<PAGE>   1

                                                                      EXHIBIT 13

 SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
Year ended December 31,                    1998       1997       1996        1995        1994
------------------------------------------------------------------------------------------------
<S>                                      <C>        <C>        <C>         <C>         <C>     
 In thousands, except per share amounts

 Statement of Income Data:
 Net sales                               $ 80,380   $ 65,401   $ 42,162    $ 34,639    $ 32,882
 Cost of sales                             39,962     33,378     17,621      14,259      14,533
 Selling                                    8,618      8,362      6,357       4,913       4,390
 General and administrative                17,536     15,207      8,908       8,171       8,485
 Research and development                   6,131      7,791      4,216       3,326       2,394
 Unusual item (1)                               -          -      6,600           -           -
 Other income (expense), net                  437      1,373        494      (1,130)       (440)
 ----------------------------------------------------------------------------------------------
 Income (loss) before income taxes          8,570      2,036     (1,046)      2,840       2,640
 Provision for income taxes (2)             2,869        781      2,102          39           -
 Equity income (loss)                           -          -          -         444        (444)
-----------------------------------------------------------------------------------------------
 Net income (loss)                       $  5,701   $  1,255   $ (3,148)   $  3,245    $  2,196
-----------------------------------------------------------------------------------------------

 Basic earnings (loss) per share         $   0.35   $   0.08   $  (0.26)   $   0.31    $   0.21
-----------------------------------------------------------------------------------------------
   Weighted average shares outstanding     16,322     16,290     12,039      10,348      10,317
-----------------------------------------------------------------------------------------------
 Diluted earnings (loss) per share       $   0.35   $   0.08   $  (0.26)   $   0.30           -
-----------------------------------------------------------------------------------------------
   Weighted average shares outstanding     16,417     16,459     12,039      10,667           -
-----------------------------------------------------------------------------------------------

 Pro forma data (unaudited) (2):
    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                                           $   0.20    $   0.10
-----------------------------------------------------------------------------------------------
    Weighted average shares outstanding                                      10,667      10,317
-----------------------------------------------------------------------------------------------

 Balance Sheet Data, at period end:
 Working capital                         $ 24,013   $ 32,637   $ 35,755    $ 12,374    $ (1,181)
 Property and equipment, net               37,600     25,326     19,216      10,904      10,782
 Total assets                             109,257    100,449    104,478      39,156      22,402
 Long-term debt                             6,306      6,578      6,671       6,578       2,738
 Total stockholders' equity (3)            72,950     66,076     63,995      21,990       5,856
</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 in
     September 1996.



                                       1
<PAGE>   2

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

OVERVIEW

         The Company is engaged in the business of performing contract
development and support services for large and small pharmaceutical companies
around the world and the development of new technologies to improve drug
performance. In implementing this strategy, the Company earns revenue through
fee-for-service contracts with customers and by licensing and selling internally
developed formulas and products.

         The fee-for service business consists of two main groups, an analytical
and a clinical group. The analytical group performs laboratory analysis of
various chemical compounds and small scale manufacturing of chemical compounds
used for further testing, or in some cases, for sale to the public. The services
performed by the analytical group include chemical analysis, chemical synthesis,
drug formulation, clinical supply and niche manufacturing, bio-analytical
studies, and regulatory and compliance consulting. All of these services involve
either laboratory work or consulting services. The clinical group performs
testing of new drugs for customers under controlled conditions as part of the
customers' process in gaining approval for the drug. All of the clinical
services involve contact with patients and monitoring clinical studies performed
in hospitals and clinics.

         Both the analytical and clinical groups receive requests for services
from a customer, often on a competitive basis. An estimate of costs to perform
the service is delivered to the customer based on the expected resources and
materials required to complete the project. The projects vary in length, some
lasting less than one month and others lasting several years, however, most
projects may be cancelled by the customer with 30 days notice.

         The product development business utilizes the resources and operating
capacity of the analytical and clinical groups to study and develop new
technologies that improve existing drugs. The Company licenses the developed
technologies and formulas to customers usually before the development is
complete. In general, the Company is partially paid for its efforts and
innovations at predefined events, defined as milestones, which are intended to
help cover the costs of development. The milestone payments are not refundable.
In most cases, the Company also receives royalties on the eventual sales of the
approved product. The Company bears the risk that some of the development
projects may not be approved or that the eventual sales of the product may not
meet expectations. These development projects generally last several years.

        On December 31, 1996, the Company acquired L.A.B. Gesellschaft fur
pharmakologische Untersuchungen mbH & Co. ("L.A.B."), which is now named AAI
Deutschland, GmbH & Co. KG. The operations include analytical and clinical
operations located in Germany, clinical operations in France and the
Netherlands, and a sales office in England. The acquisition significantly
expanded the Company's bio-analytical capabilities and allowed the Company to
offer multi-center clinical testing services. Analytical and clinical work
conducted in Europe is generally interchangeable with work performed in the
United States for purposes of seeking U.S. regulatory approval. Thus, the
acquisition of L.A.B. provided the Company with significant additional capacity
for analytical and clinical services to its global client base.

         On September 14, 1998, the Company acquired Kansas City Analytical
Services, Inc. ("KCAS"). KCAS provides bioanalytical services and has
significantly increased the bioanalytical capacity and expertise of the Company.
Prior to the acquisition of KCAS, the Company's primary bioanalytical operations
were located in Neu-Ulm, Germany.


                                       2
<PAGE>   3

        On March 16, 1999, the Company merged with Medical and Technical
Research Associates, Inc. ("MTRA") in a pooling-of-interests transaction for
approximately 1.3 million shares of stock, including conversion of MTRA stock
options. The addition of MTRA will bring a U.S. based clinical phase II-IV
operation to the Company and significantly increase the Company's clinical
presence and ability to compete for clinical projects.

        This Annual Report contains certain forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, 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, internal Company factors such as the management
of growth and acquisition risks and dependence on key personnel. The factors
that are outside the Company's control include government regulation, the level
of outsourcing in the pharmaceutical and biotechnology industries and the
dependence on third party marketing and distribution of internally developed
drugs.

RESULTS OF OPERATIONS
1998 COMPARED TO 1997

         Net sales increased by 23% in 1998 compared to 1997. The increase was
due in part to the acquisition of KCAS, without which the sales increase would
have been 19%. Fee-for-service sales increased 19% while product development
revenues increased 26% in 1998 over 1997.

         Gross margins in the fee-for-service business increased to 46% from 44%
partly due to the inclusion of KCAS in 1998. Without KCAS, 1998 margins would
have been 45%.

