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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                            ------------------------
 
                                   FORM 10-K
 
                ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
                      THE SECURITIES EXCHANGE ACT OF 1934
 
                  For the Fiscal Year Ended December 31, 1997
 
                        Commission File Number: 0-26980
                            ------------------------
 
                           ARV ASSISTED LIVING, INC.
             (Exact name of registrant as specified in its charter)
 
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                  CALIFORNIA                                     33-0160968
(STATE OR OTHER JURISDICTION OF INCORPORATION       (I.R.S. EMPLOYER IDENTIFICATION NO.)
               OR ORGANIZATION)
        245 FISCHER AVENUE, SUITE D-1                              92626
            COSTA MESA, CALIFORNIA                               (ZIP CODE)
   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
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       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (714) 751-7400
 
          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
 
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                TITLE OF CLASS                   NAME OF EACH EXCHANGE ON WHICH REGISTERED
                --------------                   -----------------------------------------
<S>                                            <C>
          COMMON STOCK, NO PAR VALUE                      AMERICAN STOCK EXCHANGE
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                            ------------------------
 
     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. Yes [X]  No [ ]
 
     As of March 24, 1998, the aggregate market value of the voting stock held
by non-affiliates of registrant was $78,730,556 (for purposes of calculating the
preceding amount only, all directors, executive officers and shareholders
holding 5% or greater of the registrant's Common Stock are assumed to be
affiliates). The number of shares of Common Stock of the registrant outstanding
as of March 24, 1998 was 15,860,998.
 
                      DOCUMENTS INCORPORATED BY REFERENCE:
 
     Portions of Registrant's definitive Proxy Statement for its 1998 Annual
Meeting of Stockholders are incorporated by reference into Part III of this
report.
 
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                           ARV ASSISTED LIVING, INC.
 
                      INDEX TO ANNUAL REPORT ON FORM 10-K
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
 
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                                     PART I
Item 1:     Business....................................................      1
Item 2:     Properties..................................................     19
Item 3:     Legal Proceedings...........................................     20
Item 4:     Submission of Matters to a Vote of Security Holders.........     21
                                    PART II
Item 5:     Market for Registrant's Common Equity and Related
            Shareholder Matters.........................................     22
Item 6:     Selected Financial Data.....................................     24
Item 7:     Management's Discussion and Analysis of Financial Condition
            and Results of Operations...................................     26
Item 8:     Financial Statements and Supplementary Data.................     33
Item 9:     Changes in and Disagreements with Accountants on Accounting
            and Financial Disclosures...................................     33
                                    PART III
Item 10:    Directors and Executive Officers of the Registrant..........     33
Item 11:    Executive Compensation......................................     33
Item 12:    Security Ownership of Certain Beneficial Owners and
            Management..................................................     33
Item 13:    Certain Relationships and Related Transactions..............     33
                                    PART IV
Item 14:    Exhibits, Financial Statement Schedules, and Reports on Form
            8-K.........................................................     33
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                                     PART I
 
ITEM 1. BUSINESS
 
GENERAL
 
     ARV Assisted Living, Inc. ("ARV" or the "Company") is one of the largest
operators of licensed assisted living communities ("ALCs") in the United States.
The Company is a fully integrated provider of assisted living accommodations and
services that operates, acquires and develops ALCs. The Company's operating
objective is to provide high quality, personalized assisted living services to
senior elderly residents in a cost effective manner, while maintaining
residents' independence, dignity and quality of life. ALCs comprise a
combination of housing, personalized support services and health care in a
non-institutional setting designed to respond to the individual needs of the
senior elderly who need assistance with certain activities of daily living, but
who do not need the level of health care provided in a skilled nursing facility.
 
     The Company has implemented its plan to expand its operations through the
acquisition and development of new ALCs. To this end, the Company has expanded
its operations through acquisitions in California, Ohio, Florida, Indiana,
Michigan and Virginia, and it has developed or is in the process of constructing
new ALCs in California, Florida, Texas, New Mexico, Indiana, Massachusetts and
Nevada. At December 31, 1997, the Company operated 49 ALCs containing 6,297
units. Of the 49 ALCs, the Company operates 14 Owned ALCs (as defined below) and
32 Leased ALCs (as defined below), and manages three ALCs ("Managed ALCs").
"Owned ALCs" means ALCs owned by the Company directly or by affiliated limited
partnerships for which the Company serves as managing general partner and
community manager ("Affiliated Partnerships") in which the Company has a
majority ownership interest. "Leased ALCs" means ALCs operated under long-term
operating leases for the Company's own account or for Affiliated Partnerships in
which the Company has a majority ownership interest. "Managed ALCs" means ALCs
operated by the Company on behalf of an affiliated partnership. On February 12,
1998, the Company entered into Purchase and Sale Agreements to purchase
interests in 13 ALCs and one skilled nursing facility ("SNF") located in
California, containing approximately 1,900 units, for approximately $88 million.
In addition, the Company has five ALCs currently under construction that are
expected to contain 633 units.
 
     The Company has utilized lease and mortgage financing with health care real
estate investment trusts ("Health Care REITs"), private companies, commercial
banks and a convertible subordinated debt issuance to help effectuate its growth
strategy. During the nine-month period ended December 31, 1997, the Company
received additional capital of approximately $82.2 million, after deducting
associated expenses, from the sale of newly issued common shares and the
issuance of convertible subordinated notes (which were redeemed for common
shares in December 1997). This additional capital will allow the Company to
facilitate its growth strategy.
 
     The Company intends to continue to expand its existing portfolio through
the acquisition and development of Owned ALCs as well as through the operation
of Leased ALCs and Managed ALCs. This blend of ownership structures is
anticipated by management to allow the Company to fund its growth in a balanced
and efficient manner.
 
     The Company intends to continue to focus on "private-pay" residents, who
pay for the Company's services from their own funds or through private
insurance, rather than relying on potential residents who live in the few states
that have enacted legislation enabling ALCs to receive Medicaid funding similar
to funding generally provided to skilled nursing facilities. Currently,
approximately 97% of the Company's ALC revenue comes from private-pay residents,
while the remaining 3% of such revenue comes from residents in the Supplemental
Security Income ("SSI") program.
 
     The Company's ALCs provide residents with a combination of living
accommodations, basic care services and assisted living services. The residents
of the Company's ALCs average 85 years of age and often require assistance with
certain activities of daily living. The Company provides its assisted living
residents with private or semi-private rooms or suites, meals in a communal
setting, housekeeping, linen and laundry services, activities programs,
security, utilities, and transportation in a Company van or minibus. The
 
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Company also provides assisted living services to which residents can subscribe
as they require assistance with other activities of daily living, including
personal care, assistance with bathing, grooming, dressing, personal hygiene and
escort services to meals and activities. Further, the Company has implemented a
Wellness Program at each of its 49 communities, pursuant to which the Company
arranges for the provision of certain health care services to its residents.
 
     In August 1996, the Company, through its wholly owned subsidiary, ARV
Health Care, Inc., acquired SynCare, Inc., a physical, speech and occupational
therapy provider, in a stock-for-stock merger. SynCare, Inc. was the holding
company of three corporations, BayCare Rehabilitative Services Inc., ProMotive
Rehabilitation Services and Pro Motion Rehab. BayCare Rehabilitative Services
Inc. and Pro Motion Rehab were merged into ProMotive Rehabilitation Services,
which does business under the name GeriCare ("GeriCare"). GeriCare specializes
in rehabilitative services, including speech, occupational and physical therapy.
 
     Partnerships affiliated with the Company have acquired or developed market
rate senior apartments as well as affordable senior and multifamily apartment
communities, using the sale of tax credits under a federal low income housing
tax credit program (the "Federal Tax Credit Program" or the "Apartment Group")
to generate the equity funding for development.
 
     As part of its strategic plan, management and the Board of Directors have
determined that GeriCare and the Apartment Group are not part of the core
business of the Company, and have adopted a plan for disposing of both lines of
business.
 
     The Company or its affiliated entities have been continuously involved in
the acquisition, development and operation of senior housing facilities for more
than 20 years. Since its founding in 1980, the Company has built an executive
management team and assisted living operation with experience and expertise in
the management, financing, acquisition, development and operation of ALCs.
 
THE ASSISTED LIVING MARKET
 
     Assisted Living. Assisted living can be viewed as falling near the middle
of the elder care continuum, between home-based care at one end and long-term
skilled nursing facilities and acute care hospitals at the other. Assisted
living represents a combination of housing, personalized support services, and
health care designed to respond to the individual needs of the senior elderly
who need help in activities of daily living, but do not need the medical care
provided in a skilled nursing facility.
 
     The Company believes its assisted living business benefits from significant
trends affecting the long-term care industry. The first is an increase in the
demand for elder care resulting from the continued aging of the U.S. population,
with the average age of the Company's assisted living residents falling within
the fastest growing segments of the U.S. population. While increasing numbers of
Americans are living longer and healthier lives, many gradually require
increasing assistance with activities of daily living, and are not able to
continue to age in place at home. The second is the effort to contain health
care costs by the government, private insurers and managed care organizations by
limiting lengths of stay, services, and reimbursement amounts to persons in
acute care hospitals and skilled nursing facilities. Assisted living offers a
cost effective long-term care alternative while preserving a more independent
lifestyle for those senior elderly who do not require the broader array of
medical services that acute care hospitals and skilled nursing facilities are
required to provide. As of December 31, 1997, monthly revenue from the Company's
ALCs on a "same community basis" (defined as those communities which the Company
owned, managed or leased for a period of four quarters or more as of December
31, 1997) averaged $1,734 per occupied unit compared to $1,610 per occupied unit
as of March 31, 1997. Other trends benefiting the Company include the increased
financial net worth of the elderly population, the increase in the population of
individuals living alone and the increasing number of women who work outside the
home and are therefore less able to care for their elderly relatives. The
Company believes that these trends will result in an increasing demand for
assisted living services and communities to fill the gap between aging at home
and aging in more expensive skilled nursing facilities.
 
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     Aging Population. The primary consumers of long-term health care services
are persons over the age of 65. This group represents one of the fastest growing
segments of the population. According to U.S. Bureau of the Census data, the
segment of the population over 65 years of age is currently 13% of the total
population or 34 million people. That number is projected to grow to 20% of the
total population or 69 million people by the year 2030. Additionally, the number
of people aged 85 and older, which comprises the largest percentage of residents
at long-term care facilities, is currently 3.7 million and is projected to
increase to 8.5 million by the year 2030.
 
     The Company believes that growth in the assisted living industry is being
driven by several factors. Advances in the medical and nutrition fields have
resulted in an increased life expectancy, resulting in larger numbers of elderly
people. The increased number of women in the labor force has reduced the supply
of caregivers. Historically, unpaid women (mostly daughters or daughters-in-law)
represented a large portion of the caregivers of the non-institutionalized
senior elderly. As a result of changing societal patterns, the population of
individuals living alone has increased significantly since 1960. This increase
has been the result of an aging population in which women outlive men by an
average of 6.8 years, rising divorce rates, and an increase in the number of
unmarried individuals.
 
     Limitation on the Supply of Long-Term Care Facilities. The majority of
states in the U.S. have enacted Certificate of Need or similar legislation,
which generally limits the construction of skilled nursing facilities and the
addition of beds or services in existing skilled nursing facilities. High
construction costs, limitations on government reimbursement for the full cost of
construction, and start-up expenses also act to constrain growth in the supply
of such facilities. Such legislation benefits the assisted living industry by
limiting the supply of skilled nursing beds for the senior elderly. Cost factors
are placing pressure on skilled nursing facilities to shift their focus toward
higher acuity care which enables them to charge higher fees, thus creating a
shortage of lower acuity care availability, and thereby increasing the pool of
potential assisted living residents.
 
     While Certificates of Need generally are not required for assisted living
communities, except in a few states, most states do require assisted living
providers to license their communities and comply with various regulations
regarding building requirements and operating procedures and regulations. States
typically impose additional requirements on assisted living facilities over and
above the standard congregate care requirements. Further, the limited pool of
experienced assisted living staff and management, as well as the costs and
start-up expenses to construct an assisted living community, provide an
additional barrier to entry into the assisted living business.
 
     Cost Containment Pressures of Health Reform. In response to rapidly rising
health care costs, both government and private pay sources have adopted cost
containment measures that have encouraged reduced lengths of stay in hospitals
and skilled nursing facilities. The federal government has acted to curtail
increases in health care costs under Medicare by limiting acute care hospital
reimbursement for specific services to preestablished fixed amounts. Private
insurers have also begun to limit reimbursement for medical services in general
to predetermined "reasonable" charges. Managed care organizations, such as
health maintenance organizations ("HMOs") and preferred provider organizations
("PPOs") are reducing hospitalization costs by negotiating for discounted rates
for hospital services and by monitoring and decreasing hospitalization. The
Company anticipates that both HMOs and PPOs increasingly may direct patients
away from the more expensive nursing care facilities into less expensive ALCs.
 
     These cost containment measures have produced a "push-down" effect. As the
number of patients being "pushed down" from acute care hospitals to skilled
nursing facilities increases, the demand for residential options such as
assisted living communities to serve patients who historically have been served
by skilled nursing facilities will also increase. In addition, skilled nursing
facility operators are continuing to focus on improving occupancy and expanding
services (and fees) to subacute patients requiring very high levels of nursing
care. As the level of skilled nursing facility patients increases, the supply of
nursing facility space will be filled by patients with higher acuity needs
paying higher fees, which again will provide opportunities for assisted living
communities to increase their occupancy and services to residents requiring
lesser levels of care than generally can be expected for patients in skilled
nursing facilities.
 
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THE COMPANY'S ASSISTED LIVING SERVICES
 
     The Company provides services and care which are designed to meet the
individual needs of its residents. The services provided by the Company are
designed to enhance both the physical and mental well-being of the senior
elderly in each of its communities by promoting their independence and dignity
in a home-like setting. The Company's assisted living program includes the
following:
 
          Personalized Care Plan. A primary element of the Company's strategy is
     the concept of "personalized" care to meet each resident's specific needs.
     This concept of customizing services to meet the needs of the residents
     begins with the resident admissions process, where the community's
     management staff, the resident, the resident's family, and the resident's
     physician discuss the resident's needs and develop a plan for the
     resident's care. If recommended by the resident's physician, additional
     health care or medical services may be provided at the community by a third
     party home health care agency or other medical provider. The care plan is
     reviewed and modified on a regular basis.
 
          Basic Service and Care Package. The basic service and care package at
     the Company's ALCs generally includes the following: meals in a communal,
     "home-like" setting, housekeeping, linen and laundry service, social and
     recreational programs, security, utilities and transportation in a Company
     van or minibus. Other care services can be provided under the basic package
     based upon the individual's personalized health care plan. While the amount
     of the fee for the basic service package varies from community to
     community, on a same community basis the average basic monthly rate per
     unit was approximately $1,461 per month as of December 31, 1997, compared
     to an average of $1,380 as of March 31, 1997.
 
          Additional Services. The Company has designed its additional assisted
     living services generally on a tiered program available to residents on a
     personalized basis.
 
             Level One: Assistance to residents in the self-administration of
        medication. Where necessary, the assisted living staff will consult with
        the family, the physician or the insurance company of a resident to
        designate a home health care agency to administer the appropriate
        medication.
 
             Level Two: In addition to the services provided under Level One,
        assistance with bathing, dressing and grooming, escorting to and from
        meals and activities, reading mail, writing letters, shopping and other
        specialized activities. These services are provided on an as-needed
        basis and at the convenience of the resident within the overall
        operation of the community.
 
             Level Three: All of the services provided under Level One and Level
        Two, and, in addition, provision of those services on a 24-hour basis.
        Further, this level provides appropriate services for individuals who
        need help with incontinence.
 
In addition to the above three levels, the Company provides other levels of
assistance to its residents at selected ALCs in order to meet their individual
needs.
 
             Level Four: All of the services provided under the previous levels,
        plus assistance with diabetic care and monitoring, Catheter, Colostomy
        and Illosotomy Care, minor wound care needs and light to moderate
        transferring needs.
 
             Dementia/Alzheimer's Care: Provides the attention and services
        required to help cognitively impaired residents maintain a high quality
        of life in a secure environment. Specially trained staff provide
        personalized care and specialized activity programs.
 
     In addition to the base rent, the Company typically charges a $375 per
month fee for Level One assisted living services, $700 per month for Level Two
assisted living services, $1,125 to $1,400 per month for Level Three assisted
living services, $2,000 per month for Level Four assisted living services, and
$1,425 to $1,700 for Dementia/Alzheimer's Care, but the fee levels vary from
community to community. At some communities, the Company may charge additional
fees for other specialized assisted living services. As the Company's residents
age at the communities, the Company expects that an increasing number of
residents will utilize additional levels of services. The Company's internal
growth plan is focused on increasing revenue by
 
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continuing to expand the number and diversity of its tiered assisted living
services and the number of residents using these services. There can be no
assurance that, at any time, any assisted living community will be substantially
occupied at assumed rents. In addition, lease-up and full occupancy may be
achievable only at rental rates below those assumed. If operating expenses
increase, local rental market conditions may limit the extent to which rents may
be increased. Because rent increases generally can only be implemented at the
time of expiration of leases, rental increases may lag behind increases in
operating expenses.
 
     On a same community basis, the average monthly revenue per occupied unit
for both the basic service and the additional services as of December 31, 1997
increased to $1,734 from $1,610 at March 31, 1997.
 
     Wellness Program. The Company has implemented a Wellness Program for the
residents of its communities designed to identify and respond to changes in a
resident's health or condition and then, together with the resident and the
resident's family and physician, as appropriate, design a solution to fit that
resident's particular needs. The Company monitors the physical and mental
well-being of its residents. This monitoring activity takes place at meals and
other scheduled activities, and informally as the staff performs its services
around the facility. Under the Wellness Program, the Company works with home
health care agencies to provide services the community cannot provide, with
physical and occupational therapists to provide these services to residents in
need of such therapy, and with a long-term care pharmacy to facilitate cost
effective and reliable ordering and distribution of medication. The Company
arranges for these services to be provided to residents as needed in
consultation with their physicians and families. At the present time, all of
Company's ALCs have a comprehensive Wellness Program.
 
GROWTH STRATEGIES
 
     Overview. The Company's growth strategy focuses on the (i) acquisition and
development of ALCs and (ii) expansion of the level and depth of assisted living
services.
 
     The Company expects to grow by increasing its portfolio of ALCs through
acquisition, development and management. The Company's strategic plan calls for
the acquisition and development of ALCs through direct ownership and the use of
long-term operating leases with institutional investors, as well as through
direct ownership financed with secured debt. While the Company has financed a
portion of its direct ownership of ALCs with secured debt from Health Care
REITs, it does not have any participation or sponsorship interest in these
entities. The Company believes that this blend of ownership structures allows
the Company to fund its growth in a balanced and cost effective manner. In
addition, the Company may seek to add to its portfolio of Managed ALCs.
 
     The Company and its predecessors have acquired and developed assisted
living and senior housing communities for more than 20 years. During this
period, the Company and its predecessors have acquired 37 ALCs, including one
portfolio of eight communities, and developed twelve ALCs currently in
operation. Additionally, during February 1998, the Company entered into purchase
and sale agreements to acquire interests in 13 ALCs and one SNF. Management
believes the Company has made significant progress in developing and expanding
its operational procedures and has begun to establish an infrastructure to
support development on a national basis.
 
     The Company's strategy is to expand by targeting areas where there is a
need for ALCs based on demographics and market studies. The Company intends to
continue to expand its assisted living operations throughout the U.S., locating
its communities in clusters, that is, areas where it has other existing
communities or geographic areas where it intends to acquire or develop other
ALCs. In this way, the Company seeks to increase the efficiency of its
management resources and to achieve broader economies of scale.
 
     A substantial portion of the business and operations of the Company are
conducted in California, where 31 of the 54 (as of December 31, 1997) ALCs
operated, managed or in development by the Company are located. Additionally,
all of the 13 ALCs and one SNF for which the Company has entered into agreements
to purchase interests are located in California. Other regional concentrations
of ALCs are planned for Florida, Texas, the Midwest and the Northeast. The
market value of these properties and the income generated from
 
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properties owned, managed or leased by the Company could be negatively affected
by changes in local and regional economic conditions and by acts of nature. A
worsening of current economic conditions in these areas of concentration, or a
downturn in the economic conditions in its other regions, could have a negative
effect on the Company's business.
 
     Development. The Company will seek to grow through the development of new
ALCs in its targeted markets. The Company's primary development strategy is to
conduct its development activities in conjunction with developers and builders
in clustered geographic areas throughout the U.S. The Company is in the process
of negotiating a strategic alliance with Kapson Senior Quarters ("Kapson"), a
major provider of assisted living services in the Northeast (see "Transactions
with Prometheus Assisted Living"). It is the Company's intention to utilize
Kapson to develop communities for the Company in certain markets. However, there
can be no assurance that the Company will successfully enter into a strategic
alliance with Kapson. Typically, regional developers receive development or
construction fees in connection with the construction of the project. In all
cases, the Company has the right to approve acquisitions and all aspects of
development including site selection, design, plans and specifications,
development budgets, choice of general contractor and major subcontractors, and
other significant criteria.
 
     In developments financed through long-term operating leases, the financier
typically acquires the property when it is ready for construction, with the
development performed by the Company, either on its own or in conjunction with
regional developers in certain cases, under a contractual arrangement with the
owner. Concurrently, the Company enters into a long-term operating lease which
becomes effective when the facility is completed. The financier typically bears
100% of the budgeted development costs which may also include development or
construction supervision fees for the Company. In most instances where the
Company provides development services it bears the risk for cost overruns. The
Company typically incurs up-front development costs in connection with the due
diligence and entitlement process and architectural and engineering fees in
connection with preparing the property for purchase by the financier at the
beginning of construction. The Company currently leases its new development ALCs
from four Health Care REITs and two private entities. Leases between the Company
and a lessor entity are typically interconnected in that the Company will not be
entitled to exercise its right to renew one lease with a particular lessor
without exercising its right to renew all other leases with that lessor and
leases with each lessor contain certain cross default provisions. Therefore, in
order to exercise lease renewal terms, the Company will be required to maintain
and rehabilitate all of the Leased ALCs with any one lessor on a long-term
basis.
 
     As part of its growth strategy, the Company plans to develop new ALCs. The
Company's ability to achieve its development plans will depend upon a variety of
factors, many of which are beyond the Company's control. These and other factors
are detailed below. See "Risks Common to the Company's Assisted Living
Operations -- Development and Construction Risks." The successful development of
additional ALCs would involve a number of risks, including the possibility that
the Company may be unable to locate suitable sites at acceptable prices or may
be unable to obtain, or may experience delays in obtaining, necessary zoning,
land use, building, occupancy, licensing and other required governmental permits
and authorizations. Certain construction risks are beyond the Company's control,
including strikes, adverse weather, natural disasters, supply of materials and
labor, and other unknown contingencies which could cause the cost of
construction and the time required to complete construction to exceed estimates.
In order to keep its internal costs to a minimum, the Company relies, and will
continue to rely, on third party general contractors to construct its new ALCs.
If construction is not commenced or completed, or if there are unpaid
subcontractors or suppliers, or if required occupancy permits are not issued in
a timely manner, cash flow could be significantly reduced. In addition, any
property in construction is subject to risks including construction defects,
cost overruns, adverse weather conditions, the discovery of geological or
environmental hazards on the property and changes in zoning restrictions or the
method of applying such zoning restrictions. The nature of licenses and
approvals necessary for development and construction, and the timing and
likelihood for obtaining them vary widely from state to state, and from
community to community within a state.
 
     Acquisitions. The Company believes that the assisted living industry's
fragmentation and ongoing consolidation provide attractive acquisition
opportunities. Through its internal acquisition team, its network of real estate
broker contacts and its regional partners and allies, the Company seeks to
acquire single ALCs or
 
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groups of ALCs from smaller owners and operators in its targeted markets. In
evaluating possible acquisitions, the Company considers (i) the location,
construction quality, condition and design of the facility, (ii) the current and
projected cash flow of the community and the anticipated ability to increase
revenue through rent and occupancy increases, additional assisted living
services and management and (iii) the ability to acquire the community below
replacement cost. However, there can be no assurance that the Company will be
able to find additional suitable communities to continue its current growth
rate. As of February 12, 1998, the Company entered into purchase and sale
agreements to purchase interests in 13 ALCs located in California, containing
approximately 1,900 units.
 
     By developing and operating ALCs in 10 states, the Company has generated
numerous contacts through which it is able to identify possible acquisitions in
the early stage of the sale process. The Company's sources for prospective
acquisitions range from Affiliated Partnerships to management's contacts with
potential ALC sellers to the Company's local and regional personnel who monitor
the assisted living market in their area. Management intends to pursue both
individual and portfolio acquisitions and believes the Company will be able to
achieve greater value from its acquisitions due to its management capabilities.
 
