<PAGE>   1

EXHIBIT 13
1996 ANNUAL REPORT TO SHAREHOLDERS
(PORTIONS INCORPORATED BY REFERENCE)


                             SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                           -----------------------------------------------------------------
                                               1996          1995          1994          1993          1992
                                           ---------       -------      --------       -------      --------
                                                          (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                        <C>             <C>          <C>            <C>          <C>
STATEMENT OF INCOME DATA:
Net sales ...........................      $  42,162       $34,639      $ 32,882       $26,378      $ 21,846
Cost of sales .......................         17,621        14,259        14,533         9,731         8,989
Selling expense .....................          6,357         4,913         4,390         3,654         2,871
General and administrative expense ..          8,908         8,171         8,485         8,738         7,329
Research and development expense ....          4,216         3,326         2,394         1,273           207
Unusual item (1) ....................          6,600
Other (income) expense, net .........           (494)        1,130           440           156           199
                                           ---------       -------      --------       -------      --------
Income (loss) before income taxes ...         (1,046)        2,840         2,640         2,826         2,251
Provision for income taxes ..........          2,102            39          --            --            --
Equity income (loss) (b) ............           --             444          (444)         --            --
                                           ---------       -------      --------       -------      --------
Net income (loss) ...................      $  (3,148)      $ 3,245      $  2,196       $ 2,826         2,251
                                           =========       =======      ========       =======      ========
PRO FORMA DATA (UNAUDITED)(2):
Pro forma earnings (loss) per share .      $   (0.23)
Pro forma weighted average shares....         13,440
Pro forma income taxes ..............                      $ 1,129      $  1,118       $ 1,125      $    878
Pro forma net income ................                        2,116         1,078         1,701         1,373
Pro forma earnings per common share .                      $  0.18
Pro forma weighted average common
  shares ............................                       11,918
BALANCE SHEET DATA (AT PERIOD END)
Working capital .....................      $  35,755       $12,374      $ (1,181)      $   601      $   (549)
Property and equipment, net .........         19,216        10,904        10,782         9,121         8,477
Total assets ........................        104,478        39,156        22,402        18,443        14,179
Long-term debt, less current
  maturities ........................          6,671         3,379         2,738         3,273         3,526
Total stockholders' equity(3) .......         63,995        21,990         5,856         5,549         3,649
</TABLE>

----------

(1)    In connection with the acquisition of L.A.B., the Company recognized an
       unusual item representing the write-off of certain in-process research
       and development costs with an appraised value of approximately $6.6
       million as of December 31, 1996.
(2)    Pro forma information is presented prior to 1996 to reflect pro forma
       provisions for income taxes for the periods prior to November 17, 1995,
       when the Company was treated as an S corporation for income tax purposes.
(3)    The Company completed an initial public offering of its common stock on
       September 25, 1996.


                        APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES  13

<PAGE>   2

           MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                            AND RESULTS OF OPERATIONS


OVERVIEW

       The Company derives its revenue primarily from performing contract
product development and support services for the pharmaceutical and
biotechnology industries, including chemical analysis, synthesis and other
laboratory services; drug formulation development; clinical supply and niche
manufacturing; and regulatory and compliance consulting. In general, the Company
provides services to a client under an estimate that establishes the anticipated
price and scope of a project, although estimates may be adjusted during the term
of the project. The terms of the Company's engagements vary, ranging from less
than one month to several years, and generally may be terminated upon notice of
30 days or less by the client.

       In addition to its core fee-for-service business, the Company has
allocated a growing proportion of its technical resources and operating capacity
to its internal drug and drug technology development projects. These projects
are either internally funded or shared-risk projects with development partners.
The Company has applied a portion of the net proceeds from its issuance of
convertible preferred stock in 1995 and a portion of the net proceeds
from its initial public offering of common stock in 1996 to expand its capacity
to enable growth in its internal development program, as well as its core
fee-for-service business. Internal development projects are undertaken to
develop targeted drugs and proprietary drug technologies with the intention of
licensing the marketing rights to third parties. The Company has also entered
into selective shared-risk development projects, reducing its fees for
development services in return for license fees, typically paid upon performance
of certain milestones, and royalties based on a percentage of product sales or
profit. Substantially all of the Company's research and development expenses are
the result of internal development and shared-risk projects.

       The Company has only recently begun to recognize license revenue from its
internal development efforts due to the significant time required for
development and approval of pharmaceutical products. Historically, as the
Company expanded its internal development program, less capacity was available
for fee-for-service work to generate more immediate revenue. The Company
anticipates that licensing revenue, including royalties, from internal drug and
technology development will represent a larger proportion of its revenue,
although there can be no assurance that internal development projects will yield
products that will be approved by the appropriate regulatory authorities or will
be attractive to potential clients. The Company believes that the profit margins
from internal drug and technology development potentially exceed the margins on
its standard core fee-for-service engagements.

       On December 31, 1996, the Company acquired all of the outstanding equity
in L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co. ("L.A.B."),
a European contract research and development organization headquartered in
Neu-Ulm, Germany with operational units in Neu-Ulm, Stuttgart and Munich,
Germany as well as in France, Netherlands, England and Hungary. L.A.B. focuses
on both clinical and non-clinical pharmaceutical product development and
provides services that include drug formulation development; chemical analysis;
Phase I clinical studies; bioanalytical testing; and European regulatory
consulting. The firm also provides controlled Phase II-A studies and
multi-center trials focused in niche therapeutic areas including hepatic
disease, chemotherapeutics, and hormone replacement therapy. The acquisition of
L.A.B. significantly expands the Company's bioanalytical capabilities and allows
the Company to offer multi-center clinical testing services.

       In 1994, the Company and private investors organized Endeavor to fund the
development of generic hormone pharmaceutical products, which initially focused
on certain products then under development by the Company. The Company owns
approximately 40% of the fully diluted common equity of Endeavor and continues
the development of these products under agreements with Endeavor. The Company's
net sales to Endeavor were approximately $6.2 million, $3.5 million and $2.0
million in 1996, 1995 and 1994, respectively. The Company also provides
development services to Aesgen, an affiliate, and recognized net sales to
Aesgen of $4.7 million and $5.6 million in 1996 and 1995, respectively.

