medicare and Medicaid, are attempting to manage
costs, resulting in declining amounts paid or reimbursed to hospitals for the
services provided. As a result, the Company anticipates that the number of
patients served by general acute care hospitals on a per diem, episodic or
capitated basis will increase in the future. There can be no assurance that if
amounts paid or reimbursed to hospitals decline, it will not adversely affect
the Company.

         Medicare regulations limit reimbursement for mental health, physical
rehabilitation and other health care charges paid to related parties. A party is
considered "related" to a provider if it is deemed to be controlled by the
provider. One test for determining control for this purpose is whether the
percentage of the total revenues of the party received from services rendered to
the provider is so high that it effectively constitutes control. Although the
Company believes that it does not receive sufficient revenues from any customer,
including Columbia/HCA, that would make it a related party, it is possible that
such regulations could limit the number of management contracts that the Company
could have with Columbia/HCA or any other client.

         Federal law contains certain provisions designed to ensure that
services rendered by hospitals to Medicare and Medicaid patients are medically
necessary and meet professionally recognized standards. These provisions include
a requirement that admissions of Medicare and Medicaid patients to hospitals
must be reviewed in a timely manner to determine the medical necessity of the
admissions. In addition, these provisions state that a hospital may be required
by the federal government to reimburse the government for the cost of
Medicare-reimbursed services that are determined by a peer review organization
to have been medically unnecessary. The Company and its client hospitals have
developed and implemented quality assurance programs and procedures for
utilization review and retrospective patient care evaluation intended to meet
these requirements.

         PATIENT REFERRAL LAWS

         Various state and federal laws regulate the relationships between
health care providers and referral sources, including federal and state fraud
and abuse laws prohibiting individuals and entities from knowingly and willfully
offering, paying, soliciting or receiving remuneration in order to induce
referrals for the furnishing of health care services or items. These federal
laws generally apply only to referrals for items or services reimbursed under
the Medicare or Medicaid programs or any state health care program. The
objective of these laws is generally to ensure that the purpose of a referral is
quality of care and not monetary gain by the referring party. Violations of such
laws can result in felony criminal penalties, civil sanctions and exclusion from
participation in the Medicare and Medicaid programs.

         The Medicare and Medicaid anti-kickback statute, 42 U.S.C. (delta)
1320a-7b, prohibits the knowing and willful solicitation or receipt of any
remuneration "in return for" referring an individual, or for recommending or
arranging for the purchase, lease, or ordering, of any item or service for which
payment may be made under Medicare or a state health care program. In addition,
the statute prohibits the offer or payment of remuneration "to induce" a person
to refer an individual, or to recommend or arrange for the purchase, lease, or
ordering of any item or service for which payment may be made under the Medicare
or state health care programs. The statute contains exceptions for certain
discounts, group purchasing organizations, employment relationships, waivers of
coinsurance by community health centers, health plans, and practices defined in
regulatory safe harbors.

         Under a significant number of its management contracts, the Company
receives a variable fee related in part to average daily patient census of the
mental health or physical rehabilitation program. In addition, the Company has
entered into agreements with physicians to serve as medical directors at the
mental health and physical rehabilitation programs and facilities managed by the
Company, which generally provide for payments to such persons by the Company as
compensation for their administrative services. These medical directors also
generally provide




                                    Page 17
<PAGE>   18


professional services at such programs and facilities. In 1991, regulations were
issued under federal fraud and abuse laws creating certain "safe harbors" for
relationships between health care providers and referral sources. Any
relationship that satisfies the terms of the safe harbor is considered
permitted. Failure to satisfy a safe harbor, however, does not mean that the
relationship is prohibited. Although the contracts and relationships between the
Company and its client hospitals and medical directors are not within the safe
harbors, the Company believes that such contracts and relationships comply with
applicable laws. There can be no assurance, however, that the Company's
activities will not be challenged by regulatory authorities.

         The Omnibus Budget Reconciliation Act of 1993 contains provisions
("Stark II") prohibiting physicians from referring Medicare and Medicaid
patients to an entity with which the physician has a "financial relationship"
for the furnishing of a list of "designated health services" including physical
therapy, occupational therapy, home health services, and others. If a financial
relationship exists, the entity is generally prohibited from claiming payment
for such services under the Medicare or Medicaid programs. Compensation
arrangements are generally exempted from the Stark provisions if, among other
things, the compensation to be paid is set in advance, does not exceed fair
market value and is not determined in a manner that takes into account the
volume or value of any referrals or other business generated between the
parties.

         Other provisions in the Social Security Act authorize other penalties,
including exclusion from participation in Medicare and Medicaid, for various
billing-related offenses. HHS can also initiate permissive exclusion actions for
such improper billing practices as submitting claims "substantially in excess"
of the provider's usual costs or charges, failure to disclose ownership and
officers, or failure to disclose subcontractors and suppliers. Executive Order
12549 prohibits any corporation or facility from participating in federal
contracts if it or its principals have been disbarred, suspended or are
ineligible, or have been voluntarily excluded, from participating in federal
contracts. A principal has been defined as an officer, director, owner, partner,
key employee or other person with primary management or supervisory
responsibilities.

         Additionally, the Health Insurance Portability and Accountability Act
of 1996 granted expanded enforcement authority to HHS and the U.S. Department of
Justice ("DOJ"), and provided enhanced resources to support the activities and
responsibilities of the Office of Inspector General ("OIG") of HHS and DOJ by
authorizing large increases in funding for investigating fraud and abuse
violations relating to health care delivery and payment. On January 24, 1997,
the OIG issued guidelines for the Fraud and Abuse Control Program as mandated by
the Act, and on February 19, 1997 issued an interim final rule establishing
procedures for seeking advisory opinions on the application on the anti-kickback
statute and certain other fraud and abuse laws. The recently-enacted Balanced
Budget Act also includes numerous health fraud provisions, including: new
exclusion authority for the transfer of ownership or control interest in an
entity to an immediate family or household member in anticipation of, or
following, a conviction, assessment, or exclusion; increased mandatory exclusion
periods for multiple health fraud convictions, including permanent exclusion for
those convicted of three health care-related crimes; authority of the Secretary
to refuse to enter into Medicare agreements with convicted felons; new civil
money penalties for contracting with an excluded provider or violating the
Medicare and Medicaid antikickback statute; new surety bond and information
disclosure requirements for certain providers and suppliers; and an expansion of
the mandatory and permissive exclusions added by the Health Insurance
Portability and Accountability Act of 1996 to any federal health care program
(other than the Federal Employees Health Benefits Program).

         In addition, federal and some state laws impose restrictions on
referrals for certain designated health services by physicians and, in a few
states, psychologists and other mental health care professionals to entities
with which they have financial relationships. The Company believes that its
operations comply with these restrictions to the extent applicable, although no
assurance can be given regarding compliance in any particular factual situation.
Federal legislation has been considered to expand current law from its
application to Medicare and Medicaid business to all payors and to additional
health services. Certain states are considering adopting similar restrictions or
expanding the scope of existing restrictions. There can be no assurance that the
federal government or other states in which the Company operates will not enact
similar or more restrictive legislation or restrictions that could under certain
circumstances impact the Company's operations.




                                    Page 18
<PAGE>   19


         MENTAL HEALTH CARE PATIENT RIGHTS

         Many states have adopted "patient bill of rights" regulations which set
forth standards for least restrictive treatment, patient confidentiality,
patient access to mail and telephones, patient access to legal counsel and
requirements that patients be treated with dignity. There are also laws and
regulations relating to the civil commitment of patients to mental health
programs, disclosure of information concerning patient treatments and related
matters.

         HEALTH CARE REFORM

         The Clinton Administration and various federal legislators have
considered health care reform proposals intended to control health care costs
and to improve access to medical services for uninsured individuals. These
proposals included proposed cutbacks to the Medicare and Medicaid programs and
steps to permit greater flexibility in the administration of Medicaid. In
addition, some states in which the Company operates are considering various
health care reform proposals. It is uncertain at this time what legislation on
health care reform may ultimately be enacted or whether other changes in the
administration or interpretation of governmental health care programs will
occur. There can be no assurance that future health care legislation or other
changes in the administration or interpretation of governmental health care
programs will not have a material adverse effect on the Company's business,
financial condition or results of operations.

         LICENSING REQUIREMENTS

         Certain of the services provided by the Company's managed behavioral
services subsidiaries may be subject to certain licensing requirements in some
states. The Company currently holds licenses in Colorado, Florida, and
Pennsylvania. If the business operations of such entities are determined to
require licenses in other states, then obtaining such licenses or the inability
to obtain such licenses could adversely affect the business operations of such
entities. In addition, several states have laws that prohibit business
corporations from providing, or holding themselves out as providers of, medical
care. While the Company has no reason to believe that it is in violation or has
violated such statutes, these laws vary from state to state and have seldom been
interpreted by the courts or regulatory agencies.

EMPLOYEES

         At August 31, 1998, the Company employed 1,485 people, including 1,140
full-time employees, 290 part-time employees, and 55 temporary employees. The
Company has no collective bargaining agreements with any unions and believes
that its overall relations with its employees are good. In addition, at August
31, 1998, the Company had administrative services contracts with 240 physicians
to serve as medical directors for the clinical programs managed by the Company.

INSURANCE

         The Company carries general liability, comprehensive property damage,
malpractice, workers' compensation and other insurance coverages that management
considers adequate for the protection of the Company's assets and operations.
There can be no assurance, however, that the coverage limits of such policies
will be adequate. A successful claim against the Company in excess of its
insurance coverage could have a material adverse effect on the Company.





                                    Page 19
<PAGE>   20


ITEM 2.  PROPERTIES

         In September 1996, the Company leased a building consisting of
approximately 40,000 square feet for its National Support Center in Lewisville,
Texas under a lease term expiring on September 26, 2001. In addition, at August
31, 1998 the Company leased an aggregate of 7,211 square feet of space for three
regional offices in the Chicago, Los Angeles and Tampa metropolitan areas, with
lease terms expiring from January 1999 to April 2001. Except for one partial
hospitalization program operating in approximately 3,150 square feet of space,
the space required for the clinical programs managed by the Company is provided
by the client hospitals either within their existing facilities or at other
locations owned or leased by the hospitals.

         The Company leases approximately 38,997 square feet of office space in
the Philadelphia, Tampa, Jacksonville, San Antonio, and Orlando metropolitan
areas, with lease terms expiring from February 1999 to August 2003 for its
managed care operations. In addition, the Company leases approximately 17,999
square feet in various locations throughout the state of Florida with lease
terms expiring from March 2000 to August 2003 for its clinical operations.

         Effective October 5, 1998, the Company leases 12,987 square feet of
office space in the Denver metropolitan area with a lease term expiring on July
1, 2002, as a result of the acquisition of ChoiceHealth.


ITEM 3.  LEGAL PROCEEDINGS

         The Company is, and may be in the future, party to litigation arising
in the course of its business. While the Company has no reason to believe that
any pending claims are material, there can be no assurance that the Company's
insurance coverage will be adequate to cover all liabilities arising out of such
claims or that any such claims will be covered by the Company's insurance. Any
material claim which is not covered by insurance may have an adverse effect on
the Company's business. Claims against the Company, regardless of their merit or
outcome, may also have an adverse effect on the Company's reputation and
business.





                                    Page 20
<PAGE>   21



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

         None.

                      EXECUTIVE OFFICERS OF THE REGISTRANT

<TABLE>
<CAPTION>

         NAME                        AGE                      POSITION
         ----                        ---                      --------
<S>                                   <C>      <C>

         James W. McAtee............  53       President, Chief Executive Officer, Treasurer, Secretary and Director
         Robert A. Lefton...........  42       Executive Vice President - Operations
         Gary A. Kagan..............  47       Executive Vice President - Development
         Linda A. Laitner...........  50       Senior Vice President - Operations
         David S. Tingue............  43       Senior Vice President - Marketing
         David K. White, Ph.D. .....  42       Senior Vice President - Operations
</TABLE>

         James W. McAtee has been President and Chief Executive Officer of the
Company since November 1, 1998. He has been Chief Financial Officer, Treasurer
and Secretary of the Company since September 1990 and has been a director of the
Company since July 1995. He formerly served as Executive Vice President -
Finance & Administration of the Company from February 1992 to October 1998. He
was a Senior Vice President of the Company from September 1990 to February 1992.

         Robert A. Lefton has been Executive Vice President - Operations since
November 1, 1998. He formerly served as President and Chief Operating Officer
from September 1997 to October 1998. He was Executive Vice President -
Operations from September 1996 to August 1997. He was a Senior Regional Vice
President of the Company from March 1995 until September 1996 and served as a
Regional Vice President of the Company from November 1991 to March 1995.

         Gary A. Kagan has been Executive Vice President - Development of the
Company since January 1992. From April 1990 to December 1991, he served as
President of the subsidiary of the Company engaged in the contract management
business.

         Linda A. Laitner has been Senior Vice President - Operations since
November 1, 1998. She has been President - Horizon Behavioral Services since
February 1998. She was previously Vice President Operations-Government Programs
for CMG Health from January 1997 to January 1998. She also served as Vice 
President Operations-Implementation for CMG Health from January 1994 to January
1997 and as a Regional Vice President from January 1993 to January 1994.

         David S. Tingue has been has been Senior Vice President - Marketing
since November 1, 1998. He has been President - Mental Health Outcomes since
October 1997. He formerly served as Executive Vice President, Marketing from
July 1998 to October 1998. He was previously Vice President Operations for SDMS
Inc. from January 1997 to September 1997. He also served as Vice President,
Strategic Planning for SDMS from March 1996 to December 1996 and Vice President,
Marketing from July 1994 to March 1996. Prior to this, he was a Regional
Business Director for Zeneca Pharmaceuticals from September 1992 to June 1994.

         David K. White, Ph.D. has been Senior Vice President - Operations since
November 1, 1998. He formerly served as Executive Vice President - Operations
from February 1998 to October 1998. He was a Regional Vice President from
September 1996 to January 1998. He also served as a Regional Director of
Operations from April 1995 to August 1996. He was President and Chief Executive
Officer of Charles River Health Management, Inc. from December 1990 to November
1994.

         Officers of the Company are elected by the Board of Directors of the
Company and serve at the pleasure of the Board of Directors until their
respective successors are elected and qualified.






                                    Page 21
<PAGE>   22


PART II


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


         The Company completed an initial public offering of its Common Stock in
March 1995. The Common Stock of the Company was originally listed on the
American Stock Exchange and was traded under the symbol "HMH". On May 7, 1996,
the Common Stock of the Company began trading on the Nasdaq National Market
under the symbol "HMHM". On August 12, 1997, the Nasdaq trading symbol for the
Company was changed to "HORC" following the change of its corporate name from
Horizon Mental Health Management, Inc.

         The following table sets forth the high and low sale prices per share
for the Common Stock of the Company as reported by the Nasdaq National Market,
for the periods indicated:

<TABLE>
<CAPTION>

                                                                        High                   Low
                                                                        ----                   ---
<S>                                                                   <C>                    <C>
FISCAL YEAR ENDED AUGUST 31, 1998:
    September 1, 1997 -- November 30, 1997........................... $ 29.13                $ 20.50
    December 1, 1997 -- February 28, 1998............................   23.75                  19.00
    March 1, 1998 -- May 31, 1998....................................   24.63                  17.25
    June 1, 1998 -- August 31, 1998..................................   19.00                   4.50

FISCAL YEAR ENDED AUGUST 31, 1997:
    September 1, 1996 -- November 30, 1996 (1).......................   18.67                  14.67
    December 1, 1996 -- February 28, 1997 (1)........................   19.67                  16.33
    March 1, 1997 -- May 31, 1997....................................   20.00                  15.38
    June 1, 1997 -- August 31, 1997..................................   26.12                  18.00
</TABLE>


(1)  Adjusted to reflect three-for-two stock split effected by the Company as a
     50% stock dividend on January 31, 1997.

         The reported last sale price per share of the Common Stock as reported
by the Nasdaq National Market on November 23, 1998 was $7.00. As of November 23,
1998, the Company had 6,967,750 shares of Common Stock outstanding. As of
November 23, 1998, there were 50 stockholders of record of the Common Stock of
the Company.

         The Company has not paid or declared any cash dividends on its capital
stock since its inception. The Company currently intends to retain all future
earnings for use in the expansion and operation of its business. Future
borrowings may limit the Company's ability to pay dividends. The payment of any
future cash dividends will be determined by the Board of Directors in light of
conditions then existing, including the Company's earnings, financial condition
and capital requirements, restrictions in financing agreements, business
conditions and other factors. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Liquidity and Capital
Resources."





                                    Page 22
<PAGE>   23
ITEM 6.  SELECTED CONSOLIDATED FINANCIAL INFORMATION AND
         STATISTICAL DATA

         The selected historical consolidated financial data presented below for
the fiscal years ended August 31, 1996, 1997 and 1998, and at August 31, 1997
and August 31, 1998, are derived from the audited Consolidated Financial
Statements of the Company included elsewhere in this Report. The selected
historical consolidated financial data presented below for the fiscal years
ended August 31, 1994 and 1995, and at August 31, 1994, 1995 and 1996, are
derived from the audited consolidated financial statements of the Company not
included herein. Effective August 11, 1997, Horizon acquired Specialty
Healthcare Management, Inc. ("Specialty") in a share exchange transaction with
the stockholders of Specialty which was accounted for as a pooling of interests.
The Consolidated Financial Statements of the Company give effect to the
Specialty exchange by combining (a) the financial statements of Horizon for the
years ended August 31, 1995 and 1996 with the financial statements of Specialty
for the years ended December 31, 1995 and 1996 and (b) the results of operations
of Horizon for the year ended August 31, 1997 with the results of operations of
Specialty for the twelve month period ended August 31, 1997, in each case on a
pooling of interests basis. Specialty was a division of National Medical
Enterprises, Inc. during the year ended December 31, 1994. The operations of
Specialty for the four month period ended December 31, 1996 resulting in net
revenues and net income of $10.8 million and $849,000, respectively, have been
included in the restated statement of operations for both the year ended August
31, 1996 and the year ended August 31, 1997. The effect of including Specialty's
net income for the four months in both periods is eliminated in stockholders'
equity in the Consolidated Financial Statements of the Company. The selected
financial information presented below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and with the Consolidated Financial Statements of the Company and
Notes thereto included elsewhere in this Report.