         Selling expenses increased by 1% but decreased as a percentage of sales
from 13% to 11% in 1998 from 1997 levels. General and administrative expenses
increased by 15% in 1998, but decreased as a percentage of fee for service
revenues to 22% in 1998 from 23% in 1997. The increase was due mainly to
increases in staff costs which support the higher volumes and revenues. Both
selling and general and administrative expenses decreased as a percentage of
fee-for-service revenues in 1998 from 1997 levels. Management believes that
while dollar levels of selling and administrative spending will increase, the
level of spending as a percentage of revenues will continue to decline in future
years.

         Research and development expenses decreased by 21% in 1998 from 1997
levels. Overall research spending as a percent of net sales also decreased from
12% in 1997 to 8% in 1998. The decrease was due partially to the stage of
development of the internal products. In addition, this decrease was partially
due to the Company internally performing various research activities which had
previously been sent to outside parties. The Company was able to perform these
research activities internally as a result of its acquisitions of L.A.B., KCAS
and through internal expansion. Management believes that performing high cost
research activities with internal resources (which will be further enhanced with
the addition of MTRA) will continue to provide a lower level of research
expenses as a percentage of net sales than had been experienced in prior years.

1997 COMPARED TO 1996

         Net sales increased by 55% in 1997 compared to 1996. The increase in
net sales was primarily attributable to the inclusion of L.A.B. net sales in
1997. The fee-for-service sales increased by 47% in 1997 compared to 1996 and
product development revenues increased by nearly 300% in 1997 compared to 1996.

         Gross margins in the fee-for-service business declined to 44% in 1997
compared to 57% in 1996. This decrease is primarily attributable to the
inclusion of L.A.B. in 1997 with lower operating margins than the historical
levels attained by AAI. Margins were also impacted by increases in professional
staffing in 1997 to meet increased client demand.



                                       3
<PAGE>   4

         Selling expense increased 32%, in 1997 compared to 1996, primarily as a
result of the inclusion of L.A.B. in 1997. Selling expense as a percent of net
sales declined to 13% in 1997 compared to 15% in 1996. General and
administrative expense increased 71% in 1997 compared to 1996, primarily as a
result of the inclusion of L.A.B. in 1997. General and administrative expense as
a percentage of net sales increased to 23% in 1997 from 21% in 1996. The Company
experienced a higher level of general corporate type expenses in 1997 as a
result of being a public company. Management believes these general corporate
type items should not increase significantly as a percent of net sales in future
years.

         Research and development expense increased 85% in 1997 compared to
1996. Research and development expense represented 12% of net sales in 1997
compared to 10% of net sales in 1996. The increase in research and development
expense reflects the Company's decision to allocate an increasing proportion of
its development capabilities to internal product development to accelerate
certain drug development activities. The Company anticipates that research and
development expense will continue to increase over the next several years,
consistent with its business strategy of investing approximately 10% of net
sales.

         The Company terminated certain business combination discussions during
the third quarter of 1997. In relation to these discussions, the Company
recognized a net credit of $400,000 in other income, representing a $1 million
payment made to its L.A.B. subsidiary and approximately $600,000 of expenses
incurred by AAI.

LIQUIDITY AND CAPITAL RESOURCES

         The Company has funded its business through cash flows from operations,
borrowings and the sale of equity. In 1998, $1.4 million of cash was generated
from operations. Cash was used in 1998 as follows: $4.0 million to acquire KCAS;
$14.1 million to purchase capital assets; and a $6.8 million increase in
non-cash working capital. The major capital assets purchased in 1998 include a
clinical supply manufacturing and distribution facility in Wilmington, North
Carolina, and the opening of an analytical facility in New Brunswick, New
Jersey.

         In 1997, $13.0 million of cash was used by operations predominately to
increase non-cash working capital and $4.4 million was received through
additional borrowings. Cash was used to purchase capital assets in the amount of
$10.9 million.

         In 1996, $45.0 million of cash was provided through the sale of equity
and $2.4 million was generated from operations. $7.6 million of cash was used in
1996 to purchase capital assets.

         Capital assets purchased were for new equipment and facility
improvements to increase capacity and productivity. The Company anticipates
capital expenditures in 1999 to be at or below the 1998 level.

         Working capital was $24.0 million at December 31, 1998 and $32.6
million at December 31, 1997. The Company has a $20 million credit facility
available 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. The Company is constantly evaluating
acquisition or other growth opportunities. At some point in the future there may
be 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.



                                       4
<PAGE>   5

YEAR 2000 DISCLOSURE

         The Company has commenced efforts to assess and where required,
remediate, issues associated with Year 2000 (Y2K) issues. Generally defined, Y2K
issues arise from computer programs which use only two digits to refer to the
year and which may experience problems when the two digits become "00" in the
year 2000. In addition, imbedded hardware microprocessors may contain time and
two-digit year fields in executing their functions. Much literature has been
devoted to the possible effects such programs may experience in the Year 2000,
although significant uncertainty exists as to the scope and effect the Y2K
issues will have on industry and the Company.

         The Company has recognized the need to address the Y2K issue in a
comprehensive and systematic manner and has taken steps to assess the possible
Y2K impact on the Company. Although the Company has not completed a 100%
assessment of all its information technology ("IT") and non-IT systems for Y2K
issues, the Company has completed its assessment of all mission-critical
systems. All mission-critical systems and most of the major applications and
hardware have been assessed to determine the Y2K impact and a plan is in place
for timely resolution of potential issues by the end of September 1999. In
addition, the Company is asking all of its significant vendors and clients for
an assessment of the impact of Y2K on their operations.

         In 1996, the Company developed a strategic plan to identify the IT
systems needed to accomplish the Company's overall growth plans. As part of this
process, potential Y2K issues were considered and addressed through an
enterprise resource planning process. The Company's Board of Directors
authorized approximately $3 million of initial spending to implement portions of
this strategic plan.

         In 1997, the Company established an internal multi-discipline task
force to specifically address Y2K issues. The task force has inventoried IT and
non-IT systems and made assessments as to Y2K compliance. In those instances
where a system would be replaced or eliminated through the implementation of our
strategic plan before being impacted by Y2K issues, no further action was deemed
necessary. All mission-critical systems not being addressed in the strategic
plan have been further assessed and protocols have been developed to test
compliance. This testing is ongoing. As issues are identified they are remedied
as soon as possible. In addition, as upgrades are made to the Company's
proprietary software, Company employees are revising the computer code to ensure
Y2K compliance. All Company purchase orders for new equipment and systems
contain representations regarding Y2K compliance. Based on our current
information, the non-IT systems used by the Company are not expected to cause
significant problems or expense to the Company. While AAI relies heavily on its
technical equipment, much of the equipment can be upgraded to Y2K compliant
versions. Items that are not mission-critical can continue to be operated if
they are not linked to other systems.

         The Company has communicated with our major customers and suppliers and
is not aware of any such business associates that will cause a material
third-party risk to the Company. While management does not believe this issue
will materially affect its products, services or competitive condition, it has
not fully completed its assessment and remediation process at this time.