       The Company accounts for its investment in Endeavor under the equity
method which limits the recognition of losses to the amount invested or
committed for investment and financial support. The Company acquired its equity
interest in Endeavor in return for its contribution of existing formulations and
technology developed by the Company that had been fully expensed. Other
investors' cash contribution to Endeavor created a gain for AAI that was
deferred. In connection with its investment, the Company extended a $1.5 million
revolving credit facility to Endeavor. Because of this financial support
commitment under the credit facility, the Company recognized a liability during
1994 and the first three quarters of 1995 equal to its proportionate share of
Endeavor's operating losses, net of amortization of the deferred gain on the
original investment. Such amounts were reported as equity loss. In connection
with a cash investment in Endeavor by new investors in November 1995, loans
under this facility were repaid during the fourth quarter of 1995, and the
Company's obligation to make further loans was terminated. As a result of the
termination of the Company's obligation to make further loans to Endeavor under
the credit facility, the previously recorded liability was reversed in the
fourth quarter of 1995 and was reported as equity income.


14  APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES

<PAGE>   3

       Effective November 17, 1995, upon the issuance of the convertible
preferred stock the Company ceased to be treated as an S corporation for federal
and state income tax purposes, which had allowed all taxable income and expenses
to pass directly to the stockholders. Accordingly, the Company began to account
for income taxes.

       This Prospectus contains certain forward-looking statements that involve
risks and uncertainties. The Company's actual results may differ significantly
from the results discussed in those forward-looking statements. Factors that
might cause such differences include, but are not limited to, the Company's
dependence on and effect of government regulation; its management of growth and
acquisition risks; the level of outsourcing of research, development and testing
activities in the pharmaceutical and biotechnology industries; its dependence on
key personnel, and its dependence on third-party marketing and distribution of
internally developed drugs.

RESULTS OF OPERATIONS

       1996 COMPARED TO 1995

       Net sales increased $7.5 million, or 22%, to $42.2 million in 1996
compared to 1995. The increase was principally due to the performance of a
greater number of laboratory service projects and increased licensing revenue.
Net sales from the core fee-for-service business increased 20% to $40.6 million
in 1996 from $33.9 million in 1995. Licensing revenues in 1996 increased 103% to
$1.5 million versus $738,000 in 1995.

       Cost of sales increased by $3.4 million, or 24%, to $17.6 million for
1996 compared to 1995. Cost of sales increased slightly as a percentage of net
sales to 41.8% from 41.2%, reflecting the increased resources needed to perform
the greater inflow of work from fee-for-service clients.

       Selling expense increased by $1.4 million, or 29%, to $6.4 million in
1996 compared to 1995. The increase was primarily attributable to the opening of
sales locations in Boston, Massachusetts; San Diego and San Francisco,
California; Copenhagen, Denmark; and London, England, as well as higher
commission expense associated with increased sales.

       General and administrative expense increased by $737,000, or 9%, to $8.9
million in 1996 compared to 1995. The increase in general and administrative
expense is primarily a function of the Company's growth with no significant
change attributable to any specific items. As a percentage of sales, the
Company's general and administrative expense continued its downward trend,
decreasing to 21.1% for 1996 from 23.6% for 1995. Such trend may not continue in
the near term, as management anticipates selected increases in administrative
staffing and information technology spending to support the Company's continued
growth.

       Research and development expense increased by $890,000, or 27%, to $4.2
million in 1996 compared to 1995, and represented 10.0% of net sales for 1996
compared to 9.6% of net sales in 1995. The increase in research and development
expense reflects the Company's decision to allocate an increasing proportion of
its development capabilities to its internal development program. The Company
anticipates that, consistent with its business strategy, investments in research
and development will continue to increase over the next several years.

       In connection with the acquisition of L.A.B. the Company recognized an
unusual item representing the write-off of certain in-process research and
development costs with an appraised value of approximately $6.6 million as of
December 31, 1996.

       Other income (expense), net, which is primarily interest, was income of
$494,000 in 1996 compared to a net expense of $1.1 million in 1995. This change
is primarily due to the reduced borrowing levels during 1996 compared to 1995.
In addition, interest income from marketable securities, purchased with a
portion of the net proceeds of the issuance of the Preferred Stock in late 1995
and the initial public offering in September 1996, offset expense incurred with
respect to the Company's remaining interest-bearing liabilities.

       As a result of the termination of the Company's obligations under the
credit facility to Endeavor during the fourth quarter of 1995, the Company
recognized no activity associated with its investment in Endeavor during 1996,
compared with income of $444,000 in 1995.

       The provision for income taxes for 1996 was $2.1 million compared to
$39,000 in 1995. No income taxes were recognized for most of 1995 because the
Company was treated as an S corporation for federal and state income tax
purposes through November 17, 1995.

       1995 COMPARED TO 1994

       Net sales increased by $1.8 million, or 5%, to $34.6 million in 1995
compared to 1994. The increase in net sales was primarily attributable to a
greater number of fee-for-service projects undertaken by the Company. These
increases were partially offset by a $1.8 million reduction of net sales to a
single customer from the winding down of one project and by the Company's
decision to allocate an increasing proportion of its technical resources and
operating capacity to internal research and development projects.


                        APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES  15

<PAGE>   4

       Cost of sales declined by $274,000, or 2%, to $14.3 million in 1995
compared to 1994. Cost of sales as a percentage of net sales decreased to 41.2%
in 1995 from 44.2% in 1994. This decrease is primarily attributable to the high
level of cost of sales in 1994 associated with increases in professional
staffing in 1994 and with the opening of the Company's Research Triangle Park
facility in 1994.

       Selling expense increased by $523,000, or 12%, to $4.9 million in 1995
compared to 1994. Such increase is primarily the result of the full-year impact
of increases in the sales and marketing personnel implemented in 1994. Selling
expense as a percent of net sales increased to 14.2% in 1995 compared to 13.4%
in 1994 reflecting the delay in productivity as new sales personnel were trained
and established relationships with prospective clients.

       General and administrative expense decreased by $314,000, or 4%, to $8.2
million in 1995 compared to 1994 primarily as a result of reductions in the
level of executive compensation and the departure in 1995 of certain employees
to manage an affiliate. General and administrative expense as a percentage of
net sales continued its downward trend, decreasing to 23.6% in 1995 from 25.8%
in 1994. The Company believes that such trend reflects the compensation
reductions discussed above and the utilization of administrative leverage during
the period, with the expansion of operating facilities requiring no significant
increase in administrative staffing or management information systems.

       Research and development expense increased $932,000, or 39%, to $3.3
million in 1995 compared to 1994. Research and development expense represented
9.6% of net sales in 1995 compared to 7.3% of net sales in 1994. The increase
in research and development expense reflects the Company's decision to allocate
an increasing proportion of its development capabilities to proprietary
products.

       Other expense increased by $690,000 to $1.1 million in 1995 compared to
1994, reflecting higher interest expense from increased borrowing levels during
1995 and a provision of $363,000 established in connection with litigation with
a former employee of the Company.

       Equity income of $444,000 was recognized in 1995 with respect to the
Company's investment in Endeavor, reversing equity losses of $444,000 in 1994,
due to the termination in 1995 of the Company's obligation to provide Endeavor
funding under a credit facility.

