<PAGE>
 
                    U.S. SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549
                                  Form 10-KSB

[X]  Annual report under section 13 or 15(d) of the Securities Exchange Act of
     1934 for the fiscal year ended December 31, 1996.
[_]  Transition report under section 13 or 15(d) of the Securities Exchange Act
     of 1934 for the transition period from _______________________ to
     ____________________.
Commission file number:  0-24988

                    LABORATORY SPECIALISTS OF AMERICA, INC.
                 (Name of small business issuer in its charter)
<TABLE>
<CAPTION>

<S>                                                               <C>
                           Oklahoma                                              73-145065
(State or other jurisdiction of incorporation or organization)      (I.R.S. Employer Identification No.)


                  101 Park Avenue, Suite 810
                   Oklahoma City, Oklahoma                                          73102
           (Address of principal executive offices)                              (Zip Code)


Issuer's telephone number:  (405) 232-9800


Securities to be registered under Section 12(b) of the Act:

                    Title of each class                           Name of each exchange on which registered
                           None                                                     None



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

                         Common Stock, $.001 par value
                               (Title of class)

</TABLE>

Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Securities Exchange Act during the past 12 months (or such
shorter period that the registrant was required to file such reports), and has
been subject to such filing requirements for the past 90 days.  Yes  X    No
                                                                   -----    ----
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B is not contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB.  [X]
Issuer's revenues for its most recent fiscal year was $8,726,799.
The aggregate market value of the voting stock held by non-affiliates based upon
the average bid and asked prices of such stock as of April 15, 1997, was
$5,672,212.
The number of outstanding of Common Stock as of April 14, 1997, was 3,313,405.

                     Transitional Small Business Disclosure
                              Format (Check one):
                                 Yes     No  X
                                     ---    ---
<PAGE>
 
                               TABLE OF CONTENTS
<TABLE>
<CAPTION>


                                                                                                                        PAGE
                                                                                                                        ----
<C>       <S>                                                                                                           <C>
Part I
Item 1.   Description of Business.......................................................................................   1
          Background....................................................................................................   1
                Acquisition by MBf USA..................................................................................   1
                Peterson Share Exchange.................................................................................   1
                LSI Acquisition.........................................................................................   1
                Private Placement and Prior Operations of LSAI..........................................................   2
                Initial Public Offering.................................................................................   2
                NDAC Asset Purchase.....................................................................................   2
                NPLI Acquisition........................................................................................   2
                PLL Asset Purchase......................................................................................   3
          Business......................................................................................................   3
          Industry Background...........................................................................................   4
          Expansion Strategy............................................................................................   4
          Drug Testing Operations.......................................................................................   6
          Contractual Arrangements......................................................................................   8
          Competition...................................................................................................   8
          Certification and Government Regulation.......................................................................   8
          Other Regulation..............................................................................................   9
          Environmental Matters.........................................................................................   9
          Employees.....................................................................................................   9
Item 2.   Description of Property.......................................................................................   9
Item 3.   Legal Proceedings.............................................................................................  10
Item 4.   Submission of Matters to a Vote of Security Holders...........................................................  11

Part II
Item 5.   Market for Common Equity and Related Stockholders Matters.....................................................  11
Item 6.   Management's Discussion and Analysis or Plan of Operation.....................................................  11
          Results of Operations.........................................................................................  12
          Liquidity and Capital Resources...............................................................................  15
          Future Operations and Liquidity...............................................................................  16
                Future Assessment of Recoverability and Impairment of Goodwill and Customer List........................  16
Item 7.   Financial Statements..........................................................................................  17
Item 8.   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure..........................  17

Part III
Item 9.   Directors, Executive Officers, Promoters and Control Persons; Compliance
          with Section 16(a) of the Exchange Act........................................................................  17
Item 10.  Executive Compensation........................................................................................  19
          Aggregate Option Grants and Exercises in 1995 and Year-End Options Values.....................................  20
          Compensation of Directors.....................................................................................  21
          Employment Arrangements.......................................................................................  21
          Stock Option Plan.............................................................................................  21
          Officer and Director Liability................................................................................  22
Item 11.  Security Ownership of Certain Beneficial Owners and Management................................................  23
Item 12.  Certain Relationships and Related Transactions................................................................  24
Item 13.  Exhibits and Reports on Form 8-K..............................................................................  24
          (a)  Exhibits.................................................................................................  24
          (b)  Reports on Form 8-K......................................................................................  25
</TABLE>
<PAGE>
 
Part I

Item 1.   Description of Business.

          Laboratory Specialists of America, Inc. (the "Company" or "LSAI"),
through its wholly-owned subsidiary, Laboratory Specialists, Inc. ("LSI"), owns
and operates an independent laboratory providing drug testing services to
corporate and institutional clients seeking to detect and deter the use of
illegal drugs. The drug testing market is in an expansion mode in part due to
the recent adoptions of additional Department of Transportation regulations,
which became effective in 1995, that substantially expanded the previous
regulations which mandated random drug testing of workers, especially in such
safety-sensitive jobs such as trucking, aviation, railroads and pipelines. Under
these new regulations, 50 percent of transportation workers (mass-transit
workers and interstate truckers and bus drivers) will be required to be tested
annually.

          LSI is certified by the Substance Abuse and Mental Health Services
Administration ("SAMHSA"), a federal agency and regulatory successor to the
National Institute on Drug Abuse ("NIDA"), to conduct drug testing using legally
defensible (forensic) procedures required for legal defensibility of test
results.  The essential elements of these procedures are a secure chain-of-
custody for each specimen from collection to the reporting of test results and
accurate and reliable testing in which a second independent test is performed to
confirm each positive test result.  The drug testing services offered by LSI
also include assisting clients with the development of drug testing programs,
training client personnel, managing specimen collection, arranging for
transportation of specimens to LSI's laboratory, identifying trends in local and
national drug use, interpreting test results, and providing expert testimony
concerning challenged test results.  All of these services are customized to the
individual needs of the clients to assist in the implementation and cost-
effective maintenance of test programs.

          LSAI was incorporated in Oklahoma on March 24, 1994, and its executive
offices are located at 101 Park Avenue, Suite 810, Oklahoma City, Oklahoma 73102
and its telephone number is (405) 232-9800.  LSI was incorporated in 1978 in
Louisiana, and its executive offices and laboratory are located at 113 Jarrell
Drive, Belle Chasse, Louisiana 70037, which is near New Orleans, and its
telephone numbers are (504) 392-7961 and (800) 433-3823.

Background

          Peterson Share Exchange. In April 1994, LSI issued 706,244 shares of
LSI Preferred Stock to MBf USA, Inc. ("MBf USA") with a stated value of $1.00
per share, and pursuant to a Stock Exchange Agreement, MBf USA transferred to
Arthur R. Peterson, Jr. all of the outstanding common stock of LSI in exchange
for 1,300,000 shares of the common stock of MBf USA (having a market value of
$1,178,125), and, effective February 23, 1994, LSI issued a promissory note (the
"MBf USA Promissory Note") in the principal amount of $353,123 to MBf USA, which
resulted in LSI ceasing to be a wholly-owned subsidiary of MBf USA (the
"Peterson Share Exchange"). The MBf Promissory Note bears interest at the rate
of seven percent per annum and becomes due and payable on February 23, 1999. The
acquisition of the LSI common stock by Mr. Peterson was accounted for under the
purchase method of accounting. The purchase price exceeded the fair market value
of the net tangible assets of LSI by approximately $1,565,000 and represented a
material payment for goodwill, an intangible asset, which is being amortized at
over 40 years.

          LSI Acquisition.  Pursuant to an Exchange Agreement dated June 30,
1994, Arthur R. Peterson, Jr. exchanged the outstanding common stock of LSI for
1,000,000 shares of Common Stock and 300,000 shares of Series I Preferred Stock
of LSAI, and MBf USA exchanged the LSI Preferred Stock for 239,405 shares of
Common Stock of LSAI (the "LSI Acquisition"). As a result of the LSI
Acquisition, LSI became a wholly-owned subsidiary of LSAI on July 8, 1994. The
LSI Acquisition was accounted for as a reverse acquisition of LSAI by LSI.
Therefore, the results of operations and other historical information of the
Company prior to June 30, 1994, presented in this Report

                                      -1-
<PAGE>
 
are those of LSI.  On July 10, 1995, the Series I Preferred Stock was redeemed
by LSAI in full and ceased to be issued and outstanding.

          Private Placement and Prior Operations of LSAI.  Prior to the LSI
Acquisition, the operations of LSAI were limited to completion of a private
placement of 150,000 shares of its Common Stock for net proceeds of
approximately $145,000 and the operations associated with the LSI Acquisition.

           Initial Public Offering.  On October 11, 1994, the Company completed
its offering of 1,320,000 shares of Common Stock and 660,000 1994 Warrants in
units of two shares of Common Stock and one 1994 Warrant at a price of $5.49 per
unit, which represented a 10 percent discount of the public offering price of
$6.10 per unit (the "IPO Offering"). The proceeds after offering expenses to the
Company were $3,261,660. As a portion of underwriting compensation, the Company
issued to Barron Chase Securities, Inc. and its designees the warrants (the
"Underwriters' Warrants") exercisable for the purchase of 66,000 units for $7.32
per unit on or before October 11, 1999.

           NDAC Asset Purchase.  On December 1, 1994, the Company acquired from
National Drug Assessment Corporation ("NDAC") certain intangible assets pursuant
to an Asset Purchase Agreement, dated November 30, 1994, ("NDAC Asset
Purchase").  The assets purchased included the customer list of NDAC and all
contracts, contract rights and agreements, correspondence with the customers for
which NDAC provided drug testing services (the "Customer List"), all urine
specimens with respect to which testing was in process and had not been
completed, all rights to business conducted by NDAC related to drug testing, and
all rights in the name "National Drug Assessment" or "National Drug Assessment
Corporation" and all trade names, trade marks and service marks, and
registrations thereof and applications for registration thereof, logos, designs
and intellectual rights related to or utilized in the marketing of drug testing
services provided by NDAC (the "NDAC Purchased Assets").

          In connection with the acquisition of the NDAC Purchased Assets, the
Company (i) paid $750,000 and issued and delivered 189,000 shares of Common
Stock, (ii) assumed the obligations of NDAC under an office lease agreement,
(iii) reimbursed NDAC $82,731 for certain costs and expenses incurred by NDAC,
and (iv) agreed to pay the costs of one-time piggyback registration of the
Common Stock issued (and to be issued to NDA Corporation, the successor in
interest and former parent corporation of NDAC) under the applicable securities
laws.  The $1,070,940 purchase price of the NDAC Purchased Assets was allocated
entirely to the Customer List, which was recorded as an intangible asset, which
is being amortized over 15 years.

          NPLI Acquisition.   On January 2, 1996, LSAI acquired all of the
issued and outstanding capital stock (the "NPLI Stock") of National
Psychopharmacology Laboratory, Inc., a Tennessee corporation ("NPLI"), and
purchased goodwill (the "NPLI Goodwill"), pursuant to a Stock Purchase Agreement
dated January 1, 1996 (the "NPLI Purchase Agreement"), and NPLI became a wholly-
owned subsidiary of the Company. NPLI was engaged in forensic drug testing and
clinical testing and analysis.

          Pursuant to the Purchase Agreement, (i) the Company agreed to pay
$1,513,000 for the NPLI Stock (the "NPLI Stock Purchase Price") of which
$800,000 was paid at closing to the shareholders of NPLI (the "NPLI
Shareholders"), two unsecured promissory notes (the "Promissory Notes"), in the
aggregate principal amount of $638,000, were issued and delivered to the NPLI
Shareholders, and NPLI conveyed to the NPLI shareholders an office building and
NPLI's leasehold interest in the real property on which the office building is
located and affixed at an agreed market value of $75,000, and (ii) the Company
agreed to pay $140,000 for the NPLI Goodwill payable in 24 monthly installments
commencing on February 1, 1996.

          Pursuant to the NPLI Purchase Agreement, the aggregate principal
amount of the Promissory Notes was reduced to $510,000 effective January 2,
1996, further reduced by principal payments, and eliminated based upon the
revenues from forensic testing (employee urine drug screens that have a chain of
custody) being less than $1,000,000 during the 12 months ending on January 2,
1997 (the "Testing Revenues Adjustment"). The Company is required to issue and
deliver 153,282 shares of Common Stock ("Contingent Shares") to the former NPLI
shareholders in

                                      -2-
<PAGE>
 
connection with the Testing Revenues Adjustment of the outstanding principal
amounts of the Promissory Notes.   The Company has not issued and delivered the
Contingent Shares to the NPLI Shareholders based upon certain representations
made by the NPLI Shareholders which management believes to have been misleading
and false at closing of the NPLI Acquisition.  See "Item 3.  Legal Proceeding."

          Furthermore, pursuant to the NPLI Purchase Agreement, (i) the Company
paid certain NPLI shareholder loans in the aggregate amount of $275,000, (ii)
entered into a certain First Amendment of Lease Agreement with DJ Associates, a
general partnership of which the NPLI Shareholders are the general partners, and
pursuant to which the Company and NPLI leased certain office and laboratory
facilities for a term of six months and agreed to pay monthly rent of $3,000,
and (iii) entered into a certain Registration Rights Agreement with each of the
NPLI Shareholders, pursuant to which the Company, at its expense, agreed to
include the Contingent Shares, if issued and delivered pursuant to the Purchase
Agreement, in a registration statement filed by the Company for the registration
of its common stock under the Securities Act of 1933, as amended (the "1933
Act"), subject to certain conditions.

          The Company consolidated and assimilated the forensic drug testing
operations of NPLI with those of LSI during the first quarter of 1996.  The
Company discontinued the clinical testing and analysis operations of NPLI during
the fourth quarter of 1996 after several attempts to dispose of the clinical
testing and analysis operations.

          PLL Asset Purchase.  On January 31, 1997, the Company acquired from
Pathology Laboratories, Ltd., a Mississippi corporation ("PLL"), certain
intangible assets (the "PLL Asset Purchase") pursuant to an Asset Purchase
Agreement dated January 31, 1997 (the "PLL Purchase Agreement").  The assets
purchased included the customer list of PLL and all contracts, contract rights
and agreements, correspondence with the customers for which PLL has provided
forensic drug testing services, and all assets owned by PLL used in connection
with the PLL office in Greenville, South Carolina.

          Pursuant to the Purchase Agreement, (i) the Company paid $1,600,000 at
closing and (ii) the Company assumed the obligations of PLL under a certain
Lease between Edith Schlien and PLL, dated September 16, 1996, covering
approximately 2,500 square feet of office space located in Greenville, South
Carolina, which requires monthly base rental payments of $2083 and which expires
on September 16, 1999.  Furthermore, the Company agreed to make four additional
installment payments to PLL within 60 days following the end of each three month
period during the 12 months ending January 31, 1998, as follows:  (i) the first
installment payment being equal to 75 percent of  Forensic Testing Revenues (as
defined below) during the first three month period ending April 30, 1997, in
excess of $400,000; (ii) the second installment payment being equal to 75
percent of Forensic Testing Revenues during the six month period ending July 31,
1997, in excess of the aggregate sum of the prior installment payment and
$800,000, (iii) the third installment payment being equal to 85 percent of
Forensic Testing Revenues during the nine month period ending October 30, 1997,
in excess of the aggregate sum of the prior installment payments and $1,200,000,
and (iv) the fourth installment being equal to Forensic Testing Revenues during
the 12 month period ended January 31, 1998, in excess of the aggregate sum of
the prior installment payments and $1,600,000.  Under the Purchase Agreement,
"Forensic Testing Revenues" defined as the gross revenues during the calendar
quarter or 12 month period ending January 31, 1998, directly attributable to
each customer comprising the customer base of PLL acquired by the Company.

Business

          The Company, through LSI, its wholly-owned subsidiary, owns and
operates an independent laboratory providing drug testing services to corporate
and institutional clients seeking to detect and deter the use of illegal drugs.
LSI is certified by SAMHSA, to conduct drug testing using procedures required
for legal defensibility ("forensic") of test results. These procedures provide
reliable and accurate test results and a secure chain-of-custody for each
specimen from its collection to the reporting of test results. LSI tests for a
number of drugs of abuse, including cocaine, methamphetamine, heroin, PCP,
marijuana and alcohol, primarily by urinalysis. In addition to forensic drug
testing, LSI offers a range of services which are customized to assist clients
in implementing cost-effective drug testing

                                      -3-
<PAGE>
 
programs.  LSI's high volume clients have enabled it to develop cost-efficient
means of delivering its services while maintaining forensic testing standards.

Industry Background

     The Office of National Drug Control Policy estimates that Americans spend
more than $40 billion a year on illegal drugs.  A NIDA 1990 National Survey
concluded that 12.9 million Americans had used illegal drugs in the one-month
period prior to the survey, including an estimated 10.2 million who had used
marijuana and 1.6 million who had used cocaine.  This study also estimated that
1.6 million Americans had used heroin in their lifetime.  In addition, law
enforcement data indicate that drugs are involved in a majority of the nation's
violent crimes and that more than 60 percent of arrestees in 1990 had illegal
drugs in their bodies.  Government data indicate that drug abuse costs American
business $100 billion annually in lost productivity, increased accidents,
absenteeism, medical claims and employee theft.

     In the 1970s, drug testing was limited largely to criminal justice agencies
and drug treatment programs.  In the 1980s, however, increased awareness of the
drug abuse problem and its consequences led to increased drug testing in the
workplace.  This, in turn, led to litigation which has settled many of the
formerly open legal and constitutional questions on drug testing.  These court
decisions, generally favoring properly implemented drug testing programs, have
reinforced the acceptance of drug testing in the workplace.  In 1986, President
Reagan signed an Executive Order which mandated drug testing for many key
federal employees, and there are now comprehensive federal regulations for drug
testing by many agencies.  In the private sector, the number of the America's
200 largest corporations screening applicants and employees for drug use rose
from three percent to 98 percent from 1983 to 1991, according to the Institute
for a Drug Free Workplace.  Furthermore, in 1995, the Department of
Transportation adopted additional regulations that substantially expand the then
current regulations which mandate random drug testing of workers, especially in
safety-sensitive jobs such as trucking, aviation, transportation, railroads and
pipelines.  Under these new regulations, 50 percent of transportation workers
(mass-transit workers, interstate truckers and bus drivers) are required to be
tested annually.  It is expected that under these additional regulations, 7.5
million workers will be required to undergo drug testing each year, up from 3.5
million.