     In certain instances, the Company may target existing ALCs which may be
redeveloped or repositioned as management believes a number of acquisition
opportunities may reflect situations where existing owners are not operating,
maintaining or leasing such facilities efficiently. Although the Company will
focus future acquisition efforts primarily on the acquisition, directly or
through long-term operating leases, of additional ALCs, it may in certain cases
also target additional third party management contracts.
 
     The Company has acquired certain existing ALCs from affiliated entities as
well as third parties and may consider acquiring additional existing ALCs from
such parties. There can be no assurance that the Company will pursue any such
transactions or that, if pursued, such transactions will be completed
successfully by the Company.
 
     The Company's acquisitions of existing ALCs are anticipated to be financed
using equity and debt and through direct long-term operating lease transactions
with institutional investors such as Health Care REITs. In long-term operating
lease transactions, the Company typically arranges the sale of the prospective
assisted living community to a Health Care REIT or other institutional investor
while concurrently entering into a long-term operating lease for the facility.
The Company's initial cost generally is limited to a security deposit which is
typically provided through standby letters of credit. Thereafter, the Company is
obligated to make certain rental payments (which may include an additional
amount related to revenue of the community) for the term of the lease. While the
Company believes that it has been and will continue to be conservative in
projecting lease-up costs and expenses as well as the achievement of rent
stabilization, the failure of the Company to generate sufficient revenue could
result in an inability to meet minimum rent obligations under the Company's
long-term operating leases.
 
     In addition to the above, the Company has entered into a letter agreement
which could result in the formation of a jointly owned management company in
which the Company could lease or manage all existing or planned communities and
all future developments of Kapson Senior Quarters Corp. See "Transactions with
Prometheus Assisted Living".
 
     Increase of Sales of Additional Assisted Living Services. The Company
believes that many custodial services provided in skilled nursing facilities are
available at approximately two-thirds of the cost in the Company's ALCs. The
Company believes that this differential will enable the Company to attract
additional residents. By increasing the usage of these services by its
residents, the Company believes it should enable residents to stay at the
Company's ALCs longer, rather than having to transfer to more expensive skilled
nursing facilities. The Company has been a pioneer in providing these services,
which allow its senior elderly residents to age in place at the community
without having to move to a more expensive alternative until that move becomes
absolutely necessary.
 
     The Company seeks to enhance and increase the amount and diversity of
assisted living services it provides through (i) the continued education of the
senior community, and particularly the residents and their families, concerning
the cost effectiveness of receiving additional services in an assisted living
community,
 
                                        7
<PAGE>   10
 
(ii) the continued development and refinement of assisted living programs
designed to meet the needs of its residents as they age in place and (iii) the
consistent delivery of quality services for residents.
 
     At March 24, 1998, the Company had approximately 2,735 employees.
 
CAPITAL REQUIREMENTS
 
     In July 1997, as part of the implementation of its growth strategy, the
Company sold approximately 1.9 million shares (the "Prometheus Shares") of its
common stock to Prometheus Assisted Living LLC ("Prometheus"), an affiliate of
Lazard Freres Real Estate Investors, LLC ("Lazard" or "LFREI") for $26.9
million. In October 1997, the Company issued $60 million of Convertible
Subordinated Notes (the "Notes") to Prometheus. The Notes were convertible into
shares of the Company's common stock subject to a declining optional redemption
premium starting at $17.25 per share. The Company had the option to call the
Notes at any time, and on December 5, 1997, the Board approved the redemption of
the Notes (the "Note Redemption"). Per the terms of the Notes, the Note
Redemption was made in common stock of the Company. Including the approximately
23.214% optional redemption premium less interest paid to the date of
redemption, the issuance amounted to approximately 4.3 million shares at $17.25
per share. As a result of these transactions (the "Prometheus Transactions"),
the Company raised additional capital, net of costs, of $82.2 million.
 
     As of December 31, 1997, the Company has expended substantially all of the
$55.2 million net proceeds received from the sale of its 6 3/4% Convertible
Subordinated Notes due 2006 (the "2006 Convertible Notes"). The Company intends
to refinance certain notes payable maturing September 1998. The Company has
entered into separate agreements with Health Care REIT, Inc., Meditrust, Bank
United of Texas and Imperial Bank to provide up to $210 million of financing for
acquisitions, development and general corporate purposes. At December 31, 1997,
$39.9 million of these commitments had been expended ($23.4 million for Leased
ALCs, $8.8 million for mortgage financing of Owned ALCs, and $7.7 million for
the construction of an ALC owned by an Affiliated Partnership which is
guaranteed by the Company). Additionally, at December 31, 1997, the Company has
used $9.2 million of its line of credit with Imperial Bank in the form of
non-cash advances to provide letters of credit used primarily as security
deposits for leased ALCs.
 
     The Company estimates that the net proceeds of the Prometheus Transactions
and the previously existing financing agreements, in conjunction with other
financial resources, will provide adequate capital to fund the Company's
development and acquisition program for additional ALCs over the next 12 months.
The Company will be required from time to time to incur additional indebtedness
or issue additional debt or equity securities to finance its growth strategy,
including the acquisition and development of facilities as well as other capital
expenditures and additional funds to meet increased working capital
requirements. The Company may finance future acquisitions and development
through a combination of its cash reserves, its cash flow from operations,
utilization of its current lines of credit, leasing of additional ALCs and ALCs
in development, sale/leaseback arrangements with respect to its Owned ALCs, and
additional indebtedness or public or private sales of debt securities or capital
stock. The Company has arranged financing of its ALCs under construction and
development through its commitments from various Health Care REITs and other
lessors and lenders. With respect to these ALCs, the Company's commitments for
capital expenditures consist of potential liability for cost overruns incurred
during the construction of ALCs and the Company's obligation to fund start-up
losses incurred in the operation of the ALCs prior to the achievement of
stabilized operations. While the amount of such obligations are contingent on
the Company's ability to develop its ALCs within budget and achieve profitable
operations, the probable amount of these obligations cannot be definitively
quantified. While such obligations may not be definitively quantified,
management believes that it has made adequate provision for such obligations in
its financing plan. There can be no assurance, however, that funds will be
available on terms favorable to the Company, that such funds will be available
when needed, or that the Company will have adequate cash flows from operations
for such requirements.
 
                                        8
<PAGE>   11
 
TRANSACTIONS WITH PROMETHEUS ASSISTED LIVING
 
     In July 1997, the Company entered into the Stock Purchase Agreement (the
"Stock Purchase Agreement"), by and among the Company, LFREI, a New York limited
liability company and Prometheus, a Delaware limited liability company.
 
     Subject to the terms and conditions of the Stock Purchase Agreement, the
Company was to sell to Prometheus up to approximately 9.6 million shares (the
"Shares") of Common Stock of the Company ("Common Stock") at a purchase price of
$14.00 per share (the "Transaction"), representing an aggregate investment of
approximately $135 million (the "Total Equity Commitment"). Proceeds from the
sale of the Shares were to be used by the Company to continue to implement its
acquisition and development plans, to repay debt, to strengthen systems and
operations, and to expand services. The Transaction was to be consummated in
three phases, the first of which, the initial closing (the "Initial Closing"),
was completed on July 23, 1997. At the Initial Closing, the Company sold to
Prometheus approximately 1.9 million Shares, representing an aggregate
investment of approximately $26.9 million. The Shares sold to Prometheus in the
Initial Closing represented approximately 16.6% of the outstanding Common Stock
(19.9% of the outstanding Common Stock prior to issuance).
 
     At a second closing of the Transaction (the "Second Closing"), the Company
planned to sell to Prometheus approximately 3.1 million Shares ("Phase II").
Thereafter, at one or more subsequent closings (each a "Subsequent Closing")
("Phase III"), the Company planned from time to time at its election to sell
additional Shares to Prometheus at $14.00 per share, in minimum increments of
715,000 shares, until the Total Equity Commitment was invested. At such time as
Prometheus acquired all of the Shares under the Transaction, it would have owned
approximately 49.9% of the outstanding Common Stock.
 
     In October 1997, the Company entered into the Amended and Restated Stock
and Note Purchase Agreement (the "Amended Stock and Note Purchase Agreement"),
by and among the Company, LFREI and Prometheus. The Amended Stock and Note
Purchase Agreement amended and restated the Stock Purchase Agreement.
 
     Under the Amended Stock and Note Purchase Agreement, Prometheus, in lieu of
purchasing the additional shares of Common Stock contemplated by the Stock
Purchase Agreement, purchased $60,000,000 aggregate principal amount of the
Company's 6.75% Convertible Subordinated Notes due 2007 (the "Prometheus
Notes"). In connection with the issuance of the Company Notes, the Company and
The Chase Manhattan Bank, N.A. entered into an indenture dated as of October 30,
1997 (the "Indenture"), and the Company executed a $60,000,000 note in favor of
Prometheus dated as of October 30, 1997.
 
     In December 1997, the Board approved the optional redemption of the Company
Notes. Per the terms of the Notes, the redemption was made in common stock of
the Company. Including the 23.214% optional redemption premium and accrued
interest to date, the issuance amounted to approximately 4.3 million shares at
$17.25 per share. As a result, Prometheus acquired from the Company
approximately 6.2 million common shares of the Company, representing a 39.0%
ownership stake in the Company.
 
     Under the terms of an amended letter agreement dated October 29, 1997 (the
"Amended Kapson Letter Agreement") by and among the Company, LFREI and
Prometheus relating to LFREI's proposed acquisition of Kapson Senior Quarters
Corp. ("Kapson"), Prometheus and LFREI agreed that if LFREI consummated its
proposed acquisition of Kapson, until a Termination Event or such time as LFREI
or its affiliates own less than 10% of the stock of Kapson: (i) until the date
that Prometheus funded its purchase of $60 million aggregate principal amount of
the Company Notes, Kapson was prohibited from developing or acquiring any new
facilities (other than those in its pipeline at the time of the closing of the
Kapson acquisition) without the written consent of a majority of the independent
non-LFREI affiliated or appointed members of the Board; (ii) the Company has the
first right to negotiate management, lease and/or purchase arrangements on any
new developments or acquisitions by Kapson; (iii) LFREI will seek in good faith
to negotiate with the Company for leasing or management agreements of all
existing or currently-planned facilities of Kapson; (iv) LFREI will not enter
into or permit Kapson to enter into any leasing or management arrangements on
Kapson's existing facilities other than with the Company or a Kapson affiliate;
(v) LFREI granted to the
 
                                        9
<PAGE>   12
 
Company the right to acquire from LFREI shares representing up to 19.9% of the
stock of Kapson at the pro rata amount of LFREI's investment in Kapson for a
period of 30 days after the later of the completion of the Kapson Investment or
the closing with respect to of the Company Investment; and (vi) LFREI will
explore a joint venture arrangement between the Company and Kapson which would
combine the corporate management of the Company and Kapson in a separate
management company jointly owned by Kapson and the Company to achieve economies
of scale.
 
     LFREI represented to the Company in the Amended Kapson Letter Agreement
that, upon completion of the Kapson acquisition, it would have the necessary
authority to cause Kapson to enter into all of the arrangements described in
(i)-(vi) above.
 
     The parties to the Amended Kapson Letter Agreement agreed that if mutually
agreeable arrangements regarding the matters set forth in subparagraph (iii)
above are not entered into by the later of three months following the closing of
the Kapson acquisition or May 1, 1998, then the Amended Kapson Letter Agreement
will terminate. The Company and LFREI are in negotiations to accomplish
subparagraph (iii) above at this time. ARV and LFREI are currently in
negotiations regarding the strategic alliance with Kapson. The strategic
alliance requires the careful analysis of numerous structural, economic, tax,
accounting and valuation matters. There can be no assurance that the Company
will successfully conclude negotiations with LFREI and, if not concluded within
90 days of LFREI's acquisition of Kapson, LFREI will be free to invest in other
assisted living companies either by itself or through Kapson.
 
     All transactions between the Company and Kapson will require approval from
the directors of both companies who are not affiliated with LFREI.
 
TENDER OFFER BY EMERITUS CORPORATION
 
     On December 19, 1997, Emeritus Corporation ("Emeritus"), through its
wholly-owned subsidiary, EMAC Corp. ("EMAC"), commenced a tender offer (the
"Tender Offer") to purchase all outstanding shares of common stock of the
Company (the "Common Stock"), together with the associated preferred stock
purchase rights (the "Rights") at a price of $17.50 per share, net to the seller
in cash, upon the terms and subject to the conditions set forth in the Offer to
Purchase dated December 19, 1997 (the "Offer"). The purpose of the Offer was to
acquire control of, and the entire equity interest in, the Company. Previously,
on October 12, 1997, Emeritus proposed an acquisition of all of the outstanding
Common Stock for $16.50 per share in cash.
 
     On November 23, 1997, Emeritus nominated its own slate of nominees (the
"Emeritus Nominees") to the Company's Board of Directors and on November 24,
1997, filed preliminary proxy materials with the Securities and Exchange
Commission (the "Commission") indicating that Emeritus would be soliciting
proxies to elect the Emeritus Nominees.
 
     On December 9, 1997, Emeritus commenced litigation against the Company in
Orange County Superior Court in the State of California, asking the court, among
other things, to rescind the Prometheus Transaction. Concurrently, Emeritus
sought a preliminary injunction to rescind the Prometheus Transactions.
 
     On January 5, 1998, the Company filed a recommendation statement with the
Securities and Exchange Commission on Schedule 14D-9 in which the Company's
Board of Directors unanimously concluded that the Emeritus tender offer was
inadequate and not in the best interests of the Company and recommended that the
shareholders of the Company reject the Emeritus offer and not tender their
shares pursuant to the Emeritus tender offer.
 
     The Board's determination, which was reached at meetings held on January 2,
1998 and January 5, 1998, was based on its belief that, in light of the
prospects of the Company's business, the potential benefits of the investment of
$86.9 million in the Company by Prometheus, the Company's potential strategic
alliance with Kapson and the other factors described below, the Company's and
its shareholders' interests would be best served if the Company were to remain
independent and pursue its business strategy.
 
                                       10
<PAGE>   13
 
     In researching its determinations and recommendations, the Board considered
a number of factors, including, without limitation, the following:
 
          (i) the Board's belief that the Emeritus Offer did not adequately
     reflect the inherent value of the Company;
 
          (ii) the Board's continued belief that execution of the Company's
     strategic plan will produce greater long-term value for the shareholders of
     the Company and greater benefits for the Company's employees and customers;
 
          (iii) a presentation by Salomon Smith Barney ("SSB"), financial
     advisors to the Company, concerning the financial aspects of the Emeritus
     Offer, and the opinion of SSB to the effect that, as of January 5, 1998,
     the proposed consideration to be received by the shareholders of the
     Company was inadequate;
 
          (iv) the numerous and significant conditions contained in Emeritus'
     proposal, including: (A) the valid tender of at least a majority of the
     total number of outstanding shares on a fully diluted basis exclusive of
     any Shares issuable upon conversion of the Company's 6 3/4% Convertible
     Subordinated Notes due 2006); (B) redemption of the Rights by the Board;
     (C) Emeritus and EMAC being satisfied, in their discretion, that EMAC has
     obtained financing upon terms satisfactory to them in an amount sufficient
     to consummate the offer, including the redemption or refinancing of all
     outstanding debt and payment of all fees and expenses; (D) Emeritus and
     EMAC being satisfied, in their discretion, that the Board has approved and
     recommended or will approve and recommend a merger between the Company and
     EMAC; (E) rescission of the December 5, 1997 Note Redemption of the
     Company's Prometheus Notes; (F) EMAC being satisfied that all necessary
     consents and approvals, including those from the lessors under the
     Company's existing leases, have been obtained on terms satisfactory to
     EMAC, in its discretion; and (G) that no material adverse change shall have
     occurred in the operations or prospects of the Company or any of its
     subsidiaries (the Board concluded that the defaults under the Company's
     existing leases that would result from EMAC's taking control of the Company
     would constitute such a material adverse change); and
 
          (v) the Board's concern that, in light of these numerous and
     significant conditions, the offer was illusory in that Emeritus had no
     intention of paying the Company's shareholders $17.50 per share, but rather
     intended to renegotiate with the Company for a lower price or a different
     form of consideration.
 
     On January 26, 1998, the California State Court denied, in its entirety,
Emeritus' request for a preliminary injunction to rescind the series of
transactions that culminated in the $86.9 million investment by Lazard, and
Emeritus requested to prevent Lazard from voting the approximately 4.3 million
shares it received in December 1997 when the Company redeemed the Prometheus
Notes.
 
     At the Annual Meeting of Shareholders on January 28, 1998, the shareholders
voted in favor of the Company's Board of Directors by a margin exceeding 5-to-1.
According to the Inspectors of Election, shareholders voted more than 10.5
million shares, which represented approximately 85% of the approximately 12.4
million shares voted, in favor of the Company's directors.
 
     On January 30,1998, Emeritus announced that it had terminated the tender
offer. As of March 24, 1998, this litigation remains pending.
 
FACTORS AFFECTING FUTURE RESULTS AND FORWARD-LOOKING STATEMENTS
 
     The Company's business, results of operations and financial condition are
subject to many risks, including those set forth below. Certain statements
contained in this report, including without limitation statements containing the
words "believes," "anticipates," "expects," and words of similar import,
constitute "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements
involve known and unknown risks, uncertainties and other factors which may cause
the actual results, performance or achievements of the Company, or industry
results, to be materially different from any future results, performance or
achievements expressed or implied by such forward-looking
 
                                       11
<PAGE>   14
 
statements. The Company has made forward-looking statements in this report
concerning, among other things, the impact of future acquisitions and
developments, if any, and the level of future capital expenditures. These
statements are only predictions, however; actual events or results may differ
materially as a result of risks facing the Company. These risks include, but are
not limited to, those items discussed below. Certain of these factors are
discussed in more detail elsewhere in this report, including without limitation
under the captions "Business' and "Management's Discussion and Analysis of
Financial Condition and Results of Operations." Given these uncertainties,
readers are cautioned not to place undue reliance on such forward-looking
statements, which speak only as of the date of this report. The Company
disclaims any obligation to update any such factors or to publicly announce the
result of any revisions to any of the forward-looking statements contained
herein to reflect future events or developments.
 
     The Company has experienced rapid growth through the development of new
ALCs, acquisition of existing ALCs and by acquiring property for the development
of new ALCs. Certain risks are inherent with the execution of the Company's
growth strategies. These risks include, but are not limited to, access to
capital necessary for acquisition and development, the Company's ability to
sustain and manage growth, the successful integration of ALCs into the Company's
portfolio, governmental regulation, competition, and the risks common to the
assisted living industry.
 
HISTORY OF LOSSES
 
     For the nine-month period ended December 31, 1997 and the years ended March
31, 1997 and 1996, respectively, the Company had net losses of approximately
$22.1 million, $1.8 million and $1.0 million, respectively. At December 31,
1997, the Company's accumulated deficit was approximately $31.5 million. The
Company's loss for the nine months ended December 31, 1997 was primarily the
result of (i) the establishment of a provision related to the disposition of
GeriCare and the Apartment Group, (ii) costs incurred related to the Company's
successful proxy fight with Emeritus, (iii) severance expenses from the
retirement of three senior executives, and (iv) the write-off of conversion
costs upon determining that the accounting software that the Company purchased
contained numerous application errors. The Company's losses for the periods
ended March 31, 1997 and 1996 resulted principally from (i) the development of
the Apartment Group assets financed through the Federal Tax Credit Program, (ii)
provision for estimated future obligations of the Company for the Apartment
Group assets and certain allowances established for Medicare reimbursement
regarding the Company's rehabilitation subsidiary, GeriCare, (iii) the expansion
of the Company's staffing and infrastructure to accommodate the Company's
acquisition and development strategy, (iv) start-up losses incurred in
operations of newly developed ALCs, and (v) certain discontinued project costs.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Results of Operations." There can be no assurance that the risks
associated with the opening of newly developed ALCs or assuming operations of
purchased ALCs can be managed to reduce or eliminate start-up losses, that other
similar costs and expenses or losses will not occur in the future or that other
expected revenue will be recognized when expected. See "-- Indebtedness, Lease
and Other Obligations of the Company," "-- General Partner Liability and
Status," and "Management's Discussion and Analysis of Financial Condition and
Results of Operations -- Results of Operations" and "-- Liquidity and Capital
Resources." While management believes that internal review procedures have been
put into place which should reduce Medicare's disallowance of current
receivables, there can be no assurance that the risks associated with the
existing Medicare-reimbursed segment of the Company's business can be eliminated
or even substantially reduced. See "-- Dependence on Reimbursement by
Third-Party Payors."
 
RAPID GROWTH
 
     Management of Growth. As part of its ongoing business, the Company has
experienced and expects to continue to experience rapid growth. The Company is
planning significant expansion both through internal expansion and acquisitions
and development. In order to maintain and improve operating results, the
Company's management must manage growth and expansion effectively. See "-- Risks
Common to the Company's Assisted Living Operations." The Company's ability to
manage its growth effectively requires it to continue to expand its operational,
financial and management information systems and to continue to attract,
 
                                       12
<PAGE>   15
 
train, motivate, manage and retain key employees. As the Company continues its
expansion, it may become more difficult to manage geographically dispersed
operations and effectively manage each ALC. The Company's failure to effectively
manage growth could have a material adverse effect on the Company's results of
operations.
 
     External Growth. In line with its growth strategy, the Company has entered
into, and will continue to enter into, a number of agreements to acquire
properties for development and for the acquisition of existing ALCs which are
subject to certain conditions. There can be no assurance that one or more of
such acquisitions will be completed or that the Company will be able to find
additional suitable properties and ALCs to continue its current rate of growth.
The Company may experience a slowing of its growth through acquisition of ALCs
due to shortages of suitable ALCs available for acquisition at prices attractive
to the Company. Similarly, the Company has acquired a number of properties to be
developed into ALCs, or has contracted to operate ALCs being developed by
third-party developers. The development of ALCs is subject to a number of risks,
many of which are outside the Company's control. There can be no assurance that
the Company will be able to complete its planned facilities in the manner, for
the amount, or in the time frame currently anticipated. Delays in the progress
or completion of development projects could affect the Company's ability to
generate revenue or to recognize revenue when anticipated. See " -- Risks Common
to the Company's Assisted Living -- Development and Construction Risks."
 
COMPETITION
 
     The health care industry is highly competitive and the Company expects that
the assisted living business in particular will become more competitive in the
future. The Company continues to face competition from numerous local, regional
and national providers of assisted living and long-term care whose facilities
and services are on either end of the senior care continuum from skilled nursing
facilities and acute care hospitals to companies providing home based health
care, and even family members. In addition, the Company expects that as assisted
living receives increased attention among the public and insurance companies,
competition from current and new market entrants, including companies focused on
assisted living as well as hospitality companies expanding into the market, will
increase. Some of the Company's competitors operate on a not-for-profit basis or
as charitable organizations, while others have, or may obtain, greater financial
resources than those available to the Company.
 
     Moreover, in the implementation of the Company's growth program, the
Company expects to face competition for the acquisition and development of ALCs.
Some of the Company's present and potential competitors are significantly larger
or have, or may obtain, greater financial resources than those of the Company.
Consequently, there can be no assurance that the Company will not encounter
increased competition in the future which could limit its ability to attract
residents, expand its business, or increase the cost of future acquisitions,
each of which could have a material adverse effect on the Company's financial
condition, results of operations and prospects.
 
INDEBTEDNESS, LEASE AND OTHER OBLIGATIONS OF THE COMPANY
 
     The Company has financed, and will continue to finance, the acquisition and
development of ALCs through a combination of loans, leases and other
obligations. As of December 31, 1997, the Company had outstanding consolidated
indebtedness of $90.9 million, including $57.5 million of the Company's 2006
Convertible Notes, the holders of which have the right to convert such notes
into the common stock of the Company at any time on or before maturity of the
notes. In addition, at December 31, 1997, the Company had $10.8 million in notes
maturing within two years. As a result, a portion of the Company's cash flow
will be devoted to debt service. The Company intends to refinance certain notes
payable maturing in September 1998 totaling approximately $8.8 million. There is
a risk that the Company will not be able to refinance its maturing note
obligations on terms favorable to the Company or that it will not be able to
generate sufficient cash flow from operations to make required interest and
principal payments.
 
     At December 31, 1997, approximately $14.7 million of the Company's
indebtedness bore interest at floating rates. Indebtedness that the Company may
incur in the future may also bear interest at a floating rate
 
                                       13
<PAGE>   16
 
or be fixed at some time in the future. Therefore, increases in prevailing
interest rates could increase the Company's interest payment obligations and
could have an adverse effect on the Company's business, financial condition and
results of operations. In addition, the Company has guaranteed mortgage and
construction debt for the benefit of Affiliated Partnerships of up to
approximately $55.7 million, including $51.6 million outstanding as of December
31, 1997, of which $35.1 million will become due and payable within the next two
years. This effectively subjects the Company to risks normally associated with
leverage, including the risk that Affiliated Partnerships will not be able to
refinance this debt with permanent financing, an increased risk of partnership
cash flow deficits, and the risk that if economic performance of any mortgaged
asset declines, the obligation to make payments on the mortgage debt may be
borne by the Company, which could adversely affect the Company's results of
operations and financial condition. Because certain of the indebtedness which
the Company has guaranteed bears interest at rates which fluctuate with certain
prevailing interest rates, increases in such prevailing interest rates could
increase the Company's interest payment obligations and could have an adverse
effect on the Company's results of operations and financial condition.
 