                                    Page 23
<PAGE>   24




<TABLE>
<CAPTION>
                                                                            FISCAL YEAR ENDED AUGUST 31,
                                                  -------------------------------------------------------------------------
                                                    1994(1)         1995(1)          1996            1997           1998
                                                  ----------      ----------      ----------      ----------     ----------
                                                                       (in thousands, except per share data)

<S>                                                   <C>             <C>             <C>            <C>            <C>    
STATEMENT OF OPERATIONS DATA:
Revenues:
   Contract management revenues .............         24,962          68,721          95,244         102,263        102,156
   Premiums and fees ........................           --              --               437           6,154         21,383
Other(2) ....................................          5,297             634             558             850            279
                                                  ----------      ----------      ----------      ----------     ----------
              Total Revenues ................         30,259          69,355          96,239         109,267        123,818
Operating expenses:
   Salaries and benefits ....................         16,814          40,083          55,810          60,048         65,725
   Purchased services .......................          4,731          10,794          13,880          16,466         23,205
   Provision for bad debts ..................            312           1,680           1,435           3,034            760
   Other ....................................          5,745           9,189          11,848          12,796         14,755
   Depreciation and amortization ............            560           1,133           1,812           2,201          3,166
   Merger expenses ..........................           --              --              --             3,528           --
                                                  ----------      ----------      ----------      ----------     ----------
Operating income ............................          2,097           6,476          11,454          11,194         16,207
Interest and other income
 (expense), net .............................         (1,005)         (1,003)            (67)            120             74
                                                  ----------      ----------      ----------      ----------     ----------
Income before income taxes ..................          1,092           5,473          11,387          11,314         16,281
Income tax expense (benefit) ................            (20)          1,695           4,609           4,518          6,515
                                                  ----------      ----------      ----------      ----------     ----------
Income before equity in net earnings of
 Horizon LLC and minority interest ..........          1,112           3,778           6,778           6,796          9,766
Equity in net earnings of Horizon LLC .......            364           1,568            --              --             --
Minority interest............................           --              --                (2)           (140)           (34)
                                                  ----------      ----------      ----------      ----------     ----------
Net income ..................................     $    1,476      $    5,346      $    6,776      $    6,656     $    9,732
                                                  ==========      ==========      ==========      ==========     ==========

Basic earnings per share (3) ................     $     0.47      $     1.05      $     1.03      $     0.96     $     1.37
                                                  ==========      ==========      ==========      ==========     ==========
Weighted average shares outstanding (3)  ....          3,123           5,111(4)        6,561(4)        6,929(4)       7,120
                                                  ==========      ==========      ==========      ==========     ==========
Diluted earnings per share (3) ..............     $     0.38      $     0.89      $     0.90      $     0.87     $     1.26
                                                  ==========      ==========      ==========      ==========     ==========
Weighted average shares and dilutive
  potential common shares outstanding (3) ...          3,934           5,997(4)        7,510(4)        7,681(4)       7,754
                                                  ==========      ==========      ==========      ==========     ==========

BALANCE SHEET DATA (AT END OF PERIOD):
Cash and short-term investments .............     $    2,144      $    3,249      $    8,346      $    5,517     $    6,204
Working capital .............................            162           4,394           8,751           5,064          6,498
Intangible assets (net) (5) .................          7,676          14,998          19,887          26,005         59,538
Total assets ................................         15,079          33,587          45,214          48,728         86,672
Total debt ..................................         12,121           3,216           3,576            --           26,029
Stockholders' equity (deficit) ..............         (1,434)         17,225          25,149          31,682         42,662
</TABLE>




<TABLE>
<CAPTION>
                                      AUG. 31,  NOV. 30,   FEB. 28,   MAY 31,   AUG. 31,   NOV. 30,   FEB. 28,   MAY 31,   AUG. 31,
                                        1996      1996       1997      1997       1997       1997       1998      1998       1998
                                      --------  --------   --------  --------   --------   --------   --------  --------   --------
<S>                                    <C>       <C>        <C>       <C>        <C>        <C>        <C>       <C>      <C>      
STATISTICAL DATA:
Covered Lives                          204,291   204,301    216,260   262,059    288,519    744,103    783,560   762,414  1,874,323
NUMBER OF CONTRACT LOCATIONS (6):
Contract locations in
 operation ..........................      163       162        162       176        181        179        172       166        161
Contract locations signed
 and unopened .......................       16        22         10        18         14         15         12        16         11
                                      --------  --------   --------  --------   --------   --------   --------  --------   --------
Total contract locations ............      179       184        172       194        195        194        184       182        172
                                      ========  ========   ========  ========   ========   ========   ========  ========   ========
SERVICES COVERED BY CONTRACTS (6):
Inpatient ...........................      156       152        157       164        166        165        159       152        149
Partial hospitalization .............       84        84         86       101        104        103        107       109        102
Outpatient ..........................       20        29         28        21         24         27         30        33         32
Home health .........................       13        14         13        15         17         13         12        13         10
CQI+ ................................       64        67         71        78         86         87         88        83         82
TYPES OF TREATMENT PROGRAMS (6):
Geropsychiatric .....................      144       145        153       183        197        193        195       193        189
Adult psychiatric ...................       82        83         80        74         75         70         72        75         67
Substance abuse .....................       20        22         21        16         10         12         12        12          8
Other mental health .................        5         7          8         4          9         12          9         8          9
Physical rehabilitation .............       22        22         22        22         20         21         20        19         20
</TABLE>

                                    Page 24
<PAGE>   25

(1) Effective August 1, 1994, the Company and Mental Health Management, Inc.
    ("MHM") formed Horizon Mental Health Management Company, L.L.C., a Delaware
    limited liability company ("Horizon LLC"). Horizon LLC assumed management
    responsibility for all of the then existing management contracts of the
    Company and MHM. Certain provisions of the limited liability company
    agreement which required the consent of MHM for certain transactions
    prevented the Company from having the ability to control Horizon LLC under
    generally accepted accounting principles and therefore Horizon LLC was not
    consolidated with Horizon for accounting purposes through February 28, 1995.
    As a result, the revenues and expenses of Horizon LLC for the period August
    1, 1994 through February 28, 1995 are not included in the revenues and
    expenses of the Company; instead, for such periods the Company accounted for
    its investment in Horizon LLC by the equity method and reflected its share
    of Horizon LLC's net income for the period in question as "Equity in
    Earnings of Horizon LLC." Effective with the acquisition of the minority
    interest in Horizon LLC of MHM on March 20, 1995, the MHM contracts were
    assigned to the Company and Horizon LLC became a wholly owned subsidiary of
    Horizon. Horizon LLC was consolidated with the Company effective March 1,
    1995. The Company's share of Horizon LLC's net earnings was $364,000 through
    August 31, 1994 and $1,567,720 from September 1, 1994 through February 28,
    1995. The Horizon LLC agreement stipulated that MHM, as a member of Horizon
    LLC, would be allocated the first $1,750,000 of Horizon LLC net earnings in
    each of the fiscal years ending August 31, 1995 and 1996. $1,750,000 was
    allocated to MHM during the six months ended February 28, 1995.

(2) Other revenues for the fiscal years ended August 31, 1994, 1995 and 1996 
    consist primarily of revenues earned from a psychiatric hospital formerly 
    operated by the Company, patient services and physician contract management 
    fees, or subsequent adjustments for Medicare settlements recognized during 
    the respective period. The Company subleased the operations of the hospital
    to a third party effective July 31, 1994. Other revenues for the fiscal 
    years ended August 31, 1997 and 1998 consist primarily of physician contract
    management fees and a favorable cost report adjustment.

(3) Adjusted to reflect a three-for-two stock split effected by the Company as a
    50% stock dividend on January 31, 1997.

(4) Adjusted for the Specialty transaction based on historical share amounts,
    converting each outstanding share of Specialty Common Stock into 147.4616
    shares of Horizon Common Stock.

(5) Effective June 1, 1998, the Company acquired all of the outstanding capital
    stock of FPM Behavioral Health, Inc. of Winter Park, Florida. The purchase
    price exceeded the fair value of FPM's tangible net assets by $22,170,668,
    of which $20,665,912 was recorded as goodwill and $1,504,756 as service
    contracts. Effective October 31, 1997, the Company acquired all of the
    outstanding capital stock of Acorn. The purchase price exceeded the fair
    value of Acorn's tangible net assets by $12,629,261, of which $9,258,513 was
    recorded as goodwill and $3,370,748 as service contracts. The Company
    recorded additional goodwill of $4,498,038 and $714,672 and additional
    management contract values of $507,948 and $141,066, as a result of the
    acquisitions on March 15, 1997 of Geriatric Medical Care, Inc., a Tennessee
    corporation ("Geriatric") and Clay Care Inc., a Texas corporation ("Clay
    Care"), respectively. On August 1, 1996, the Company purchased 80% of the
    outstanding common stock of Florida PPS. Due to this purchase, $3,298,885
    was recorded as goodwill during 1996 and 1997. On February 27, 1998, the
    Company acquired 16% of the remaining outstanding common stock of Florida
    PPS. The purchase price exceeded the fair market value of PPS's tangible net
    assets acquired by $764,400 of which $560,315 was recorded as goodwill and
    $204,085 as service contracts. On March 10, 1998, the Company acquired the
    remaining 4% of the outstanding common stock of Florida PPS. The purchase
    price exceeded the fair market value of PPS's tangible net assets acquired
    by $192,332 of which $141,311 was recorded as goodwill and $51,021 as
    service contracts. On April 1, 1996, the Company purchased all of the
    outstanding capital stock of the Parkside Company. In connection with this
    purchase, approximately $1,400,000 was recorded as goodwill and $2,100,000
    as management contracts. Effective January 3, 1995, the Company acquired the
    net assets and operations of National Medical Management Services, a
    division of National Medical Enterprises, Inc. Due to this purchase,
    $120,350 was recorded as goodwill and $1,000,000 as management contracts. On
    March 20, 1995, $9,683,467 of the net proceeds to the Company from its
    initial public offering were used to purchase MHM's minority interest in
    Horizon LLC. The purchase transaction eliminated $2,794,715 of MHM's equity
    interest in Horizon LLC and recognized an increase in intangible assets of
    $2,355,000 based upon the value of Horizon LLC management contracts. The
    remaining purchase price of $4,533,752 was recorded as goodwill. The
    recorded goodwill was increased by $376,639 in March, 1996 based on a final
    valuation of MHM's minority 






                                    Page 25
<PAGE>   26


    interest. In each such acquisition, the increase in contract value will be
    amortized over seven years and the goodwill over forty years.

(6) Represents combined information for both Horizon and Specialty.






                                    Page 26
<PAGE>   27

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

OVERVIEW

         The Company is a growing provider of employee assistance plans ("EAP")
and mental health services to business and managed care organizations, as well
as the leading contract manager of clinical programs offered by general acute
care hospitals in the United States. The Company has grown both internally and
through acquisitions, increasing both the variety of its treatment programs and
services and the number of its management contracts. As of August 31, 1998, the
Company had over 200 contracts to provide EAP and mental health services
covering nearly 2.0 million lives. Over the last six years, the Company has
increased its management contracts from 43 to a total of 172 as of August 31,
1998 and currently operates in 37 states. Of those management contracts, 150
relate to mental health programs and 22 relate to physical rehabilitation
programs. The Company has also developed a proprietary mental health outcomes
measurement system known as CQI+ and at August 31, 1998 provided outcome
measurement services at 82 contract locations. The Company was incorporated in
1989 and is the successor to Horizon Health Management Company, which began the
development and management of mental health programs for general acute care
hospitals in 1981.

         The Company's strategy is to enhance its position as the leader in the
contract management of mental health programs and to further expand the range of
services which it offers to its existing and new client hospitals to include
other clinical and related services and programs. A significant challenge in
obtaining clinical management contracts from hospitals is overcoming the initial
reservations that many hospital administrators have with outsourcing key
clinical services. The Company believes its expertise in working with hospital
administrators, its reputation in the industry and its existing contractual
relationships with 172 hospitals nationwide provide it with a significant
advantage in obtaining new contracts. The Company also believes it has
opportunities to cross-sell a range of mental health and physical rehabilitation
services to client hospitals by marketing and selling its mental health services
to client hospitals for which the Company currently manages only physical
rehabilitation programs, and by marketing and selling its physical
rehabilitation services to client hospitals for which the Company currently
manages only mental health programs. The Company is pursuing the development of
such opportunities as a primary part of its business strategy. The Company has
successfully expanded the breadth of services it offers to include the full
continuum of mental health services, including outcome measurement services, and
physical rehabilitation services and its contracts increasingly provide for
multiple services. In addition, the Company capitalizes on its expertise in
managing the delivery of mental health services by directly offering managed
behavioral health care services and employee assistance programs to businesses
and managed care organizations. The Company believes it is strategically-sized
to deliver national programs, while providing local, individualized service to
both employer and health plan clients and their employees or clients.

         REVENUES

         Mental Health Services

         The primary factors affecting revenues in any period are the number of
management contracts with treatment programs in operation in the period and the
number of services covered by each such management contract. The Company
provides its management services under contracts with terms generally ranging
from three to five years. Each contract is tailored to address the differing
needs of each client hospital and its community and increasingly cover multiple
treatment programs and services. The Company and the client hospital determine
the programs and services to be offered by the hospital and managed by the
Company, which may consist of one or more mental health or physical
rehabilitation treatment programs offering inpatient, partial hospitalization,
outpatient or home health services. Under the contracts, the hospital is the
actual provider of the mental health or physical rehabilitation services and
utilizes its own facilities (including beds for inpatient programs), nursing
staff and support services (such as billing, dietary and housekeeping) in
connection with the operations of its programs. As the Company has expanded the
breadth of treatment programs it offers to hospitals, it has moved from managing
one treatment program under a single contract with a hospital to managing
multiple treatment programs under such contract.





                                    Page 27
<PAGE>   28


         Contracts are frequently renewed prior to or at their stated expiration
dates. Some contracts are terminated prior to their stated expiration dates
pursuant to agreement of the parties or early termination provisions included in
the contracts. As of August 31, 1996, 1997 and 1998, the Company had
successfully retained 80%, 78% and 73%, respectively, of the management
contracts in existence at the beginning of such fiscal years. The Company
believes the most frequent reason its client hospitals do not renew their
contracts with the Company is that the hospitals decide to manage such programs
themselves, the economic viability of the programs have changed resulting in
their closing the programs, or a change in hospital administration results in a
change in philosophy regarding the use of contract managers. 

         Under each contract, the Company receives a fee for its management
services from the client hospital. Management fees may be either a variable fee
related in part to patient volume, a fixed monthly fee or reimbursement for
direct program costs plus a fixed fee. The management fee is frequently subject
to periodic adjustments as a result of changes in the consumer price index or
other economic factors. Payors, including Medicare and Medicaid, are attempting
to manage costs, resulting in declining amounts paid or reimbursed to hospitals
for the services provided. As a result, the Company anticipates that the number
of patients served by general acute care hospitals on an inpatient basis will
decrease and, as an alternative, the number of patients served on a per diem,
episodic or capitated basis will increase in the future.

         Over the past three years, the Company has increased revenues through
acquisitions (discussed below) and through internal growth by adding services,
price escalators and volume increases at existing contract locations. The
increases have primarily been due to the increased range of services offered per
contract and the increased demand for geropsychiatric services as general
hospitals have sought to enter this market. An additional factor in the pricing
strategy has been the Company's policy of establishing a minimum direct margin
threshold for its management contracts. Because the pooling with Specialty
occurred on August 11, 1997, fiscal 1997 margins do not reflect the integration
or the elimination of Specialty's executive, administrative, accounting and
personnel functions and information systems, the closing of two Specialty office
facilities and other synergies.

         The Company's mix of programs has changed over the last three years
reflecting the increased interest in geropsychiatric programs by general
hospitals. Geropsychiatric programs as a percentage of the Company's total
mental health programs have increased from approximately 57% to 69% during that
period.

         Most of the Company's client hospitals receive reimbursement under one
or more of the Medicare or Medicaid programs for mental health and physical
rehabilitation services provided in programs managed by the Company. The Company
is paid directly by its client hospitals for the management services it
provides. Under many of its management contracts the Company is obligated to
refund all or a portion of its fee if either Medicare denies reimbursement to
the client hospital for individual patient treatment or if the fee paid to the
Company is denied by Medicare as a reimbursable cost. During the fiscal years
ended August 31, 1998 and 1997, the Company refunded approximately $207,801 and
$219,294, respectively, of its fees as a result of these denials.

         Recent amendments to the Medicare regulations established maximum
reimbursement amounts on a per case basis for both inpatient mental health and
physical rehabilitation services. Effective as of October 1, 1997, regulations
promulgated pursuant to these amendments establish a ceiling on the rate of
increase in operating costs per case for mental health and physical
rehabilitation services furnished to Medicare beneficiaries. Prior to these
amendments, the reimbursement amounts were tied to each hospital's mental health
or physical rehabilitation unit cost during such unit's first year of
operations, subject to adjustment. The new regulations establish a nationwide
cap limiting the reimbursement target amount on a per case basis for mental
health and physical rehabilitation services to $10,534 and $19,104,
respectively, subject to adjustments based on market indices. The limitations
have resulted, in some cases, in decreased amounts reimbursed to the Company's
client hospitals. This decrease in reimbursement has, in some cases, led to the
renegotiation of a lower contract management fee structure for the Company and
in other cases has resulted in termination or nonrenewal of the management
contract. The new reimbursement limitations become applicable to the client
hospitals at the beginning of their respective Medicare fiscal years. The trend
of renegotiated fees and canceled or nonrenewed contracts, resulting in reduced
management fees, which the Company first encountered in its fiscal 1998 second
quarter, can be expected to continue in the first and second quarters of fiscal
1999.



                                    Page 28
<PAGE>   29
         A recently enacted amendment to the Medicare statutes provides for a
gradual phase-out of cost-based reimbursement for physical rehabilitation
services over a three-year period commencing on October 1, 2000. The resulting
phase-in of reimbursement for physical rehabilitation services based on PPS
could significantly lower Medicare reimbursements to hospitals and thus have a
material adverse effect on the business, operations and financial results of the
Company.

         Managed Behavioral Health Care Services and Employee Assistance
Programs

         Through its subsidiary Horizon Behavioral Services, Inc., the Company
offers an array of managed care products to corporate clients, self-funded
employer groups, commercial HMO and PPO plans, government agencies, and
third-party payors. Revenues are derived from EAP plans, administrative services
only contracts, and managed behavioral health plans.

         Revenues from employee assistance plans, are typically derived from a
per employee per month capitated rate multiplied by the number of eligible
employees. The rate for EAP plans is dependent upon services provided under the
contract terms. Each plan is specifically written to fulfill the clients' needs
and can offer different numbers of counseling sessions and other benefits, such
as child care and elder care consultation, referral resources and critical
incident debriefing and intervention.

         Revenues for administrative services only related to the management and
treatment of behavioral health benefits are dependent upon the number of
contracts and the services provided. Fees are usually a case rate or a per
employee per month fee multiplied by the number of eligible members. The client
is able to benefit from the mental health professionals employed or
independently contracted by the Company at favorably discounted rates.

         The primary factors affecting revenues derived from managed behavioral
health care services are the behavioral health benefits provided and the number
of members covered. The capitated rate is dependent upon the benefit designs of
the customer and is set forth in the contract, usually as a per member per month
capitated rate, which is multiplied by the number of eligible members to
determine a monthly fee.

         The nine clinics operated in the state of Florida derive income from
patients or insurance for counseling and therapy services rendered.

         OPERATING EXPENSES

         The primary factor affecting operating expenses in any period is the
number of management contracts with programs in operation in the period. The
Company's operating expenses consist primarily of salaries and benefits paid to
its therapists and supporting personnel. Each mental health program managed by
the Company has a psychiatric medical director, a program director who is
usually a psychologist or a social worker, a community relations coordinator and
additional social workers or therapists as needed. Each physical rehabilitation
program managed by the Company has an independent medical director, a program
director, and additional clinical staff tailored to meet the needs of the
program and the client hospital, which may include physical and occupational
therapists, a speech pathologist, a social worker and other appropriate
supporting personnel. Each medical director has a contract with the Company
under which on-site administrative services needed to administer the program are
provided. Except for the nursing staff, which is typically provided by the
hospital, the other personnel are employees of the Company. At August 31, 1998,
the Company had an average of six employees per contract location.

         Purchased services includes payments to independent health care
professionals providing services under the capitated mental health services
contracts and employee assistance programs offered by the Company. Operating
expenses for the Company's managed behavioral health care services and employee
assistance programs are comprised of approximately 37% salaries and benefits and
approximately 51% purchased services from network providers. Other costs and
expenses include items such as marketing costs and expenses, accounting and
legal fees and expenses, employee relocation expenses, rent, utility and
property taxes.