     Historically, the drug testing market has been served by national clinical
laboratory chains, independent national drug testing laboratories and numerous
regional and local laboratories such as LSI.  Thousands of general clinical
laboratories nationwide can conduct non-forensic drug testing.  Over the past 12
years, however, many corporate and government organizations have begun to
require drug testing laboratories to be certified to conduct forensic drug tests
and to offer testing services on a cost-effective basis.  In addition, many of
the largest of these organizations, particularly those in the public sector,
utilize a competitive bidding procedure to select their drug testing
laboratories.  The bidding process for these competitive contracts is
increasingly limited to certified drug testing laboratories, such as LSI's
laboratory, which can demonstrate the ability to meet the service and volume
levels specified by the client.  As of January 3, 1997, there were approximately
71 SAMHSA certified drug testing laboratories.

Expansion Strategy

     The Company's strategy is to become a leading drug testing laboratory
providing legally defensible ("forensic") test results through the acquisition
of additional companies that perform and provide drug testing services and
expansion of its current client base and services.  There are no assurances that
the Company will be able to achieve its expansion strategy or that its expanded
operations will be successful.  The Company's strategy includes the following
key elements:

     Acquisitions.  The Company has and intends to continue the expansion of its
client base and drug testing services through the acquisition of companies and
the assets of companies providing drug testing services compatible with and
comparable to those provided by LSI.  The Company completed the NDAC Asset
Purchase in 1994, the

                                      -4-
<PAGE>
 
NPLI Acquisition in 1996 and the PLL Asset Purchase in January 1997. See "Item
1. Description of Business --Background." In connection with NPLI Acquisition,
the Company acquired, in addition to the drug testing operations, the clinical
testing and analysis operation conducted by NPLI. After several attempts to sell
the clinical testing and analysis operation of NPLI, the Company discontinued
the clinical testing and analysis operation in the fourth quarter of 1996. This
resulted in a net loss from discontinued operation of $500,636 and a net loss on
disposal of the clinical business of $773,580. See "Item 3. Legal Proceedings"
and "Item 6. Management's Discussion and Analysis or Plan of Operations."

     The principal objective of the Company's acquisition strategy is to acquire
companies that, through the consolidation and assimilation of the operations of
drug testing companies acquired with and into the operations of LSI, will result
in increased testing volume with minimal additional specimen processing cost,
resulting in increased profitability and cash flows.  Although the Company will
not consummate an acquisition unless, at the time of the acquisition, it is
anticipated that such acquisition will contribute to the profitability and
provide positive cash flows from operations following consolidation and
assimilation of the operations of the acquired company with those of LSI, there
can be no assurance of such increased profitability and positive cash flows, as
well as operations other than forensic drug testing may be acquired, which may
be discontinued or disposed of at a loss.  In the event the Company fails to
make acquisitions which contribute to the profitability of the Company and
provide positive cash flows to the Company, the Company may be required to
reduce general and administrative expenses, possibly including consolidation of
Company operations into the offices of LSI and reduction of management
compensation, and may be required to utilize borrowings to fund negative cash
flows from operations until such reductions of general and administrative
expenses are achieved.  See "Item 6.  Management's Discussion and Analysis or
Plan of Operations--Future Operations and Liquidity."

     In selecting companies for acquisition, the various criteria that will be
considered include (i) the ability to consolidate and assimilate the operations
of the acquisition target with and into those of LSI with the objective of
achieving the anticipated increase in profitability and cash flows from
operations, (ii) the ability on a post-acquisition basis to maintain the
acquisition target's client base and market share, (iii) the ability to preserve
the essential marketing personnel of the acquisition target, (iv) the terms of
the acquisition, such as the cash requirements and willingness of the target's
owners to accept equity securities of LSAI, (v) the revenue base of the
acquisition target, and (vi) the legal and accounting costs of the acquisition.

     Such acquisitions will be completed through the issuance of Common Stock or
Preferred Stock of LSAI, cash acquisitions utilizing available cash and cash
equivalents, borrowings or other sources of equity capital.  The non-specific
nature of the acquisitions makes an estimation of amount to be allocated to
acquisitions from these sources impossible to estimate or determine at the date
of this Report.  LSAI's growth strategy will require expanded customer services
and support, increased personnel, expanded operational and financial systems and
implementation of control procedures.  There can be no assurance that LSAI will
be able to manage expanded operations effectively and efficiently.  LSAI's
acquisitions may involve a number of risks including the diversion of
management's attention to the assimilation of the acquired company, adverse
short-term effects on the Company's results of operations, the amortization of
acquired intangible assets, and the possibility that the acquired company will
not contribute to the Company's profitability and cash flows as expected, and
the acquisition may include business operations, other than forensic drug
testing, the may be discontinued or disposed of at a loss.

     LSAI's shareholders will, in all likelihood, not be afforded the
opportunity to approve the terms of any such acquisitions because the Board of
Directors will, in most cases, have the authority to consummate acquisitions
without shareholder approval. Shareholders will also not have an opportunity,
prior to consummation of an acquisition, to review the financial statements of
an acquisition candidate, except where shareholder approval is required.

     Expanding its Client Base.  LSI intends to continue to compete aggressively
for clients, with a greater emphasis on potential clients currently served by
competitors.  In this effort, LSI intends to focus in particular on the
institutional and private employers, where LSI believes demand for drug testing
services is the greatest and the average

                                      -5-
<PAGE>
 
price per specimen historically has been higher.  LSI also is targeting numerous
moderate volume clients which have yet to implement drug testing programs.

     Emphasizing Client Service.  SAMHSA certification requirements have
established a quality baseline for forensic drug testing.  As a result, it has
become increasingly difficult for laboratories to differentiate their drug
testing services on the basis of quality.  LSI has chosen to differentiate
itself by providing drug testing services, customized to address each client's
needs including assisting clients with the development of drug testing programs,
training client personnel, managing specimen collection, arranging for
transportation of specimens to LSI's laboratory, identifying trends in local and
national drug use, interpreting test results and providing expert testimony
concerning challenged test results.  Unlike most of LSI's competitors, LSI
specializes in drug testing, and, through specialization, LSI believes that its
customer services equal or exceed those provided by its competitors.

     Improving Operating Efficiencies.  LSI believes that price continues to be
an important factor in obtaining new clients and maintaining current clients.
LSI intends to continue focusing on being a low-cost provider by improving the
efficiency of both its laboratory operations and customer services.  Achievement
of improved efficiency is primarily a function of increased specimen testing
volume.  Increased specimen testing volume reduces the cost per specimen tested
because of the somewhat fixed nature of general and administrative costs and
permits LSI to obtain volume purchase price concessions from its vendors which
also lower the direct cost per specimen tested.  See "Item 6.  Management's
Discussion and Analysis or Plan of Operations--Results of Operations."

Drug Testing Operations

     The essential elements of legally defensible (forensic) drug testing are a
secure chain-of-custody for each specimen from its collection to the reporting
of test results, and accurate and reliable testing in which a second independent
test is performed to confirm each positive test result.  LSI carefully controls
each step of the testing process by following detailed written procedures and by
using the specific forensic testing methods required for legal defensibility of
results.  LSI tests for drugs of abuse, including cocaine, methamphetamine,
heroin, PCP, marijuana and alcohol, primarily by urinalysis.  LSI performs all
testing at its laboratory in Belle Chasse, Louisiana which operates 24 hours per
day, six days per week.  The steps in LSI's forensic drug testing process are as
follows:

     Collection and Transportation.  Forensic drug testing begins with specimen
collection conducted under carefully controlled conditions.  Once a donor has
provided a specimen which consists of two specimen bottles, each specimen is
assigned a unique specimen identification number.  A bar-coded or numbered label
with this specimen identification number is affixed to each specimen bottle as a
tamper-proof seal.  The donor is then required to sign a statement on a chain-
of-custody form which is bar-coded or numbered to match the specimen bottles.
The donor certifies that the urine in the bottles belongs to the donor, that the
bottles were sealed and labeled in the donor's presence and that the
identification number on the bottles matches the number on the form.  The
collector also signs the form to certify the integrity of the collection process
and then prepares the specimen for shipment to LSI's laboratory, together with a
signed chain-of-custody form, which are delivered to LSI by overnight or same
day courier or by U.S. mail.

     Receiving and Accessioning.  LSI receives specimens in its restricted
accessioning rooms, where they are inspected for tampering and checked for
proper chain-of-custody documentation.  The unique specimen identification
number is entered into the laboratory computer which automatically orders the
proper screening and confirmation testing and directs the reporting of test
results.  A small portion, or aliquot, of the specimen is then poured from one
of the specimen bottles and prepared for screening.  The specimen bottle is
resealed with a tamper-proof seal and placed in locked cold storage for
approximately 12 months.

     Screening.  Each specimen submitted to LSI is screened for the presence of
the drugs specified by the client. During 1996, LSI performed more than
3,750,000 screening tests on more than 45,000 specimens per month to

                                      -6-
 
<PAGE>
 
determine the presence of drugs.  In conducting these tests, LSI employs several
different screening methods using automated analyzers and procedures which
provide rapid, reliable screening of large numbers of specimens.

     Confirmation Testing.  Specimens that screen negative are reported to the
client without further testing. Specimens that screen positive are confirmed by
testing a separate portion or aliquot using a different and independent
technology from that used for initial screening.  The confirmation technologies
employed by LSI include those required by SAMHSA.

     Quality Assurance and Control.  LSI carefully monitors the accuracy and
reliability of its test results by internal and external quality assurance and
control programs.  LSI's staff evaluates laboratory performance by inserting
"open" and "blind" quality control samples into each batch of client specimens
during both screening and confirmation testing.  An "open" sample is a urine
specimen sample containing known quantities of one or more drugs of which the
testing operator may have been informed contains drugs, but is not made aware of
the kind and quantity of drugs contained in the sample.  A "blind" sample is a
urine specimen sample containing unknown quantities and kinds of drugs and which
is indistinguishable from other specimen samples contained within a testing
batch of samples.  All specimens in a testing batch are retested if the results
obtained for these control samples are not within specified limits.  In
addition, LSI is subject to frequent proficiency testing by various certifying
bodies which send their own open and blind samples to the laboratory.

     LSI's laboratory is certified by SAMHSA, the College of American Pathology
("CAP"), as well as eight states and local jurisdictions.  Of the various
certifications, SAMHSA certification is considered the most important by LSI.
SAMHSA is a federal regulatory agency charged with the responsibility and
authority to license laboratories performing forensic drug testing services for
the Federal Government and its agencies and industries which are federally
regulated, such as the Department of Transportation, Department of Defense, etc.
SAMHSA certifies, inspects, and monitors laboratories that perform forensic drug
testing services under numerous specific mandated guidelines, including (i)
strict adherence to chain-of-custody procedures, (ii) strict security of urine
specimens from collection through testing, (iii) qualifications of technicians
and the procedures employed in testing and the supervision thereof, (iv)
segregation of SAMHSA-related specimens from non-SAMHSA-related specimens, (v)
proficiency testing standards, and (vi) strict adherence to confidential
reporting of test results.

     SAMHSA certification is essential to LSI's business because a major number
of its clients are required to use certified laboratories, and many of its
clients look to certification as an indication of reliability and accuracy of
tests. In order to remain certified, LSI is subject to frequent inspections and
proficiency tests.  Failure to meet any of the numerous certification
requirements, to which LSI is subject, could result in suspension or loss of
certification.  Such suspension or loss of certification could have a material
adverse effect on LSI and LSAI.  In such event, until the suspension is lifted
or certification reobtained, LSI would be required to utilize the drug testing
services of a SAMHSA certified competitor to process SAMHSA-related specimens,
which would result in a substantial reduction in the number of specimens tested
at LSI's laboratory and the price received per specimen received net of such
competitor's cost to LSI of performing such testing services.  In the event such
suspension or loss of certification continued for a substantial period, LSI may
be required to downsize its laboratory personnel and operations and, upon
lifting of the suspension or reobtaining of SAMHSA certification, restaffing of
the laboratory could occur over an extended period,  and client base and market
share may be required to be reestablished, all at substantial cost and expense
to LSI.

     Data Review.  Each test result, whether negative or positive, undergoes
four independent levels of review before being reported.  A result is first
reviewed by the laboratory analyst conducting the test.  Following the analyst's
review, the screening or confirmation laboratory supervisor reviews the result.
Next, a quality assurance and control technician reviews the result.  Finally,
the test result, including all chain-of-custody and testing documentation, is
reviewed by a certifying scientist.  It is only after all of these reviews have
been successfully completed and all documentation is in order that the
certifying scientist signs and releases a test result.

                                      -7-
<PAGE>
 
     Reporting of Results.  LSI transmits an increasing number of its test
results electronically through a secured national communications network.  This
network immediately encrypts and transmits each test result from the laboratory
computer to the client's personal computer or secure fax machine as soon as it
has been released by the certifying scientist.  Using this network, LSI
routinely reports results for specimens that screen negative within 24 hours of
receipt in the laboratory and within 48 hours for specimens that require
confirmation.  Other clients receive test results via overnight courier or U.S.
mail.

Contractual Arrangements

     Most large drug testing clients, including the majority of public employers
and criminal justice agencies, use a formal competitive bid process in which the
potential client provides a detailed specification of the drug testing services
it requires.  While price is an important factor, in most cases these
organizations are not required to accept the lowest bid, but rather may choose
the winning bidder on the basis of technical superiority and client service.
LSI has previously obtained contracts through biding and procurement procedures
and will continue to obtain such contracts through competitive bidding.  Such
contracts are typically long-term, but are also subject to termination on short
notice with little or no penalty.

     Other than drug testing services performed pursuant to contracts obtained
through competitive bidding procedures, LSI performs most of its drug testing
services without a formal contract.  In most cases, LSI accepts and tests
specimens for an agreed price which is generally renegotiated periodically.
Because LSI does not currently have any long-term contracts, which is typical of
high volume clients, LSI is not dependent to any significant degree upon any one
client or contractual relationship with a client, the termination of which would
have a material adverse effect upon LSI.

Competition

     Drug testing laboratories compete primarily on the basis of technical
superiority, client service and price. The Company believes that LSI competes
favorably in each of these categories.  LSI competes with three types of
companies which offer forensic drug testing services, i.e., national SAMHSA
laboratory chains such as Smith-Kline Beecham Clinical Laboratories and
Laboratory Corporation of America, regional SAMHSA laboratories such as LabOne,
Inc. and Clinical Reference Lab and companies providing on site screening
devices.  Many of these competitors have greater financial resources than the
Company.  In addition, some clients and potential clients of LSI operate their
own drug testing facilities, or may develop such facilities in the future.

Certification and Government Regulation

     Companies which compete in the forensic drug testing market generally must
be certified by SAMHSA and may be required to have other types of certification
imposed by certain states or clients.  LSI's laboratory is currently certified
by SAMHSA and CAP, as well as eight states and local jurisdictions.  LSI is
subject to frequent inspections by certifying bodies, including two SAMHSA
inspections per year, and is also subject to frequent proficiency testing by
SAMHSA, CAP and other certifying bodies.  Failure to meet certification
requirements could result in suspension or loss of certification.  Certification
is essential to LSI's business because some of its clients are required to use a
certified laboratory, and many of its clients look to certification as an
indication of reliability and accuracy of test results.  With respect to its
operations, LSI considers SAMHSA certification to be the most important of its
various certifications.  In order to obtain SAMHSA certification, a laboratory
must apply for certification, meet certain minimum facility requirements and
then successfully complete a series of proficiency tests, which takes
approximately 12 months to complete at substantial cost and expense.  
See "-- Drug Testing Operations--Quality Assurance and Control," above.

     Employee drug testing by federal agencies and certain private employers is
subject to regulation by certain federal agencies.  Legislation currently exists
in a number of states regulating the circumstances under which

                                      -8-
 
<PAGE>
 
employers may test employees and the procedures under which such tests must be
conducted.  In addition, the circumstances under which drug testing can legally
be required by employers is subject to court precedent and judicial review.

Other Regulation

     The operations of LSAI and LSI are also subject to various federal, state
and local requirements which affect businesses generally, such as taxes, postal
regulations, labor laws, and environment and zoning regulations and ordinances.

Environmental Matters

     Certain testing procedures used by LSI require the use of hazardous
materials.  Failure to comply with current or future federal, state or local
environmental laws or regulations could have a material adverse effect on LSI
and LSAI.  LSI believes that it has adequately warned employees of potential
risks associated with working at LSI and has provided a workplace safe from
hazard, as required by the Occupational Safety and Health Administration and
certain Louisiana laws.

Employees

     As of April 15, 1997, LSAI had three full-time employees, and LSI had 95
full-time and 18 part-time employees, none of which are represented by a labor
organization.  LSAI considers its and LSI's relations with their employees to be
good.

Item 2.   Description of Property.

     LSAI maintains its executive office in approximately 1800 square feet at
Suite 810, 101 Park Avenue, Oklahoma City, Oklahoma 73102.  The office premises
are occupied under a long-term lease which expires August 31, 2000, and the
monthly rental payment is $1,685.  LSAI considers such space to be adequate for
its current needs.

     LSI's executive offices and laboratory are located in approximately 7,390
square feet at 113 Jarrell Drive, Belle Chasse, Louisiana 70037, in a building
owned by LSAI.  In addition, LSI maintains its accounting and customer service
operations in leased offices at 3520 General DeGaulle Drive, New Orleans,
Louisiana 70114 in approximately 3,200  square feet.  This lease is on a month-
to-month basis, and requires monthly rental payments of $2,400.

     The Company and LSI have entered into agreements to acquire and remodel a
20,000 square foot building at an estimated cost of $890,000 for the relocation
of LSI's laboratory facilities and consolidation of its customer service and
accounting offices.  It is anticipated that the laboratory facilities and
customer service and accounting offices will be relocated to the building by the
end of the June 1997.  The Company believes that, with the acquisition of the
building, the new location of  the offices and laboratory will be adequate for
the current and anticipated future needs of LSI.  Following the relocation,
LSI's laboratory and administrative offices will be at 1121 Newton Street,
Gretna, Louisiana 70053.

     Following the relocation of the laboratory and administrative offices, it
is anticipated that the building and real property currently used for the
laboratory operations will be sold, and lease of the office space used for
customer administrative offices will be terminated.