         The cost of bringing the Company in full compliance should not result
in a material increase in the recent levels of capital spending or any material
one-time expenses. The Company has not been tracking the direct cost of solving
potential Y2K issues. Since 1996, the Company has spent approximately $3.7
million for all IT items. It is not reasonably possible to determine what
portion of such spending was directly related to correcting Y2K issues. This
amount includes spending on replacing systems, as well as upgrading existing
systems. The future spending on IT items is expected to be approximately $2
million per year. Again, the Company has not segregated the direct costs
associated with Y2K issues in its IT capital spending plans.



                                       5
<PAGE>   6

         The failure of either the Company, its vendors or clients to correct
the systems affected by Y2K issues could result in a disruption or interruption
of business operations. The Company uses computer programs and systems in its
operations to collect, assimilate and analyze data. Failure of such programs and
systems could affect the Company's ability to perform contracts to test,
develop, or manufacture pharmaceutical and biotechnology products or perform
clinical trials, thereby causing delays in the development and commercialization
of pharmaceutical and biotechnology products. Similarly, failure of
vendor-provided products and services could result in delay of the Company's
internal development efforts. Although the Company does not believe that any of
the foregoing worst-case scenarios will occur, there can be no assurance that
unexpected Y2K problems of either the Company, its vendors or clients will not
have a material adverse effect on the Company.

         While it is difficult to classify the Company's state of readiness,
management believes that the Company's internal plans should have the Company
ready by the end of 1999 to avoid any material Y2K issues. We are in the process
of completing the assessment, testing systems and developing contingency plans.
Management is in frequent communication with the task force and has made and
will continue to make reports to the Company's Board of Directors.

INFLATION

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

EURO CONVERSION

         On January 1, 1999, the European Community began denominating
significant financial transactions in a new monetary unit, the Euro. The Euro is
intended to replace the traditional currencies of the individual EU member
countries. The Company's operations in Europe are continuing to operate in the
traditional currencies and are not converting internal financial systems to the
Euro as a functional currency. The Company's significant operations all have
multi-currency capable systems and will account for Euro denominated
transactions without additional modification or difficulty. The Company is
evaluating when to convert its local currency in Europe to the Euro with as
little disruption to customer and vendors as possible. The Company does not
intend to make such a conversion in 1999.


                                       6
<PAGE>   7

CONSOLIDATED STATEMENTS OF INCOME
In thousands, except per share amounts

<TABLE>
<CAPTION>
For the years ended December 31,                                     1998            1997            1996
<S>                                                                <C>             <C>             <C>      
 Net sales (includes related party net
    sales of $1,807, $5,170 and $10,916)                           $ 80,380        $ 65,401        $ 42,162

 Operating costs and expenses:
    Cost of sales                                                    39,962          33,378          17,621
    Selling                                                           8,618           8,362           6,357
    General and administrative                                       17,536          15,207           8,908
    Research and development                                          6,131           7,791           4,216
    Unusual item                                                          -               -           6,600
------------------------------------------------------------------------------------------------------------
                                                                     72,247          64,738          43,702
------------------------------------------------------------------------------------------------------------
 Income (loss) from operations                                        8,133             663          (1,540)

 Other income (expense):
    Interest, net                                                       239             608             511
    Other                                                               198             765             (17)
------------------------------------------------------------------------------------------------------------
                                                                        437           1,373             494
------------------------------------------------------------------------------------------------------------
 Income (loss) before income taxes                                    8,570           2,036          (1,046)
 Provision for income taxes                                           2,869             781           2,102
------------------------------------------------------------------------------------------------------------
 Net income (loss)                                                 $  5,701        $  1,255        $ (3,148)
------------------------------------------------------------------------------------------------------------

 Basic earnings (loss) per share                                   $   0.35        $   0.08        $  (0.26)
------------------------------------------------------------------------------------------------------------
   Weighted average shares outstanding - basic                       16,322          16,290          12,039
------------------------------------------------------------------------------------------------------------

 Diluted earnings (loss) per share                                 $   0.35        $   0.08        $  (0.26)
------------------------------------------------------------------------------------------------------------
   Weighted average shares outstanding - diluted                     16,417          16,459          12,039
------------------------------------------------------------------------------------------------------------
</TABLE>


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


                                       7
<PAGE>   8

CONSOLIDATED BALANCE SHEETS
in thousands, except share data

<TABLE>
<CAPTION>
December 31,                                                                1998              1997
<S>                                                                      <C>               <C>      
      ASSETS
 Current assets:
 Cash and cash equivalents                                               $  10,802         $  26,219
 Accounts receivable, net                                                   22,130            19,415
 Work-in-progress                                                           15,570             8,968
 Prepaid and other current assets                                            5,352             4,481
-----------------------------------------------------------------------------------------------------
      Total current assets                                                  53,854            59,083
-----------------------------------------------------------------------------------------------------
 Property and equipment, net                                                37,600            25,326
 Goodwill and other intangibles                                             15,509            13,747
 Other assets                                                                2,294             2,293
-----------------------------------------------------------------------------------------------------
      Total assets                                                       $ 109,257         $ 100,449
-----------------------------------------------------------------------------------------------------

     LIABILITIES AND STOCKHOLDERS' EQUITY
 Current liabilities:
 Current maturities of long-term
     debt and short-term debt                                            $   6,627         $   5,561
 Accounts payable                                                            5,494             4,005
 Customer advances                                                           6,818             7,869
 Accrued wages and benefits                                                  4,323             3,561
 Other accrued liabilities                                                   6,579             5,450
-----------------------------------------------------------------------------------------------------
 Total current liabilities                                                  29,841            26,446
-----------------------------------------------------------------------------------------------------
 Long-term debt                                                              6,306             6,578
 Other liabilities                                                             160             1,349
 Commitments and contingencies
 Stockholders' equity:
   Preferred stock                                                               -                 -
   Common stock, $.001 par value;100 million
     shares authorized, 16,390,511 outstanding - 1998;
     16,295,271 outstanding - 1997                                              16                16
 Paid-in capital                                                            68,687            67,550
 Retained earnings (deficit)                                                 4,365           (1,336)
 Accumulated other comprehensive income (losses)                              (53)               (5)
 Stock subscriptions receivable                                               (65)             (149)
-----------------------------------------------------------------------------------------------------
 Total stockholders' equity                                                 72,950            66,076
-----------------------------------------------------------------------------------------------------
 Total liabilities and stockholders' equity                              $ 109,257         $ 100,449
-----------------------------------------------------------------------------------------------------
</TABLE>

