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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

                                    FORM 10-K

             [ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                   For the fiscal year ended December 31, 1997

            [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934

                         Commission File Number 0-21185

                       APPLIED ANALYTICAL INDUSTRIES, INC.
             (Exact name of Registrant as specified in its charter)

                               DELAWARE 04-2687849
                (State or other jurisdiction of (I.R.S. employer
               incorporation or organization) identification no.)

                      5051 NEW CENTRE DRIVE, WILMINGTON, NC
                           28403 (Address of principal
                          executive office) (Zip code)

Registrant's telephone number, including area code:    (910) 392-1606

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

                    Common Stock, $0.001 par value per share
                                (Title of class)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.   YES X    NO

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K of any
amendment to this Form 10-K. [ ]

The number of shares outstanding of the Registrant's common stock, as of
March 20, 1998 was 16,302,208 shares. The aggregate market value for the
voting stock held by non-affiliates of the Registrant on March 20, 1998 was
approximately $110,411,000.

                       Documents Incorporated by Reference
Portions of the Registrant's 1997 Annual Report to Shareholders are incorporated
by reference in Parts I, II, and IV hereof. Portions of the Registrant's 1997
Proxy Statement dated approximately April 10, 1998 are incorporated by reference
in Part III hereof.


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                                     PART I

Item 1.  Business.

         The terms "Company", "Registrant" or "AAI" in this Form 10-K include
Applied Analytical Industries, Inc., its corporate predecessors and its
subsidiaries, except where the context may indicate otherwise. The Company was
incorporated in 1986, although its corporate predecessor was founded in 1979.
AAI operates in two business segments which include a fee-for-service business
and a product development business. Financial information by business segment is
included on page 26 of the 1997 Annual Report to Shareholders (the "Annual
Report") and is incorporated herein by reference.

         In the fee-for-service business, AAI is a leading integrated contract
research and development resource to the worldwide pharmaceutical and
biotechnology industries, offering an efficient, variable cost alternative to
its clients' internal drug development, compliance and quality control programs.
The Company provides a broad array of value-added services, including chemical
analysis, synthesis and other laboratory services; drug formulation development;
clinical trial and bioanalytical services; clinical supply and niche
manufacturing; and regulatory and compliance consulting. AAI has contributed to
the submission, approval or continued marketing of client products worldwide,
encompassing a wide range of therapeutic categories and technologies. The
Company believes that its ability to offer an extensive portfolio of high
quality drug development and support services enables it to effectively compete
as pharmaceutical and biotechnology companies look for integrated drug
development solutions that offer cost-effective results on an accelerated basis.

       In addition to the fee-for-service business, AAI leverages its expertise
by allocating a significant proportion of its technical resources and operating
capacity to internal drug and drug technology development. The Company generally
funds the expense of development and then participates in the benefits of any
potential commercial success through licensing and royalty arrangements.
Internal drug development is focused on generic products, line extensions and
patented technologies. Certain of these products have been licensed or sold. The
Company's proprietary technology includes patents and pending patent
applications on formulations, methods and drug delivery vehicles. Since 1993,
the Company has allocated a growing proportion of its technical resources and
operating capacity to its internal drug and drug technology development program.
The Company has only recently begun to recognize significant license and royalty
revenues from its internal development efforts because of the significant time
required for development and regulatory approval of pharmaceutical products.

       In 1994, as part of its internal development program, the Company
organized Endeavor Pharmaceuticals Inc. ("Endeavor") to develop certain hormone
pharmaceutical products, focusing initially on several such products then under
development by AAI. The Company owns approximately 40% of the fully diluted
common equity of Endeavor.

       On December 31, 1996, the Company acquired L.A.B. Gesellschaft fur
pharmakologische Untersuchungen mbH & Co. ("L.A.B."). L.A.B. is a European
contract research and development organization headquartered in Neu-Ulm, Germany
with principal operating units in Neu-Ulm and Munich, Germany; and in Paris,
France, as well as smaller operational units in London, England and Arnheim,
Netherlands. L.A.B. focuses on both clinical and non-clinical pharmaceutical
product development and provides services that include drug formulation
development; chemical analysis; Phase I clinical trial studies; bioanalytical
testing; and European regulatory consulting. L.A.B. also provides Phase II-IV
multi-center clinical trial studies focused in niche therapeutic areas including
hepatic disease, chemotherapeutics, and hormone replacement therapy.

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Fee-for-Services Business

       The Company provides a broad array of drug development services,
including chemical analysis, synthesis and other laboratory services;
formulation development; clinical trial and bioanalytical services; clinical
supply and niche manufacturing; and regulatory and compliance consulting. The
Company assigns project management teams consisting of customer service
representatives and technical employees that meet with clients at frequent
intervals to monitor and guide projects through the development process.
Continual client interaction allows the Company to efficiently manage the drug
development process.

       Historically, the Company's laboratory services have accounted for
approximately one half of its fee-for-service revenue, although relative amounts
vary from year to year. Formulation development projects and clinical supply and
niche manufacturing generally have contributed the major portions of remaining
annual fee-for-service revenue. With the addition of L.A.B., the Company
anticipates that clinical trials services will contribute more significantly to
total revenues.

Laboratory Services

       In support of drug development and compliance programs, the Company
offers laboratory services to characterize and measure drug components and
impurities. The Company has over 18 years experience in providing analytical
testing services dedicated exclusively to the drug industry and has developed
the scientific expertise, state-of-the-art equipment and broad range of
scientific methods to accurately and quickly analyze almost any compound or
product. The Company's laboratory services include method development and
validation; stability studies; raw materials and release testing; biotechnology,
microbiology and bioanalytical testing; product characterization and organic
synthesis.

       Method Development and Validation. The Company develops and validates
methods used in a broad range of laboratory testing necessary to determine
physical or chemical characteristics of compounds. Analytical methods are
developed to demonstrate potency, purity, stability or physical attributes.
These methods are validated to ensure the data generated by these methods are
accurate, precise, reproducible and reliable and are used throughout the drug
development process and in product support testing.