     In connection with the PLL Asset Purchase (see "Item 1.  Description of
Business--Background--PLL Asset Purchase"), the Company assumed the obligations
of Pathology Laboratories Limited ("PLL") under a certain Lease between Edith
Schlien and PLL, dated September 16, 1996, covering  approximately 2,500 square
feet of office space

                                      -9-
<PAGE>
 
located in Greenville, South Carolina.  This lease requires monthly base rental
payments of $2,083, and will expire on September 16, 1999.

Item 3.   Legal Proceedings.

     In connection with the NPLI Acquisition, LSAI agreed to issue 153,282
additional shares of Common Stock to the former shareholders of NPLI in
connection with the aggregate $462,911 reduction in the principal amounts of
certain promissory notes issued to and held by the former NPLI shareholders.
See "Item 1.  Description of Business--Background--NPLI Acquisition."  The
former shareholders made upon certain representations to LSAI regarding certain
contracts and agreements for the providing of forensic drug testing, which were
relied upon by LSAI in consummation of the NPLI Acquisition and which management
of LSAI believes such representations to have been inaccurate and misleading
based upon information obtained by LSAI following consummation of the NPLI
Acquisition.  LSAI has refused to make additional payments of accrued interest
and principal of the promissory notes and has also refused to deliver the
additional shares of Common Stock.  On February 21, 1997, the former NPLI
shareholders initiated an action against the Company,  styled Kenneth O. Jobson
and Haroutune K. Dekirmenjian v. Laboratory Specialists of America, Inc., Case
No. 3:97-CV-117, in the United States District Court for the Eastern District of
Tennessee at Knoxville, seeking recovery of the accrued interest and outstanding
principal amounts of the promissory notes, which, based upon the NPLI Purchase
Agreement, the Company has no obligation to pay.  The Company filed its answer
in this action and made a counterclaim against the former NPLI shareholders
seeking a declaratory judgment that the Company is not in default under the
terms of the promissory notes and recovery of an unspecified amount of damages
for misrepresentation of known material facts with the intent that the Company
would rely upon such misrepresentation in connection with the consummation of
the NPLI Acquisition.

     On April 15, 1997, the Company initiated a legal action against the former
NPLI shareholders, styled Laboratory Specialists of America, Inc. and National
Psychopharmacology Laboratory, Inc. v. Kenneth O. Jobson and Haroutune K.
Dekirmenjian, Case No. 97-2582-63, in the District Court of Oklahoma County,
State of Oklahoma, seeking a declaratory judgment that the Company is not in
default under the terms of the promissory notes and recovery of damages in
excess of $10,000 for misrepresentation of known material facts with the intent
that the Company would rely upon such misrepresentation in connection with the
consummation of the NPLI Acquisition. The former NPLI shareholders have not
filed an answer in this action.

     The Company is vigorously defending and prosecuting the respective actions.
It is believed by management of the Company that the former shareholders of NPLI
will not be successful in obtaining payment of the accrued interest and formerly
outstanding principal amounts of the promissory notes; however, there is no such
assurance. Furthermore, there is no assurance that the Company will recover any
damages based upon the representations of the NPLI stockholders made with the
intent of inducing the Company to consummate the NPLI Acquisition.  It is
anticipated by management that the Company will eventually deliver all or a
portion of the additional shares of Common Stock; however, such number is not
determinable as of the date of this Report.

     Other than the litigation described above, LSAI does not have any pending
litigation.  In the ordinary course of their businesses, LSI and NPLI from time
to time are sued by individuals who have tested positive for drugs of abuse or
who allege that improper clinical analysis has been performed by NPLI.  To date,
LSI and NPLI have not experienced any material liability related to these
claims, although there can be no assurance that LSI or NPLI will not at some
time in the future experience significant liability in connection with these
types of claims.  Based upon the prior successful defense of similar-type
litigation, management believes LSI and NPLI have valid defenses to the
plaintiffs' claims in all pending litigation, and LSI and NPLI intend to
vigorously defend themselves in such litigation. LSI and NPLI are not currently
defendant parties in any legal proceedings other than routine litigation that is
incidental to the business of LSI and NPLI, and management of LSI and NPLI
believes the outcome of such legal proceedings will not have a material adverse
effect upon the results of operations or financial condition of LSI and NPLI.
Furthermore, management of LSI and NPLI believe that the liability insurance
coverage is adequate with respect to the pending litigation and, in general, for
the businesses of LSI and NPLI.

                                      -10-
<PAGE>
 
Item 4.   Submission of Matters to a Vote of Security Holders.

     During the fourth quarter of the fiscal year ended December 31, 1996, the
Company did not submit any matters to a vote of its shareholders through the
solicitation of proxies or otherwise.

Part II

Item 5.   Market for Common Equity and Related Stockholders Matters.

     The LSAI's Common Stock is traded in the over-the-counter market and is
quoted on Nasdaq Small Cap Market System under the symbol LABZ.  The following
table sets forth, for the periods presented, the high and low closing bid
quotations in the over-the-counter market as quoted by Nasdaq Small Cap Market
System.  The bid quotations reflect inter-dealer prices without adjustment for
retail markups, markdowns or commissions and may not reflect actual
transactions.
<TABLE>
<CAPTION>
 
                                                          Closing Bid
                                                          -----------
                                                      High           Low
                                                      ----           ---
1996:
<S>                                                   <C>          <C>
    First Quarter Ended March 31, 1996..............  $4.00        $2.88
    Second Quarter Ended June 30, 1996..............  $3.69        $3.00
    Third Quarter Ended September 30, 1996..........  $3.38        $2.38
    Fourth Quarter Ended December 31, 1996..........  $3.26        $2.56
1995:
    First Quarter Ended March 31, 1995..............  $3.44        $3.00
    Second Quarter Ended June 30, 1995..............  $3.63        $3.13
    Third Quarter Ended September 30, 1995..........  $4.00        $2.88
    Fourth Quarter Ended December 31, 1995..........  $3.75        $2.88

</TABLE>

     On April 15, 1997, the closing bid and asked prices of the Common Stock as
quoted on Nasdaq Small Cap Market System were $2.38.  On April 15, 1997, there
were approximately 650 holders of LSAI's Common Stock.

     LSAI's dividend policy is to retain its earnings to support the expansion
of its operations.  The Board of Directors of LSAI does not intend to pay cash
dividends on the Common Stock in the foreseeable future.  Any future cash
dividends will depend on future earnings, capital requirements, LSAI's financial
condition and other factors deemed relevant by the Board of Directors.  LSAI's
future earnings and cash flow currently are dependent principally upon the
operating results of LSI and such dependency may continue indefinitely in the
future, even following expansion of LSAI's operations through acquisitions as
anticipated.

Item 6.   Management's Discussion and Analysis or Plan of Operation.

     The following discussion should be read in conjunction with the financial
statements and notes thereto appearing elsewhere in this Report.

     LSAI was formed on March 24, 1994, and prior to June 30, 1994, the
effective date of the LSI Acquisition, the operations of LSAI were limited to
completion of a private placement of its Common Stock and the operations
associated with the LSI Acquisition.  Therefore, the following discussion and
analysis of results of operations are only those of LSI prior to the LSI
Acquisition.  On the effective date of the LSI Acquisition, LSI became a wholly-
owned subsidiary of LSAI which was accounted for as a reverse acquisition of
LSAI by LSI under the purchase method of accounting. See "Item 1. The Company--
Background--LSI Acquisition" and "--Private Placement and Operations of LSAI."

                                      -11-
<PAGE>
 
Results of Operations

     The following table sets forth selected results of operations for the
fiscal years ended December 31,  1996, 1995 and 1994, which are derived from the
audited consolidated financial statements of the Company.  The results of
operations for the fiscal year ended December 31, 1994, are a combination of the
Pre-Acquisition Period of January 1, 1994, through April 17, 1994, and the Post-
Acquisition Period of April 18, 1994, through December 31, 1994. The Pre-
Acquisition Period ended April 17, 1994, is not comparable to the Post-
Acquisition Period and the fiscal year ended December 31, 1994, 1995 and 1996,
due to the purchase accounting adjustments and the resulting increase in
amortization of additional goodwill recorded in connection with and following
the Peterson Share Exchange.  See "Item 1.  Description of Business--Background
--Peterson Share Exchange."
<TABLE>
<CAPTION>

                                                              For the Year Ended December 31,
                                             -----------------------------------------------------------------
                                                      1994                 1995                   1996
                                             -------------------   --------------------  --------------------- 
                                               Amount    Percent     Amount    Percent     Amount     Percent
                                             ----------  --------  ----------  --------  -----------  --------
<S>                                          <C>         <C>       <C>         <C>       <C>          <C>
Revenues..............................       $5,000,524    100.0%  $6,925,716    100.0%  $8,726,799     100.0%
Cost of revenues......................        2,291,345     45.8%   3,246,470     46.9%   3,816,114      43.7%
                                             ----------    -----   ----------    -----   ----------     -----
Gross profit..........................        2,709,179     54.2%   3,679,246     53.1%   4,910,685      56.3%
                                             ----------    -----   ----------    -----   ----------     -----
Operating expenses:
  Selling.............................          432,920      8.7%     561,470      8.1%     601,945       6.9%
  General and administrative..........        1,681,722     33.6%   2,157,410     31.2%   2,442,602      28.0%
  Depreciation and
     amortization.....................          158,884      3.2%     232,535      3.3%     504,123       5.8%
  Asset impairment....................               --      -- %          --      -- %     124,531       1.4%
                                             ----------    -----   ----------    -----   ----------     -----
Total operating expenses..............        2,273,526     45.5%   2,951,415     42.6%   3,673,201      42.1%
                                             ----------    -----   ----------    -----   ----------     -----
                                                435,653      8.7%     727,831     10.5%   1,237,484      14.2%
Other income (expense)................           65,682      1.3%     421,134      6.1%     (21,808)       .2%
                                             ----------    -----   ----------    -----   ----------     -----
Income from continuing
  operations before income taxes......          501,335     10.0%   1,148,965     16.6%   1,215,676      13.9%
Income tax expense....................          211,023      4.2%     474,405      6.9%     527,171       6.0%
                                             ----------    -----   ----------    -----   ----------     -----
Income from continuing operations.....          290,312      5.8%     674,560      9.7%     688,505       7.9%
Discontinued Operations:
  Loss from operations of
        discontinued clinical
        business, net of tax benefit..               --      -- %          --      -- %    (500,636)      5.7%
                                       
  Loss on disposal of clinical                                                       
        business, net of tax benefit..               --      -- %          --      -- %    (773,580)      8.9%
                                             ----------    -----   ----------    -----   ----------     -----
Net income (loss).....................       $  290,312      5.8%  $  674,560      9.7%  $ (585,711)      6.7%
                                             ==========    =====   ==========    =====   ==========     =====
</TABLE>


     During 1996 and 1995, LSI experienced a 4.7 and 5.0 percent decrease in the
price per specimen, respectively, compared to the preceding fiscal year
principally due to increased price competition amongst providers of drug testing
services, price per specimen being the most important factor in obtaining and
maintaining clients. Management of LSI closely monitors its price per specimen,
the prices of its competitors and the costs of processing specimens to remain
competitive, as well as profitable.  Although it appears that the price decline
per specimen has moderated, there can be no assurance that price decline per
specimen will not further decline during 1997.  In the event price stabilization
does not continue and further declines are experienced, LSI will, as it has in
the past, take appropriate measures to downsize its drug testing personnel and
possibly further automate the testing process and employ additional technology
to continue profitability, although there can be no assurance that such measures
will assure profitability in the event of substantial price reductions within
the short term.  Although the price per specimen declined in 1996 and 1995
compared to the preceding fiscal year, the number of specimens analyzed
increased 34.5 percent and 45.1 percent in 1996 and 1995, respectively, compared
to the preceding fiscal year, which offset the decrease in the price per
specimen analyzed during 1996 and 1995.

                                      -12-
<PAGE>
 
     In connection with NPLI Acquisition, the Company acquired the clinical
testing and analysis operation conducted by NPLI.  After several attempts to
sell the clinical testing analysis operation of NPLI, the Company discontinued
the clinical testing and analysis operation in the fourth quarter of 1996.  This
resulted in a loss from the discontinued operation of $500,636 (after giving
effect to the associated tax benefit of $257,904) and a loss on disposal of the
clinical business of $773,580 (after giving effect to the associated tax benefit
of $489,420), which resulted in a loss of $.39 per weighted average number of
common shares and common share equivalents used to compute primary earnings per
share.  Before such discontinued operation, the Company's income from continuing
operations was $688,505 or $.21 per weighted average number of common shares and
common share equivalents used to compute primary earnings per share.   See "Item
1.  Description of Business--Background--NPLI Acquisition" and "Item 3.  Legal
Proceedings."

     Through the Company's acquisition strategy, management anticipates,
although there can be no assurance, that the consolidation and assimilation of
the operations associated with additional companies or the assets of forensic
drug testing companies that may be acquired will result in increased testing
volume with minimal additional indirect specimen processing cost, resulting in
increased profitability from operations. See "Item 1. Description of Business--
Expansion Strategy." In the event the Company fails to make acquisitions which
contribute to the profitability of the Company, LSI and LSAI may be required to
reduce general and administrative expenses, possibly including consolidation of
Company operations into the offices of LSI and reduction of management
compensation.

     Comparison of Fiscal 1996 and 1995

     Revenues increased to $8,726,799 in 1996 from $6,925,716 in 1995, an
increase of 26 percent.  The increase in revenues was due to a 34.5 percent
increase in the number of specimens analyzed during 1996 as compared to 1995,
although partially offset by a decrease of 4.7 percent in the average price per
specimen.  The increase in number of specimens analyzed was attributable to the
NPLI Acquisition as well as the obtaining of additional accounts through LSI's
normal sales and marketing efforts.  The decrease in the average price per
specimen was principally due to increased price competition among providers of
drug testing services, price per specimen being the most important factor in
obtaining and maintaining clients.  There can be no assurance that the price per
specimen will not further decline in 1997 which will directly impact
profitability.  See "Item 1. Description of Business--Competition."  Cost of
laboratory services increased $569,644 from $3,246,470 in 1995 to $3,816,114 in
1996.  This increase was primarily due to the increased volume of specimen
testing and decreased as a percentage of revenues by 3.2 percent. Gross profit
on revenues increased as a percentage of revenues from 53.1 percent in 1995 to
56.3 percent in 1996.

     Operating expenses increased from $2,951,415 in 1995 to $3,673,201 in 1996,
an increase of 24.5 percent, but decreased as a percentage of revenues from 42.6
percent to 42.1 percent.  The increase in operating expenses was attributable to
the increase in general and administrative expenses of $285,192, selling expense
of $40,475, depreciation and amortization of $271,588, and the recognition of
asset impairment of $124,531.  The increase in general and administrative
expenses was principally due to the increase in executive officer compensation
of LSAI and accrued bonuses for certain key employees of LSI.  The increase in
selling expenses was due to the addition of one sales representative and
increased personnel to assist in maintaining forensic drug testing clients and
customers obtained in connection with the NPLI Acquisition, although partially
offset by a reduction in commission expenses. Depreciation increased due to the
acquisition of new laboratory equipment in March 1996, and amortization
increased due to the  amortization of the customer list and goodwill acquired in
connection with the NPLI Acquisition.  Asset impairment was attributable
principally to the write-down, to the estimated fair market value, of LSI's
current laboratory facilities which are held for sale as of the date of this
Report.

     Interest expense increased from $29,651 in 1995 to $67,185 in 1996, a 126.6
percent increase.  The increase in interest expense was the result of a capital
lease agreement for certain laboratory equipment.  Interest income decreased
from $126,939 in 1995 to $41,208 in 1996, a 67.5 percent decrease.  The decrease
resulted from a reduction of cash equivalents held for investment due to the
NPLI Acquisition and other acquisition activities.  Other income decreased from
$323,846 in 1995 to $4,169 in 1996.  The decrease in other income was primarily
due to the

                                      -13-
<PAGE>
 
receipt during 1995 of a non-reoccurring settlement of a lawsuit in which LSI
was the plaintiff.  Income from continuing operations, after provision for
income taxes, increased from $674,560 in 1995 to $688,505 in 1996, a 2.1 percent
increase.  Income per share of common stock from continuing operations on a
primary basis was $.21 ($.17 per share on a fully diluted basis) in 1996,
compared to net income per share of common stock on a primary basis of $.20
($.17 per share on a fully diluted basis) in 1995.

     During the fourth quarter of 1996, the clinical testing and analysis
operation conducted by NPLI was discontinued, which resulted in a loss from
discontinued operation of $500,636 (after giving effect to the associated tax
benefit of $257,904) and a loss on disposal of the clinical business of $773,580
(after giving effect to the associated tax benefit of $489,420), which resulted
in a net loss from continued and discontinued operations of $585,711.  Net loss
from continued and discontinued operations per share of common stock on a
primary basis was $.18 and $.15 per share of common stock on a fully diluted
basis.

     Comparison of Fiscal 1995 and 1994

     Revenues increased to $6,925,716 in 1995 from $5,000,524 in 1994, an
increase of 38.5 percent.  The increase in revenues was due to a 45.1 percent
increase in the number of specimens analyzed during 1995 as compared to 1994,
although partially offset by a decrease of five percent in the average price per
specimen.  The increase in number of specimens analyzed was attributable to the
NDAC Asset Purchase as well as the obtaining of additional accounts through
LSI's normal sales and marketing efforts.  The decrease in the average price per
specimen was principally due to increased price competition among providers of
drug testing services, price per specimen being the most important factor in
obtaining and maintaining clients.  Cost of laboratory services increased
$955,125 from $2,291,345 in 1994 to $3,246,470 in 1995.  This increase was
primarily due to the increased volume of specimen testing and only increased as
a percentage of revenues by 1.1 percent.  Gross profit on revenues decreased as
a percentage of revenues from 54.2 percent in 1994 to 53.1  percent in 1995.
The decrease was directly attributable to the decrease in the price per
specimen.

     Operating expenses increased from $2,273,526 in 1994 to $2,951,415 in 1995,
an increase of 29.8 percent, but decreased as a percentage of revenues from 44.5
percent to 42.6 percent.  The increase in operating expenses was attributable to
the increase in general and administrative expenses of $475,688, selling expense
of $128,550, and depreciation and amortization of $73,651.  The increase was
principally as a result of the NDAC Asset Purchase, the increase in the number
of specimens analyzed in 1995, and a full year of administrative costs
associated with LSAI's Oklahoma City office.

