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

                                   FORM 10-KSB

(MARK ONE)

            [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                 SECURITIES EXCHANGE ACT OF 1934 [FEE REQUIRED]
                  For the fiscal year ended September 30, 1996

             [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
                SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
                   For the transition period from      to

                         Commission File Number 0-16011

                           WATSON GENERAL CORPORATION
                 (Name of small business issuer in its charter)

         CALIFORNIA                                          95-2873757
(State or other jurisdiction of                              (I.R.S. Employer
incorporation of organization                                Identification No.)

         32-B MAUCHLY                                          92718
      IRVINE, CALIFORNIA                                     (Zip Code)
     (Address of principal
       executive offices)

Issuer's telephone number:  (714) 727-4020

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

Securities registered pursuant to Section 12(g) of the Act:  COMMON
STOCK, NO PAR VALUE

Check whether the issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 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 [ ]

Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B contained herein, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy
or information statements incorporated by reference in Part III of
Form this 10-KSB or any amendment thereto. [X]

State issuer's revenues for its most recent fiscal year:  $  4,089,000

The aggregate market value of the voting stock held by non-affiliates computed
by reference to the price at which the stock was sold on December 17, 1996 was
$8,959,930 For purposes of the foregoing calculation only, all directors and
executive officers of the registrant have been deemed affiliates.

The number of shares outstanding of the issuer's common stock, as of December
17, 1996, was 10,487,401.

                                       1
<PAGE>   2
                                 PART 1

ITEM 1.  DESCRIPTION OF BUSINESS

Watson General Corporation (the "Registrant" or the "Company"), a California
Corporation founded in 1947 and based in Irvine, California, is an emerging
growth company in the environmental services industry. The Company is currently
engaged in three different businesses through its wholly-owned operating
subsidiaries:

         Watson Systems, Inc. - an industry leader in the leak detection/remote
         monitoring of underground storage tanks ("UST's").

         Toxguard Fluid Technologies, Inc. - the largest provider in the U.S. of
         on-site antifreeze recycling. It operates throughout Southern
         California.

         Toxguard Systems, Inc. - engaged in consulting and site remediation for
         environmentally impacted locations and installation of underground
         storage tanks.

                            Representative Customers

                   Amoco                                     ARCO
                 Circle K                             Econo Lube N' Tune
                  Texaco                                   Goodyear
                    GTE                                     Hertz
              IT Corporation                           City of San Diego
             Kaiser Permanente                      Laidlaw Transportation
            City of Long Beach                        Port of Long Beach
           County of Los Angeles                   Los Angeles Freightliner
         Mayflower Transportation                             MCI
             Los Angeles Times                           Pacific Bell
                    UPS                                Port of San Diego
                   Sears                            Southern California Gas
         Sheetz Convenience Stores                      TNT Truck Lines
          Union Pacific Railroad               Univ. of Southern California(USC)

THE MARKETS AND PRODUCTS

Watson Systems, Inc.

       In 1992, the Company entered the business of remote monitoring/management
       of UST's through its acquisition EnvirAlert, which developed innovative
       proprietary software for the remote monitoring of UST's including
       TankControl(TM), a PC/Central station remote monitoring software that can
       monitor multiple sites and is compatible with most brands of Automated
       Tank Gauge ("ATG") hardware currently on the market. Although its remote
       monitoring/management software has been validated and is currently being
       utilized (including tanks for the U.S. Navy, GTE, Amoco and Texaco), the
       Company believes that its substantial market potential is just now being
       recognized as the industry pushes to meet the December 1998 requirements.

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       In early 1996, the Company completed the acquisition of EnviroQuest
       Technologies, Ltd., an industry leader in Statistical Inventory
       Reconciliation ("SIR") software. EnviroQuest was consolidated
       operationally with EnvirAlert, and a new corporate name, Watson Systems,
       Inc. ("WSI"), officially was adopted.

       The Company believes that this combination of EnviroQuest and EnvirAlert
       resulted in superior and synergistic technology for total tank/site
       management. It provides the industry's most comprehensive "total
       solutions" approach for leak detection for both 1) those tank owners who
       currently are using Tank Tightness Testing, or are not in compliance, and
       2) those using ATG's for leak detection. Many ATG's currently in use do
       not include leak detection for the entire system which will also be
       required in December 1998. SIR may become an important tool for these ATG
       owners to achieve compliance. Moreover, because SIR is performed by an
       outside third party, it provides the tank owner with greater assurances
       of regulatory compliance than if performed in-house.

       WSI's services/products are directed to the owners of UST's by providing
       cost-effective regulatory compliance for leak detection monthly
       monitoring, and fuel management. WSI's customers are primarily
       petroleum-related, including oil, transportation and retail companies,
       but also include federal and municipal agencies, and other commercial and
       industrial tank owners.

       By December 1998, compliance requirements for over 1,000,000 remaining
       underground storage tanks (UST's) will accelerate to require monthly
       monitoring for most tanks and their surrounding delivery systems (i.e.,
       pipes and dispensers).

       Leak detection emerged as a major issue in the U.S. during the second
       half of the 1980's. Public and regulatory concerns arose that leaking
       tanks (whether the tanks were in fact leaking, or whether they might leak
       in the future) posed a contamination threat to the U.S. underground water
       supply, which supplies a large part of the drinking water used in the
       U.S. Additionally, leaks from tanks containing petroleum products or
       derivatives created the risk of underground or aboveground fires and
       explosions, resulting from discharges or fumes. As any UST was vulnerable
       to leakage over time, without a proper leak detection system installed
       and working, the harmful effects of leaking UST's remained a constant
       threat.

       Regulation of UST's is not new, nor are long-standing commitments by
       regulators to address this issue likely to change. Beginning in 1988, the
       EPA mandated that virtually every tank (depending on local and State
       regulatory requirement) must have a leak detection system in place by
       December 1998. This mandate was implemented on a phased approach based
       upon the age of the tank.

       There are 3 primary methods of leak detection currently used:

           1)   Tank Tightness Testing,

           2)   Automatic Tank Gauges ("ATG's"); and

           3)   Statistical Inventory Reconciliation ("SIR").

       The first method, Tank Tightness Testing, will for the most part not meet
       the new EPA requirements for monthly monitoring, which become effective
       in December 1998, as Tank Tightness Testing is generally performed
       annually. Tank Tightness Testing normally requires that


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       the station be closed, the tank be filled, isolated and shut down, and
       then tested for loss of product. These tests result in loss of sales and
       corresponding customer inconvenience.

       Automatic Tank Gauges, which have been used since the 1970's, are
       instruments (i.e., electronic gauges) that go into the tank. They 1)
       report the gallons in the tank; and 2) test for leaks (however, like the
       Tank Tightness Test, many existing ATG's currently in use only test the
       tank, and not the piping). ATG's were originally used for fuel management
       purposes (i.e., inventory control), and not for regulatory compliance for
       release detection requirements.

       Of the 3 methods, Statistical Inventory Reconciliation ("SIR") is the
       most cost-effective method that complies with the December 1998 leak
       detection/monthly monitoring requirements. Unlike Tank Tightness Testing
       and many existing ATG's, it checks the integrity of piping, dispensers
       and tanks since it looks for losses of inventory from the whole system,
       rather than just from one part of it. Its annual cost is normally less
       than that of a Tank Tightness Test, and, in addition to meeting the
       December 1998 regulatory requirements for monthly monitoring, it provides
       greater information useful for inventory management and control.

       In 1988, when the EPA leak detection requirements first went into effect,
       there were about 2 million UST's in the U.S. Since then, the number has
       declined dramatically, to about 1 million tanks, as a result of the
       phase-out of older tanks, and an improvement in tank construction
       methods. However, there exists a core UST population in the U.S.,
       representing the existing 1 million UST's, which are used primarily for
       storage of petroleum products and derivatives, which must be located
       underground, and for which no alternative method of storage exists.

       Of these 1 million tanks, it is estimated that up to one-half, or 500,000
       tanks, are either 1) using Tank Tightness Testing, and will have to
       convert to another method by December 1998, or 2) not utilizing any leak
       detection system. Because of SIR's inherent advantage in providing the
       most practical and cost-effective means for regulatory compliance (as
       well as inventory management), the industry has recognized that SIR may
       become the choice for the preponderance of these tank owners because SIR
       most closely approximates, or is less than, their current costs of Tank
       Tightness Testing.

       As one of the industry leaders in SIR services and software, WSI believes
       it is well-positioned to capture a significant portion of this market.
       WSI has one of the industry's largest installed bases of customers
       (including top-tier national oil and gas companies and leading
       independent petroleum marketers); a national sales force and
       marketing/distribution network; and cutting-edge, competitively superior
       software products and services. WSI believes it will have significant
       market advantages which will enable it to gain market share. These
       include:

         -    The ability to bundle its various products and services into
              cost-effective packages to meet the specifics of individual
              customer requirements and provide cost-effective regulatory
              compliance, inventory management, and remote monitoring
              capabilities.

         -    An existing alliance with Alexander & Alexander, a leading
              insurance broker and risk manager, which may significantly lower
              pollution liability insurance costs for UST owners that utilize
              WSI's SIRAS(R) SIR or TankAlert(TM) Services.