       Stability Studies. The Company provides stability testing and secure
storage facilities necessary to establish and confirm product purity, potency
and other shelf-life characteristics. Stability testing is required at all
phases of product development, from dosage form development through commercial
production, to confirm shelf life of each manufactured batch. The Company
maintains state-of-the-art controlled-climate facilities in the United States
and Germany to determine the range of storage conditions a product can
withstand. FDA regulations and the regulations of European regulatory
authorities require that samples of clinical and commercial products placed in
stability chambers be analyzed in a timely fashion after scheduled "pull points"
occur, based on the date of manufacture. The Company's proprietary LTS systems
track client products maintained at the Company's stability storage facilities
and automatically schedules required testing as pull points occur.

       Raw Materials and Product Release Testing. The Company offers testing
required by the FDA to confirm that raw materials used in production and
resulting finished products are consistent with established specifications. Due
to the incorporation of "just in time" inventory control systems and variations
in client production schedules, release testing for both raw materials and the
finished product often cannot be scheduled by clients in advance, yet must be
performed immediately. The Company believes that its internal scheduling
systems, analytical



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laboratory expertise and systems for prompt testing provide it with a
competitive advantage in providing both raw material and batch release testing.
The Company believes that this service enhances its client's confidence in
adopting cost-saving "just in time" inventory control systems.

       Biotechnology Analysis and Synthesis. Although the types of analytical
investigations of biotechnology products are similar to those required for more
traditional pharmaceutical products, the complex molecular structure of many
biotechnology products requires different technology and expertise. The Company
provides a broad array of biotechnology services, including both analytical and
biological testing and method development and validation. AAI's breadth of
services allows the Company to rapidly deduce and characterize the complex
structure of the biotechnology product and measure the molecule or its
metabolites in human blood plasma to support clinical trial evaluation. The
Company has expertise in a broad spectrum of biochemical and immunochemical
methods for characterization and analysis of biotechnology drugs. These methods
include amino acid sequencing, amino acid analysis, peptide mapping,
carbohydrate and lipid analysis and electrophoresis. The Company also has
expertise in developing chromatographic methods that precisely evaluate the
purity and stability of biotechnology products. This service breadth and
diversity of analytical skills and technologies enable the Company to assist its
clients from early product development through the investigational new drug
application and product license application stages and commercial production.

       Microbiological Testing. Microbiological testing is an essential
indicator to ensure that a drug product, whether raw material or finished
product, does not contain harmful micro-organisms. The Company has significant
experience conducting various microbial tests to identify and quantify
micro-organisms that may be present, including limulus amebocyte lysate (LAL)
testing, which measures toxic byproducts of micro-organisms, and particulate
matter testing to determine the presence of foreign matter in injectable drug
products. The Company also performs sterility testing to identify the genus and
species of any micro-organisms that are present. In addition, the Company
performs tests to determine the effectiveness of antibiotics against
micro-organisms and the minimum levels of preservatives necessary in product
formulations.

       The Company also assists clients with environmental monitoring, including
water and air systems testing, using an automated biochemical system to identify
micro-organisms present and determine whether such systems are within applicable
microbial limits. The Company assists clients in validating their environmental
control systems to ensure compliance with GMP regulations.

       Bioanalytical Testing. The Company offers bioanalytical testing services
to support clinical trials, analyzing plasma samples to characterize the
metabolized forms of the drug and determine the rate of absorption.
Bioanalytical studies of new drugs often present challenging and complex issues,
with products being metabolized into multiple active and inactive forms, each of
which must be measured. The Company works with its clients to develop and
validate analytical methods to permit detection and measurement of the various
components to trace levels. The acquisition of L.A.B. significantly enhanced the
Company's bioanalytical capabilities.

       Product Characterization. The Company has the expertise and instruments
required to identify and characterize a broad range of chemical entities.
Characterization analysis identifies the chemical composition, structure and
physical properties of a compound, and characterization data forms a significant
portion of a regulatory application. The Company uses numerous techniques to
characterize the compound, including spectroscopy, chromatographic analysis and
other physical chemistry techniques. Additionally, the Company uses such
information for control testing to be performed throughout development and
marketing to confirm consistent



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drug composition. Once appropriate test methods are developed and validated, and
appropriate reference standards (highly pure samples) are characterized and
certified, the Company can assist clients by routinely testing compounds for
clinical and commercial use.

       Organic Synthesis. The Company develops synthesis methods for producing
experimental quantities of new compounds needed for analytical characterization,
toxicological studies, formulation development and clinical trials. Through
organic synthesis techniques, the Company can produce reference standards of the
active compound, specific impurities, degradation by-products, bioassay
reference standards or molecular analogs to permit sufficient quantities of such
compounds to be separately characterized and studied.

Formulation Development Services

       The Company provides integrated formulation development services,
enabling the Company to take a client's compound and develop a safe and stable
product with desired characteristics. The Company believes its formulation
expertise and extensive analytical capabilities enable it to provide an
efficient, seamless development program, with a dedicated project team tracking
the product through all stages of formulation development. The Company provides
formulation development services to its clients during each phase of the drug
development process, from new compounds and modifications of existing products
to generic versions of branded products. The Company's formulation development
projects may support a small segment of critical development activities or may
last for several years going from early formulation development to optimized and
validated production-scale, packaged product.

       The Company's formulation development expertise spans a broad spectrum of
therapeutic areas. The Company works with clients to develop products with
desired characteristics, including dosage form, strength, release rate,
absorption properties, stability and appearance. The Company has developed
significant product and process capabilities that enable it to more efficiently
solve the complex problems that arise in developing formulations with targeted
characteristics and has developed a range of proprietary product technologies
that allow it to better achieve desired results in product design and
development.