     Income from operations increased from $435,653 in 1994 to $727,831 in 1995,
a 67.1 percent increase. Operating income increased from 8.7 percent of revenues
in 1994 to 10.5 percent of revenues in 1995, principally due to the increase in
the number of specimens analyzed, while cost of laboratory services and
operating expenses only marginally increased.

     Interest expense decreased from $32,375 in 1994 to $29,651 in 1995, an 8.4
percent decrease, principally as a result of reduction of outstanding
indebtedness during 1995.  Other income increased from $66,578 in 1994 to
$323,846 in 1995.  This was primarily due to a $320,000 settlement of certain
litigation brought by LSI.  Net income, after provision for income taxes,
increased from $290,312 in 1994 to $674,560  in 1995, a 132.4 percent increase.

     Pro Forma Effect of Stock-Based Compensation

     The Company has historically used options to retain and compensate its
officers, directors, employees and others.  During 1996 and 1995, the Company
granted 310,000 stock options for the purchase of the Common Stock of LSAI to
certain officers, directors,  employees and others.  In accordance with
Accounting Principles Board Opinion No. 25, the compensation cost  of such stock
options is not recognized in the consolidated financial statements of the
Company.  The outstanding stock options granted in 1996 and 1995 had an
aggregate weighted average fair value at

                                      -14-
<PAGE>
 
the date of grant of the options of $134,250, utilizing the methodology
prescribed under SFAS No. 123, Accounting for Stock-Based Compensation. After
giving effect to the weighted average fair value of such options, the Company
had a net pro forma loss of $673,516 ($.20 per common share on a primary basis
and $.17 per common share on a fully diluted basis) for the year ended December
31, 1996, and had a net pro forma income of $614,771 ($.19 per common share on a
primary basis and $.16 per common share on a fully diluted basis) for the year
ended December 31, 1995.

     Quarterly Results of Operations

     LSI's operations are affected by seasonal trends to which drug testing
laboratories are generally subject.  In LSI's experience, testing volume tends
to be higher in the second calendar quarter and lower in the winter holiday
season and the beginning of the first calendar quarter primarily due to hiring
patterns which affect pre-employment drug testing.  Because the general and
administrative expenses associated with maintaining and adding to LSI's testing
work force are relatively fixed over the short term, LSI's margins tend to
increase in periods of higher testing volume and decrease in periods of lower
testing volume.  These effects are not always apparent because of the impact and
timing of the startup of new businesses and other factors such as the timing and
amount of price increases or decreases and additional acquisitions.
Nevertheless, LSI's results of operations for a particular quarter may not be
indicative of the results to be expected during other quarters.

     Income Taxes

     The provisions for income taxes from continuing operations on pretax income
were based on the effective combined federal and state graduated corporate
income tax rates of approximately 43 percent in 1996 and 41 percent for 1995,
and were $527,171 and $474,405 for the years ended December 31, 1996 and 1995,
respectively.

Liquidity and Capital Resources

     Historically, the Company has financed its growth from bank borrowings and
the sale of equity securities. Net cash provided by operating activities totaled
$472,801 and $734,475 during the years ended December 31, 1996 and 1995,
respectively.  As of December 31, 1996, the Company had working capital of
$1,002,712, compared to working capital of $3,128,818 at December 31, 1995.  In
connection with the NPLI Acquisition, which was consummated on January 2, 1996,
during the first quarter of 1996, the Company paid and expended approximately
$1,740,000 as a result of payments to the former NPLI shareholders and payment
of certain NPLI bank borrowings, shareholder loans and other indebtedness.  See
"Item 1.  Description of Business--Background--NPLI Acquisition." In the event
the Company's revenues increase as anticipated by management, the Company's
working capital requirements will also increase and such requirements may exceed
the net cash provided by operating activities and require that cash be used in
operating activities from sources other than operations, including the available
cash and cash equivalents (which were $727,381 at December 31, 1996) and
borrowings.  The increase in cash used in operations will principally be due to
the timing differential between Company's payment for materials and services to
its suppliers and employee work force, and the time at which the Company
receives payment from its customers.

     On December 27, 1996, LSI's revolving line credit facility with Hibernia
National Bank expired, at which time there were no outstanding borrowings.  On
January 9, 1997, LSI entered in to a loan agreement with Hibernia National Bank
(the "Bank") which established a credit facility comprised of a five-year term
loan of up to $1,700,000 and a one-year revolving loan of $250,000 to be used
for the acquisition of Pathology Laboratories Limited.  The term loan was fully
advanced upon execution of the loan agreement.   Advances under the revolving
loan are based upon LSI maintaining certain ratios and compliance with the
covenants of the loan agreement and LSI's liquid assets including its accounts
receivable.  The outstanding principal amount of the revolving loan bears
interest at Citibank, N.A. rate and the term loan bears interest at such rate
plus one-half percent.  The loan is secured by the accounts receivable,
intangible assets, and by a mortgage on the building owned by LSI, and is
guaranteed by LSAI.

                                      -15-
 
<PAGE>
 
Future Operations and Liquidity

     In connection with the Peterson Share Exchange, LSI issued to MBf USA, its
former parent, the MBf Promissory Note (in the principal amount of $353,123,
providing for interest at seven percent per annum).  See "Item 1. Description of
Business--Background--LSI Acquisition."  The MBf Promissory Note is secured by
substantially all of the assets of LSI and becomes due February 23, 1999.

     Although the Company experienced substantial losses from the discontinuance
and disposal of the clinical operation of NPLI, which were acquired in January
1996 in connection with the NPLI Acquisition, the continued forensic drug
testing operations of the Company were profitable during 1996.  Through its
acquisition strategy, management of the Company intends to continue its growth
through the acquisition of drug testing companies and the assets of such
companies, and assimilation of the acquired drug testing operations and assets
with and into LSI, to obtain increased testing volume with minimal additional
specimen processing cost, resulting in increased profitability and cash flows.
See "Item 1.  Description of Business--Expansion Strategy."  Although the
Company will not consummate an acquisition unless, at the time of the
acquisition, it is anticipated that such acquisition will contribute to the
profitability and provide positive cash flows from operations following
consolidation and assimilation of the operations of the acquired company with
those of the Company, there can be no assurance of such profitability and
positive cash flows.  In the event the Company fails to make acquisitions which
contribute to the profitability of the Company and provide positive cash flows
to the Company, LSI and LSAI may be required to reduce general and
administrative expenses, possibly including consolidation of Company operations
into the offices of LSI and reduction of management compensation, and may be
required to utilize borrowings to fund negative cash flows from operations until
such reductions of general and administrative expenses are achieved.

     On December 3, 1996, LSI purchased a building to be renovated for its new
laboratory.  The purchase was financed by a note payable to the seller due on
June 3, 1997, with no stated interest rate.  This note has been classified as
long-term based on a written commitment from a bank to refinance the purchase
and construction costs up to the lesser of 80% of appraised value or cost, not
to exceed $720,000.  The bank note will be payable monthly based on a fifteen-
year amortization with the balance due five years from issuance.  In connection
with the renovation of the new laboratory, LSI entered into an agreement to pay
$439,572 upon completion of the renovation, which is expected during mid 1997.
See "Item 2.  Description of Property."

      On January 31, 1997, the Company acquired from Pathology Laboratories,
Ltd. ("PLL") certain intangible assets pursuant to an Asset Purchase Agreement
dated January 31, 1997 (the "Purchase Agreement").  See "Item 1. Description of
Business--Background--PLL Asset Purchase."    Pursuant to the Purchase
Agreement, (i)  the Company paid $1,600,000 at closing and (ii) the Company
assumed the obligations of PLL under a certain lease, dated September 16, 1996,
which requires monthly base rental payments of $2,083 and which expires on
September 16, 1999.  Furthermore, the Company is required to make four
additional quarterly installment payments to PLL within 60 days following the
end of each three-month period during the twelve months ending January 31, 1998.
These quarterly payments are based on gross revenues directly attributable to
each customer comprising the customer base of PLL for the year ending January
31, 1998, exceeding $1,600,000.  The gross revenues attributable to this
customer base for the year ended December 31, 1996, were approximately
$3,200,000.

     The Company anticipates that existing cash and cash equivalent balances and
short-term investments, and funds to be generated from future operations will be
sufficient to fund operations, and budgeted capital expenditures of LSAI and LSI
through 1997.

     Future Assessment of Recoverability and Impairment of Goodwill and Customer
List. In connection with the Peterson Share Exchange, LSI recorded goodwill
which is being amortized over 40 years on a straight-line basis. Furthermore, in
connection with the NDAC Asset Purchase, LSAI recorded the assets purchased
pursuant to the NDAC Asset Purchase as a customer list which is being amortized
over 15 years on a straight-line basis. In addition, in connection with the NPLI
Acquisition, LSAI recorded the excess of the purchase over the value of the

                                      -16-
<PAGE>
 
assets of NPLI as goodwill and a customer list, which is being amortized over 20
years and 15 years, respectively, on a straight-line basis.  At December 31,
1996, the unamortized portion of the goodwill and the customer lists were
$2,663,850 and $1,863,061, respectively.  The carrying value and recoverability
of unamortized goodwill and customer lists will  be periodically reviewed by
management of the Company.  If the facts and circumstances suggest that the
goodwill or customer list may be impaired, the carrying value of goodwill or
customer list will be adjusted which will result in an immediate charge against
income during the period of the adjustment and/or the length of the remaining
amortization period may be shortened, which will result in an increase in the
amount of goodwill or customer list amortization during the period of adjustment
and each period thereafter until fully amortized.  Once adjusted, there can be
no assurance that there will not be further adjustments for impairment and
recoverability in future periods.  Of the various factors to be considered by
management of the Company in determining goodwill or customer list impairment,
the most significant will be (i) losses from operations, (ii) loss of customers,
(iii) developments within the drug testing industry, including the Company's
inability to maintain its market share, development of drug testing
technologies, imposition of additional regulatory and certification
requirements, and (iv) loss or suspension for an extended period of laboratory
certification, especially by SAMHSA.  See "Item 1. Description of Business--
Certification and Government Regulation."  In the event management of the
Company determines that goodwill or the customer list has become impaired, the
adjustment for impairment and recoverability will most likely occur during a
period of operations in which the Company has sustained losses or has only
marginal profitability from operations, and the impairment and/or increased
amortization amount will either increase such losses from operations or further
reduce profitability.

Item 7.   Financial Statements

     The response to this Item is set forth herein in a separate section of this
report, appearing on page F-2 through F-22.

Item 8.   Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.

     There have been no disagreements of the type required to be reported under
this Item between management of LSAI and LSI and their independent accountants
during 1996 and 1995.

Part III

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

     The following table sets forth certain information with respect to each
executive officer and director of LSAI and LSI.  Directors are generally elected
at the annual shareholders' meeting and hold office until the next annual
shareholders' meeting and until their successors are elected and qualified.
Executive officers are elected by the Board of Directors and serve at its
discretion.  LSAI's Bylaws authorize the Board of Directors to be constituted of
not less than one and such number as the Board of Directors may from time to
time determine by resolution or election.  The Board currently consists of seven
members.

                                      -17-
<PAGE>
 
<TABLE>
<CAPTION>
 

         Name                   Age        Position with LSAI            Position with LSI
         ----                   ---        ------------------            -----------------
<S>                             <C>     <C>                          <C>
John Simonelli.................  50     Chairman of the Board,
                                        Chief Executive Officer,
                                        Secretary, and Director
Larry E. Howell................  50     President and Chief
                                        Operating Officer, and
                                        Director
Arthur R. Peterson, Jr.(1).....  51     Treasurer and Director       President and Chief
                                                                     Executive Officer, and
                                                                     Director
Robert A. Gardebled, Jr........  32     Director                     Controller, Secretary
                                                                     and Director
Jerome P. Welch(1)(2)..........  59     Director                     --
Michael E. Dunn(1)(2)..........  50     Director                     --
Harry Gray Browne, M.D.(2).....  67     Director                     --
------------------------
</TABLE>
(1)  Member of the Compensation Committee.
(2)  Member of Stock Option Committee.  See "--Stock Option Plan," below.

     The executive officers of LSI devote their full-time to LSI's business,
while Messrs. Simonelli and Howell will devote such time to the business and
affairs of LSAI as may be required, but not less than 50 percent of their time
will be devoted to the business and affairs of LSAI.

     The following is a brief description of the business background of the
executive officers and directors of LSAI:

     John Simonelli is Chairman of the Board, Chief Executive Officer, Secretary
and a Director of LSAI. Mr. Simonelli served as a Director, Chief Executive
Officer and Secretary of Vantage Capital Resources, Inc. from March 1996 until
its merger with Applied Intelligence Group, Inc. and thereafter served as a
Director and Vice President of Applied Intelligence Group, Inc. until October
14, 1996.  He served as Chairman of the Board and Chief Executive Officer of MBf
USA, Inc. (formerly American Drug Screens, Inc.), a publicly-held company
engaged in the medical products and services industry, from February 1988
through June 1992.  He served as Chief Executive Officer of Unico, Inc.
(formerly CMS Advertising, Inc.), a publicly-held company engaged in the
franchising of cooperative direct mail advertising businesses, from June 1986 to
June 1988.  From July 1981 through June 1985, he served in various capacities,
including President and Director, with Moto Photo, Inc., a publicly-held company
engaged in the business of franchising one-hour, photo development laboratories.
Mr. Simonelli served as President and CEO, from May 1985 until November 1985,
and a Director, from May 1985 through 1988, of TM Communications, Inc. (formerly
Video Image, Inc. and TM Century, Inc.), a publicly-held company engaged in
radio broadcasting and corporate communications.

     Larry E. Howell is President and Chief Operating Officer, and a Director of
LSAI.  Mr. Howell served as a Director, President and Treasurer of Vantage
Capital Resources, Inc. from March 1996 until its merger with Applied
Intelligence Group, Inc. and thereafter served as a Director and Vice President
of Applied Intelligence Group, Inc. until October 14, 1996.   He served as
President and Chief Operating Officer of MBf USA, Inc. (formerly American Drug
Screens, Inc.), a publicly-held company engaged in the medical products and
services industry, from February 1988 through June 1992.  From June 1986 to
April 1988, Mr. Howell served first as Vice President and than as President and
Chief Operating Officer of Unico, Inc. (formerly CMS Advertising, Inc.), a
publicly-held company engaged in the franchising of cooperative direct mail
advertising businesses.  Since January 1982, Mr. Howell as the sole proprietor
of Howell and Associates, Inc. provides consulting services principally related
to corporate acquisitions and mergers.

                                      -18-
<PAGE>
 
     Arthur R. Peterson, Jr. was elected Treasurer and a Director of LSAI in
July 1994 in connection with the LSI Acquisition.  Mr. Peterson founded LSI in
1978 and served as its President and Chief Executive Officer and a Director from
inception.  From March 1989 until April 1994, he served as a Director of MBf
USA, Inc. (formerly American Drug Screens, Inc.), a publicly held company in the
medical products and services industry and former parent of LSI.  Prior to 1978,
Mr. Peterson was Chairman of the Board and Chief Executive Officer of Clinical
Laboratories of La., Inc., a company he founded which served the medical
community in clinical studies.

     Robert A. Gardebled, Jr. was elected a Director of LSAI in July 1994 in
connection with the LSI Acquisition.  Since July 1989, he has served as an
assistant to the President and was elected Controller of LSI and in connection
with the LSI Acquisition, he was elected Secretary of LSI.  From July 1991 until
April 1994, Mr. Gardebled served as a Director of MBf USA, Inc. (formerly
American Drug Screens, Inc.), a publicly held company in the medical products
and services industry and former parent of LSI.  Prior to joining LSI, he was a
Production Manager for Halter Yachts, Inc., a Louisiana ship building company.

     Jerome P. Welch was elected a Director of LSAI on August 26, 1994.  Mr.
Welch is President of Prospect Publishers, Inc., a publisher of literary
hardback anthologies and newsletters.  From May 1990 through June 1992, he
served as a Director and in July 1990 was elected Secretary of MBf USA, Inc.
(formerly American Drug Screens, Inc.), a publicly-held company engaged in the
medical products and services industry.  From July 1988 to January 1990, Mr.
Welch served as President of Simon & Schuster Supplementary Publishers, a
subsidiary of Paramount Communications, Inc. and was Senior Vice President and
Publisher of McGraw Hill Educational Publishing from July 1987 to July 1988.

     Michael E. Dunn was elected a Director of LSAI on August 26, 1994.  Since
April 1980 to January 1995, he was a member, shareholder and director of the law
firm of Zrenda Dunn & Swan, A Professional Corporation (formerly Bright Zrenda &
Dunn), in Oklahoma City, Oklahoma,  and President from April 1992 until January
1995. Mr. Dunn has been a member, shareholder and President of Dunn Swan &
Cunningham, A Professional Corporation, since February 28, 1995.  He has been
the owner of the Woodlake Racquet Club, a recreational athletic club, since
1981.  From November 1991 to November 1992, he served as a director of Tide West
Oil Company, a publicly-held, independent oil and gas exploration and production
company.  Mr. Dunn was graduated from the University of Oklahoma College of Law
in 1972, and holds a Bachelor of Science in Accounting and pursued graduate
studies at the University of Oklahoma.

     Harry Gray Browne, M.D. was elected a Director of LSAI on December 12,
1994.  Dr. Browne is President and Chairman of the Board of NDA Corporation and
held the same positions with National Drug Assessment Corporation until their
merger on December 19, 1994.  Further, he is Vice Chairman and Senior Vice
President of Scientific Affairs of Therapeutic Antibodies, Inc., and a Director
of Therapeutic Antibodies London, Ltd. (both are international biopharmaceutical
companies), Chairman of the Board of Winchester Research Laboratories (a
development stage, genetic research company), a Director of Harley Screen PLC (a
clinical laboratory in London, England), and a member of the Board of Governors
of St. Thomas Aquinas College (a liberal arts college in Santa Paula,
California).  Until December 1, 1994, National Drug Assessment Corporation was
engaged in the providing of drug testing services.  Dr. Browne received a
Bachelor of Arts from Yale University in 1951 and a Medicinae Doctorate from
Cornell University Medical College in 1956 and a Diploma of Tropical Medicine
and Parasitology from the University of Havana in 1953.

Item 10.  Executive Compensation

     The following table sets forth certain information with respect to the
total cash compensation, paid or accrued, of the President and Chief Executive
Officer of LSAI and each of the executive officers that during 1996 received
compensation in excess of $100,000.