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         -    The PLS-850 Electronic Stick ("PLS-850"), a new product (which was
              introduced at the Petroleum Equipment Industry national trade show
              conference in October 1996), and which will be available for
              market delivery beginning in early 1997. The PLS-850 is an
              automated system for collecting stick/inventory levels with a
              proprietary electronic volume measurement device. It is the
              industry's first inexpensive alternative to a conventional ATG,
              having the capability to receive, either manually or
              electronically, the key information for SIR processing.

       At September 30, 1996, the Company's subsidiary Watson Systems,
       Inc. had no material backlog, and employed twenty two people.

Toxguard Fluid Technologies

       Toxguard Fluid Technologies, Inc. ("TFT") is the nation's largest
       provider of on-site antifreeze recycling, a newly emerging growth
       business in the environmental services industry.

       Each year, over 300 million gallons of new antifreeze is manufactured in
       the U.S. When water is added for dilution for use in engines, over 600
       million gallons of waste product (i.e., used antifreeze) is generated
       annually that must be disposed of. Although antifreeze prior to use is
       not classified under EPA regulations as hazardous waste material, it
       becomes a hazardous waste material after use because of the various
       contaminants present (including copper, lead and other metallic
       substances).

       Traditionally, used antifreeze has been disposed of by hauling waste to
       disposal sites. A certain percentage is just poured "down the drain,"
       which is illegal. Waste antifreeze not only involves costs to dispose of,
       but waste disposal is undesirable from a public policy perspective.
       Moreover, the generator of used antifreeze has substantial
       "cradle-to-grave" liability for illegal or improper disposal. Such
       liability remains with the generator even if disposal is performed by a
       third party. Only recently, however, has technology and mobile equipment
       become available to enable on-site recycling.

       TFT utilizes a proprietary Reverse Osmosis technology that is far
       superior to any other mobile on-site system currently available or in use
       (the only other on-site recycling technology currently in use is
       filtration). This same type of Reverse Osmosis technology used by TFT is
       also used for water purification, desalinization and dairy applications,
       as well as kidney and blood dialysis. As a result, purity, clarity and
       consistency of TFT's recycled antifreeze is unsurpassed by any
       competitor.

       Thus, in addition to saving transportation costs and eliminating
       "cradle-to-grave" transportation risks, the recycled antifreeze produced
       by TFT has been demonstrated to offer superior performance to that of
       newly purchased antifreeze, actually exceeding ASTM (American Society of
       Testing and Materials) standards.

       TFT entered the mobile antifreeze/coolant recycling business in June
       1993, commencing operations in Irvine, CA. Today, TFT has grown to become
       the largest on-site mobile recycler of used antifreeze in the U.S. It
       services over 1,400 customers through-out Southern California including
       gasoline stations, repair facilities and related automotive service
       outlets, trucking and fleet companies, and governmental facilities.

       TFT offers convenient, mobile, on-site recycling that minimizes both the
       cost of waste coolant disposal and the potential risk of
       "cradle-to-grave" liability for coolant users. TFT's technology


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       produces a clean, clear mixture that removes chlorides, minerals,
       dissolved solids, metals and other chemicals found in waste and municipal
       water, that can react with additives and form on the cooling system
       parts.

       Thus, in TFT's recycled antifreeze, the antifreeze base is purified and
       the water is demineralized (the best possible combination for engine
       performance). The recycled product is a clean, clear mixture that is
       re-inhibited and re-colored. TFT's inhibitor formula is phosphate free
       (phosphate free is a requirement of many manufacturers - may void the
       warranty if phosphates are present) and is low in silicate (also may void
       manufacture's warranty if silicate is present). It meets or exceeds ASTM
       specifications for new antifreeze, meets recommended standards set by
       numerous automotive and heavy-duty service manuals, and does not require
       additional additives to meet truck fleet initial fill specifications.

       For smaller customers, e.g., radiator shops, repair facilities, etc. the
       primary motivating consideration is price. For these smaller customers,
       TFT provides a more cost-effective solution than the existing practice of
       hauling away the used antifreeze and buying replacement antifreeze. For
       larger customers such as fleet operations, government agencies, etc., the
       quality of product and reduction of disposal liability tends to be of
       greater concern than the cost considerations. This is because these
       larger customers are more attuned to issues of maintenance of fleet and
       other capital equipment. In addition to the quantifiable cost-savings,
       TFT's recycling also eliminates or greatly reduces the "cradle-to-grave"
       transportation risks and associated liability of over-the-road hauling
       and the co-mingling of wastes from other businesses. Obviously, should
       these risks eventuate, the costs and liabilities to the waste generator
       which can be sought are virtually unlimited.

       Using TFT's recycled antifreeze saves the customer or technician time by
       eliminating mixing. Finally, TFT's recycled antifreeze actually results
       in a superior product to new antifreeze, reducing engine wear and tear,
       and prolonging engine life.

       Virtually all types of repair and maintenance facilities have waste
       antifreeze on premises in some form and quantity, and are required under
       various federal, state and local regulations to dispose of this waste by
       a timely and environmentally safe method. In addition, nearly all
       trucking and fleet companies, and many governmental agencies, also
       generate used antifreeze requiring disposal.

       Toxguard Fluid Technologies employs eleven people.

Toxguard Systems

       Toxguard Systems ("TSI") provides custom environmental consulting
       services focused on "site closure" of environmentally distressed or
       impacted sites. The Company performs site assessments, remediates and
       monitors contaminated sites, and specializes in the design and
       installation of under and above ground storage tank systems.

       In addition, TSI also designs clean-up programs for contaminated soil and
       groundwater locations. TSI offers 24-hour remote monitoring to the
       underground storage tank owners and remote control and monitoring of site
       clean-up projects by utilizing the specialized computer software
       capabilities of its sister company, Watson Systems.

       TSI entered the environmental consulting and construction business in
       1987 to provide a comprehensive range of services in tank management and
       remote monitoring. Since its inception,


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       TSI has established a reputation for providing custom environmental
       consulting services designed to meet clients specific needs on a
       cost-effective basis. As a result, its clients range from independent
       businesses, to Fortune 500 industries, to governmental agencies.

       Toxguard Systems employs fourteen people.

COMPLIANCE WITH ENVIRONMENTAL REGULATIONS

Compliance with federal, state and local environmental regulations has not had a
material effect on the capital expenditures, operations or competitive position
of the Company or its subsidiaries. Such regulations should, however, increase
the need for the environmental companies' products and services, thus enhancing
the future operations and competitive position of the Company.

BUSINESS UNIT CHANGES

In May 1995, the Company divested its interest in Biopraxis, Inc. a development
stage enterprise formed during 1994 to develop and commercialize certain
worldwide patents related to the removal and prevention of heavy metals and
radioactive contaminants from affected sites, by selling all of its Biopraxis
common stock in exchange for a promissory note in the amount of $80,000 for
which the company is fully reserved.

On January 30, 1996, the Company acquired all of the outstanding capital stock
of EnviroQuest Technologies, Ltd. ("ETL"), a Kansas City, Missouri based
developer of Statistical Inventory Reconciliation (SIR) software to monitor
underground storage tanks for leak detection. After acquisition the subsidiary
was renamed Watson Systems, Inc. ("WSI"), and the Company's previous
environmental software activities were combined into WSI.

The adjusted purchase price was $1,740,000, consisting of 184,000 shares of the
Company's common stock valued at $483,000, options to acquire 220,000 shares of
common stock valued at $367,000, $800,000 in cash $51,000 in promissory notes
and $39,000 of direct acquisition costs. In accordance with settlement and
release agreements entered into by the Company and the former shareholders of
ETL following the acquisition, the number of common shares of the Company issued
in exchange for ETL shares was reduced by 816,000 shares, promissory notes in
the amount of $194,000 issued by the Company were returned and a former owner of
ETL resigned as a Director of the Company and released the Company from its
obligation to seek his election to the Board.

ITEM 2.  DESCRIPTION OF PROPERTY

The Company and its subsidiaries currently operate out of leased office and
warehouse space located at 32-B Mauchly, Irvine, California, and 4501 Madison
Ave., Kansas City, Missouri.

Management believes that its corporate offices are suitable and adequate for its
present needs. There are no plans to lease any additional space.

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ITEM 3.  LEGAL PROCEEDINGS

There are no material legal proceedings pending to which the Company is a party,
or to which any of its property is subject, nor is such litigation threatened,
other than ordinary routine litigation which is incidental to its business.

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

No matters were submitted to a vote of security holders during the fourth
quarter of the fiscal year ended September 30, 1996.

                                     PART II

ITEM 5.  MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Company's Common Stock is traded over-the-counter on the NASDAQ SmallCap
market. The symbol for the Company's Common Stock is "WGEN". High and low bid
prices for each quarterly period within the two most recent fiscal years were as
follows based upon information supplied to the Company by NASDAQ:

<TABLE>
<CAPTION>
<S>                                 <C>             <C>             <C>             <C>
Year Ended September 30, 1996        4th Qtr.        3rd Qtr.        2nd Qtr.        1st Qtr.
                                     --------        --------        --------        --------

         High bid                    $2-3/8          $2-7/8          $3-1/8          $4-1/8

         Low bid                      1-1/2           1-11/16         2-1/4           2

Year Ended September 30, 1995        4th Qtr.        3rd Qtr.        2nd Qtr.        1st Qtr.
                                     --------        --------        --------        --------

         High bid                     4-3/8           2-3/8           3-1/4           5

         Low bid                      1-11/16         1-11/16         1-7/8           3-1/8
</TABLE>

As of December 17, 1996, there were approximately 400 record holders of the
Company's Common Stock. This number does not include shareholders who maintain
their security positions with their security broker in street name.