       In providing formulation services, the Company works closely with clients
to design and conduct feasibility studies to chart the potential of formulating
a drug using a combination of active drug ingredients and inert materials called
excipients. Using experimental designs, initial prototype formulations are
prepared to identify potential problems in stability, bioavailability and
manufacturing. Generally, formulation development is an iterative process, with
numerous initial formulations being modified as problems are encountered. The
Company believes its experience and expertise in formulation development, as
well as certain proprietary technologies, permit it to design efficient
protocols for identifying and optimizing prototypes with the greatest potential.

       Upon selection of the final product prototypes, the Company develops
protocols to scale the product batch size from development stage (hundreds to
thousands of units) to clinical scale (thousands to millions of units). During
the clinical phase the Company refines the formulation in response to clinical,
bioanalytical and stability data. The manufacturing scale-up process involves
identifying and resolving manufacturing problems to facilitate an efficient
transfer to the full-scale production equipment of the Company's clients.
Throughout the development process, the Company develops and validates the
analytical methods necessary to test the product to establish and confirm
product specifications.

       In addition to new drug development, the Company offers product
modification and line extension services to clients, generally for marketed
products facing patent expiration. Modifications of existing products offer the
Company's clients an opportunity to improve product characteristics, increasing
product market viability. Improved product characteristics



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include enhancement of stability, absorption profiles (e.g., quick or sustained
release), taste and appearance. Product line extensions may include new dosage
forms such as solids, liquids and chewables, as well as new dosage strengths.
Product modifications and line extensions offer clients the opportunity to
target new patient subpopulations and improve patient compliance. The Company
also offers formulation services to clients seeking to develop generic products.

Clinical Supply and Niche Manufacturing

       The Company provides clinical trials materials for Phase I through IV
clinical trials. The Company has expertise in manufacturing tablets, capsules,
sachets, liquids and suspensions, creams, gels, lotions and ointments. The
Company believes that outsourcing of clinical supply manufacturing is
particularly attractive to pharmaceutical companies that maintain large,
commercial-quantity, batch facilities, where clinical supply manufacturing would
divert resources from revenue-producing manufacturing. Similarly, pharmaceutical
companies often seek to outsource commercial manufacturing of small quantity
products. In addition, the Company provides its clients assistance in scaling up
production of clinical supply quantities to commercial quantity manufacturing,
and manufactures inventory on behalf of clients for commercial sale while client
production facilities are being built and validated.

       The Company's manufacturing facilities and equipment are qualified and
validated to operate under GMP (good manufacturing practices) regulations.

Regulatory and Compliance Consulting

       The Company assists in the preparation of regulatory submissions, audits
a client's vendors and client operations, conducts seminars, provides training
courses, and advises clients on applicable regulatory requirements. The Company
also assists clients in designing development programs for new or existing drugs
intended to be marketed in the United States and Europe. At the client's
request, the Company will either review client prepared submissions or draft
sections and assemble regulatory packages and attend FDA meetings with clients.
The Company assists clients in preparation for FDA inspections and assists them
in correcting any deficiencies noted in FDA inspections. In preparation for an
FDA inspection, the Company's regulatory affairs specialists conduct mock
inspections to anticipate FDA observations and advise clients of appropriate
remedial actions. The Company also audits manufacturers of active and excipient
ingredients used in the drug product, as well as packaging components, on behalf
of clients to ensure that the manufacturers' facilities are in compliance with
GMP regulations. Such audits generally include review of the vendor's drug
master files, analysis of written standard operating procedures ("SOP"), review
of production records, and observation of operations to ensure that written
SOP's are being followed. Audit reports include recommendations to address any
deficiencies. The Company also advises clients on validation issues concerning
their systems and processes and audits client facilities to assist them in
validating their processes, cleaning, water and air handling systems.

       The Company leverages its in-house laboratory training programs by
providing training to clients' employees. In addition, the Company organizes and
conducts seminars worldwide on a number of topical industry issues.

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Clinical Trial Studies

       The Company has a 48-bed clinical trial facility at its Research Triangle
Park location. The clinical trial unit is located in the same facility as the
Company's bioanalytical laboratory and permits time-sensitive and rapid-response
analysis in clinical trials. The clinical trial unit is initially intended for
use in bioequivalency studies of generic drug products and Phase I clinical
trials. With the acquisition of L.A.B., the Company expanded its Phase I
clinical trial capabilities and added the ability to conduct Phase II-IV studies
and multi-center trials focused in niche therapeutic areas, including hepatic
disease, chemotherapeutics and hormone replacement therapy. The Company's
Neu-Ulm, Germany operations include a 120-bed facility for conducting certain
Phase I and II clinical trial studies, as well as bioequivalency studies. The
newly expanded facility in Paris, France allows the Company to perform as a
Phase II-IV multi-center clinical trial operation serving many European
pharmaceutical companies.

Product Development Business

       The Company dedicates a significant proportion of its technical resources
and operating capacity to internal drug and technology development with the
objective of licensing marketing rights to third parties. The Company does not
independently commercialize products developed internally or otherwise directly
compete with its clients in the marketing or distribution of products and,
accordingly, believes that its internal development efforts are complementary to
its clients' development needs. The Company's internal product and technology
development program has resulted in multiple product applications filed with the
FDA and European regulatory agencies. Many of these products have been licensed
or sold. The internal development program has also resulted in patents covering
drug technology and pending patent applications

       Since 1993, the Company has significantly increased its investment in its
internal product development program. Because of the significant time required
for development and approval of pharmaceutical products, the Company has only
recently begun to recognize significant license revenue from its internal
development efforts. The Company anticipates that internal product development
revenues, including royalties and milestone license payments, will represent a
growing proportion of its revenue. However, there can be no assurance that
internal development projects will yield products that will be approved by the
appropriate regulatory authorities or will be attractive to potential clients.
Although there is a risk that any particular development project may not produce
revenues, the Company believes that the profit margins from successful drug and
technology development projects could potentially exceed the margins for
standard fee-for-service engagements.