                                    Page 29
<PAGE>   30
         ACQUISITIONS

         On October 5, 1998, the Company acquired all of the outstanding capital
stock of ChoiceHealth for approximately $2.0 million. ChoiceHealth provides
managed behavioral health care services, employee assistance programs and other
related health care services to health maintenance organizations and self
insured employers.

         On June 1, 1998, the Company acquired all of the outstanding capital
stock of FPM for approximately $20.0 million. FPM provides managed behavioral
health care services, employee assistance programs and other related health care
services to health maintenance organizations and self insured employers.

         On October 31, 1997, the Company acquired all of the outstanding
capital stock of Acorn for approximately $12.7 million in cash. Acorn provides
employee assistance programs and other related services to self-insured
employers.

         On August 11, 1997, Horizon acquired Specialty in a transaction
accounted for as a pooling of interests, resulting in a restatement of the
Company's financial results for the fiscal years ended August 31, 1995, 1996 and
1997. Included in the Company's financial statements for the fiscal years ended
August 31, 1995 and 1996 are the financial results of the Specialty acquisition
for the years ended December 31, 1995 and 1996, respectively. Included in the
Company's financial statements for the fiscal year ended August 31, 1997 are the
financial results of Specialty for the twelve months ended August 31, 1997.

         As a result of the Specialty acquisition, in the Company's financial
statements for the fiscal year ended August 31, 1995, the financial results of
Specialty are included for twelve months although Specialty, which began
operations in January 1995, was only in operation for eight months of the
Company's fiscal year. In addition, the financial results of Specialty for the
four months of September 1, 1996 through December 31, 1996 are included in the
Company's financial statements for both fiscal 1996 and 1997. The operations of
Specialty for the four months ended December 31, 1996, resulted in net revenues
and net income of $10.8 million and $849,000, respectively. As a result, an
adjustment was made to stockholders' equity in the consolidated financial
statements of the Company to eliminate the effect of including Specialty's net
income for the four months in both periods. Additionally, the consolidated
statement of cash flows was adjusted to reflect the cash flows of Specialty for
the four months ended December 31, 1996. The treatment of the Specialty
acquisition as a pooling of interests resulted in the Company recognizing
merger-related expenses of approximately $3,528,000 and an offsetting tax
benefit of approximately $1,340,000.

         Other acquisitions during the last three years have significantly
affected the Company's results of operation and financial condition. The Company
acquired 39 management contracts from Mental Health Management, Inc. ("MHM") on
March 20, 1995, 19 management contracts from Parkside on April 1, 1996 and 23
management contracts with the acquisition of Geriatric and Clay Care on March
15, 1997. In addition, on August 1, 1996 the Company acquired Florida PPS, a
company specializing in providing mental health services under capitated
contracts.






                                    Page 30
<PAGE>   31
RESULTS OF OPERATIONS

         The following table sets forth for the fiscal years ended August 31,
1996, 1997 and 1998, the percentage relationship to total net revenues of
certain costs, expenses and income and the number of management contracts in
operation at the end of each fiscal year.


<TABLE>
<CAPTION>
                                                        FISCAL YEAR ENDED AUGUST 31,
                                                    -----------------------------------

                                                      1996          1997         1998
                                                    --------      --------     --------
<S>                                                 <C>           <C>          <C>   
Revenues:
  Contract management revenues ..............           99.0%         93.6%        82.5%
  Premiums and fees .........................            0.5           5.6         17.3
  Other .....................................            0.5           0.8          0.2
                                                    --------      --------     --------
Total revenues ..............................          100.0         100.0        100.0

Operating expenses
  Salaries and benefits .....................           58.0          55.0         53.1
  Purchased services ........................           14.4          15.1         18.7
  Provision for bad debts ...................            1.5           2.8          0.6
  Other .....................................           12.3          11.7         11.9
  Depreciation and amortization .............            1.9           2.0          2.6
  Merger expenses ...........................            --            3.2          --
                                                    --------      --------     --------

Total operating expenses ....................           88.1          89.8         86.9
                                                    --------      --------     --------
Operating income ............................           11.9          10.2         13.1
                                                    --------      --------     --------

Interest and other income (expense), net ....           (0.1)          0.1          0.1
                                                    --------      --------     --------
Income before taxes .........................           11.8          10.3         13.2

Income tax expense ..........................            4.8           4.1          5.3
                                                    --------      --------     --------

Income before minority interest .............            7.0           6.2          7.9

Minority interest ...........................            --            0.1          --
                                                    --------      --------     --------

Net income ..................................            7.0%          6.1%         7.9%
                                                    ========      ========     ========

Number of contracts in operation, end of year            163           181          161
</TABLE>










                                    Page 31
<PAGE>   32
FISCAL YEAR ENDED AUGUST 31, 1998 COMPARED TO FISCAL YEAR ENDED AUGUST 31, 1997

         Revenue. Revenues for the fiscal year ended August 31, 1998 were $123.8
million representing an increase of $14.5 million, or 13.2%, as compared to
revenues of $109.3 million for the prior fiscal year. Premiums and fees
increased $15.2 million as a result of revenue recorded for Acorn and FPM.
Horizon acquired 100% of the voting stock of Acorn and FPM effective October 31,
1997 and June 1, 1998, respectively. The increase in premiums and fees was
offset by a decrease in other revenues of $571,000. The decrease in other
revenues results from a favorable cost report adjustment for Mountain Crest
Hospital recognized in the prior fiscal year.

         Salaries and Benefits. Salaries and benefits for the fiscal year ended
August 31, 1998 were $65.7 million representing an increase of $5.6 million, or
9.3%, as compared to salaries and benefits of $60.1 million for the prior fiscal
year. Salary and benefits cost per full time equivalent for the year ended
August 31, 1998 were $57,290 representing an increase of $404 per full time
equivalent, or 0.7%, as compared to salary and benefits cost of $56,821 per full
time equivalent for the prior fiscal year. The number of full time equivalents
for the year ended August 31, 1998 was approximately 1,147, representing an
increase of 90, or 8.6%, as compared to approximately 1,057 full time
equivalents in the prior fiscal year. FTE's increased by 52 as a result of the
acquisition of Acorn. FTE's also increased by 160 as a result of the acquisition
of FPM. These increases are offset by a decline in FTE's resulting from a
decrease in the number of contract locations in operation, from 181 at August
31, 1997 to 161 at August 31, 1998, a decrease of 11%.

         Depreciation and Amortization. Depreciation and amortization expenses
for the fiscal year ended August 31, 1998 were $3.2 million representing an
increase of $965,000, or 43.8%, as compared to depreciation and amortization
expenses of $2.2 million for the prior fiscal year. $928,000 of the increase
resulted from additional depreciation and amortization arising from the
acquisitions of Acorn and FPM. The remainder of the increase resulted from the
depreciation expense associated with additional capital expenditures during the
fiscal year.

         Other Operating Expenses (Including Purchased Services and Provision
for Bad Debts). Other operating expenses for the fiscal year ended August 31,
1998 were $38.7 million representing an increase of $6.4 million, or 19.8%, as
compared to other operating expenses of $32.3 million for the previous fiscal
year. A major factor in the increase in purchased services and other operating
expense resulted from medical claims paid by Acorn and FPM. Purchased services
increased $6.7 million, of which $5.7 million was due to the inclusion of Acorn
and FPM in the Company's consolidated financial statements. Other operating
expenses increased $2.0 million, of which $1.3 million was related to the
acquisitions of Acorn and FPM. The increases in purchased services and other
operating expenses were offset by a decrease in the provision for bad debts of
$2.3 million, of which $2.1 million related to one Specialty contract which
terminated April 30, 1997.

         Merger Expenses. Merger expenses were $3.5 million for the fiscal year
ended August 31, 1997. The Company did not have merger expenses for the current
fiscal year.

         Interest and Other Income (Expense), Net. Interest income, interest
expense and other income for the fiscal year ended August 31, 1998 was $74,000,
as compared to $120,000 in net interest income and other income for the prior
fiscal year. This change results from an increase in interest expense of
$405,000 related to amounts borrowed under the new credit facility for
acquisitions. This decrease is offset by an increase in other income of $514,000
due to the final receipt of the rent obligation for Mountain Crest Hospital. In
addition, interest income decreased by $126,000 when compared to the
corresponding period in the prior fiscal year due to the use of cash for
acquisitions.




                                    Page 32
<PAGE>   33
         Income Tax Expense. Income tax expense for the fiscal year ended August
31, 1998 was $6.5 million representing an increase of $2.0 million, or 44.4%, as
compared to income tax expense of $4.5 million for the prior fiscal year. The
increase in income tax expense was largely due to a corresponding increase in
pre-tax earnings.


FISCAL YEAR ENDED AUGUST 31, 1997 COMPARED TO FISCAL YEAR ENDED AUGUST 31, 1996

         Revenue. Revenues for the fiscal year ended August 31, 1997 were $109.3
million representing an increase of $13.0 million, or 13.5%, as compared to
revenues of $96.3 million for the prior fiscal year. Approximately $3.0 million
(3.1%) of the revenue increase for the year was attributable to a 9.4% increase
in the number of contract locations in operation, from a daily average of 156.0
contract locations in operation during the year ended August 31, 1996 to a daily
average of 170.7 contract locations in operation during the year ended August
31, 1997. Approximately $4.8 million (5.0%) of the revenue increase resulted
from a 7.0% increase in same site revenues on an average quarterly
year-over-year basis at contract locations in operation throughout each
comparison period, which in the aggregate represented approximately 66.7% of
fiscal 1997 revenues. Approximately $5.2 million (5.4%) of the revenue increase
resulted from the operations of Florida PPS, of which twelve months of results
were included in fiscal 1997 versus one month in fiscal 1996 following its
acquisition on August 1, 1996.

         Salaries and Benefits. Salaries and benefits for the fiscal year ended
August 31, 1997 were $60.0 million representing an increase of $4.2 million, or
7.6%, as compared to salaries and benefits of $55.8 million for the prior fiscal
year. Salary and benefits cost per full time equivalent for the year ended
August 31, 1997 were $56,821 representing an increase of $3,430 per full time
equivalent, or 6.4%, as compared to salary and benefits cost of $53,391 per full
time equivalent for the prior fiscal year. The number of full time equivalents
for the year ended August 31, 1997 was approximately 1,057, representing an
increase of 11.5, or 1.1%, as compared to approximately 1,045 full time
equivalents in the prior fiscal year. The increase in the number of full time
equivalents of 1.1% was less than the 9.4% increase in the number of contract
locations in operation because the contract locations terminated during fiscal
year 1997 were mature programs which typically employ more personnel per
location than the newly signed and acquired contract locations during fiscal
year 1997.

         Depreciation and Amortization. Depreciation and amortization expenses
for the fiscal year ended August 31, 1997 were $2.2 million representing an
increase of $389,000, or 21.5%, as compared to depreciation and amortization
expenses of $1.8 million for the prior fiscal year. $277,000 of the increase
resulted from additional depreciation and amortization arising from the
acquisitions of Florida PPS, Parkside, Geriatric and Clay Care. The remainder of
the increase resulted from the depreciation expense associated with the
operation of additional contract locations and the equipment and furniture
purchased for the Company's new national support center which opened in
September 1996.

         Other Operating Expenses (Including Purchased Services and Provision
for Bad Debts). Other operating expenses for the fiscal year ended August 31,
1997 were $32.3 million representing an increase of $5.1 million, or 18.8%, as
compared to other operating expenses of $27.2 million for the previous fiscal
year. A major factor in the increase in other operating expense resulted from
the 9.4% increase in the number of contract locations in operation for the
fiscal year ended August 31, 1997, as compared to the prior fiscal year. $1.7
million of the increase resulted from an increase in bad debt expense due to the
write-off of the receivable associated with a contract location which closed on
April 30, 1997. Purchased services increased by $2.6 million, of which $1.8
million was due primarily to the inclusion of Florida PPS in the Company's
consolidated financial statements for the entire twelve months in fiscal 1997
versus only one month in fiscal 1996 following its acquisition on August 1,
1996.

         Merger Expenses. Merger expenses were $3.5 million for the fiscal year
ended August 31, 1997. The Company did not have merger expenses for the prior
fiscal year.

         Interest and Other Income (Expense), Net. Interest income, interest
expense and other income for the fiscal year ended August 31, 1997 was $122,000,
as compared to net interest expense and other income of negative $66,000 for the
prior fiscal year. The increase in interest income was due to the investment of
the positive cash flow from earnings.





                                    Page 33
<PAGE>   34
         Income Tax Expense. Income tax expense for the fiscal year ended August
31, 1997 was $4.5 million representing a decrease of $92,000, or 2.0%, as
compared to income tax expense of $4.6 million for the prior fiscal year. The
small decrease in income tax expense was largely due to a small decrease in
pre-tax earnings.


LIQUIDITY AND CAPITAL RESOURCES

         On December 9, 1997, the Company entered into a Credit Agreement (the
"Credit Agreement") with Texas Commerce Bank National Association (now known as
Chase Bank of Texas, National Association) as Agent (the "Agent") for itself and
other lenders party to the Credit Agreement, for a senior secured credit
facility in an aggregate amount of up to $50.0 million (the "New Credit
Facility"). The New Credit Facility consists of a $10.0 million revolving credit
facility to fund ongoing working capital requirements (the "Revolving Credit
Facility") and a $40.0 million advance term loan facility to refinance certain
existing debt and to finance future acquisitions by the Company (the "Advance
Term Loan Facility"). The New Credit Facility replaced the Company's existing
$14.0 million revolving credit facility. At August 31, 1998, the revolving
credit facility and advance term loan facility had $3 million and $23 million
outstanding, respectively.

         The following summary of certain material provisions of the Credit
Agreement does not purport to be complete, and is subject to, and qualified in
its entirety by reference to, the Credit Agreement, a copy of which was filed as
Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q, for the quarter
ended November 30, 1997, as filed with the Securities and Exchange Commission
(the "Commission") on December 19, 1997.

         The Company is the borrower under the New Credit Facility which is
unconditionally guaranteed by all material domestic subsidiaries of the Company.
The Revolving Credit Facility terminates November 30, 2000 and the Advance Term
Loan Facility has a term of five years, with drawdowns available until November
30, 1999. Once a drawdown is made under the Advance Term Loan Facility, the
commitment thereunder will be reduced by the amount funded. Amounts outstanding
under the Advance Term Loan Facility on November 30, 1999 are to be repaid in
twelve quarterly principal payments, beginning February 28, 2000, based upon a
five year amortization schedule with the first eleven principal payments being
1/20th of the outstanding balance on November 30, 1999, and the twelfth being
the remaining unpaid principal balance. Principal outstanding under the New
Credit Facility bears interest at the "Base Rate" (the greater of the Agent's
"prime rate" or the federal funds rate plus .5%) plus 0% to .5% (depending on
the Company's Indebtedness to EBITDA Ratio as defined in the Credit Agreement)
or the "Eurodollar Rate" plus .75% to 1.5% (depending on the Indebtedness to
EBITDA Ratio), as selected by the Company. The Company incurs quarterly
commitment fees ranging from .25% to .375% per annum (depending on the
Indebtedness to EBITDA Ratio) on the unused portion of the Revolving Credit
Facility (until November 30, 2000) and unused portion of the Advance Term Loan
Facility (until November 30, 1999).

         The Company is subject to certain covenants which include prohibitions
against (i) incurring additional debt or liens, except specified permitted debt
or permitted liens, (ii) certain material acquisitions, other than specified
permitted acquisitions (including any single acquisition not greater than $10.0
million or cumulative acquisitions not in excess of $30.0 million during any
twelve consecutive monthly periods), (iii) certain mergers, consolidations or
asset dispositions by the Company or changes of control of the Company, (iv)
certain management vacancies at the Company, and (v) material change in the
nature of business conducted. In addition, the terms of the New Credit Facility
require the Company to satisfy certain ongoing financial covenants. The New
Credit Facility is secured by a first lien or first priority security interest
in and/or pledge of substantially all of the assets of the Company and of all
present and future subsidiaries of the Company.

         On September 9, 1998 the New Credit Facility was amended to allow the
Company to finance, under the Term Loan Facility, the redemption or repurchase
of its capital stock. As a result of this amendment a limit of $10 million for
cumulative acquisitions was imposed for the period of September 30, 1998 through
August 31, 1999.

         Effective September 1996, the Company entered into a lease agreement
with a term of five years for a building which had been constructed to the
Company's specifications for its National Support Center. In connection with the
lease transaction, the Company guaranteed a loan of approximately $900,000. The
loan was by a financial 




                                    Page 34
<PAGE>   35
institution to the owner. The Company also agreed to purchase the leased
building for approximately $4.5 million at the end of the lease term in
September 2001 if either the building is not sold to a third party or the
Company does not extend its lease.

         The Company believes that its cash flow from operations, cash of $6.2
million at August 31, 1998 and $7.0 million currently available under the
revolving credit facility will be sufficient to cover all cash requirements over
the next twelve months, including estimated capital expenditures of $1.2
million. The Company generated $7.7 million in net cash from operations during
the year ended August 31, 1998. The Company is likely to require additional
capital to fund any further acquisitions.

         Effective October 5, 1998, the Company acquired all of the outstanding
capital stock of ChoiceHealth for approximately $2.0 million. The acquisition
was funded by incurring debt of $2.0 million under the term loan facility.

         Effective June 1, 1998, the Company acquired from Ramsay Health Care,
Inc. all the outstanding capital stock of FPM for $20.0 million, subject to
certain post-closing adjustments. The acquisition was funded by incurring debt
of $20.0 million under the term loan facility.

         On October 31, 1997, the Company acquired all the outstanding capital
stock of Acorn for approximately $12.7 million. To fund the acquisition, the
Company utilized approximately $1.7 million of existing cash and incurred debt
of approximately $11.0 million under the revolving credit facility.

         Horizon acquired Specialty on August 11, 1997. Specialty was a contract
manager of mental health and physical rehabilitation treatment programs for
general acute care hospitals. At August 11, 1997, Specialty had 44 management
contracts. In the Specialty transaction, 1,400,000 shares of Horizon common
stock were issued and exchanged for all outstanding shares of Specialty capital
stock. The 1,400,000 shares represented approximately 20.1% of the Company's
common stock outstanding after the acquisition. The Company accounted for the
transaction as a pooling of interests, which resulted in the Company recognizing
merger-related expenses of approximately $3,528,000 and an offsetting tax
benefit of approximately $1,341,000, which taken together resulted in a one-time
charge to earnings of $.27 per share. Upon the acquisition, the Specialty
outstanding bank indebtedness of approximately $3.2 million was paid in full.

         Effective March 15, 1997, the Company purchased all of the outstanding
capital stock of Geriatric. Geriatric is a contract manager of mental health
programs for general acute care hospitals and, at March 15, 1997, had 18
management contracts. The purchase price was approximately $4.6 million, and was
paid from existing cash.

         Also effective March 15, 1997, the Company purchased all of the
outstanding capital stock of Clay Care. Clay Care is a contract manager of
mental health programs for general acute care hospitals and, at March 15, 1997
had five management contracts. The purchase price was $1.0 million, and was paid
from existing cash.

         In July 1996, the Company acquired 80% of the outstanding common stock
of Florida PPS. The purchase price for 80% of the outstanding capital stock was
approximately $3.3 million, based primarily on a 6.25 multiple of the 1996
pre-tax income of Florida PPS, and was paid from existing cash. The Company
accounted for the acquisition of Florida PPS by the purchase method as required
by generally accepted accounting principles. In February and March 1998, the
Company acquired the remaining outstanding common stock of PPS. The purchase
price of approximately $1,030,000 was based primarily on a multiple of the 1997
pretax income of PPS. Based in Clearwater, Florida, Florida PPS specializes in
full risk, capitated managed mental health programs and employee assistance
programs.