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


                                       8
<PAGE>   9


CONSOLIDATED STATEMENTS OF CASH FLOWS
In thousands

<TABLE>
<CAPTION>
For the years ended December 31,                                   1998         1997         1996
                                                             ---------------------------------------
<S>                                                               <C>          <C>          <C>     
 Cash flows from operating activities:
 Net income (loss)                                                $ 5,701      $ 1,255      $(3,148)
 Adjustments to reconcile to net cash
  (used) provided by operating activities:
       Depreciation and amortization                                4,958        5,116        2,062
       Deferred income taxes                                          752         (510)          25
       Unusual item                                                     -            -        6,600
       Other                                                         (487)         251          110
       Changes in assets and liabilities:
           Trade and other receivables                             (1,453)      (9,610)      (1,073)
           Work-in-progress                                        (5,838)         200         (969)
           Prepaid and other assets, net                             (538)      (2,225)        (494)
           Accounts payable                                         1,067       (4,090)         245
           Customer advances                                       (1,680)         540         (943)
           Other accrued liabilities                               (1,049)      (3,921)         (48)
----------------------------------------------------------------------------------------------------
 Net cash provided (used) by operating activities                   1,433      (12,994)       2,367
----------------------------------------------------------------------------------------------------
 Cash flows from investing activities:
 Purchase of property and equipment                               (14,147)     (10,929)      (7,609)
 Acquisition of L.A.B., net of cash acquired                          -            -         (2,206)
 Acquisition of KCAS, net of cash acquired                         (4,008)         -            -
 Short-term investment                                                  -        3,961       (3,961)
 Other                                                                (34)        (376)          31
----------------------------------------------------------------------------------------------------
 Net cash used by investing activities                            (18,189)      (7,344)     (13,745)
----------------------------------------------------------------------------------------------------
 Cash flows from financing activities:
 Net proceeds (payments) short-term debt                              773        3,269       (2,656)
 Proceeds from long-term borrowings                                     -        1,128         -
 Payments on long-term borrowings                                    (617)        (633)        (565)
 Issuance of common stock                                           1,080          600       44,794
 Dividends                                                              -            -       (1,051)
----------------------------------------------------------------------------------------------------
 Net cash provided by financing activities                          1,236        4,364       40,522
----------------------------------------------------------------------------------------------------
 Net (decrease) increase in cash and
    cash equivalents                                              (15,520)     (15,974)      29,144
 Effect of exchange rate changes on cash                              103          (32)           -
 Cash and cash equivalents, beginning of period                    26,219       42,225       13,081
----------------------------------------------------------------------------------------------------
 Cash and cash equivalents, end of period                         $10,802      $26,219      $42,225
----------------------------------------------------------------------------------------------------
 Supplemental information, cash paid for:
   Interest                                                       $   887      $   870      $   402
   Income taxes                                                   $ 1,977      $ 1,378      $ 1,945
</TABLE>


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



                                       9
<PAGE>   10


CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
In thousands, except per share amount

<TABLE>
<CAPTION>
                                                                                            Accumulated     Retained 
                                      Common Stock       Class B Stock                        Other         Earnings
                                   ---------------------------------------  Paid-in        Comprehensive (Accumulated
                                    Shares    Amount    Shares    Amount   Capital (1)        Income        Deficit)        Total
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                 <C>       <C>       <C>       <C>      <C>             <C>            <C>               <C>
 Balance, December 31, 1995             447    $  150     9,993    $  171    $ 21,510       $       -       $    308     $  22,139
-----------------------------------------------------------------------------------------------------------------------------------

 Dividend adjustment                      -         -         -         -           -               -            249           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         -         -      44,788               -              -        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                  -         -         -         -           3               -              -             3
 Deferred compensation earned             -         -         -         -         110               -              -           110
 Net loss                                 -         -         -         -           -               -         (3,148)       (3,148)
-----------------------------------------------------------------------------------------------------------------------------------
 Balance, December 31, 1996          16,286        16         -         -      66,722               -         (2,591)       64,147
-----------------------------------------------------------------------------------------------------------------------------------
 Stock options exercised                 10         -         -         -          75               -              -            75
 Stock option tax benefits                -         -         -         -         525               -              -           525
 Stock award forfeitures                 (1)        -         -         -           -               -              -             -
 Deferred compensation earned             -         -         -         -         228               -              -           228

 Currency translation adjustment          -         -         -         -           -              (5)             -            (5)
 Net income                               -         -         -         -           -               -          1,255         1,255
                                                                                                                     --------------
 Total comprehensive income                                                                                                  1,250
-----------------------------------------------------------------------------------------------------------------------------------
 Balance, December 31, 1997          16,295        16         -         -      67,550              (5)        (1,336)       66,225
-----------------------------------------------------------------------------------------------------------------------------------

 Stock issued in acquisition of KCAS     27         -         -         -         291               -              -           291
 Stock options exercised                 69         -         -         -         602               -              -           602
 Stock option tax benefits                -         -         -         -          99               -              -            99
 Stock award forfeitures                  -         -         -         -          (6)              -              -            (6)
 Deferred compensation earned             -         -         -         -         151               -              -           151

 Currency translation adjustment          -         -         -         -           -             (48)             -           (48)
 Net income                               -         -         -         -           -               -          5,701         5,701
                                                                                                                     --------------
 Total comprehensive income                                                                                                  5,653
-----------------------------------------------------------------------------------------------------------------------------------
 Balance, December 31, 1998          16,391    $   16         -    $    -    $ 68,687       $     (53)      $  4,365      $ 73,015
-----------------------------------------------------------------------------------------------------------------------------------
</TABLE>


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


                                       10
<PAGE>   11

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.   SIGNIFICANT ACCOUNTING POLICIES

Organization

         The Company is a multinational provider of contract research services
with its principal offices in the United States and Germany. The majority of
revenues are earned in the fee-for-service business as explained in Note 10, and
a portion of the Company's resources are devoted to research and development of
new products. Major customers are large and small pharmaceutical companies.

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, of
Endeavor Pharmaceuticals Inc. ("Endeavor") which is accounted for under the
equity method.

Revenue Recognition

         Revenues from fee-for-service contracts are recognized generally on a
percentage-of-completion basis as the work is performed. Licensing revenues are
recognized generally on a percentage-of-completion basis for interim contract
milestones. Contract milestones based on product approval are recognized when
the applicable product is approved. Royalty revenues are recognized as earned in
accordance with contract terms. Work-in-progress represents revenues recognized
prior to contract billing terms. Provisions for losses on contracts, if any, are
recognized when identified.

Income Taxes

         Income taxes have been provided using the liability method in
accordance with Financial Accounting Standards Board ("FASB") Statement No. 109
"Accounting for Income Taxes". Deferred tax assets and liabilities are
recognized for the expected tax consequences of temporary differences between
the tax bases of assets and liabilities and their reported amounts.