       The Company's research and development committee, composed of
representatives from the formulations development, finance and marketing
departments, identifies potential drug development candidates for the program.
The committee selects development candidates after reviewing market size and
trends, current therapies and potential advances and patent and formulation
issues. In certain instances, the committee has also invited outside consultants
and medical panels to review selections.

       In 1994, as part of its internal development program, the Company
organized Endeavor with certain financial investors and an affiliate of Berlex
Laboratories, Inc. to continue the development of certain generic hormone
products then under development by AAI. The Company assigned its rights to such
products to Endeavor in return for approximately 47% of Endeavor's equity during
a private placement of Endeavor stock, and the Company entered into a contract
with Endeavor to continue product development and clinical supply manufacture.
AAI currently owns approximately 40% of the fully diluted common equity of
Endeavor. The


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Company's fee-for-service net sales to Endeavor were approximately $3.2 million,
$6.2 million and $3.5 million in 1997, 1996 and 1995, respectively. The Company
believes that such services are provided at terms that are no less favorable
than terms that would be obtained from an unrelated third party.

       Endeavor has had one product approved by the FDA, which will be launched
in early 1998. It is also currently developing another product, in multiple
dosage strengths; however, there can be no assurance that such product will
ultimately be approved by the FDA. Endeavor does not directly market any
products and its revenues are dependent upon licensing fees and royalties from
third parties. Continued product development by Endeavor is dependent upon
revenues from the approved product or additional capital funding.

       In 1995 the Company entered into an agreement with Aesgen, Inc.
("Aesgen"), a company organized by the Company with an affiliate of Mayo Clinic,
MOVA Pharmaceutical Corporation and certain financial investors, to develop
certain pharmaceutical products. AAI recognized net sales to Aesgen of $1.9
million, $4.7 million and $5.6 million in 1997, 1996 and 1995, respectively. In
1996, the Company sold to Aesgen marketing rights to a product being developed
by the Company. Under the agreement, Aesgen will pay license fees and additional
royalties upon marketing the product, although there can be no assurance that
the product will be approved by the FDA or marketed. AAI continues to hold a
$1.6 million non-voting, non-convertible preferred stock investment in Aesgen.

       In addition to its development work for Endeavor and Aesgen, the Company
has continued its internal development of products to be licensed to third
parties that have marketing and distribution capabilities. The Company has
entered into numerous license agreements for products that are currently in
development. The terms of the license agreements vary as to amounts of milestone
payments, as well as methods and extent of revenue participation. While the
Company anticipates that most of its product license agreements will provide
that prospective clients will ultimately sponsor the approved product, in
certain instances the Company has made submissions for internally developed
products in its own name.

       Continuing to leverage its development capabilities, the Company has
moved into product line extension development and has also begun reviewing new
compounds that are chemically similar to currently marketed products with proven
therapeutic and safety profiles, and that offer improved characteristics over
the marketed product. Such improved characteristics would include enhanced or
new therapeutic indices, reduced side effects, improved bioavailability and
improved pharmacokinetics. Because considerable toxicity data already exists for
the marketed product, the Company believes that product lines extensions and
pro-drugs generally could be developed with less risk of failure and in a
shorter time frame than new chemical entity development. The Company believes
that virtual and limited-resource drug companies provide opportunities to enter
into collaborative ventures to identify and develop these types of compounds.

Technology Development Program

       As an adjunct to the internal development program, the Company has sought
to protect certain intellectual property it has developed relative to the drug
development process. The Company has established a patent committee that meets
regularly to review employee-generated submissions of possible patentable
subject matter. The patent committee reviews the novelty and usefulness of the
submission and, with input from the marketing department as to commercial
viability, determines to either pursue a patent application or designate the
submission as a trade secret.

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       The Company's internal development program has yielded multiple issued
patents and has several pending applications. For example, the Company's
patented Pro-Sorb(TM) formulation technology has been shown to facilitate the
oral absorption of a number of non-steroidal anti-inflammatory drugs or NSAIDs,
such as diclofenac, to reduce gastric irritation and speed the onset of
therapeutic activity. In addition, the Company has patented a novel oral
delivery system for certain biotechnology compounds that may currently be
administered only by injection.

       The Company has one licensing agreement for a patented technology for the
manufacture of low-dose products which are typically difficult to uniformly
blend and an additional licensing arrangement for its patented chewable
formulations to mask the otherwise bitter taste of certain ulcer drugs. The
Company is seeking licensing partners for its other recently developed
technologies.

Information Technology

       The Company has made significant investments in information technology.
The Company's LTS system tracks laboratory workflow and enables the Company to
monitor and plan work through the Company's laboratories. The LTS system
monitors the progress of a client's project, records time expended by laboratory
personnel, tracks sample locations and controls document revisions. The
Company's customized data management system connects analytical instruments with
multiple software architectures permitting automated data capture.

       The Company believes that information technology will enable it to
expedite the development process by designing innovative services for individual
client needs, providing project execution, monitoring and control capabilities
that exceed a client's internal capabilities, streamlining and enhancing data
presentation to the FDA and enhancing its own internal operational productivity
while maintaining its quality.

       Disclosure regarding the impact of year 2000 is included on page 16 of
the Annual Report and is incorporated herein by reference.

Clients

       The Company has provided services to most of the large pharmaceutical
companies in the world. The Company believes that concentration of business
among certain large clients is not uncommon in the contract research
organization (CRO) industry. The Company has experienced such concentration in
the past and may experience such concentration in the future. Although AAI
strives to reduce its reliance on a limited number of major clients, there can
be no assurance that the Company's business will not be dependent upon certain
major clients, the loss of which could have a material adverse effect on the
Company. In addition, due to the project nature of the Company's business, there
can be no assurance that significant clients in any one period will continue to
be significant clients in other periods.

Marketing and Business Development

       Since its inception, the Company has taken a customer-focused approach in
marketing its services, often placing the Company's technical personnel with its
clients' development teams to participate in planning meetings for the
development of a product. The Company assigns sales and technical personnel as
contacts for its larger clients, understanding that technical personnel may be
better able to identify the full scope of the client's needs and suggest
innovative approaches before the client formally develops the parameters of an
anticipated project. Generally, the Company also hosts more than ten technical
seminars per year for the



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pharmaceutical and biotechnology industries addressing a variety of formulation
development issues, stability testing and other topics.