LIQUIDITY AND CAPITAL RESOURCES

       The Company has funded its business through operating cash flows,
proceeds from borrowings and the issuance of equity securities in September 1996
and November 1995. During 1996, 1995 and 1994, the Company generated $2.4
million, $3.8 million and $4.9 million, respectively, in cash flow from
operations and raised $44.8 million and $21.5 million in net proceeds in its
1996 and 1995 sales of equity securities, respectively.

       Total capital expenditures were $7.6 million in 1996, $1.7 million in
1995 and $3.1 million in 1994. Capital expenditures were incurred predominantly
in connection with the opening of the Company's Research Triangle Park facility
and with improvements made to existing facilities. The Company anticipates
capital expenditures in 1997 to be approximately $10 million, to be used in part
for the expansion of facilities and the upgrading of certain information
systems.

       Working capital was $35.8 million at December 31, 1996 compared to $12.4
million at December 31, 1995. The increase in working capital is primarily
attributable to the net proceeds from the September 1996 initial public offering
offset by approximately $17.6 million of negative working capital from the
L.A.B. acquisition. The Company has available a $20 million credit facility to
supplement its liquidity needs.

       The Company expects to continue expanding its operations through internal
growth and strategic acquisitions. The Company expects such activities will be
funded from existing cash and cash equivalents, cash flow from operations and
borrowings under its credit facility. The Company believes that such sources of
cash will be sufficient to fund operations for the current and foreseeable
future and to pay existing debt as it becomes due and other capital obligations.
Although the Company has no present acquisition agreements or arrangements there
may be acquisition or other growth opportunities that require additional
external financing, and the Company may from time to time seek to obtain funds
from the public or private issuance of equity or debt securities. There can be
no assurances that such financing will be available on terms acceptable to the
Company.

INFLATION

       The Company believes the effects of inflation generally do not have a
material adverse effect on its results of operations or financial condition.


16  APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES

<PAGE>   5

                        CONSOLIDATED STATEMENT OF INCOME

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                              ---------------------------
                                                               1996      1995      1994
                                                              -------   -------   -------
                                                               (IN THOUSANDS, EXCEPT PER
                                                                      SHARE DATA)
<S>                                                           <C>       <C>       <C>
Net sales (includes related party net sales of $10,916;
  $9,088 and $1,991)........................................  $42,162   $34,639   $32,882
Operating costs and expenses:
  Cost of sales.............................................   17,621    14,259    14,533
  Selling...................................................    6,357     4,913     4,390
  General and administrative................................    8,908     8,171     8,485
  Research and development..................................    4,216     3,326     2,394
  Unusual item..............................................    6,600        --        --
                                                              -------   -------   -------
                                                               43,702    30,669    29,802
                                                              -------   -------   -------
Income (loss) from operations...............................   (1,540)    3,970     3,080
Other income (expense):
  Interest..................................................     (456)   (1,004)     (766)
  Other.....................................................      950      (126)      326
                                                              -------   -------   -------
                                                                  494    (1,130)     (440)
                                                              -------   -------   -------
Income (loss) before income taxes...........................   (1,046)    2,840     2,640
Provision for income taxes..................................    2,102        39        --
Equity income (loss)........................................       --       444      (444)
                                                              -------   -------   -------
Net income (loss)...........................................  $(3,148)  $ 3,245   $ 2,196
                                                              =======   =======   =======
Pro forma data (unaudited):
Pro forma earnings (loss) per share.........................  $ (0.23)
                                                              =======
Pro forma weighted average shares...........................   13,440
                                                              =======
  Net income, as reported...................................            $ 3,245   $ 2,196
  Pro forma income taxes....................................              1,129     1,118
                                                                        -------   -------
  Pro forma net income......................................            $ 2,116   $ 1,078
                                                                        =======   =======
  Pro forma earnings per share..............................            $  0.18
                                                                        =======
  Pro forma weighted average shares.........................             11,918
                                                                        =======
</TABLE>

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


                        APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES  17
<PAGE>   6

                           CONSOLIDATED BALANCE SHEET

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                              ---------------------
                                                                1996         1995
                                                              --------      -------
                                                              (IN THOUSANDS, EXCEPT
                                                                   SHARE DATA)
<S>                                                           <C>           <C>
                                      ASSETS
Current assets:
Cash and cash equivalents...................................  $ 42,186      $13,081
Accounts receivable.........................................    10,033        7,375
Work-in-progress............................................     9,462        4,134
Prepaid and other current assets............................     6,357        1,238
                                                              --------      -------
          Total current assets..............................    68,038       25,828
                                                              --------      -------
Property and equipment, net.................................    19,216       10,904
Goodwill and other intangibles..............................    14,953          576
Other assets................................................     2,271        1,848
                                                              --------      -------
          Total assets......................................  $104,478      $39,156
                                                              ========      =======

                       LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current maturities of long-term debt and short-term debt....  $  2,092      $ 4,726
Accounts payable............................................     8,429        2,311
Customer advances...........................................     7,790        1,677
Accrued wages and benefits..................................     5,127        1,530
Other accrued liabilities...................................     8,845        3,210
                                                              --------      -------
          Total current liabilities.........................    32,283       13,454
                                                              --------      -------
Long-term debt..............................................     6,671        3,379
Other liabilities...........................................     1,529          333
Commitments and contingencies
Stockholders' equity:
  Convertible preferred stock, series A, $.01 par value,
     none -- 1996; 1,000 shares authorized, 883 shares
     outstanding -- 1995....................................        --           --
  Common stock, voting, $.001 par value -- 1996, no
     par -- 1995; 100 million shares authorized, 16,286,236
     outstanding -- 1996; 446,799 shares
     outstanding -- 1995....................................        16          150
  Common stock, Class B, non-voting, $.001 par
     value -- 1996, no par -- 1995, none -- 1996; 9,993,076
     shares outstanding -- 1995.............................        --          171
Paid-in capital.............................................    66,719       21,510
Retained earnings (deficit).................................    (2,591)         308
Stock subscriptions receivable..............................      (149)        (149)
                                                              --------      -------
          Total stockholders' equity........................    63,995       21,990
                                                              --------      -------
          Total liabilities and stockholders' equity........  $104,478      $39,156
                                                              ========      =======
</TABLE>