                                       11
<PAGE>   12

Earnings per Share

         Basic earnings per share are based on the weighted average number of
common shares outstanding during the year. The weighted average number of common
shares outstanding was approximately 16,322,000, 16,290,000 and 12,039,000 in
1998, 1997 and 1996, respectively. Diluted earnings per share were computed
assuming that the weighted average number of shares was increased by the
conversion of stock options issued to employees and members of the Company's
Board of Directors. The diluted per share amounts reflect a change in the number
of shares outstanding (the "denominator") to include the options as if they were
converted to shares and issued. In each year presented, the net income (the
"numerator") is the same for both basic and diluted per share computations. The
following table provides a reconciliation of the denominators for the basic and
diluted earnings per share computations for each of the years ended December 31 
(In thousands):

<TABLE>
<CAPTION>
                                                       1998          1997         1996
                                                    ------------------------------------
<S>                                                    <C>          <C>          <C>   
 Basic Earnings per Share:
   Weighted average number of shares                   16,322       16,290       12,039

 Effect of Dilutive Securities:
   Employee and Director stock options                     95          169            -
                                                    ------------------------------------

 Diluted Earnings per Share:
    Adjusted weighted average number of shares
       and assumed conversions                         16,417       16,459       12,039
                                                    ====================================
</TABLE>


Cash and Cash Equivalents

         The Company considers all highly liquid investments purchased with a
maturity of three months or less to be cash equivalents. Cash pledged as
security has been included in cash as described in Note 4.

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. Leasehold improvements are amortized over the lesser of the
asset life or the lease term. Depreciation expense was approximately $4.2
million, $4.4 million and $2.0 million for the years ending December 31, 1998,
1997 and 1996, respectively.



                                       12
<PAGE>   13

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. At December 31,
1998 and 1997, the amounts for accumulated amortization of goodwill were
approximately $806,000 and $694,000 respectively. 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. At December 31, 1998 and
1997, the amounts of accumulated amortization of other intangibles were
approximately $446,000 and $228,000 respectively.

         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.

         The carrying values of goodwill, intangibles and other assets are
reviewed if the facts and circumstances indicate potential impairment of their
carrying value. Any impairment in the carrying value of such assets is recorded
when identified.

Foreign Currency Translation

         The financial statements of foreign subsidiaries have been translated
into U.S. dollars in accordance with FASB Statement No. 52 "Foreign Currency
Translation". All balance sheet accounts have been translated using the exchange
rates in effect at the balance sheet date. Income statement amounts have been
translated using the average exchange rate for the year. The gains and losses
resulting from the changes in exchange rates from year to year have been
reported in other comprehensive income. The effect on the statements of income
of transaction gains and losses is insignificant for all years presented.

Impact of Recently Issued Accounting Standards

         During 1998, the FASB issued Statement No. 130 "Reporting Comprehensive
Income". The statement requires the Company to provide disclosure of all changes
in equity resulting from recognized transactions of the period other than
transactions with owners. The FASB also issued Statement No. 131 "Disclosures
about Segments of an Enterprise and Related Information". This statement
requires that the Company disclose certain information about its major business
lines, as well as certain geographic information. The Company has adopted both
statements.

         In June 1998, the FASB issued Statement No. 133 "Accounting for
Derivative and Hedging Activities" which is required to be adopted in years
beginning after June 15, 1999. Because of the Company's minimal use of
derivatives, if any, management does not anticipate that the adoption of this
statement will have a material impact on net earnings or the financial position
of the Company.

Stock Based Compensation

         The Company grants stock options to certain employees with an exercise
price equal to the fair market value at the date of grant. The Company accounts
for stock option grants in accordance with APB Opinion No. 25, "Accounting for
Stock Issued to Employees". Because the exercise price of the stock options
equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.

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 investments, which is recorded at zero, as no readily
determinable market exists for investments in such entities.


                                       13
<PAGE>   14

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.

2.       ACQUISITIONS AND UNUSUAL ITEM

Kansas City Analytical Services, Inc.

         On September 14, 1998, the Company acquired all of the outstanding
equity of Kansas City Analytical Services, Inc. (KCAS), a bioanalytical and
pharmaceutical analysis laboratory located near Kansas City, Kansas. The
acquisition has been accounted for using the purchase method of accounting. The
aggregate purchase price was approximately $5.5 million, consisting of cash
($5.2 million) and the issuance of 26,642 shares of common stock. The excess of
the purchase price over the fair value of the assets acquired was $1.5 million
and has been recorded as goodwill which is being amortized on a straight line
basis over 20 years. Accordingly, the results of KCAS's operations have been
included in the Company's consolidated results from the date of acquisition.

L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co.

         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 head-quartered in
Neu-Ulm, Germany with operational units in Neu-Ulm and Munich, Germany as well
as in France, Netherlands and England.

         The aggregate purchase price for L.A.B. was approximately $20.5
million, which included payments to former equity holders, L.A.B. debt and
negative working capital. 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 original goodwill of approximately $12.8 million which is being
amortized on a straight-line basis over 20 years. Goodwill was adjusted during
1997 by approximately $2.0 million to reflect resolution of certain
pre-acquisition contingencies. The results of operations for L.A.B. are included
in the consolidated financial statements of AAI in 1997 and 1998.

         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, L.A.B. and KCAS as if the acquisitions had occurred on
January 1, 1996. 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,                  1998        1997           1996
---------------------------------------------------------------------------
<S>                                    <C>          <C>          <C>     
In thousands, except per 
share amounts (unaudited)

Net sales                              $85,363      $71,204      $ 67,557
Net income (loss)                      $ 6,075      $ 1,288      $ (7,710)
Diluted earnings (loss) per share      $   .37      $   .08      $   (.64)
</TABLE>



                                       14
<PAGE>   15

3.  INCOME TAXES

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

<TABLE>
<CAPTION>
Year ended December 31,                          1998         1997         1996
----------------------------------------------------------------------------------
<S>                                             <C>          <C>          <C>    
 In thousands

 Income (loss) before income taxes:
     United States                              $ 8,368      $ 2,165      $ 5,554
     Non-U.S.                                       202         (129)      (6,600)
----------------------------------------------------------------------------------
         Net income before taxes                $ 8,570      $ 2,036      $(1,046)
----------------------------------------------------------------------------------

 Provision for income taxes:
 Current:
     Federal                                    $ 1,972      $ 1,228      $ 1,709
     Non-U.S.                                        31           63            -
     State                                          135            -          368
----------------------------------------------------------------------------------
         Total current taxes                      2,138        1,291        2,077
----------------------------------------------------------------------------------
 Deferred:
     Federal                                        627         (365)          18
     Non-U.S.                                         -            -            -
     State                                          104         (145)           7
----------------------------------------------------------------------------------
         Total deferred taxes                       731         (510)          25
----------------------------------------------------------------------------------

----------------------------------------------------------------------------------
 Total income taxes                             $ 2,869       $  781      $ 2,102
----------------------------------------------------------------------------------
</TABLE>


         The following table presents the reconciliation of the provision for
income taxes to the amount computed by applying the U.S. federal statutory
income tax rate.