                                      -19-
 
<PAGE>
 

                          Officer Compensation Table

<TABLE>
<CAPTION>
                                                                                 Annual Compensation
                                                                     -------------------------------------------
                                                                                                   All Other
Name and Principal Position                                Year      Salary(1)      Bonus(2)    Compensation(3)
---------------------------                                ----      ---------      --------    ----------------
<S>                                                        <C>       <C>            <C>          <C>
John Simonelli.............................................1996...   $100,000       $  --             $12,600
  Chief Executive Officer of LSAI                          1995...   $ 75,000       $  --             $12,000
                                                           1994...   $ 75,000       $  --             $ 8,592
Larry E. Howell............................................1996...   $100,000       $  --             $14,100
  President and Chief Operating Officer of LSAI            1995...   $ 75,000       $  --             $12,000
                                                           1994...   $ 75,000       $  --             $ 8,592
Arthur R. Peterson, Jr. ...................................1996...   $120,133       $50,000           $21,700
  Treasurer of LSAI and Chief Executive Officer of LSI     1995...   $100,000       $50,000           $16,000
    Officer of LSI                                         1994...   $100,000       $76,956           $16,000
</TABLE>
------------
(1)  Dollar value of base salary (both cash and non-cash) earned during the
     year.
(2)  Dollar value of bonus (both cash and non-cash) earned during the year.
(3)  The amounts reflected are for an automobile allowance and life and
     disability insurance premiums paid by the Company.

Aggregate Option Grants and Exercises in 1996 and Year-End Option Values

     Stock Options and Option Values. The following table sets forth information
related to options granted to the executive officers named in the Officer
Compensation Table during 1996.

<TABLE>
<CAPTION>
                                                 Individual Grants
                             -----------------------------------------------------------  Potential Realizable Value at
                                                                                             Assumed Rates of Stock
                                         Percent of Total                                      Price Appreciation
                               Number    Options Granted   Exercise or                         for Option Term(1)
                             of Options  to Employees in   Base Price                     -----------------------------
Name                          Granted          1996         Per Share    Expiration Date  Five Percent      Ten Percent
----                         ----------  ----------------  -----------  ----------------  ------------      -----------
<S>                          <C>         <C>               <C>          <C>               <C>               <C>
John Simonelli.............    50,000           27%           $2.75     October 30, 2006    $223,973           $356,640
Larry E. Howell............    50,000           27%           $2.75     October 30, 2006    $223,973           $356,640
Arthur R. Peterson, Jr. ...    50,000           27%           $2.75     October 30, 2006    $223,973           $356,640
</TABLE>
------------
(1)  The potential realizable value portion of the foregoing table illustrates
     the value that might be realized upon exercise of the options immediately
     prior to the expiration of their term, assuming the specified compound
     rates of appreciation of LSAI's Common Stock over the term of the options.
     These amounts do not take into consideration provisions restricting
     transferability and represent certain assumed rates of appreciation only.
     Actual gains on stock option exercises are dependent on the future
     performance of LSAI's Common Stock and overall stock market conditions.
     There can be no assurance that the potential values reflected in this table
     will be achieved. All amounts have been rounded to the nearest whole dollar
     amount.

     Aggregate Stock Option Exercise and Year-End and Option Values. The
following table sets forth information related to the number of options
exercised in 1996 and the value realized by the named executive officers, as
well as, information related to the number and value of options held by the
named executive officers at the end of 1996. During 1996, there were no options
to purchase LSAI's Common Stock exercised by the named executive officers.

                                     -20-
<PAGE>

<TABLE>
<CAPTION>


                           Number of Unexercised Options     Value of Unexercised In-the-Money
                              as of December 31, 1996        Options as of December 31, 1996(1)
                           -----------------------------    -----------------------------------
Name                       Exercisable     Unexercisable    Exercisable           Unexercisable
----                       -----------     -------------    -----------           -------------
<S>                        <C>             <C>               <C>                  <C>
John Simonelli............    10,000           50,000          $  --                    $12,500
Larry E. Howell...........    10,000           50,000          $  --                    $12,500
Arthur R. Peterson, Jr....    10,000           50,000          $  --                    $12,500
------------
</TABLE>
(1)  The closing sale price of the Common Stock as quoted on Nasdaq SmallCap
     Market on December 31, 1996, was $3.00.  Because the closing highest bid
     price of the Common Stock on December 31, 1996, was equal to the exercise
     price, exercisable options were not in the money on such date.

Compensation of Directors

     The directors of LSAI that are employees of LSAI or LSI are not currently
compensated for attending meetings of directors and committees of the Board of
Directors, but are reimbursed out-of-pocket expenses.  The compensation of non-
employee directors has not been determined by the Board of Directors, but non-
employee directors are reimbursed out-of-pocket expenses incurred in attending
meetings of directors and committees on which they serve.  During 1996, the
Board of Directors of LSAI did not have any meetings and the directors of LSAI
were not paid any compensation nor was any compensation accrued.

Employment Arrangements

     LSAI has employment agreements with Messrs. Simonelli and Howell, which
were amended on April 15, 1996, and expire on April 15, 2000, each of which
provides, among other things, (i) an annual base salary of $112,500, (ii)
bonuses at the discretion of the Board of Directors, but not in excess of 10
percent of the net income of LSAI, (iii) eligibility for stock options under
LSAI's Stock Option Plan, (iv) health and disability insurance benefits and life
insurance, (v) an automobile allowance, and (vi) benefits consistent with
similar executive employment agreements.  The agreements require Messrs.
Simonelli and Howell to devote not less than 50 percent of their time and
attention to the business and affairs of LSAI.  The agreements also restrict the
employee's right to participate in other activities outside of LSAI to the
extent such activities conflict with the employee's ability to perform his
duties and that would violate his duty and loyalty to LSAI.  The Board of
Directors has delegated to the Compensation Committee, which is comprised of
Messrs. Peterson, Welch and Dunn, the responsibility of determining the bonus
compensation to be paid to the officers of LSAI.

     Furthermore, LSI has an employment agreement with Mr. Peterson which
expires April 15, 2000, and which provides, among other things, (i) an annual
base salary of $125,000, (ii) annual bonuses equal to the lesser of $50,000 or
10 percent of the net income of LSI before provision for income taxes, (iii)
eligibility for stock options under LSAI's Stock Option Plan, (iv) health and
disability insurance benefits and life insurance, maintained at the Company's
cost and expense, covering the life of Mr. Peterson in the face amount of
$1,000,000, (v) an automobile allowance, and (vi) benefits consistent with
similar executive employment agreements.  The agreement requires Mr. Peterson to
devote his full time and attention to the business and affairs of LSI.

     Each of the employment agreements with the officers of LSAI and LSI may be
terminated by LSAI or LSI in the event the Board of Directors determines in good
faith that the officer is guilty of gross negligence or fraud materially
injurious to LSAI or LSI.

Stock Option Plan

     LSAI established the Laboratory Specialists of America, Inc. 1994 Stock
Option Plan (the "Stock Option Plan" or the "Plan") in May 1994.  The Board of
Directors amended and restated the Plan on October 30, 1996, which will not
become effective unless and until approved of the shareholders of LSAI.  The
following summary of the Plan

                                      -21-
<PAGE>
 
does not reflect the amended and restated Plan, which in part will increase the
total number of shares of Common Stock authorized and reserved for issuance
under the Plan to 425,000.

     The Plan provides for the issuance of incentive stock options ("ISO
Options") with or without stock appreciation rights ("SARs") and nonincentive
stock options ("NSO Options") with or without SARs to employees and consultants
of the Company, including employees who also serve as directors of the Company.
The total number of shares of Common Stock authorized and reserved for issuance
under the Plan is 225,000.  As of December 31, 1996, NSO Options to purchase
50,000 (exercisable on or before July 20, 2005), and 185,000 shares (exercisable
after April 30, 1997 and on or before October 30, 2006) of Common Stock at an
exercise price of $3.00 and $2.75 per share, respectively, were outstanding.  In
the event the Plan as amended and restated is not approved by the shareholders,
10,000 of the NSO Options granted under the Plan will be canceled.  No options
have been exercised and no SARs have been granted.

     The Stock Option Committee, which is currently comprised of Messrs. Browne,
Welch and Dunn, administers and interprets the Plan and has authority to grant
options to all eligible employees and determine the types of options, with or
without SARs, granted, the terms, restrictions and conditions of the options at
the time of grant, and whether SARs, if granted, are exercisable at the time of
exercise of the Option to which the SAR is attached.

     The option price of the Common Stock is determined by the Stock Option
Committee, provided such price may not be less than the fair market value of the
shares on the date of grant of the option.  The fair market value of a share of
the Common Stock is determined by averaging the closing high bid and low asked
quotations for such share on the date of grant of the option as reported by
Nasdaq or, if not quoted on Nasdaq, by the Stock Option Committee. Upon the
exercise of an option, the option price must be paid in full, in cash or with an
SAR.  Subject to the Stock Option Committee's approval, upon exercise of an
option with an SAR attached, a participant may receive cash, shares of Common
Stock or a combination of both in an amount or having a fair market value equal
to the excess of the fair market value, on the date of exercise, of the shares
for which the option and SAR are exercised over the option exercise price.

     Options granted under the Plan may not be exercised until six months after
the date of the grant and rights under an SAR may not be exercised until six
months after the SAR is attached to an option, if not attached at the time of
the grant of the option, except in the event of death or disability of the
participant.  ISO Options and any SARs are exercisable only by participants
while actively employed as an employee or a consultant by LSAI or a subsidiary
of LSAI, except in the case of death, retirement or disability.  Options may be
exercised at any time within three months after the participant's retirement or
within one year after the participant's disability or death, but not beyond the
expiration date of the option.  No option may be granted after April 30, 2004.
Options are not transferable except by will or by the laws of descent and
distribution.

Officer and Director Liability

     As permitted by the provisions of the Oklahoma General Corporation Act, the
Certificate of Incorporation (the "Certificate") eliminates in certain
circumstances the monetary liability of directors of LSAI for a breach of their
fiduciary duty as directors.  These provisions do not eliminate the liability of
a director for (i) a breach of the director's duty of loyalty to LSAI or its
shareholders, (ii) acts or omissions by a director not in good faith or which
involve intentional misconduct or a knowing violation of law, (iii) liability
arising under Section 1053 of the Oklahoma General Corporation Act (relating to
the declaration of dividends and purchase or redemption of shares in violation
of the Oklahoma General Corporation Act), or (iv) any transaction from which the
director derived an improper personal benefit.  In addition, these provisions do
not eliminate liability of a director for violations of federal securities laws,
nor do they limit the rights of LSAI or its shareholders, in appropriate
circumstances, to seek equitable remedies such as injunctive or other forms of
non-monetary relief.  Such remedies may not be effective in all cases.

                                      -22-
<PAGE>
 
     The Certificate and Bylaws of LSAI provide that LSAI shall indemnify all
directors and officers of LSAI to the full extent permitted by the Oklahoma
General Corporation Act.  Under such provisions, any director or officer, who in
his capacity as such, is made or threatened to be made, a party to any suit or
proceeding, may be indemnified if the Board of Directors determines such
director or officer acted in good faith and in a manner he reasonably believed
to be in or not opposed to the best interest of LSAI.  The Certificate and
Bylaws of LSAI and the Oklahoma General Corporation Act further provide that
such indemnification is not exclusive of any other rights to which such
individuals may be entitled under the Certificate, the Bylaws, an agreement,
vote of shareholders or disinterested directors or otherwise.  Insofar as
indemnification for liabilities arising under the Act may be permitted to
directors and officers of LSAI pursuant to the foregoing provisions, or
otherwise, LSAI has been advised that in the opinion of the Commission such
indemnification is against public policy as expressed in the Act and is,
therefore, unenforceable.

Item 11.  Security Ownership of Certain Beneficial Owners and Management.

     The following table presents certain information as to the beneficial
ownership of LSAI's Common Stock as of April 15, 1997, and the beneficial
ownership of the Common Stock of (i) each person who is known to LSAI to be the
beneficial owner of more than five percent thereof, (ii) each current director
and executive officer of LSAI, and (iii) all current executive officers and
directors as a group, together with their percentage holdings of the outstanding
shares.  All persons listed have sole voting and investment power with respect
to their shares unless otherwise indicated, and there is no family relationship
between the executive officers and directors of LSAI.
<TABLE>
<CAPTION>

                                                     Common Stock
                                               -------------------------
                                                  Shares      Percent of
                                               Beneficially      Share
Name and Address of Beneficial Owner              Owned        Ownership
------------------------------------           ------------   ----------

<S>                                            <C>           <C>
Arthur R. Peterson, Jr.(1).......................   490,000        14.8%
  113 Jarrell Drive
  Belle, Chasse, Louisiana 70037

Joan Peterson....................................   490,000        14.8%
  3712 Fran Street
  Metairie, Louisiana

John Simonelli(1)................................   200,000         6.0%
  101 Park Avenue, Suite 810
  Oklahoma City, Oklahoma 73102

Larry E. Howell(1)...............................   200,000         6.0%
  101 Park Avenue, Suite 810
  Oklahoma City, Oklahoma 73102

Robert A. Gardebled, Jr.(1)......................    25,000          .8%
Jerome P. Welch(2)...............................     8,000          .2%
Michael E. Dunn(2)...............................        --         -- %
Harry Gray Browne, M.D.(2).......................        --         -- %
Executive Officers and Directors as a group
   (seven persons)...............................   923,000        27.9%

------------------------
</TABLE>
(1)  The number and percent of shares do not include options for the purchase of
     10,000 shares which were re-granted on March 28, 1997, in replacement of
     previously granted options that were then exercisable.
(2)  The number and percent of shares do not include options for the purchase of
     5,000 shares which were re-granted on March 28, 1997, in replacement of
     previously granted options that were then exercisable.

                                      -23-

<PAGE>
 
Item 12.  Certain Relationships and Related Transactions.

     Set forth below is a description of transactions entered into between LSI
and LSAI and certain of its officers, directors and shareholders during the last
two years.  Certain of these transactions will continue in effect  and may
result in conflicts of interest between the Company and such individuals.
Although these persons have fiduciary duties to the Company and its
shareholders, there can be no assurance that conflicts of interest will always
be resolved in favor of the Company.

     In connection with the LSI Acquisition (see "Item 1.  Description of
Business--Background--LSI Acquisition"), Arthur R. Peterson, Jr. exchanged all
outstanding common stock of LSI for 1,000,000 shares of Common Stock and 300,000
shares of Series I Cumulative Convertible Preferred Stock ("Series I Preferred
Stock") of LSAI.  The Series I Preferred Stock was fully redeemed on July 10,
1995, at the aggregate stated value of $300,000 and cumulative dividends of
$24,748 were paid in full.

     Until June 1996, LSAI's offices located at 1101-A Sovereign Row in Oklahoma
City were subleased from Unico, Inc. ("Unico") on a month-to-month basis
currently for $1,500 per month, and the lessors of such premises to Unico
include Messrs. Simonelli and Howell, who are officers and directors of LSAI.
Messrs Simonelli and Howell own, in the aggregate, a 50 percent undivided
interest in such premises, and are former directors of Unico. During 1996 and
1995, LSAI paid Unico, pursuant to the sublease, aggregate monthly rent of
$6,000 and $21,000, respectively.

     During 1995, the law firm of Zrenda Dunn & Swan, A Professional
Corporation, performed legal services as counsel to LSI and LSAI.  During 1994,
Michael E. Dunn, a Director of the Company, was President, a Director and a
shareholder of Zrenda Dunn & Swan.  During 1995, LSAI paid Zrenda Dunn & Swan
$8,520 for services rendered and $992.95 in reimbursement of expenses advanced
on behalf of LSAI.  During 1996 and 1995, LSAI paid Dunn Swan & Cunningham, A
Professional Corporation, $27,525 and  $112,530.42, respectively, for services
rendered and $3,576.91 and $5,576.91, respectively, in reimbursement of expenses
advanced on behalf of LSAI. During 1996 and 1995, Michael E. Dunn, a Director of
the Company, was President, a Director and a shareholder of Zrenda Dunn & Swan
and Dunn Swan & Cunningham.

     On July 20, 1995, Jerome P. Welch, Michael E. Dunn and Harry Gray Browne,
M.D., were each granted option to purchase 5,000 shares of LSAI Common Stock at
$3.00 per share, which became exercisable on January 20, 1996, and remain
exercisable until July 20, 2005.

     The Board of Directors of LSAI believes that the terms of the transactions
described above were at least as favorable as could be obtained from
unaffiliated third parties.  LSAI has adopted policies that any loans to
officers, directors and five percent or more shareholders ("affiliates") are
subject to approval by a majority of the disinterested independent directors of
LSAI and that further transactions with affiliates will be on terms no less
favorable than could be obtained from unaffiliated parties and approved by a
majority of the disinterested independent directors.

Item 13.  Exhibits and Reports on Form 8-K.

(a)  Exhibits:

     2.1  The Stock Purchase Agreement with National Psychopharmacology
          Laboratory, Inc., Haroutune K. Dekirmenjian and Kenneth O. Jobson,
          dated January 1, 1996.*

     3.1  The Registrant's Certificate of Incorporation.**

     3.2  The Registrant's Bylaws.**

                                      -24-
<PAGE>
 
       4.1   Form of Certificate of Common Stock of the Registrant.***

       4.2   Certificate of the Powers Designation, Rights and Preferences for
             the Series I Cumulative Convertible Preferred Stock of the
             Registrant.**

       4.3   Form of 1994 Warrant.***

       4.4   Form of Warrant Agreement Between the Registrant and Liberty Bank
             and Trust Company of Oklahoma City, N.A., dated September 27,
             1994.***

       4.5   Form of Representative's Warrants.***

       4.6   Laboratory Specialists of America, Inc. 1994 Stock Option Plan,
             adopted May 10, 1994.**

      10.1   Employment Agreement with John Simonelli, dated April 15, 1996.****

      10.2   Employment Agreement with Larry E. Howell, dated April 15,
             1996.****

      10.3   Employment Agreement between Arthur R. Peterson, Jr. and Laboratory
             Specialists, Inc., dated April 15, 1996.****

      10.4   Standard Oklahoma Business Complex Lease with 101 Park L.L.C.,
             dated June 25, 1996.****

      10.5   Garden Offices Building Lease Agreement between Swiss/M Ltd
             Partners and Laboratory Specialists, Inc., dated July 22, 1996.****

      10.6   Credit Sale Agreement among Hugh O'Connor, Laboratory Specialists,
             Inc. and Laboratory Specialists of America, Inc., dated December 3,
             1996.