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


18  APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES

<PAGE>   7

                      CONSOLIDATED STATEMENT OF CASH FLOWS

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                             ------------------------------
                                                               1996       1995       1994
                                                             --------    -------    -------
                                                                     (IN THOUSANDS)
<S>                                                          <C>         <C>        <C>
Cash flows from operating activities:
Net income (loss)..........................................  $ (3,148)   $ 3,245    $ 2,196
Adjustments to reconcile to net cash provided (used) by
  operating activities:
  Depreciation and amortization............................     2,062      1,591      1,515
  Deferred income taxes....................................        25        (16)        --
  Unusual item.............................................     6,600         --         --
  Equity (income) loss.....................................        --       (444)       444
  Other....................................................       110        278         --
  Changes in assets and liabilities:
     Trade and other receivables...........................    (1,073)       380     (1,763)
     Work-in-progress......................................      (969)    (1,827)      (224)
     Prepaid and other assets, net.........................      (494)      (385)       (44)
     Accounts payable......................................       245      1,197        (61)
     Customer advances.....................................      (943)      (509)     1,456
     Other accrued liabilities.............................       (48)       301      1,382
                                                             --------    -------    -------
Net cash provided (used) by operating activities...........     2,367      3,811      4,901
                                                             --------    -------    -------
Cash flows from investing activities:
Purchase of property and equipment.........................    (7,609)    (1,720)    (3,091)
Investment in affiliate....................................        --     (1,593)        --
Acquisition of L.A.B., net of cash acquired................    (2,206)        --         --
Short-term investment......................................    (4,000)        --         --
Other......................................................        31       (249)      (340)
                                                             --------    -------    -------
Net cash used by investing activities......................   (13,784)    (3,562)    (3,431)
                                                             --------    -------    -------
Cash flows from financing activities:
Net proceeds (payments) short-term debt....................    (2,656)      (926)     1,260
Proceeds from long-term borrowings.........................        --      1,505      1,165
Payments on long-term borrowings...........................      (565)      (978)    (1,996)
Payment of stockholder note................................        --     (1,159)        --
Sale of preferred stock....................................        --     21,510         --
Sale of common stock.......................................    44,794         --         --
Dividends..................................................    (1,051)    (7,593)    (1,889)
                                                             --------    -------    -------
Net cash provided (used) by financing activities...........    40,522     12,359     (1,460)
                                                             --------    -------    -------
Net increase in cash and cash equivalents..................    29,105     12,608         10
Cash and cash equivalents, beginning of period.............    13,081        473        463
                                                             --------    -------    -------
Cash and cash equivalents, end of period...................  $ 42,186    $13,081    $   473
                                                             ========    =======    =======
Supplemental information, cash paid for:
  Interest.................................................  $    402    $   938    $   669
  Income taxes.............................................  $  1,945    $   146    $    --
</TABLE>

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


                        APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES  19
<PAGE>   8

                 CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                         COMMON STOCK      CLASS B STOCK
                                        ---------------   ----------------     PAID-IN     RETAINED
                                        SHARES   AMOUNT   SHARES    AMOUNT   CAPITAL (1)   EARNINGS
                                        ------   ------   -------   ------   -----------   --------
                                                              (IN THOUSANDS)
<S>                                     <C>      <C>      <C>       <C>      <C>           <C>
Balance at January 1, 1994............     447   $ 322      9,784   $ 284      $    --     $ 5,026
Sale of stock to officer (2)..........      --      --        103      33           --          --
Dividends.............................      --      --         --      --           --      (1,889)
Net income............................      --      --         --      --           --       2,196
                                        ------   -----    -------   -----      -------     -------
Balance, December 31, 1994............     447   $ 322      9,887   $ 317      $    --     $ 5,333
                                        ------   -----    -------   -----      -------     -------
Sale of stock to officer (2)..........      --      --        106     305           --          --
Sale of preferred stock, Series A,
  (883 shares)........................      --      --         --      --       21,510          --
Dividends.............................      --    (172)        --    (451)          --      (8,270)
Net income............................      --      --         --      --           --       3,245
                                        ------   -----    -------   -----      -------     -------
Balance, December 31, 1995............     447   $ 150      9,993   $ 171      $21,510     $   308
                                        ------   -----    -------   -----      -------     -------
Dividend adjustment...................      --      --         --      --           --         249
Stock award...........................      --      --        105     490         (490)         --
Establish common stock par value of
  $0.001 per share....................      --    (150)        --    (651)         801          --
Sale of common stock..................   3,105       3         --      --       44,791          --
Conversion to common stock:
  Preferred stock (883 shares)........   2,636       3         --      --           (3)         --
  Class B common stock................  10,098      10    (10,098)    (10)          --          --
Stock options exercised...............      --      --         --      --           --          --
Deferred compensation earned..........      --      --         --      --          110          --
Net income (loss).....................      --      --         --      --           --      (3,148)
                                        ------   -----    -------   -----      -------     -------
Balance, December 31, 1996............  16,286   $  16         --   $  --      $66,719     $(2,591)
                                        ======   =====    =======   =====      =======     =======
</TABLE>

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

(1) Paid-in capital includes deferred compensation of $(378) at December 31,
    1996, with no amounts for 1995 and 1994, respectively.
(2) The sale of stock to officer in 1995 and 1994 each increased stock
    subscription receivable by $(33) to $(149) at December 31, 1995 from $(116)
    at December 31, 1994 and $(83) at January 1, 1994.

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


20  APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES
<PAGE>   9

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  SIGNIFICANT ACCOUNTING POLICIES

  Basis of presentation

     The consolidated financial statements include the accounts of Applied
Analytical Industries, Inc. (the "Company" or "AAI") and its wholly-owned
subsidiaries. All material intercompany transactions have been eliminated. The
Company has ownership of approximately 40%, on a fully diluted basis, in
Endeavor Pharmaceuticals Inc. ("Endeavor") which is accounted for under the
equity method.

  Revenue recognition

     Revenues from contract pharmaceutical product development and support
services are recognized on a percentage of completion basis. Work-in-progress
represents revenues recognized prior to contract billing terms. Provisions for
losses on contracts, if any, are recognized when identified.

     Licensing revenues from Company funded development projects are primarily
recognized as significant contract requirements are met. Royalty revenues are
recognized as earned in accordance with contract terms.

  Income taxes

     The financial statements of the Company prior to November 17, 1995 do not
include a provision for income taxes because, under an S corporation election,
all income and loss passed directly to the stockholders. The Company no longer
qualified as an S corporation as a result of the preferred stock issuance in
November 1995. At that time AAI was directly subject to federal and state income
taxes and, accordingly, began accounting for income taxes.

  Unaudited pro forma data

     For information purposes, the Consolidated Statement of Income includes a
pro forma income tax provision for financial reporting purposes using federal
and state tax rates that would have applied if the Company had been directly
subject to income taxes.