         The Company acquired the assets of National Medical Management Services
effective January 1, 1995. In the transaction, the Company paid approximately
$3.95 million in cash and a note of approximately $731,000 payable to NME as
payment for the assets. The Company also issued to NME a warrant to acquire 
common stock of the Company, which warrant was subsequently exercised as part of
Horizon's acquisition of Specialty in August 1997. The NME promissory note was
paid in January 1996. In April, 1996 the Company acquired The Parkside Company,
a contract manager of mental health programs, in a merger in which common stock
was issued and approximately $2.6 million was paid in cash which was financed
under a bank credit facility.


                                    Page 35
<PAGE>   36
YEAR 2000 ISSUE

         The Year 2000 issue is the result of computer programs being written
using two digits rather than four digits to define the applicable year. The
Company's computer equipment and software and devices with embedded technology
that are time-sensitive may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in system failure or miscalculations,
causing disruptions of operations, including, among other things, a temporary
inability to process transactions, send invoices or engage in similar normal
business activities.

         The Company has undertaken various initiatives intended to ensure that
the computer equipment and software used by the Company will function properly
with respect to dates in the Year 2000 and thereafter. For this purpose, the
term "computer equipment and software" includes systems thought of as
information technology ("IT") systems, including accounting, data processing and
telephone/PBX systems and other miscellaneous systems that may contain embedded
technology, as well as systems that are not commonly thought of as IT systems,
such as alarm systems, fax machines or other miscellaneous systems that may
contain embedded technology. Based upon its identification and assessment
efforts to date, the Company believes that certain of the computer equipment and
software systems it currently uses will require replacement or modification. In
addition, in the ordinary course of replacing computer equipment and software,
the Company attempts to obtain replacements that are Year 2000 compliant.
Utilizing both internal and external resources to identify and assess needed
Year 2000 remediation, the Company currently anticipates that its Year 2000
identification, assessment, remediation and testing efforts, which began in
April 1998, will be completed by December 31, 1999, and that such efforts will
be completed prior to any currently anticipated impact on its computer equipment
and software systems. The Company estimates that as of November 19, 1998 it had
completed approximately 55% of the initiatives that it believes will be
necessary to fully address potential Year 2000 issues related to its computer
equipment and software. The projects comprising the remaining 45% of the
initiatives are in process and are expected to be completed by December 31,
1999.

<TABLE>
<CAPTION>

                                                                                                     PERCENT
                       YEAR 2000 INITIATIVE                              TIME PERIOD                 COMPLETE
<S>                                                         <C>                                      <C>

       Initial IT systems identification and assessment     April 1998 to December 1998                90%

       Remediation and testing of IT systems                July 1998 to December 1998                 20%

       Identification and assessment of non-IT systems      September 1998 to December 1998            20%

       Remediation and testing of non-IT systems            January 1999 to December 1999               0%
</TABLE>


         The Company is beginning assessment of the Year 2000 readiness of its
suppliers. Such assessment will include hardware, software and service
suppliers. The Company expects to complete its assessment of suppliers' Year
2000 readiness by March 1999. The Company is beginning assessment of the Year
2000 readiness of its customers. Such assessment will include contacting
significant customers regarding their state of Year 2000 readiness. The Company
expects to complete its assessment of customers' Year 2000 readiness by June
1999.


         The Company believes that the costs to modify its computer equipment
and software systems to be Year 2000 compliant, as well as the currently
anticipated costs with respect to Year 2000 issues of third parties, will not
exceed $100,000, which expenditures will be funded from the operating cash
flows. All of the $100,000 relates to analysis, repair or replacement of
existing software, upgrades of existing software or evaluation of information
received from significant suppliers or customers. Such amounts represent
approximately 2% of the Company's total actual and anticipated IT expenditures 
for fiscal 1998 and 1999. As of November 23, 1998, the Company had incurred 
costs of approximately $55,000 related to its Year 2000 identification, 
assessment, remediation and testing efforts. Other non-Year 2000 IT efforts have
not been materially delayed or impacted by Year 2000 initiatives. 





                                    Page 36
<PAGE>   37
However, if all Year 2000 issues are not properly identified, or assessment,
remediation and testing are not effected timely, there can be no assurance that
the Year 2000 issue will not have a material adverse effect on the Company's
result of operations, or adversely affect the Company's relationships with
customers, suppliers or others. Additionally, there can be no assurance that the
Year 2000 issues of other entities will not have a material adverse effect on
the Company's systems or results or operations.

         The Company has begun, but not yet completed, a comprehensive analysis
of the operational problems and costs (including loss of revenues) that would be
reasonably likely to result from the failure by the Company and certain third
parties to complete efforts necessary to achieve Year 2000 compliance on a
timely basis. A contingency plan has not been developed for dealing with the
most reasonably likely worse case scenario, and such scenario has not yet been
clearly identified. The Company plans to complete such cost analysis and
contingency planning by June 1999.

         The costs of the Company's Year 2000 identification, assessment,
remediation and testing efforts and the date by which the Company believes it
will complete such efforts are based upon management's best estimates, which are
derived utilizing numerous assumptions regarding future events, including the
continued availability of certain resources, third-party remediation plans, and
other factors. However, there can be no assurance that these estimates will
prove to be accurate, and actual results could differ materially from those
currently anticipated. Specific factors that might cause such material
differences include but are not limited to the availability and cost of
personnel trained in Year 2000 issues, the ability to identify, assess,
remediate and test all relevant computer codes and embedded technology, and
similar uncertainties.

DISCLOSURE REGARDING FORWARD LOOKING STATEMENTS

         Certain written and oral statements made or incorporated by reference
from time to time by the Company or its representatives in this report, other
reports, filings with the Commission, press releases, conferences, or otherwise,
are "forward looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Such statements include, without limitation, any
statement that may predict, forecast indicate, or imply future results,
performance or achievements, and may contain the words "believe", "expect",
"estimate", "project", "will be", "will continue", "will likely result", or
words or phrases of similar meaning. Such statements involve risks,
uncertainties or other factors which may cause actual results to differ
materially from the future results, performance or achievements expressed or
implied by such forward looking statements. Certain risks, uncertainties and
other important factors are detailed in this report and will be detailed from
time to time in reports filed by the Company with the Commission, including
Forms 8-K, 10-Q, and 10-K, and include, among others, the following: general
economic and business conditions which are less favorable than expected;
unanticipated changes in industry trends; decreased demand by general hospitals
for the Company's services; the Company's inability to retain existing
management contracts or to obtain additional contracts; adverse changes in
reimbursement to general hospitals by Medicare or other third-party payers for
costs of providing mental health services; adverse changes to other regulatory
provisions relating to mental health services; fluctuations and difficulty in
forecasting operating results; the ability of the Company to sustain, manage or
forecast its growth; heightened competition, including specifically the
intensification of price competition; the entry of new competitors and the
development of new products or services by new and existing competitors; changes
in business strategy or development plans; inability to carry out marketing and
sales plans; business disruptions; liability and other claims asserted against
the Company; loss of key executives; the ability to attract and retain qualified
personnel; customer services; adverse publicity; demographic changes; and other
factors referenced or incorporated by reference in this report and other reports
or filings with the Commission. Moreover, the Company operates in a very
competitive and rapidly changing environment. New risk factors emerge from time
to time and it is not possible for management to predict all such risk factors,
nor can it assess the impact of all such risk factors on the Company's business
or the extent to which any factor, may cause actual results to differ materially
from those contained in any forward looking statements. These forward looking
statements represent the estimates and assumptions of management only as of the
date of this report. The Company expressly disclaims any obligation or
undertaking to disseminate any updates or revisions to any forward looking
statement contained herein to reflect any change in its expectations with regard
thereto or any change in events, conditions or circumstances on which any
statement is based. Given these risks and uncertainties, investors should not
place undue reliance on forward looking statements as a prediction of actual
results.






                                    Page 37
<PAGE>   38
INFLATION

         The Company's management contracts generally provide for annual
adjustments in the Company's fees based upon various inflation indexes, thus
mitigating the effect of inflation. During the last three years, inflation has
had little effect on the Company's business.






                                    Page 38
<PAGE>   39
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

         In its normal operations, the Company has market risk exposure to 
interest rates due to its interest bearing debt obligations, which were entered 
into for purposes other than trading purposes. To manage its exposure to 
changes in interest rates, the Company uses both fixed and variable rate debt. 
The Company has estimated its market risk exposure using sensitivity analyses 
assuming a 10% change in market rates.

         At August 31, 1998, the Company had approximately $26.0 million of 
debt obligations outstanding with variable interest rates with a weighted
average interest rate of 6.4375%. A hypothetical 10% change in the effective
interest rate for these borrowings, assuming debt levels as of August 31, 1998,
would change interest expense by approximately $167,000.

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         Reference is made to the Consolidated Financial Statements of the
Company and the Notes thereto appearing at page F-1 to F-25 attached hereto, all
of which information is incorporated by reference into this Item 8.



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

         None.






                                    Page 39
<PAGE>   40
PART III


ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

         The Company will file with the Commission a definitive proxy statement
with respect to the annual meeting of stockholders of the Company to be held on
January 28, 1999 (the "Proxy Statement"). The Company hereby incorporates into
this Item 10 by reference to the Proxy Statement the information required by
this Item 10 that will appear in the Proxy Statement under the caption ELECTION
OF DIRECTORS.

         The information called for by this Item 10 and Item 401 of Regulation
S-K with respect to executive officers of the Company appears under the caption
EXECUTIVE OFFICERS OF THE REGISTRANT following Item 4 of Part I of this Report,
and is incorporated by reference into this Item 10.


ITEM 11. EXECUTIVE COMPENSATION


         The Company hereby incorporates into this Item 11 by reference to the
Proxy Statement the information required by this Item 11 that will appear in the
Proxy Statement under the caption EXECUTIVE COMPENSATION.



ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
         MANAGEMENT

         The Company hereby incorporates into this Item 12 by reference to the
Proxy Statement the information required by this Item 12 that will appear in the
Proxy Statement under the caption SECURITY OWNERSHIP BY MANAGEMENT AND PRINCIPAL
STOCKHOLDERS.



ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The Company hereby incorporates into this Item 13 by reference to the
Proxy Statement the information required by this Item 13 that will appear in the
Proxy Statement under the caption CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS.






                                    Page 40
<PAGE>   41


PART IV


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



         (a)      (1)   Reference is made to the Index to Consolidated Financial
                        Statements appearing at page F-1 of this report.

                  (2)   Reference is made to the Index to Financial Statement
                        Schedules appearing at page S-1 of this report.

                  (3)   Exhibits.


         NUMBER   EXHIBIT



         3.1  -   Certificate of Incorporation of the Company, as amended
                  (incorporated herein by reference to Exhibit 3.1 to the
                  Company's Current Report on Form 8-K dated August 11, 1997).

         3.2  -   Amended and Restated Bylaws of the Company, as amended
                  (incorporated herein by reference to Exhibit 3.2 to Amendment
                  No. 2 as filed with the Commission on February 16, 1995
                  ("Amendment No. 2") to the Company's Registration Statement on
                  Form S-1 filed with the Commission on January 6, 1995
                  (Registration No. 33-88314) (the "Form S-1").

         4.1  -   Specimen certificate for the Common Stock, $.01 par value of
                  the Company (incorporated herein by reference to Exhibit 4.1
                  to the Company's Current Report on Form 8-K dated August 11,
                  1997).

         4.2  -   Rights Agreement, dated February 6, 1997, between the
                  Company and American Stock Transfer & Trust Company, as Rights
                  Agent (incorporated by reference to Exhibit 4.1 to the
                  Company's Registration Statement on Form 8-A, Registration No.
                  000-22123, as filed with the Commission on February 7, 1997).








                                    Page 41
<PAGE>   42





         10.1 -   Lease dated as of December 15, 1990 between Charter Hospital
                  of Fort Collins, Inc. and HHG Colorado, Inc. (incorporated
                  herein by reference to Exhibit 10.12 to the Company's Form
                  S-1).

         10.2 -   Sublease Agreement dated as of July 31, 1997 between HHG
                  Colorado, Inc. and MHM of Colorado, Inc. (incorporated herein
                  by reference to Exhibit 10.13 to the Company's Form S-1).

         10.3 -   Employment Agreement dated as of August 21, 1990 between
                  Horizon Health Management Company, Inc. and Gary A. Kagan
                  (incorporated herein by reference to Exhibit 10.44 to the
                  Company's Form S-1).

         10.4 -   Letter dated November 23, 1992 between Horizon Mental Health
                  Services, Inc. and Robert A. Lefton regarding severance
                  arrangements (incorporated herein by reference to Exhibit
                  10.45 to the Company's Form S-1).

         10.5  -  Agreed Permanent Injunction and Final Judgment dated
                  December 8, 1994 (incorporated herein by reference to Exhibit
                  10.32 to the Company's Form S-1).

         10.6 -   Letter Loan Agreement dated December 20, 1995 among North
                  Central Development Company, as borrower, Texas Commerce Bank,
                  National Association, ("TCB") as lender, and Horizon Mental
                  Health Management, Inc., a Delaware corporation, Horizon
                  Mental Health Management, Inc., a Texas corporation, and
                  Mental Health Outcomes, Inc., a Delaware corporation, as
                  guarantors (incorporated herein by reference to Exhibit 10.7
                  to the Company's Quarterly Report on Form 10-Q for the quarter
                  ended November 30, 1995 (the "November 1995 Form 10-Q").

         10.7 -   First Amendment to Letter Loan Agreement and Note
                  Modification Agreement dated December 9, 1997 among North
                  Central Development Company and its subsidiaries and TCB
                  (incorporated herein by reference to Exhibit 10.3 to the
                  Company's Quarterly Report on Form 10-Q for the quarter ended
                  November 30, 1997.)

         10.8 -   Lease Agreement dated as of December 20, 1995 between North
                  Central Development Company and Horizon Mental Health
                  Management, Inc., a Delaware corporation (incorporated herein
                  by reference to Exhibit 10.8 to the November 1995 Form 10-Q).

         10.9 -   Horizon Health Group, Inc. 1989 Stock Option Plan, as
                  amended (incorporated herein by reference to Exhibit 10.52 of
                  Amendment No. 2 to the Company's Form S-1).

        10.10 -   Horizon Mental Health Management, Inc. 1995 Stock Option
                  Plan (incorporated herein by reference to Exhibit 10.11 to the
                  November 1995 Form 10-Q).

        10.11 -   Horizon Mental Health Management, Inc. Amended and Restated
                  1995 Stock Option Plan for Eligible Outside Directors
                  (incorporated herein by reference to Exhibit 10.12 to the
                  November 1995 Form 10-Q).

        10.12 -   Amendments to 1989 Stock Option Plan and 1995 Stock Option
                  Plan (incorporated herein by reference to Exhibit 10.5 to the
                  Company's Current Report on Form 8-K dated September 1, 1997).

        10.13 -   Amendments to 1995 Stock Option Plan and 1995 First Amended
                  and Restated Stock Option Plan for Eligible Outside Directors
                  (incorporated herein by reference to Exhibit 10.6 to the
                  Company's Current Report on Form 8-K dated September 1, 1997).





                                    Page 42
<PAGE>   43


        10.14 -   Horizon Mental Health Management Bonus Plan Fiscal 1997
                  (incorporated herein by reference to Exhibit 10.36 to
                  Amendment No. 1 to the Company's Annual Report on Form 10-K/A
                  for the fiscal year ended August 31, 1996 (the "1996 Form
                  10-K/A")).

        10.15 -   Horizon Mental Health Management Contingent Bonus Plan
                  (incorporated herein by reference to Exhibit 10.37 to the
                  Company's 1996 Form 10-K/A).

        10.16 -   Horizon Health Corporation Bonus Plan Fiscal 1998
                  (incorporated herein by reference to Exhibit 10.21 to the
                  Company's Annual Report on Form 10-K for the fiscal year ended
                  August 31, 1997).

        10.17 -   Horizon Health Corporation Bonus Plan Fiscal 1999 (filed
                  herewith).

        10.18 -   Amendment dated February 10, 1997 between the Company and
                  the stockholders of Florida Professional Psychological
                  Services, Inc. (incorporated herein by reference to the
                  Company's Quarterly Report on Form 10-Q for the quarter ended
                  February 28, 1997, as filed with the Commission on March 31,
                  1997 (the "February 1997 Form 10-Q)).

        10.19 -   Stock Purchase Agreement dated as of February 24, 1997,
                  among the Company and Geriatric Medical Care, Inc. and its
                  stockholders, as amended (incorporated herein by reference to
                  Exhibit 10.1 to the Company's February 1997 Form 10-Q).

        10.20 -   Share Exchange Reorganization Agreement dated as of April
                  25, 1997, among the Company, Howard B. Finkel, John Harrison,
                  Larry Reiff, Argentum Capital Partners, L.P., Denise Dailey,
                  Ken Dorman, G. Phillip Woellner, and Michael S. McCarthy, and
                  Specialty Healthcare Management, Inc., as amended by a First
                  Amendment to Share Exchange Reorganization Agreement dated as
                  of July 2, 1997 (incorporated herein by reference to Appendix
                  A to the definitive Proxy Statement filed with the Commission
                  by the Company on July 11, 1997, relating to a Special Meeting
                  of Stockholders of the Company to be held on August 11, 1997).

        10.21 -   Post-Closing Escrow Agreement dated August 11, 1997 between
                  the Company and Howard B. Finkel, as Agent (incorporated
                  herein by reference to Exhibit 10.2 to the Company's Current
                  Report on Form 8-K dated August 11, 1997).

        10.22 -   Registration Rights Agreement dated August 11, 1997, between
                  the Company and Howard B. Finkel, et al. (incorporated herein
                  by reference to Exhibit 10.3 to the Company's Current Report
                  on Form 8-K dated August 11, 1997).

        10.23 -   Executive Retention Agreement effective September 1, 1997,
                  between the Company and James Ken Newman (incorporated herein
                  by reference to Exhibit 10.4 to the Company's Current Report
                  on Form 8-K dated September 1, 1997).

        10.24 -   Stock Purchase Agreement, dated October 20, 1997, among the
                  Company, Dr. Melvyn S. Goldsmith, Ph.D., Barbara C. Goldsmith
                  and Acorn Behavioral HealthCare Management Corporation
                  (incorporated herein by reference to Exhibit 2.1 to the
                  Company's Current Report on Form 8-K dated September 1, 1997).

        10.25 -   Credit Agreement dated December 9, 1997 among the Company,
                  Texas Commerce Bank National Association, as Agent, and the
                  banks named therein (incorporated herein by reference to
                  Exhibit 10.2 to the Company's Quarterly Report on Form 10-Q
                  for the quarter ended November 30, 1997).

        10.26 -   Stock Purchase Agreement dated as of May 1, 1998, by and
                  among Ramsay Managed Care, Inc., Ramsay Health Care, Inc., and
                  the Company (incorporated herein by reference to Exhibit 10.1
                  to the Company's Current Report on Form 8-K dated June 2,
                  1998).





                                    Page 43
<PAGE>   44


        11.1  -   Statement Regarding Computation of Per Share Earnings (filed
                  herewith).

        21.1  -   List of Subsidiaries of the Company (filed herewith).

        23.1  -   Consent of PricewaterhouseCoopers LLP (filed herewith).