     In addition, as of December 31, 1997, the Company is a party to long-term
operating leases for certain of its Leased ALCs, which leases require minimum
annual lease payments aggregating $20.6 million for the year ending December 31,
1998. These leases typically have an initial term of 10 to 15 years, and in
general are not cancelable by the Company.
 
     The Company also has entered into guarantees (the "Tax Credit Guarantees")
which extend 15 years after project completion, relating to certain Apartment
Group assets financed under the Federal Tax Credit Program with respect to (i)
lien free construction, (ii) operating deficits and (iii) obtaining and
maintaining tax credit benefits to certain corporate investors (see "-- Tax
Credit Apartment Properties"), the obligations under which, excluding potential
penalties and interest factors, could amount to an approximate limit of $78.4
million as of December 31, 1997. There can be no assurance that the Company will
be able to negotiate a settlement of these liabilities during the disposition of
the properties at terms favorable to the Company.
 
GENERAL PARTNER LIABILITY AND STATUS
 
     The Company, directly or through its subsidiaries, is a general partner in
22 partnerships. As a general partner, it is liable for partnership obligations
such as partnership indebtedness (which at December 31, 1997, was approximately
$87.6 million), potential liability for construction defects, including those
presently unknown or unobserved, and unknown or future environmental
liabilities. The cost of any such obligations or claims, if partially or wholly
borne by the Company, could materially adversely affect the Company's results of
operations and financial condition.
 
     Each affiliated partnership property is managed by the Company pursuant to
a written management contract, some of which are cancelable on 30 or 60 days
notice at the election of the managing general partner of the partnership.
Action can be taken in each partnership by a majority in interest of limited
partners on such matters as the removal of the general partners, the request for
or approval or disapproval of a sale of a property owned by a partnership, or
other actions affecting the properties or the partnership. Where the Company is
the general partner of the partnership, termination of the contracts generally
would require removal of the Company as general partner by the vote of a
majority of the holders of limited partner interests and would result in loss of
the management fee income under those contracts.
 
     The Company has funded and expects to fund amounts in its capacity as
guarantor for various obligations related to certain tax credit properties. See
"-- Indebtedness, Lease and Other Obligations of the Company" and "Tax Credit
Apartment Properties."
 
DEPENDENCE ON REIMBURSEMENT BY THIRD-PARTY PAYORS
 
     GeriCare specializes in rehabilitative services, including speech,
occupational and physical therapy. Although the Company intends to dispose of
GeriCare, any revenue received or earned before such disposal occurs that
directly or indirectly benefits from the Medicare program for GeriCare's
services is subject to statutory and regulatory changes, retroactive and
prospective rate adjustments, administrative rulings and funding restrictions,
all of which could have the effect of limiting or reducing reimbursement levels
for
 
                                       14
<PAGE>   17
 
GeriCare's services. The Company cannot predict whether any changes in this
program will be adopted or, if adopted, the effect, if any, such changes will
have on the Company.
 
     Medicare reimburses GeriCare monthly for services provided on a cost basis,
subject to certain adjustments. GeriCare submits cost reports to the Health Care
Financing Administration ("HCFA") on an annual basis and is subject to having
amounts previously reimbursed adjusted retroactively. The result of a
retroactive reimbursement would be either a requirement to repay the amount
previously reimbursed or an adjustment downward in future reimbursements for
services rendered, or both. The Company has reviewed cost reports for GeriCare
filed prior to August 22, 1996, and has prepared cost reports which it filed as
of August 22, 1996 and thereafter. The Company has established an allowance for
amounts which it reasonably believes may be adjusted by HCFA, but there can be
no certainty that significant charges in addition to those provided for may be
denied, which could materially adversely affect the Company's results of
operations. Mutual of Omaha, GeriCare's intermediary with HCFA, made a
retroactive rate adjustment regarding services provided by GeriCare from 1995
through the early spring of 1997, resulting in the disallowance of approximately
$106,000 of fees previously paid to GeriCare.
 
     A certain portion of the Company's general and administrative expenses are
believed to be reimbursable by Medicare because the Company provides accounting,
legal and general office services to GeriCare. To the extent Medicare would deny
reimbursement for such overhead, the Company's general and administrative
expenses will increase accordingly.
 
GOVERNMENT REGULATION
 
     Assisted Living. Health care is an area subject to extensive regulation and
frequent regulatory change. Currently, no federal rules explicitly define or
regulate assisted living. While a number of states have not yet enacted specific
assisted living regulation, the Company is and will continue to be subject to
varying degrees of regulation and licensing by health or social service agencies
and other regulatory authorities in the various states and localities in which
it operates or intends to operate. Changes in, or the adoption of, such laws and
regulations, or new interpretations of existing laws and regulations, could have
a significant effect on methods of doing business, costs of doing business and
amounts of reimbursement from governmental and other payors. In addition, the
President and Congress have proposed in the past, and may propose in future,
health care reforms that could impose additional regulations on the Company or
limit the amounts that the Company may charge for its services. The Company
cannot make any assessment as to the ultimate timing and impact that any pending
or future health care reform proposals may have on the assisted living, home
health care, nursing facility or on the health care industry in general. No
assurance can be given that any such reform will not have a material adverse
effect on the business, financial condition or results of operations of the
Company.
 
     SSI Payments. A portion of the Company's revenue (currently, approximately
3% of the Company's assisted living revenue) is derived from residents who are
recipients of SSI payments. Revenue derived from these residents is generally
lower than that received from the Company's other residents and could be subject
to payment delay. There can be no assurance that the Company's proportionate
percentage of revenue received from SSI receipts will not increase, or that the
amounts paid under SSI programs will not be further limited. In addition, if the
Company were to become a provider of services under the Medicaid program, the
Company would be subject to Medicaid regulations designed to limit fraud and
abuse, violations of which could result in civil and criminal penalties and
exclusion from participation in the Medicaid program.
 
RISKS COMMON TO THE COMPANY'S ASSISTED LIVING OPERATIONS
 
     Staffing and Labor Costs. The Company competes with other providers of
assisted living and senior housing with respect to attracting and retaining
qualified personnel. The Company also is dependent upon the available labor pool
of employees. In many of the areas in which the Company's communities are
located, unemployment rates are low. A shortage of qualified personnel may
require the Company to enhance its wage and benefits package in order to
compete. In addition, many health care workers in the nursing home industry are
unionized. While there are currently no unionized employees at any of the
Company's communities, any unionization or threat of unionization of workers in
the assisted living industry or at the Company's facilities
 
                                       15
<PAGE>   18
 
could increase the Company's labor costs. No assurance can be given that the
Company's labor costs will not increase, or that if they do increase, they can
be matched by corresponding increases in rental, assisted living or management
revenue.
 
     Obtaining Residents and Maintaining Rental Rates. As of December 31, 1997,
the ALCs owned or operated by the Company had a combined occupancy rate of 85%.
Lease-up on development projects may take longer than assumed periods of time,
thereby lengthening the time in which newly developed ALCs experience start-up
losses. The Company may revise its schedule of construction of new developments
in order to phase in start-up losses from new ALCs. Occupancy may drop in
existing ALCs primarily due to changes in the health of residents, increased
competition from other providers of assisted living services which may give
residents more choices with respect to the provision of such services, and, in
ALCs acquired by the Company, due to the re-evaluation of residents regarding
retention criteria, changes in management and staffing, and implementation of
the Company's assisted living programs. There can be no assurance that, at any
time, any ALC will be substantially occupied at assumed rents. In addition,
lease-up and full occupancy may be achievable only at rental rates below those
assumed. If operating expenses increase, local rental market conditions may
limit the extent to which rents may be increased. With respect to the new
acquisitions, rental increases may lag behind increases in operating expenses
since rent increases generally can only be implemented at the time of expiration
of leases. In addition, the failure of the Company to generate sufficient
revenue could result in an inability to meet minimum rent obligations under the
Company's long-term operating leases and make interest and principal payments on
its indebtedness.
 
     General Real Estate Risks. The performance of the Company's ALCs is
influenced by factors affecting real estate investments, including the general
economic climate and local conditions, such as an oversupply of, or a reduction
in demand for, ALCs. Other factors include the attractiveness of properties to
residents, zoning, rent control, environmental quality regulations or other
regulatory restrictions, competition from other forms of housing and the ability
of the Company to provide adequate maintenance and insurance and to control
operating costs, including maintenance, insurance premiums and real estate
taxes. At the time the Company acquires existing ALCs, or opens newly developed
ALCs, budgets for known or expected rehabilitation expenses are prepared.
Unknown or unforeseen rehabilitation or lease-up expenses may be incurred. Real
estate investments are also affected by such factors as applicable laws,
including tax laws, interest rates and the availability of financing. Real
estate investments are relatively illiquid and, therefore, limit the ability of
the Company to vary its portfolio promptly in response to changes in economic or
other conditions. Any failure by the Company to integrate or operate acquired or
developed ALCs effectively may have a material adverse effect on the Company's
business, financial condition and results from operations. In addition, the
Company currently leases facilities from only four Health Care REITs.
 
     The lease agreements with each of the Health Care REITs are interconnected
in that the Company will not be entitled to exercise its right to renew one
lease with a particular lessor without exercising its right to renew all other
leases with that lessor and leases with each lessor contain certain cross
default provisions. Therefore, in order to exercise all lease renewal terms, the
Company will be required to maintain and rehabilitate the Leased ALCs on a
long-term basis. The Company anticipates that similar renewal and cross-default
provisions will be included in leases with other Health Care REITs or lessors.
 
     Bond Financing. The Company has entered into four long-term leases of ALCs,
the acquisition and construction of which have been or are being financed by tax
exempt multi-unit housing revenue bonds. In order to meet the lease obligations
and to allow the landlord to continue to qualify for favorable tax treatment of
the interest payable on the bonds, the ALC must comply with certain federal
income tax requirements, principally pertaining to the maximum income level of a
specified portion of the residents. The Company anticipates executing additional
leases for ALCs to be constructed with bond financing, and the same and possibly
additional restrictions are anticipated to be imposed for such ALCs. Failure to
satisfy these requirements will constitute an event of default under the leases,
thereby permitting the landlord to accelerate their termination. Failure to
obtain low-income residents in the sequence and time required could materially
affect the lease-up schedule and, therefore, cash flow from such ALCs.
 
                                       16
<PAGE>   19
 
     Development and Construction Risks. As part of its growth strategy during
the next few years, the Company plans to develop a number of new ALCs. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operation -- Overview." The Company's ability to achieve its development plans
will depend upon a variety of factors, many of which are beyond the Company's
control. The successful development of additional ALCs involves a number of
risks, including the possibility that the Company may be unable to locate
suitable sites at acceptable prices or may be unable to obtain, or may
experience delays in obtaining, necessary zoning, land use, building, occupancy,
licensing and other required governmental permits and authorizations.
Development schedules may be changed by the Company in order to accommodate
requirements of staffing of new ALCs and to allow a phase-in of start-up losses
inherent in the marketing and lease-up of new facilities. Certain construction
risks are beyond the Company's control, including strikes, adverse weather,
natural disasters, supply of materials and labor, and other unknown
contingencies which could cause the cost of construction and the time required
to complete construction to exceed estimates. If construction is not commenced
or completed, or if there are unpaid subcontractors or suppliers, or if required
occupancy permits are not issued in a timely manner, cash flow could be
significantly reduced. In addition, any property in construction carries with it
its own risks such as construction defects, cost overruns, adverse weather
conditions, the discovery of geological or environmental hazards on the property
and changes in zoning restrictions or the method of applying such zoning
restrictions. The nature of licenses and approvals necessary for development and
construction, and the timing and likelihood for obtaining them vary widely from
state to state, and from community to community within a state.
 
     Possible Environmental Liabilities. Under various federal, state and local
environmental laws, ordinances and regulations, a current or previous owner or
operator of real property may be held liable for the costs of removal or
remediation of certain hazardous or toxic substances including, without
limitation, asbestos-containing materials ("ACMs"), which could be located on,
in or under such property. Such laws and regulations often impose liability
whether or not the owner or operator knows of, or is responsible for, the
presence of the hazardous or toxic substances. When acquiring land for
development or existing facilities, the Company typically obtains environmental
reports on the properties as part of its due diligence in order to lessen its
risk of exposure. Nonetheless, the costs of any required remediation or removal
of these substances could be substantial and the owner's liability as to any
property is generally not limited under such laws and regulations and could
exceed the value of the property and the aggregate assets of the owner or
operator. The presence of these substances or failure to remediate such
substances properly may also adversely affect the owner's ability to sell or
rent the property or to borrow using the property as collateral. Under these
laws and regulations, an owner, operator, or any entity who arranges for the
disposal of hazardous or toxic substances such as ACMs at a disposal site may
also be liable for the costs of any required remediation or removal of the
hazardous or toxic substances at the disposal site. When entering into leases
with Health Care REITs and other landlords of facilities, the Company typically
enters into environmental indemnity agreements in which it agrees to indemnify
the landlord against all risk of environmental liability both during the term of
the lease and beyond such term. In connection with the ownership or operation of
its properties or those of its Affiliated Partnerships, the Company could be
liable for these costs, as well as certain other costs, including governmental
fines and injuries to persons or properties.
 
     Restrictions Imposed by Laws Benefiting Disabled Persons. Under the
Americans with Disabilities Act of 1990 (the "ADA"), all places of public
accommodation are required to meet certain federal requirements related to
access and use by disabled persons. A number of additional federal, state and
local laws exist which also may require modifications to existing and planned
properties to create access to the properties by disabled persons. The Company
believes that its properties are substantially in compliance with present
requirements or are exempt therefrom and it attempts to check for such
compliance in all facilities it considers acquiring. However, if required
changes involve a greater expenditure than anticipated or must be made on a more
accelerated basis than anticipated, additional costs would be incurred by the
Company. Further legislation may impose additional burdens or restrictions with
respect to access by disabled persons and the costs of compliance therewith
could be substantial.
 
     Geographic Concentration. A substantial portion of the business and
operations of the Company are conducted in California, where 31 of the 54 ALCs
currently operated, managed or in construction by the
 
                                       17
<PAGE>   20
 
Company are located. Other regional concentrations of ALCs are planned for
Florida, Texas, the Midwest and the Northeast. The creation of regions allows
the Company to manage the ALCs without undue increases in management personnel.
The market value of these properties and the income generated from properties
managed or leased by the Company could be negatively affected by changes in
local and regional economic conditions or the governing laws, and regulatory
environment in, states within those regions, and by acts of nature. There can be
no assurance that such geographic concentration will not have an adverse effect
on the Company's business, financial condition, results of operations and
prospects.
 
     Insurance. The Company currently maintains insurance policies in amounts
and with such coverage and deductibles as it believes are adequate, based on the
nature and risks of its business, historical experience and industry standards.
The Company's business entails an inherent risk of liability. In recent years,
participants in the assisted living industry, including the Company, have become
subject to an increasing number of lawsuits alleging negligence or related legal
theories, many of which may involve large claims and significant legal costs.
The Company is from time to time subject to such suits as a result of the nature
of its business. There can be no assurance that claims will not arise which are
in excess of the Company's insurance coverage or are not covered by the
Company's insurance coverage. A successful claim against the Company not covered
by, or in excess of, the Company's insurance, could have a material adverse
effect on the Company's financial condition, results of operations or liquidity.
Claims against the Company, regardless of their merit or eventual outcome, may
also have a material adverse effect on the Company's ability to attract
residents or expand its business and would require management to devote time to
matters unrelated to the operation of the Company's business. In addition, the
Company's insurance policies must be renewed annually and there can be no
assurance that the Company will be able to continue to obtain liability
insurance coverage in the future or, if available, that such coverage will be
available on acceptable terms.
 
CONFLICTS OF INTEREST
 
     Certain of the Company's current and former executive officers and
Directors may, by virtue of their investment in or involvement with entities
providing services, office space or guarantees to the Company or to
Company-sponsored partnerships, or by virtue of familial ties with consultants
offering services to the Company, have an actual or potential conflict of
interest with the interests of the Company. See "Certain Relationships and
Related Transactions."
 
     In addition, the Company is the managing general partner and communities
manager for Affiliated Partnerships owning or leasing 16 ALCs and various
apartment communities. By serving in both capacities, the Company has conflicts
of interest in that it has both a duty to act in the best interests of the
limited partners of those partnerships and the desire to maximize earnings for
the Company's shareholders in the operation of those ALCs and apartment
communities.
 
TAX CREDIT APARTMENT PROPERTIES
 
     As part of the Company's plan to dispose of the Apartment Group, it may be
required to fund (i) obligations under development deficit guarantees and
operating deficit guarantees and (ii) shortfalls in permanent loan financing to
replace construction financing on projects where permanent financing has not
been finalized. In addition, with regard to tax credit benefits, the Company may
be required to make adjustments if sufficient projected tax credits are not
generated in order to meet agreed-upon levels of tax credit benefits. The
Company has funded shortfalls through December 31, 1997, and has established a
provision of $7.5 million to fund any additional amounts due under such
arrangements.
 
                                       18
<PAGE>   21
 
ITEM 2. PROPERTIES
 
     The following charts set forth, the location, number of units, acquisition
date and ownership for the Company's communities as of December 31, 1997:
 
<TABLE>
<CAPTION>
                                                                           MONTH        PERCENT
                     COMMUNITY                       LOCATION    UNITS    ACQUIRED    OWNERSHIP(A)
                     ---------                       --------    -----    --------    ------------
<S>                                                  <C>         <C>      <C>         <C>
LEASED
Amber Wood.........................................  FL            187    Jun-96         100.0%
Baypointe Village..................................  FL            232    Mar-96         100.0%
Buena ViST,,,0a Knolls.............................  CA             91    Feb-96         100.0%
Chateau San Juan...................................  CA            114    Dec-95         100.0%
Collier Park.......................................  TX            162    Dec-96         100.0%
El Camino Gardens..................................  CA            282    Jun-95         100.0%
EaST,,,0lake Terrace...............................  IN             93    Apr-97         100.0%
Hacienda de Monterey...............................  CA            180    Apr-94         100.0%
Kinghaven Manor....................................  MI            144    Feb-95         100.0%
Inn at Summit Ridge................................  NV             76    Apr-97         100.0%
Inn at Willow Glen(b)..............................  CA             84    Aug-96          52.3%
Lodge..............................................  OH            216    Jan-97         100.0%
Mallard Cove.......................................  OH            121    Feb-95         100.0%
Maria del Sol......................................  CA            124    Oct-95         100.0%
Northgate..........................................  OH            126    Aug-96         100.0%
Rancho Park Villas.................................  CA            163    Oct-95         100.0%
Shorehaven Manor...................................  MI            120    Sep-96         100.0%
Retirement Inn of Burlingame(b)....................  CA             68    Aug-96          52.3%
Retirement Inn of Campbell(b)......................  CA             72    Aug-96          52.3%
Retirement Inn of Fremont(b).......................  CA             70    Aug-96          52.3%
Retirement Inn of Sunnyvale(b).....................  CA            123    Aug-96          52.3%
Tamalpais Creek....................................  CA            120    Oct-95         100.0%
Tanglewood Trace...................................  IN            159    Jan-97         100.0%
Villa Bonita.......................................  CA            130    Oct-95         100.0%
Villa de Palma.....................................  CA            111    May-95         100.0%
Villa del Obispo...................................  CA             96    May-95         100.0%
Villa del Rey......................................  CA            103    Jun-95         100.0%
Villa del Sol......................................  CA             91    Jun-95         100.0%
Villa Encinitas....................................  CA            117    Jun-95         100.0%
Villa at Palm Desert...............................  CA             77    Nov-95         100.0%
ViST,,,0a Del Rio..................................  NM            150    Jun-97         100.0%
Woodside Village of Columbus.......................  OH            156    Feb-96         100.0%
                                                                 -----
    Total Leased...................................              4,158
                                                                 -----
OWNED
Acacia Villa(b)....................................  CA             66    Dec-95          89.5%
Amber Park.........................................  OH            127    Jan-96         100.0%
Bella Vita.........................................  FL            120    Apr-96         100.0%
Collwood Knolls....................................  CA            117    Jan-96          95.5%
Covell Gardens.....................................  CA            157    Mar-97         100.0%
Covina Villa(b)....................................  CA             64    Aug-96          52.3%
Gayton Terrace.....................................  VA             92    Aug-96         100.0%
Retirement Inn of Daly City(b).....................  CA             95    Aug-96          52.3%
Retirement Inn of Fullerton(b).....................  CA             68    Aug-96          52.3%
Montego Heights Lodge(b)...........................  CA            170    Aug-96          52.3%
Valley View Lodge(b)...............................  CA            125    Aug-96          52.3%
Villa Colima(b)....................................  CA             94    Jun-96          60.5%
Woodside Village of Bedford........................  OH            217    Jan-96         100.0%
Wyndham Lakes......................................  FL            248    Mar-96         100.0%
                                                                 -----
    Total Owned....................................              1,760
                                                                 -----
    Total Leased and Owned.........................              5,918
                                                                 =====
MANAGED
Bradford Square....................................  CA             92
Chandler Villa.....................................  AZ            164
Villa Las Posas....................................  CA            123
                                                                 -----
    Total Managed..................................                379
                                                                 -----
    Total..........................................              6,297
                                                                 =====
</TABLE>
 
                                       19
<PAGE>   22
 
---------------
(a) Represents percentage ownership of Leased ALCs and Owned ALCs through
    leasehold or fee ownership of the Company or an Affiliated Partnership.
 
(b) Community managed by the Company, owned or leased by Affiliated Partnership
    in which the Company has obtained a majority ownership interest.
 
     At December 31, 1997, the Company had the following projects under
construction and anticipates that the schedule set forth below can be met,
although there can be no assurance in this regard. Construction is subject to
numerous risks which could cause delays or the abandonment of a project or
projects. See "Risks Common to the Company's Assisted Living
Operations -- Development and Construction Risks."
 
<TABLE>
<CAPTION>
                                                          ANTICIPATED     ANTICIPATED/
                                           LOCATION       # OF UNITS     ACTUAL OPENING
                                       ----------------   -----------   -----------------
<S>                                    <C>                <C>           <C>
Sun Lake Terrace(1)..................  Las Vegas, NV          129        1st Quarter 1998
Canterbury Woods.....................  Attleboro, MA          132        2nd Quarter 1998
Bayside Landing......................  Stockton, CA            76        2nd Quarter 1998
The Lakes............................  Fort Myers, FL         154        3rd Quarter 1998
Sutton Place.........................  Las Vegas, NV          142        4th Quarter 1998
                                                              ---
          Total units under
            construction.............                         633
                                                              ===
</TABLE>
 
---------------
(1) Sun Lake Terrace opened in February 1998.
 
ITEM 3. LEGAL PROCEEDINGS
 
     On September 27, 1996, American Retirement Villas Partners II, a California
limited partnership ("ARVP II") of which the Company is the managing general
partner and a majority limited partner, filed actions in Superior Court, County
of Santa Clara, seeking declaratory judgments against the landlords of the
Retirement Inn of Campbell ("Campbell") and the Retirement Inn of Sunnyvale
("Sunnyvale"). ARVP II leases the Campbell and Sunnyvale assisted living
communities under long-term leases. A dispute has arisen as to the amount of
rent due during the 10-year lease renewal periods which commenced in August 1995
for Campbell and March 1996 for Sunnyvale. ARVP II seeks a determination that it
is not required to pay any higher rent during the 10-year renewal periods than
during the original 20-year lease terms.
 
     In the event that the court finds against ARVP II, rent for the Campbell
and Sunnyvale communities could increase significantly, which would reduce
distributions to unit holders (including the Company as the majority unit
holder) in the future. These rent increases would be retroactive to the
commencement of the lease renewal periods. Management is of the opinion, based
in part upon opinions of legal counsel, that an adverse outcome is unlikely, and
that the ultimate resolution will not have a material adverse effect on the
financial position, results of operations or liquidity of the Company.
 
     Two other communities leased by ARVP II, the Retirement Inn of Fremont
("Fremont") and the Retirement Inn at Burlingame ("Burlingame") are owned by
entities which are related to the entities that own the Campbell and Sunnyvale
communities. It is not known whether the landlords of those communities will
dispute the amount of rent due during the renewal periods which began January
1997 for Fremont and August 1997 for Burlingame. If so, ARVP II may be required
to file litigation to determine its rights under those leases.
 