Contractual Arrangements

       The Company's fee-for-service contracts are typically evidenced by signed
service estimates establishing an estimated fee for identified services. During
the Company's performance of a project, clients often adjust the scope of
services to be provided by the Company in light of interim project results, at
which time the amount of fees is adjusted accordingly.

       Generally, the Company's fee-for-service contracts are terminable by the
client upon notice of 30 days or less, although certain major formulation
development and manufacturing agreements are not unilaterally terminable by the
client. Although the contracts typically permit payment of certain fees for
winding down a project, the loss of a large contract or the loss of multiple
contracts could adversely affect the Company's future revenue and profitability.
Contracts may be terminated for a variety of reasons, including the client's
decision to forego a particular study, the failure of product prototypes to
satisfy safety requirements and unexpected or undesired results of product
testing.

Backlog

       Backlog consists of anticipated net sales from signed service estimates
and other fee-for-service contracts that have not been completed and provide for
a readily ascertainable price. Once contracted work begins, net sales are
recognized as the service is performed on the percentage of completion basis. In
certain cases, the Company begins work for a client before a contract is signed.
Accordingly, backlog does not include anticipated net sales for which the
Company has begun work but for which the Company does not have a signed service
estimate, or for any variable-priced contracts. In addition, during the course
of a project the client may substantially adjust the requested scope of services
and corresponding adjustments are made to the price of services under the
contract.

       The Company believes that its backlog as of any date is not a meaningful
predictor of future results because backlog can be affected by a number of
factors, including variable size and duration of contracts and adjustments in
the scope of a contracted project as interim results become available.
Additionally, contracts generally are subject to termination by clients upon 30
days notice or less. Moreover, the scope of a contract can change over the
course of a project. At December 31, 1997 and 1996 backlog was approximately
$31.5 and $20.3 million, respectively.

Competition

       The Company competes primarily with in-house research, development,
quality control and other support service departments of pharmaceutical and
biotechnology companies, as well as university research laboratories. In
addition, the Company believes that although there are numerous competitors in
its industry, there are few competitors that offer the broad array of services
that it provides. Certain of the Company's competitors may have significantly
greater resources than the Company. Competitive conditions for service areas
vary.

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       Competitive factors include reliability, turn-around time, reputation for
innovative and quality science, capacity to perform numerous required services,
financial viability and price. The Company believes that it competes favorably
in these areas.

Government Regulation

       The services performed by the Company are subject to various regulatory
requirements designed to ensure the quality and integrity of pharmaceutical
products, primarily under the Federal Food, Drug and Cosmetic Act and associated
GMP regulations which are administered by the FDA in accordance with current
industry standards. Services being performed outside the United States or for
products intended to be substituted to non-U.S. jurisdictions may be subject to
additional regulatory requirements and government agencies applicable to that
jurisdiction. U.S. regulations apply to all phases of drug manufacture, testing
and record keeping, including personnel, facilities, equipment, control of
materials, processes and laboratories, packaging, labelling and distribution.
Noncompliance with such regulations by the Company in a project could result in
disqualification of data collected by the Company for such project. Material
violation of regulatory requirements could result in additional regulatory
sanctions. In severe cases violations could result in a mandated closing of the
Company's facilities which would materially and adversely affect the Company's
business.

       To help assure compliance with applicable regulations, the Company has
established quality assurance controls at its facilities that monitor ongoing
compliance by auditing test data and regularly inspecting facilities, procedures
and other regulatory compliance parameters. In addition, FDA regulations and
guidelines, as well as applicable international standards, serve as a basis for
the Company's standard operating procedures. Certain of the Company's
development and testing activities are subject to the Controlled Substances Act,
administered by the Drug Enforcement Agency (the "DEA"), which regulates
strictly all narcotic and habit-forming substances. The Company maintains
separate, restricted-access facilities and heightened control procedures for
projects involving such substances due to the level of security and other
controls required by the DEA.

       The Company's activities involve the controlled use of hazardous
materials and chemicals. The Company is subject to federal, state and local laws
and regulations governing the use, storage, handling and disposal of such
materials and certain waste products. Although the Company believes that its
safety procedures for handling and disposing of such materials comply with the
standards prescribed by federal, state and local laws and regulations, the risk
of accidental contamination or injury from these materials cannot be completely
eliminated. In the event of such an accident, the Company could be held liable
for any damages that result which could materially and adversely affect the
financial condition of the Company.

Employees

       At December 31, 1997, the Company had approximately 850 full-time
equivalent employees, of which approximately 74 hold Ph.D. or M.D. degrees, or
their U.S. equivalent. The Company believes that its relations with its
employees are good. None of the Company's employees in the U.S. are represented
by a union. German law provides certain representative rights to employees.

       The Company's performance depends on its ability to attract and retain
qualified professional, scientific and technical staff. The level of competition
among employers for such skilled personnel is high. The Company believes that
its employee benefit plans, including its health benefit, profit-sharing and
employee stock option plans, enhance employee morale,


                                       11
<PAGE>   12

professional commitment and work productivity and provide an incentive for
employees to remain with the Company. In addition, the Company operates an
employee day-care and after-school program facility at its Wilmington, North
Carolina campus as a benefit to its employees. While the Company has not
experienced any significant problems in attracting or retaining qualified staff,
there can be no assurance that the Company will be able to avoid these problems
in the future.

       All employees enter into confidentiality agreements protecting the
Company's proprietary information, as well as client-confidential material. New
U.S.-based technical employees are generally required to sign non-competition
agreements, prohibiting the employee from engaging in activities in competition
with the Company for a period of one year after termination of employment.

Special Item. Executive  Officers of the Company.

         The following table sets forth the name, age, principal occupation and
business experience for the executive officers of the Company.