  Pro forma earnings per share

     The weighted average shares used in the calculation of pro forma earnings
per share include the effect of the conversion of convertible preferred stock
and Class B common stock as if they were converted at the beginning of the year.
Additionally, common stock or equivalent shares from stock options or awards
sold or issued at prices below $16.00 per share in the twelve months preceding
July 1996 have been included in the calculation as if outstanding as of the
beginning of the year.

  Cash and cash equivalents

     The Company considers all highly liquid debt investments purchased with an
original maturity of three months or less to be cash equivalents.

  Accounts receivable

     Unbilled accounts receivable represent specific invoices that, in keeping
with certain client billing arrangements, are mailed to clients approximately 15
days after the month during which the work was completed.

  Property and equipment

     Property and equipment is recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets.
Depreciable lives are 31.5 years for buildings and improvements and 3 to 15
years for equipment.

  Goodwill, intangibles and other assets

     Goodwill, the excess of the purchase price over the fair value of the net
assets of acquired companies, is amortized over 20 years. Other identifiable
intangible assets are amortized, if applicable, on a straight-line basis over
their estimated useful lives which range from 3 to 17 years.

     The Company has an investment in non-voting, mandatorily redeemable
preferred stock of a related party which is carried at original cost in other
assets. Management monitors this investment for impairment and will write-down
the carrying value below cost for any impairment considered to be other than
temporary.

  Fair value of financial instruments

     The carrying value of cash and cash equivalents, accounts receivable, the
preferred stock investment, current liabilities and long-term debt approximate
fair value. It is not practicable to estimate the fair value of the Company's
equity investment, which is recorded at zero, as no readily determinable market
exists for investments in such entities.

  Use of estimates

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from such
estimates and changes in such estimates may affect amounts reported in future
periods.

  New Accounting Pronouncements

     In 1996, the Company adopted the requirements of two new statements, issued
by the Financial Accounting Standards Board, related to accounting for
impairment of long-lived assets and accounting for stock compensation. The
effect of adoption of these statements has not resulted in a material impact to
the Company's financial position or results of operations.

  Reclassifications

     Certain amounts in prior year financial statements have been reclassified
to conform with the current year presentation.


                        APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES  21
<PAGE>   10

2.  ACQUISITION AND UNUSUAL ITEM

     On December 31, 1996, the Company acquired all the outstanding equity in
L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co. ("L.A.B."), a
European contract research and development organization headquartered in
Neu-Ulm, Germany with operational units in Neu-Ulm, Stuttgart and Munich,
Germany as well as in France, Netherlands, England and Hungary.

     The aggregate purchase price for L.A.B. was approximately $20.9 million,
which includes current and future payments to former equity holders, L.A.B.
debt and other liabilities, and accrued AAI acquisition costs. The acquisition
has been accounted for using the purchase method of accounting. The
consolidated financial statements reflect the allocation of the purchase price
to the fair value of the assets acquired, including goodwill of approximately
$14.4 million. The results of operations for L.A.B. will be included in the
consolidated financial statements of AAI beginning in 1997.

     In connection with the acquisition of L.A.B. the Company recognized an
unusual item representing the write-off of certain in-process research and
development costs with an appraised value of approximately $6.6 million as of
December 31, 1996.

     The following table reflects the unaudited pro forma combined results of
operations of AAI and L.A.B. as if the acquisition had occurred at the beginning
of each period. Such pro forma information is presented for informational
purposes only and is not necessarily indicative of the consolidated results that
would have been achieved had the acquisition been consummated as of that time.

<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                              ------------------------
                                                                1996           1995
                                                              ---------      ---------
                                                               (IN THOUSANDS, EXCEPT
                                                                 PER SHARE AMOUNTS)
                                                                    (UNAUDITED)
<S>                                                           <C>            <C>
Net sales...................................................    $60,385        $57,594
Net income (loss)...........................................    $(8,473)       $   (98)
Earnings (loss) per share...................................    $ (0.63)       $ (0.01)
</TABLE>

     The identifiable assets of the Company as of December 31,1996 were located
in the United States ($82.5 million) and Europe ($22.0 million). Prior to the
acquisition of L.A.B., the Company's assets were predominantly located in the
United States.

3.  INCOME TAXES

     The following table presents the components for the provision for income
taxes.

<TABLE>
<CAPTION>
                                                                YEAR ENDED
                                                               DECEMBER 31,
                                                              --------------
                                                               1996     1995
                                                              ------    ----
                                                              (IN THOUSANDS)
<S>                                                           <C>       <C>
Change in tax status........................................  $   --    $ 31
Current:
  Federal...................................................   1,709      44
  State.....................................................     368      11
                                                              ------    ----
                                                               2,077      55
                                                              ------    ----
Deferred:
  Federal...................................................      18     (38)
  State.....................................................       7      (9)
                                                              ------    ----
                                                                  25     (47)
                                                              ------    ----
                                                              $2,102    $ 39
                                                              ======    ====
</TABLE>

     A table reconciliation of the provision for income taxes to the amount
computed by applying the federal statutory income tax rate is not presented.
Reconciling items are state income taxes for both 1996 and 1995 and the 1996
write-off of in-process research and development costs related to the L.A.B.
acquisition. This unusual item was excluded from taxable income in calculating
the provision for income taxes. This amount will result in the recognition of an
income tax benefit as L.A.B. has taxable income.

     Deferred income taxes arise from temporary differences between the tax
bases of assets and liabilities and their reported amounts in the financial
statements. The following table presents the deferred tax assets and deferred
tax liability.

<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                              -------------   NOVEMBER 17,
                                                              1996    1995        1995
                                                              -----   -----   ------------
                                                                     (IN THOUSANDS)
<S>                                                           <C>     <C>     <C>
Deferred tax assets, resulting from:
  Accrued liabilities.......................................  $ 308   $ 321      $ 227
  Other items...............................................     49      28         41
                                                              -----   -----      -----
                                                                357     349        268
Deferred tax liability, resulting from:
  Property and equipment....................................   (366)   (333)      (299)
                                                              -----   -----      -----
  Net deferred tax (liability) asset........................  $  (9)  $  16      $ (31)
                                                              =====   =====      =====
</TABLE>

     Deferred tax assets of approximately $3.0 million have resulted from the
L.A.B. acquisition; however, a valuation allowance for the total asset amount
has been provided, since realization of such assets can not be predicted with
reasonable certainty.


22  APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES

<PAGE>   11
4.  DEBT

     The following table presents the components of current maturities of
long-term debt and short-term debt.

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              ----------------
                                                               1996      1995
                                                              ------    ------
                                                               (IN THOUSANDS)
<S>                                                           <C>       <C>
Industrial revenue bonds....................................  $1,425    $1,750
Bank debt...................................................      --     2,331
Current maturities of long-term debt........................     667       645
                                                              ------    ------
                                                              $2,092    $4,726
                                                              ======    ======
</TABLE>

     The following table presents the components of long-term debt.