     Starting in July 1997, the Company entered into a series of transactions
with Prometheus (the "Prometheus Transactions"), whereby Prometheus ultimately
acquired a 39.1% stake in the Company for $86.9 million before deducting
expenses. In the course of consummating those agreements, Emeritus Corporation,
a competitor of ARV, made a series of proposals to acquire the Company. The
Company's Board determined that the Emeritus proposals were unattractive and
inadequate, and voted to reject them.
 
     Emeritus subsequently launched a proxy contest, attempting to take control
of the Company's Board of Directors, and filed a complaint against the Company
and several of its Board members. The complaint was filed in Orange County
Superior Court on December 9, 1997, primarily alleging that the Company's Board
of
 
                                       20
<PAGE>   23
 
Directors violated its fiduciary duty owed to Emeritus as a shareholder. The
complaint sought, among other things, an injunction rescinding the Prometheus
Transactions and the Company's Shareholder Rights Plan adopted in July 1997, and
an order requiring the Company to enter into negotiations with Emeritus.
 
     On January 8, 1998, Emeritus filed a motion for preliminary injunction,
seeking to rescind the Prometheus Transactions (see "Business -- Transactions
with Prometheus Assisted Living"). On January 26, 1998, following a hearing, the
court denied Emeritus' motion. On January 28, 1998, the Company's shareholders
rejected Emeritus' slate of nominated directors. In light of the shareholder
vote, it is presently unclear whether Emeritus plans to proceed with this
action. Management intends to defend this action vigorously.
 
     On December 12, 1997, a class action lawsuit was brought on behalf of all
the Company's shareholders, alleging that the Company's Board violated its
fiduciary duty to shareholders by "wrongfully entering into a transaction with
Prometheus". The Complaint seeks injunctive relief as well as monetary damages.
On February 20, 1998, the Company filed a demurrer to the complaint, and a
hearing on that demurrer is currently set for April 3, 1998. If Emeritus
continues to pursue its claims, or any other claims, Management intends to
defend such actions vigorously.
 
     The Company is from time to time subject to claims and disputes for legal
and other matters in the normal course of its business. While the results of
such matters cannot be predicted with certainty, management does not believe
that the final outcome of any pending matters will have a material effect on the
Company's consolidated financial position, results of operations or liquidity.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     The Company submitted the following matters to a vote of its security
holders during the quarter ended December 31, 1997 which were voted upon at the
Company's Annual Meeting of Stockholders held on January 28, 1998:
 
     1. Approval of the reincorporation of the Company as a Delaware
        corporation, which will also be named ARV Assisted Living, Inc.,
        pursuant to a merger of the Company into a wholly-owned Delaware
        subsidiary and the conversion of the Common Stock of the Company into
        the common stock, par value $.01 per share, of the surviving corporation
        and of all of the provisions set forth in the Certificate of
        Incorporation and Bylaws of the surviving corporation.
 
     2. Approval of the Amendment to the Restated Articles of Incorporation of
        the Company to, among other things, increase the maximum number of
        authorized directors from nine to ten.
 
     3. Elect members of the Board of Directors of ARV Assisted Living, Inc. as
        follows:
 
       Class A Directors (to serve until the 1998 annual meeting of
               shareholders): John Booty, Robert P. Freeman and Howard G.
               Phanstiel.
 
       Class B Directors (to serve until the 1999 annual meeting of
               shareholders): R. Bruce Andrews, David P. Collins and Kenneth M.
               Jacobs.
 
       Class C Directors (to serve until the 2000 annual meeting of
               shareholders): Maurice J. Dewald, Murry N. Gunty and John J.
               Rydzewski.
 
     The Stockholders approved, among other things, the proposals discussed
above. A copy of the final report of the Inspectors of Election relating to the
Annual Meeting of Stockholders is included in the Company's Form 8-K filed
February 19, 1998.
 
                                       21
<PAGE>   24
 
                                    PART II
 
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
 
     The Company's Common Stock is listed and traded on the American Stock
Exchange under the symbol "SRS." Prior to October 13, 1997, the Company's common
stock was listed on the NASDAQ National Market ("NASDAQ") under the symbol
"ARVI." The following table sets forth, for the periods indicated, the high and
low closing prices for the Company's Common Stock.
 
<TABLE>
<CAPTION>
                                                                          HIGH      LOW
                                                                         ------    ------
<S>                                           <C>       <C>  <C>         <C>       <C>
FISCAL YEAR ENDED MARCH 31, 1996
  Third Quarter(1)..........................  10/17/95   --  12/31/95    $15.25    $ 9.25
  Fourth Quarter............................    1/1/96   --   3/31/96    $17.75    $10.50
FISCAL YEAR ENDED MARCH 31, 1997
  First Quarter.............................    4/1/96   --   6/30/96    $20.25    $15.50
  Second Quarter............................    7/1/96   --   9/30/96    $17.00    $12.50
  Third Quarter.............................   10/1/96   --  12/31/96    $15.25    $10.06
  Fourth Quarter............................    1/1/97   --   3/31/97    $11.63    $ 9.00
NINE-MONTH PERIOD ENDED DECEMBER 31, 1997
  First Quarter.............................    4/1/97   --   6/30/97    $11.63    $ 8.06
  Second Quarter............................    7/1/97   --   9/30/97    $12.75    $10.25
  Third Quarter.............................   10/1/97   --  12/31/97    $16.88    $12.50
</TABLE>
 
---------------
(1) The Company completed its initial public offering on October 17, 1995.
 
     The Company does not currently pay dividends on its Common Stock and does
not anticipate paying dividends in the foreseeable future. It is the present
policy of the Company's Board of Directors to retain earnings, if any, to
finance the expansion of the Company's business.
 
SHARES ELIGIBLE FOR FUTURE SALE
 
     As of March 24, 1998, the Company had outstanding 15,860,998 shares of
Common Stock, assuming no conversion of the 2006 Convertible Notes or exercise
of outstanding warrants and options. Approximately 8,308,142 of the outstanding
shares of Common Stock are freely tradable, except for any shares acquired in
the public market by "affiliates" of the Company, as that term is defined in
Rule 144 of the Securities Act ("Rule 144"). The remaining outstanding shares of
Common Stock are "restricted securities" within the meaning of Rule 144 and may
only be sold subject to the limitations imposed by Rule 144. At March 24, 1998,
approximately 1,345,517 shares of Common Stock were eligible for resale under
Rule 144.
 
     As part of the SynCare acquisition, the Company entered into a Holdback
Escrow Agreement (the "Agreement") with the former sole shareholders of SynCare
(the "Sellers"). Under the Agreement, one-half of the 85,146 shares issued to
Sellers as consideration for their stock in SynCare were delivered to the
General Counsel for the Company as escrowholder, defined as the "Buyer's Agent"
in the Agreement. Pursuant to the Agreement, Buyer's Agent retains possession of
the escrowed shares pending distribution of all or a portion thereof to Sellers
on the first, second and third anniversaries of the closing date, as determined
by offsetting, as of each such anniversary, uncollected accounts receivable
listed on the closing balance sheet against the reserves established therefore
on the closing balance sheet. It was a further condition to delivery of the
escrowed shares to Sellers that Sellers remain as full-time employees of the
Company or a subsidiary thereof as of each anniversary, without being terminated
for cause prior to such anniversary dates. Prior to the first anniversary of the
closing date, both Sellers were terminated for cause. Based thereon, the Company
has taken the position that the undelivered shares are the property of the
Company under the Agreement, and the matter is in dispute between the parties.
 
     In addition to the outstanding shares described above, options to purchase
a total of 1,537,002 shares of Common Stock, warrants to purchase a total of
116,152 shares of Common Stock, and the 2006 Convertible
 
                                       22
<PAGE>   25
 
Notes are convertible into approximately 3,096,392 shares of Common Stock are
outstanding as of March 24, 1998. The Company has registered for public resale
all of the shares of Common Stock issuable on conversion of the 2006 Convertible
Notes.
 
     Sales of substantial amounts of Common Stock in the public market under
Rule 144 or otherwise, and the potential for such sales, may have a material
adverse effect on the prevailing market price of the Common Stock and could
impair the Company's ability to raise capital through the sale of its equity
securities.
 
VOLATILITY OF STOCK PRICE
 
     Sales of substantial amounts of shares of Common Stock in the public market
or the perception that those sales could occur could adversely affect the market
price of the Common Stock and the Company's ability to raise additional funds in
the future in the capital markets. The market price of the Common Stock could be
subject to significant fluctuations in response to various factors and events,
including the liquidity of the market for the shares of the Common Stock,
variations in the Company's operating results, changes in earnings estimates by
the Company and/or securities analysts, publicity regarding the industry or the
Company and the adoption of new statutes or regulations (or changes in the
interpretation of existing statutes or regulations) affecting the health care or
real estate industries in general or the assisted living industry in particular.
In addition, the stock market in recent years has experienced broad price and
volume fluctuations that often have been unrelated to the operating performance
of particular companies. These market fluctuations may adversely affect the
market price of the shares of Common Stock.
 
CONTROL BY DIRECTORS AND EXECUTIVE OFFICERS; ANTI-TAKEOVER MEASURES
 
     As of December 31, 1997, the Company's Directors and executive officers and
their affiliates beneficially own approximately 56.7% of the Company's
outstanding shares of Common Stock (exclusive of unexercised options to purchase
shares of Common Stock). In addition, outside directors will receive 2,500
shares of restricted stock immediately following the end of each year such
directors serve for the entire year. As of March 24, 1998, 2,500 shares have
been issued to each of R. Bruce Andrews, Maurice J. Dewald and John J.
Rydzewski. As a result, these stockholders, acting together, would be able to
significantly influence many matters requiring approval by the stockholders of
the Company, including the election of Directors. The Company's articles of
incorporation provide for authorized but unissued preferred stock, the terms of
which may be fixed by the Board of Directors. Further, the articles provide,
among other things, that upon the satisfaction of certain conditions specified
in the California General Corporation Law relating to the number of holders of
Common Stock, the Board of Directors will be classified and the holders of
Common Stock will not be permitted to cumulate votes. These conditions have been
met. Such provisions could have the effect of delaying, deferring or preventing
a change of control of the Company.
 
     In July 1997, the Company adopted a shareholders rights plan under which
the Company has declared a dividend distribution of one Preferred Share Purchase
Right on each outstanding share of the Company's common stock. Subject to
limited exceptions, the Rights will be exercisable if a person or group acquires
10% or more of the Company's stock or announces a tender offer for 10% of the
common stock. When exercisable, each Right (except the Rights held by the
acquiring person) will entitle its holder to purchase, at the Right's
then-current exercise price, a number of common shares of the Company having a
market value at the time of twice the Right's exercisable price. If the Company
is acquired in a merger or other business combination transaction which has not
been approved by the Company's Board of Directors, each Right will entitle its
holder to purchase, at the Right's then-current exercise price, a number of the
acquiring company's common shares having a market value at that time of twice
the Right's exercise price.
 
                                       23
<PAGE>   26
 
ITEM 6. SELECTED FINANCIAL DATA
 
     The following selected financial data has been derived from the audited
consolidated financial statements of the Company and its subsidiaries as of
December 31, 1997, the nine-month period then ended and for each of the four
fiscal years ended March 31, 1997. The data set forth below should be read in
conjunction with the consolidated financial statements and related notes thereto
included in Item 14, "Exhibits, Financial Statement Schedules and Reports on
Form 8-K -- Financial Statements," along with Item 7, "Management's Discussion
and Analysis of Financial Condition and Results of Operations."
 
<TABLE>
<CAPTION>
                                                         NINE-MONTH
                                                        PERIOD ENDED        FISCAL YEAR ENDED MARCH 31,
                                                        DECEMBER 31,   --------------------------------------
                                                            1997         1997      1996      1995      1994
                                                        ------------   --------   -------   -------   -------
                                                                (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                     <C>            <C>        <C>       <C>       <C>
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenue:
  Assisted living community revenue(1)................    $ 76,887     $ 73,770   $25,479   $ 4,838   $    --
  Management fees from affiliates.....................         388        1,141     2,536     3,463     3,492
                                                          --------     --------   -------   -------   -------
         Total revenue................................      77,275       74,911    28,015     8,301     3,492
                                                          --------     --------   -------   -------   -------
Operating expenses:
  Assisted living community operating expense(1)......      51,247       47,117    16,395     3,201        --
  Assisted living community lease expense.............      15,773       12,872     6,644       814        --
  General and administrative..........................      15,759        7,575     7,705     9,179     5,887
  Depreciation and amortization.......................       4,896        4,366     1,031       320        92
                                                          --------     --------   -------   -------   -------
         Total operating expenses.....................      87,675       71,930    31,775    13,514     5,979
                                                          --------     --------   -------   -------   -------
         Income (loss) from operations................     (10,400)       2,981    (3,760)   (5,213)   (2,487)
Other income (expense):
  Interest income.....................................       1,821        1,668     1,071       211         4
  Other income, net...................................         321        1,402     2,203       833       904
  Gain on sale of LLC interests.......................       5,511           --        --        --        --
  Interest expense....................................      (4,568)      (5,470)   (1,362)     (171)     (103)
                                                          --------     --------   -------   -------   -------
         Total other income (expense).................       3,085       (2,400)    1,912       873       805
                                                          --------     --------   -------   -------   -------
  Income (loss) from continuing operations before
    income taxes......................................      (7,315)         581    (1,848)   (4,340)   (1,682)
  Income tax expense (benefit)........................         484          297       233    (1,724)     (348)
                                                          --------     --------   -------   -------   -------
  Income (loss) from continuing operations before
    minority interest in income of majority owned
    entities, discontinued operations and
    extraordinary item................................      (7,799)         284    (2,081)   (2,616)   (1,334)
Minority interest in income of majority owned
  entities............................................         773          783        --        --        --
                                                          --------     --------   -------   -------   -------
Loss from continuing operations.......................      (8,572)        (499)   (2,081)   (2,616)   (1,334)
  Income (loss) from discontinued operations, net of
    income tax........................................     (13,563)        (889)    1,116      (383)     (319)
  Early extinguishment of debt, net of income tax.....          --         (386)       --        --        --
                                                          --------     --------   -------   -------   -------
         Net loss.....................................     (22,135)      (1,774)     (965)   (2,999)   (1,653)
Preferred dividends declared..........................          --           --       351       398        40
                                                          --------     --------   -------   -------   -------
Net loss available for common shares(2)...............    $(22,135)    $ (1,774)  $(1,316)  $(3,397)  $(1,693)
                                                          ========     ========   =======   =======   =======
Basic and diluted loss per common share:
Loss from continuing operations.......................    $  (0.77)    $   (.05)  $  (.39)  $  (.61)  $  (.27)
Income (loss) from discontinued operations............       (1.21)        (.10)      .18      (.08)     (.06)
Loss from extraordinary item..........................          --         (.04)       --        --        --
                                                          --------     --------   -------   -------   -------
    Net loss..........................................    $  (1.98)    $   (.19)  $  (.21)  $  (.69)  $  (.33)
                                                          ========     ========   =======   =======   =======
Weighted average common shares outstanding(2).........      11,171        9,400     6,246     4,903     5,113
                                                          ========     ========   =======   =======   =======
</TABLE>
 
                                       24
<PAGE>   27
 
<TABLE>
<CAPTION>
                                                                                     MARCH 31,
                                                        DECEMBER 31,   --------------------------------------
                                                            1997         1997      1996      1995      1994
                                                        ------------   --------   -------   -------   -------
                                                                (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                     <C>            <C>        <C>       <C>       <C>
SELECTED OPERATING DATA:
Assisted living units owned or leased (end of
  period)(1)..........................................       5,918        5,599     3,277       445        --
Assisted living units managed (end of period).........         379          256     1,289     2,803     3,042
Weighted average occupancy of assisted living units
  (end of year).......................................          85%          88%       90%       92%       88%
BALANCE SHEET DATA:
Working capital (deficit).............................    $ 75,279     $ 12,947   $10,014   $(4,660)  $ 1,363
         Total assets.................................     233,085      161,947    77,403    15,399     8,054
Long-term notes payable, excluding current portion....      81,560       90,481    24,814     3,213        --
Series A Preferred Stock, convertible and
  redeemable..........................................          --           --     2,358     4,586     3,969
         Total shareholders' equity (deficit).........     111,435       51,374    39,947    (3,536)   (1,316)
</TABLE>
 
---------------
(1) The Company began operating ALCs under long-term operating leases during the
    fiscal year ended March 31, 1995. Prior to that fiscal year, the Company
    managed those facilities for Affiliated Partnerships for which it acted as
    the managing general partner and recognized management fees and other income
    with respect to those assisted living facilities but did not receive
    assisted living revenue from and did not incur assisted living facility
    operating or lease expenses in connection with its operations.
 
(2) Net loss available for common shares reflects the effect of preferred stock
    dividends. Weighted average common shares outstanding give effect to the 1
    for 3.04 reverse stock split which occurred upon the completion of the IPO
    Offering.
 
                                       25
<PAGE>   28
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
OVERVIEW
 
     As of December 31, 1997, the Company operated 49 ALCs containing 6,297
units, including 32 Leased ALCs, 14 Owned ALCs and three Managed ALCs.
Additionally, the Company was in various stages of construction on five ALCs
with an anticipated total of 633 units. On February 12, 1998, the Company
entered into purchase and sale agreements to purchase interests in 13 ALCs and
one SNF located in California, containing approximately 1,900 units, for
approximately $88 million.
 
     From 1980 until 1994 when the Company began operating ALCs for its own
account, all of the ALCs operated by the Company were owned or leased by
Affiliated Partnerships. From 1991 until 1994, other Affiliated Partnerships
also acquired or began development of senior, affordable senior and multifamily
apartments primarily utilizing the sale of tax credits under the Federal Tax
Credit Program for the equity funding of the development.
 
     Since commencing operation of ALCs for its own account in April 1994, the
Company embarked upon an expansion strategy and achieved significant growth in
revenue resulting primarily from the acquisition of ALCs. The Company focused
its growth efforts on the acquisition and development of additional ALCs and
expansion of services to its residents as they "age in place."
 
     Growth has been achieved through the acquisition of ALCs which the Company
owns for its own account or leases pursuant to long-term operating leases
primarily from Health Care REITs. Since April 1994 when the Company entered into
its first long-term operating lease from a Health Care REIT, the Company has
developed, acquired for its own account or entered into long-term operating
leases from Health Care REITs or other lessors, 47 ALCs totaling 6,047 units
(94% of its portfolio of 6,426 units at March 24, 1998). Of the ALCs operated by
the Company for its own account as of March 24, 1998, 24 communities (2,476
units) were previously owned or leased by Affiliated Partnerships, inclusive of
10 communities (941 units) owned or leased by American Retirement Villas
Properties II, a California limited partnership in which a controlling interest
was acquired by the Company, as described below. Of the remaining communities,
18 communities (2,961 units) were acquired from unrelated third-party owners,
and four communities (457 units) were developed by the Company.
 
EVENTS SUBSEQUENT TO DECEMBER 31, 1997
 
     In February 1998, the Company entered into purchase and sale agreements to
purchase interests in 13 ALCs and one SNF containing approximately 1,900 units,
located in California, for $88.0 million. The communities, which complement
ARV's geographic clusters in Southern and Northern California, are expected to
be purchased from affiliates of Burlingame, California-based Hillsdale Group,
L.P., and of Fremont Realty Capital, L.L.C.
 
     Following the closing of the transaction, which would further consolidate
the Company's position as California's largest assisted living provider, the
Company will operate 43 communities containing approximately 5,300 units in
California. On a national basis, ARV will have 63 operating communities
containing approximately 8,300 units located in 10 states.
 
THE NINE-MONTH PERIOD ENDED DECEMBER 31, 1997 COMPARED WITH THE FISCAL YEAR
ENDED MARCH 31, 1997
 
     Revenues for the nine-months ended December 31, 1997 increased to $77.3
million from $74.9 million for the fiscal year ended March 31, 1997 due to an
increase in ALC revenue, partially offset by a decrease in management fees from
affiliates.
 
     ALC revenue increased to $76.9 million for the nine months ended December
31, 1997 from $73.8 million for the fiscal year ended March 31, 1997. ALC
revenue increased primarily due to the increase in the number of ALCs operated
during the nine months ended December 31, 1997 as well as the inclusion of
revenues for the full nine months for nine ALCs opened during the fiscal year
ended March 31, 1997. As of
 
                                       26
<PAGE>   29
 
December 31, 1997, the Company operated 14 Owned ALCs, 32 Leased ALCs and three
Managed ALCs compared to 14 Owned ALCs, 29 Leased ALCs and two Managed ALCs as
of March 31, 1997.
 
     Management fees from affiliates decreased $0.7 million to $0.4 million from
$1.1 million due primarily to the purchase of controlling interests in two
affiliated partnerships, in June and August 1996, which owned or leased 11 ALCs
previously managed by the Company.
 
     ALC operating and lease expenses increased to $51.2 million and $15.8
million, respectively, for the nine-month period ended December 31, 1997 from
$47.1 million and $12.9 million for the fiscal year ended March 31, 1997. The
increase is due primarily to the increase in the number of ALCs during the nine
months ended December 31, 1997 as well as the inclusion of expenses for the full
nine months for nine ALCs opened during the fiscal year ended March 31, 1997.
 
     General and administrative expenses increased to $15.8 million for the
nine-month period ended December 31, 1997 from $7.6 million for the fiscal year
ended March 31, 1997. This increase was due to the increased support and
staffing required with the addition of new communities, the costs incurred to
develop the Company's strategic plan, as well as several special charges
including: severance costs related to the retirement of three senior executives
($2.3 million), amounts incurred related to the proxy fight with Emeritus ($1.6
million) and the write-off of certain costs incurred in the conversion of the
Company's accounting software ($1.1 million), which was abandoned when the
Company discovered numerous application errors in the software package it
purchased.
 
     Depreciation and amortization increased to $4.9 million for the nine months
ended December 31, 1997 from $4.4 million for the fiscal year ended March 31,
1997. This increase is primarily due to the increase in the number of ALCs.
 
     Interest income increased to $1.8 million for the nine-month period ended
December 31, 1997 from $1.7 million for the fiscal year ended March 31, 1997.
This increase was due to higher cash balances available for investment. The
increase in cash was due to the Prometheus Transactions.
 
     Gain on sale of LLC interests represents the gain on the sale of the
Company's 50 percent interest in two limited liability companies which owned one
ALC and one development site during December 1997.
 
     Income tax expense increased to $484,000 for the nine-month period ended
December 31, 1997 from $297,000 for the year ended March 31, 1997. The primary
component of this increase is the additional valuation allowance recorded
against the Company's deferred tax asset.
 
     Interest expense decreased to $4.6 million for the nine-month period ended
December 31, 1997 from $5.5 million for the fiscal year ended March 31, 1997. On
an annualized basis, this actually results in a slight increase which is the
result of the Prometheus Notes on which the Company paid interest for
approximately one month.
 
     Losses from discontinued operations reflect the operations of GeriCare and
the Apartment Group both of which the Company is currently in the process of
disposing. While developing the plan to dispose of these assets, the Company
determined that the fair value less selling costs of each was less than their
current carrying cost. In addition, it was determined that the Company will have
to provide capital to fund current operation and projected permanent financing
deficits. The Company has, accordingly, provided $2.0 million and $8.6 million
for the cost of disposing of GeriCare and the Apartment Group, respectively.
 
FISCAL YEAR ENDED MARCH 31, 1997 COMPARED WITH FISCAL YEAR ENDED MARCH 31, 1996.
 
     As a result of the Company's growth through acquisition and development,
revenue for the year ended March 31, 1997 increased to $74.9 million from $28.0
million for the year ended March 31, 1996 due primarily to an increase in ALC
revenue and offset partially by a decrease in management fees. During the year
ended March 31, 1997, the Company added a total of 20 ALCs to its portfolio of
Owned ALCs and Leased ALCs.
 
                                       27
<PAGE>   30
 
     ALC revenue increased to $73.8 million for the year ended March 31, 1997
from $25.5 million for the year ended March 31, 1996. ALC revenue increased due
to an increase in the number of Owned ALCs and Leased ALCs operated by the
Company. Management fees decreased to $1.1 million for the fiscal year ended
March 31, 1997 from $2.5 million for the fiscal year ended March 31, 1996. This
decrease occurred primarily as a result of the Company's purchase of controlling
interest in Affiliated Partnerships and the resultant elimination of a portion
of management fee income resulting from those purchases.
 
     As of March 31, 1997, the Company operated 14 Owned ALCs, 29 Leased ALCs
and two Managed ALCs compared to six Owned ALCs, 17 Leased ALCs and 13 Managed
ALCs as of March 31, 1996. During the year ended March 31, 1997, the Company
acquired controlling interests in two Affiliated Partnerships which owned or
leased 11 ALCs previously managed by the Company. The consolidated operations of
these Affiliated Partnerships for a portion of the year increased ALC revenue by
$12.0 million. The acquisition of eight ALCs from third parties and the
development of one ALC provided additional ALC revenue of $9.2 million.
Moreover, the operations of 19 ALCs acquired at various times during the year
ended March 31, 1996 were recognized for a full twelve months during the year
ended March 31, 1997 increasing ALC revenue by $25.2 million over the prior
year.
 