      10.7   Standard Form of Agreement between Owner and Contractor amoung
             Kerry O'Connor General Contractor, Inc., Laboratory Specialists,
             Inc. and Laboratory Specialists of America, Inc.

      10.8   The Stock Purchase Agreement with National Psychopharmacology
             Laboratory, Inc., Haroutune K. Dekirmenjian and Kenneth O. Jobson,
             dated January 1, 1996.*

      10.9   Loan Agreement between Hibernia National Bank and Laboratory
             Specialists, Inc., dated December 27, 1995.*****

      10.10  Promissory Note issued by Laboratory Specialists, Inc. to Hibernia
             National Bank, dated December 27, 1995.*****

      21.1   Subsidiaries of Registrant.*****
--------------------
*     Incorporated by reference to Form 8-K, dated January 2, 1996, filed with
      the Commission on April 9, 1997.

**    Incorporated by reference to Form SB-2 Registration Statement No. 
      33-82058-D as filed with the Central Regional Office of the Commission on
      July 28, 1994.

***   Incorporated by reference to Amendment No. 2 to Form SB-2 Registration
      Statement No. 33-82058-D as filed with the Central Regional Office of the
      Commission on September 21, 1994.

****  Incorporated by reference to Form 10-QSB Quarterly Report for the
      quarterly period ended June 30, 1996, filed with the Commission on August
      15, 1996.

***** Incorporated by reference to Form 10-KSB Annual Report for the year ended
      December 31, 1995, filed with the Commission on April 15, 1996.


(b)  Reports on Form 8-K.


                                      -25-

<PAGE>
 
     During the last quarter of 1995, the Company did not file any reports on
Form 8-K.



                                      -26-


<PAGE>
 
SIGNATURES

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

                                   LABORATORY SPECIALISTS OF AMERICA, INC.
                                    (Registrant)


                               By: /S/JOHN SIMONELLI
                                   --------------------------------------------
                                      John Simonelli, Chief Executive Officer

Date:  April 15, 1997

     In accordance with the Exchange Act, this Report has been signed below by
the following persons on behalf of the Registrant and in the capacities and on
the dates indicated.
<TABLE>
<CAPTION>

Name                            Title                                    Date
----                            -----                                    ----
<S>                             <C>                                      <C>


                                Chief Executive Officer, Secretary
 /S/JOHN SIMONELLI              and Director                             April 15, 1997
------------------------------
    John Simonelli

                                President, Chief Operating Officer,
 /S/LARRY E. HOWELL             and Director                             April 15, 1997
------------------------------
    Larry E. Howell


 /S/ARTHUR R. PETERSON, JR.     Treasurer and Director                   April 15, 1997
------------------------------
    Arthur R. Peterson, Jr.


 /S/ROBERT A. GARDEBLED, JR.    Director                                 April 15, 1997
------------------------------
    Robert A. Gardebled, Jr.


 /S/JEROME P. WELCH             Director                                 April 15, 1997
------------------------------
    Jerome P. Welch


 /S/MICHAEL E. DUNN             Director                                 April 15, 1997
------------------------------
    Michael E. Dunn

</TABLE>

                                      -27-

<PAGE>
 
                         INDEX TO FINANCIAL STATEMENTS


LABORATORY SPECIALISTS OF AMERICA, INC.:
<TABLE>
<CAPTION>

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

     Consolidated Balance Sheets, December 31, 1996 and 1995..............................   F-3

     Consolidated Statements of Income, Pre-Acquisition Period
       (for the Period January 1, 1994, through April 17, 1994)...........................   F-5

     Consolidated Statement of Income, Post-Acquisition Periods
       (for the Years Ended December 31, 1996 and 1995, and for the
       Period April 18, 1994, through December 31, 1994)..................................   F-6

     Consolidated Statements of Stockholders' Equity, Pre-Acquisition Period
       (for the Period January 1, 1994, through April 17, 1994)...........................   F-7

     Consolidated Statement of Stockholders' Equity, Post-Acquisition Periods
       (for the Years Ended December 31, 1996 and 1995 and for the
       Period April 18, 1994, through December 31, 1994)..................................   F-8

     Consolidated Statements of Cash Flows, Pre-Acquisition Period
       (for the Period January 1, 1994, through April 17, 1994)...........................   F-9

     Consolidated Statement of Cash Flows, Post-Acquisition Periods
       (for the Years Ended December 31, 1996 and 1995, and for the
       Period April 18, 1994, through December 31, 1994)..................................  F-10

     Notes to Consolidated Financial Statements...........................................  F-11
</TABLE>

                                      F-1
<PAGE>
 
                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS



To the Board of Directors of
Laboratory Specialists of America, Inc.:


We have audited the accompanying consolidated balance sheets of Laboratory
Specialists of America, Inc. (an Oklahoma corporation) and subsidiaries as of
December 31, 1996 and 1995, and the related consolidated statements of income,
stockholders' equity and cash flows for the period January 1, 1994 through April
17, 1994 (pre-acquisition), and the period April 18, 1994 through December 31,
1994 (post-acquisition), and for each of the years ended December 31, 1995 and
1996. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Laboratory Specialists of
America, Inc. and subsidiaries as of December 31, 1996 and 1995, and the results
of their operations and their cash flows for the period January 1, 1994 through
April 17, 1994 (pre-acquisition), and the period April 18, 1994 through December
31, 1994 (post-acquisition), and the years ended December 31, 1995 and 1996, in
conformity with generally accepted accounting principles.


                                        ARTHUR ANDERSEN LLP


Oklahoma City, Oklahoma,
  March 7, 1997


                                      F-2

<PAGE>

                                                                     Page 1 of 2
 
           LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
           --------------------------------------------------------

                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------

                          DECEMBER 31, 1996 AND 1995
                          --------------------------

<TABLE>
<CAPTION>
 
 
                                                          1996          1995
                                                       ----------    ----------
<S>                                                    <C>           <C>
                  ASSETS
                  ------
CURRENT ASSETS:
    Cash and cash equivalents                          $  727,381    $2,411,051
    Accounts receivable, net of allowance of
      $597,499 in 1996 and $91,546 in 1995              1,696,744     1,096,477
    Income tax refund receivable                          312,664       131,626
    Inventories                                            99,754        87,542
    Prepaid expenses and other                            146,859       115,491
    Deferred tax asset                                    211,078             -
                                                       ----------    ----------
        Total current assets                            3,194,480     3,842,187
                                                       ----------    ----------
 
PROPERTY, PLANT AND EQUIPMENT, net of accumulated
  depreciation of $900,948 in 1996 and $899,559
  in 1995                                               1,592,599       830,660
                                                       ----------    ----------
 
OTHER ASSETS:
    Goodwill, net of accumulated amortization of
      of $171,355 in 1996 and $69,104 in 1995           2,663,850     1,539,045
    Customer lists, net of accumulated amortization
      of $216,429 in 1996 and $77,783 in 1995           1,863,061     1,001,707
    Deferred costs                                         80,818       105,437
                                                       ----------    ----------
 
        Total other assets                              4,607,729     2,646,189
                                                       ----------    ----------
        Total assets                                   $9,394,808    $7,319,036
                                                       ==========    ==========
</TABLE>


                                      F-3

<PAGE>
                                                                     Page 2 of 2

 
           LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
           --------------------------------------------------------

                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------

                          DECEMBER 31, 1996 AND 1995
                          --------------------------

<TABLE>
<CAPION>
                                                          1996         1995
                                                       ----------   ----------
<S>                                                    <C>          <C>
       LIABILITIES AND STOCKHOLDERS' EQUITY                 
       ------------------------------------                    
CURRENT LIABILITIES:
    Accounts payable                                   $  521,705   $  446,223
    Accrued payroll expenses                              300,103      215,308
    Other accrued expenses                                 57,310       51,838
    Short-term debt                                       410,293            -
    Current portion of long-term debt                     118,085            -
    Obligations related to discontinued operation         784,272            -
                                                       ----------   ----------
        Total current liabilities                       2,191,768      713,369
                                                       ----------   ----------
LONG-TERM DEBT                                          1,245,690      353,123
                                                       ----------   ----------
DEFERRED INCOME TAXES                                     307,100       40,958
                                                       ----------   ----------
COMMITMENTS AND CONTINGENCIES (Note 10)
 
STOCKHOLDERS' EQUITY:
    Common stock, $0.001 par value, 20,000,000  
      shares authorized, 3,313,405 shares issued
      and outstanding in 1996 and 3,298,405
      shares and outstanding in 1995                        3,313        3,298
    Paid in capital in excess of par, common stock      5,366,027    5,341,667
    Retained earnings                                     280,910      866,621
                                                       ----------   ----------
       Total stockholders' equity                       5,650,250    6,211,586
                                                       ----------   ----------
       Total liabilities and stockholders' equity      $9,394,808   $7,319,036
                                                       ==========   ==========
</TABLE>


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

                                      F-4

<PAGE>
 
           LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
           --------------------------------------------------------

                       CONSOLIDATED STATEMENTS OF INCOME
                       ---------------------------------

                        PRE-ACQUISITION PERIOD (NOTE 1)
                        -------------------------------

<TABLE>
<CAPTION>
                                                              For the Period
                                                              January 1, 1994
                                                               Through April
                                                                 17, 1994
                                                              ---------------
<S>                                                           <C>
REVENUES                                                        $1,294,775 
 
COST OF LABORATORY SERVICES                                        635,653
                                                                ----------
        Gross profit                                               659,122
                                                                ----------
OPERATING EXPENSES: 
    Selling                                                        121,764
    General and administrative                                     381,899
    Depreciation and amortization                                   41,830
                                                                ----------
        Total operating expenses                                   545,493
                                                                ----------
OTHER INCOME (EXPENSE):
    Interest expense                                                (7,966)
    Interest income                                                     57
    Other income                                                        32
                                                                ----------
        Total other expense                                         (7,877)
                                                                ----------
        Income before income taxes                                 105,752
 
INCOME TAX EXPENSE                                                  32,249
                                                                ----------
        Net income                                              $   73,503
                                                                ==========
Weighted average number of common stock shares outstanding       1,550,000
                                                                ==========
Primary earnings per share                                      $     0.05
                                                                ==========
Fully diluted earnings per share                                $     0.05
                                                                ==========
 
</TABLE>


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


                                      F-5

<PAGE>
 
            LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
            --------------------------------------------------------
                       CONSOLIDATED STATEMENTS OF INCOME
                       ---------------------------------
                       POST-ACQUISITION PERIODS (NOTE 1)
                       ---------------------------------
<TABLE>
<CAPTION>
                                                                                      For the Period
                                                 For the Year       For the Year      April 18, 1994
                                                    Ended              Ended             Through
                                                 December 31,       December 31,       December 31,
                                                     1996               1995               1994
                                                 -----------        ------------      --------------
<S>                                              <C>                <C>               <C>
REVENUES                                          $8,726,799          $6,925,716         $3,705,749

COST OF LABORATORY SERVICES                        3,816,114           3,246,470          1,655,692
                                                  ----------          ----------         ----------
     Gross profit                                  4,910,685           3,679,246          2,050,057
                                                  ----------          ----------         ----------
OPERATING EXPENSES:
  Selling                                            601,945             561,470            311,156
  General and administrative                       2,442,602           2,157,410          1,299,823
  Depreciation and amortization                      504,123             232,535            117,054
  Asset impairment                                   124,531                   -                  -
                                                  ----------          ----------         ----------
     Total operating expenses                      3,673,201           2,951,415          1,728,033
                                                  ----------          ----------         ----------

OTHER (EXPENSE) INCOME:
  Interest expense                                   (67,185)            (29,651)           (24,409)
  Interest income                                     41,208             126,939             31,422
  Other income                                         4,169             323,846             66,546
                                                  ----------          ----------         ----------
     Total other (expense) income                    (21,808)            421,134             73,559
     Income from continuing operations before     ----------          ----------         ----------
      income taxes                                 1,215,676           1,148,965            395,583


INCOME TAX EXPENSE                                   527,171             474,405            178,774
                                                  ----------          ----------         ----------
     Income from continuing operations               688,505             674,560            216,809

DISCONTINUED OPERATION:
  Loss from operations of discontinued clinical
   business, net of tax benefit of $257,904         (500,636)                  -                  -
  Loss on disposal of clinical business, net of
   tax benefit of $489,420                          (773,580)                  -                  -
                                                  ----------          ----------         ----------

     Net (loss) income                              (585,711)            674,560            216,809

DIVIDENDS ON PREFERRED STOCK                               -              13,344             11,404
                                                  ----------          ----------         ----------
     Net (loss) income available for
      common stockholders                         $ (585,711)         $  661,216         $  205,405
                                                  ==========          ==========         ==========

PRIMARY EARNINGS PER SHARE:
  Weighted average number of common stock and
   common stock equivalents outstanding            3,316,198           3,301,582          2,227,498
                                                  ==========          ==========         ==========
  Continuing operations                           $     0.21          $     0.20         $     0.09
  Discontinued operation                               (0.39)                  -                  -
                                                  ----------          ----------         ----------

     Total                                        $    (0.18)         $     0.20         $     0.09
                                                  ==========          ==========         ==========

FULLY DILUTED EARNINGS PER SHARE:
  Weighted average number of common stock
   and common stock equivalents outstanding        3,954,787           3,843,391          2,227,498
                                                  ==========          ==========         ==========
  Continuing operations                           $     0.17          $     0.17         $     0.09
  Discontinued operation                               (0.32)                  -                  -
                                                  ----------          ----------         ----------

     Total                                        $    (0.15)         $     0.17         $     0.09
                                                  ==========          ==========         ==========
</TABLE>
  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                      F-6

<PAGE>
 
            LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
            --------------------------------------------------------


                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                -----------------------------------------------

                        PRE-ACQUISITION PERIODS (NOTE 1)
                        --------------------------------

<TABLE>
<CAPTION>

                                                                                  For the Period
                                                                                    January 1,
                                                                                  1994 Through
                                                                                  April 17, 1994
                                                                                  --------------
<S>                                                                                  <C>
Common stock, $0.001 par value                                                       $    1,550
                                                                                     ----------

Paid in capital in excess of par, common stock:
        Balance, beginning of period                                                  2,290,152
        Dividends to MBf (Note 1)                                                      (949,082)
                                                                                     ----------

          Balance, end of period                                                      1,341,070
                                                                                     ----------

Retained earnings:
        Balance, beginning of period                                                    139,868
        Net income                                                                       73,503
                                                                                     ----------

          Balance, end of period                                                        213,371
                                                                                     ----------

          Total stockholders' equity                                                 $1,555,991
                                                                                     ==========

</TABLE>


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

                                      F-7
<PAGE>


           LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
           --------------------------------------------------------


                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                -----------------------------------------------

                       POST-ACQUISITION PERIODS (NOTE 1)
                       ---------------------------------


<TABLE>
<CAPTION>
                                                                                                     For the Period
                                                                    For the Year    For the Year     April 18, 1994
                                                                       Ended           Ended            Through
                                                                    December 31,    December 31,      December 31,
                                                                        1996            1995              1994
                                                                    ------------    ------------     --------------
<S>                                                                 <C>             <C>              <C>
Preferred stock, $0.001 par value, $1 stated value:                 
  Balance, beginning of period                                      $        -      $    300,000     $          -
  Issuance of stock in connection with the Exchange (Note 1)                 -               -              300,000
  Issuance to MBf in connection with Peterson's acquisition
    of LSI (Note 1)                                                          -               -              658,896
  Effect of the Exchange (Note 1)                                            -               -             (658,896)
  Redemption of stock (Note 1)                                               -          (300,000)               -
                                                                    ------------    ------------     --------------
      Balance, end of period                                                 -               -              300,000
                                                                    ------------    ------------     --------------

Common stock, $0.001 par value:
  Balance, beginning of period                                             3,298           3,298              1,550
  Issuance of stock in connection with the Exchange (Note 1)                 -               -                  239
  Public offering of stock (Note 1)                                          -               -                1,320
  Issuance of stock in connection with the purchase of the
    customer list (Note 3)                                                   -               -                  189
  Other issuance of stock                                                     15             -                  -
                                                                    ------------    ------------     --------------

      Balance, end of period                                               3,313           3,298              3,298
                                                                    ------------    ------------     --------------

Paid in capital in excess of par, common stock:
  Balance, beginning of period                                         5,341,667       5,341,667          1,341,070
  Eliminate retained earnings and record the effect of                               
    Peterson's acquisition of LSI (Note 1)                                   -               -               29,023
  Effect of the Exchange (Note 1)                                            -               -              427,923
  Public offering of stock (Note 1)                                          -               -            3,260,340
  Issuance of stock in connection with the purchase of the
    customer list (Note 3)                                                   -               -              283,311
  Other issuance of stock                                                 24,360             -                  -
                                                                    ------------    ------------     --------------

      Balance, end of period                                           5,366,027       5,341,667          5,341,677
                                                                    ------------    ------------     --------------

Retained earnings:
  Balance, beginning of period                                           866,621         205,405            213,371
  Net (loss) income                                                     (585,711)        674,560            216,809 
  Eliminate retained earnings and record the effect of
    Peterson's acquisition of LSI (Note 1)                                   -               -             (213,371) 
  Preferred stock dividends                                                  -           (13,344)           (11,404) 
                                                                    ------------    ------------     --------------

      Balance, end of period                                             280,910         866,621            205,405
                                                                    ------------    ------------     --------------

      Total stockholders' equity                                    $  5,650,250    $  6,211,586     $    5,850,370   
                                                                    ============    ============     ==============
</TABLE> 

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

                                      F-8
<PAGE>
 

           LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
           --------------------------------------------------------


                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                     -------------------------------------

                       PRE-ACQUISITION PERIODS (NOTE 1)
                       --------------------------------

<TABLE>
<CAPTION>
                                                                 For the Period
                                                                    January 1,
                                                                  1994 Through
                                                                 April 17, 1994
                                                                 --------------
<S>                                                              <C>
CASH FLOWS FROM OPERATING ACTIVITIES:               
 Net income                                                           $  73,503
 Adjustments to reconcile net income to net cash provided by
  operating activities--                                                 
      Depreciation and amortization                                      42,421
      Provision for bad debts and other                                  45,229
      Impact of changes in assets and liabilities-- 
       Accounts receivable                                             (218,844)
       Inventories                                                        3,460
       Prepaid expenses and other                                        35,515
       Other assets                                                         567
       Accounts payable and accrued expenses                            137,963
                                                                      ---------
                                                    