Frederick D. Sancilio, Ph.D., 48, Chairman of the Board, President, Chief
Executive Officer and Director. Dr. Sancilio has served in his current capacity
for more than five years. Before founding the Company in 1979 Dr. Sancilio's
experience in the pharmaceutical industry included various positions with
Burroughs-Wellcome Co., Schering-Plough Corporation, and Hoffmann-LaRoche, Inc.
He has published more than 30 scientific articles discussing various aspects of
pharmaceutical chemistry and regularly makes scientific presentations at
pharmaceutical seminars and meetings worldwide.

Dr. Werner Gorlich, M.D., Ph.D., 50, Executive Vice President. Dr. Gorlich has
served as Executive Vice President since June 1997. Prior to joining the Company
he served as Medical Director of Research and Development at Glaxo, GmbH. Dr.
Gorlich has also held positions as Co-Managing Director of EuMcCom, a Glaxo
subsidiary; as a member of Glaxo Group's International Medical Board and other
management positions with both SmithKline and Sandoz.

Eugene T. Haley, 48, Executive Vice President and Chief Financial Officer. Mr.
Haley has served as Executive Vice President and Chief Financial Officer since
February 1998. Prior to joining the Company he served as the Chief Financial
Officer of Kodak Worldwide Consumer Imaging Services during 1997 and as Senior
Vice President of Qualex (an Eastman-Kodak subsidiary) from 1993 to 1997.

Martin S. Hunicutt, 47, Executive Vice President. Mr. Hunicutt has served as
Executive Vice President since May 1997. He had served as Vice President of
Marketing and Sales from 1994 to 1997. Prior to joining AAI in 1994, Mr.
Hunicutt was a Director of Marketing for Burroughs-Wellcome Co. and has 24 years
of experience in the pharmaceutical industry.

Kenneth Lomartire, 51, Executive Vice President Worldwide Research &
Development. Mr. Lomartire has served as Executive Vice President Worldwide
Research & Development since January 1997. Prior to joining the Company he was
Director, Pharmaceutical Development for Astra USA from 1990 to 1996. Mr.
Lomartire has over 28 years in the pharmaceutical industry.

                                       12
<PAGE>   13

Frances M. Sakers, 40, Executive Vice President and Chief Operating Officer. Ms.
Sakers has served in her current position since September 1997. Prior to joining
the Company, Ms. Sakers was Executive Director of Quality Control at Novartis
Pharmaceuticals U.S. and has held various positions in Pharmaceutical Operations
at CIBA-Geigy Corporation for 14 years.

William H. Underwood, 50, Executive Vice President and Director. Mr. Underwood
has served in his current position since 1992 and has been a Director since
1996. He also served as Chief Operating Officer from 1995 to May 1997. He has
held various positions in the pharmaceutical and cosmetic industries, prior to
joining the Company in 1986, with Mary Kay Cosmetics, Inc. and
Burroughs-Wellcome Co.

R. Forrest Waldon, 35, Executive Vice President, General Counsel and Secretary.
Mr. Waldon has served as Executive Vice President since May 1997 and as General
Counsel and Secretary since 1989. He has been a Vice President since 1993. Prior
to his employment at the Company, Mr. Waldon practiced law with Thrasher &
Whitley, P.C. in Atlanta, Georgia.

Item 2.  Properties.

         The Company's principal executive offices are located in Wilmington,
North Carolina, in a 19,000-square foot leased facility. The Company's primary
U.S. facilities are located in Wilmington and Research Triangle Park, North
Carolina constituting approximately 150,000 square feet of operational and
administrative space. The Company's primary European facilities are located in
Neu-Ulm, Germany and include approximately 120,000 square feet of operational
and administrative space. This facility is leased under renewable leases
expiring in 2001. The Company maintains other operating units at leased
facilities in Munich, Germany; Paris, France; London, England; and Arnheim,
Netherlands. The Company maintains sales offices in Chicago, Illinois; Boston,
Massachusetts; San Diego and San Francisco, California; Elmwood Park, New
Jersey; Copenhagen, Denmark; London, England; Milan, Italy and Tokyo, Japan. The
Company believes that its facilities are adequate for the Company's operations
and that suitable additional space will be available when needed.

Item 3.  Legal Proceedings.

         The Company may be party to lawsuits and administrative proceedings
incidental to the normal course of its business which are not considered
material. In connection with the 1995 issuance of preferred stock, James L.
Waters and Frederick D. Sancilio (directors and significant stockholders of the
Company) have agreed to indemnify the Company for certain, then existing, claims
if any losses are 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.

         In December 1997, the North Carolina Supreme Court overturned a
judgement against the Company in the action, Kurtzman v. Applied Analytical
Industries, Inc. and directed the trial court to enter a judgment in favor of
the Company on all matters under the suit. Accordingly, such litigation was
ended.

Item 4.   Submission of Matters to a Vote of Security Holders

         None during the quarter ended December 31, 1997.

                                       13
<PAGE>   14

                                     PART II

Item 5.   Market for the Registrant's Common Equity and Related Stockholder
Matters.

         Market and other related information required by Item 5 is included on
page 28 of the Annual Report and is incorporated herein by reference.

Use of Proceeds.

         In 1996, the Company completed the sale of 3,105,000 shares of common
stock through an offering filed on Registration Statement Form S-1 (No.
333-5535) which became effective on September 19, 1996. The net offering
proceeds to the Company after underwriting discounts and other expenses, as
previously disclosed in other Company filings, was $44,793,000. A reasonable
estimate for the application of such proceeds is described below. Such
information represents cumulative totals through the reporting date of this
periodic report and all amounts, unless indicated otherwise, are for direct or
indirect payments to others.

         Construction of plant, building and facilities       $ 4,951,000
         Purchase and installation of machinery and equipment $ 8,630,000
         Repayment of indebtedness                            $ 1,221,000
         Working capital                                      $ 5,654,000
         Research and development                             $ 9,032,000
         Temporary investments (short-term, investment
         grade, Interest-bearing)                             $15,305,000

         Use of proceeds                                      $44,793,000

Item 6.   Selected Financial Data.