     As a result of the growth experienced by the Company, expenses increased to
$71.9 million for the year ended March 31, 1997 from $31.8 million for the year
ended March 31, 1996. The principal components of the increased expenses, higher
ALC operating and lease expenses, were incurred as additional ALCs were leased
or purchased by the Company in the execution of its growth strategy. The Company
also incurred operating expenses attributable to the acquisition of GeriCare in
August 1996.
 
     ALC operating and lease expenses increased to $47.1 million and $12.9
million, respectively, for the year ended March 31, 1997 from $16.4 million and
$6.6 million respectively, for the year ended March 31, 1996. The increases
reflect the net addition of eight Owned ALCs and 12 Leased ALCs acquired by the
Company during the year ended March 31, 1997. Of these ALCs, six Owned ALCs and
five Leased ALCs were procured through the Company's purchases of controlling
interests in Affiliated Partnerships. Five Owned ALCs were acquired from
third-party owners, three of which were subsequently sold to a Health Care REIT
and leased back by the Company. The Company added four Leased ALCs pursuant to
long-term operating leases, one of which was developed by the Company for a
Health Care REIT. The consolidated operations of these Affiliated Partnerships
for a portion of the year, increased ALC operating and lease expenses by $7.5
million and $0.7 million, respectively. The acquisition of eight ALCs from third
parties and the development of one ALC increased ALC operating and lease
expenses by $6.3 million and $1.0 million, respectively. Moreover, the
operations of 19 ALCs acquired at various times during the year ended March 31,
1996 were recognized for a full twelve months during the year ended March 31,
1997, increasing ALC operating and lease expenses by $16.1 million and $4.1
million, respectively over the prior year.
 
     General and administrative expenses remained consistent at $7.6 million and
$7.7 million for the years ended March 31, 1997 and 1996, respectively.
 
     Depreciation and amortization expenses increased to $4.4 million for the
year ended March 31, 1997 from $1.0 million for the year ended March 31, 1996
primarily due to an increase in depreciation expenses incurred as a result of
the increased number of Owned ALCs. Depreciation expense for Owned ALCs was $3.6
million for the year ended March 31, 1997 compared to $420,000 for the year
ended March 31, 1996. The Company also incurred amortization of issuance costs
associated with the convertible notes due in 1999 and the 2006 Notes totaling
$291,000 for the year ended March 31, 1997 compared to $342,000 for the year
ended March 31, 1996.
 
     Interest income increased to $1.7 million for the year ended March 31, 1997
from $1.1 million for the year ended March 31, 1996 due primarily to higher
average cash and cash equivalents on hand in fiscal 1997 following the
successful offering of the 2006 Notes in April 1996.
 
     Other income decreased to $606,000 for the year ended March 31, 1997 from
$2.1 million for the year ended March 31, 1996. During the year ended March 31,
1996, the Company had recognized gains primarily
 
                                       28
<PAGE>   31
 
resulting from the sale of ALCs owned by Affiliated Partnerships in which the
Company held ownership interests. All but one of these ALCs are currently
operated by the Company as Leased ALCs.
 
     Interest expense increased to $5.5 million for the year ended March 31,
1997 from $1.4 million for the year ended March 31, 1996 due primarily to
additional interest incurred on the 2006 Convertible Notes and mortgage
financing of certain of the Company's Owned ALCs.
 
     Income tax expense increased to $297,000 for the year ended March 31, 1997
from $233,000 for the year ended March 31, 1996. The primary component of this
increase is the valuation allowance on the Company's deferred tax asset.
 
     During the year ended March 31, 1997, the Company recognized an expense of
$783,000 attributable to the minority interest in the income of Affiliated
Partnerships in which the Company acquired a controlling interest.
 
     Losses from discontinued operations reflect the operations of GeriCare for
the period from August 1996 to March 1997 and the Apartment Group for the entire
fiscal year. The Company is currently in the process of disposing of both of
these assets. The loss from discontinued operations, net of income taxes, was
$889,000 for the fiscal year ended March 31, 1997 compared to income from
discontinued operations, net of income tax, of $1.1 million for the fiscal year
ended March 31, 1996. The primary reason for the decline was the $2.0 million
charge taken related to the Apartment Group in the fiscal year ended March 31,
1997. The charge represented the write-off of previously advanced operating
deficit loans and a provision for anticipated future obligations.
 
     During the year ended March 31, 1997, the Company recognized an
extraordinary loss of $386,000, net of income tax benefit of $231,000, resulting
primarily from the early extinguishment of the 1999 Notes. Pursuant to the terms
of the 1999 Notes, Noteholders who chose to redeem their 1999 Notes rather than
convert into common stock were paid a premium of 6.7% upon redemption. These
premiums totaled $261,000. Additionally, unamortized note issuance costs of
$335,000 were expensed upon the redemption.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The Company's unrestricted cash and cash equivalents balances were $102.8
million and $15.8 million at December 31, 1997 and March 31, 1997, respectively.
 
     Working capital increased to $75.3 million as of December 31, 1997,
compared to working capital of $12.9 million at March 31, 1997 and $10.0 million
at March 31, 1996 resulting primarily from the net proceeds from the Prometheus
Transactions.
 
     For the nine months ended December 31, 1997 cash used in operations was
$7.4 million compared to cash provided by operating activities of $0.9 million
for the fiscal year ended March 31, 1997 and cash used in operating activities
of $0.5 million for the fiscal year ended March 31, 1996. During the nine-month
period ended December 31, 1997, the Company's net loss of $22.1 million was
offset by non-cash charges of $4.9 million for depreciation and amortization,
$13.6 million for losses from discontinued operations, and $600,000 for
provision for doubtful accounts and discontinued projects. For the year ended
March 31, 1997, the Company's net loss of $1.8 million was offset by non-cash
charges of $4.4 million for depreciation and amortization, $600,000 for the loss
from discontinued operations, $163,000 for the provision for doubtful accounts
and discontinued project costs, and a $386,000 charge (net of $231,000 of taxes)
for the early extinguishment of its 1999 Notes. For the year ended March 31,
1996, the Company's net loss of $1.0 million was offset by non-cash charges of
$1.0 million for depreciation and amortization and $400,000 for income from
discontinued operations. Net cash used in operating activities from discontinued
operations was $4.3 million, $2.4 million and net cash provided by operating
activities from discontinued operations of $55,000 for the nine-month period
ended December 31, 1997 and the fiscal years ended March 31, 1997 and 1996,
respectively.
 
     For the nine-month period ended December 31, 1997, cash provided by
investing activities was $11.8 million compared to cash used in investing
activities of $59.3 million and $53.9 million for the fiscal years ended March
31, 1997 and 1996, respectively. Proceeds from the sale of the Company's
interest in two
 
                                       29
<PAGE>   32
 
LLC's of $24.3 million, proceeds from the sale and leaseback of communities of
$1.9 million, distributions received from the Company's investment in Senior
Income fund of $3.6 million, and the decrease in restricted cash as collateral
for letters of credit pledged as security deposits for leased communities of
$1.7 million were the primary sources of cash flows for investing activities
during the nine-month period ended December 31, 1997. These amounts were offset
by purchases of property, furniture and equipment totaling $18.6 million during
the nine-month period ended December 31, 1997. Purchases of property, furniture
and equipment totaling $70.1 million, investments in real estate of $3.8 million
and purchases of limited partnership interests totaling $18.5 million were the
primary uses of cash for investing activities in the fiscal year ended March 31,
1997. These amounts were offset by $29.1 million proceeds from the
sale/leaseback of four ALCs and a $3.0 million decrease in restricted cash as
collateral for letters of credit pledged as security deposits for leased
communities. Purchases of property, furniture and equipment totaling $45.7
million, investments in real estate of $6.8 million, increases in restricted
cash of $4.9 million as collateral for letters of credit pledged as security
deposits for leased communities, increases in leased property security deposits
of $559,000 and acquisition of limited partnership interests of $1.8 million
were partially offset by proceeds of $5.1 million from the sale/leaseback of one
ALC to a Health Care REIT during the fiscal year ended March 31, 1996.
 
     Net cash provided by financing activities was $82.6 million, $66.7 million
and $61.1 million for the nine month period ended December 31, 1997 and the
fiscal years ended March 31, 1997 and 1996, respectively. During the nine month
period ended December 31, 1997, $84.8 million (net of issuance costs) was
provided from the Prometheus Transactions offset by $1.6 million of repayments
of notes payable. During the fiscal year ended March 31, 1997, the issuance of
the 2006 Notes provided $55.2 million net of issuance costs while borrowings
under notes payable provided $31.1 million. Repayments of notes payable and the
redemption of the 1999 Notes totaled $18.6 million and $1.7 million,
respectively for the year ended March 31, 1997. During the year ended March 31,
1996, $42.7 million (net of issuance cost) was provided by the issuance of
common stock in the initial public offering, $10.8 million (net of issuance
costs) was provided from the issuance of the 1999 Convertible Notes, and $14.5
million was provided from mortgage and loan borrowings. These proceeds were
offset by $6.1 million of debt repayments, $400,000 of preferred stock dividends
paid and $352,000 paid to repurchase common stock.
 
     On June 6, 1996, the Company obtained a $60 million commitment from Health
Care REIT, Inc. for financing the construction of new ALCs. The commitment
expires on June 6, 1998. Pursuant to the terms of the commitment, Health Care
REIT, Inc. will finance up to 100% of the approved costs, as defined, for the
construction of new ALCs. Upon completion of construction, the Company will
lease the communities from Health Care REIT, Inc. on an initial lease term of 15
years, with three options to renew, at the Company's option, for periods of ten
years each. The initial lease rate will be based upon the yield of comparable
term U.S. Treasury Notes plus 3.75%. In December, 1996, this commitment was
increased to $90 million to include $30 million for the acquisition of existing
ALCs. The initial lease rate to be paid by the Company on acquisitions funded
under this facility will be based upon the yield of comparable term U.S.
Treasury Notes plus 3.40%.
 
     On June 24, 1996, the Company obtained a $35 million commitment from Bank
United of Texas for the construction or acquisition of ALCs. The terms of the
commitment provide for interest at 2.75% over the thirty day LIBOR rate. Of the
commitment, a $20 million sub-limit has been established for the construction of
ALCs. As of December 31, 1997 and March 31, 1997, the Company had outstanding
indebtedness of $8.8 million used as mortgage financing of existing ALCs.
Additionally, the Company had guaranteed a $7.7 million loan borrowed by an
Affiliated Partnership for the construction of a new ALC.
 
     On September 10, 1996, the Company obtained a $10 million revolving line of
credit with Imperial Bank to be used for acquisition, development, the provision
of letters of credit and general corporate purposes. Advances under this line of
credit are priced at the Imperial Bank prime rate plus 0% to .5% or LIBOR plus
2.0% to 2.5% based upon the Company's achievement of financial ratios. As of
December 31, 1997, the Company had used $9.2 million of this line of credit for
the provision of letters of credit used as Leased ALC security deposits.
 
                                       30
<PAGE>   33
 
     In July 1997, the Company sold approximately 1.9 million shares of its
common stock to Prometheus for $26.9 million. In October 1997, the Company
issued the $60 million Prometheus Notes. The Prometheus Notes were convertible
to shares of the Company's common stock subject to a declining optional
redemption premium starting at $17.25 per share. The Company had the option to
call the Notes at any time, and on December 5, 1997, the Board approved the 2006
note redemption. Per the terms of the Prometheus Notes, the note redemption was
made in common stock of the Company. Including the approximately 23.214%
optional redemption premium less interest paid to the date of redemption, the
issuance amounted to approximately 4.3 million shares at $17.25 per share. As a
result of the Prometheus Transactions, the Company raised additional capital,
net of costs, of $82.2 million.
 
     As of December 31, 1997, the Company has expended substantially all of the
$55.2 million net proceeds received from the sale of the 2006 Convertible Notes.
The Company intends to refinance certain notes payable maturing September 1998.
 
     In November 1996, the Company obtained a $75 million commitment from
Meditrust for the acquisition of additional existing ALCs. As of December 31,
1997, none of this commitment has been expended.
 
     The Company believes that its financing commitments, existing liquidity and
ability to refinance certain Owned ALCs and investments will provide adequate
resources to meet its current operating and investing needs and support its
current growth plans for the next 12 months. The Company's long-term plans for
acquisition and development of ALCs will require substantial amounts of
additional capital. The Company will be required from time to time to incur
additional indebtedness or issue additional debt or equity securities to finance
its growth strategy, including the acquisition and development of ALCs as well
as other capital expenditures and additional funds to meet increased working
capital requirements.
 
YEAR 2000
 
     The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. The Company had
developed a plan to address the Year 2000 issue for its financial information
systems and, during the nine months ended December 31, 1997, began converting
its computer systems to be Year 2000 compliant. However, the Company abandoned
its attempted accounting software conversion in February 1998, when numerous
application errors were discovered in the software package the Company
purchased. As a result, the Company is currently reassessing its planned
conversion efforts for its financial and operational information systems as well
as related operational issues at its communities. While an estimate of the total
project costs is not currently available due to the recent events, it is
anticipated that such costs will be funded from currently available cash flows.
 
IMPACT OF INFLATION AND CHANGING PRICES
 
     Operating revenue from ALCs operated by the Company is the primary source
of revenue earned by the Company. These ALCs are affected by rental rates which
are highly dependent upon market conditions and the competitive environments
where the facilities are located. Employee compensation is the principal cost
element of property operations. Although there can be no assurance it will be
able to continue to do so, the Company has been able historically to offset the
effects of inflation on salaries and other operating expenses by increasing
rental and assisted living rates.
 
NEW ACCOUNTING PRONOUNCEMENTS
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130") which is effective for fiscal years beginning after December 15, 1997, and
requires restatement of earlier financial statements for comparative purposes.
SFAS 130 requires that items meeting the criteria of a component of
comprehensive income, including foreign currency items and unrealized gains and
losses on certain investments in debt and equity securities, be shown in the
financial statements. SFAS 130 does not require a specific format for disclosure
of comprehensive income and its components in the financial statements. The
adoption of SFAS 130 is not expected to have an impact on the Company's
financial statements.
 
                                       31
<PAGE>   34
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "Disclosure about Segments of an
Enterprise and Related Information" ("SFAS 131"). This standard requires that a
public business enterprise report financial and descriptive information about
its reportable operating segments. Operating segments are components of an
enterprise about which separate financial information is available that is
regularly evaluated by the chief operating decision makers in deciding how to
allocate resources and in assessing performance. SFAS 131 also requires that all
public business enterprises report information about the revenues derived from
the enterprise's products or services (or groups of similar products or
services), about the countries in which the enterprise earns revenues and holds
assets and about major customers regardless of whether that information is used
in making operating decisions. However, this Statement does not require an
enterprise to report information that is not prepared for internal use if
reporting it would be impractical. This Statement is effective for financial
statements for periods beginning after December 15, 1997. In the initial year of
application, comparative information for earlier years is required to be
restated. Comparative information for interim periods is not required until the
second year of application. The adoption of SFAS 131 is not expected to have an
impact on the Company's financial statements.
 
                                       32
<PAGE>   35
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     The financial statements and the Independent Auditors' Report are listed at
Item 14 and are included beginning on Page F-1.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
     None.
 
                                    PART III
 
ITEMS 10, 11, 12 AND 13. DIRECTORS AND EXECUTIVE OFFICERS OF REGISTRANT,
EXECUTIVE COMPENSATION, SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT, AND CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     The information required by these Items is incorporated by reference to the
Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
within 120 days after the end of the Company's fiscal year covered by this
Report.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
(a) The following documents are filed as a part of the report:
 
     (1) Financial Statements. The following financial statements of the
         Registrant and the Report of Independent Public Accountants therein are
         filed as part of this Report on Form 10-K:
 
<TABLE>
<CAPTION>
                                                     PAGE
                                                     ----
<S>                                                <C>
Independent Auditors' Report.....................     F-1
Consolidated Balance Sheets......................     F-2
Consolidated Statements of Operations............     F-3
Consolidated Statements of Shareholders'
  Equity.........................................     F-4
Consolidated Statements of Cash Flows............     F-5
Notes to Consolidated Financial Statements.......     F-7
</TABLE>
 
     (2) Financial Statement Schedules. Schedule II-Valuation and Qualifying
         Accounts. Other Financial Statement Schedules have been omitted because
         the information required to be set forth therein is not applicable or
         is shown in the financial statements or notes thereto.
 
(b) Reports on Form 8-K. The Registrant filed the following reports with the
    Securities and Exchange Commission ("SEC") on Form 8-K during the quarter
    ended December 31, 1997:
 
     (1) The Company's current report on Form 8-K filed with the SEC on October
         10, 1997 reported under Item 5, concerning the unanimous consent to the
         purchase by an affiliate of LFREI of substantially all of the stock of
         Kapson Senior Quarters Corporation.
 
     (2) The Company's current report on Form 8-K filed with the SEC on October
         22, 1997 reported under Item 5, concerning the resignation of Gary L.
         Davidson as Chairman, Chief Executive Officer and President of the
         Company. John J. Rydzewski, an outside director, was appointed Chairman
         of the Board. John A. Booty, the co-founder and former President of the
         Company, and a director of the Company, became the President and Chief
         Executive Officer on an interim basis.
 
     (3) The Company's current report on Form 8-K filed with the SEC on October
         28, 1997 reported under Item 8, concerning the change in the Company's
         fiscal year end to December 31 from its previous March 31 year end.
         This change is effective with the current period ending December 31,
         1997.
 
                                       33
<PAGE>   36
 
     (4) The Company's current report on Form 8-K filed with the SEC on November
         14, 1997 reported under Item 5, concerning the $60 million of
         Convertible Subordinated Notes due 2007 issued by the Company to
         Prometheus.
 
     (5) The Company's current report on Form 8-K filed with the SEC on December
         12, 1997 reported under Item 5, concerning the (i) appointment of
         Howard G. Phanstiel as Chairman of the Board of Directors and Chief
         Executive Officer and as a Director and (ii) appointment of Lawrence B.
         Murphy as President and Chief Operating Officer, (iii) resignation of
         James M. Peters as a Director, (iv) rescheduling of the Company's
         Annual Meeting of Shareholders to January 28, 1998 and a new record
         date with respect to the Annual Meeting of December 18, 1997 and (v)
         optional redemption of the $60 million principal amount of 6.75%
         Convertible Subordinated Notes due 2007 held by Prometheus.
 
     (6) The Company's current report on Form 8-K filed with the SEC on December
         30, 1997 reported under Item 5, concerning that Lawrence B. Murphy will
         not be joining the Company as its new President and Chief Operating
         Officer. The Company also announced that John A. Booty will continue as
         interim President of the Company.
 
(c) EXHIBITS: The following exhibits are filed as part of, or incorporated by
    reference into this report on Form 10-K:
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                           DESCRIPTION
-------                          -----------
<S>      <C>
 3       Articles of Incorporation and By Laws, as amended,
         incorporated by reference to the Company's S-1 filing on
         October 17, 1995.
 4       Rights Agreement, dated as of July 14, 1997, between ARV
         Assisted Living, Inc., and ChaseMellon Shareholder Services,
         L.L.C. which includes the form of Certificate of
         Determination of the Series C Junior Participating Preferred
         Stock of ARV Assisted Living, Inc. as Exhibit A, the form of
         Right Certificate as Exhibit B and the Summary of Rights to
         Purchase Preferred Shares as Exhibit C, incorporated by
         reference to Exhibit 4.1 to the Company's 8-K filed with the
         Securities and Exchange Commission on August 8, 1997.
 9       Stockholders' Voting Agreement dated July 14, 1997, by and
         among Prometheus Assisted Living LLC; Lazard Freres Real
         Estate Investors L.L.C.; Gary L. Davidson; Davidson Family
         Partnership; Gary L. Davidson Funded Revocable Living Trust;
         John A. Booty; Booty-Jones Family Partnership; Booty Family
         Trust; Karen A. Booty Charitable Remainder Trust; John A.
         Booty Charitable Remainder Unitrust; David P. Collins; D&V
         Collins Family Limited Partnership; Collins Family Community
         Property Trust; David P. Collins Annuity Trust; and Graham
         P. Espley-Jones, incorporated by reference to Exhibit 9.1 of
         the Company's 8-K filed with the Securities and Exchange
         Commission on July 23, 1997.
10.1     Stock Purchase Agreement dated as of July 14, 1997, by and
         among Prometheus Assisted Living LLC, Lazard Freres Real
         Estate Investors L.L.C. and the Company, incorporated by
         reference to Exhibit 10.1 to the Company's 8-K filed with
         the Securities and Exchange Commission on July 23, 1997.
10.2     Amendment to Stock Purchase Agreement dated as of July 20,
         1997, by and among Prometheus Assisted Living LLC, Lazard
         Freres Real Estate Investors L.L.C. and the Company,
         incorporated by reference to Exhibit 10.2 to the Company's
         8-K filed with the Securities and Exchange Commission on
         July 23, 1997.
10.3     Second Amendment to Stock Purchase Agreement dated as of
         July 22, 1997, by and among Prometheus Assisted Living LLC,
         Lazard Freres Real Estate Investors L.L.C. and the Company,
         incorporated by reference to Exhibit 10.3 to the Company's
         8-K filed with the Securities and Exchange Commission on
         July 23, 1997.
10.4     Stockholders Agreement dated as of July 14, 1997, by and
         among Prometheus Assisted Living LLC, Lazard Freres Real
         Estate Investors L.L.C. and the Company, incorporated by
         reference to Exhibit 10.4 to the Company's 8-K filed with
         the Securities and Exchange Commission on July 23, 1997.
</TABLE>
 
                                       34
<PAGE>   37
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER                           DESCRIPTION
-------                          -----------
<S>      <C>
10.5     Registration Rights Agreement dated as of July 14, 1997, by
         and between Prometheus Assisted Living LLC and the Company,
         incorporated by reference to Exhibit 10.5 to the Company's
         8-K filed with the Securities and Exchange Commission on
         July 23, 1997.
10.6     Confidential Separation Agreement, dated as of October 13,
         1997, between the Company and Gary L. Davidson, incorporated
         by reference to Exhibit 10.1 to the Company's 8-K filed with
         the Securities and Exchange Commission on October 22, 1997.
10.7     Amended and Restated Stock and Note Purchase Agreement dated
         as of October 29, 1997, by and among the Company, LFREI and
         Prometheus, incorporated by reference to Exhibit 1 to the
         Amendment No. 2 to Schedule 13D filed by Prometheus and
         LFREI on November 7, 1997.
10.8     Amended and Restated Stockholders Agreement dated as of
         October 29, 1997, by and among the Company, LFREI and
         Prometheus, incorporated by reference to Exhibit 2 to the
         Amendment No. 2 to Schedule 13D filed by Prometheus and
         LFREI on November 7, 1997.
10.9     Amended and Restated Registration Rights Agreement dated as
         of October 29, 1997, by and among the Company, LFREI and
         Prometheus, incorporated by reference to Exhibit 3 to the
         Amendment No. 2 to Schedule 13D filed by Prometheus and
         LFREI on November 7, 1997.
10.10    Indenture dated as of October 30, 1997, by and between the
         Company and Chase Manhattan Bank, N.A., incorporated by
         reference to Exhibit 5 to the Amendment No. 2 to Schedule
         13D filed by Prometheus and LFREI on November 7, 1997.
10.11    Noted dated as of October 30, 1997, by the Company in favor
         of Prometheus, incorporated by reference to Exhibit 6 to the
         Amendment No. 2 to Schedule 13D filed by Prometheus and
         LFREI on November 7, 1997.
10.12    Letter Agreement dated October 29, 1997 by and among
         Prometheus, LFREI and the Company, incorporated by reference
         to Exhibit 7 to the Amendment No. 2 to Schedule 13D filed by
         Prometheus and LFREI on November 7, 1997.
10.13    Stockholders' Voting Agreement dated as of October 29, 1997,
         by and among Prometheus, LFREI and certain stockholders of
         the Company, incorporated by reference to Exhibit 4 to the
         Amendment No. 2 to Schedule 13D filed by Prometheus and
         LFREI on November 7, 1997.
10.14    Prospect Park Residence, LLC Buy-Sell Notice dated November
         6, 1997, by and between Castle Service Co., LLC and ARV
         Assisted Living, Inc.
10.15    Prospect Park Residence, LLC Reply Notice dated November 26,
         1997, from ARV Assisted Living, Inc. to Castle Service Co.,
         LLC.
10.16    Amendment to Consulting Services Agreement, by and between
         ARV Assisted Living, Inc. and John A. Booty dated October
         13, 1997.
10.17    Separation Agreement, dated December 31, 1997, by and
         between ARV Assisted Living, Inc. and John A. Booty.
10.18    Separation Agreement, dated December 31, 1997, by and
         between ARV Assisted Living, Inc. and David P. Collins.
10.19    Mutual General Release dated December 31, 1997, by and
         between ARV Assisted Living, Inc. and David P. Collins.
10.20    Consulting Services Agreement dated December 31, 1997, by
         and between ARV Assisted Living, Inc. and David P. Collins.
23       Consent of KPMG Peat Marwick LLP.
27       Financial Data Schedule.
</TABLE>
 
                                       35
<PAGE>   38
 
                                   SIGNATURES
 
     Pursuant to the requirements of Section 13 or 15(d) of the Securities and
Exchange Act of 1934, as amended, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
 
                                          ARV ASSISTED LIVING, INC.
 