<TABLE>
<CAPTION>
Year ended December 31,                          1998         1997         1996
 In thousands
----------------------------------------------------------------------------------
<S>                                             <C>          <C>         <C>      
 Income (loss) before income taxes              $ 8,570      $ 2,036     $ (1,046)
----------------------------------------------------------------------------------

 Tax expense (benefit) using statutory
    U.S. income tax rate of 34%                 $ 2,914      $   692     $   (356)
 State income taxes, net                            194          (96)          247
 Permanent items, net                               198          286           35
 Research and Development credits                  (400)        (411)        (173)
 Non-U.S. operations, net                           (37)         107            -
 Write-off of in-process R&D                          -            -        2,244
 Other, net                                           -          203          105
----------------------------------------------------------------------------------
 Provision for income taxes                     $ 2,869      $   781      $ 2,102
----------------------------------------------------------------------------------
</TABLE>



                                       15
<PAGE>   16

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

<TABLE>
<CAPTION>
December 31,                                     1998         1997
---------------------------------------------------------------------
<S>                                             <C>          <C>    
 In thousands
 Deferred tax assets, resulting from:
    Accrued liabilities                         $    84      $   272
    Accounts receivable                             299          483
    Write-off of in-process R&D                   2,740        2,826
    Non-U.S. net operating losses                 1,918        1,745
    Tax credits                                       -          226
    Other items                                     345          139

 Deferred tax liability, resulting from:
    Property and equipment                         (957)        (619)

 Valuation allowances on tax assets              (4,658)      (4,571)
---------------------------------------------------------------------
 Net deferred tax assets (liability)            $  (229)     $   501
---------------------------------------------------------------------
</TABLE>


         Valuation allowances have been provided for certain assets resulting
from the L.A.B. acquisition since realization of such assets cannot be
predicted with reasonable certainty at this time.

4.  DEBT AND CREDIT LINE

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

<TABLE>
<CAPTION>
December 31,                                                              1998         1997
 In thousands
<S>                                                                     <C>          <C>    
 Industrial revenue bonds                                               $   900      $ 1,125
 Bank debt                                                                5,117        3,778
 Current maturities of long-term debt                                       610          658
---------------------------------------------------------------------------------------------
      Total short-term debt and current maturities of long-term debt    $ 6,627      $ 5,561
---------------------------------------------------------------------------------------------
</TABLE>

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

<TABLE>
<CAPTION>
 December 31,                                         1998         1997
 In thousands
<S>                                                 <C>          <C>    
 Bank term loans                                    $ 6,916      $ 7,180
 Other                                                    -           56
-------------------------------------------------------------------------
      Total long-term debt                            6,916        7,236
-------------------------------------------------------------------------
 Less current maturities of long-term debt             (610)        (658)
-------------------------------------------------------------------------
      Total long-term debt due after one year       $ 6,306      $ 6,578
-------------------------------------------------------------------------
</TABLE>




                                       16
<PAGE>   17

         The industrial revenue bonds were secured 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, 1998 and 1997 were 4.15% and 4.35%, 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 re-marketing agreement with such bank to re-market 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 include approximately $2.1 million and $2.7 million
with a U.S. bank as of December 31, 1998 and 1997 respectively. 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
6.9% and 7.2% for 1998 and 1997, respectively. The bank term loans also include
approximately 8 million Deutsche marks, as of December 31, 1998 and 1997. This
amount represents a subsidiary's note payable to a German bank, which is due in
March 2000 with interest payable quarterly at 4.85%. AAI has issued a stand-by
letter of credit to this bank to cover borrowings outstanding. Approximately
$6.8 million of cash is held in certificates of deposit, pledged as security for
the letter of credit.

         In 1996, the Company entered into a revolving credit agreement with a
U.S. bank which, as amended, expires in May 1999. The agreement provides for
borrowings of up to $20 million at variable interest rates, adjusted quarterly.
The rates are be based on the 30-day LIBOR rate and can be reduced or increased
depending on certain financial ratios of the Company at the end of each quarter.
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, 1998 or 1997.

         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 maintenance of
certain financial ratios, and incurring additional indebtedness. The Company was
in compliance with these covenants at December 31, 1998.

         Scheduled maturities of long-term debt as of December 31, 1998 are
$610,000 - 1999; $5,405,000 - 2000; $458,000 - 2001; and $443,000 - 2002.

5.   STOCKHOLDERS' EQUITY

         The authorized capital stock of the Company at December 31, 1998 and
1997 was 100 million shares of voting common stock, $0.001 par value per share,
and 5 million shares of preferred stock, $0.001 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. No preferred stock was
outstanding at December 31, 1998 or 1997. The Company has reserved 2,057,636
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 $45 million, in
September 1996 (the "IPO"). Upon the completion of the IPO the Company's then
outstanding Class B common stock, $0.001 par value per share, and Series A
convertible preferred stock, $0.001 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 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 were retroactively
adjusted to reflect these stock splits.


                                       17
<PAGE>   18

Stock Option and Award Plans

         In 1996, the Board of Directors awarded 104,696 shares of 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 was
expensed over a two-year period.

         The Company has three stock option plans, the 1997 Stock Option Plan
("1997 Plan"), the 1996 Stock Option Plan ("1996 Plan") and the 1995 Stock
Option Plan ("1995 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 1997 and 1996 Plans, the Board of Directors may grant options to purchase up
to 1,644,000 and 495,627, respectively, newly issued shares of common stock. The
plans require that the exercise price of options cannot be less than either 100%
(1997 Plan) or 75% (1996 and 1995 Plans) of the estimated fair market value of
the Company's shares of common stock on the date of grant.

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

<TABLE>
<CAPTION>
                                                        Weighted average
                                           Shares        exercise price
-----------------------------------------------------------------------
<S>                                        <C>                 <C>    
 Outstanding, January 1, 1997              442,755             $  8.35
-----------------------------------------------------------------------
 Granted                                   508,100               14.74
 Exercised                                 (92,023)               8.36
 Forfeited                                (176,480)              15.02
-----------------------------------------------------------------------
 Outstanding, December 31, 1997            682,352               11.39
-----------------------------------------------------------------------
 Exercisable, December 31, 1997            124,413                8.35
-----------------------------------------------------------------------
 Granted                                   977,100               13.02
 Exercised                                 (76,679)               9.02
 Forfeited                                (199,245)              11.87
-----------------------------------------------------------------------
 Outstanding, December 31, 1998          1,383,528             $ 12.61
-----------------------------------------------------------------------
 Exercisable, December 31, 1998            207,242             $ 10.84
-----------------------------------------------------------------------
</TABLE>


Information regarding stock options outstanding at December 31, 1998 is
summarized in the table below.