The Company has never declared a cash dividend on its Common Stock.

ITEM 6.  MANAGEMENT'S DISCUSSION OF ANALYSIS OR PLAN OF OPERATION

Results of Operations

The Company reported a net loss of $2,066,000 for fiscal 1996 compared to
$1,106,000 for fiscal 1995. The increase in operating losses are due in
significant part to:

         Acquisition of EnviroQuest Technologies, Ltd. and the operational
         merger of this new subsidiary with the Company's Enviralert, Inc.
         subsidiary to form Watson Systems, Inc. The discovery, of certain
         alleged inaccuracies of certain representation,


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         warranties, and covenants made to the Company in connection with the
         acquisition caused both additional costs, as well as delays in sales
         and marketing.

         Ramp up of sales, marketing, and processing capacity costs for Watson
         Systems, Inc.

Though losses were incurred in fiscal year 1996 the Company has continued to
improve its sales and gross margins. The Company's gross profit for fiscal 1996
was $1,591,000 or 39% of sales versus gross profit of $1,144,000 or 38% of sales
in fiscal 1995, and gross profit of $610,000 or 36% of sales in fiscal 1994. The
Company expects to maintain these higher gross margins.

Net sales for fiscal 1996 were $4,089,000, an increase from $2,990,000 for
fiscal 1995. With the acquisition of EnviroQuest Technologies, Ltd. the Company
now monitors over 22,000 underground storage tanks. During the year the Company
established affiliate relationships in Australia and Korea and see strong
international potential for its products and services.

The Company's sales depend in part upon its customer's decision as to when to
implement measures to meet 1998 compliance requirements. The Company believes
that the market for its services may accelerate as compliance deadlines
approach.

Selling, general and administrative expenses increased to $3,368,000 in fiscal
1996 compared to $2,193,000 in fiscal 1995. This increase is in large part due
to additional costs of the new Watson Systems, Inc. operating subsidiary.

Liquidity & Capital Resources

The Company effectively financed its net cash used in operating activities for
the fiscal year by issuance of common stock.

At September 30, 1996 the Company's current liabilities exceeded current assets
by $598,000 compared to a surplus of current assets over current liabilities of
$731,000 at September 30, 1995.

The Company has historically relied upon shareholder capital to fund operational
deficits, and expects to continue funding any operating deficits through equity
infusions in fiscal 1997. The Company is in the process of negotiating an equity
financing arrangement expected to net funds in excess of amounts required to
adequately finance operations and expansion plans. The Company also intends to
sell certain real estate assets to generate working capital.

If the Company does not obtain adequate equity financing, management plans to
recommend to the Company's Board of Directors that the Company divest certain
subsidiaries or assets, and severely curtail operating expenses in order to
finance its ongoing environmental monitoring software business.

ITEM 7.  FINANCIAL STATEMENTS

The financial statements are attached as an exhibit to this report.

                                       9
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ITEM 8.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE.

None.

                                    PART III

ITEM 9.  DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

CHARLES A. WATSON has served as a director of the Company since 1972
and as the Company's Chairman of the Board since 1985.  He was
appointed the Company's President, Chief Executive Officer and Chief
Financial Officer in September 1987.  He relinquished the post of Chief
Financial Officer in 1991, the post of President in January 1993, and
the post of  Chief Executive Officer in July 1994.  Mr. Watson is 66.

RONALD G. CRANE has served as a Director of the Company since 1973.  At
the January 19, 1993 Watson General Corporation Board of Directors
meeting, Mr. Crane was appointed President and Chief Operating Officer
of the Company.  In July 1994 Mr. Crane was appointed Chief Executive
Officer.  Mr. Crane is also President and Chief Executive Officer of
Toxguard Systems, Inc. and EnvirAlert, Inc.  Mr. Crane is 50.

JOSEPH L. CHRISTOFFEL has served on the Board of Directors since February 1993.
He is a certified public accountant and was appointed by the Board of Directors
as Secretary and Chief Financial Officer of the Company in January 1993. He has
been a CPA since 1977, has practiced public accounting and has held the position
of Chief Financial Officer for both private and public organizations. Mr.
Christoffel is 44.

DENNIS E. MULLIGAN was elected to serve on the Board of Directors in
1992.  Since 1977, he has been a principal with Lambert Smith Hampton
and Sperry Van Ness, large commercial real estate brokerage companies
as well as an independent broker.  He has been a Watson General
shareholder since 1978.  Mr. Mulligan is 51.

ROGER H. SHERWOOD was elected to serve on the Board of Directors in
1996. He became the President of Watson Systems, Inc. in February 1996
after the Company's acquisition of EnviroQuest (he was employed as
EnviroQuest's President in October 1995). From 1965 to 1994 he was
employed by Amoco Oil Company in various executive positions, including
District Manager, and in 1994 to 1995 by MPSI Systems, Inc.  Mr.
Sherwood is 55.

JAMES M. SMATHERS has served as a Director of the Company since 1972.
Mr. Smathers has been a certified public accountant for over 29 years,
and had established his own accounting firm from 1968 until he retired
in 1985.  Mr. Smathers is 70.

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ITEM 10. EXECUTIVE COMPENSATION

The following table sets forth information concerning compensation provided to
the Company's Chief Executive Officer. No other executive officer or employee
received, total annual salary and bonus exceeding $100,000.00.

<TABLE>
<CAPTION>
NAME AND PRINCIPAL                   FISCAL    SALARY        ALL OTHER
  POSITION                           YEAR                    COMPENSATION

<S>                                   <C>      <C>           <C>
RONALD G. CRANE(1)                    1996     75,000
         Chief Executive Officer      1995     75,000
         President                    1994     73,558

CHARLES A. WATSON(2)                  1996     84,000        36,183(3)
         Chairman of the Board        1995     84,000        34,992(3)
                                      1994     82,385        33,792(3)
</TABLE>

(1)Mr. Crane did not receive any bonus or other annual compensation
during the fiscal year ended September 30, 1996.  Mr. Crane did not
receive or exercise any options to purchase Common Stock during the
fiscal year ended September 30, 1996.  Mr. Crane did not receive any
long-term incentive plan award during the fiscal year ended September
30, 1996. Mr. Crane received no other compensation during the fiscal
year ended September 30, 1996. Mr. Crane does not have an employment
agreement with the Company.

(2)Mr. Watson did not receive any bonus or other annual compensation.
Mr. Watson did not receive or exercise any options to purchase Common
Stock during the fiscal year ended September 30, 1996 and held no
unexercised options on September 30, 1996.  In addition, Mr. Watson did
not receive any long-term incentive plan award during the fiscal year
ended September 30, 1996.  Mr. Watson does not have an employment
agreement with the Company.

(3)The Company has also adopted a retirement plan for Mr. Charles A.
Watson.  Benefits of $2,700 per month are payable to Mr. Watson or his
wife, if she survives him, for life with a ten year guaranteed payment,
subject also to annual cost of living increases.

In accordance with the Statement of Financial Accounting Standards No. 106
("SFAS 106"), "Employers' Accounting for Post Retirement Benefits Other Than
Pensions," the Company elected for immediate recognition under SFAS 106 and the
projected benefit obligation of $462,000 or $.08 per share relating to prior
service costs under the agreement was recognized as a cumulative effect of
accounting change as of October 1, 1991.

Other Compensation

Commencing January 4, 1994, the Company began compensating outside Directors
$250.00 for physical attendance per Board of Directors meetings. Prior to this
date members of the Board of Directors received no compensation for services
rendered in their capacity as Directors.

                                       11
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ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth certain information regarding the beneficial
ownership of Common Stock as of December 17, 1996 of persons (other than
officers or directors of the Company) known to the Company to own more than 5%
of the Company's outstanding Common Stock.

<TABLE>
<CAPTION>
                             Number of Shares              Percent of
Name                         Beneficially Owned            Outstanding Shares
----                         ------------------            ------------------
<S>                             <C>                        <C>
James C. Ray                    914,287(1)                 8.72%
1140 Airport Road
Minden, NV 89423
</TABLE>

(1) Includes 57,143 shares of common stock owned by June M. Ray, the
spouse of James C. Ray.

The following table sets forth certain information regarding the beneficial
ownership of Common Stock as of December 17, 1996 of (i) each director, (ii) the
chief executive officer of the Company named in the Summary Compensation Table
appearing in Item 10, and (iii) all directors and executive officers of the
Company as a group.