                                          By:    /s/ HOWARD G. PHANSTIEL
                                            ------------------------------------
                                                    Howard G. Phanstiel
                                                   Chairman of the Board
 
                                            Date: March 31, 1998
 
     Pursuant to the requirements of the Securities Act of 1934, as amended,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
 
<TABLE>
<CAPTION>
                      SIGNATURE                                     TITLE                    DATE
                      ---------                                     -----                    ----
<C>                                                    <S>                              <C>
               /s/ HOWARD G. PHANSTIEL                 Chief Executive Officer and      March 31, 1998
-----------------------------------------------------  Chairman of the Board
                 Howard G. Phanstiel
 
             /s/ GRAHAM P. ESPLEY-JONES                Executive Vice President and     March 31, 1998
-----------------------------------------------------  Chief Financial Officer
               Graham P. Espley-Jones
 
                /s/ R. BRUCE ANDREWS                   Director                         March 31, 1998
-----------------------------------------------------
                  R. Bruce Andrews
 
                  /s/ JOHN A. BOOTY                    Director                         March 31, 1998
-----------------------------------------------------
                    John A. Booty
 
                /s/ DAVID P. COLLINS                   Director                         March 31, 1998
-----------------------------------------------------
                  David P. Collins
 
                /s/ MAURICE J. DEWALD                  Director                         March 31, 1998
-----------------------------------------------------
                  Maurice J. DeWald
 
                /s/ ROBERT P. FREEMAN                  Director                         March 31, 1998
-----------------------------------------------------
                  Robert P. Freeman
 
                 /s/ MURRY N. GUNTY                    Director                         March 31, 1998
-----------------------------------------------------
                   Murry N. Gunty
 
                /s/ KENNETH M. JACOBS                  Director                         March 31, 1998
-----------------------------------------------------
                  Kenneth M. Jacobs
 
                /s/ JOHN J. RYDZEWSKI                  Director                         March 31, 1998
-----------------------------------------------------
                  John J. Rydzewski
</TABLE>
 
                                       36
<PAGE>   39
 
                          INDEPENDENT AUDITORS' REPORT
 
The Board of Directors
ARV Assisted Living, Inc.:
 
     We have audited the accompanying consolidated balance sheets of ARV
Assisted Living, Inc. and subsidiaries as of December 31, 1997 and March 31,
1997, and the related consolidated statements of operations, shareholders'
equity and cash flows for the nine-month period ended December 31, 1997 and each
of the years in the two-year period ended March 31, 1997. In connection with our
audits of the consolidated financial statements, we have also audited the
financial statement schedule described in Item 14(a)(2). These consolidated
financial statements and financial statement schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and financial statement schedule based on our
audits.
 
     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of ARV Assisted
Living, Inc. and subsidiaries as of December 31, 1997 and March 31, 1997, and
the results of their operations and their cash flows for the nine-month period
ended December 31, 1997 and each of the years in the two-year period ended March
31, 1997, in conformity with generally accepted accounting principles. Also in
our opinion, the related financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly, in all material respects, the information set forth therein.
 
                                          /s/  KPMG PEAT MARWICK LLP
 
Orange County, California
March 24, 1998
 
                                       F-1
<PAGE>   40
 
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
                          CONSOLIDATED BALANCE SHEETS
                      DECEMBER 31, 1997 AND MARCH 31, 1997
                                 (IN THOUSANDS)
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,    MARCH 31,
                                                                  1997          1997
                                                              ------------    ---------
<S>                                                           <C>             <C>
Current assets:
  Cash and cash equivalents.................................    $102,776      $ 15,809
  Fees receivable and other amounts due from affiliates.....         571           523
  Investments in real estate held for sale..................          --         1,985
  Prepaids and other current assets.........................       3,920         4,642
  Net current assets from discontinued operations...........          --         1,829
                                                                --------      --------
          Total current assets..............................     107,267        24,788
Restricted cash.............................................         206         1,912
Deferred project costs......................................         246           647
Property, furniture and equipment...........................     117,557       122,027
Deferred tax asset..........................................          --           518
Other noncurrent assets.....................................       6,575         9,975
Net non-current assets from discontinued operations.........       1,234         2,080
                                                                --------      --------
                                                                $233,085      $161,947
                                                                ========      ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable..........................................    $  6,696      $  3,277
  Accrued liabilities.......................................       7,864         4,556
  Notes payable, current portion............................       9,388         2,027
  Notes payable and other amounts due to affiliates.........          --            40
  Accrued interest payable..................................       1,482         1,941
  Net current liabilities from discontinued operations......       6,558            --
                                                                --------      --------
          Total current liabilities.........................      31,988        11,841
Lease concessions...........................................         565            --
Deferred revenue, less current portion......................         369           244
Notes payable, less current portion.........................      81,560        90,481
                                                                --------      --------
                                                                 114,482       102,566
                                                                --------      --------
Commitments and contingent liabilities......................
Minority interest in majority owned entities................       7,168         8,007
Series A Preferred stock, convertible and redeemable; 2,000
  shares authorized none issued or outstanding at December
  31, 1997 and March 31, 1997...............................          --            --
Shareholders' equity:
  Preferred stock, no par value. Authorized 8,000 shares,
     none issued and outstanding............................          --            --
  Common stock, no par value. Authorized 100,000 shares;
     issued and outstanding 15,848 and 9,655 shares at
     December 31, 1997 and March 31, 1997, respectively.....     142,945        60,749
  Accumulated deficit.......................................     (31,510)       (9,375)
                                                                --------      --------
          Total shareholders' equity........................     111,435        51,374
                                                                --------      --------
                                                                $233,085      $161,947
                                                                ========      ========
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       F-2
<PAGE>   41
 
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
  FOR THE NINE-MONTH PERIOD ENDED DECEMBER 31, 1997 AND THE FISCAL YEARS ENDED
                            MARCH 31, 1997 AND 1996
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)
 
<TABLE>
<CAPTION>
                                                                                 MARCH 31,
                                                             DECEMBER 31,    ------------------
                                                                 1997         1997       1996
                                                             ------------    -------    -------
<S>                                                          <C>             <C>        <C>
Revenue:
  Assisted living community revenue:
     Rental revenue........................................    $ 64,411      $63,475    $22,515
     Assisted living and other services....................      12,476       10,295      2,964
  Management fees from affiliates..........................         388        1,141      2,536
                                                               --------      -------    -------
          Total revenue....................................      77,275       74,911     28,015
                                                               --------      -------    -------
Operating expenses:
  Assisted living community operating expense..............      51,247       47,117     16,395
  Assisted living community lease expense..................      15,773       12,872      6,644
  General and administrative...............................      15,759        7,575      7,705
  Depreciation and amortization............................       4,896        4,366      1,031
                                                               --------      -------    -------
          Total operating expenses.........................      87,675       71,930     31,775
                                                               --------      -------    -------
Income (loss) from operations..............................     (10,400)       2,981     (3,760)
Other income (expense):
  Interest income..........................................       1,821        1,668      1,071
  Other income, net........................................         321        1,402      2,203
  Gain on sale of LLC interests............................       5,511           --         --
  Interest expense.........................................      (4,568)      (5,470)    (1,362)
                                                               --------      -------    -------
          Total other income (expense).....................       3,085       (2,400)     1,912
                                                               --------      -------    -------
Income (loss) from continuing operations before income
  taxes....................................................      (7,315)         581     (1,848)
Income tax expense.........................................         484          297        233
                                                               --------      -------    -------
Income (loss) from continuing operations before minority
  interest in income of majority owned entities,
  discontinued operations, and extraordinary item..........      (7,799)         284     (2,081)
Minority interest in income of majority owned entities.....         773          783         --
                                                               --------      -------    -------
Loss from continuing operations............................      (8,572)        (499)    (2,081)
Income (loss) from operations of discontinued operations,
  net of income tax expense (benefit) of $1,580, ($96) and
  $142 for the nine-month period ended December 31, 1997
  and the fiscal years ended March 31, 1997 and 1996,
  respectively.............................................     (13,563)        (889)     1,116
Extraordinary loss from early extinguishment of debt, net
  of income tax benefit of $231............................          --         (386)        --
                                                               --------      -------    -------
          Net loss.........................................    $(22,135)     $(1,774)   $  (965)
                                                               ========      =======    =======
Basic and diluted loss per common share:
  Loss from continuing operations..........................    $  (0.77)     $  (.05)   $  (.39)
  Income (loss) from discontinued operations...............       (1.21)        (.10)       .18
  Loss from extraordinary item.............................          --         (.04)        --
                                                               --------      -------    -------
          Net loss.........................................    $  (1.98)     $  (.19)   $  (.21)
                                                               ========      =======    =======
Weighted average common shares outstanding.................      11,171        9,400      6,246
                                                               ========      =======    =======
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       F-3
<PAGE>   42
 
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
                 CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
  FOR THE NINE-MONTH PERIOD ENDED DECEMBER 31, 1997 AND THE FISCAL YEARS ENDED
                            MARCH 31, 1997 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                 COMMON STOCK      RECEIVABLE
                                               -----------------      FROM      ACCUMULATED
                                               SHARES    AMOUNT       ESOP        DEFICIT      TOTAL
                                               ------   --------   ----------   -----------   --------
<S>                                            <C>      <C>        <C>          <C>           <C>
Balance at March 31, 1995....................   5,098   $  3,009     $(262)      $ (6,284)    $ (3,537)
Issuance of common stock (IPO), net of
  issuance costs of $4,893...................   3,384     42,662        --             --       42,662
Collection of ESOP receivable................      --         --       262             --          262
Preferred stock dividends declared...........      --         --        --           (352)        (352)
Repurchase of common stock...................    (493)      (351)       --             --         (351)
Preferred stock conversion...................     320      2,228        --             --        2,228
Net loss.....................................      --         --        --           (965)        (965)
                                               ------   --------     -----       --------     --------
Balance at March 31, 1996....................   8,309     47,548        --         (7,601)      39,947
Issuance of common stock, net of issuance
  costs of $1,572............................   1,346     13,201        --             --       13,201
Net loss.....................................      --         --        --         (1,774)      (1,774)
                                               ------   --------     -----       --------     --------
Balance at March 31, 1997....................   9,655     60,749        --         (9,375)      51,374
Issuance of common stock, net issuance cost
  of $4,792..................................   6,193     82,196        --             --       82,196
Net loss.....................................      --         --        --        (22,135)     (22,135)
                                               ------   --------     -----       --------     --------
Balance at December 31, 1997.................  15,848   $142,945     $  --       $(31,510)    $111,435
                                               ======   ========     =====       ========     ========
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       F-4
<PAGE>   43
 
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
  FOR THE NINE-MONTH PERIOD ENDED DECEMBER 31, 1997 AND THE FISCAL YEARS ENDED
                            MARCH 31, 1997 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                                                                   MARCH 31,
                                                              DECEMBER 31,    --------------------
                                                                  1997          1997        1996
                                                              ------------    --------    --------
<S>                                                           <C>             <C>         <C>
Cash flows provided by (used in) operating activities:
  Net loss..................................................    $(22,135)     $ (1,774)   $   (965)
  Adjustments to reconcile net loss to net cash provided by
    (used in) operating activities:
    Loss (income) from discontinued operations..............      13,563           889      (1,116)
    Gain on sale of LLC interests...........................      (5,511)           --          --
    Extraordinary loss from early extinguishment of debt....          --           386          --
    Depreciation and amortization...........................       4,896         4,366       1,031
    Provision for doubtful accounts and discontinued project
      costs.................................................         597           163          --
    Minority interest in income of majority owned
      entities..............................................         773           783          --
    Other...................................................        (277)          (90)        (96)
    Changes in assets and liabilities, net of acquisitions:
      (Increase) decrease in:
      Fees receivable and other amounts due from
        affiliates..........................................         300          (141)       (230)
      Deferred tax asset....................................         518          (290)        265
      Prepaids and other assets.............................         (63)       (4,439)       (943)
    Increase (decrease) in:
      Accounts payable and accrued liabilities..............       4,894         2,438       2,031
      Deferred revenue......................................        (166)         (484)       (594)
      Accrued interest payable..............................        (459)        1,811         130
      Due to affiliates.....................................         (40)          (22)       (864)
                                                                --------      --------    --------
        Net cash provided by (used in) operating activities
          of continuing operations..........................      (3,110)        3,596      (1,351)
        Net cash provided by (used in) operating activities
          of discontinued operations........................      (4,328)       (2,681)        807
                                                                --------      --------    --------
        Net cash provided by (used in) operating
          activities........................................      (7,438)          915        (544)
                                                                --------      --------    --------
Cash flows provided by (used in) investing activities:
  (Increase) decrease in deferred project costs.............        (128)          198       1,273
  Increase in investments in real estate held for sale......          --        (3,769)     (6,807)
  Additions to property, furniture and equipment............     (18,619)      (70,115)    (45,747)
  (Increase) decrease in leased property security
    deposits................................................        (282)          879        (559)
  (Increase) decrease in restricted cash....................       1,706         3,003      (4,915)
  Proceeds from sale and leaseback of communities...........       1,871        29,052       5,083
  Purchase of limited partnership interests.................        (524)      (18,542)     (1,794)
  Proceeds from sale of LLC interests.......................      24,253            --          --
  Distributions received from limited partnership...........       3,570            --          --
  Other.....................................................          --            41        (442)
                                                                --------      --------    --------
        Net cash provided by (used in) investing
          activities........................................      11,847       (59,253)    (53,908)
                                                                --------      --------    --------
Cash flows provided by financing activities:
  Proceeds from issuance of common stock, net of issuance
    costs...................................................      24,806           739      42,662
  Common stock purchased by ESOP............................          --            --         262
  Borrowings under notes payable............................          --        31,081      14,475
  Repayments of notes payable...............................      (1,560)      (18,633)     (6,140)
  Proceeds from convertible subordinated notes, net of
    issuance costs..........................................      60,000        55,195      10,762
  Distributions paid from majority owned entities...........        (688)           --          --
  Repurchase of convertible subordinated notes..............          --        (1,689)       (139)
  Repurchase of common stock................................          --            --        (351)
  Preferred stock dividends paid............................          --            --        (400)
                                                                --------      --------    --------
        Net cash provided by financing activities...........      82,558        66,693      61,131
                                                                --------      --------    --------
        Net increase in cash and cash equivalents...........      86,967         8,355       6,679
Cash and cash equivalents at beginning of period............      15,809         7,454         775
                                                                --------      --------    --------
Cash and cash equivalents at end of period..................    $102,776      $ 15,809    $  7,454
                                                                ========      ========    ========
  Supplemental schedule of cash flow information:
    Cash paid during the year for:
      Interest..............................................    $  6,351      $  4,481    $  1,183
                                                                ========      ========    ========
      Income taxes..........................................    $     14      $    671    $    128
                                                                ========      ========    ========
  Supplemental schedule of non-cash investing and financing
    activities:
    Conversion of convertible subordinated notes to common
      stock.................................................    $ 60,000      $ 10,106    $     --
    Minority interests in majority owned entities...........          --         7,141       1,283
    Purchase of buildings...................................          --            --       9,350
    Sale of buildings, net of closing costs.................          --            --       9,400
    Debt assumed in conjunction with purchase of building...          --            --         350
    Preferred stock dividends declared......................          --            --          51
    Conversion of preferred stock to common stock...........          --         2,356       2,228
    Acquisition of SynCare..................................          --           485          --
    Accrual of stock issuance costs.........................       2,610            --          --
</TABLE>
 
          See accompanying notes to consolidated financial statements.
                                       F-5
<PAGE>   44
 
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
  General
 
     ARV Assisted Living, Inc. and subsidiaries (the Company) owns, operates,
acquires and develops assisted living facilities that provide housing to senior
citizens, some of whom require assistance with the activities of daily living
such as bathing, dressing and grooming.
 
     At December 31, 1997, the Company operated 49 assisted living facilities
("ALCs") in 10 states including 14 which are owned by the Company ("Owned
ALCs"), 32 which the Company operates pursuant to long-term operating leases
("Leased ALCs") and three in which the Company serves as the general partner of
the owner partnership ("Managed ALCs"). Thirty of the ALCs are located in
California with other concentrations in Florida, Texas, the Midwest and the
Northeast. The Company also managed three senior apartment communities, and 19
affordable senior and multifamily apartments (the "Apartment Group") in 17 of
which the Company serves as the general partner. However, in December 1997, the
Company's Board of Directors adopted a plan to discontinue the operations of the
Apartment Group.
 
  Change in Fiscal Year
 
     The Company changed its fiscal year end to December 31, from March 31,
effective with the current period ending December 31, 1997.
 
  Principles of Consolidation
 
     The consolidated financial statements include the accounts of the Company
and its subsidiaries. Subsidiaries, which include limited partnerships and
limited liability companies in which the Company has controlling interests, have
been consolidated into the financial statements. All significant intercompany
balances and transactions have been eliminated in consolidation.
 
  Use of Estimates
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and 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.
 
  Accounting Changes
 
     During the nine-month period ended December 31, 1997, the Company adopted
Statement of Financial Accounting Standards No. 128 "Earnings Per Share" ("SFAS
128"). This statement replaces the presentation of "primary" earnings per share
with "basic" earnings per share and the presentation of "fully diluted" earnings
per share with "diluted" earnings per share.
 
     During the nine-month period ended December 31, 1997, the Company adopted
Statement of Financial Accounting Standards No. 129, "Disclosure of Information
about Capital Structure" ("SFAS 129") which incorporates the already existing
requirements of APB Opinion No. 15. This statement requires disclosure in
summary form of the pertinent rights and privileges of various securities
outstanding including dividend and liquidation preferences, participation
rights, call prices and dates, sinking-fund requirements, unusual voting rights
and significant terms of contracts to issue additional shares. As the Company is
already in compliance
 
                                       F-6
<PAGE>   45
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
with the provisions of APB Opinion No. 15, the adoption of SFAS 129 did not have
an impact on the financial statements.
 
     During the fiscal year ended March 31, 1997, the Company adopted Statement
of Financial Accounting Standards 123 "Accounting for Stock-Based Compensation"
("SFAS 123"), which requires disclosure of the fair value and other
characteristics of stock options. The Company has chosen under the provisions of
SFAS 123 to continue using the intrinsic-value method of accounting for employee
stock-based compensation in accordance with Accounting Principles Board Opinion
No. 25 "Accounting for Stock Issued to Employees" ("APB 25").
 
     During the fiscal year ended March 31, 1996, the company adopted Statement
of Financial Accounting Standards 121 "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed Of" ("SFAS 121")
which requires the Company to review its long-lived assets for impairments when
events or changes in circumstances indicate that the carrying amount of the
assets may not be recoverable. In reviewing recoverability, the Company
estimates the future cash flows expected to result from using the assets and
eventually disposing of them. If the sum of the expected future cash flows
(undiscounted and without interest charges) is less than the carrying amount of
the asset, an impairment loss is recognized based upon the asset's fair value.
 
  Cash and Cash Equivalents
 
     For purposes of reporting cash flows, the Company considers all highly
liquid investments purchased with an original maturity of three months or less
to be cash equivalents.
 
  Investment in Real Estate Held for Sale
 
     Investment in real estate held for sale at March 31, 1997 includes costs
related to projects expected to be sold within one year. Such investments are
carried at the lower of cost or market.
 
  Restricted Cash
 
     Restricted cash represents cash held as collateral for letters of credit
issued to lessors in lieu of security deposits.
 
  Deferred Project Costs
 
     Deferred project costs are payments incurred prior to the acquisition of
real property which are capitalized as incurred. These preacquisition costs
primarily include land acquisition, legal and architectural fees, feasibility
study costs and other direct costs associated with new ALC development. Deferred
project costs are transferred to property furniture and equipment upon the
successful acquisition of an assisted living community or site. If a project is
discontinued, any deferred project costs are expensed.
 
  Property, Furniture and Equipment
 
     Property, furniture and equipment are stated at cost less accumulated
depreciation which is charged to expense on a straight-line basis over the
estimated useful lives of the assets as follows:
 
<TABLE>
<S>                                                   <C>
Buildings and improvements..........................  27.5 to 35 years
Furniture, fixtures and equipment...................  3 to 7 years
</TABLE>
 
                                       F-7
<PAGE>   46
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
     Property, furniture and equipment consisted of the following (in
thousands):
 
<TABLE>
<CAPTION>
                                               DECEMBER 31,    MARCH 31,
                                                   1997          1997
                                               ------------    ---------
<S>                                            <C>             <C>
Land.........................................    $ 14,712      $ 19,897
Construction in progress.....................      15,387        18,097
Buildings and improvements...................      82,180        78,196
Furniture, fixtures and equipment............      13,746        10,295
                                                 --------      --------
                                                  126,025       126,485
Accumulated depreciation.....................      (8,468)       (4,458)
                                                 --------      --------
                                                 $117,557      $122,027
                                                 ========      ========
</TABLE>
 
     Capitalized interest amounted to $1,065,000 for the nine-month period ended
December 31, 1997 and $721,000 for the fiscal year ended March 31, 1997. No
interest was capitalized during fiscal 1996.
 
  Investments in Partnerships
 
     The Company is general partner in five limited partnerships, four of which
are consolidated, which operate ALCs and senior apartments (ownership interests
range from less than 1% to 89.5%). The Company is also a general partner in 17
tax credit partnerships (ownership is generally less than 1%). The Company
accounts for its investment in one consolidated partnership where significant
influence exists using the equity method because it has less than a controlling
interest. Other investments in partnerships are accounted for using the cost
method. Under the terms of the partnership agreements, profits and losses are
allocated to the general and limited partners in specified ratios. The Company
generally has unlimited liability for obligations of certain partnerships in
which it is the general partner. Liabilities under these obligations have
generally not been significant. The Company has unlimited liability under
separate guarantees and has recorded significant provisions for these guarantees
(see Note 3).
 
     On January 31, 1997, the Company acquired a 12.8% limited partnership
interest in Senior Income Fund, L.P. ("Senior Income Fund") pursuant to a tender
offer for any and all outstanding limited partnership units in Senior Income
Fund. The partnership is a limited partnership that owned and operated four
senior residential properties. The Company accounts for its investment in Senior
Income Fund under the equity method. Effective October 1, 1997, the Company
discontinued the recognition of income related to this investment and recorded
an impairment provision of $150,000 following Senior Income Fund's announced
plans to liquidate its assets and receipt of a substantial return of capital.
 
  Income Taxes
 
     The Company accounts for income taxes under Statement of Financial
Accounting Standards No. 109 "Accounting for Income Taxes" ("SFAS 109"). Under
the asset and liability method of SFAS 109, deferred tax assets and liabilities
are recognized for the future tax consequences attributable to differences
between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. Deferred tax assets and liabilities
are measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. A valuation allowance is recorded to adjust net deferred tax assets to
the amount which management believes will more likely than not be recoverable.
The effect on deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the enactment date.
 
                                       F-8
<PAGE>   47
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
  Revenue Recognition
 
     The Company recognizes rental and assisted living services revenue from
owned and leased communities on a monthly basis as earned. The Company receives
fees for property management and partnership administration services from
managed communities. The Company also receives wholesaling commissions for the
sale of limited partnership interests, acquisition fees for the selection,
development and purchase of partnership properties, commissions on the sale of
partnership properties and certain other fees as specified in the partnership
agreements. Fees are recognized when earned.
 
     The Company is the general partner in various tax credit partnerships, and
provides services related to the purchase, development, construction and, later,
management of the projects. Fees earned for services provided are reduced by
amounts that the general partner is required to advance to the tax credit
partnerships, such as Owner Equity Contributions, as defined in the partnership
agreements, plus any anticipated operating support requirements. Fees are
recognized when there is reasonable assurance that future rent receipts will
cover operating expenses and debt service, including payments due the Company
under the terms of the transaction (see Note 12).
 
     GeriCare records therapy revenue at the estimated net realizable amounts
due from patients, third-party payors and others for services rendered,
including estimated retroactive adjustments under reimbursement agreements with
third-party payors. Such contractual adjustments are accrued on an estimated
basis during the period the related services are rendered. Therapy revenue is
adjusted as required in subsequent periods based on final settlements.
 