        27.1  -   Financial Data Schedule (filed herewith).


        (b)       The Company filed the following report on Form 8-K during the
                  last quarter of the period covered by this report:

                  Current Report on Form 8-K dated June 2, 1998 and filed with
                  the Commission on June 17, 1998, which included Item 2
                  relating to the acquisition of FPM.






                                    Page 44
<PAGE>   45


                                   SIGNATURES

       Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

DATE: NOVEMBER 25, 1998

                                       HORIZON HEALTH CORPORATION


                                       BY: /s/ JAMES W. MCATEE
                                          -------------------------------------
                                                  JAMES W. MCATEE
                                          PRESIDENT, CHIEF EXECUTIVE OFFICER, 
                                             AND CHIEF FINANCIAL OFFICER

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

<TABLE>
<CAPTION>
           SIGNATURE                      CAPACITY                                  DATE
           ---------                      --------                                  ----
<S>                                 <C>                                          <C> 
    /s/ JAMES W. MCATEE             Director, President, Chief Executive         November 25, 1998
------------------------------      Officer, Chief Financial Officer,
        James W. McAtee,            Secretary and Treasurer
                                    (Principal Executive Officer and 
                                    Principal Financial Officer)

    /s/ CLIFF W. GARDNER            Vice President - Controller,                 November 25, 1998
------------------------------      Principal Accounting Officer
       Cliff W. Gardner

   /s/ JAMES KEN NEWMAN             Director and Chairman of the Board           November 25, 1998
------------------------------
      James Ken Newman,

   /s/ JACK R. ANDERSON             Director                                     November 25, 1998
------------------------------
     Jack R. Anderson

   /s/ GEORGE E. BELLO              Director                                     November 25, 1998
------------------------------
      George E. Bello

   /s/ WILLIAM H. LONGFIELD         Director                                     November 25, 1998
------------------------------
   William H. Longfield

   /s/ JAMES E. BUNCHER             Director                                     November 25, 1998
------------------------------
     James E. Buncher

  /s/ DONALD E. STEEN               Director                                     November 25, 1998
------------------------------
      Donald E. Steen

  /s/ HOWARD B. FINKEL              Director                                     November 25, 1998
------------------------------
     Howard B. Finkel
</TABLE>





                                    Page 45
<PAGE>   46
                           INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<CAPTION>

<S>                                                                                              <C>
Report of Independent Accountants................................................................F - 2


Consolidated Balance Sheets at August 31, 1997 and 1998..........................................F - 3


Consolidated Statements of Income
     For the Years Ended August 31, 1996, 1997, and 1998.........................................F - 5


Consolidated Statements of Changes in Stockholders' Equity (Deficit)
     For the Years Ended August 31, 1996, 1997, and 1998.........................................F - 6


Consolidated Statements of Cash Flows
     For the Years Ended August 31, 1996, 1997, and 1998.........................................F - 7


Notes to Consolidated Financial Statements.......................................................F- 9

</TABLE>







                                      F-1


<PAGE>   47
                        REPORT OF INDEPENDENT ACCOUNTANTS



To the Board of Directors
and Stockholders of
Horizon Health Corporation


In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, of changes in stockholders' equity and of
cash flows present fairly, in all material respects, the financial position of
Horizon Health Corporation and its subsidiaries at August 31, 1997 and 1998, and
the results of their operations and their cash flows for each of the three years
in the period ended August 31, 1998, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.



PRICEWATERHOUSECOOPERS LLP


Dallas, Texas
October 12, 1998





                                       F-2


<PAGE>   48

                           HORIZON HEALTH CORPORATION

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>

                                                                                                   August 31,
                                                                                     -------------------------------------
                                                                                          1997                  1998
                                                                                     ----------------     ----------------
<S>                                                                                  <C>                  <C>             
CURRENT ASSETS:
     Cash and short-term investments                                                 $      5,516,575     $      6,204,297
     Accounts receivable less allowance for uncollectible accounts of
          $1,357,423 and $1,902,112 at August 31, 1997 and 1998, respectively              11,995,254           13,464,705
     Receivable from employees                                                                 63,303               91,715
     Prepaid expenses and supplies                                                            182,208              211,288
     Income taxes receivable                                                                  951,256              317,197
     Other receivables                                                                         51,877              166,714
     Other current assets                                                                     170,154              469,540
     Current deferred taxes                                                                 1,687,512            2,006,880
                                                                                     ----------------     ----------------

          TOTAL CURRENT ASSETS                                                             20,618,139           22,932,336
                                                                                     ----------------     ----------------

PROPERTY AND EQUIPMENT:
     Equipment                                                                              3,694,717            5,874,100
     Building improvements                                                                    255,406              421,331
                                                                                     ----------------     ----------------

                                                                                            3,950,123            6,295,431

     Less accumulated depreciation                                                          2,208,083            2,868,062
                                                                                     ----------------     ----------------

                                                                                            1,742,040            3,427,369

Goodwill, net of accumulated amortization of $2,078,177 and
     $3,002,194 at August 31, 1997 and 1998, respectively                                  21,553,594           51,310,574
Contracts, net of accumulated amortization of $2,744,666 and $4,099,012
     at August 31, 1997 and 1998, respectively                                              4,451,426            8,227,689
Other assets                                                                                  363,208              774,100
                                                                                     ----------------     ----------------

          TOTAL ASSETS                                                               $     48,728,407     $     86,672,068
                                                                                     ----------------     ----------------
</TABLE>







          See accompanying notes to consolidated financial statements.


                                       F-3

<PAGE>   49
                           HORIZON HEALTH CORPORATION

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>

                                                                                             August 31,
                                                                                --------------------------------------
                                                                                      1997                 1998
                                                                                -----------------    -----------------
<S>                                                                             <C>                  <C>             
CURRENT LIABILITIES:
     Accounts payable                                                           $      1,747,393     $      2,314,404
     Employee compensation and benefits                                                6,233,477            6,166,226
     Accrued expenses (Note 4)                                                         7,572,929            7,934,916
     Current debt maturities                                                                   -               18,470
                                                                                ----------------     ----------------

          TOTAL CURRENT LIABILITIES                                                   15,553,799           16,434,016

     Other liabilities                                                                   355,803              237,308
     Long-term debt, net of current debt maturities                                            -           26,010,901
     Deferred income taxes                                                               987,704            1,327,532
                                                                                ----------------     ----------------

          TOTAL LIABILITIES                                                           16,897,306           44,009,757
                                                                                ----------------     ----------------

Commitments and contingencies (Note 8)

Minority interest                                                                        148,648                    -
                                                                                ----------------     ----------------

STOCKHOLDERS' EQUITY:
     Preferred stock, $.10 par value, 500,000 shares authorized; none issued                   -                    -
or
          outstanding
     Common stock, $.01 par value, 40,000,000 shares
          authorized at August 31, 1997 and 1998; 6,966,762 shares issued and
          outstanding at August 31, 1997 and 7,231,812 shares issued and
          outstanding at August 31, 1998                                                  69,668               72,318
     Additional paid-in capital                                                       16,739,425           17,984,638
     Retained earnings                                                                14,873,360           24,605,355
                                                                                ----------------     ----------------
                                                                                      31,682,453           42,662,311
                                                                                ----------------     ----------------

          TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                            $     48,728,407     $     86,672,068
                                                                                ================     ================
</TABLE>




          See accompanying notes to consolidated financial statements.


                                       F-4
<PAGE>   50
                           HORIZON HEALTH CORPORATION

                        CONSOLIDATED STATEMENTS OF INCOME


<TABLE>
<CAPTION>
                                                           For the years ended August 31,
                                             ---------------------------------------------------------
                                                   1996                 1997                 1998
                                             ---------------      ---------------      ---------------
<S>                                          <C>                  <C>                  <C>            
REVENUES:
     Contract management revenue             $    95,244,454      $   102,263,283      $   102,156,150
     Premiums and fees                               436,693            6,153,540           21,383,040
     Other                                           557,819              849,972              278,659
                                             ---------------      ---------------      ---------------
          Total revenues                          96,238,966          109,266,795          123,817,849
                                             ---------------      ---------------      ---------------

EXPENSES:
     Salaries and benefits                        55,809,614           60,048,345           65,725,221
     Purchased services                           13,880,426           16,466,115           23,205,211
     Provision for bad debt                        1,435,049            3,033,693              759,467
     Other                                        11,848,384           12,795,910           14,754,707
     Depreciation and amortization                 1,811,790            2,201,450            3,166,073
     Merger expenses (Note 3)                           --              3,527,671                 --
                                             ---------------      ---------------      ---------------

     Operating expenses                           84,785,263           98,073,184          107,610,679
                                             ---------------      ---------------      ---------------

Operating income                                  11,453,703           11,193,611           16,207,170
                                             ---------------      ---------------      ---------------

Other income (expense)

     Interest expense                               (419,421)            (402,003)            (799,347)
     Interest income and other                       353,231              523,877              875,268
     Loss on sale of equipment                          --                 (1,888)              (2,324)
                                             ---------------      ---------------      ---------------

Income before income taxes                        11,387,513           11,313,597           16,280,767
Income tax expense                                 4,609,360            4,517,688            6,514,812
                                             ---------------      ---------------      ---------------

Income before minority interest                    6,778,153            6,795,909            9,765,955
Minority interest                                     (2,397)            (139,893)             (33,960)
                                             ---------------      ---------------      ---------------

Net income                                   $     6,775,756      $     6,656,016      $     9,731,995
                                             ===============      ===============      ===============
Earnings per common share:
     Basic                                   $          1.03      $          0.96      $          1.37
                                             ===============      ===============      ===============
     Diluted                                 $          0.90       $         0.87      $          1.26
                                             ===============      ===============      ===============
Weighted average shares outstanding:
     Basic                                         6,561,481            6,928,827            7,120,303
                                             ===============      ===============      ===============
     Diluted                                       7,510,048            7,681,269            7,754,467
                                             ===============      ===============      ===============
</TABLE>




          See accompanying notes to consolidated financial statements.

                                       F-5
<PAGE>   51

                           HORIZON HEALTH CORPORATION
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
               FOR THE YEARS ENDED AUGUST 31, 1996, 1997, AND 1998

<TABLE>
<CAPTION>
                                     Common Shares           Additional                                   Treasury
                               -------------------------      Paid-in       Retained       Deferred        Stock,
                                 Shares         Amount        Capital       Earnings     Compensation      at Cost         Total
                               -----------   -----------    -----------    -----------    -----------    -----------    -----------

<S>                            <C>           <C>            <C>            <C>           <C>             <C>            <C>
Balance at August 31, 1995       6,314,674   $              $              $              $              $              $
                                                  63,202     14,926,859      2,290,643        (50,000)        (5,281)    17,225,423
     Net income                       --            --             --        6,775,756           --             --        6,775,756
     Sale of common shares          55,298           553         59,446           --             --             --           59,999
     Issuance of shares in
          conjunction with
purchase
          of the Parkside          192,437         1,924        868,076           --             --             --          870,000
Company
     Payments on notes                --            --           50,000           --             --             --           50,000
receivable
     Amortization of
deferred
          compensation                --            --             --             --           25,000           --           25,000
     Tax benefit associated
with
          stock options               --            --           37,717           --             --             --           37,717
     Exercise of stock             134,440         1,344        104,065           --             --             --          105,409
options
                               -----------   -----------    -----------    -----------    -----------    -----------    -----------

Balance at August 31, 1996       6,696,849        67,023     16,046,163      9,066,399        (25,000)        (5,281)    25,149,304
     Net income                       --            --             --        6,656,016           --             --        6,656,016
     Adjustment applicable
to
          transition period           --            --             --         (849,055)          --             --         (849,055)
(Note 3)
     Amortization of
deferred
          compensation                --            --             --             --           25,000           --           25,000
     Retirement of treasury           --             (55)        (5,226)          --             --            5,281           --
shares
     Payment on note                  --            --           25,000           --             --             --           25,000
receivable
     Exercise of warrants          179,178         1,793         (1,793)          --             --             --             --
     Tax benefit associated
with
          stock options               --            --          511,949           --             --             --          511,949
     Exercise of stock              90,735           907        163,332           --             --             --          164,239
options
                               -----------   -----------    -----------    -----------    -----------    -----------    -----------

Balance at August 31, 1997       6,966,762        69,668     16,739,425     14,873,360           --             --       31,682,453
     Net income                       --            --             --        9,731,995           --             --        9,731,995
     Tax benefit associated
with
          stock options               --            --          773,229           --             --             --          773,229
     Exercise of stock             265,050         2,650        471,984           --             --             --          474,634
options
                               -----------   -----------    -----------    -----------    -----------    -----------    -----------

Balance at August 31, 1998       7,231,812   $              $              $              $              $              $
                                                  72,318     17,984,638     24,605,355           --             --       42,662,311
                               -----------   -----------    -----------    -----------    -----------    -----------    -----------
</TABLE>






          See accompanying notes to consolidated financial statements.

                                       F-6
<PAGE>   52
<TABLE>
<CAPTION>
                           HORIZON HEALTH CORPORATION
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
               FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998

                                                                                      1996              1997              1998
                                                                                  ------------      ------------      ------------
<S>                                                                               <C>               <C>               <C>         
Operating activities:
     Net income                                                                   $  6,775,756      $  6,656,016      $  9,731,995
     Adjustments to reconcile net income to net cash provided by operating
          activities:
          Depreciation and amortization                                              1,811,790         2,201,450         3,166,073
          Loss on sale of equipment                                                       --               1,888             2,324
          Minority interest                                                              2,397           139,893            33,960
          Deferred income taxes                                                          9,909            94,139           240,337
          Non-cash expenses                                                             25,000            25,000              --
     Changes in net assets and liabilities:
          Decrease (increase) in restricted cash                                      (205,857)          218,606              --
          Decrease (increase) in accounts receivable                                (1,307,286)        1,143,322          (294,089)
          Decrease (increase) in income taxes receivable                                  --                --             951,256
          Decrease (increase) in other receivables                                     285,346           264,589          (460,046)
          Decrease (increase) in prepaid expenses and supplies                         (80,875)         (599,553)           80,066
          Increase in other assets                                                    (127,188)         (144,101)       (1,009,400)
          Increase (decrease) in accounts payable, employee compensation
               and benefits, accrued expenses, and other current liabilities         1,525,817           758,732        (4,592,617)
          Decrease in payable to health insurance program                                 --            (661,248)             --
          Increase (decrease) in other non-current liabilities                         151,872          (749,532)         (118,495)
                                                                                  ------------      ------------      ------------

Net cash provided by operating activities                                            8,866,681         9,349,201         7,731,364
                                                                                  ------------      ------------      ------------

Investing activities:
     Purchase  of property and equipment                                              (393,703)       (1,412,441)         (864,049)
     Proceeds from sale of equipment                                                      --              13,485             9,569
     Increase in goodwill and management contracts                                    (123,222)             --                --
     Payment for purchase of the Parkside Company, net of cash acquired             (2,600,000)             --                --
     Payment for purchase of net assets of National Medical Management                (302,817)             --                --
          Services Payment for purchase of Professional Psychological 
          Services, Inc., net of cash acquired                                        (786,767)       (1,898,230)       (1,240,834)
     Payment for purchase of Clay Care, Inc., net of cash acquired                        --            (913,634)             --
     Payment for purchase of Geriatric Medical Care Inc., net of cash                     --          (4,577,970)             --
          acquired 
     Payment for purchase of Acorn Behavioral HealthCare Management
          Corporation, net of cash acquired                                               --                --         (12,726,120)
     Payment for purchase of FPM Behavioral Health, Inc., net of cash                    
          acquired                                                                        --                --         (19,449,488)
                                                                                  ------------      ------------      ------------
Net cash used in investing activities                                               (4,206,509)       (8,788,790)      (34,270,922)
                                                                                  ------------      ------------      ------------
Financing activities:
     Payments on long-term debt                                                     (3,108,047)       (4,114,862)       (6,520,583)
     Payment on notes receivable for purchase of common stock                           50,000            25,000              --
     Proceeds from long term borrowings                                              3,291,820              --          32,500,000
     Net proceeds from issuance of common stock                                        165,408           164,239           474,634
     Tax benefit related to stock option exercise                                       37,717           511,949           773,229
                                                                                  ------------      ------------      ------------
Net cash provided by (used in) financing activities                                    436,898        (3,413,674)       27,227,280
                                                                                  ------------      ------------      ------------
Change in cash during transition period                                                   --              23,465              --
Net increase (decrease) in cash and short-term investments                           5,097,070        (2,829,798)          687,722
Cash and short-term investments at beginning of year                                 3,249,303         8,346,373         5,516,575
                                                                                  ------------      ------------      ------------
Cash and short-term investments at end of year                                    $  8,346,373      $  5,516,575      $  6,204,297
                                                                                  ============      ============      ============

Supplemental disclosure of cash flow information Cash paid during the period
     for:
          Interest                                                                $    419,421      $    402,003      $    778,962
                                                                                  ============      ============      ============
          Income taxes                                                            $  4,930,499      $  4,584,015      $  5,212,080
                                                                                  ============      ============      ============
</TABLE>


                                       F-7
<PAGE>   53
                           HORIZON HEALTH CORPORATION
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
               FOR THE YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
<TABLE>
<CAPTION>
                                                                                    1996              1997              1998
                                                                                ------------      ------------      ------------
<S>                                                                             <C>               <C>               <C>         
Supplemental disclosure on non-cash investing activities:
     Acquisition of 80% of the common stock of  Professional Psychological
     Services, Inc., and 100% of  the common stock of the Parkside Company
     during fiscal year 1996;

     Acquisition of Geriatric Medical Care, Inc., Clay Care, inc., and
          additional payments for the acquisition of 80% of the common
          stock of Professional Psychological Services, Inc., during fiscal
          year 1997 

     Acquisition of Acorn Behavioral Health Care Management Corporation,
          FPM Behavioral Health, Inc., and additional payments for the 
          acquisition of  the remaining 20% of the common stock of
          Professional Psychological Services, Inc., during fiscal year 1998

               Fair value of assets acquired                                    $  5,815,535      $  9,004,431      $ 39,717,058

               Cash paid                                                          (3,825,000)       (7,524,968)      (33,967,191)

               Common stock exchanged                                               (870,000)             --                --
                                                                                ------------      ------------      ------------
               Liabilities assumed                                              $  1,120,535      $  1,479,463      $  5,749,867
                                                                                ------------      ------------      ------------
</TABLE>

          See accompanying notes to consolidated financial statements.



                                       F-8
<PAGE>   54

                           HORIZON HEALTH CORPORATION
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                            AUGUST 31, 1997 AND 1998

1.     ORGANIZATION

       Horizon Health Corporation (the "Company"), formerly known as Horizon
       Mental Health Management, Inc., is a contract manager of clinical and
       related services, primarily of mental health programs, offered by general
       acute care hospitals in the United States as well as a provider of
       employee assistance programs ("EAP") and mental health services to
       business and managed care organizations. The management contracts are
       generally for terms ranging from three to five years, the majority of
       which have automatic renewal provisions. The Company currently has
       offices in the Dallas, Texas; Los Angeles, California; Chicago, Illinois;
       Tampa, Florida; Orlando, Florida; and Philadelphia, Pennsylvania
       metropolitan areas. The Company's National Support Center is in
       Lewisville, Texas.

       The Company was formed in July 1989 for the purpose of acquiring all the
       assets of two companies. One of these companies, known as Horizon Health
       Management Company, had been formed in 1981 and since that time had been
       engaged in the mental health contract management business. The other
       company owned a freestanding psychiatric hospital in California.
       Effective March 1, 1990, the assets constituting the contract management
       business and the psychiatric hospital of the two companies were
       transferred to the Company. On January 3, 1995, the Company acquired the
       net assets and operations of National Medical Management Services, a
       division of National Medical Enterprises, Inc.