<TABLE>
<CAPTION>
                                    Options Outstanding                         Options Exercisable
                                 ------------------------                    ------------------------
                                                 Weighted      Weighted                     Weighted
                                                 Average        Average                     Average
                                    Shares      Remaining      Exercise        Shares       Exercise
 Range of Exercise Prices        Outstanding       Life         Price        Exercisable      Price
 ------------------------        -----------    ---------      --------      -----------    ---------
 <S>                             <C>            <C>            <C>           <C>            <C>    
        $8.350 - $12.720             346,596      8.38          $10.413        139,920       $ 9.240
            $12.813                  770,400      9.34           12.813              -             -
       $13.625 - $22.000             266,532      8.69           14.854         67,322        14.159
                                   ---------      ----          -------        -------       -------
        $8.350 - $22.000           1,383,528      8.98          $12.605        207,242       $10.838
</TABLE>


                                       18
<PAGE>   19

         The weighted average fair value in excess of the exercise price at date
of grant for options granted during 1998 and 1997 was $6.87 and $7.84 per
option, respectively. 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 (5.1% - 1998, 5.9 % - 1997);
volatility factor (55% - 1998, 54% - 1997) and dividend yield (none).

         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. If compensation cost for the Company's
plans had 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 income (loss) and diluted earnings (loss) per share would have
been changed to the pro forma amounts indicated below.

<TABLE>
<CAPTION>
                                         Years Ended December 31,
----------------------------------------------------------------------------
                                       1998           1997           1996
----------------------------------------------------------------------------
<S>                                  <C>            <C>          <C>       
(In thousands, except per share amounts)
 Net income (loss):
    As reported                      $  5,701       $  1,255     $  (3,148)
    Pro forma                        $  4,577       $    771     $  (3,323)

 Earnings (loss) per share:
    As reported -
       Basic                         $   0.35       $   0.08     $   (0.26)
       Diluted                       $   0.35       $   0.08     $   (0.26)

    Pro forma -
       Basic                         $   0.28       $   0.05     $   (0.28)
       Diluted                       $   0.28       $   0.05     $   (0.28)
</TABLE>


6.  RELATED PARTY TRANSACTIONS AND MAJOR CUSTOMERS

Endeavor

         In 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 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
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 1995.



                                       19
<PAGE>   20

         This investment has been recorded at zero value since 1995. Endeavor
has accumulated losses of approximately $16 million. The Company will not be
able to record any income from this investment until Endeavor has earned income
in an amount equal to such accumulated losses and becomes profitable

         The Company had net sales to Endeavor for product development services
of approximately $1.6 million, $3.2 million and $6.2 million (15% of AAI net
sales) for the years ended December 31, 1998, 1997 and 1996, respectively. These
services are provided on terms and conditions management believes are comparable
to those afforded unrelated entities. Additionally, AAI had approximately $2.3
million in accounts receivable at December 31, 1997 and approximately $1.6
million and $184,000 in work-in-progress related to Endeavor at December 31,
1998 and 1997, respectively.

         The Company has agreed, upon the completion of a specified development
milestone, to grant Endeavor an option to lease or purchase certain production
space, at fair market value, intended for use by AAI in manufacturing Endeavor's
products. The facilities subject to this option are currently used by the
Company. The Company has also agreed to permit Endeavor, under certain
circumstances, the first right to purchase additional proprietary hormone
pharmaceutical products developed by AAI.

Aesgen, Inc.

      Aesgen, Inc. ("Aesgen") was formally organized with an affiliate of the
Mayo Clinic and MOVA Pharmaceutical Corporation and funded in 1995 through the
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
non-current assets on the balance sheet. As the Company did not intend to hold
an equity interest in Aesgen, it entered into a series of related transactions
commencing in 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 $0.2 million, $1.9 million and $4.7 million (11% of AAI
net sales) from Aesgen for the years ended December 31, 1998, 1997 and 1996,
respectively. AAI also had accounts receivable of approximately $555,000 from
Aesgen at December 31, 1997, and work-in-progress of approximately $145,000 and
$97,000 at December 31, 1998 and 1997 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.



                                       20
<PAGE>   21

7. SUPPLEMENTAL BALANCE SHEET INFORMATION

         The following table presents the components of accounts receivable.

<TABLE>
<CAPTION>
December 31,                                        1998          1997
<S>                                                <C>           <C>    
 In thousands
 Trade and other:
 Billed                                            $18,395       $13,496
 Unbilled                                            3,195         3,161
 Related parties                                       980         2,867
-------------------------------------------------------------------------
 Total accounts receivable                          22,570        19,524
 Allowance for doubtful accounts                      (440)         (109)
-------------------------------------------------------------------------
 Total accounts receivable, net                    $22,130       $19,415
-------------------------------------------------------------------------
</TABLE>

         In February 1997, one of the Company's investments in commercial paper
for approximately $4 million was not redeemed because of a cancellation of the
writer's credit facility supporting their commercial paper. This company began
making payments for principal and interest during 1997. In October 1997,
management made the decision to sell a portion of this investment and reserve
for a loss on the remaining holdings.

         The following table presents the components of property and equipment.

<TABLE>
<CAPTION>
December 31,                                        1998          1997
 In thousands
<S>                                               <C>           <C>     
 Land                                             $    990      $    945
 Buildings and improvements                         14,491        10,882
 Machinery and equipment                            42,116        27,295
 Construction-in-progress                            4,801         1,586
-------------------------------------------------------------------------
 Total cost of property and equipment               62,398        40,708
 Less, accumulated depreciation                    (24,798)      (15,382)
-------------------------------------------------------------------------
      Property and equipment, net                 $ 37,600      $ 25,326
-------------------------------------------------------------------------
</TABLE>


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 Company has expensed $300,000, $219,000 and $557,000 for the years ended
December 31, 1998, 1997 and 1996, respectively.



                                       21
<PAGE>   22

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, 1998, 1997 and 1996 was $2.5 million, $2.8
million, and $1.3 million, respectively. Future minimum rentals due under lease
agreements as of December 31, 1998 are $3.2 million - 1999; $2.9 million - 2000;
$2.5 million - 2001; $1.8 million - 2002; $1.8 million - 2003 and $8.3 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.

The Company has entered into an agreement with two banks which allows the
Company to lease a facility being built in Wilmington, North Carolina, adjacent
to the Company's laboratories. When the facility is complete, the Company will
enter into an operating lease for an initial period of 3 years with 2 one year
renewal periods. At the end of the initial term, the Company may elect to
purchase the facility at fair market value, extend the lease or the property may
be sold.