     In December 1997, the Company's Board of Directors adopted a plan to
discontinue the operations of GeriCare and the Apartment Group.
 
  Assisted Living Facility Sale-Leaseback Transactions
 
     Certain facilities are sold subject to leaseback provisions. Leases are
structured to ensure they meet the provisions for operating lease treatment.
Gains are deferred and amortized into income over the lives of the leases.
 
  Gain on Sale of LLC Interests
 
     In December 1997, the Company sold its interest in two limited liability
companies one of which owned a community in New York and the second of which
owned a parcel of land in New Jersey. As a result of this sale, the Company
recognized a gain on sale of approximately $5.5 million during the final quarter
of 1997.
 
  Loss Per Share
 
     In February 1997, the Financial Accounting Standards Board issued SFAS 128
"Earnings Per Share", which specifies the computation, presentation and
disclosure requirements for earnings per share ("EPS"). It replaces the
presentation of primary and fully diluted EPS with basic and diluted EPS. Basic
EPS excludes all dilution and is based upon the weighted average number of
common shares outstanding during the period. Diluted EPS reflects the potential
dilution that would occur if securities or other contracts to issue common stock
were exercised, or converted into common stock. The effect of potentially
dilutive securities was not included for any of the periods presented as the
effect was antidilutive. Potentially dilutive securities include convertible
notes, stock options and warrants which convert to 3,096,392, 1,085,002 and
116,152 shares of common stock for the nine month period ended December 31, 1997
and the years ended March 31, 1997 and 1996, respectively. For the year ended
March 31, 1996, preferred stock dividends declared totaling $352,000 have been
included in the calculation of basic and dilutive earnings per share. The
Company adopted
                                       F-9
<PAGE>   48
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
SFAS 128 during the final quarter of 1997. The adoption of this statement did
not have an impact on the Company's financial statements.
 
  New Accounting Pronouncements
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" ("SFAS
130") which is effective for fiscal years beginning after December 15, 1997, and
requires restatement of earlier financial statements for comparative purposes.
SFAS 130 requires that items meeting the criteria of a component of
comprehensive income, including foreign currency items and unrealized gains and
losses on certain investments in debt and equity securities, be shown in the
financial statements. SFAS 130 does not require a specific format for disclosure
of comprehensive income and its components in the financial statements. The
adoption of SFAS 130 is not expected to have an impact on the Company's
financial statements.
 
     In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards Board No. 131, "Disclosure about Segments of an
Enterprise and Related Information" ("SFAS 131"). This standard requires that a
public business enterprise report financial and descriptive information about
its reportable operating segments. Operating segments are components of an
enterprise about which separate financial information is available that is
regularly evaluated by the chief operating decision makers in deciding how to
allocate resources and in assessing performance. SFAS 131 also requires that all
public business enterprises report information about the revenues derived form
the enterprise's products or services (or groups of similar products or
services), about the countries in which the enterprise earns revenues and holds
assets and about major customers regardless of whether that information is used
in making operating decisions. However, this Statement does not require an
enterprise to report information that is not prepared for internal use if
reporting it would be impractical. This Statement is effective for financial
statements for periods beginning after December 15, 1997. In the initial year of
application, comparative information for earlier years is required to be
restated. Comparative information for interim periods is not required until the
second year of application. The adoption of SFAS No. 131 is not expected to have
an impact on the Company's financial statements.
 
  Reclassifications
 
     Reclassifications have been made to certain fiscal March 31, 1997 and 1996
amounts to conform to the December 31, 1997 presentation.
 
(2) ACQUISITIONS
 
     In August 1996, ARV Health Care, Inc. ("ARV Health Care"), a wholly owned
subsidiary of the Company, acquired all of the outstanding stock of SynCare,
Inc., a California corporation and its three wholly owned subsidiaries
("GeriCare"), in a stock for stock merger valued at approximately $1.2 million.
The Company recorded the acquisition under the purchase method of accounting at
the cost of approximately $1.2 million and recorded the assets and liabilities
of the merged entity at their estimated fair value. As part of the SynCare
acquisition, the Company entered into a Holdback Escrow Agreement (the
"Agreement") with the former sole shareholders of SynCare (the "Sellers"). Under
the Agreement, one-half of the 85,146 shares issued to Sellers as consideration
for their stock in SynCare were delivered to the General Counsel for the Company
as escrowholder, defined as the "Buyer's Agent" in the Agreement. Pursuant to
the Agreement, Buyer's Agent retains possession of the escrowed shares pending
distribution of all or a portion thereof to Sellers on the first, second and
third anniversaries of the closing date, as determined by offsetting, as of each
such anniversary, uncollected accounts receivable listed on the closing balance
sheet against the reserves
 
                                      F-10
<PAGE>   49
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
established therefore on the closing balance sheet. It was a further condition
to delivery of the escrowed shares to Sellers that Sellers remain as full-time
employees of the Company or a subsidiary thereof as of each anniversary, without
being terminated for cause prior to such anniversary dates. Prior to the first
anniversary of the closing date, both Sellers were terminated for cause. Based
thereon, the Company has taken the position that the undelivered shares are the
property of the Company under the Agreement, and the matter is in dispute
between the parties. In December 1997, Management and the Board of Directors
concluded that the operation of ARV Health Care was no longer part of its
strategic plan or core business. Management plans to dispose of this business
during 1998 (see Note 3).
 
     In August 1996, the Company acquired a 51% controlling interest in American
Retirement Villas Properties II, a California limited partnership, which has
five Owned ALCs and five Leased ALCs totaling 941 units. The acquisition was
completed pursuant to a tender offer for limited partnership units not already
owned by the Company. Additional limited partnership units were acquired
increasing the Company's ownership to 52.3% at December 31, 1997.
 
     The following unaudited pro forma information presents a summary of the
consolidated results of operations as if the acquisition of American Retirement
Villas Properties II took place on April 1, 1995.
 
<TABLE>
<CAPTION>
                                                       UNAUDITED
                                                       MARCH 31,
                                                 ----------------------
                                                   1997          1996
                                                 --------      --------
                                                 (IN THOUSANDS, EXCEPT
                                                   PER SHARE AMOUNTS)
<S>                                              <C>           <C>
Total revenue..................................  $82,219       $42,480
Total operating expenses.......................  $78,482       $44,177
Net loss.......................................  $(1,371)      $  (132)
Loss per common share..........................  $  (.15)      $  (.08)
</TABLE>
 
     In June 1996, the Company purchased an aggregate 18.6% limited partner
interest for $469,000 in San Gabriel Retirement Villa ("Villa Colima") for which
it serves as the general partner. Subsequently, the Company purchased an
additional 19.0% for $954,000. Additional limited partnership units were
acquired increasing the Company's ownership to 60.5% at December 31, 1997.
 
     The following unaudited pro forma information presents a summary of
consolidated results of operations as if the acquisition of Villa Colima took
place on April 1, 1995.
 
<TABLE>
<CAPTION>
                                                       UNAUDITED
                                                       MARCH 31,
                                                 ----------------------
                                                   1997          1996
                                                 --------      --------
                                                 (IN THOUSANDS, EXCEPT
                                                   PER SHARE AMOUNTS)
<S>                                              <C>           <C>
Total revenue..................................  $75,299       $29,635
Total operating expenses.......................  $72,246       $33,058
Net loss.......................................  $(1,749)      $  (850)
Loss per common share..........................  $  (.19)      $  (.19)
</TABLE>
 
(3) DISCONTINUED OPERATIONS
 
     In December 1997, the Company's Board of Directors adopted a plan to
discontinue the operations of GeriCare, its therapy business, and the Apartment
Group (previously referred to as Tax Credit Properties) by the end of fiscal
1998. In March 1998, the Company reached an agreement in principle to form a
strategic alliance with a national provider of physical-rehabilitation services.
The alliance will offer residents of ARV
 
                                      F-11
<PAGE>   50
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
communities rehabilitation and wellness care services and assist those residents
to age in place while allowing the Company to exit the rehabilitation business.
The Company is in negotiations with lenders for certain of the Apartment Group's
tax credit partnerships to resolve outstanding issues which would increase the
marketability of the partnerships and is in discussions with several potential
buyers of the Apartment Group's assets.
 
     Accordingly, the results of these operations for the nine-month period
ended December 31, 1997, including provisions for impairments of the divisions
assets and provision for anticipated future operating deficit loan funding and
projected permanent loan financing deficits of $10.6 million, have been
segregated from continuing operations and reported separately in the statement
of operations. During the fiscal year ended March 31, 1997, the Company took a
$2.0 million charge related to its Apartment Group. Provisions for operating
deficit loan funding and permanent loan financing deficits are based on
management's estimates and include assumptions for occupancy, projected revenues
and expenses and timing until lease-up. Such estimates are revised as additional
information and operating history is available.
 
     The Company has restated its prior financial statements to present the net
current and long-term assets and liabilities operating results and cash flows of
these divisions as discontinued operations. The assets and liabilities of such
operations have been reflected in the balance sheet on a net basis, based
substantially on the original current or long-term classification of such assets
and liabilities. The Company allocates interest to discontinued operations based
on average advances outstanding at the Company's incremental borrowing rate of
6.75%, 10% and 10% for the nine months ended December 31, 1997 and the fiscal
years ended March 31, 1997 and 1996.
 
     Operating results from discontinued operations are as follows (in
thousands):
 
<TABLE>
<CAPTION>
                                               FOR THE          FOR THE FISCAL YEARS
                                          NINE-MONTH PERIOD       ENDED MARCH 31,
                                          ENDED DECEMBER 31,    --------------------
                                                 1997             1997        1996
                                          ------------------    --------    --------
<S>                                       <C>                   <C>         <C>
Revenue.................................       $  7,129          $5,507      $1,564
Costs and expenses......................         19,112           6,492         306
                                               --------          ------      ------
Income (loss) before income taxes.......        (11,983)           (985)      1,258
Income tax provision (benefit)..........          1,580             (96)        142
                                               --------          ------      ------
Net income (loss).......................       $(13,563)         $ (889)     $1,116
                                               ========          ======      ======
</TABLE>
 
                                      F-12
<PAGE>   51
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
     The components of net assets (liabilities) of discontinued operations
included in the Company's consolidated balance sheets at December 31, 1997 and
March 31, 1997, are as follows:
 
<TABLE>
<CAPTION>
                                                       DECEMBER 31,    MARCH 31,
                                                           1997          1997
                                                       ------------    ---------
<S>                                                    <C>             <C>
Current:
Cash.................................................    $   132        $   154
Accounts receivable and other........................      3,171          3,626
Accounts payable and other...........................     (1,460)          (732)
Accrued liabilities..................................     (8,401)        (1,219)
                                                         -------        -------
     Net current assets (liabilities) from
       discontinued operations.......................     (6,558)         1,829
                                                         -------        -------
Non-current:
Deferred project costs...............................         --            425
Property, furniture and equipment....................         --            171
Deferred tax asset...................................         --          1,486
Other non-current assets.............................      1,633            328
Deferred revenue.....................................       (399)          (330)
                                                         -------        -------
     Net non-current assets from discontinued
       operations....................................      1,234          2,080
                                                         -------        -------
Net asset (liability) from discontinued operations...    $(5,324)       $ 3,908
                                                         =======        =======
</TABLE>
 
                                      F-13
<PAGE>   52
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
(4) NOTES PAYABLE
 
     Notes payable consist of (in thousands):
 
<TABLE>
<CAPTION>
                                                              DECEMBER 31,   MARCH 31,
                                                                  1997         1997
                                                              ------------   ---------
<S>                                                           <C>            <C>
Convertible subordinated notes due April 1, 2006 with
  interest at 6.75%. The notes require monthly semi-annual
  payments of interest and are convertible to common stock
  at $18.57 per share. The notes, offered in a maximum
  amount of $57,500, may be called by the Company beginning
  in April 1999 at declining premiums starting at 110% of
  the principal amount......................................    $57,500       $57,500
Notes payable, including notes payable to banks of $6,625
  and $6,666 at December 31, 1997 and March 31, 1997,
  respectively, bearing interest at fixed rates between 7.5%
  and 10.5%, payable in monthly installments of principal
  and interest totaling $155, collateralized by property,
  maturities ranging from February 1999 through July 2035...     18,456        19,494
Notes payable to banks bearing interest at floating rates of
  LIBOR (5.69% at December 31, 1997) plus 2.75% payable in
  monthly installments of interest only collateralized by
  Owned ALCs, maturing September 30, 1998...................      8,750         8,750
Notes payable to banks, bearing interest at floating rates
  between prime (8.5% at December 31, 1997) plus rates
  between 1.0% through 2.0%, payable in monthly installments
  of principal and interest totaling $25 due March 2004,
  collateralized by an ALC and the Company's corporate
  headquarters..............................................      5,969         6,453
Other -- primarily capitalized equipment leases.............        273           311
                                                                -------       -------
                                                                 90,948        92,508
Less amounts currently payable..............................      9,388         2,027
                                                                -------       -------
                                                                $81,560       $90,481
                                                                =======       =======
</TABLE>
 
     The future annual principal payments of the notes payable at December 31,
1997 are as follows (in thousands):
 
<TABLE>
<S>                                                          <C>
1998.......................................................  $ 9,388
1999.......................................................    1,404
2000.......................................................      790
2001.......................................................      495
2002.......................................................      511
Thereafter.................................................   78,360
                                                             -------
                                                             $90,948
                                                             =======
</TABLE>
 
     Convertible subordinated notes due in 1999 were called by the Company in
the fiscal year ended March 31, 1997. Note holders who chose to redeem their
notes were paid a premium of 6.7% upon redemption, totaling $261,000, and
unamortized note issuance costs of $335,000 were expensed, resulting in the
extraordinary loss of $386,000, net of income tax benefit. Holders of
approximately $11.0 million of the notes converted the notes into 900,662 shares
of common stock.
 
                                      F-14
<PAGE>   53
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
     On June 24, 1996, the Company obtained a $35 million commitment from Bank
United for the construction or acquisition of ALCs. The terms of the commitment
provide for interest at 2.75% over the thirty day LIBOR rate. Of the commitment,
a $20 million sub-limit has been established for the construction of ALCs. As of
December 31, 1997 and March 31, 1997, the Company had outstanding indebtedness
of $8.8 million used as mortgage financing of existing ALCs. Additionally, the
Company had guaranteed a $7.7 million loan borrowed by an Affiliated Partnership
for the construction of a new ALC.
 
     On September 10, 1996, the Company obtained a $10 million revolving line of
credit with Imperial Bank to be used for acquisition, development, the provision
of letters of credit and general corporate purposes. Advances under this line of
credit are priced at the Imperial Bank prime rate plus 0% to .5% or LIBOR plus
2.0% to 2.5% based upon the Company's achievement of financial ratios. As of
December 31, 1997, the Company had used $9.2 million of this line of credit for
the provision of letters of credit used as Leased ALC security deposits.
 
     As of December 31, 1997, the Company has expended substantially all of the
$55.2 million net proceeds received from the sale of the 2006 Notes. The Company
intends to refinance certain notes payable maturing September 1998.
 
     In November 1996, the Company obtained a $75 million commitment from
Meditrust for the acquisition of additional existing ALCs. As of December 31,
1997 none of this commitment has been expended.
 
     The various debt agreements contain restrictive covenants requiring the
Company to maintain certain financial ratios, including current ratio, working
capital, minimum net worth, debt-to-equity and debt service coverage, among
others. At December 31, 1997, the Company was not in compliance with minimum net
worth, debt service coverage ratios and cross default covenants. For those debt
covenants with which the Company was not in compliance, it has obtained waivers
for such requirements. The lenders have waived compliance with these covenants
through maturity of the debt in September 1998, with the exception of the debt
service coverage ratio which has been waived through March 31, 1998. The Company
believes that several alternatives are available to remedy the default before
the next measurement date of June 30, 1998. Had the Company not obtained
waivers, it would have been in default on $13.8 million of mortgage debt, $16.5
million of guaranteed debt and $9.2 million of standby letters of credit issued
as security for ALC operating leases.
 
(5) EMPLOYEE BENEFIT PLANS
 
  ESOP
 
     The Company has an Employee Stock Ownership Plan ("ESOP") which covers all
employees of the Company. Contributions to the ESOP are made at the discretion
of the Company's Board of Directors. For the nine-month period ended December
31, 1997 and the fiscal years ended March 31, 1997 and 1996, no contributions
were made to the ESOP by the Company.
 
  Savings Plan
 
     Effective January 1, 1997, the Company established a savings plan (the
"Savings Plan") that qualifies as a deferred salary arrangement under Section
401(k) of the Internal Revenue Code. Under the Savings Plan, participating
employees may defer a portion of their pretax earnings, up to the Internal
Revenue Service annual contribution limit. The Company matches 25% of each
employee's contributions up to a maximum of 6% of the employee's earnings. An
employee becomes eligible to participate in the plan upon completing one year
and 1,000 hours of service and by being at least 21 years of age. The Company's
expense related to the Savings Plan was approximately $129,000 and $38,000 for
the nine-month period ended December 31, 1997 and the fiscal year ended March
31, 1997, respectively.
 
                                      F-15
<PAGE>   54
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
(6) STOCK OPTIONS
 
     The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees' ("APB 25") and related
Interpretations in accounting for its employee stock options. Under APB 25,
because the exercise price of the Company's employee stock options usually
equals the market price of the underlying stock on the date of grant, no
compensation expense is recorded.
 
     Effective October 1, 1995, the Company adopted the 1995 Stock Option and
Incentive Plan of ARV Assisted Living, Inc. (the Plan) for the benefit of its
eligible employees, consultants and directors. The Plan consists of two plans,
one for the benefit of key employees and consultants and one for the benefit of
nonemployee directors. The maximum number of shares which may be issued under
the Plan is 15% of the total outstanding shares at the end of the fiscal year.
The number of shares which may be issued for Incentive Stock Options is limited
to 1,155,666 shares. Options granted under the Plan vest over periods ranging
from one and one-half to five years from the date of the grant. During the
nine-month period ended December 31, 1997, 265,434 of the options were eligible
for exercise. None of the vested options had been exercised as of December 31,
1997.
 
     A summary of stock options at December 31, 1997 is as follows:
 
<TABLE>
<CAPTION>
                                           SHARES     SHARES UNDER
                                         AVAILABLE    OUTSTANDING       PRICE PER
                                         FOR GRANT      OPTIONS           SHARE
                                         ----------   ------------   ---------------
<S>                                      <C>          <C>            <C>
Authorization of shares................   2,377,275           --                 N/A
Options granted........................  (1,502,900)   1,502,900     $ 8.06 - $16.25
Options canceled.......................     417,898     (417,898)    $10.25 - $14.00
                                         ----------    ---------     ---------------
Balance at December 31, 1997...........   1,292,273    1,085,002     $ 8.06 - $16.25
                                         ==========    =========     ===============
</TABLE>
 
     Pro forma information regarding net loss and net loss per share is required
by SFAS 123, which also requires that the information be determined as if the
Company has accounted for its employee stock options granted subsequent to
December 31, 1994 under the fair value method of SFAS 123. The fair value for
these options was estimated at the date of grant using a Black-Scholes option
pricing model with a weighted-average expected life of the option of 7 years.
 
     The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. Option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of trade options, and because changes in subjective input
assumptions can materially affect the fair value estimate, actual fair values
may differ from those estimates.
 
                                      F-16
<PAGE>   55
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
     The following represents the estimated fair value of options granted and
the assumptions used for calculation:
 
<TABLE>
<CAPTION>
                                                                  MARCH 31,
                                               DECEMBER 31,    ----------------
                                                   1997         1997      1996
                                               ------------    ------    ------
<S>                                            <C>             <C>       <C>
Average estimated fair value per option at
  grant date.................................     $14.00       $11.21    $13.84
Average exercise price per option granted....     $14.07       $11.21    $13.91
Expected Stock volatility....................        53%          57%       57%
Risk -- free interest rate...................       5.7%         6.5%      6.5%
Option term -- years.........................         10           10        10
Stock dividend yield.........................         --           --        --
</TABLE>
 
     For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. The Company's
pro forma information is as follows (in thousands, except per share amounts):
 
<TABLE>
<CAPTION>
                                                                 MARCH 31,
                                             DECEMBER 31,    ------------------
                                                 1997         1997       1996
                                             ------------    -------    -------
<S>                                          <C>             <C>        <C>
Pro forma net loss.........................    $(23,865)     $(2,122)   $(1,368)
Pro forma loss per share...................    $  (2.14)     $  (.23)   $  (.22)
</TABLE>
 
     A summary of the Company's stock option activity and related information
for the nine-month period ended December 31, 1997 and the fiscal years ended
March 31, 1997 and 1996 is as follows:
 
<TABLE>
<CAPTION>
                                                                             MARCH 31,
                               DECEMBER 31,           --------------------------------------------------------
                                   1997                          1997                          1996
                       ----------------------------   ---------------------------   --------------------------
                                   WEIGHTED AVERAGE              WEIGHTED AVERAGE             WEIGHTED AVERAGE
                        OPTIONS     EXERCISE PRICE    OPTIONS     EXERCISE PRICE    OPTIONS    EXERCISE PRICE
                       ---------   ----------------   --------   ----------------   -------   ----------------
<S>                    <C>         <C>                <C>        <C>                <C>       <C>
Outstanding --
  beginning of the
  year...............    976,392        $12.87         775,782        $13.90             --            --
Granted..............    259,500        $14.07         389,000        $11.21        854,400        $13.90
Exercised............         --            --              --            --             --            --
Forfeited............   (150,890)       $12.72        (188,390)       $13.68        (78,618)        14.00
                       ---------                      --------                      -------
Outstanding -- end of
  year...............  1,085,002        $13.18         976,392        $12.87        775,782         13.90
                       =========                      ========                      =======
Exercisable at end of
  year...............    265,434        $13.67         142,415        $13.74             --            --
Weighted average fair
  value of options
  granted during the
  year...............                   $14.07                        $11.21                       $13.84
                                        ======                        ======                       ======
</TABLE>
 
     At December 31, 1997, options outstanding had a weighted average life of
8.61 years.
 
     Subsequent to year-end, approximately 452,000 additional options were
granted.
 
                                      F-17
<PAGE>   56
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
(7) INCOME TAXES
 
     The provision for income tax expense from continuing operations consists of
the following for the nine-month period ended December 31, 1997 and the fiscal
years ended March 31, 1997 and 1996 (in thousands):
 
<TABLE>
<CAPTION>
                                                                   MARCH 31,
                                                 DECEMBER 31,    -------------
                                                     1997        1997     1996
                                                 ------------    -----    ----
<S>                                              <C>             <C>      <C>
Current:
  Federal......................................      $(29)       $ 364    $
  State........................................        (5)          64      --
                                                     ----        -----    ----
          Total current........................       (34)         428      --
                                                     ----        -----    ----
Deferred:
  Federal......................................       440         (111)    198
  State........................................        78          (20)     35
                                                     ----        -----    ----
          Total deferred.......................       518         (131)    233
                                                     ----        -----    ----
                                                     $484        $ 297    $233
                                                     ====        =====    ====
</TABLE>
 
     The Company has Federal net operating loss carryovers of $11,030,000 which
expire in 2011 to 2012.
 
     A reconciliation of income tax expense (benefit) related to income from
continuing operations at the Federal statutory rate of 34% to the Company's
provision for income taxes is as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                                  MARCH 31,
                                                DECEMBER 31,    --------------
                                                    1997        1997     1996
                                                ------------    -----    -----
<S>                                             <C>             <C>      <C>
Income tax expense (benefit) at statutory
  rate........................................    $(2,487)      $ 198    $(628)
State income tax expense, net of Federal
  income taxes................................         48          29       23
Change in Federal valuation allowance due to
  change in assumptions at beginning of the
  year........................................        440        (219)     197
Change in Federal valuation allowance due to
  current year operations                           3,878         709     (287)
Impact on taxes of minority interest in income
  of majority owned partnerships..............       (262)       (292)      --
Fully reserved tax benefits
  absorbed(generated) by discontinued
  operations that will not (will) benefit
  continuing operations in the future.........     (1,133)         --      961
Other.........................................         --        (128)      33
                                                  -------       -----    -----
          Total income tax expense............    $   484       $ 297    $ 233
                                                  =======       =====    =====
</TABLE>
 
                                      F-18
<PAGE>   57
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
     Temporary differences giving rise to a significant amount of deferred tax
assets and liabilities from continuing operations at December 31, 1997 and March
31, 1997 are as follows (in thousands):
 
<TABLE>
<CAPTION>
                                                       DECEMBER 31,    MARCH 31,
                                                           1997          1997
                                                       ------------    ---------
<S>                                                    <C>             <C>
Deferred tax assets:
  Deferred gain on sale..............................    $   140        $  152
  Other partnership income...........................        586            --
  Net operating loss carryforwards...................      4,427           618
  Other..............................................      1,049           626
                                                         -------        ------
          Gross deferred tax asset...................      6,202         1,396
  Less valuation allowance...........................     (5,844)         (764)
  Deferred tax liabilities -- other..................       (358)         (114)
                                                         -------        ------
          Net long-term deferred tax asset...........    $    --        $  518
                                                         =======        ======
</TABLE>
 
     A valuation allowance is provided against the deferred tax asset when it is
more likely than not that some portion of the deferred tax asset will not be
realized. The Company has established a valuation allowance for the deferred tax
asset as, in management's best estimate, it is not likely to be realized in the
near term.
 