         The information required by Item 6 is included on page 13 of the Annual
Report and is incorporated herein by reference.

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.

         The information required by Item 7 is included on pages 14 through 16
of the Annual Report and is incorporated herein by reference.

Item 7A.  Quantitative and Qualitative Disclosures About Market Risk.

         This item is not applicable.

Item 8.   Financial Statements and Supplementary Data.

         The information required by Item 8 is included on pages 17 through 28
of the Annual Report and is incorporated herein by reference.


                                       14
<PAGE>   15



Item 9. Changes In and Disagreements with Accountants on Accounting and
Financial Disclosure.

         None.

                                    PART III

Item 10.   Directors and Executive Officers of the Registrant.

         The directors of the Company and their business experience are set
forth on page 2 of the Company's Notice of Annual Meeting of Stockholders, dated
approximately April 10, 1998 (the "Proxy Statement") and are incorporated herein
by reference. The discussion of executive officers of the Company is included in
Part I under "Executive Officers of the Company."

Item 11.   Executive Compensation.

         A description of the compensation of the Company's executive officers
is set forth on pages 5 through 8 of the Proxy Statement and is incorporated
herein by reference.

Item 12.   Security Ownership of Certain Beneficial Owners and Management.

         A description of the security ownership of certain beneficial owners
and management is set forth on pages 3 and 4 of the Proxy Statement and is
incorporated herein by reference.

Item 13.   Certain Relationships and Related Transactions.

         Certain relationships and related transactions with management are
described on pages 10 and 12 of the Proxy Statement and in Items 11 and 12, and
are incorporated herein by reference.

                                     PART IV

Item 14.   Exhibits, Financial Statement Schedules, and Reports on Form 8-K.

Exhibits:

         A list of the exhibits required to be filed as part of this Report on
Form 10-K is set forth in the "Exhibit Index", which immediately precedes such
exhibits, and is incorporated herein by reference.

Financial Statement Schedules:

         The consolidated balance sheets as of December 31, 1997 and 1996, and
related consolidated statements of income, cash flows and stockholders' equity
for each of the three years in the period ended December 31, 1997 and the
related notes to financial statements, together with the report of independent
accountants thereon of Price Waterhouse LLP, dated March 18, 1998, appearing on
pages 17 through 28 of the Annual Report, are incorporated herein by reference.
With the exception of the aforementioned information and the information
incorporated by reference in Items 1, 5 through 8, the Annual Report is not to
be deemed filed as part of this report. The additional financial data listed
below should be read in


                                       15
<PAGE>   16

conjunction with the financial statements in the Annual Report. Schedules not
included with this additional financial data have been omitted because they are
not applicable or the required information is shown in the financial statements
or notes thereto.


Reports on Form 8-K:

         None filed during the quarter ended December 31, 1997.

Additional Financial Data
                                                                       Page

Applied Analytical Industries, Inc., for years ended
   December 31, 1997, 1996 and 1995:
         Report of Independent Accountants                             F-1
         Financial Statement Schedule:
         Schedule II - Valuation and Qualifying Accounts               F-2





                                       16
<PAGE>   17




                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.

/s/ FREDERICK D. SANCILIO          Chairman of the Board,         March 31, 1998
--------------------------------   President and Chief Executive
    Frederick D. Sancilio, Ph.D.   Officer


Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons, or in their behalf by their duly
appointed attorney-in-fact, on behalf of the Registrant in the capacities and on
the date indicated.

<TABLE>
<CAPTION>
             Signatures                                       Title                            Date
             ----------                                       -----                            ----
<S>                                                           <C>                              <C>
/s/ FREDERICK D. SANCILIO                      Chairman of the Board,                      March 31, 1998
--------------------------------               President, Chief Executive
    Frederick D. Sancilio, Ph.D.               Officer and Director
                                               (Principal Executive Officer)

/s/ EUGENE T. HALEY                            Executive Vice President                    March 31, 1998
--------------------------------               and Chief Financial Officer
    Eugene T. Haley

/s/ STEPHEN F. RIZZO                           Vice President and                          March 31, 1998
-------------------------------                Controller (Principal
    Stephen F. Rizzo                           Accounting Officer)

/s/ WILLIAM H. UNDERWOOD                       Executive Vice President                    March 31, 1998
-------------------------------                and Director
    William H. Underwood

/s/ JOSEPH H. GLEBERMAN                        Director                                    March 31, 1998
-------------------------------
    Joseph H. Gleberman

/s/ JOHN M. RYAN                               Director                                    March 31, 1998
-------------------------------
    John M. Ryan

/s/ JAMES L. WATERS                            Director                                    March 31, 1998
-------------------------------
    James L. Waters

</TABLE>


                                       17
<PAGE>   18


REPORT OF INDEPENDENT ACCOUNTANTS
ON FINANCIAL STATEMENT SCHEDULE OF REGISTRANT


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

Our audits of the consolidated financial statements referred to in our report
dated March 18, 1998 appearing in the 1997 Annual Report to Shareholders of
Applied Analytical Industries, Inc. (which report and consolidated financial
statements are incorporated by reference in this Annual Report on Form 10-K)
also included an audit of the Financial Statement Schedule listed in Item 14 of
this Form 10-K. In our opinion, this Financial Statement Schedule presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.


PRICE WATERHOUSE LLP
Raleigh, North Carolina
March 18, 1998



                                       F-1

                                       18
<PAGE>   19



                                                                     Schedule II
                       APPLIED ANALYTICAL INDUSTRIES, INC.
                        Valuation and Qualifying Accounts
                                 (In thousands)


<TABLE>
<CAPTION>
                                     Balance at   Charged to                 Balance at
                                     beginning    costs and    Deductions      end of
         Description                 of period    expenses     - describe      period
         -----------                 ---------    ----------   ----------    ----------
<S>                                  <C>          <C>          <C>           <C>
Allowance for doubtful accounts

         1995                          $125            23         78  (1)       $ 70

         1996                          $ 70             4          1  (1)       $ 73

         1997                          $ 73            36          -  (1)       $109
</TABLE>


(1) Represents amounts written off as uncollectible accounts receivable.