<TABLE>
<CAPTION>
                             Number of Shares              Percent of
Name                         Beneficially Owned            Outstanding Shares
----                         ------------------            ------------------
<S>                           <C>                          <C>
Charles A. Watson             1,125,000                    10.73%
5166 Soledad Road
San Diego, CA 92109

Ronald G. Crane               1,121,500(1)                 10.02%
9152 Shady Hollow Way
Fair Oaks, CA 95628

Joseph L. Christoffel           350,000(2)                  3.23%
4711 Copperfield Cir
Roseville, CA 95746

Roger H. Sherwood               139,000(3)                  1.31%
13815 Woodward
Overland Park, KS 66223

James M. Smathers               133,750(4)                  1.27%
3261 Purer Road
Escondido, CA 92029

Dennis E. Mulligan               55,000(5)                 less than 1%
141 Seventh Street
Del Mar, CA 92108

All officers and directors
as a group (five persons)     2,924,250                    24.82%
</TABLE>

                                       12
<PAGE>   13

(1) Includes options granted by the Company to purchase up to 400,000 shares of
common stock. The options are fully vested and expire September 30, 1998. The
options are exercisable at $1.50 per share. Includes options granted by the
Company to purchase up to 300,000 shares of Common Stock. Options vest as to
100,000 shares on each of May 27, 1994, 1995, and 1996. All options expire five
years from vesting and are exercisable at $2.625 per share after vesting.

(2) Includes options granted by the Company to purchase up to 350,000 shares of
common stock. Options to purchase 50,000 shares are fully vested and expire on
May 27, 1998. The remainder vest as to 100,000 shares on each of May 27, 1994,
1995, and 1996 and expire five years from vesting. All options are exercisable
at $2.625 per share after vesting.

(3) Includes options granted by the Company to purchase up to 120,000 shares of
common stock. Options vest as to 40,000 shares on each of January 30, 1996,
1997, and 1998 and expire five years from vesting. All options are exercisable
at $2.50 per share after vesting.

(4) Includes options granted by the Company to purchase up to 76,518 shares of
common stock. The options are fully vested and expire June 28, 1998, and are
exercisable at $2.44 per share.

(5) Includes options granted by the Company to purchase up to 50,000 shares of
common stock. The options are fully vested and expire February 17, 2000, and are
exercisable at $2.625 per share.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

In December 1994, Charles A. Watson loaned $49,900 to the Company at no interest
as earnest monies for the potential acquisition of real property located in San
Diego, California. The transaction contemplated involves the acquisition,
remediation of petrochemical contamination, and resale of a small strip shopping
center. The real property was acquired with debt financing and certain
receivership monies gained upon acquisition of the property. The loan of $49,900
was repaid by the Company.

In November 1996, Charles A. Watson agreed to loan the Company $200,000 at an
annual interest rate of 10.25% for a period of 120 days. In November and
December 1996 $165,000 was drawn from this commitment. The loan is secured by
the Company's stock in Watson Value Assets LLC which was formed in October 1996.

ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

(A)      EXHIBITS

         3.1 Certificate of Amendment of Articles of Incorporation dated
         February 14, 1991 is incorporated herein by reference to Form 10-K for
         fiscal year 1991.

         3.2 The Articles of Incorporation and bylaws are incorporated herein by
         reference to Form 10-Q for the quarter ended March 31, 1989.

         Material contracts:

         10.1 The non-statutory stock option agreement between the Company and
                  Ronald G. Crane is an informal plan adopted by the Board of
                  Directors in July 1992. A description of this plan is
                  incorporated herein by reference to the information contained
                  in Item 11 of this report.

                                       13
<PAGE>   14
         10.2 Watson General Corporation Retirement Plan is incorporated herein
                  by reference to the Company's Form 10-K for fiscal year 1992.

         10.3 Modified stock option agreement dated January 4, 1994 between the
                  Company, on the one hand, and Ronald G. Crane, Joseph L.
                  Christoffel, and William R. Kughn on the other hand is
                  incorporated herein by reference to the Company's Form
                  10-KSB/A2 for fiscal year 1993.

         10.4 Stock option agreement dated June 28, 1993 between the Company and
                  James M. Smathers is incorporated herein by reference to the
                  Company's Form 10-KSB/A2 for fiscal year 1993.

         10.5 Stock option agreement dated February 16 , 1995 between the
                  Company and Dennis Mulligan is incorporated herein by
                  reference to the Company's Form 10-KSB for fiscal year 1995.

         10.6 Stock purchase agreement dated January 30 , 1996 between the
                  Company and the Shareholders of EnviroQuest Technologies, Ltd.
                  is incorporated herein by reference to the Company's Current
                  Form 8-K filed on February 13, 1996.

         10.6 Settlement agreement and release agreement dated April 5 , 1996
                  between the Company and Frances Marencik a former shareholder
                  of EnviroQuest Technologies, Ltd. is incorporated herein by
                  reference to the Company's Current Form 8-K/A filed on April
                  15, 1996.

         10.7 Settlement agreement and release agreement dated July 29 , 1996
                  between the Company and John Marencik a former shareholder of
                  EnviroQuest Technologies, Ltd. is incorporated herein by
                  reference to the Company's Current Form 8-K filed on August
                  12, 1996.

         21   Subsidiaries of Registrant
              A-Accurate Moving, Inc.             California   Idle Corporation
              EnvirAlert, Inc.                    Delaware

              Toxguard Fluid Technologies, Inc.   California

              Three Generations Moving, Inc.      California   Idle Corporation
              Toxguard Systems, Inc.              Nevada
              Watson Systems, Inc.                Missouri
              Watson Value Assets, LLC            California

         23   Consent of Independent Auditors

         27   Financial Data Schedule

                                       14
<PAGE>   15
(B)               DURING THE REGISTRANT'S FISCAL QUARTER ENDED SEPTEMBER 30,
                  1996, THE REGISTRANT FILED THE FOLLOWING CURRENT REPORTS ON
                  FORM 8-K:

<TABLE>
         <S>      <C>                                                 <C>
         8/K      Private Placement of shares                         Filed 1/10/96

         8/K      Acquisition of EnviroQuest Technologies, Ltd.       Filed 2/13//96
                                                                      Amended April 15, 1996
                                                                      Amended May 2, 1996

         8/K      Settlement with Former Shareholder of               Filed 8/12//96
                  EnviroQuest Technologies, Ltd.
</TABLE>

                                       15
<PAGE>   16
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned hereunto duly authorized.

                                       WATSON GENERAL CORPORATION

Date:  December 26, 1996               By  /s/ Ronald G. Crane
                                           -----------------------
                                           Ronald G. Crane
                                           Chief Executive Officer and President

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

<TABLE>
<CAPTION>
SIGNATURE                                         TITLE                         DATE
---------                                         -----                         ----

<S>                                     <C>                                     <C>
/s/ Charles A. Watson                   Chairman of the Board,                  December 26, 1996
-----------------------------           and Director
(Charles A. Watson)


/s/ Ronald G. Crane                     Chief Executive Officer,                December 26, 1996
-----------------------------           President and Director
(Ronald G. Crane)


/s/ Joseph L. Christoffel               Chief Financial Officer (Principal      December 26, 1996
-----------------------------           Financial Officer and Principal
(Joseph L. Christoffel)                 Accounting Officer), Secretary and
                                        Director


/s/ Dennis E. Mulligan                  Director                                December 26, 1996
-----------------------------
(Dennis E. Mulligan)


/s/ Roger H. Sherwood                   Director                                December 26, 1996
-----------------------------
(Roger H. Sherwood)


/s/ James M. Smathers                   Treasurer, and Director                 December 26, 1996
-----------------------------
(James M. Smathers)
</TABLE>

                                       16
<PAGE>   17
                           Watson General Corporation

                        Consolidated Financial Statements

                     Years ended September 30, 1996 and 1995




                                    CONTENTS

Report of Independent Auditors.............................................F-1

Financial Statements

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-6
<PAGE>   18





                         Report of Independent Auditors

Board of Directors and Shareholders
Watson General Corporation

We have audited the accompanying consolidated balance sheets of Watson General
Corporation as of September 30, 1996 and 1995, and the related consolidated
statements of operations, shareholders' equity and cash flows for each of the
two years in the period ended September 30, 1996. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Watson
General Corporation at September 30, 1996 and 1995, and the consolidated results
of its operations and its cash flows for each of the two years in the period
ended September 30, 1996, in conformity with generally accepted accounting
principles.

As discussed in Note 1 to the financial statements, the Company's recurring
losses from operations and working capital deficiency raise substantial doubt 
about its ability to continue as a going concern. Management's plans as to these
matters are also described in Note 1. The 1996 financial statements do not
include any adjustments that might result from the outcome of this uncertainty.