(8) RELATED PARTY TRANSACTIONS
 
     The results of the Company and its subsidiaries are substantially affected
by transactions and agreements with related parties.
 
     Fees receivable from affiliates of $107,000 and $93,000 at December 31,
1997 and March 31, 1997, respectively, consists of receivables related to
management services rendered by the Company. Related management fees received
from affiliates total $388,000, $1,141,000, and $2,536,000 during the nine-month
period ended December 31, 1997 and the years ended March 31, 1997 and 1996,
respectively.
 
     Other amounts due from affiliates of $464,000 and $430,000 at December 31,
1997 and March 31, 1997, respectively, consist of non-interest bearing expense
advances to various partnerships. Amounts due from affiliates are generally
expected to be repaid in subsequent years with cash from operations or from bank
financing obtained by the affiliates.
 
     The Company pays certain expenses such as repair and maintenance, supplies,
payroll and retirement benefit expenses on behalf of affiliated Partnerships and
is subsequently reimbursed by the Partnerships. During the nine-month period
ended December 31, 1997 and the fiscal years ended March 31, 1997 and 1996,
respectively, the expenses incurred on behalf of affiliates and the related
reimbursements from these affiliates amounted to approximately $4.8 million,
$7.1 million and $10.0 million, respectively. The Company accounts for these
reimbursements as a reduction of the related expenses.
 
     The Company leases office space under operating leases from affiliated
entities. During the year ended March 31, 1996, the leases were amended to
expire between 2001 and 2003. Total rental expense related to these leases for
the nine-month period ended December 31, 1997 and the fiscal years ended March
31, 1997 and 1996 was $112,000, $141,000 and $161,000, respectively.
 
     In May 1995, the Company purchased from an affiliated entity one of the
offices that it occupies for $611,000. Debt assumed in the transaction was
$531,000, prior to a principal payment of $181,000. The balance of the purchase
price was paid in cash. The remaining $350,000 obligation was due in two years
and
 
                                      F-19
<PAGE>   58
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
required monthly principal and interest payments based on a ten-year
amortization schedule. The note was repaid in April 1997.
 
     In fiscal 1996, three partnerships for which the Company is the General
Partner obtained the limited partners' approval to sell their ALCs to an
unrelated third party with the Company leasing them back. The sales were
consummated in fiscal 1996, and the Company simultaneously entered into leases
for these ALCs.
 
     To address certain structural issues in connection with tax credit
partnerships, Pacific Demographics Corporation ("Pacific Demographics")
(formerly ARVTC, Inc.), was formed in August 1994 by Messrs. Gary Davidson,
Booty, Collins and Espley-Jones, as well as two former Company officers, to
provide certain development services for these partnerships in exchange for cash
and deferred development fees generated by the tax credit partnerships. In order
to lessen potential conflicts of interest, in July 1995, the Company's then
principal shareholders, who included but were not limited to Messrs. Gary
Davidson, Booty, Collins and Espley-Jones sold Pacific Demographics, Inc. to the
Company for $100,000 in cash. In addition, they formed a general partnership,
Hunter Development ("Hunter") and became co-developers with Pacific Demographics
and retained the right to receive 20% of all developer fees up to a maximum of
$850,000. Subsequently each of the general partners of Hunter assigned his
interest in Hunter to Redhill Development, LLC. Of the maximum amount of
$850,000 which could be distributed, $215,553 has been distributed to date of
which Messrs. Gary Davidson, Booty, Collins and Espley-Jones have received
$40,437, $40,437, $23,800 and $13,460, respectively. During March 1996, $5.2
million of current and future receivables were sold to former employees of the
Company in exchange for $191,000 in cash and notes receivable of $1.4 million.
These receivables consisted of deferred development fees which were carried on
the books of the Company, yet they were fully reserved as the potential for
collection was deemed remote. In determining the valuation of these receivables,
management considered their potential for collection and applied a discount
factor to a projected future stream of cash flows based upon the associated risk
of collection. These deferred development fees had been recognized as income by
the Company for Federal Income Tax purposes, but had not been recognized under
generally accepted accounting principles. During the year ended March 31, 1996,
the sale of these receivables reduced the Company's income tax expense by $1.2
million.
 
     John A. Booty, former President of the Company and the current Vice
Chairman of the Board of Directors, provided consulting services to the Company
for which Mr. Booty was paid a varying sum not to exceed $30,000 per month for
development and acquisition services between October 1996 and September 1997.
During the nine-month period ended December 31, 1997 and the fiscal year ended
March 31, 1997, Mr. Booty was paid $175,000 and $180,000 for consulting
services, respectively. No consulting fees were paid to Mr. Booty during the
fiscal year ended March 31, 1996.
 
     The Company utilizes the services of J&D Design, as well as others, for
interior design work at its facilities. The principal of J&D Design is Joan
Davidson, wife of Senior Vice President Eric Davidson and daughter-in-law of the
former Chairman, President and Chief Executive Officer, Gary Davidson. Services
provided by J&D Design include design work and the purchase of furniture,
fixtures and equipment ("FF&E") for developed facilities and rehabilitation of
existing or newly acquired facilities. The Company paid J&D Design approximately
$755,000, $431,000 and $328,000 for the nine-month period ended December 31,
1997 and the fiscal years ended March 31, 1997 and March 31, 1996, respectively,
a portion of which was for design services and a portion of which was for
reimbursement of costs for FF&E.
 
     Mr. R. Bruce Andrews, a member of the Board of Directors, is President of
Nationwide Health Properties, Inc. ("NHP"), a Health Care REIT. NHP is the owner
of 16 ALCs which are leased to the Company. Of that number, leases for 13 ALCs
were entered into prior to November 29, 1995, the date Mr. Andrews became a
Board member, and leases for three ALCs were entered into during Mr. Andrews'
tenure as Board member. Lease payments have aggregated approximately $8.2
million, $10.3 million and
                                      F-20
<PAGE>   59
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
$3.7 million for the nine-month period ended December 31, 1997, the fiscal year
ended March 31, 1996 and from November 1, 1995 through March 31, 1996,
respectively.
 
     John J. Rydzewski, a Director of the Company and member of the Compensation
Committee, is a principal in the investment banking firm of Benedetto, Gartland
and Company, Inc. ("BG&C"). The Company retained BG&C to provide advice
concerning the Company's investment in Senior Income Fund L.P., a Delaware
limited partnership owning four congregate care facilities in Southern
California. The Company paid BG&C appropriately $206,000 during the fiscal year
ended March 31, 1997. No amounts were paid to BG&C during the nine month period
ended December 31, 1997.
 
  Common Stock
 
     During the year ended March 31, 1996, the Company repurchased 493,000
shares of its common stock from three former employee shareholders for
approximately $351,000.
 
(9) SHAREHOLDERS' EQUITY
 
  Sale of Shares to Prometheus
 
     In July 1997, the Company sold approximately 1.9 million shares of its
common stock to Prometheus Assisted Living LLC ("Prometheus"), an affiliate of
Lazard Freres Real Estate Investors, LLC ("Lazard" or "LFREI") for $26.9
million. In October 1997, the Company issued $60 million of Convertible
Subordinated Notes (the "Notes") to Prometheus. The Notes were convertible into
approximately 3.5 million shares of the Company's common stock at $17.25 per
share. The Company had the option to call the Notes at any time, and on December
5, 1997, the Board approved the redemption of the Notes. Per the terms of the
Notes, the redemption was made in common stock of the Company. Including a
23.214% optional redemption premium and accrued interest to date, the issuance
amounted to approximately 4.3 million shares at $17.25 per share. As a result of
these two transactions, the Company raised additional capital, net of costs, of
$82.2 million.
 
  Warrants
 
     At March 31, 1997 and 1996, the Company had outstanding warrants issued in
connection with its Series A Preferred Stock which give the holders the option
to purchase approximately 35,695 and 54,197 shares of common stock,
respectively, at $7.60 per share. All of these warrants outstanding which were
not exercised expired during the nine months ended December 31, 1997. These
warrants were exercisable at any time at the option of the holder within three
years of the date of issuance, the latest of which was August 1, 1994. At
December 31, 1997 and March 31, 1997 and 1996, the Company had outstanding
warrants issued to selling brokerage firms in connection with its convertible
subordinated notes which give the holders the option to purchase an aggregate
maximum of 116,152, 117,650 and 115,304 shares of common stock, respectively at
$12.16 per share. These warrants are exercisable at any time at the option of
the holder within three years of the date of issuance, the latest of which was
July 31, 1995. As of December 31, 1997, warrants to purchase 28,415 shares of
Common Stock have been exercised.
 
  Shareholders Rights Plan
 
     In July 1997, the Company adopted a shareholders rights plan under which
the Company has declared a dividend distribution of one Preferred Share Purchase
Right on each outstanding share of ARV common stock. Subject to limited
exceptions, the Rights will be exercisable if a person or group acquired 10% or
more of the Company's stock or announces a tender offer for 10% of the common
stock. When exercisable, each Right (except the Rights held by the acquiring
person) will entitle its holder to purchase, at the Right's then-
 
                                      F-21
<PAGE>   60
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
current exercise price, a number of common shares of ARV having a market value
at the time of twice the Right's exercisable price. If ARV is acquired in a
merger or other business combination transaction which has not been approved by
ARV's Board of Directors, each Right will entitle its holder to purchase, at the
Right's then-current exercise price, a number of the acquiring company's common
shares having a market value at that time of twice the Right's exercise price.
 
(10) REDEEMABLE PREFERRED STOCK
 
     The Company issued Series A 8% cumulative, convertible and redeemable
preferred stock. Each share was convertible at any time, at the option of the
holder, in whole or in part, into one share of common stock; redeemable, at the
option of the holder, any time after December 31, 1998 for $7.60 per share.
 
     As of February 7, 1996, the Company exercised its right to redeem all
outstanding shares of the Series A 8% cumulative convertible redeemable
preferred stock on May 9, 1996. Preferred shareholders had the option of
converting their shares into Common Stock at any time prior to April 29, 1996.
As of March 31, 1996, 48.6% of the shareholders had converted their Preferred
Stock into 319,664 shares of Common Stock. During the fiscal year ended March
31, 1997, the balance of the shareholders converted their preferred stock into
338,141 shares of common stock.
 
(11) ASSISTED LIVING COMMUNITY LEASES
 
     At December 31, 1997, the Company leased 32 ALCs. The ALC leases expire
from 1998 to 2017, and contain two to three renewal options ranging from five to
ten years.
 
     During the fiscal year ended March 31, 1997, the Company sold four owned
ALCs to a subsidiary of Meditrust for proceeds of $29.1 million and
simultaneously entered into long-term operating leases. The minimum annual
payments for these leases are $2.9 million, subject to future increase as
described below. The leases are for terms of 15 years, with renewal options to
extend under similar terms for five years each. No gain was recognized on the
transaction.
 
     Generally, leases for Leased ALCs owned by a common lessor contain cross
default provisions permitting the lessor to declare a default under all leases
in the event of a default on one lease.
 
     Minimum lease payments required under assisted living community operating
leases in effect at December 31, 1997, are as follows:
 
<TABLE>
<CAPTION>
                YEAR ENDED DECEMBER 31:                  (IN THOUSANDS)
                -----------------------                  --------------
<S>                                                      <C>
1998...................................................     $ 20,641
1999...................................................       20,773
2000...................................................       20,773
2001...................................................       20,773
2002...................................................       20,773
Thereafter.............................................      142,173
                                                            --------
                                                            $245,906
                                                            ========
</TABLE>
 
     Certain of the leases require the payment of additional rent based on a
percentage increase of gross revenues. Such amounts were not material. Leases
are subject to increase based upon changes in the consumer price index or gross
revenues, subject to certain limits, as defined in the individual lease
agreements.
 
     On June 6, 1996, the Company obtained a $60 million commitment from Health
Care REIT, Inc. for financing the construction of new ALCs. This commitment
expires June 6, 1998. Pursuant to the terms of the
 
                                      F-22
<PAGE>   61
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
commitment, Health Care REIT, Inc. will finance up to 100% of the approved
costs, as defined, for the construction of new ALCs. Upon completion of
construction, the Company will lease the communities from Health Care REIT, Inc.
on an initial lease term of 15 years, with three options to renew, at the
Company's option, for periods of ten years each. The initial lease rate will be
based upon the yield of comparable term U.S. Treasury Notes plus 3.75%. In
December, 1996, this commitment was increased to $90 million to include $30
million for the acquisition of existing ALCs. The initial lease rate to be paid
by the Company on acquisitions funded under this facility will be based upon the
yield of comparable term U.S. Treasury Notes plus 3.40%.
 
(12) COMMITMENTS AND CONTINGENT LIABILITIES
 
     COMMITMENTS
 
     The Company and certain shareholders have guaranteed the indebtedness at
December 31, 1997, of certain affiliated partnerships as follows:
 
<TABLE>
<CAPTION>
                                                                      CERTAIN
                                                          COMPANY   SHAREHOLDERS
                                                          -------   ------------
                                                              (IN THOUSANDS)
<S>                                                       <C>       <C>
Notes secured by real estate............................  $16,814     $16,814
Land and construction loans associated with the
  development and construction of affordable housing
  apartments............................................  $34,778     $26,081
</TABLE>
 
     The maximum aggregate amounts of guaranteed indebtedness is $55.7 million
at December 31, 1997. The Company has guaranteed tax credits for certain
partnerships in the aggregate amount of $78.4 million, excluding interest,
penalties or other charges which might be assessed against the partners. The
Company and certain shareholders have provided development and operating deficit
guarantees for certain Affiliated Partnerships. In December 1997, the Company's
Board of Directors adopted a plan to discontinue operations of the Apartment
Group. As of December 31, 1997, the Company recorded an $8.6 million charge for
development and operating deficit guarantees and permanent loan shortfalls.
 
     In management's opinion, no claims may be currently asserted under any of
the aforementioned guarantees based on the terms of the respective agreements
other than those accrued.
 
     At December 31, 1997, the Company has used $9.2 million of its line of
credit with Imperial Bank in the form of non-cash advances to provide letters of
credit used as security deposits for leased ALCs. The
 
                                      F-23
<PAGE>   62
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
Company intends to finance certain of its ALCs and investments in property to be
developed in order to redeploy the capital.
 
     At December 31, 1997, the Company leased office space under various
operating leases expiring from 2001 to 2003, some of which are from affiliated
entities (See Note 8). Noncancelable operating lease commitments for office
space at December 31, 1997 are:
 
<TABLE>
<CAPTION>
                YEAR ENDED DECEMBER 31:                  (IN THOUSANDS)
                -----------------------                  --------------
<S>                                                      <C>
     1998..............................................      $  332
     1999..............................................         338
     2000..............................................         314
     2001..............................................         243
     2002..............................................         178
     Thereafter........................................         184
                                                             ------
          Total........................................      $1,589
                                                             ======
</TABLE>
 
     Rent expense for these leases amounted to $257,000, $333,000 and $161,000
in the nine-month period ended December 31, 1997 and the fiscal years ended
March 31 1997 and 1996, respectively.
 
     CONTINGENCIES
 
     On September 27, 1996, American Retirement Villas Partners II, a California
limited partnership ("ARVP II") of which the Company is the managing general
partner and a majority limited partner, filed actions in Superior Court, County
of Santa Clara seeking declaratory judgments against the landlords of the
Retirement Inn of Campbell ("Campbell") and the Retirement Inn of Sunnyvale
("Sunnyvale"). ARVP II leases the Campbell and Sunnyvale assisted living
communities under long-term leases. A dispute has arisen as to the amount of
rent due during the 10-year lease renewal periods which commenced in August 1995
for Campbell and March 1996 for Sunnyvale. ARVP II seeks a determination that it
is not required to pay any higher rent during the 10-year renewal periods than
during the original 20-year lease terms.
 
     In the event that the court finds against ARVP II, rent for the Campbell
and Sunnyvale communities could increase significantly, which would reduce
distributions to unit holders (including the Company as the majority unit
holder) in the future. These rent increases would be retroactive to the
commencement of the lease renewal periods. Management is of the opinion, based
in part upon opinions of legal counsel, that an adverse outcome is unlikely, and
that the ultimate resolution will not have a material adverse effect of the
financial position, results of operations or liquidity of the Company.
 
     Two other communities leased by ARVP II, the Retirement Inn of Fremont
(Fremont) and the Retirement Inn at Burlingame ("Burlingame") are owned by
entities which are related to the entities that own the Campbell and Sunnyvale
communities. It is not known whether the landlords of those communities will
dispute the amount of rent due during the renewal periods which began January
1997 for Fremont and August 1997 for Burlingame. If so, ARVP II may be required
to file litigation to determine its rights under those leases.
 
     Starting in July 1997, the Company entered into a series of transactions
with Prometheus (the "Prometheus Transactions"), whereby Prometheus ultimately
acquired a 39.1% stake in the Company for $86.9 million, before deducting
expenses. In the course of consummating those agreements, Emeritus Corporation,
a competitor of ARV, made a series of proposals to acquire the Company. The
Company's Board determined that the Emeritus proposals were unattractive and
inadequate, and voted to reject them.
 
                                      F-24
<PAGE>   63
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
     Emeritus subsequently launched a proxy contest, attempting to take control
of the Company's Board of Directors, and filed a complaint against the Company
and several of its Board members. The complaint was filed in Orange County
Superior Court on December 9, 1997, primarily alleging that the Company's Board
of Directors violated its fiduciary duty owed to Emeritus as a shareholder. The
complaint sought, among other things, an injunction rescinding the Prometheus
Transactions and the Company's Shareholder Rights Plan adopted in July 1997 and
an order requiring the Company to enter into negotiations with Emeritus.
 
     On January 8, 1998, Emeritus filed a motion for preliminary injunction,
seeking to rescind the ARV/ Prometheus transaction. On January 26, 1998,
following a hearing, the court denied Emeritus' motion. On January 28, 1998, the
Company's shareholders rejected Emeritus' slate of nominated directors. In light
of the shareholder vote, it is presently unclear whether Emeritus plans to
proceed with this action. Management intends to defend this action vigorously.
 
     On December 12, 1997, a class action lawsuit was brought on behalf of all
the Company's shareholders, alleging that the Company's board violated its
fiduciary duty to shareholders by "wrongfully entering into a transaction with
Prometheus". The Complaint seeks injunctive relief as well as monetary damages.
On February 20, 1998, the Company filed a demurrer to the complaint, and a
hearing on that demurrer is currently set for April 3, 1998. If Emeritus
continues to pursue its claims, or any other claims, Management intends to
defend such actions vigorously.
 
     The Company is from time to time subject to claims and disputes for legal
and other matters in the normal course of its business. While the results of
such matters cannot be predicted with certainty, management does not believe
that the final outcome of any pending matters will have a material effect on the
Company's consolidated financial position, results of operations, or liquidity.
 
(13) DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS
 
     The estimated fair value of the Company's financial instruments have been
determined using available market information and appropriate valuation
methodologies. However, considerable judgment is necessarily required to
interpret market data to develop the estimates of fair value. Accordingly, the
estimates presented herein are not necessarily indicative of the amounts that
could be realized in a current market exchange. The use of different market
assumptions or estimation methodologies may have a material impact on the
estimated fair value amounts.
 
     The carrying amounts reported in the consolidated balance sheets for cash
and cash equivalents, fees receivable and other amounts due from affiliates and,
accounts payable and accrued liabilities, approximate fair value due to the
short-term nature of these instruments. The notes payable and other amounts due
to affiliates and notes payable bear interest at rates which approximate current
market rates. Therefore, management believes that the carrying value
approximates fair value.
 
                                      F-25
<PAGE>   64
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
(14) FINAL QUARTER TRANSACTIONS AND ADJUSTMENTS
 
     In December 1997, the Board of Directors adopted a plan to discontinue the
operations of GeriCare and the Apartment Group. As part of the plan to dispose
of these assets, the Company recorded a provision of $10.6 million. Of that
provision, $8.6 million relates to amounts the Company expects to incur in
funding shortfalls in projected permanent financing on the assets of the
Apartment Group as well as anticipated operating losses to be incurred before
disposal and the write-down of certain assets. The remaining provision of $2.0
million relates to anticipated operating losses on GeriCare, as well as the
write-off of its intangible assets.
 
     The operating results for the final quarter in the nine-month period ended
December 31, 1997, include the expenses incurred in connection with the
Company's successful proxy contest with Emeritus Corporation of $1.6 million
(see Note 16), severance costs of $1.1 million incurred in connection with the
retirement of two senior executives which were approved by the Company's
Compensation Committee in December 1997, the write-off of $1.1 million of costs
incurred in connection with the Company's accounting software conversion, which
was abandoned in February 1998 upon discovering numerous application errors in
the software package it purchased, and an impairment provision of $150,000
following Senior Income Fund's announced plans to liquidate its assets and
receipt of a substantial return of capital.
 
(15) YEAR 2000
 
     The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. The Company had
developed a plan to address the Year 2000 issue for its financial information
systems and, during the nine months ended December 31, 1997, began converting
its computer systems to be Year 2000 compliant. However, the Company abandoned
its attempted accounting software conversion in February 1998. As a result, the
Company is currently reassessing its planned conversion efforts for its
financial and operational information systems as well as related operational
issues at its communities. While an estimate of the total project costs is not
currently available due to the recent events, it is anticipated that such costs
will be funded from currently available cash flows.
 
(16) SUBSEQUENT EVENTS
 
     On December 19, 1997, Emeritus Corporation ("Emeritus"), through its
wholly-owned subsidiary, EMAC Corp. ("EMAC"), commenced a tender offer (the
"Tender Offer") to purchase all outstanding shares of common stock of the
Company (the "Common Stock"), together with the associated preferred stock
purchase rights (the "Rights") at a price of $17.50 per share. On January 5,
1998, the Company's Board unanimously concluded that the Emeritus tender offer
was inadequate and not in the best interests of the Company and recommended that
the shareholders of the Company reject the Emeritus offer and not tender their
shares pursuant to the Emeritus tender offer. On January 30, 1998, Emeritus
announced that it had terminated the tender offer (see Note 12).
 
     In February 1998, the Company entered into an agreement to purchase
interests in 13 ALCs communities containing approximately 1,900 units, located
in California, for $88.0 million. The Company expects to assume operation of
most of the communities during the second quarter of 1998. Following the closing
of the transaction, the Company would operate 43 communities containing 5,300
units in California. On a national basis, the Company will have 63 operating
communities containing 8,300 units located in 10 states.
 
                                      F-26
<PAGE>   65
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
                 DECEMBER 31, 1997 AND MARCH 31, 1997 AND 1996
 
     In March 1998, the Company and Omnicare, Inc., a national geriatric
pharmaceutical care company, formed a joint venture -- equally owned by ARV and
Omnicare -- under which network pharmacy and related clinical information
services will be provided for the residents of ARV's assisted living
communities. The joint venture agreement is for a three-year term. The venture
is expected to commence operations during the second quarter of 1998 and be
rolled out to all ARV communities by third quarter 1998.
 
     In March 1998, the Company reached an agreement in principle to form a
strategic alliance with NovaCare Inc., a national provider of
physical-rehabilitation services. The alliance will offer residents of ARV
communities rehabilitation and wellness care services and assist those residents
to "age in place," while allowing the Company to exit the Geri Care therapy
business.
 
                                      F-27
<PAGE>   66
 
                           ARV ASSISTED LIVING, INC.
                                AND SUBSIDIARIES
 
                SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
  FOR THE NINE-MONTH PERIOD ENDED DECEMBER 31, 1997 AND THE FISCAL YEARS ENDED
                            MARCH 31, 1997 AND 1996
                                 (IN THOUSANDS)
 
<TABLE>
<CAPTION>
                                               BALANCE AT                                   BALANCE AT
               DESCRIPTION                  BEGINNING OF YEAR    ADDITIONS    DEDUCTIONS    END OF YEAR
               -----------                  -----------------    ---------    ----------    -----------
<S>                                         <C>                  <C>          <C>           <C>
Allowance for Other Assets:
  March 31, 1996..........................       $   --               65           --             65
  March 31, 1997..........................           65               86           38            113
  December 31, 1997.......................          113               90          203             --
Discontinued operations:
  March 31, 1996..........................           --              536          272            264
  March 31, 1997..........................          264            3.489          504          3,249
  December 31, 1997.......................        3,249           11,212        1,640         12,821
</TABLE>
 
                 See accompanying independent auditor's report.
                                      F-28