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              ----------------
                                                               1996      1995
                                                              ------    ------
                                                               (IN THOUSANDS)
<S>                                                           <C>       <C>
Bank term loans.............................................  $3,307    $3,867
L.A.B. bank debt............................................   3,879        --
Other.......................................................     152       157
                                                              ------    ------
                                                               7,338     4,024
Less current maturities.....................................    (667)     (645)
                                                              ------    ------
                                                              $6,671    $3,379
                                                              ======    ======
</TABLE>

     The industrial revenue bonds were secured in 1988 to finance the
acquisition and construction of facilities in North Carolina. They have a
variable interest rate which is adjusted annually with a maximum allowable rate
of 15%. The rates at December 31, 1996 and 1995 were 4.45% and 5.45%,
respectively. The bonds are payable in monthly installments of $25,000, plus
interest, through November 2000, and are redeemable at the option of the
bondholders. The Company has entered into an agreement with a bank to pay any
bonds redeemed under a stand-by letter of credit covering the outstanding
principal of the bonds. The Company also has a bond remarketing agreement with
such bank to remarket any bonds presented for early redemption, on a best
efforts basis. These bonds have been classified as short-term debt because of
the early redemption feature.

     The bank term loans represent amounts outstanding under a credit facility
with a bank which expired in November 1996. The loans have variable interest
rates based on the 30-day LIBOR rate plus a margin based on the Company's debt
to equity ratio. The loans are payable in monthly installments including
interest. The average interest rate on these loans was 7.07% and 8.86% for 1996
and 1995, respectively.

     In December 1996, the Company replaced the above credit facility with a new
revolving credit agreement with the same bank through May 1998. The agreement
provides for borrowings of up to $20 million at variable interest rates,
adjusted quarterly. The rates can be based , at the Company's option, on either
the 90-day LIBOR rate or an applicable CD rate. The rates can be reduced or
increased depending on the Company's ratio of total liabilities to tangible net
worth.

     At the end of the revolving credit period any outstanding balances under
this facility convert to a term loan payable in monthly installments, including
interest, through the year 2004. The agreement requires the payment of a nominal
commitment fee based on the unused portion of the line of credit. There were no
amounts outstanding under this agreement at December 31, 1996.

     The Company has classified the L.A.B. bank debt, which is approximately 6
million Deutsche marks, as long-term debt as of December 31, 1996, since it has
the intent and the ability to renew or convert these obligations through 1997
and future periods.

     Under the terms of the revolving credit facility and the stand-by letter of
credit agreement, the Company is required to comply with various covenants
including, but not limited to, those pertaining to working capital, maintenance
of certain financial ratios, and incurring additional indebtedness outside the
agreement. The Company was in compliance with these covenants at December 31,
1996.

     Scheduled maturities of long-term debt as of December 31, 1996 are
$667,000 -- 1997; $2,344,000 -- 1998; $200,000 -- 1999; $4,079,000 -- 2000; and
$48,000 -- 2001.

5.  STOCKHOLDERS' EQUITY

     The authorized capital stock of the Company at December 31, 1996 was 100
million shares of voting common stock, $.001 par value per share, and 5 million
shares of preferred stock, $.001 par value per share. The preferred stock is
issuable in one or more series by the Company's Board of Directors without
further stockholder approval. The Company has reserved 495,293 shares of common
stock for issuance under stock option plans.

     AAI completed an initial public offering of 3,105,000 shares of common
stock, with net proceeds to the Company of approximately $44.8 million, on
September 25, 1996 (the "IPO"). Upon the completion of the IPO the Company's
then outstanding Class B common stock, $.001 par value per share, and Series A
convertible preferred stock, $.001 par value per share ("Series A Preferred"),
converted to a single class of common stock. Prior to the IPO, the Board of
Directors authorized two stock splits for all common stock, on May 31, 1996 a
stock split of 200 to 1 and on June 5, 1996 a reverse split of .6325 to 1,
resulting in a net increase to shares outstanding of 126.5 to 1. All numbers of
common shares and per share amounts in the accompanying financial statements
have been retroactively adjusted to reflect these stock splits.

  Preferred Stock

     On November 17, 1995, the Company issued 883 shares of Series A Preferred
resulting in net proceeds to the Company of approximately $21.5 million. This
stock was mandatorily converted into common stock of AAI upon the IPO. Pursuant
to a Stockholder Agreement among the Company and the holders


                        APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES  23
<PAGE>   12

of the Series A Preferred, certain conditions remain in effect after the IPO
regarding transferability rights and the appointment of one board seat.

  Dividends

     The Company elected to distribute its S corporation retained earnings
concurrent with the change to a C corporation tax status in November 1995. A
portion was paid in 1995 with the remainder paid in 1996 upon filing the final S
corporation tax returns for the period January 1, 1995 to November 17, 1995.

  Stock Option and Award Plans

     In 1996, the Board of Directors awarded 104,696 shares of Class B common
stock to certain employees and officers of the Company. The fair value at the
time of such award is recognized as deferred compensation in paid-in capital and
is being expensed over a two year period.

     The Company has two stock option plans, the 1995 Stock Option Plan ("1995
Plan") and the 1996 Stock Option Plan ("1996 Plan"). Under the 1995 Plan, the
Board of Directors may grant options to purchase up to 242,538 shares of common
stock. However, the Company has no obligation to issue the shares upon exercise
of such options until it has purchased an equal number of shares from certain
existing stockholders. Under the 1996 Plan, the Board of Directors may grant
options to purchase up to 495,627 newly issued shares of common stock. Both
plans require that the exercise price of options cannot be less than 75% of the
estimated fair market value of the Company's shares of common stock on the date
of grant.

     The combined activity from both plans is presented in the following table.

<TABLE>
<CAPTION>
                                                                           WEIGHTED AVERAGE
                                                              SHARES       PRICE PER SHARE
                                                              -------      ----------------
<S>                                                           <C>          <C>
Outstanding, January 1, 1996................................       --
  Granted...................................................  452,658           $8.35
  Exercised.................................................     (334)          $8.35
  Forfeited.................................................   (9,569)          $8.35
                                                              -------
Outstanding, December 31, 1996..............................  442,755           $8.35
                                                              =======
Exercisable, December 31, 1996..............................  110,445           $8.35
                                                              =======
</TABLE>

     The outstanding options have an exercise range of $8.35 to $9.10 per share
with a weighted average remaining life of 9.3 years. The weighted average fair
value at date of grant for options granted during 1996 was $2.20 per option. The
fair value of options at date of grant was estimated using the Black-Scholes
option pricing model with the following weighted average assumptions: expected
life (5 years); interest rate (6.3%); no volatility and no dividend yield.