       On March 13, 1995, the Company's initial public offering of 3,120,000
       shares of common stock at an offering price to the public of $6.67 per
       share was declared effective by the Securities and Exchange Commission.
       On April 11, 1995, the Company sold an additional 118,150 shares of
       common stock at the initial offering price of $6.67 per share pursuant to
       the exercise of the overallotment option granted to the underwriters in
       the initial public offering.

       On April 1, 1996, the Company acquired the Parkside Company ("Parkside"),
       a contract manager of mental health services for acute care hospitals.
       Parkside has been consolidated with the Company as of April 1, 1996. On
       July 31, 1996, the Company acquired eighty percent (80%) of the
       outstanding common stock of Florida Professional Psychological Services,
       Inc., also known as Professional Psychological Services, Inc. ("PPS") and
       PPS has been consolidated with the Company as of August 1, 1996.
       Effective March 15, 1997, the Company purchased all of the outstanding
       capital stock of Geriatric Medical Care, Inc., a Tennessee corporation
       ("Geriatric"), and Clay Care, Inc., a Texas corporation ("CCI"), and they
       have been consolidated with the Company as of March 15, 1997 (see Note
       3).

       On August 11, 1997, the Company exchanged 1,400,000 shares of its common
       stock for all of the outstanding common stock of Specialty Healthcare
       Management, Inc. ("Specialty"). Specialty was a privately held contract
       manager of mental health and physical rehabilitation treatment programs
       for general acute care hospitals. The exchange has been accounted for
       under the pooling of interests method. Accordingly, all financial
       statements presented have been restated to include the results of
       Specialty (see Note 3).

       Effective October 31, 1997, the Company acquired all of the outstanding
       capital stock of Acorn Behavioral HealthCare Management Corporation
       ("Acorn"), a Pennsylvania corporation, and Acorn has been consolidated
       with the Company as of October 31, 1997. Effective February 27, 1998, the
       Company acquired an additional sixteen percent (16%) of the outstanding
       common stock PPS. On March 10, 1998, the Company acquired the remaining
       four percent (4%) of the outstanding common stock of PPS. These
       acquisitions have been consolidated with the Company as of their
       respective effective dates. Effective June 1, 1998, the Company acquired
       all of the outstanding capital stock of FPM Behavioral Health, Inc.
       ("FPM") of Winter Park, Florida. FPM has been consolidated with the
       Company as of June 1, 1998 (see Note 3).


                                       F-9
<PAGE>   55
                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2.     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

       CONSOLIDATION: The consolidated financial statements include those of the
       Company and its wholly-owned and majority owned subsidiaries; investments
       in unconsolidated affiliated companies are accounted for on the equity
       method.

       CASH AND SHORT-TERM INVESTMENTS: Cash and short-term investments include
       securities with original maturities of three months or less when
       purchased.

       PROPERTY AND EQUIPMENT: Property and equipment are recorded at cost.
       Depreciation expense is recorded on the straight-line basis over the
       assets' estimated useful lives. The useful lives of furniture and
       fixtures and computer equipment are estimated to be five years and three
       years, respectively. Building improvements are recorded at cost and
       amortized over the estimated useful lives of the improvements or the
       terms of the underlying lease, whichever is shorter. Routine maintenance,
       repair items, and customer facility and site improvements are charged to
       current operations.

       CONTRACTS: Contracts represent the fair value of management contracts and
       service contracts purchased and are being amortized using the
       straight-line method over seven years.

       GOODWILL: Goodwill represents the excess of cost over fair value of net
       assets acquired and is being amortized using the straight-line method
       over 40 years.

       LONG-LIVED AND INTANGIBLE ASSETS: The Company has adopted Statement of
       Financial Accounting Standards ("SFAS") No. 121, "Accounting for the
       Impairment of Long-lived Assets and Assets to be Disposed of." Under SFAS
       121, the Company recognizes impairment losses on property and equipment
       and intangible assets whenever events or changes in circumstances
       indicate that the carrying amount of long-lived assets, on an individual
       property basis, may not be recoverable through undiscounted future cash
       flows. Such losses are determined using estimated fair value or by
       comparing the sum of the expected future discounted net cash flows to the
       carrying amount of the asset. Impairment losses are recognized in
       operating income as they are determined.

       REVENUE: Contract management revenue is reported at the estimated net
       realizable amounts from contracted hospitals for contract management
       services rendered. Adjustments are accrued on an estimated basis in the
       period the related services are rendered and adjusted in future periods
       as final settlement is determined. Contract management revenue is based
       on a per diem calculation using patients per day, a fixed fee,
       admissions, discharges, direct expenses, or any combination of the
       preceding depending on the specific contract.

       Capitated patient services revenues are defined by contract and are
       calculated on a per-member/per-month fee, fixed fee and/or a fee for
       service basis. Capitated revenue is accrued in the same manner as
       contract management revenue. The Company bears the economic risk if
       capitated revenue is insufficient to meet the cost of behavioral health
       care services incurred by covered members. At August 31, 1998 capitated
       revenue was sufficient to meet these costs.

       Some management contracts include a clause which states that the Company
       will indemnify the hospital for any third-party payor denials, including
       Medicare. At the time the charges are denied, an allowance for 100% of
       the disputed amount is recorded by the Company. Management believes it
       has adequately provided for any potential adjustments that may result
       from final settlement of these denials.



                                      F-10
<PAGE>   56
                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       The customers of the Company are not concentrated in any specific
       geographic region, but are concentrated in the health care industry. At
       August 31, 1998, the Company had management contracts with 27 hospitals
       directly or indirectly owned by Columbia/HCA Healthcare Corporation
       ("Columbia/HCA"), all of which had programs in operation. These 27
       contracts accounted for 12.5% of the Company's net revenues for the year
       ended August 31, 1998. In the aggregate, including terminated contracts,
       revenues generated by hospitals directly or indirectly owned by
       Columbia/HCA accounted for 20.3%, 20.3%, and 15.4% of the Company's net
       revenues for the years ended August 31, 1996, 1997, and 1998. Of the 27
       Columbia/HCA contracts at August 31, 1998, 9 contracts contain a
       provision limiting the number of contracts which Columbia/HCA can cancel
       without cause to 33.3% during any calendar year. The termination or
       non-renewal of all or a substantial part of the management contracts with
       hospitals owned by Columbia/HCA could have a material adverse effect on
       the Company's business, financial condition or results of operations.

       At August 31, 1997 and 1998, accounts receivable from hospitals directly
       or indirectly owned by Columbia/HCA were approximately $2,089,000 and
       $1,756,649, respectively. The Company generally does not require
       collateral to support outstanding accounts receivable.

       ADVERTISING COSTS:  The Company expenses advertising costs as incurred.

       OUTSTANDING MEDICAL CLAIMS: Outstanding claims include medical claims and
       related expenses reported but not paid and an estimate of costs incurred
       but not reported (IBNR) to the Company by health care providers.
       Management of the Company estimated IBNR costs utilizing the Company's
       historical experience and current factors.

       INCOME TAXES: The Company has adopted SFAS No. 109, "Accounting for
       Income Taxes." SFAS 109 generally requires an asset and liability
       approach and requires recognition of deferred tax assets and liabilities
       resulting from differing book and tax bases of assets and liabilities. It
       requires that deferred tax assets and liabilities be determined using the
       tax rate expected to apply to taxable income in the periods in which the
       deferred tax asset or liability is expected to be realized or settled.
       Under this method, future financial results will be impacted by the
       effect of changes in income tax rates on cumulative deferred income tax
       balances.

       EARNING PER SHARE: Earnings per share has been computed in accordance
       with Statement of Financial Accounting Standards No. 128, "Earnings Per
       Share" ("SFAS 128"). Basic earnings per share is computed by dividing
       income available to common stockholders by the weighted-average number of
       common shares outstanding for the period. Diluted earnings per share
       reflects the potential dilution that could occur if the Company's stock
       options and warrants were exercised. Such dilutive potential common
       shares are calculated using the treasury stock method. All prior-period
       earnings per share data presented has been restated in accordance with
       SFAS 128. All shares and per share data, except par value per share, have
       been retroactively adjusted to reflect a three for two stock split
       effected as a 50% stock dividend by the Company on January 31, 1997.

       FINANCIAL INSTRUMENTS: Financial instruments consist of cash and
       short-term investments, accounts receivable, current liabilities and
       long-term debt obligations. The carrying amounts reported in the balance
       sheets for these financial instruments approximate fair value.

       USE OF ESTIMATES: The Company has made a number of estimates and
       assumptions relating to the reporting of assets and liabilities and the
       disclosure of contingent assets and liabilities at the date of the
       financial statements and the reported amounts of revenues and expenses
       during the reporting period to prepare these financial statements in
       conformity with generally accepted accounting principles. Actual results
       could differ from those estimates.


                                      F-11
<PAGE>   57
                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       RECLASSIFICATIONS: Certain prior year amounts have been reclassified to
       conform to the current year presentation.

       NEW ACCOUNTING STANDARDS: In June 1997, the Financial Accounting
       Standards Board issued Statement of Financial Accounting Standard No.
       130, "Reporting Comprehensive Income," which establishes standards for
       reporting and display of comprehensive income and its components. SFAS
       No. 130 is effective for the Company for fiscal years beginning after
       December 15, 1997, and requires reclassification of financial statements
       in earlier periods for comparative purposes. Adoption of this Statement
       is not expected to have a material impact on the presentation of the
       Company's financial statements.

       In June 1997, the Financial Accounting Standards Board issued Statement
       of Financial Accounting Standards No. 131, "Disclosures About Segments of
       an Enterprise and Related Information," which establishes standards for
       the way that public business enterprises report information about
       operating segments in interim and annual financial statements. SFAS No.
       131 is effective for the Company for fiscal years beginning after
       December 15, 1997, and requires comparative information for earlier years
       to be restated. Management has not yet completed its assessment of how
       this Statement will impact segment disclosures.

       In June 1998, the Financial Accounting Standards Board issued Statement
       of Financial Accounting Standard No. 133, "Accounting for Derivative
       Instruments and Hedging Activities," which establishes accounting and
       reporting standards for derivative instruments and for hedging
       activities. It requires that an entity recognize all derivatives as
       either assets or liabilities in the statement of financial position and
       measure those instruments at fair value. SFAS 133 is effective for all
       fiscal quarters of fiscal years beginning after June 15, 1999. Adoption
       of this Statement is not expected to have a material impact on the
       presentation of the Company's financial statements

3.     ACQUISITIONS

       FPM BEHAVIORAL HEALTH, INC.

       Effective June 1, 1998, the Company acquired all of the outstanding
       capital stock of FPM Behavioral Health, Inc. of Winter Park, Florida, and
       FPM has been consolidated with the Company as of June 1, 1998. The
       Company accounted for the acquisition of FPM by the purchase method as
       required by generally accepted accounting principles. FPM provides
       managed behavioral health care services, employee assistance programs and
       other related health care services to health maintenance organizations
       and self-insured employers. FPM had total revenues of approximately $19.9
       million for the nine months ended March 31, 1998 and, at February 28,
       1998, FPM had 46 contracts covering 1,135,000 lives in nine states. FPM
       provides its services both through health care professionals employed by
       FPM and through independent health care professionals that have been
       contracted with FPM on a fee-for-service basis. At April 1998, the FPM
       provider network was composed of over 2,000 providers. The purchase price
       was $20.0 million in cash, subject to certain post closing adjustments,
       and was funded by incurring debt of $20.0 million under the term loan
       facility. The preliminary allocation of the purchase price exceeded the
       fair value of FPM's tangible net assets by $22,170,668, of which
       $20,665,912 is recorded as goodwill and $1,504,756 as service contracts.
       Tangible assets acquired and liabilities assumed totaled $3,301,876 and
       $5,472,544, respectively.

       The unaudited pro forma combined results of the Company and FPM for the
       years ended August 31, 1997 and 1998 after giving effect to certain pro
       forma adjustments are presented at the end of this footnote.





                                      F-12
<PAGE>   58

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       ACORN

       Effective October 31, 1997, the Company acquired all of the outstanding
       capital stock of Acorn. The Company accounted for the acquisition of
       Acorn by the purchase method as required by generally accepted accounting
       principles. Acorn provides employee assistance programs and other related
       services to self-insured employers. Acorn had total revenues of
       approximately $7.0 million for the year ended August 31, 1997. The
       purchase price of approximately $12.7 million in cash was funded from
       $1.7 million of working capital and $11.0 million from an advance under
       the Company's existing revolving credit facility with Texas Commerce
       Bank, N.A., (now known as Chase Bank of Texas, National Association). The
       purchase price exceeded the fair value of Acorn's tangible net assets by
       $12,629,261, of which $9,258,513 is recorded as goodwill and $3,370,748
       as service contracts. Tangible assets acquired and liabilities assumed
       totaled $274,929 and $177,832 respectively.

       The unaudited pro forma combined results of operations of the Company and
       Acorn for the years ended August 31, 1997 and 1998 after giving effect to
       certain pro forma adjustments are presented at the end of this footnote.

       SPECIALTY HEALTHCARE MANAGEMENT, INC.

       On August 11, 1997, the Company exchanged 1,400,000 shares of its common
       stock for all of the outstanding common stock of Specialty Healthcare
       Management, Inc. The exchange has been accounted for under the pooling of
       interests method. Accordingly, all financial statements presented have
       been restated to include the results of Specialty. Prior to the exchange
       Specialty prepared its financial statements on a December 31 calendar
       year end which has subsequently been changed to conform to the Company's
       fiscal year end.

       For purposes of recording the pooling of interests combination,
       Specialty's financial statements for the twelve months ended December 31,
       1996 were combined with Horizon Health Corporation's ("Horizon")
       financial statements for the twelve months ended August 31, 1996.
       Specialty's results of operations for the twelve months ended August 31,
       1997 have been combined with Horizon's results of operations for the same
       period. The operations of Specialty for the four months ended December
       31, 1996, resulting in net revenues and net income of $10.8 million and
       $849,055, respectively, have been included in the statement of income for
       both the year ended August 31, 1996 and 1997. As a result, an adjustment
       was made to stockholders' equity in the consolidated financial statements
       of the Company to eliminate the effect of including Specialty's net
       income for the four months in both periods. Additionally, the
       consolidated statement of cash flows was adjusted to reflect the cash
       flows of Specialty for the four months ended December 31, 1996.
















                                      F-13
<PAGE>   59

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       Combined and separate results of Horizon and Specialty during periods
       preceding the exchange were as follows (in thousands):

<TABLE>
<CAPTION>
                                                                                   Nine months
                                                         Twelve months                ended
                                                             ended                 May 31, 1997
                                                        August 31, 1996            (unaudited)
                                                       ------------------       -------------------
<S>                                                    <C>                      <C>                
                           Revenues:
                           Horizon                     $           62,445       $            57,894
                           Specialty                               33,794 (a)                23,286
                           Combined                                96,239                    81,180

                           Net Income:
                           Horizon                     $            5,564       $             5,483
                           Specialty                                1,212 (a)                   871
                           Combined                                 6,776                     6,354
</TABLE>

       (a) For the fiscal year ended December 31, 1996.

       Merger expenses of $3,527,671, before a related tax benefit of
       $1,340,515, include legal, investment banking and accounting fees.

       GERIATRIC MEDICAL CARE, INC.

       Effective March 15, 1997, the Company purchased all of the outstanding
       capital stock of Geriatric Medical Care, Inc., a Tennessee corporation,
       and Geriatric has been consolidated with the Company as of March 15,
       1997. The Company accounted for the acquisition of Geriatric by the
       purchase method as required by generally accepted accounting principles.
       Geriatric is a contract manager of mental health services for acute care
       hospitals. Geriatric had total revenues of approximately $5.7 million in
       1996 and, at March 15, 1997, had 18 management contract locations, of
       which three were not yet in operation. The purchase price of
       approximately $4.6 million, of which approximately $4.3 million was paid
       at closing from existing cash of the Company, included retiring
       essentially all of Geriatric's outstanding debt. The final purchase price
       payment of $270,000 was made on April 16, 1997. The purchase price
       exceeded the fair value of Geriatric's tangible net assets by $5,005,986,
       of which $4,498,038 is recorded as goodwill and $507,948 as management
       contracts. Tangible assets acquired and liabilities assumed totaled
       $1,042,683 and $1,421,931, respectively. Pro forma financial data is not
       presented because the impact of this acquisition is not material to the
       Company's results of operations for any period presented.





                                      F-14
<PAGE>   60

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       CLAY CARE, INC.

       Also effective March 15, 1997, the Company purchased all of the
       outstanding capital stock of Clay Care, Inc., a Texas corporation, and
       CCI has been consolidated with the Company as of March 15, 1997. The
       Company accounted for the acquisition of CCI by the purchase method as
       required by generally accepted accounting principles. CCI was a contract
       manager of mental health services for acute care hospitals. At March 15,
       1997, CCI had management contracts with five hospitals of which four were
       in operation and one of which opened in April 1997. CCI had total
       revenues of approximately $1.3 million in 1996. A total of $475,000 of
       the $1,000,000 purchase price was paid at the closing from existing cash
       of the Company. The remaining $525,000 of the total purchase price was
       paid by the Company in April 1997 and June 1997. The purchase price
       exceeded the fair value of CCI's tangible net assets by $855,738, of
       which $714,672 is recorded as goodwill and $141,066 as management
       contracts. Tangible assets acquired and liabilities assumed totaled
       $201,794 and $57,532, respectively. Pro forma financial data is not
       presented because the impact of this acquisition is not material to the
       Company's results of operations for any period presented.

       PPS

       On July 31, 1996, the Company acquired eighty percent (80%) of the
       outstanding common stock of Florida Professional Psychological Services,
       Inc., also known as Professional Psychological Services, Inc., and PPS
       has been consolidated with the Company as of August 1, 1996. The Company
       accounted for the acquisition of PPS by the purchase method as required
       by generally accepted accounting principles. Based in Clearwater,
       Florida, PPS specializes in full risk, capitated managed behavioral
       health programs and employee assistance programs. The final purchase
       price of $3,324,310 was based primarily on a multiple of the 1996 pre-tax
       income of PPS. The purchase price exceeded the fair value of PPS' net
       assets by $3,298,885 which is recorded as goodwill. Assets acquired and
       liabilities assumed totaled $540,960 and $515,535, respectively. Cash
       payments for the purchase of PPS, net of cash acquired, were $786,767 and
       $1,898,230 during 1996 and 1997, respectively. The final payment of
       $200,985 was made on September 30, 1997.

       On February 27, 1998, the Company acquired an additional sixteen percent
       (16%) of the outstanding common stock of PPS. The Company accounted for
       the acquisition of PPS by the purchase method as required by generally
       accepted accounting principles. The purchase price of $831,879 was based
       primarily on a multiple of the 1997 pre-tax income of PPS. The purchase
       price exceeded the fair market value of PPS's tangible net assets
       acquired by $764,400 of which $560,315 is recorded as goodwill and
       $204,085 as service contracts. Tangible assets acquired and liabilities
       assumed totaled $147,072 and $79,593, respectively. On March 10, 1998,
       the Company acquired the remaining four percent (4%) of the outstanding
       common stock of PPS, under similar terms, for a purchase price of
       $207,970. The Company accounted for the acquisition by the purchase
       method as required by generally accepted accounting principles. The
       purchase price exceeded the fair value of PPS's tangible assets acquired
       by $192,332 of which $141,311 is recorded as goodwill and $51,021 as
       service contracts. Tangible assets acquired and liabilities assumed
       totaled $35,536 and $19,898 respectively. The acquisitions were funded by
       incurring debt of approximately $1.0 million under the term loan
       facility. Pro forma financial data is not presented because the impact of
       this acquisition is not material to the Company's results of operations
       for any period presented.