         Net cash provided by operating activities                      119,814
                                                                      ---------
                                                    
CASH FLOWS FROM INVESTING ACTIVITIES:               
 Capital expenditures                                                    (8,097)
 Due to/from affiliate                                                  (75,000)
                                                                      ---------
                                                    
         Net cash used in investing activities                          (83,097)
                                                                      ---------
                                                    
CASH FLOWS FROM FINANCING ACTIVITIES:               
                                                    
 Payments under line of credit                                         (110,858)
 Payments on long-term debt                                             (20,376)
                                                                      ---------
                                                    
         Net cash used in financing activities                         (131,234)
                                                                      ---------
                                                    
DECREASE IN CASH AND CASH EQUIVALENTS                                   (94,517)
                                                    
CASH AND CASH EQUIVALENTS, beginning of period                           94,517
                                                                      ---------
                                                    
CASH AND CASH EQUIVALENTS, end of period                              $     -
                                                                      =========
                                                    
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:  
 Cash paid during the period for interest                             $   7,966
                                                                      =========
                                                    
 Cash paid during the period for income taxes                         $     -
                                                                      =========
</TABLE>

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

                                      F-9
<PAGE> 
 
            LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
            --------------------------------------------------------
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                     -------------------------------------
                       POST ACQUISITION PERIODS (NOTE 1)
                       ---------------------------------
<TABLE>
<CAPTION>
                                                                                                               For the Period
                                                                        For the Year        For the Year       April 18, 1994
                                                                            Ended               Ended              Through
                                                                        December 31,         December 31,        December 31,
                                                                            1996                1995                 1994
                                                                        ------------        -------------      --------------
<S>                                                                     <C>                 <C>                <C> 
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net (loss) income                                                     $   (585,711)       $    674,560       $      216,809
  Adjustments to reconcile net (loss) income to net cash
    provided by operating activities-
     Depreciation and amortization                                           550,933             232,535              116,463
     Provision for bad debts and other                                       446,087              84,246               73,011
     Gain on sales of assets                                                 (50,000)                -                 (3,631)   
     Deferred income taxes                                                  (744,936)            (18,694)                 -
     Asset impairment                                                        174,531                 -                    -
     Disposal of clinical business                                         1,263,000                 -                    -
     Impact of changes in assets and liabilities-                       
       Accounts receivable                                                  (411,079)           (222,300)            (186,042)
       Income tax refund receivable                                          (54,939)              8,600             (140,226)
       Inventories                                                            43,582              (3,745)             (18,001)
       Prepaid expenses and other                                             64,182             (13,045)             (34,814)    
       Other assets                                                              -                   -                    433
       Accounts payable and accrued expenses                                (222,849)             (7,682)             233,273
                                                                        ------------        ------------       --------------
 
         Net cash provided by operating  activities                          472,801             734,475              257,275
                                                                        ------------        ------------       --------------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Capital expenditures                                                      (127,915)           (211,886)            (127,747)
  Proceeds from sales of assets                                               50,000                 -                  5,300
  Purchase of customer list                                                      -                   -               (787,440)
  Purchase of NPLI stock, net of cash acquired                            (1,022,597)                -                    -
  Acquisition costs                                                         (301,816)           (101,826)                 -
                                                                        ------------        ------------       -------------- 
 
         Net cash used in investing activities                            (1,402,328)           (313,712)            (909,887)
                                                                        ------------        ------------       -------------- 
CASH FLOWS FROM FINANCING ACTIVITIES:
  Dividends paid                                                                 -               (24,748)                 -
  Redemption of preferred stock                                                  -              (300,000)                 -
  Warrant offering costs                                                         -               (38,821)                 -
  Payments on short-term debt                                               (598,515)                -                (89,142)
  Payments on long-term debt                                                (155,628)            (90,585)             (75,464)
  Net proceeds from issuance of common stock                                     -                   -              3,261,660
                                                                        ------------        ------------       --------------
         Net cash (used in) provided by financing activities                (754,143)           (454,154)           3,097,054
                                                                        ------------        ------------       --------------
(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                          (1,683,670)            (33,391)           2,444,442
 
CASH AND CASH EQUIVALENTS, beginning of period                             2,411,051           2,444,442                  -
                                                                        ------------        ------------       --------------
CASH AND CASH EQUIVALENTS, end of period                                $    727,381        $  2,411,051       $    2,444,442
                                                                        ============        ============       ==============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
  Cash paid during the period for interest                              $    112,698        $     29,651       $       24,409
                                                                        ============        ============       ==============
 
  Cash paid during the period for income taxes                          $    631,564        $    480,405       $      319,000
                                                                        ============        ============       ==============
</TABLE>

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

                                     F-10
<PAGE>
 
            LABORATORY SPECIALISTS OF AMERICA, INC. AND SUBSIDIARIES
            --------------------------------------------------------

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                   ------------------------------------------



1. GENERAL:
   ------- 

Effective July 8, 1994, Laboratory Specialists of America, Inc. (the "Company"
or "LSAI"), an Oklahoma corporation, acquired all of the capital stock of
Laboratory Specialists, Inc. ("LSI"), and LSI became a wholly owned subsidiary
of LSAI.  This transaction was accounted for as a reverse acquisition of LSAI by
LSI, and LSI is treated as the acquiror for accounting purposes.  Therefore, the
accompanying financial statements for the periods prior to July 8, 1994, are
those of LSI and not those of LSAI.

Through LSI, the Company operates an independent forensic drug testing
laboratory providing integrated drug testing services to corporations and
governmental bodies, by negotiated contract, for detection of illegal drug use
by employees and prospective employees. The Company's customers are primarily in
the construction, transportation, service, mining and manufacturing industries,
principally located in the southeast and southwest United States.

On February 27, 1992, LSI's then parent, American Drug Screens, approved a
transaction whereby American Health Products Corporation ("AHP"), a Texas
corporation, acquired control of American Drug Screens. The transaction was
accounted for as a purchase. The excess purchase price over the fair value of
the net assets acquired amounting to $2,875,703 was recorded as goodwill, of
which $1,125,703 was allocated to the Company and $1,750,000 to AHP. The
goodwill allocated to the Company is being amortized using the straight-line
method over 40 years. The retained earnings of the Company at the date of
acquisition were eliminated in accordance with purchase accounting. Subsequent
to the date of the transaction, American Drug Screens changed its name to MBf
USA, Inc. ("MBf").

On February 23, 1994, LSI's then parent, MBf, exchanged its common stock
investment in LSI for 1,300,000 shares of MBf's common stock (having a market
value of $1,178,125) held by LSI's president and former owner, Arthur R.
Peterson, Jr., and 706,244 shares of cumulative, redeemable, convertible
preferred stock of LSI (the "LSI Preferred Stock"). Additionally, LSI paid a
cash dividend of $75,000, declared a noncash dividend forgiving amounts due from
MBf of approximately $545,000, and issued a note payable to MBf in the amount of
$353,123. These transactions have been reflected as dividends to MBf reducing
the Company's paid in capital balance in the accompanying consolidated statement
of stockholders' equity. The acquisition of the LSI common stock by Mr. Peterson
was accounted for under the purchase method of accounting. The purchase price
exceeded the fair market value of the net tangible assets of LSI by
approximately $1,565,000 which was recorded as goodwill on April 18, 1994, to be
amortized over 40 years. All of the above transactions, except the $75,000 cash
dividend, are noncash transactions, and have been excluded from the accompanying
statement of cash flows.

                                      F-11
<PAGE>

The pre-acquisition period presented is not comparable to the post-acquisition
period due to the purchase accounting adjustments recorded by LSI. The primary
difference is the recording of additional goodwill, as described above, and the
increase in the related amortization of $11,000 annually. Retained earnings of
LSI at the date of acquisition were eliminated in accordance with purchase
accounting.

On July 8, 1994, (i) Arthur R. Peterson, Jr. exchanged all of the outstanding
common stock of LSI for 1,000,000 shares of common stock and 300,000 shares of
Series I Cumulative Redeemable Convertible Preferred Stock (the "Series I
Preferred Stock") of LSAI, and (ii) MBf exchanged all of its LSI Preferred Stock
for 239,405 shares of common stock of LSAI (the "Exchange"). The Series I
Preferred Stock was entitled to annual cumulative dividends based upon the
national prime rate which initially was 6.75% subject to a maximum 2% rate
increase or decrease adjustment. LSAI redeemed the Series I Preferred Stock in
July 1995 at $1.00 per share, totaling $300,000. As a result of the Exchange,
LSI became a subsidiary of LSAI. The Exchange was accounted for as a reverse
acquisition of LSAI by LSI and LSI was treated as the acquiror for accounting
purposes.

On October 11, 1994, LSAI completed a public offering of 660,000 units comprised
of two shares of common stock and one 1994 warrant at a price of $6.10, which
resulted in net proceeds to the Company of approximately $3,260,000, net of
underwriting discounts, commissions and other offering expenses.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
   -------------------------------------------

Cash and Cash Equivalents
-------------------------

Cash equivalents consist of all highly liquid debt instruments with a maturity
of three months or less at the date of purchase. The Company invests excess cash
overnight in repurchase agreements, which are government collateralized
securities. The carrying amount of cash and cash equivalents approximates fair
value of those instruments due to their short maturity.

Inventories
-----------

Inventories consist of supplies of laboratory chemicals and specimen collection
materials. Inventories are valued at the lower of cost, on a first-in, first-out
basis, or market.

Property, Plant and Equipment
-----------------------------

Property, plant and equipment are recorded at cost, and are depreciated over the
estimated useful lives of the assets using the straight-line method as follows:

<TABLE> 
<CAPTION> 
                                Estimated Useful
                                  Useful Lives           1996            1995
                                ----------------      ----------     ----------
<S>                             <C>                   <C>           <C>  
  Land                               N/A              $   29,353     $   29,353
  Building and improvements     10 - 40 Years            867,110        631,244
  Equipment                      5 - 12 Years          1,492,633        987,480
  Vehicles                          5 Years               32,419         26,511
  Furniture and fixtures         5 - 10 Years             72,032         55,631
                                                      ----------     ----------

                                                       2,493,547      1,730,219

  Less - Accumulated 
   depreciation and
   amortization                                         (900,948)      (899,559)
                                                      ----------     ----------

                                                      $1,592,599     $  830,660
                                                      ==========     ==========
</TABLE> 
                                     F-12
<PAGE>
 
Goodwill and Customer Lists
---------------------------

Goodwill is amortized on a straight-line basis over 20 or 40 years and the
customer lists are amortized on a straight-line basis over fifteen years. The
Company continually evaluates whether events and circumstances have occurred
that indicate the remaining estimated useful life of goodwill or the customer
lists may warrant revision or that the remaining unamortized balance of goodwill
or the customer lists may not be recoverable. When factors, such as operating
losses, loss of customers, loss or suspension of laboratory certification for an
extended period, or changes in the drug testing industry, if present, indicate
that goodwill or the customer lists should be evaluated for possible impairment,
the Company uses an estimate of the related undiscounted net cash flows over the
remaining life of the goodwill or the customer lists in measuring whether they
are recoverable. Although management believes that goodwill and the customer
lists are currently recoverable over the respective remaining amortization
periods, it is possible, due to a change in circumstances, that the carrying
value could become impaired in the future. Such impairment could have a material
effect on the results of operations in a particular reporting period.

Deferred Costs
--------------

Deferred costs at December 31, 1996, include $38,821 of legal and accounting
expenses incurred in connection with the pending registration of the Company's
outstanding warrants (see Note 12), $33,523 related to construction in progress,
and $8,474 other. The deferred registration costs will be recorded as a
reduction of the proceeds from the exercise of the warrants; if the warrants are
not exercised, the costs deferred will be expensed. The Company will begin
depreciating the deferred building costs when the related building is put into
use during 1997.

Employee Stock Option Plan
--------------------------

The Company accounts for its employee stock option plan using the intrinsic
value method in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (see Note 11).

Income Taxes
------------

Deferred income taxes are provided to reflect the future tax consequences of
differences between the tax bases of assets and liabilities and their reported
amounts in the financial statements.

Earnings Per Common Share
-------------------------

Earnings per common share for the pre-acquisition period presented have been
computed using the number of common shares outstanding prior to the Exchange and
public offering as the Securities and Exchange Commission requires promotional
shares issued within one year of the initial filing date of the public offering
to be treated as outstanding for all reported periods. Primary earnings per
common share for the post-acquisition periods were computed using the weighted
average number of common shares outstanding after adding the dilutive effect of
the conversion of stock options. Outstanding warrants and a note payable to be
paid in stock are included in the fully diluted weighted average shares
outstanding calculation for the years ended December 31, 1996 and 1995.

                                     F-13
<PAGE>
 
Use of Estimates
----------------

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities, 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.
Actual results could differ from those estimates as additional information
becomes known.

3. BUSINESS ACQUISITIONS:
   ----------------------

National Drug Assessment Corporation
------------------------------------

On December 1, 1994, the Company acquired from National Drug Assessment
Corporation ("NDAC"), pursuant to an Asset Purchase Agreement dated November 30,
1994, certain intangible assets. The assets purchased included the customer list
of NDAC and all contracts, contract rights and agreements, correspondence with
the customers for which NDAC provided drug testing services (the "customer
list"), all specimens with respect to which testing was in process and had not
been completed, all rights to business conducted by NDAC related to drug
testing, and all rights in the name "National Drug Assessment" or "National Drug
Assessment Corporation" (the "Purchased Assets"). The purchase price of these
assets included: (i) a cash payment of $750,000; (ii) the issuance of 189,000
shares of LSAI common stock; and (iii) the contingent issuance, on or before
February 1, 1996, of such number of additional shares of common stock that have,
in the aggregate, a value equal to the revenues attributable to the customer
list during the 12 months ended December 1, 1995, in excess of $1,175,000. Based
on the revenues attributable to the customer list during the Company's first 12
months of ownership, no additional shares were issued by LSAI. The $1,070,940
purchase price of the NDAC purchased assets was allocated entirely to the
customer list and recorded as an intangible asset on December 1, 1994, to be
amortized over 15 years. The issuance of 189,000 shares of common stock has been
excluded from the accompanying consolidated statement of cash flows as it is a
non-cash transaction.

National Psychopharmacology Laboratory, Inc.
--------------------------------------------

On January 2, 1996, the Company acquired all of the issued and outstanding
capital stock (the "NPLI Stock") of National Psychopharmacology Laboratory,
Inc., a Tennessee corporation ("NPLI"), and purchased goodwill (the "NPLI
Goodwill"), pursuant to a Stock Purchase Agreement dated January 1, 1996 (the
"Purchase Agreement"), and NPLI became a wholly owned subsidiary of the Company
(the "NPLI Acquisition"). NPLI is engaged in forensic drug testing (urine drug
screening with chain of custody) and clinical testing and analysis.

Pursuant to the Purchase Agreement and in connection with the NPLI Acquisition,
(i) the Company agreed to pay $1,585,000 for the NPLI Stock (the "NPLI Stock
Purchase Price") of which $1,075,000 was paid at closing to the shareholders of
NPLI (the "NPLI Shareholders"), and two unsecured promissory notes (the "NPLI
Promissory Notes"), with an aggregate adjusted face value of $510,000, were
issued and delivered to the NPLI Shareholders, (ii) the Company agreed to pay
$140,000 for the NPLI Goodwill payable in 24 monthly installments commencing on
February 1, 1996, (iii) assumed net liabilities of NPLI of approximately
$875,000, and (iv) incurred deferred income taxes of approximately $800,000 as a
result of NPLI's tax basis being significantly less than the purchase price of
the NPLI Stock. All of the above resulted in a total purchase price of
approximately $3,400,000, substantially all of which was recorded as intangible
assets.

The forensic portion of NPLI's business was merged into LSI's operation
effective February 1996. The Company intended to sell the clinical business
during 1996, but after negotiations with three potential buyers failed, the
Company shut down the clinical operations effective in the fourth quarter of
1996. The revenues related to the discontinued clinical operation for the year
ended December 31, 1996, were approximately $3,413,000. The related operating
loss and shut down

                                     F-14
<PAGE>
 
expenses of the clinical business are included in the accompanying income
statement as "Discontinued Operation" and "Disposition of Discontinued
Operation," respectively. Assuming the acquisition had occurred at the beginning
of 1995, the unaudited consolidated pro forma results of operations (excluding
the clinical business) for the year ended December 31, 1995, are as follows (in
thousands of dollars):
<TABLE>
<CAPTION>
 
                                                                               (Unaudited)
                                                                               -----------
 
<S>                                                                            <C>
                    Revenues                                                   $8,626,000
 
                    Net income from continuing operations                         851,000
 
                    Primary earnings per share from continuing operations            0.26
 
</TABLE>

4. OTHER INCOME:
   -------------

Other income, as reflected in the consolidated statement of income for the year
ended December 31, 1995, includes proceeds of $320,000 received from the
settlement of litigation brought by LSI.

5. ACCOUNTING CHANGES:
   -------------------

Effective January 1, 1996, the Company adopted Statement of Financial Accounting
Standards ("SFAS") No. 121, "Accounting for the Impairment of Long-Lived Assets
and for Long-Lived Assets to be Disposed Of," which requires that long-lived
assets, certain identifiable intangibles and goodwill related to those assets be
reviewed for impairment.  The adoption resulted in no adjustment to the
financial statements.  During the fourth quarter of 1996, the Company made a
decision to hold for sale the laboratory building, which resulted in an
impairment of approximately $111,000 being recorded, which reduced the net book
value to $225,000.  The impairment is included in "Asset Impairment" in the
accompanying income statements.

The Financial Accounting Standards Board also recently issued SFAS No. 128,
"Earnings Per Share," which specifies the computation, presentation, and
disclosure requirements for earnings per share.  This statement is effective for
financial statements with periods ending after December 15, 1997.  Management
has not determined the impact this standard will have on earnings per share.

6. TRANSACTIONS WITH RELATED PARTIES:
   --------------------------------- 

During the years 1996, 1995 and 1994, LSAI incurred approximately $30,000,
$130,000 and $125,000, respectively, for legal services rendered by a director
of the Company who also serves as legal counsel for the Company.  Management
believes that the amounts incurred approximate those which would have been paid
to unrelated parties for the same services.