     The Company applies APB Opinion 25 and related interpretations in
accounting for its stock option plans; therefore, compensation expense has not
been recognized for all options granted. Had compensation cost for the Company's
plans been determined based on the fair value at the grant dates for awards
under those plans consistent with the method of FASB Statement 123, the
Company's net loss and loss per share would have been changed to the pro forma
amounts indicated below for the year ended December 31, 1996.

<TABLE>
<CAPTION>
                                                                               EARNINGS (LOSS)
                                                               NET LOSS           PER SHARE
                                                              -----------      ---------------
<S>                                                           <C>              <C>
As reported.................................................  $(3,148,000)         $(0.23)
Pro forma...................................................  $(3,323,000)         $(0.25)
</TABLE>

6.  RELATED PARTY TRANSACTIONS AND MAJOR CUSTOMERS

  Endeavor

     In April 1994, AAI organized Endeavor with Berlex Laboratories, Inc. and
several other investors to fund the development of hormone pharmaceutical
products, initially focusing on several generic hormone products already under
development by the Company. AAI obtained a 47% equity interest in Endeavor
through the contribution of its accumulated product research and development and
technical know-how. The other investors contributed cash in exchange for their
interests which, for all investors, was in the form of convertible preferred
stock. Based on a subsequent cash infusion by a new investor in November 1995,
the Company's interest in Endeavor was diluted to approximately 40%, on a fully
diluted basis.

     The Company's initial investment in Endeavor was recorded at zero. The gain
for its share of the cash contributed by the other investors was deferred over
the period the proceeds from such equity were expended by Endeavor. Due to a
commitment to provide financial support under a line of credit, AAI recognized a
liability for its proportionate share of Endeavor's losses, net of amortization
of the deferred gain, in 1994 and part of 1995. As a result of the November 1995
cash infusion from a third party, the Company was repaid all amounts outstanding
under the line of credit and terminated its obligation to provide any further
funding under such line of credit. Since AAI had no requirement to provide any
additional funding to Endeavor, the previously recorded liability was reversed
in the fourth quarter of 1995. During 1996, the remaining deferred gain offset
the Company's unrecorded share of Endeavor's net loss.

     The Company had net sales to Endeavor for product development services of
approximately $6.2 million (15% of AAI net sales), $3.5 million (10% of AAI net
sales) and $2.0 million for the years ended December 31, 1996, 1995, and 1994,
respectively. These services are provided on terms and conditions management
believes are comparable to those afforded unrelated entities. Additionally, AAI
had approximately $967,000 and $21,000 in accounts receivable and approximately
$372,000 and $948,000 in work-in-progress related to Endeavor at December 31,
1996 and 1995, respectively.

     The Company has agreed, upon the completion of a specified development
milestone, to grant Endeavor an option to lease certain production space
intended for use by AAI in


24  APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES

<PAGE>   13

manufacturing Endeavor's products or to purchase that part of the facility.
Upon exercise of the option to lease, Endeavor would be required to pay $2
million to the Company and may purchase that portion of the facility at its
fair market value. If the option is exercised but AAI fails to perform certain
development milestones by a specified date, AAI must repay the option exercise
price to Endeavor. The facilities subject to the option are currently used by
the Company for its clinical supply and niche manufacturing operations.

     The Company is expanding its clinical supply and niche manufacturing
facilities to maintain necessary capacity in the event Endeavor exercises its
option. The Company has also agreed to permit Endeavor under certain
circumstances the first right to purchase additional proprietary hormone
pharmaceutical products developed by AAI.

     The following tables present certain summary financial data for Endeavor.

<TABLE>
<CAPTION>
                                                                     DECEMBER 31,
                                                              ---------------------------
                                                               1996      1995      1994
                                                              -------   -------   -------
                                                                    (IN THOUSANDS)
<S>                                                           <C>       <C>       <C>
Current assets..............................................  $ 1,330   $ 7,878   $ 1,525
Noncurrent assets...........................................      176       301       351
Current liabilities.........................................     (726)   (1,149)     (532)
Noncurrent liabilities......................................   (3,458)   (3,176)       --
                                                              -------   -------   -------
Stockholders' equity........................................  $(2,678)  $ 3,854   $ 1,344
                                                              =======   =======   =======
</TABLE>

<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                              ---------------------------
                                                               1996      1995      1994
                                                              -------   -------   -------
                                                                    (IN THOUSANDS)
<S>                                                           <C>       <C>       <C>
Net revenues................................................  $ 1,333   $   250   $   250
Net loss....................................................  $(6,532)  $(4,217)  $(2,767)
Excess of AAI's equity (deficit) in net assets over carrying
  value.....................................................  $(1,152)  $ 1,652   $ 1,076
</TABLE>

  Aesgen, Inc.

     Aesgen, Inc. ("Aesgen") was formally organized with an affiliate of the
Mayo Clinic and MOVA Pharmaceutical Corporation and funded in April 1995 via
issuance of approximately $11 million of nonconvertible, non-voting, mandatorily
redeemable, preferred stock. The Company made a cash investment of $1.6 million
in such preferred stock, which is carried at cost, and is included in other
noncurrent assets on the balance sheet. As the Company did not intend to hold an
equity interest in Aesgen, the Company entered a series of related transactions
commencing in December 1995 to transfer to a corporation owned by the holders,
at that time, of substantially all of the outstanding capital stock of the
Company, all of its shares of Aesgen common stock in return for $50,000 (amount
paid by AAI for such shares) and such corporation's assumption of an obligation
to invest an additional $1.2 million in Aesgen.

     The Company provides product development services to Aesgen at terms and
conditions that management believes are similar to those afforded unrelated
entities. In 1996, the Company sold to Aesgen marketing rights to a product
under development by the Company. Under the agreement, Aesgen paid a license fee
and will pay additional royalties upon marketing the product. AAI recognized net
sales of approximately $4.7 million (11% of AAI net sales) and $5.6 million (16%
of AAI net sales) from Aesgen for the years ended December 31, 1996 and 1995,
respectively. AAI also had accounts receivable of approximately $352,000 and
$51,000 from Aesgen and work-in-process balances of approximately $345,000 and
$1.0 million at December 31, 1996 and 1995, respectively. AAI has the right
under its development agreement with Aesgen to provide certain product
development and support services to Aesgen with respect to some generic drugs
currently being developed by Aesgen, provided that AAI's fees for such services
are comparable to those of a competitor. In addition, under such development
agreement, the Company has agreed not to develop, for its own account or any
other person, a formulation of any of the generic products currently under
development for Aesgen and any additional drugs that AAI agrees to develop in
the future for Aesgen under the development agreement.