                                                           /s/ Ernst & Young LLP


Orange County, California
December 12, 1996

                                       F-1
<PAGE>   19
                           Watson General Corporation

                           Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                                                     SEPTEMBER 30
                                                                                1996              1995
                                                                            -----------         -----------
<S>                                                                         <C>                 <C>
ASSETS
Current assets:
    Cash and cash equivalents                                               $   240,000         $   393,000
    Restricted cash                                                                  --              73,000
    Accounts receivable (less allowance for doubtful accounts of
       $93,000 in 1996 and $6,000 in 1995) (Note 3)                             670,000             723,000
    Prepaid expense and other current assets                                     93,000             129,000
                                                                            -----------         -----------
Total current assets                                                          1,003,000           1,318,000

Furniture and equipment:
    Machinery and equipment                                                     754,000             392,000
    Computers and equipment                                                     169,000             163,000
    Furniture and fixtures                                                      137,000              99,000
    Automobiles and trucks                                                      160,000             151,000
    Leasehold improvement                                                         5,000                  --
                                                                            -----------         -----------
                                                                              1,225,000             805,000
    Accumulated depreciation                                                    756,000             496,000
                                                                            -----------         -----------
                                                                                469,000             309,000
Property held for sale (less accumulated depreciation of $11,000 in
    1996 and $4,000 in 1995) (Note 4)                                          337,000             303,000

Intangible assets (less accumulated amortization of $272,000 in 1996
    and $103,000 in 1995) (Note 1)                                            2,434,000             386,000

Deposits and other assets                                                            --               5,000
                                                                            -----------         -----------
Total assets                                                                $ 4,243,000         $ 2,321,000
                                                                            ===========         ===========

LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities:
    Note payable (Note 5)                                                   $   105,000         $        --
    Accounts payable                                                            564,000             329,000
    Accrued expenses (Note 1)                                                   346,000             192,000
    Deferred revenue                                                            132,000                  --
    Current portion of long-term debt (Note 5)                                  454,000              66,000
                                                                            -----------         -----------
Total current liabilities                                                     1,601,000             587,000

Long-term debt, less current portion (Note 5)                                   450,000             351,000

Other long-term liabilities                                                      20,000               8,000

Deferred employee benefits (Note 8)                                             435,000             435,000

Commitments and contingencies (Note 8)

Shareholders' equity (Note 7):
    Common stock, no par value:
       Authorized shares - 25,000,000
       Issued and outstanding shares - 10,487,401 in 1996 and
          9,118,019 in 1995                                                   9,100,000           6,737,000
    Additional paid-in capital                                                  653,000             153,000
    Accumulated deficit                                                      (8,016,000)         (5,950,000)
                                                                            -----------         -----------
Total shareholders' equity                                                    1,737,000             940,000
                                                                            -----------         -----------
Total liabilities and shareholders' equity                                  $ 4,243,000         $ 2,321,000
                                                                            ===========         ===========
</TABLE>

See accompanying notes.


                                      F-2
<PAGE>   20
                           Watson General Corporation

                      Consolidated Statements of Operations

<TABLE>
<CAPTION>

                                                        YEAR ENDED SEPTEMBER 30
                                                        1996               1995
                                                    -----------         -----------

<S>                                                 <C>                 <C>
Net sales                                           $ 4,089,000         $ 2,990,000

Cost of sales                                         2,498,000           1,846,000

Selling, general and administrative expenses          3,368,000           2,193,000

Research and development expenses                       185,000                  --
                                                    -----------         -----------
                                                     (1,962,000)         (1,049,000)

Other income (expense):
    Interest expense                                   (134,000)            (79,000)
    Interest income                                      35,000              27,000
                                                    -----------         -----------

Loss before provision for income taxes               (2,061,000)         (1,101,000)

Provision for income taxes                               (5,000)             (5,000)
                                                    -----------         -----------
Net loss                                            $(2,066,000)        $(1,106,000)
                                                    ===========         ===========


Per share amounts:
    Net loss                                        $      (.22)        $      (.13)
                                                    ===========         ===========
</TABLE>

See accompanying notes.


                                      F-3
<PAGE>   21
                           Watson General Corporation

                 Consolidated Statements of Shareholders' Equity

<TABLE>
<CAPTION>
                                                                                                TOTAL
                                                                 ADDITIONAL     ACCUMU-        SHARE-
                                           COMMON STOCK           PAID-IN        LATED        HOLDERS'
                                       SHARES        AMOUNT       CAPITAL       DEFICIT        EQUITY
                                    -----------------------------------------------------------------------

<S>                                  <C>           <C>           <C>          <C>           <C>
Balance at September 30, 1994          7,934,446     $5,354,000    $153,000     $(4,844,000)  $   633,000
    Adjustment of common stock and
       common stock issued to
       settle accounts payable             2,852          8,000           -               -         8,000
    Common stock issued in
       connection with the
       Regulation S offering
       (Note 7)                        1,180,721      1,375,000           -               -     1,375,000
    Net loss                                   -              -           -      (1,106,000)   (1,106,000)
                                    -----------------------------------------------------------------------
Balance at September 30, 1995          9,118,019      6,737,000     153,000      (5,950,000)      940,000
    Common stock issued in exchange
       for shares of Envir-Alert,
       Inc.                               11,095         32,000           -               -        32,000
    Common stock and options issued
       in connection with the
       acquisition of Watson
       System, Inc., net of
       adjustment (Note 2)               184,000        483,000     367,000               -       850,000
    Costs associated with prior
       year Private Placement                  -        (18,000)          -               -       (18,000)
    Common stock and options issued
       in connection with current
       year private placements
       (Note 7)                        1,174,287      1,866,000     133,000               -     1,999,000
    Net loss                                   -              -           -      (2,066,000)   (2,066,000)
                                    -----------------------------------------------------------------------
Balance at September 30, 1996         10,487,401     $9,100,000    $653,000     $(8,016,000)   $1,737,000
                                    =======================================================================
</TABLE>

See accompanying notes.

                                      F-4
<PAGE>   22
                           Watson General Corporation

                      Consolidated Statements of Cash Flows


<TABLE>
<CAPTION>
                                                                          YEAR ENDED SEPTEMBER 30
                                                                           1996              1995
                                                                      --------------------------------

<S>                                                                    <C>                 <C>
OPERATING ACTIVITIES
Net loss                                                               $(2,066,000)        $(1,106,000)
Adjustments to reconcile net loss to net cash used in
    operating activities:
       Depreciation and amortization                                       435,000             133,000
       Deferred revenue                                                    (13,000)                 --
       Common stock issued to settle accounts payable                           --               8,000
       Deferred employee benefits                                               --               1,000
       Net changes in operating assets and liabilities (Note 1)            443,000            (372,000)
                                                                       --------------------------------
Net cash used in operating activities                                   (1,201,000)         (1,336,000)

INVESTING ACTIVITIES
Purchases of furniture and equipment, net                                 (139,000)           (100,000)
Improvements on property held for sale (Note 4)                            (41,000)             (7,000)
Acquisition of Watson System, Inc., net of cash acquired                  (612,000)                 --
                                                                       --------------------------------
Net cash used in investing activities                                     (792,000)           (107,000)

FINANCING ACTIVITIES
Proceeds from issuance of common stock                                   1,866,000           1,375,000
Proceeds from issuance of stock options                                    133,000                  --
Proceeds from issuance of long-term debt                                   337,000             103,000
Principal payments on long-term debt                                      (454,000)            (90,000)
Principal payments on notes payable                                        (24,000)                 --
Prior year private placement costs                                         (18,000)                 --
                                                                       --------------------------------
Net cash provided by financing activities                                1,840,000           1,388,000
                                                                       --------------------------------

Decrease in cash and cash equivalents                                     (153,000)            (55,000)
Cash and cash equivalents at beginning of year                             393,000             448,000
                                                                       --------------------------------
Cash and cash equivalents at end of year                               $   240,000         $   393,000
                                                                       ================================
</TABLE>

See accompanying notes.

                                      F-5
<PAGE>   23
                           Watson General Corporation

                   Notes to Consolidated Financial Statements

                               September 30, 1996

1. ACCOUNTING POLICIES

BUSINESS

Watson General Corporation (the Company) is a holding company with investments
in Watson Systems, Inc. (Note 2), which provides underground storage tank
monitoring and leak detection services using proprietary software; Toxguard
Systems, Inc. (Toxguard), an environmental consulting and construction project
management company; Envir-Alert, Inc. (Envir-Alert), an environmental software
company; and Toxguard Fluid Technologies, Inc., an antifreeze recycling
business. The Company owns 87% of the outstanding preferred stock and 96% of the
outstanding common stock of Toxguard. All other subsidiaries are wholly owned by
the Company.

The Company's consolidated operations in fiscal 1996 and 1995 were concentrated
in a single business segment-environmental service to industry. The Company's
largest customer accounted for approximately 12% of sales in fiscal 1996.

During May 1995, the Company divested its interest in Biopraxis, Inc., a
development stage enterprise formed during 1994 to develop and commercialize
certain worldwide patents related to the removal and prevention of heavy metals
and radioactive contaminants from affected sites, by selling all of its
Biopraxis common stock in exchange for a promissory note in the amount of
$80,000, which is fully reserved.

BASIS OF PRESENTATION

The accompanying financial statements have been prepared assuming that Watson
General Corporation will continue as a going concern. The Company incurred net
losses of $2,066,000 and $1,106,000 for the years ended September 30, 1996 and
1995, respectively. Additionally, the Company's operations have resulted in
negative cash flows of $1,201,000 and $1,336,000 for the years then ended, and,
as discussed in Note 5, the Company's note payable to bank in the amount of
$105,000 is currently in default. These conditions raise substantial doubt about
the Company's ability to continue as a going concern. The Company has
historically relied upon raising additional shareholder capital to fund
operational deficits. Subsequent to September 30, 1996, management has obtained
a $200,000 short-term loan commitment from a shareholder and is seeking equity
financing arrangements and asset sales in amounts sufficient to adequately
finance operations and expansion plans during fiscal 1997. The financial
statements do not include any adjustments to reflect the possible future effects
on the recoverability and classification of assets or the amounts and
classification of liabilities that may result from the outcome of this
uncertainty.