Until June 1996, LSAI's office in Oklahoma City was subleased from Unico, Inc.
("Unico") on a month-to-month basis.  Rental expense paid to Unico for 1996,
1995 and 1994 totaled approximately $6,000, $21,000 and $13,000, respectively.
The lessors of such premises to Unico include the President and Chief Executive
Officer of LSAI, who own, in the aggregate, a 50 percent undivided interest in
such premises and are former directors of Unico.

                                      F-15
<PAGE>
 
7. LINE OF CREDIT:
   -------------- 

In December 1995, LSI entered into a $1 million line of credit arrangement,
which matured in December 1996. The line of credit was renewed for $250,000 in
January 1997, maturing in January 1998, with an interest rate equal to the
Citibank N.A. rate, which was 8.25% at the date of renewal. LSAI is a guarantor
of any balances outstanding under the line of credit, which is collateralized by
LSI's accounts receivable, intangibles, inventories, equipment, and furniture
and fixtures. No drawings had been made against the line of credit as of
December 31, 1996.

8. DEBT:
   ---- 

Short-term debt at December 31, 1996, consists of a note payable to the former
shareholders of NPLI with a recorded amount of $334,460, representing the
discounted value of approximately 153,282 shares reserved for issuance pursuant
to the NPLI Purchase Agreement. The Company has not issued and delivered these
shares to the former shareholders based upon certain representations made by the
NPLI shareholders which the Company believes to have been misleading and false
at the closing of the NPLI Acquisition. The remaining short-term debt of $75,833
relates to the note payable for NPLI Goodwill (see Note 3).

Long-term debt consists of the following at December 31, 1996 and 1995:

<TABLE>
<CAPTION>
 
                                               1996           1995  
                                            ----------      --------
<S>                                       <C>              <C>
Note payable to MBf, due                    $  353,123      $353,123
  February 1999, interest                               
  rate 7%, collateralized by                            
  substantially all of the                              
  assets of LSI (see Note 1)                            
                                                        
Note payable for purchase of laboratory                 
  building                                     450,000           -
                                                        
Capital lease agreement                                 
  with Boehringer-Mannheim                              
  Corporation                                  560,652           -      
                                            ----------      --------
          Total long-term debt               1,363,775       353,123
                                                        
          Less- Current portion               (118,085)          -
                                            ----------      --------
                                                        
                                            $1,245,690      $353,123
                                            ==========      ========
</TABLE>

In late 1996, the Company purchased a building to be renovated for its new
laboratory. The purchase was financed by a note payable to the seller due on
June 3, 1997, with no stated interest rate. This was a noncash transaction and
has been excluded from the accompanying consolidated statement of cash flows.
This note has been classified as long-term based on a written commitment from a
bank to refinance the purchase and construction costs up to the lesser of 80% of
appraised value or cost, not to exceed $720,000. The bank note will be payable
monthly based on a fifteen-year amortization with the balance due five years
from issuance. In connection with the renovation of the new laboratory, the
Company entered into an agreement to pay $439,572 upon completion of the
renovation, which is expected during mid 1997.

During February 1996, LSI entered into an agreement with Boehringer-Mannheim
Corporation through February 2001, to purchase equipment and certain lab
supplies at a fixed price, per drug screen performed. The agreement resulted in
the Company recording approximately $650,000 in additional equipment, with an
equal amount recorded as a capital lease obligation payable over five years. The
amortization of the capital lease assets is included in depreciation expense in
the accompanying consolidated statement of income. The total monthly payment
during 1995 was $46,740. The agreement was amended during December 1996, and the
new monthly payment will be

                                     F-16
<PAGE>
 
$59,750, with $13,223 allocated to the principal and interest of the capital
lease obligation, with the remaining cost allocated to the cost of laboratory
supplies.  The future minimum lease payments related to the capital lease
obligation are as follows:
<TABLE>
<CAPTION>
 
            <S>                                           <C>
            1997                                          $ 158,670
            1998                                            158,670
            1999                                            158,670
            2000                                            158,670
            2001                                             26,446
                                                          ---------
 
                                                            661,126
 
            Less - Interest on capital lease obligation    (100,474)
                                                          ---------
 
            Total future minimum lease payments           $ 560,652
                                                          =========
 
</TABLE>

9. INCOME TAXES:
   -------------

For the pre-acquisition periods presented, LSI filed a consolidated income tax
return with its former parent and calculated its income taxes as though a
separate income tax return were filed.  Prior to 1995, the Company had no
material differences between the tax bases of assets and liabilities and their
reported amounts in the financial statements, except for certain goodwill which
is not deductible for tax purposes, and treated as a permanent difference.

The 1996 and 1995 provision (benefit) for income taxes on income from continuing
operations is summarized below:
<TABLE>
<CAPTION>

                                                             1996        1995
                                                          ----------  ----------
            <S>                                           <C>         <C>
            U.S. Federal--
             Current                                      $ 581,467    $390,008
             Deferred                                      (166,115)     (8,735)
                                                          ---------    --------

                                                            415,352     381,273

            State                                           111,819      93,132
                                                          ---------    --------

                 Total                                    $ 527,171    $474,405
                                                          =========    ========
</TABLE>

                                     F-17
<PAGE>
 
Deferred tax liabilities (assets) at December 31, 1996 and 1995, are composed of
the following:
<TABLE>
<CAPTION>

                                                           1996       1995
                                                        ----------  ---------

          Net deferred tax liability:
          <S>                                           <C>         <C>
             Accelerated depreciation                   $ (69,748)  $ 56,818
             Customer list, net of amortization           372,000          -
             Deferred taxable revenue, long-term            4,848     32,432
                                                        ---------   --------

                                                          307,100     89,250
                                                        ---------   --------
          Net deferred tax asset:
             Allowance for doubtful accounts             (134,273)   (37,534)
             Accrued liabilities                         (105,180)   (35,522)
             Deferred taxable revenue, short-term          28,375     27,699
             Operating loss carryforward                      -       (2,935)
                                                        ---------   --------

                                                         (211,078)   (48,292)
                                                        ---------   --------

               Total deferred taxes                     $  96,022   $ 40,958
                                                        =========   ========
</TABLE>
The results of the discontinued operation include a tax benefit of $747,324.

In the following table, the U.S. Federal income tax rate is reconciled to the
Company's 1996 and 1995 effective tax rates from continuing operations for
income as reflected in the consolidated statements of income.
<TABLE>
<CAPTION>

                                                        1996   1995
                                                        ----   ----

          <S>                                           <C>    <C>
          U.S. statutory rate                           34.0%  34.0%
             Increases resulting from--
               State income taxes                        6.1    5.4
               Goodwill amortization                     2.9    1.2
               Other                                      .4     .7
                                                        ----   ----

                                                        43.4%  41.3%
                                                        ====   ====
</TABLE>

10. COMMITMENTS AND CONTINGENCIES:
    ----------------------------- 

Contingent Liabilities
----------------------

Incidental to its business, the Company from time to time is sued by individuals
who have tested positive for drugs of abuse, generally arising from LSI's
alleged failure to properly administer drug urinalysis tests.  LSI is currently
a defendant in several such lawsuits.  Based upon prior successful defense of
similar-type lawsuits, the Company believes it has valid defenses to each of
such lawsuits, and intends to vigorously defend in such actions.  Although LSI
maintains insurance to protect itself against such liability, and LSI's
insurance carriers have assumed the defense of LSI in connection with certain
actions, the extent of such insurance coverage is limited, both in terms of
types of risks covered by the policies and the amount of coverage.  In the
opinion of the Company's management and its legal counsel, these suits and
claims should not result in judgments or settlements which would have a material
adverse effect on the Company's results of operations or financial position.
Although, LSI has not experienced any material liability related to such claims,
there can be no assurance that LSI, and possibly LSAI, will not at some time in
the future experience significant liability in connection with such claims and
such liability may exceed the extent of such insurance coverage, both in terms
of risks covered by the policies and the amount of coverage, 

                                     F-18
<PAGE>
 
which could have a material effect upon the results of operations and financial
condition of the Company.

Certification
-------------

The Company's laboratory is certified by the Substance Abuse and Mental Health
Services Administration ("SAMHSA"), the successor to the National Institute on
Drug Abuse, as well as certain state and local jurisdictions. Certification by
SAMHSA is essential to the Company's business, as certain clients are required
to use certified laboratories, and many of its clients look to certification as
an indication of reliability and accuracy of tests. In order to remain
certified, the Company is subject to frequent inspections and proficiency tests.
Failure to meet any of the numerous certification requirements could result in
suspension or loss of certification. Such suspension or loss of certification
could have a material adverse effect on the Company.

Employment Agreements
---------------------

LSAI has written employment agreements with its President and Chief Executive
Officer which provide, among other things, the following: (i) a term of four
years from April 16, 1996; (ii) a base salary of $112,500 each; (iii) bonuses at
the discretion of the Board of Directors; (iv) eligibility for stock options
under LSAI's Stock Option Plan (see Note 11); (v) health and disability
insurance benefits and life insurance of $500,000; (vi) an automobile allowance;
and (vii) benefits consistent with similar executive employment agreements. The
agreements also restrict the right to participate in other activities outside of
LSAI to the extent such activities conflict with the ability to perform duties
and that would violate duty and loyalty to LSAI.

LSI has a written agreement with its President and verbal employment agreements
with four key employees, each of which provides, among other things, the
following: (i) with respect to the President, a base salary of $125,000 for a
term of five years from April 16, 1996, and a bonus equal to 10 percent of the
pre-tax income of LSI, not to exceed $50,000; (ii) with respect to the four key
employees, bonuses equal to 1 percent for each employee of the pre-tax income of
LSI; (iii) eligibility for stock options under the stock option plan of its
parent, LSAI (see Note 11); and (iv) eligibility for health, disability and life
insurance benefits on the same terms as other employees. The agreements require
the Company's President and the four key employees to devote their full time and
attention to the business of LSI.

Judicial Decisions and Government Policy
----------------------------------------

Employee drug testing by federal agencies and certain private employers is
subject to regulation by certain federal agencies. Legislation currently exists
in a number of states regulating the circumstances under which employers may
test employees and the procedures under which such tests must be conducted. In
addition, the circumstances under which drug testing can legally be required by
employers is subject to court precedent and judicial review.

Hazardous Materials
-------------------

Certain testing procedures employed by the Company require the use of hazardous
materials. Failure to comply with current or future federal, state or local
environmental laws or regulations could have a material adverse effect on the
Company.

                                     F-19
<PAGE>
 
11. STOCK OPTION PLAN:
    ------------------

LSAI established the Laboratory Specialists of America, Inc. 1994 Stock Option
Plan (the "Stock Option Plan" or the "Plan") on May 10, 1994. On October 30,
1996, the Plan was amended, subject to shareholder approval, and the total
number of shares of common stock authorized and reserved for issuance was
increased from 225,000 to 425,000. The Plan provides for the issuance of both
incentive stock options ("ISO Options") and nonqualified stock options with or
without stock appreciation rights ("SARs") to directors, executive officers, key
employees and independent contractors and consultants of the Company and its
subsidiaries. ISO Options may be granted only to employees of the Company and
its subsidiaries. The Board of Directors interprets the Plan and establishes
certain committees to administer the Plan. These committees or the Board of
Directors have authority to grant options to all eligible employees and
determine the types of options granted, with or without SARs, the terms,
restrictions and conditions of the options at the time of grant, and whether
SARs, if granted, are exercisable at the time of the exercise of the option to
which the SAR is attached. The option price of the common stock is determined by
the Board of Directors or the various committees. The price may not be less than
85 percent of the fair market value of the shares on the date of the grant of
the option, with the exception of ISO options, which may not be less than the
fair market value of the shares on the date of grant. The Company's stock
options are fixed-price options granted at the fair market value of the
underlying common stock on the date of grant. Generally, the options vest and
become exercisable six months from the grant date and expire five to ten years
after the grant date.

The following table shows the activity for options issued under the plan as well
as other options issued:
<TABLE>
<CAPTION>

                                                                    Weighted
                                                                    Average
                                                                  Exercise Price
                                                      Options      Per Option
                                                      -------      ----------
     <S>                                              <C>          <C>    
     Balance outstanding January 1, 1995                  -             -
       Options granted                                125,000          3.00
                                                      -------

     Balance outstanding December 31, 1995            125,000          3.00
       Options granted                                185,000          2.75
                                                      -------

     Balance outstanding December 31, 1996            310,000          2.85
                                                      =======

     Options exercisable:
      December 31, 1995                                10,000          3.00
      December 31, 1996                               125,000          3.00
</TABLE>

                                     F-20
<PAGE>

Following are the range of exercise prices, the weighted-average remaining life
of all stock options outstanding at December 31, 1996, and the weighted-average
price within each price range of those options outstanding and those options
exercisable at year-end 1996.
<TABLE>
<CAPTION>

                                                                                              Options Exercisable at
                  Options Outstanding at December 31, 1996                                       December 31, 1996
------------------------------------------------------------------------------           ---------------------------------
                                          Weighted-
                                           Average               Weighted-                                Weighted-
                                          Remaining               Average                                  Average
                  Exercise Price         Contractual            Exercise Price                           Exercise Price
 Options            Per Option           Life (Years)             Per Option               Options         Per Option
---------          --------------        ------------           --------------           ----------      ---------------
 <S>               <C>                    <C>                    <C>                     <C>             <C>
 125,000              $     3.00              6.3                      $3.00               125,000           $3.00

 185,000                    2.75              9.8                       2.75                     -               -
 -------                                                                                   -------

 310,000               2.75-3.00              8.4                       2.85               125,000            3.00
 =======                                                                                   =======
</TABLE>

SFAS No. 123, "Accounting for Stock-Based Compensation," prescribes a fair-value
method of accounting for employee stock options under which compensation expense
is measured based on the estimated fair value of stock options at the grant date
and recognized over the period that the options vest. The Company will continue
to account for its stock option plan under the optional intrinsic value method
of APB No. 25, whereby no compensation expense is recognized for fixed-price
stock options. Had compensation expense been determined in accordance with SFAS
No. 123, the estimated weighted-average, grant-date fair value would have been
$1.14 and $1.23 per option for those options granted in 1996 and 1995,
respectively, and the resulting compensation expense would have reduced net
income and primary earnings per share as shown in the following pro forma
amounts. These amounts may not be representative of compensation expense that
might be expected to result in future years using the fair-value method of
accounting for employee stock options, as the number of options granted in a
particular year may not be indicative of the number of options granted in future
years.
<TABLE>
<CAPTION>
                                                       1996          1995
                                                    -----------    ---------
               <S>                                  <C>            <C>
               Net (loss) income:                              
                  As reported                        $(585,711)     $661,216
                  Pro forma                           (673,516)      614,771
                                                               
               (Loss) earnings per share:                      
                  Primary, as reported               $   (0.18)     $   0.20
                  Fully diluted, as reported             (0.15)         0.17
                  Primary, pro forma                     (0.20)         0.19
                  Fully diluted, pro forma               (0.17)         0.16
</TABLE>

The fair value of each option granted in 1996 and 1995 was estimated as of the
grant date using the Black-Scholes option pricing model with the following
weighted-average assumptions:
<TABLE>
<CAPTION>

                                                    1996         1995
                                                    -----        -----
                                             
               <S>                                  <C>          <C>
               Expected life (years)                   5            5
               Risk-free interest rate                 6%           6%
               Expected dividend yield                 -            -
               Expected volatility                    35%          35%
</TABLE>

12. COMMON STOCK WARRANTS:
    ----------------------

                                     F-21
<PAGE>

In connection with the public offering, the Company issued 660,000 warrants
which expire on September 27, 1999. Until April 15, 1997, each warrant may be
exercised to purchase two shares of common stock, for $3.50 per share. After
April 15, 1997, and on or before April 15, 1998, each warrant may be exercised
to purchase two shares of common stock for $2.00 per share. After April 15,
1998, the exercise price adjusts based on certain levels of net income per share
of common stock for the year ended December 31, 1997, as follows:
<TABLE>
<CAPTION>
 
                                     Net Income Per Share of Common Stock           Exercise Price Per Share
                             --------------------------------------------------         of Common Stock
   Exercise Period               Year Ended      Amount of Net Income Per Share     During Exercise Period
---------------------        ------------------  ------------------------------     ----------------------
<S>                          <C>                 <C>                                <C>
After April 15, 1998         December 31, 1997   $.40 or more per share                    $3.50
                                                 Less than $.40 but $.30
                                                   or more per share                       $3.00
                                                 Less than $.30 per share                  $2.50
 
</TABLE>

No warrants had been exercised at December 31, 1996 or 1995. The warrants may be
redeemed by the Company at any time, upon 30 days notice, at a price of $.01 per
warrant, only in the event the common stock trades in excess of the exercise
price of the warrant for 10 consecutive trading days.

As a portion of underwriting compensation, the Company issued warrants to
purchase 66,000 units at $7.32 per unit, consisting of two shares of common
stock and one warrant for two additional shares of common stock, exercisable
during a four-year period commencing on October 11, 1995. None of these warrants
had been exercised at December 31, 1996 or 1995. The warrant included within
each unit is exercisable under the same terms as the warrants issued in
connection with the public offering as described above.

13. SUBSEQUENT EVENTS:
    ------------------

On January 31, 1997, LSAI acquired from Pathology Laboratories, Ltd. ("PLL")
certain intangible assets pursuant to an Asset Purchase Agreement dated January
31, 1997 (the "Purchase Agreement"). PLL is a privately held corporation. The
assets purchased included the forensic drug testing customer list of PLL and all
contracts, contract rights and agreements, correspondence with the customers for
which PLL has provided forensic drug testing services, and all assets owned by
PLL used in connection with the PLL office in Greenville, South Carolina.
Pursuant to the Purchase Agreement, (i) the Company paid $1,600,000 at closing
and (ii) the Company assumed the obligations of PLL under a certain lease, dated
September 16, 1996, which requires monthly base rental payments of $2,083 and
which expires on September 16, 1999. Furthermore, the Company is required to
make four additional quarterly installment payments to PLL within 60 days
following the end of each three-month period during the twelve months ending
January 31, 1998. These quarterly payments are based on gross revenues directly
attributable to each customer comprising the customer base of PLL for the year
ending January 31, 1998, exceeding $1,600,000. The gross revenues attributable
to this customer base for the year ended December 31, 1996, were approximately
$3,200,000. The initial purchase price of $1,600,000 was financed with
additional long-term bank indebtedness. The Company consolidated the drug
testing services with its current laboratory in March 1997.

                                     F-22