  Pharmaceutical Seminars, Inc.

     The Company purchased certain assets of Pharmaceutical Seminars, Inc.
("PSI") in 1994 and 1995 for a total of $374,000. PSI organized seminars
addressing various pharmaceutical industry topics and was wholly-owned by the
spouses of two of the Company's officers and directors.

  Other Major Customer

     The Company had one unrelated customer which accounted for 12% and 19% of
net sales for the years ended December 31, 1995 and 1994, respectively. Due to
the nature of the Company's business, major customers may vary from year to
year.

7.  SUPPLEMENTAL BALANCE SHEET INFORMATION

     The following table presents the components of accounts receivable.

<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              ----------------
                                                               1996      1995
                                                              -------   ------
                                                               (IN THOUSANDS)
<S>                                                           <C>       <C>
Trade and other:
  Billed....................................................  $ 7,235   $5,905
  Unbilled..................................................    1,552    1,467
Related parties.............................................    1,319       73
                                                              -------   ------
                                                               10,106    7,445
Allowance for doubtful accounts.............................      (73)     (70)
                                                              -------   ------
                                                              $10,033   $7,375
                                                              =======   ======
</TABLE>

     The following table presents the components of property and equipment.

<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              -------------------
                                                                1996       1995
                                                              --------   --------
                                                                (IN THOUSANDS)
<S>                                                           <C>        <C>
Land........................................................  $    298   $    298
Buildings and improvements..................................     9,864      6,919
Machinery and equipment.....................................    17,388     12,468
Construction-in-progress....................................     2,927        454
                                                              --------   --------
                                                                30,477     20,139
Less, accumulated depreciation..............................   (11,261)    (9,235)
                                                              --------   --------
                                                              $ 19,216   $ 10,904
                                                              ========   ========
</TABLE>


                        APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES  25
<PAGE>   14

8.  EMPLOYEE BENEFIT PLAN

     The Company provides retirement benefits for all domestic AAI employees
with one year of service through a defined contribution plan qualified under
section 401(k) of the Internal Revenue Code of 1986, as amended. Participants
may elect to contribute a portion of their annual compensation, subject to
limitations. The Company makes matching contributions equal to 50% of a
participant's contribution up to a certain amount. Additionally, the Company
makes profit-sharing contributions at the discretion of the Board of Directors.
The discretionary contributions for the years ended December 31, 1996, 1995 and
1994 were $557,000, $226,000 and $322,000, respectively.

9.  COMMITMENTS AND CONTINGENCIES

     The Company leases land, buildings and equipment under renewable lease
agreements classified as operating leases. Rent expense under these agreements
for the years ended December 31, 1996, 1995 and 1994 was $1.3 million, $1.3
million and $1.1 million, respectively. Future minimum rentals due under lease
agreements as of December 31, 1996 are $2.8 million -- 1997; $2.2
million -- 1998; $1.7 million -- 1999; $1.7 million -- 2000; $1.5
million -- 2001 and $1.2 million -- thereafter.

     The Company is party to lawsuits and administrative proceedings incidental
to the normal course of its business. In connection with the 1995 issuance of
the Series A Preferred, two of the Company's stockholders have agreed to
indemnify the Company for certain losses, if incurred. Management does not
believe that any liabilities related to such lawsuits or proceedings will have a
material adverse effect on the Company's financial condition, results of
operations or cash flows.

10.  SUBSEQUENT EVENT

     In February 1997, one of the Company's investments in commercial paper for
$4 million was not redeemed because of a cancellation of the writer's credit
facility supporting their commercial paper. Such company has made public
statements that it will not make any debt payments while it tries to obtain new
credit facilities. In the interim, it has obtained a $50 million temporary
facility to fund its operations and continue its business. While management does
not believe that this situation will have a significant impact to the Company's
financial condition, it is unable to predict the outcome at this time. This
investment has been reclassified from cash and cash equivalents to prepaid and
other current assets as of December 31, 1996, since it is uncertain whether it
will be collected within three months.


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

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors
and Stockholders of
Applied Analytical Industries, Inc.

     In our opinion, the accompanying consolidated balance sheet and the related
consolidated statements of income, of cash flows and of stockholders' equity
present fairly, in all material respects, the financial position of Applied
Analytical Industries, Inc. and subsidiaries at December 31, 1996 and 1995, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 1996, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with generally accepted auditing standards which
require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for the opinion expressed above.

PRICE WATERHOUSE LLP

Raleigh, North Carolina
February 21, 1997


26  APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES

<PAGE>   15

FINANCIAL RESULTS BY QUARTER (UNAUDITED)

<TABLE>
<CAPTION>
QUARTER                                               FIRST    SECOND     THIRD    FOURTH
-------                                               ------   -------   -------   -------
                                                                  (UNAUDITED)
                                                        (IN THOUSANDS, EXCEPT PER SHARE
                                                                     DATA)
<S>                                                   <C>      <C>       <C>       <C>
Year ended December 31, 1996
Net sales...........................................  $9,925   $10,849   $10,396   $10,992
Gross profit........................................  $5,807   $ 6,152   $ 6,202   $ 6,380
Net income (loss) (1)...............................  $  655   $   741   $   799   $(5,343)
Pro forma earnings (loss) per share.................  $ 0.06   $  0.06   $  0.06   $ (0.33)
Price range of common stock, traded on the NASDAQ
  market under the symbol "AAII"(2)
    High                                                 --        --    $25 1/8   $29 5/8
    Low                                                  --        --    $16       $19 3/4
Year ended December 31, 1995
Net sales...........................................  $8,309   $ 8,292   $ 8,932   $ 9,106
Gross profit........................................  $4,683   $ 4,648   $ 5,456   $ 5,593
Net income..........................................  $   32   $   784   $ 1,088   $ 1,341
Pro forma net income (loss) (3).....................  $ (163)  $   475   $   655   $ 1,149
Pro forma earnings (loss) per share (3).............  $(0.01)  $  0.04   $  0.05   $  0.10
</TABLE>

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

(1) In connection with the acquisition of L.A.B. the Company recognized an
    unusual item representing the write-off of certain in-process research and
    development costs with an appraised value of approximately $6.6 million as
    of December 31, 1996. Without such write-off the net income in the fourth
    quarter would have been approximately $1.3 million.
(2) The Company completed an initial public offering of its common stock on
    September 25, 1996 at $16.00 per share. There were approximately 249
    holders of record for the common stock as of February 28, 1997.
(3) Pro forma information is presented for 1995 to reflect a pro forma provision
    for income taxes for the period prior to November 17, 1995, when the Company
    was treated as an S corporation for income tax purposes.


                         APPLIED ANALYTICAL INDUSTRIES INC. AND SUBSIDIARIES 27