                                      F-15
<PAGE>   61

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       PARKSIDE COMPANY

       Effective April 1, 1996, the Company purchased all of the outstanding
       capital stock of the Parkside Company, and Parkside has been consolidated
       with the Company as of April 1, 1996. The Company accounted for the
       acquisition of Parkside by the purchase method as required by generally
       accepted accounting principles. Parkside is a contract manager of mental
       health services for acute care hospitals. The purchase price of $3.5
       million included approximately $2,600,000 in cash and 192,437 shares of
       the Company's common stock. The purchase price exceeded the fair value of
       Parkside's tangible net assets by $3,500,000, of which $1,400,000 is
       recorded as goodwill and $2,100,000 as management contracts.

       NATIONAL MEDICAL MANAGEMENT SERVICES

       Effective January 3, 1995, the Company acquired the net assets and
       operations of National Medical Management Services, a division of
       National Medical Enterprises, Inc. (the "Division") and the Division has
       been consolidated with the Company as of January 3, 1995 (see Note 9).
       The Company accounted for the acquisition by the purchase method as
       required by generally accepted accounting principles. The purchase price
       exceeded the fair value of the net assets acquired by $1,120,350, of
       which $120,350 is recorded as goodwill and $1,000,000 as management
       contacts. Tangible assets acquired and liabilities assumed totaled
       $6,755,415 and $2,808,566, respectively.

       The following unaudited pro forma financial information gives effect to
       the acquisitions by the Company of Acorn and FPM as if the acquisitions
       occurred on September 1, 1996.

<TABLE>
<CAPTION>
                                                                    Year Ended
                                                                    August 31,
                                                       -----------------------------------
                                                             1997                1998
                                                       ---------------     ---------------
<S>                                                    <C>                 <C>            
                 Revenue                               $   139,688,095     $   145,063,467
                                                       ===============     ===============

                 Net Income                            $     6,286,235     $     9,245,713
                                                       ===============     ===============
                 Net Income per common share:
                      Basic                            $          0.91     $          1.30
                                                       ===============     ===============

                      Diluted                          $          0.82     $          1.19
                                                       ===============     ===============
</TABLE>

4.     ACCRUED EXPENSES

       Accrued expenses consisted of the following at August 31, 1997 and 1998:

<TABLE>
<CAPTION>
                                                                    August 31,
                                                       -----------------------------------
                                                             1997                1998
                                                       ---------------     ---------------
<S>                                                    <C>                 <C>            
         Reserve for contract adjustments              $     1,287,664     $       920,295
         Health insurance                                      936,639             853,561
         Outstanding  medical claims                           416,522           3,002,345
         Other                                               4,932,104           3,158,715
                                                       ---------------     ---------------

                                                       $     7,572,929     $     7,934,916
                                                       ---------------     ---------------
</TABLE>

                                      F-16
<PAGE>   62

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

5.     LONG-TERM DEBT

       At August 31, 1997 and 1998, the Company had the following long-term
       debt:

<TABLE>
<CAPTION>
                                                                                        August 31,
                                                                           -----------------------------------
                                                                                 1997                1998
                                                                           ---------------     ---------------
<S>                                                                        <C>                 <C>            
         Chase Bank of  Texas, National Association - Advance Term
         Loan Facility                                                     $          --       $    23,000,000
                                                                                               ---------------
         Chase Bank of  Texas, National Association - Revolving Credit
         Facility                                                                     --             3,000,000
         SANWA Leasing Corporation                                                    --                29,371
                                                                           ---------------     ---------------
                                                                                      --            26,029,371
                                                                           ---------------     ---------------
         Less current maturities                                                      --                18,470
                                                                           ===============     ===============
                                                                           $          --       $    26,010,901
                                                                           ===============     ===============
</TABLE>


       The aggregate maturities of long-term debt during the next five fiscal
       years are $0 in 1999, $3,460,901 in 2000, $7,600,000 in 2001, $4,600,000
       in 2002, and $10,350,000 in 2003.

       Effective September 29, 1995, the Company entered into a loan agreement
       with Texas Commerce Bank (now known as Chase Bank of Texas, National
       Association) for a revolving line of credit with maximum advance
       commitment of $11,000,000. On October 16, 1997, the Company increased its
       existing revolving line of credit from $11.0 million to $14.0 million.

       On December 9, 1997, the Company entered into a Credit Agreement (the
       "Credit Agreement") with Texas Commerce Bank, National Association (now
       known as Chase Bank of Texas, National Association), as Agent for itself
       and other lenders party to the Credit Agreement for a senior secured
       credit facility in an aggregate amount of up to $50.0 million (the "New
       Credit Facility"). The New Credit Facility consists of a $10.0 million
       revolving credit facility to fund ongoing working capital requirements
       and a $40.0 million advance term loan facility to refinance certain
       existing debt and to finance future acquisitions by the Company. The New
       Credit Facility replaced the Company's existing $14.0 million revolving
       credit facility.

       The Revolving Credit Facility terminates November 30, 2000 and the
       Advance Term Loan Facility has a term of five years, with drawdowns
       available until November 30, 1999. Amounts outstanding under the Advance
       Term Loan Facility on November 30, 1999 are to be repaid in twelve
       quarterly principal payments, beginning February 28, 2000, based upon a
       five year amortization schedule with the first eleven principal payments
       being 1/20th of the outstanding balance on November 30, 1999, and the
       twelfth being the remaining unpaid principal balance. Principal
       outstanding under the New Credit Facility bears interest at the "Base
       Rate" (the greater of the Agent's "prime rate" or the federal funds rate
       plus .5%) plus 0% to .5% (depending on the Company's Indebtedness to
       EBITDA Ratio as defined in the Credit Agreement) or the "Eurodollar Rate"
       plus .75% to 1.5% (depending on the Indebtedness to EBITDA Ratio), as
       selected by the Company. The Company incurs quarterly commitment fees
       ranging from .25% to .375% per annum (depending on the Indebtedness to
       EBITDA Ratio) on the unused portion of the Revolving Credit Facility
       (until November 30, 2000) and unused portion of the Advance Term Loan
       Facility (until November 30, 1999). The weighted average interest rate of
       the New Credit Facility debt was 6.4375% at August 31, 1998.




                                      F-17


<PAGE>   63

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       The Company is subject to certain covenants which include prohibitions
       against (i) incurring additional debt or liens, except specified
       permitted debt or permitted liens, (ii) certain material acquisitions,
       other than specified permitted acquisitions (including any single
       acquisition not greater than $10.0 million or cumulative acquisitions not
       in excess of $20.0 million during any twelve consecutive monthly
       periods), (iii) certain mergers, consolidations or asset dispositions by
       the Company or changes of control of the Company, (iv) certain management
       vacancies at the Company, and (v) material change in the nature of
       business conducted. If the aggregate outstanding principal amount of the
       Advance Term Loan Facility equals or exceeds Fifteen Million Dollars
       ($15,000,000) as of the date ninety (90) days after the end of a Fiscal
       year (the "Excess Cash Flow Payment Date") beginning with the fiscal year
       ending August 31, 1998, then Borrower shall repay the Advance Term Loan
       Facility on or before the Excess Cash Flow Date relating to such fiscal
       year in an amount equal to fifty percent (50%) of the Excess Cash Flow,
       as defined, calculated for the fiscal year then most recently ended on
       the basis of the audited financial statement for such fiscal year. In
       addition, the terms of the New Credit Facility require the Company to
       satisfy certain ongoing financial covenants. The New Credit Facility is
       secured by a first lien or first priority security interest in and/or
       pledge of substantially all of the assets of the Company and of all
       present and future subsidiaries of the Company.

       The Company currently has a capitalized lease for computer equipment with
       SANWA Leasing Corporation. The lease contains a bargain purchase option.


6.     STOCK OPTIONS

       The 1989, 1995 and 1998 Stock Option Plans and the 1995 Stock Option Plan
       for Eligible Outside Directors are collectively referred to as "The
       Plans."

       In accordance with the Plans, as amended, 2,581,843 shares of common
       stock have been reserved for grant to key employees, directors and
       consultants. Management believes the exercise prices of the options
       granted approximated or exceeded the market value of the common stock at
       the date of the grant. The options generally vest ratably over five years
       from the date of grant and terminate 10 years from the date of grant.

       On April 28, 1995 the board of directors created the 1995 Stock Option
       Plan for Eligible Outside Directors for outside directors owning less
       than 5% of the stock of the Company. 150,000 shares of common stock are
       reserved for issuance under this plan. This plan has been amended and
       restated to provide for 3,000 option grants to each eligible director
       each time he is re-elected to the board after having served as a director
       for at least one year since his initial grant under the plan. Options
       vest ratably over five years from the date of grant.

       On January 23, 1998, the Stockholders of the Company approved the 1998
       Stock Option Plan. The purpose of the Plan is to give the Company a
       competitive advantage in attracting, retaining and motivating directors,
       officers, key employees and consultants and to provide the Company and
       its subsidiaries with a stock option plan providing incentives directly
       linked to the profitability of the Company's businesses and increases in
       shareholder value. Under this plan, 500,000 shares of common stock are
       reserved for issuance.




                                      F-18
<PAGE>   64

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       The following table summarizes the status of the Plans:


<TABLE>
<CAPTION>
                                                       1996                            1997                         1998
                                          ----------------------------     --------------------------   ---------------------------
                                                           Weighted                         Weighted                      Weighted
                                                            Average                          Average                       Average
                                                           Exercise                         Exercise                      Exercise
                                           Options           Price            Options         Price       Options          Price
                                          -----------    -------------     -------------   ----------   ------------     ----------
<S>                                       <C>            <C>               <C>             <C>          <C>              <C>       
       Outstanding at beginning             1,411,268    $        2.33     $   1,521,328   $    4.04    $  1,451,843     $     4.62
       of year    
            Granted                           255,750            11.96            49,500       20.15         186,500          23.37
            Exercised                         130,690              .79            90,735        1.81         265,050           1.79
            Expired or canceled                15,000             6.40            28,250        9.72          12,000          10.31

       Outstanding at end of year           1,521,328    $        4.04     $   1,451,843   $    4.62    $  1,361,293           7.69

       Exercisable at end of year             532,452    $        1.62     $     728,166   $    1.98    $    781,113           2.96

       Available for grant at end             304,500             --             283,250        --           608,750           --
       of year
</TABLE>


       The following table summarizes information about options outstanding
       under the Plans at August 31, 1998.

<TABLE>
<CAPTION>
                                                 Options Outstanding                     Options Exercisable
                                    ----------------------------------------------  ------------------------------
                                                      Weighted
                                                       Average         Weighted                         Weighted
                                                      Remaining         Average                          Average
                                         Number      Contractual       Exercise         Number          Exercise
           Range of Exercise Price    Outstanding       Life             Price        Outstanding         Price
          ------------------------  --------------  --------------  --------------  --------------  --------------
<S>                                 <C>             <C>             <C>             <C>             <C>   
          $  0.50 - $  4.00               844,593            5.08   $        2.33   $      704,037            2.05
          $  7.42 - $  9.75               161,450            6.91            9.12           47,826            8.58
          $14.17 - $26.00                 355,250            8.62           19.79           29,250           15.68
</TABLE>

       The Company applies APB 25 in accounting for the Plans and recognizes no
       compensation cost in net earnings from the grant of options as options
       are granted at exercise prices equal to the current stock price. Had
       compensation cost been determined under the terms of SFAS 123, the
       Company's pro forma 1996, 1997 and 1998 net earnings and earnings per
       share would have been:

<TABLE>
<CAPTION>
                                               1996              1997              1998
                                        ----------------  ----------------  ---------------
<S>                                     <C>               <C>               <C>             
Net Earnings
     As reported                        $      6,775,756  $      6,656,016  $      9,731,995
     Pro forma (unaudited)              $      6,705,592  $      6,549,799  $      9,438,256

Earnings per share
     Basic
          As reported                   $           1.03  $           0.96  $           1.37
          Pro forma (unaudited)         $           1.02  $           0.95  $           1.33
     Diluted
          As reported                   $           0.90  $           0.87  $           1.26
          Pro forma (unaudited)         $           0.89  $           0.85  $           1.22
</TABLE>




                                      F-19
<PAGE>   65
                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       In accordance with SFAS 123, the fair value of options at date of grant
       was estimated using the Black-Scholes option-pricing model with the
       following weighted average assumptions:

<TABLE>
<CAPTION>
                                                           1996          1997          1998
                                                       ------------  ------------   -----------

<S>                                                    <C>           <C>            <C> 
                  Risk free interest rate                      6.2%          6.3%          6.1%
                  Expected life (years)                        6.6           6.6           6.6
                  Expected volatility                         33.2%         30.3%         30.4%
                  Expected dividend yield                      0.0%          0.0%          0.0%
</TABLE>

       In accordance with SFAS 123, the weighted average fair value of options
       granted during 1996, 1997 and 1998 was $4.43, $7.28 and $10.59,
       respectively.

       On April 1, 1996, the Company filed an S-8 registration statement which
       registered 2,054,549 shares granted or eligible for granting to employees
       and directors under the 1989 and 1995 stock option plans, as amended, and
       the outside director stock option plan. This registration includes a
       separate reoffer prospectus to allow any shares issued in the future and
       most previously exercised shares under the 1989 and 1995 stock options to
       be traded at any time without holding period or volume restrictions.

7.     INCOME TAXES

       Deferred taxes are provided for those items reported in different periods
       for income tax and financial reporting purposes. Income tax expense is
       comprised of the following components:

<TABLE>
<CAPTION>
                                                Federal           State            Total
                                             ------------     ------------     ------------
<S>                                          <C>              <C>              <C>         
         Year ended August 31, 1996
              Current                        $  3,835,706     $    770,743     $  4,606,449
              Deferred                              2,606              305            2,911
                                             ------------     ------------     ------------

                                             $  3,838,312     $    771,048     $  4,609,360
                                             ------------     ------------     ------------

         Year ended August 31, 1997
              Current                        $  3,957,913     $    465,636     $  4,423,549
              Deferred                             84,230            9,909           94,139
                                             ------------     ------------     ------------

                                             $  4,042,143     $    475,545     $  4,517,688
                                             ------------     ------------     ------------

         Year ended August 31, 1998
              Current                        $  5,526,322     $    968,030     $  6,494,352
              Deferred                             16,471            3,989           20,460
                                             ------------     ------------     ------------

                                             $  5,542,793     $    972,019     $  6,514,812
                                             ------------     ------------     ------------
</TABLE>








                                      F-20

<PAGE>   66
                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       The components of the net deferred tax asset at August 31, 1997 and 1998
       were obtained using the liability method in accordance with SFAS No. 109
       and are as follows:

<TABLE>
<CAPTION>
                                                        1997                  1998
                                                  ---------------      ---------------
<S>                                               <C>                  <C>             
         Contracts                                $    (1,377,276)     $    (1,165,792)
         Goodwill                                        (463,159)            (768,671)
                                                  ---------------      ---------------

         Deferred tax liabilities                      (1,840,435)          (1,934,463)
                                                  ---------------      ---------------

         Accounts receivable                              693,562              708,064
         Vacation accruals                                595,947              638,918
         Miscellaneous accruals                           398,004              659,898
         Fixed assets/intangibles                         332,015              171,757
         Net operating loss carryforward                  520,715              435,174
                                                  ---------------      ---------------

         Deferred tax assets                            2,540,243            2,613,811
                                                  ---------------      ---------------

         Net deferred tax asset                   $       699,808      $       679,348
                                                  ===============      ===============
</TABLE>

       At August 31, 1998, the Company had available estimated, unused net
       operating loss carryforwards for tax purposes of approximately
       $1,100,000. These carryforwards may be utilized to offset future years'
       income and will begin to expire during 2006 if unused prior to that date.
       These carryforwards are subject to annual utilization limits in
       accordance with IRC Section 382.

       The following is a reconciliation of income taxes at the U.S. federal
       income tax rate to the income taxes reflected in the Consolidated
       Statements of Income:

<TABLE>
<CAPTION>
                                                                     1996             1997             1998
                                                                 ------------     ------------     ------------
<S>                                                              <C>              <C>              <C>         
         Federal income taxes based on 35% (34% in 1996,
              1997) of book income                               $  3,871,753     $  3,846,623     $  5,698,268
         Meals and entertainment, goodwill amortization
              and other permanent adjustments                         249,236          198,464          252,838
         State income taxes and other adjustments                     488,371          472,601          563,706
                                                                 ------------     ------------     ------------

                                                                 $  4,609,360     $  4,517,688     $  6,514,812
                                                                 ------------     ------------     ------------
</TABLE>




                                      F-21
<PAGE>   67
                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)


8.     COMMITMENTS AND CONTINGENCIES

       The Company leases various office facilities and equipment under
       operating leases. The following is a schedule of minimum rental payments
       under these leases which expire at various dates:

<TABLE>
<CAPTION>
                 Year ended August 31,
<S>                                                                                    <C>             
                      1999                                                             $      1,614,520
                      2000                                                                    1,209,654
                      2001                                                                      964,954
                      2002                                                                      432,157
                      2003                                                                      238,752
                                                                                       ----------------

                                                                                       $      4,460,037
                                                                                       ================
</TABLE>

       Rent expense for the years ended August 31, 1996, 1997, and 1998 totaled
       $864,931, $980,573, and $1,385,301, respectively.

       The Company leases a building it occupies as its executive offices and
       National Support Center in Lewisville, Texas. In connection with this
       lease transaction, the Company guaranteed a loan of approximately
       $900,000 by a financial institution to the building owner. The Company
       also agreed to purchase the leased building for approximately $4.5
       million at the end of the lease term if it is not sold to a third party,
       or the Company does not extend its lease.

       The Company is insured for professional and general liability on a
       claims-made policy, with additional tail coverage being obtained when
       necessary. Management is unaware of any claims against the Company that
       would cause the final expenses for professional and general liability to
       vary materially from amounts provided.

       Effective June 1, 1998, the Company acquired all of the outstanding
       capital stock of FPM. The purchase price was $20.0 million in cash
       subject to certain post-closing adjustments. The post-closing
       adjustments, which have not yet been finalized, are limited to
       $2,000,000.

       Recent amendments to the Medicare regulations established maximum
       reimbursement amounts on a per case basis for both inpatient mental
       health and physical rehabilitation services. The limitations have
       resulted, in some cases, in decreased amounts reimbursed to the Company's
       client hospitals. This decrease in reimbursement has, in some cases, led
       to the renegotiation of lower contract management fees and in other cases
       has resulted in the termination or nonrenewal of the management contract.
       Certain of the Company's existing contracts may be similarly
       renegotiated.

       The Company is involved in litigation arising in the ordinary course of
       business, including matters involving professional liability. It is the
       opinion of management that the ultimate disposition of such litigation
       would not be in excess of any reserves or have a material adverse effect
       on the Company's financial position or results of operations.