                                       F-2


                                       19

<PAGE>   20


                       APPLIED ANALYTICAL INDUSTRIES, INC.
                                  Exhibit Index

Exhibit
  No.                           Description

  3.1      -      Amended and Restated Certificate of Incorporation of the
                  Company (incorporated by reference to Exhibit 3.1 to the
                  Company's Quarterly Report on Form 10-Q for the quarter ended
                  September 30, 1996)


  3.2      -      Restated By-laws of the Company (incorporated by reference to
                  Exhibit 3.2 to the Company's Registration Statement on Form
                  S-1 (Registration No. 333-5535))

  4.1      -      Articles Fourth, Seventh, Eleventh and Twelfth of the form of
                  Amended and Restated Certificate of Incorporation of the
                  Company (included in Exhibit 3.1)

  4.2      -      Article II of the form of Restated By-laws of the Company
                  (included in Exhibit 3.2)

  4.3      -      Specimen Certificate for shares of Common Stock, $.001 par
                  value, of the Company (incorporated by reference to Exhibit
                  4.3 to the Company's Registration Statement on Form S-1
                  (Registration No. 333-5535))

  10.1     -      Employment Agreement dated November 17, 1995 between the
                  Company and Frederick D. Sancilio (incorporated by reference
                  to Exhibit 10.1 to the Company's Registration Statement on
                  Form S-1 (Registration No. 333-5535))

  10.2     -      Applied Analytical Industries, Inc. 1995 Stock Option Plan
                  (incorporated by reference to Exhibit 10.3 to the Company's
                  Registration Statement on Form S-1 (Registration No.
                  333-5535))

  10.3     -      Applied Analytical Industries, Inc. 1996 Stock Option Plan
                  (incorporated by reference to Exhibit 10.4 to the Company's
                  Registration Statement on Form S-1 (Registration No.
                  333-5535)


  10.4     -      Applied Analytical Industries, Inc. 1997 Stock Option Plan
                  (incorporated by reference to Exhibit 10.5 to the Company's
                  Quarterly Report on Form 10-Q for the quarter ended September
                  30, 1997)

  10.5     -      Stockholder Agreement dated as of November 17, 1995 among the
                  Company, GS Capital Partners II, L.P., GS Capital Partners II
                  Offshore, L.P., Goldman, Sachs & Co. Verwaltungs GmbH, Stone
                  Street Fund 1995, L.P., Bridge Street Fund 1995, L.P.,
                  Noro-Moseley Partners III, L.P., Wakefield Group Limited
                  Partnership, James L. Waters, Frederick D. Sancilio and the
                  parties listed on Schedule 1 thereto (incorporated by
                  reference to Exhibit 10.5 to the Company's Registration
                  Statement on Form S-1 (Registration No. 333-5535))

  10.6     -      Lease Agreement dated as of March 7, 1994 between 5051 New
                  Centre Drive, L.L.C., as landlord, and the Company, as tenant
                  (incorporated by reference to Exhibit 10.10 to the Company's
                  Registration Statement on Form S-1 (Registration No.
                  333-5535))



                                       20
<PAGE>   21

  10.7     -      Development Agreement dated as of April 25, 1994 between the
                  Company and Endeavor Pharmaceuticals Inc. (formerly, GenerEst,
                  Inc.) (incorporated by reference to Exhibit 10.12 to the
                  Company's Registration Statement on Form S-1 (Registration No.
                  333-5535))

  10.8     -      Development Agreement dated as of April 4, 1995 between the
                  Company and Aesgen, Inc. (incorporated by reference to Exhibit
                  10.13 to the Company's Registration Statement on Form S-1
                  (Registration No. 333-5535))

  10.9     -      Loan Agreement dated as of December 30, 1996 between
                  NationsBank, N.A. and the Company (incorporated by reference
                  to Exhibit 10.14 to the Company's Annual Report on Form 10-K
                  for the year ended December 31, 1996)

  10.10    -      Registration Rights Agreement dated as of November 17, 1995
                  among the Company, GS Capital Partners II, L.P., Wakefield
                  Group Limited Partnership, James L. Waters, Frederick D.
                  Sancilio and the parties listed on Schedule 1 thereto
                  (incorporated by reference to Exhibit 10.16 to Post-effective
                  Amendment No. 1 to the Company's Registration Statement on
                  Form S-1 (Registration No. 333-5535))

  10.11     -     Underwriting Agreement dated September 19, 1996 between the
                  Company and Goldman Sachs & Co., Cowen & Company and Lehman
                  Brothers, Inc., as representatives of the underwriters listed
                  on Schedule 1 thereto (incorporated by reference to Exhibit
                  10.17 to the Company's Quarterly Report on Form 10-Q for the
                  quarter ended September 30, 1996)

  13       -      Portions of the 1997 Annual Report to Shareholders

  21       -      Subsidiaries of Applied Analytical Industries, Inc,

  27.1     -      Financial Data Schedule (for SEC use only) Year ended 12/31/97

  27.2     -      Financial Data Schedule (for SEC use only) 9 months ended
                  9/30/97

  27.3     -      Financial Data Schedule (for SEC use only) 6 months ended
                  6/30/97

  27.4     -      Financial Data Schedule (for SEC use only) 3 months ended
                  3/31/97

  27.5     -      Financial Data Schedule (for SEC use only) Year ended 12/31/96

  27.6     -      Financial Data Schedule (for SEC use only) 9 months ended
                  9/30/96

  27.7     -      Financial Data Schedule (for SEC use only) 6 months ended
                  6/30/96

  27.8     -      Financial Data Schedule (for SEC use only) 3 months ended
                  3/31/96



                                       21