                                      F-6
<PAGE>   24
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



1. ACCOUNTING POLICIES (CONTINUED)

PRINCIPLES OF CONSOLIDATION

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

PROPERTY, FURNITURE AND EQUIPMENT

Furniture and equipment are carried at cost and generally depreciated under the
straight-line method over their estimated useful lives of four to seven years.
Property available for sale is carried at the lower of amortized cost or
estimated net realizable value and consists of an operating retail strip center
located in El Cajon, California (Note 4). Depreciation is provided using the
straight-line method over the building's estimated useful life of 25 years.

LONG-LIVED ASSETS

In March 1995, the FASB issued Statement No. 121, Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, which requires
impairment losses to be recorded on long-lived assets used in operations when
indicators of impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets' carrying amount. 
Long-lived assets include property, furniture and equipment and identifiable
intangible assets including goodwill. Statement 121 also addresses the
accounting for long-lived assets that are expected to be disposed of. The
Company will adopt Statement 121 in the first quarter of fiscal 1997 and, based
on current circumstances, does not believe the effect of adoption will be
material.

INTANGIBLE ASSETS

Intangible assets consist of the following:

<TABLE>
<CAPTION>
                                                       SEPTEMBER 30
                                                  1996              1995
                                               ----------------------------

<S>                                            <C>               <C>
     Goodwill                                  $1,804,000        $  489,000
     Technology                                   900,000                --
     Copyrights and organization costs              2,000                --
                                               ----------------------------
                                                2,706,000           489,000
     Less accumulated amortization                272,000           103,000
                                               ----------------------------
                                               $2,434,000        $  386,000
                                               ============================
</TABLE>

                                      F-7
<PAGE>   25
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



1. ACCOUNTING POLICIES (CONTINUED)

Goodwill is amortized on a straight-line basis over 20 years with the exception
of goodwill related to the Watson Systems, Inc. acquisition which is amortized
over 15 years. Acquired technology is amortized over 8 years, and capitalized
copyrights and organization costs are amortized on a straight-line basis over 5
years. Amortization expense amounted to $169,000 and $28,000 for 1996 and 1995,
respectively.

Annually, at each balance sheet date, the Company evaluates the realizability of
goodwill based upon expectations of undiscounted cash flows and operating income
for each subsidiary having a material goodwill balance. Based upon its most
recent analysis, the Company believes that no material impairment of goodwill
exists at September 30, 1996.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The fair value of the Company's cash, accounts receivable and accounts payable
approximated their carrying amounts due to the relatively short maturity of
these items. The fair value of the Company's bank line-of-credit and long-term
debt approximated their carrying amounts at September 30, 1996, based on rates
currently available to the Company for debt with similar terms and remaining
maturities.

RESEARCH AND DEVELOPMENT

Research and development costs are expensed as incurred.

REVENUE RECOGNITION

Revenues from underground storage tank monitoring and leak detection services
are recognized as services are performed.

Sales include costs incurred and estimated profits on long-term contracts. Such
estimated profits have been computed by applying the various percentages of
completion of the contracts, measured by the ratio of costs incurred to
estimated total costs, to the estimated ultimate profits. Estimated losses are
fully recognized in the year such estimates are determined.

The Company recognizes revenue from sales of software licenses upon delivery of
the software product to a customer. The Company recognizes maintenance revenue
from service contracts over the term of the service agreement.

                                      F-8
<PAGE>   26
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



1. ACCOUNTING POLICIES (CONTINUED)

STOCK BASED COMPENSATION

In October 1995, the FASB issued Statement No. 123 Accounting for Stock-Based
Compensation. The Company will be required to adopt Statement 123 in fiscal
1997. The Company intends to continue to account for stock option grants in
accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees and
to adopt the "disclosure only" alternative available under Statement 123.

PER SHARE INFORMATION

Per share information is based on the weighted average number of common shares
outstanding. Common equivalent shares have not been considered in the loss per
share computations because the effect is antidilutive. Weighted average shares
for computing loss per share were 9,434,000 and 8,370,000 for fiscal 1996 and
1995, respectively.

INCOME TAXES

The Company accounts for income taxes in accordance with Statement of Financial
Accounting Standards (SFAS) No 109, Accounting for Income Taxes. That statement
requires that deferred income taxes are provided based on the estimated future
tax effects of differences between financial statement carrying amounts and the
tax bases of existing assets and liabilities. The statement also requires that
deferred tax assets must be reduced by a valuation allowance if, based on the
weight of available evidence, it is more likely than not that some portion or
all of the deferred tax asset may not be realized.

STATEMENT OF CASH FLOWS

The Company considers highly liquid debt instruments purchased with original
maturities of three months or less to be cash equivalents.

Changes in operating assets and liabilities as shown in the consolidated
statements of cash flows, net of acquired assets and liabilities, are as
follows:

<TABLE>
<CAPTION>
                                                       YEAR ENDED SEPTEMBER 30
                                                        1996              1995
                                                     ---------------------------

<S>                                                  <C>             <C>
     Restricted cash                                 $  73,000       $ (73,000)
     Accounts receivable, net                          158,000        (500,000)
     Prepaid expense and other current assets          102,000         (37,000)
     Deposits and other assets                           5,000          (1,000)
     Accounts payable                                  164,000         120,000
     Accrued expenses                                  (42,000)        111,000
     Other long-term liabilities                       (17,000)          8,000
                                                     ---------------------------
                                                     $ 443,000       $(372,000)
                                                     ===========================
</TABLE>

                                      F-9
<PAGE>   27
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



1. ACCOUNTING POLICIES (CONTINUED)

STATEMENT OF CASH FLOWS (CONTINUED)

The Company paid state franchise taxes of $5,000 and $5,000 and interest of
$91,000 and $79,000 in 1996 and 1995, respectively.

In connection with the acquisition of Watson Systems, Inc. in January 1996 (Note
2), the Company funded the acquisition as follows:

<TABLE>
<S>                                                              <C>
      Fair value of assets acquired                              $2,007,000
      Less:
           Cash acquired                                           (227,000)
           Liabilities assumed                                     (267,000)
           Notes payable issued                                     (51,000)
           Common stock issued                                     (483,000)
           Stock options issued                                    (367,000)
                                                            -------------------
      Cash paid                                               $     612,000
                                                            ===================
</TABLE>

Noncash investing and financing activities during fiscal 1996, in addition to
the noncash portion of the acquisition of Watson Systems, Inc., consists of the
issuance of 11,095 shares of common stock with a value of $32,000 and the
incurrence of a liability for approximately $12,000 for shares to be issued in
fiscal 1997 to acquire a former 8% minority interest in the outstanding common
stock interest in EnvirAlert.

Noncash investing and financing activities during the year ended September 30,
1995 consist of property acquired for debt in the amount of $300,000.

Restricted cash in 1995 represents cash on deposit with an insurance company as
collateral for a contract performance bond, which was refunded in 1996.

USE OF ESTIMATES

The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates. Issues
requiring significant assumptions include estimates of future cash flows used in
the evaluation of the recoverability of goodwill, and estimates made in
establishing the allowance for doubtful accounts.

                                      F-10
<PAGE>   28
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



2. ACQUISITION

On January 30, 1996, the Company acquired all of the outstanding capital stock
of EnviroQuest Technologies, Ltd., a Kansas City, Missouri based developer of
Statistical Inventory Reconciliation software to monitor underground storage
tanks for leak detection as required by federal, state and local regulations.
After acquisition the subsidiary was renamed Watson Systems, Inc. (WSI), and the
Company's previous environmental software activities were combined into WSI.

The adjusted purchase price was $1,740,000, consisting of 184,000 shares of the
Company's common stock valued at $483,000, options to acquire 220,000 shares of
common stock valued at $367,000, $800,000 in cash, $51,000 in promissory notes
and $39,000 of direct acquisition costs. The acquisition has been accounted for
under the purchase method of accounting and, accordingly, the purchase price has
been allocated to the assets acquired and liabilities assumed based on the
estimated fair value at the date of acquisition. This allocation resulted in
$1,270,000 of costs in excess of net assets acquired which has been recorded as
goodwill and is being amortized on a straight-line basis over 15 years.

In accordance with settlement and release agreements entered into by the Company
and the former shareholders of WSI following the acquisition, the number of
common shares of the Company issued in exchange for WSI shares was reduced by
816,000 shares, promissory notes in the amount of $194,000 issued by the Company
were returned and a former owner of WSI resigned as a Director of the Company
and released the Company from its obligation to seek his election to the Board.