                                      F-22
<PAGE>   68
                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

9.     COMMON STOCK AND WARRANTS

       As part of the purchase of National Medical Management Services,
       effective January 3, 1995, the Company issued warrants to National
       Medical Enterprises, Inc. to purchase 171,793 shares of common stock at
       an exercise price of $0.000558 per share. The warrants were exercisable
       at any time subsequent to January 3, 1997 and the exercise price and
       number of shares were adjustable to maintain proportional ownership of
       the Company. The value of the warrants at the date of issuance was
       determined to be $389,350. The remaining warrants of 179,178 at August
       11, 1997 were exercised in connection with the Specialty exchange (see
       Note 3). In conjunction with the purchase transaction the Company issued
       additional shares to existing management shareholders, other senior
       management and an outside shareholder. The proceeds from the sale of
       these shares were used in the purchase transaction. Certain management
       acquired shares through note receivable arrangements and the outstanding
       balance on these notes has been reflected as a reduction of shareholders'
       equity in the statement of changes in stockholders' equity. These notes
       were paid in full as of August 31, 1997.

       The Board of Directors of the Company approved a three-for-two stock
       split effected in the form of a 50% stock dividend, pursuant to which one
       additional share of Common Stock of the Company was issued on January 31,
       1997 for every two shares of Common Stock held by stockholders of record
       at the close of business on January 22, 1997. As a result of such stock
       split/dividend, a total of $18,253 originally recorded as additional paid
       in capital was reclassified as common stock. Such stock split/dividend
       has been retroactively reflected in the consolidated financial statements
       included in this report. Upon effecting the stock split/dividend, the
       stock options and their related exercise prices were adjusted
       proportionately.

       In February 1997, the Certificate of Incorporation, as amended, of the
       Company was amended to increase the number of authorized shares of Common
       Stock, $.01 par value per share, of the Company from 10,000,000 shares to
       40,000,000 shares.

       In February 1997, the Company entered into a Rights Agreement pursuant to
       which it approved the distribution of one Common Stock purchase right,
       exercisable under certain conditions, for each outstanding share of
       Common Stock of the Company.

10.      EARNINGS PER SHARE

       The Company has adopted the provisions of Statement of Financial
       Accounting Standards No. 128, "Earnings Per Share." All prior earnings
       per share data presented has been restated in accordance with SFAS 128.

       The following is a reconciliation of the numerators and the denominators
       of the basic and diluted earnings per share computations for net income.

<TABLE>
<CAPTION>
                                                            FOR THE YEARS ENDED AUGUST 31,
                       ----------------------------------------------------------------------------------------------------------
                                     1996                               1997                                  1998
                       ---------------------------------  ----------------------------------  -----------------------------------
                         Income       Shares    Per Share   Income       Shares     Per Share   Income       Shares     Per Share
                        Numerator  Denominator   Amount    Numerator   Denominator   Amount    Numerator   Denominator    Amount
                       ----------  ------------ --------  -----------  -----------  --------  -----------  -----------  ---------

<S>                    <C>         <C>          <C>       <C>          <C>          <C>       <C>          <C>          <C>  
Net Income............ $6,775,756                         $ 6,656,016                         $ 9,731,995 
BASIC EPS ............  6,775,756    6,561,481  $   1.03    6,656,016    6,928,827  $   0.96    9,731,995  7,120,303    $    1.37
                                                ========                            ========                            =========

EFFECT OF DILUTIVE
SECURITIES
Warrants and          
options..........                      948,567                             752,442                           634,164
                                   -----------                         -----------                         ---------
DILUTED                
EPS....................$6,775,756    7,510,048  $   0.90  $ 6,656,016    7,681,269  $   0.87  $ 9,731,995  7,754,467    $    1.26
                       ----------  -----------  --------  -----------  -----------  --------  -----------  ----------   ---------
</TABLE>



                                      F-23
<PAGE>   69

                           HORIZON HEALTH CORPORATION
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

       During 1997 and 1998 certain options to acquire common stock were not
       included in certain computations of EPS because the options exercise
       price was greater than the average market price of the common shares. The
       computation of the quarter ended August 31, 1997 excluded 5,054 options
       with an option price of $26.00 The computation of the quarter ended
       November 30, 1997 excluded 15,000 options with an option price of $26.00.
       The computations of the quarter ended February 28, 1998 excluded 183,222
       options with option prices ranging from $22.00 to $26.00. The computation
       of the quarter ended May 31, 1998 excluded 182,500 options with option
       prices ranging from $23.75 to $26.00. The computation of the quarter
       ended August 31, 1998 excluded 355,250 options with option prices ranging
       from $14.167 to $26.00. The year end calculations incorporate the above
       referenced exclusions within the applicable quarters.

       On September 1, 1998, the Company canceled 346,750 options with exercise
       prices ranging from $14.167 to $26.00, and granted 141,580 options with
       an exercise price of $7.00, the fair market value at the date of grant.
       In addition, the Company granted 428,000 options to employees and
       directors on September 1, 1998, with an exercise price of $7.00, the fair
       market value at the date of grant.


11.    QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

       The following is a summary of unaudited quarterly financial data for
       fiscal 1997 and 1998:

<TABLE>
<CAPTION>
                                                           Operating          Net                 Earnings Per Share
                                           Revenues         Income           Income           Basic            Diluted
                                        -------------    ------------     ------------     ------------     ------------
<S>                                     <C>              <C>              <C>              <C>              <C>         
            Quarter Ended:
                 November 30, 1996      $ 26,879,954     $  4,058,712     $  2,382,979     $       0.35     $       0.31
                 February 28, 1997        26,363,617        3,300,063        2,004,618             0.29             0.26
                 May 31, 1997             27,936,645        3,284,349        1,966,131             0.28             0.26
                 August 31, 1997          28,086,580          550,487          302,288             0.04             0.04

            Quarter Ended:
                 November 30, 1997      $ 29,322,412     $  4,193,319     $  2,523,995     $       0.36     $       0.23
                 February 28, 1998        29,400,471        4,417,075        2,555,886             0.36             0.33
                 May 31, 1998             28,827,606        4,081,228        2,726,335             0.38             0.35
                 August 31, 1998          36,267,360        3,515,548        1,925,779             0.27             0.25
</TABLE>

12.    RETIREMENT PLAN

       The Company sponsors a 401(k) plan that covers substantially all eligible
       employees. The Company can elect to make matching contributions at its
       discretion. For the years ended August 31, 1996, 1997 and 1998 the
       Company recognized matching contributions of approximately $350,000,
       $534,000, and $254,000 respectively.

13.    SUBSEQUENT EVENT

       ACQUISITION OF CHOICEHEALTH, INC.: Effective October 5, 1998, the Company
       acquired all of the outstanding capital stock of ChoiceHealth, Inc.
       ("ChoiceHealth") of Westminster, Colorado. The Company accounted for the
       acquisition of ChoiceHealth by the purchase method as required by
       generally accepted accounting principles. ChoiceHealth provides managed
       behavioral health care services, employee assistance programs and other
       related behavioral health care services to health maintenance
       organizations and self-insured employers. ChoiceHealth had annualized
       revenues of approximately $7.6 million (unaudited) based on actual
       revenues for the eight months ended August 31, 1998. The purchase price
       of approximately $2.0 million in cash was funded by $2.0 million from an
       advance under the Company's advance term loan facility.


                                      F-24

<PAGE>   70

                           HORIZON HEALTH CORPORATION
              NOTES TO CONSOLIDATED FINANCIAL STATEMENTS CONTINUED)

       STOCK REPURCHASE: On September 21, 1998, the Board of Directors of the
       Company authorized the repurchase of up to 1,000,000 shares of its common
       stock. The stock repurchase plan authorized the Company to make purchases
       from time to time in the open market or through privately negotiated
       transactions, depending on market conditions and applicable securities
       regulations. The repurchased shares will be added to the treasury shares
       of the Company and may be used for employee stock plans and for other
       corporate purposes. The stock will be repurchased utilizing available
       cash and borrowings under the Company's term bank facility.








                                      F-25

<PAGE>   71

                      INDEX TO FINANCIAL STATEMENT SCHEDULE


<TABLE>
<S>                                                                                                                  <C>
Report of Independent Accountants on Financial Statement Schedule.................................................... S-2

Schedule VIII Valuation and Qualifying Accounts...................................................................... S-3
</TABLE>




                                      S - 1


<PAGE>   72
                      REPORT OF INDEPENDENT ACCOUNTANTS ON
                          FINANCIAL STATEMENT SCHEDULE


To the Board of Directors and Stockholders
of Horizon Health Corporation


Our audits of the consolidated financial statements referred to in our report
dated October 12, 1998 appearing on page F-2 of this Annual Report on Form 10-K
also included an audit of the Financial Statement Schedule as listed in Item
14(a) of the Form 10-K. In our opinion, this Financial Statement Schedule
presents fairly, in all material respects, the information set forth herein when
read in conjunction with the related consolidated financial statements.




PRICEWATERHOUSECOOPERS LLP



Dallas, Texas
October 12, 1998



                                      S-2


<PAGE>   73

================================================================================

                           HORIZON HEALTH CORPORATION

                        VALUATION AND QUALIFYING ACCOUNTS



<TABLE>
<CAPTION>
                                                          Additions
                                         Balance at       Charged to      Uncollectible                              Balance
                                         Beginning        Costs and          Accounts                                 at End
                                         of Period         Expenses        Written Off          Adjustments          of Period 
                                        ------------     ------------     -------------        --------------      ------------

<S>                                     <C>              <C>              <C>                  <C>                 <C>         
Year ended August 31, 1994:
Allowance for doubtful accounts         $    605,365     $    312,176     $   (160,565)             --             $    756,976

Year ended August 31, 1995:
Allowance for doubtful accounts              756,976        1,680,396       (1,331,434)          249,099(1,2)         1,355,037

Year ended August 31, 1996:
Allowance for doubtful accounts            1,355,037        1,435,049         (343,990)          (58,474)(2)          2,387,622

Year ended August 31, 1997:
Allowance for doubtful accounts            2,387,622        3,033,693       (4,023,355)          (40,537)(2)          1,357,423


Year ended August 31, 1998:
Allowance for doubtful accounts         $  1,357,423          759,467         (401,910)          187,132(3)        $  1,902,112
</TABLE>


(1)      As a result of Horizon's acquisition of the 27.5% minority interest of
         MHM in the Horizon LLC effective March 20, 1995, the Horizon LLC was
         consolidated with Horizon for accounting purposes as of March 1, 1995.
         Amounts represent bad debt expenses of the Horizon LLC which were
         accounted for as "Equity in Net Earnings of Horizon LLC" through
         February 28, 1995.

(2)      Adjustment reflects reserves in which Horizon is aware that specific
         hospitals have experienced treatment day denials and to which a
         corresponding accounts receivable balance does not exist. These amounts
         are accrued as a liability.


(3)      Adjustment reflects reserves in which Horizon is aware that specific
         hospitals have experienced treatment day denials and to which a
         corresponding accounts receivable balance does not exist.  These
         amounts are accrued as a liability. In addition, adjustment reflects
         items reserved as other receivables, therefore their reserve is not
         included in the allowance for receivables.


                                      S-3

<PAGE>   74
                                INDEX TO EXHIBITS

<TABLE>
<CAPTION>
NUMBER            EXHIBIT

<S>     <C>                                                   
   3.1  -  Certificate of Incorporation of the Company, as amended (incorporated 
           herein by reference to Exhibit 3.1 to the Company's Current Report on
           Form 8-K dated August 11, 1997).

   3.2  -  Amended and Restated Bylaws of the Company, as amended (incorporated
           herein by reference to Exhibit 3.2 to Amendment No. 2 as filed with
           the Commission on February 16, 1995 ("Amendment No. 2") to the
           Company's Registration Statement on Form S-1 filed with the
           Commission on January 6, 1995 (Registration No. 33-88314) (the "Form
           S-1").

   4.1  -  Specimen certificate for the Common Stock, $.01 par value of the
           Company (incorporated herein by reference to Exhibit 4.1 to the
           Company's Current Report on Form 8-K dated August 11, 1997).

   4.2  -  Rights Agreement, dated February 6, 1997, between the Company and 
           American Stock Transfer & Trust Company, as Rights Agent
           (incorporated by reference to Exhibit 4.1 to the Company's
           Registration Statement on Form 8-A, Registration No. 000-22123, as
           filed with the Commission on February 7, 1997).

   10.1 -  Lease dated as of December 15, 1990 between Charter Hospital of Fort
           Collins, Inc. and HHG Colorado, Inc. (incorporated herein by
           reference to Exhibit 10.12 to the Company's Form S-1).

   10.2 -  Sublease Agreement dated as of July 31, 1997 between HHG Colorado, 
           Inc. and MHM of Colorado, Inc. (incorporated herein by reference to
           Exhibit 10.13 to the Company's Form S-1).

   10.3 -  Employment Agreement dated as of August 21, 1990 between Horizon
           Health Management Company, Inc. and Gary A. Kagan (incorporated
           herein by reference to Exhibit 10.44 to the Company's Form S-1).

   10.4 -  Letter dated November 23, 1992 between Horizon Mental Health 
           Services, Inc. and Robert A. Lefton regarding severance arrangements
           (incorporated herein by reference to Exhibit 10.45 to the Company's
           Form S-1).

   10.5 -  Agreed Permanent Injunction and Final Judgment dated December 8, 1994 
           (incorporated herein by reference to Exhibit 10.32 to the Company's
           Form S-1).

   10.6 -  Letter Loan Agreement dated December 20, 1995 among North Central
           Development Company, as borrower, Texas Commerce Bank, National
           Association, ("TCB") as lender, and Horizon Mental Health Management,
           Inc., a Delaware corporation, Horizon Mental Health Management, Inc.,
           a Texas corporation, and Mental Health Outcomes, Inc., a Delaware
           corporation, as guarantors (incorporated herein by reference to
           Exhibit 10.7 to the Company's Quarterly Report on Form 10-Q for the
           quarter ended November 30, 1995 (the "November 1995 Form 10-Q").

   10.7 -  First Amendment to Letter Loan Agreement and Note Modification 
           Agreement dated December 9, 1997 among North Central Development
           Company and its subsidiaries and TCB (incorporated herein by
           reference to Exhibit 10.3 to the Company's Quarterly Report on Form
           10-Q for the quarter ended November 30, 1997.)
</TABLE>





<PAGE>   75

<TABLE>
<S>        <C>                       
   10.8  - Lease Agreement dated as of December 20, 1995 between North Central
           Development Company and Horizon Mental Health Management, Inc., a
           Delaware corporation (incorporated herein by reference to Exhibit
           10.8 to the November 1995 Form 10-Q).

   10.9  - Horizon Health Group, Inc. 1989 Stock Option Plan, as amended 
           (incorporated herein by reference to Exhibit 10.52 of Amendment No. 2
           to the Company's Form S-1).

   10.10 - Horizon Mental Health Management, Inc. 1995 Stock Option Plan 
           (incorporated herein by reference to Exhibit 10.11 to the November
           1995 Form 10-Q).

   10.11 - Horizon Mental Health Management, Inc.  Amended and Restated 1995
           Stock Option Plan for Eligible Outside Directors (incorporated herein
           by reference to Exhibit 10.12 to the November 1995 Form 10-Q).

   10.12 - Amendments to 1989 Stock Option Plan and 1995 Stock Option Plan
           (incorporated herein by reference to Exhibit 10.5 to the Company's
           Current Report on Form 8-K dated September 1, 1997).

   10.13 - Amendments to 1995 Stock Option Plan and 1995 First Amended and
           Restated Stock Option Plan for Eligible Outside Directors
           (incorporated herein by reference to Exhibit 10.6 to the Company's
           Current Report on Form 8-K dated September 1, 1997).

   10.14 - Horizon Mental Health Management Bonus Plan Fiscal 1997 (incorporated
           herein by reference to Exhibit 10.36 to Amendment No. 1 to the
           Company's Annual Report on Form 10-K/A for the fiscal year ended
           August 31, 1996 (the "1996 Form 10-K/A")).

   10.15 - Horizon Mental Health Management Contingent Bonus Plan (incorporated
           herein by reference to Exhibit 10.37 to the Company's 1996 Form
           10-K/A).

   10.16 - Horizon Health Corporation Bonus Plan Fiscal 1998 (incorporated 
           herein by reference to Exhibit 10.21 to the Company's Annual Report
           on Form 10-K for the fiscal year ended August 31, 1997).

   10.17 - Horizon Health Corporation Bonus Plan Fiscal 1999 (filed herewith).

   10.18 - Amendment dated February 10, 1997 between the Company and the 
           stockholders of Florida Professional Psychological Services, Inc.
           (incorporated herein by reference to the Company's Quarterly Report
           on Form 10-Q for the quarter ended February 28, 1997, as filed with
           the Commission on March 31, 1997 (the "February 1997 Form 10-Q)).

   10.19 - Stock Purchase Agreement dated as of February 24, 1997, among the
           Company and Geriatric Medical Care, Inc. and its stockholders, as
           amended (incorporated herein by reference to Exhibit 10.1 to the
           Company's February 1997 Form 10-Q).

   10.20 - Share Exchange Reorganization Agreement dated as of April 25, 1997,
           among the Company, Howard B. Finkel, John Harrison, Larry Reiff,
           Argentum Capital Partners, L.P., Denise Dailey, Ken Dorman, G.
           Phillip Woellner, and Michael S. McCarthy, and Specialty Healthcare
           Management, Inc., as amended by a First Amendment to Share Exchange
           Reorganization Agreement dated as of July 2, 1997 (incorporated
           herein by reference to Appendix A to the definitive Proxy Statement
           filed with the Commission by the Company on July 11, 1997, relating
           to a Special Meeting of Stockholders of the Company to be held on
           August 11, 1997).
</TABLE>



<PAGE>   76

<TABLE>
<S>      <C>             
   10.21 - Post-Closing Escrow Agreement dated August 11, 1997 between the
           Company and Howard B. Finkel, as Agent (incorporated herein by
           reference to Exhibit 10.2 to the Company's Current Report on Form 8-K
           dated August 11, 1997).

   10.22 - Registration Rights Agreement dated August 11, 1997, between the
           Company and Howard B. Finkel, et al. (incorporated herein by
           reference to Exhibit 10.3 to the Company's Current Report on Form 8-K
           dated August 11, 1997).

   10.23 - Executive Retention Agreement effective September 1, 1997,
           between the Company and James Ken Newman (incorporated herein by
           reference to Exhibit 10.4 to the Company's Current Report on Form 8-K
           dated September 1, 1997).

   10.24 - Stock Purchase Agreement, dated October 20, 1997, among the Company,
           Dr. Melvyn S. Goldsmith, Ph.D., Barbara C. Goldsmith and Acorn
           Behavioral HealthCare Management Corporation (incorporated herein by
           reference to Exhibit 2.1 to the Company's Current Report on Form 8-K
           dated September 1, 1997).

   10.25 - Credit Agreement dated December 9, 1997 among the Company, Texas 
           Commerce Bank National Association, as Agent, and the banks named
           therein (incorporated herein by reference to Exhibit 10.2 to the
           Company's Quarterly Report on Form 10-Q for the quarter ended
           November 30, 1997).

   10.26 - Stock Purchase Agreement dated as of May 1, 1998, by and among
           Ramsay Managed Care, Inc., Ramsay Health Care, Inc., and the Company
           (incorporated herein by reference to Exhibit 10.1 to the Company's
           Current Report on Form 8-K dated June 2, 1998).

   11.1  - Statement Regarding Computation of Per Share Earnings (filed
           herewith).

   21.1  - List of Subsidiaries of the Company (filed herewith).

   23.1  - Consent of PricewaterhouseCoopers LLP (filed herewith).

   27.1  - Financial Data Schedule (filed herewith).

   (b)   The Company filed the following report on Form 8-K during the last
         quarter of the period covered by this report:
</TABLE>