10. FINANCIAL INFORMATION BY BUSINESS SEGMENT AND GEOGRAPHIC AREA

         The Company operates in two business segments consisting of a
fee-for-service business and a product development business. In the
fee-for-service business, AAI is an integrated contract research organization
("CRO") to the worldwide pharmaceutical and biotechnology industries. In the
product development business, the Company internally develops drugs and
technologies with the objective of licensing marketing rights to third parties
in exchange for license fees and royalties. The Company does not independently
commercialize products developed internally or otherwise directly compete with
its pharmaceutical clients in the marketing or distribution of products. The
majority of the Company's non-U.S. operations are located in Germany.



                                       22
<PAGE>   23

         In determining income from operations, costs are allocated to the
product development business based upon direct labor and materials plus an
allocation of general overhead. The corporate line includes general corporate
overhead costs and goodwill amortization, which are not directly attributable to
a business segment.

<TABLE>
<CAPTION>
Year ended December 31,                 1998         1997          1996
                                    ----------------------------------------
<S>                                    <C>          <C>           <C>     
 (In thousands)
NET SALES:
 Fee-for-service                       $ 73,126     $ 59,631      $ 40,624
 Product Development                      7,254        5,770         1,538
                                    ----------------------------------------
                                       $ 80,380     $ 65,401      $ 42,162
                                    ----------------------------------------

 United States                         $ 60,331     $ 47,959      $ 42,162
 Non-U.S.                                22,102       18,862             -
 Less inter-geographic sales             (2,053)      (1,420)            -
                                    ----------------------------------------
                                       $ 80,380     $ 65,401      $ 42,162
                                    ----------------------------------------

INCOME (LOSS) FROM OPERATIONS:
 Fee-for-service                       $  9,217     $  4,965      $  8,779
 Product development                      1,123       (2,021)       (9,278)
 Corporate                               (2,207)      (2,281)       (1,041)
                                    ----------------------------------------
                                       $  8,133     $    663      $ (1,540)
                                    ----------------------------------------

 United States                         $  8,348     $  1,799      $  5,060
 Non-US                                    (215)      (1,136)       (6,600)
                                    ----------------------------------------
                                       $  8,133     $    663      $ (1,540)
                                    ----------------------------------------

TOTAL ASSETS:
 Fee-for-service                       $ 64,253     $ 54,670      $ 42,961
 Product Development                      4,874        5,812         4,378
 Corporate                               40,130       39,967        57,139
                                    ----------------------------------------
                                       $109,257     $100,449      $104,478
                                    ----------------------------------------

 United States                         $ 81,532     $ 78,328      $ 82,529
 Non-U.S.                                27,725       22,121        21,949
                                    ----------------------------------------
                                       $109,257     $100,449      $104,478
                                    ----------------------------------------
</TABLE>



                                       23
<PAGE>   24

11. SUBSEQUENT EVENT

On March 16, 1999, the Company merged with Medical and Technical Research
Associates, Inc., (MTRA) a clinical research organization located near Boston,,
Massachusetts for approximately 1.3 million shares of stock including conversion
of MTRA stock options. The merger will be accounted for as a
pooling-of-interests, and accordingly, historical financial information will be
restated in future periods to include MTRA data. The following table reflects
the unaudited combined results of continuing operations of the Company and MTRA
as though the merger would have occurred on January 1, 1996. The results include
only the results of other acquisitions (referred to in Note 2) form the date of
purchase forward.

<TABLE>
<CAPTION>
Year ended December 31,                 1998          1997         1996  
---------------------------------------------------------------------------
<S>                                    <C>           <C>          <C>     
In thousands, except per 
share amounts (unaudited)

Net sales                              $98,243       $80,106      $ 53,728
Net income (loss)                      $ 6,539       $ 1,866      $ (2,462)
Diluted earnings (loss) per share      $  0.37       $  0.10      $  (0.18)
</TABLE>



                                       24
<PAGE>   25

Report of Independent Auditors

Applied Analytical Industries, Inc.
The Board of Directors and Shareholders of Applied Analytical Industries, Inc.

We have audited the consolidated balance sheet of Applied Analytical Industries,
Inc. and subsidiaries (the "Company") as of December 31, 1998, and the related
consolidated statements of income, shareholders' equity, and cash flows for the
year then ended. 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 audit.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Applied
Analytical Industries, Inc. and subsidiaries at December 31, 1998, and the
consolidated results of their operations and their cash flows for the year then
ended in conformity with generally accepted accounting principles.


                                                           /s/ ERNST & YOUNG LLP

Raleigh, North Carolina
February 12, 1999,
except Note 11, as to which the date is March 16, 1999

                                       25
<PAGE>   26


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 stockholders' equity and of cash flows
present fairly, in all material respects, the financial position of Applied
Analytical Industries, Inc. and its subsidiaries at December 31, 1997 and the
results of their operations and their cash flows for each of the two years in
the period ended December 31, 1997, 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 presentation. We believe that our audits provide a reasonable basis
for the opinion expressed above. We have not audited the consolidated financial 
statements of the Company for any period subsequent to December 31, 1997.


/s/ PricewaterhouseCoopers LLP

Raleigh, North Carolina
March 18, 1998

<PAGE>   27

Financial Results by Quarter  (Unaudited)
In thousands, except per share amounts

<TABLE>
<CAPTION>
Quarter                                 First        Second        Third         Fourth
<S>                                    <C>          <C>          <C>            <C>    
1998
Net sales                              $17,113      $19,426      $ 20,138       $23,703
Gross profit                           $ 8,616      $10,461      $ 10,284       $11,057
Net income (loss)                      $ 1,073      $ 1,306      $  1,413       $ 1,909
Basic earnings (loss) per share        $  0.07      $  0.08      $   0.09       $  0.12
Diluted earnings (loss) per share      $  0.07      $  0.08      $   0.09       $  0.12

1997
Net sales                              $15,175      $15,814      $ 14,021       $20,391
Gross profit                           $ 7,684      $ 8,248      $  6,027       $10,064
Net income (loss)                      $   910      $   583      $ (1,164)      $   926
Basic earnings (loss) per share        $  0.06      $  0.04      $  (0.07)      $  0.06
Diluted earnings (loss) per share      $  0.06      $  0.04      $  (0.07)      $  0.06
</TABLE>


         Price range of common stock, traded on the NASDAQ market under the
symbol "AAII"(1):

<TABLE>
<S>                                    <C>          <C>          <C>            <C> 
1998
High                                   $19 1/8      $16 1/8      $14 5/8        $18 3/4
Low                                    $13 1/4      $ 9          $ 9 5/8        $10

1997
High                                   $27 1/2      $20 1/2      $27 1/4        $20 3/8
Low                                    $17 1/2      $11 3/4      $19 1/16       $11 1/4
</TABLE>



(1)  The Company estimates there were approximately 1,200 holders of record for
     its common stock as of February 28, 1999. The Company has not declared any
     cash dividends during 1998 or 1997.