WSI's results of operations have been included in the consolidated results of
the Company from February 1, 1996. Proforma unaudited consolidated operating
results of the Company and WSI for the years ended September 30, 1996 and 1995,
assuming the acquisition had been made as of the beginning of each fiscal year
is summarized below:

<TABLE>
<CAPTION>
                                                   SEPTEMBER 30
                                           1996                   1995
                                        -----------------------------------

<S>                                     <C>                    <C>
     Net sales                          $ 4,680,000            $ 5,182,000
     Net loss                            (2,649,000)            (1,290,000)
     Net loss per share                 $      (.28)           $      (.15)
</TABLE>

                                      F-11
<PAGE>   29
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



3. ACCOUNTS RECEIVABLE

Accounts receivable net of allowance for doubtful accounts consists of the
following:

<TABLE>
<CAPTION>
                                                                       SEPTEMBER 30
                                                                   1996            1995
                                                                 ------------------------

<S>                                                              <C>             <C>
     Amounts billed                                              $650,000        $537,000
     Retainages billed                                             18,000          83,000
     Recoverable costs and accrued profit on contracts in
       process - not billed                                         2,000         103,000
                                                                 ------------------------
                                                                 $670,000        $723,000
                                                                 ========================
</TABLE>

Retainages represent amounts withheld from billings by customers or prime
contractors as security for job completion. Amounts recorded are expected to be
collected within one year.

4. PROPERTY HELD FOR SALE

Property available for sale consists of the following:

<TABLE>
<CAPTION>
                                                      SEPTEMBER 30
                                                1996                1995
                                             -----------------------------

<S>                                          <C>                 <C>
     Land                                    $ 142,000           $ 142,000
     Building                                  206,000             165,000
                                             -----------------------------
                                               348,000             307,000
     Accumulated depreciation                  (11,000)             (4,000)
                                             -----------------------------
                                             $ 337,000           $ 303,000
                                             =============================
</TABLE>

In December 1994, the Company purchased a secured adjustable rate loan dated
March 29, 1989 with a face value of $1,400,000 from a major bank. The loan was
secured with a Commercial Deed of Trust, Assignment of Rents, and Security
Agreement for a 12,215 square foot strip shopping mall located in El Cajon,
California. The bank sold the loan to the Company for $300,000. Professional
environmental assessments of the property securing the loan, made on behalf of
the bank, revealed that there was hydrocarbon contamination present.

                                      F-12
<PAGE>   30
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



4. PROPERTY HELD FOR SALE (CONTINUED)

To finance the purchase of the loan, acquisition and foreclosure costs, and in
part pay for additional environmental assessments of the property, the Company:

-     Entered into a loan agreement with a lending institution which paid the
      $300,000 to purchase the note. The loan incurred interest at a rate of 14%
      with interest only payable monthly through maturity at June 23, 1996
      (extended to December 23, 1996 through payment of a fee equal to 2% of the
      outstanding principal balance) and is secured by the purchased note and
      the Company's underlying security interest in the property. The Company
      paid a loan origination fee of $25,600.

-     Borrowed $49,900 interest free from the Mary L. Watson Trust, of which
      Charles A. Watson, a director, is the beneficial owner.

In March 1995, the Company completed foreclosure proceedings and took possession
of the property and a Receiver's account totaling $147,000. At that time, the
Company paid in full the $49,900 interest free note.

The Company completed its own environmental assessment on the property which
indicated that the level of hydrocarbon contamination was significantly less
than previously detected. On January 4, 1996, the Company's management received
a "no further action" letter from the San Diego Department of Environmental
Health which cleared the title to the property from any restrictions on
transferability.

On October 1, 1996, the Company borrowed $375,000 to refinance the original note
payable. This new borrowing is secured by the property, bears interest at 9.75%
adjustable semi-annually, and is payable in monthly installments of $3,557, with
any remaining principal due October 1, 2001.

Also on October 1, 1996, the Company formed a wholly owned limited liability
company (LLC), Watson Value Assets LLC (WVA) into which the property for sale
was transferred for liability purposes. In future years the LLC will be
consolidated with the operations of Company.

                                      F-13
<PAGE>   31
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



4. PROPERTY HELD FOR SALE (CONTINUED)

The Company leases retail space to tenants under non cancellable triple net
lease agreements. During fiscal 1996 the Company recognized rental revenues of
$81,000. At September 30, 1996, future minimum lease payments to be received are
as follows:

             FISCAL YEARS ENDING
                 SEPTEMBER 30                                     AMOUNT
          ---------------------------                      ---------------------

                  1997                                           $  86,000
                  1998                                              82,000
                  1999                                              78,000
                  2000                                              68,000
                  2001                                              39,000
                                                           ---------------------
                                                                  $353,000
                                                           =====================

5. NOTES PAYABLE AND LONG-TERM DEBT

The Company had available a line-of-credit with a bank which permitted
borrowings, based on specified percentages of qualified accounts receivable and
equipment, furniture and fixtures, as defined. At September 30, 1996 borrowings
under this agreement were $105,000, which bear interest at 1.5% over a floating
prime rate with interest payable monthly. Borrowings are collateralized by a
second security interest in the Company's accounts receivable, equipment, and
furniture and fixtures. The line-of-credit expired in July 1996 and is currently
in default.

                                      F-14
<PAGE>   32
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



5. NOTES PAYABLE AND LONG-TERM DEBT (CONTINUED)

Long-term debt consists of the following:

<TABLE>
<CAPTION>
                                                                                            SEPTEMBER 30
                                                                                       1996              1995
                                                                                 ----------------------------------

     <S>                                                                          <C>                   <C>
     Note payable to a lending institution secured by real property, interest
        only payable monthly at a rate of 14% through maturity at June 23,
        1996. The Company extended the loan through December 23, 1996 for a fee
        equal to 2% of the outstanding principal balance (Note 4)
                                                                                     $300,000           $300,000

     Service fleet vehicle loans and other amounts owed, due in monthly
        installments through 1999 at rates ranging from 8.75% to 15.9%,
        collateralized by the related asset
                                                                                       55,000            117,000

     Note payable to bank in monthly installments of $10,750 including interest
        at 1.5% over the corporate base rate (10.5% at September 30, 1996)
        adjusted quarterly, with any remaining unpaid principal due November
        2000, collaterized by a security interest in accounts receivable and
        certain property and equipment of the Company
                                                                                      447,000                 --

     Guarantor of note payable to bank in monthly installments of $3,259
        including interest at 10.5%, with any remaining
        principal due November 1997                                                    43,000                 --

     Unsecured notes payable to former employees and officers of an acquired
        subsidiary. The notes are non-interest bearing with various maturities
        through January 30, 1998
                                                                                       51,000                 --

     Unsecured note payable to a former officer and stockholder in monthly
        installments of $226, including interest at 6.5%, maturing December
        2000
                                                                                        8,000                 --
                                                                                 ----------------------------------
                                                                                      904,000            417,000
     Less current portion                                                             454,000             66,000
                                                                                 ----------------------------------
     Long-term portion                                                               $450,000           $351,000
                                                                                 ==================================
</TABLE>

                                      F-15
<PAGE>   33
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



5. NOTES PAYABLE AND LONG-TERM DEBT (CONTINUED)

The note payable to a lending institution is guaranteed by the Small Business
Administration under a loan agreement which permits borrowings up to $500,000.
The note payable is personally guaranteed by two former owners of WSI. The note
contains certain restrictions which, among other things, limit the amount of
salaries, bonuses and dividends payable to officers and directors of the
Company.

Principal payments on long-term debt are as follows:

             FISCAL YEARS ENDING
                 SEPTEMBER 30                                     AMOUNT
          ---------------------------                      ---------------------

                    1997                                         $454,000
                    1998                                          164,000
                    1999                                          127,000
                    2000                                          108,000
                    2001                                           51,000
                                                           ---------------------
                                                                  $904,000
                                                           =====================

6. INCOME TAXES

The provision for income taxes consists of the following:

                                              YEAR ENDED SEPTEMBER 30
                                              1996              1995
                                        ------------------------------------
      Current:
         Federal                             $       -       $      -
         State                                  (5,000)        (5,000)
                                        ====================================
      Total                                    $(5,000)       $(5,000)
                                        ====================================

                                      F-16
<PAGE>   34
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



6. INCOME TAXES (CONTINUED)

A reconciliation of taxes computed at the statutory federal income tax rate to
income tax expense is as follows:

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

<S>                                                             <C>               <C>
     Benefit from loss before provision for income taxes
        computed at statutory rate                              $ 642,000         $ 376,000
     Losses without tax benefit                                  (642,000)         (376,000)
     California franchise tax                                      (5,000)           (5,000)
                                                                ----------------------------
                                                                $  (5,000)        $  (5,000)
                                                                ============================
</TABLE>

At September 30, 1996, the Company has net operating loss carryforwards for
federal income tax purposes of approximately $7,300,000 which begin to expire in
fiscal year 2007. In addition, the Company has net operating loss carryforwards
for California income tax purposes of approximately $4,000,000 which begin to
expire in fiscal year 1998.

Pursuant to the Tax Reform Act of 1986, use of the Company's net operating loss
carryforwards may be substantially limited if a cumulative change in ownership
of more than 50% occurs within a three-year period.

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities as of September 30, 1996 and
1995 are as follows:

<TABLE>
<CAPTION>
                                                        1996               1995
                                                    -------------------------------
<S>                                                 <C>                 <C>
     Deferred tax assets:
        Operating loss carryforwards                $ 2,864,000         $ 1,949,000
        Accrued expenses                                 60,000              16,000
                                                    -------------------------------
     Total deferred tax assets                        2,924,000           1,965,000

     Valuation allowance                             (2,532,000)         (1,944,000)
                                                    -------------------------------
                                                        392,000              21,000

     Deferred tax liabilities:
        Amortization of purchased technology           (357,000)                 --
        Tax over book depreciation                      (35,000)            (21,000)
                                                    -------------------------------
     Net deferred tax assets                        $        --         $        --
                                                    ===============================
</TABLE>

                                      F-17
<PAGE>   35
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



6. INCOME TAXES (CONTINUED)

A valuation reserve of $2,532,000 has been established due to uncertainty as to
the realizability of the Company's net deferred tax assets and liabilities. The
change in the valuation allowance for 1996 and 1995 is approximately $588,000
and $398,000, respectively.

7. STOCKHOLDERS' EQUITY

SALES OF COMMON STOCK

During fiscal 1995, the Company completed the sale of 1,000,000 shares of common
stock to foreign investors pursuant to Regulation S of the Securities Act of
1933, as amended. Proceeds from this issuance were $1,375,000, net of issuance
costs of $296,000. The stock issuance agreement contained valuation clauses
forcing the delivery of additional shares of common stock, at no cost to the
investor, if the per unit common stock market price at a specified valuation
date fell below predetermined prices. Based on these provisions, the Company
delivered an additional 180,721 shares of common stock at no cost to the
investor.

During fiscal 1996, the Company completed three private placement offerings in
which a total of 1,174,287 shares of common stock were issued to investors in
exchange for $1,880,000. The shares issued have not been registered under the
Securities Act of 1933, as amended (the Act), as they are exempt under
Regulation D promulgated by the Securities and Exchange Commission under the
Act.

WARRANTS

During 1993, the Company completed a private placement offering of 177,380 units
at $6.00 per unit. Each unit consisted of four shares of common stock and a
warrant to purchase one share of common stock. As of September 30, 1996, 29,500
shares had been issued on warrants exercised. The warrants, of which 147,880
remain outstanding, have an exercise price of $3.50 per share and originally
expired on December 31, 1995, however, on December 12, 1995 the Board of
Directors extended the expiration date through December 31, 1997.

                                      F-18
<PAGE>   36
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



7. STOCKHOLDERS' EQUITY (CONTINUED)

WARRANTS (CONTINUED)

In connection with the fiscal 1995 private placement, the Company issued a
warrant to the selling agent for the purchase of 50,000 units, identical to
those sold in the private placement, at $6.00 per unit, exercisable through
March 16, 1998. On February 6, 1996 35,000 additional warrants were issued at
the same price per unit which are exercisable immediately and expire on February
6, 2001. All warrants issued to the selling agent remain outstanding at
September 30, 1996.

The Company issued warrants for 100,000 shares exercisable at $1.62 per share
through August 1999 in connection with the fiscal 1996 private placements of the
Company's common stock.

STOCK OPTIONS

On September 1, 1992, the Company granted to a key employee nonstatutory options
to purchase 400,000 shares of common stock at an exercise price of $1.50 per
share. These options were exercisable immediately and expire on September 30,
1998.

During 1993, the Company granted nonqualified options for the purchase of
1,083,250 shares to employees and directors at exercise prices equal to the
market price of common shares on the date of grant. As of September 30, 1996,
options for the purchase of 4,732 shares have been exercised and the remaining
options are exercisable. Options granted expire at various dates through 2000.

During 1994, the Company granted nonqualified options for the purchase of 3,000
shares to employees at exercise prices equal to the market price of common
shares on the date of grant. As of September 30, 1996, the options are
immediately exercisable and expire at various dates through 1999.

During 1995, the Company granted nonqualified options for the purchase of 52,000
shares to employees and directors at exercise prices equal to the market price
of common shares on the date of grant. As of September 30, 1996, the options are
immediately exercisable and expire at various dates through 2000.

On March 30, 1995, the Company granted nonqualified options for the purchase of
10,000 shares to a vendor at an exercise price equal to the market price of
common shares on the date of grant. These options for 10,000 shares are
immediately exercisable and expire on March 30, 2000. At September 30, 1996 none
of these options had been exercised.

                                      F-19
<PAGE>   37
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



7. STOCKHOLDERS' EQUITY (CONTINUED)

STOCK OPTIONS (CONTINUED)

On January 30, 1996, in connection with the acquisition of WSI the Company
granted nonqualified options for the purchase of 220,000 shares at an exercise
price of $2.50. As of September 30, 1996 the options are immediately exercisable
and expire at various dates through January 30, 2001. At September 30, 1996 none
of these options had been exercised.

On February 5, 1996, in connection with a private placement, the Company granted
nonqualified options for the purchase of 285,715 shares at an exercise price of
$1.75 per share. The options are immediately exercisable and expire on November
8, 1996. At September 30, 1996 none of these options had been exercised.

On July 16, 1996, the Company granted nonqualified options to purchase 5,000
shares to an employee at an exercise price of $1.63. These options are
immediately exercisable and expire on July 16, 2001. At September 30, 1996 none
of these options had been exercised.

The following table summarizes stock option activity for the two years ended
September 30, 1996.

<TABLE>
<CAPTION>
                                                                          NUMBER OF          PRICE
                                                                           SHARES           PER SHARE
                                                                     --------------------------------------

<S>                                                                  <C>                 <C>
      Outstanding and exercisable on September 30, 1994                    1,481,518     $1.00 to $5.00
         Granted                                                              62,000     $1.88 to $2.63
         Exercised                                                                 -            -
         Expired or forfeited                                                      -            -
                                                                     --------------------------------------
      Outstanding and exercisable on September 30, 1995                    1,543,518     $1.00 to $5.00
         Granted                                                             453,715     $1.63 to $1.75
         Exercised                                                                 -            -
         Expired or forfeited                                                 (1,000)         $1.50
                                                                     --------------------------------------
      Outstanding and exercisable on September 30, 1996                    1,996,233     $1.00 to $5.00
                                                                     ======================================
</TABLE>

                                      F-20
<PAGE>   38
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



8. COMMITMENTS AND CONTINGENCIES

DEFERRED EMPLOYEE BENEFIT AGREEMENT

In July 1991, the Company entered into a deferred compensation agreement with
the President and Chairman. The benefits as defined under the agreement require
the Company to pay $2,700 per month with such payments continuing throughout the
President's lifetime with a minimum ten year guaranteed payment. Upon his death,
benefits may continue to his beneficiaries as defined under the agreement.
Monthly payments will be adjusted on an annual basis based on the Department of
Labor Consumer Price Index. As of the effective date of the agreement, the
benefits are fully vested.

DEVELOPMENT AND LICENSE AGREEMENT

On July 30, 1996, the Company entered into a development and license agreement
(agreement) with Alert Technologies (Alert) to assist the Company in the
completion of the development of a wall mounted console and certain sensors (the
System). The Company has paid approximately $227,000 through September 30, 1996
towards the development. The Company will reimburse Alert for expenses incurred
by Alert in connection with its obligations, not to exceed $90,000. At September
30, 1996, the Company has recorded approximately $80,000 as an accrued liability
to Alert.

Upon completion of service and in consideration for Alert's performance, Alert
shall be entitled to cash royalties from the sale of the Systems equal to 10% of
the gross profits of such sales to be paid within 60 days after the end of each
fiscal quarter of the Company. Once the Company has received gross profits in an
amount equal to all costs and expenses paid to Alert, Alert shall receive a
royalty payable in shares of the Company's common stock, equal to 20% of the
gross profits from such sales, not to exceed 100,000 shares. These shares are
agreed to be held for investment purposes, and not for resale or distribution,
and will be issued at a 15% discount from the average bid price of the Company's
common stock during the last ten days of such fiscal quarter. Alert will then
transfer one half of the shares issued to Alltank, LLC (Alltank) .

As a result of the above agreement, Alltank is the sole owner of the System, of
which the Company has an exclusive license for a ten year term. In turn, the
Company has granted a ten year non-exclusive license to Alert to utilize the
technology of the System at a license fee of $1 per year. Any enhancements made
to the System by Alert must be approved by Alltank and the Company, and will not
modify the existing ownership and licensing agreements.

                                      F-21
<PAGE>   39
                           Watson General Corporation

             Notes to Consolidated Financial Statements (continued)



8. COMMITMENTS AND CONTINGENCIES (CONTINUED)

LEASES

The Company leases its facilities and certain equipment under noncancelable
operating leases with future minimum payments as follows:


<TABLE>
<CAPTION>
                                                    September 30
                                                 -------------------

<S>                                             <C>
                  1997                                    90,000
                  1998                                    34,000
                  1999                                     3,000
                                                 -------------------
                                                         127,000
                                                 ===================
</TABLE>

Rent expense totaled $94,000 and $75,000 for the years ended September 30, 1996
and 1995, respectively.

LITIGATION

The Company and its subsidiaries are involved in various claims and lawsuits
arising in the ordinary course of business. It is management's opinion that the
outcome of these actions will not have a material effect on the consolidated
financial statements of the Company and its subsidiaries.

                                      F-22