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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, 1996

            [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT TO 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
February 28, 1997 was 16,287,256 shares. The aggregate market value for the
voting stock held by non-affiliates of the Registrant on February 28, 1997 was
approximately $142,267,000.

                       DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's 1996 Annual Report to Shareholders are incorporated
by reference in Part I, Part II, and Part IV hereof. Portions of the
Registrant's 1996 Proxy Statement dated approximately April 8, 1997 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 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 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 its core 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, in which
the Company shares in the expense of development and participates in the
benefits of any potential commercial success through licensing arrangements.
Internal drug development is focused primarily on generic products. Certain of
these products have been licensed or sold. The Company's proprietary technology
includes patents and pending patent applications on formulations and methods,
including liquid formulations for improved delivery of nonsteroidal
anti-inflammatory drugs or NSAIDs, such as ibuprofen, and chewable formulations
to mask the otherwise bitter taste of certain ulcer drugs. 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,
and 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.

       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.") for an aggregate cost
of approximately $20.9 million. 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 Stuttgart, Germany; London, England; Arnheim,
Netherlands and Budapest, Hungary. L.A.B. also operates in China through a joint
venture. L.A.B. employs approximately 250 scientists, technicians and support
personnel, 40 or more with Ph.D. or M.D. degrees, or their U.S. equivalent.
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 controlled Phase II-A
clinical trial studies and multi-center clinical trials focused in niche
therapeutic areas including hepatic disease, chemotherapeutics, and hormone
replacement therapy.

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SERVICES

       The Company provides a broad array of drug development services,
including chemical analysis, synthesis and other laboratory services;
formulation development; clinical trial 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 account 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 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 17 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 the 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 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



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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 position 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 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



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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 "know-how" 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 "filler"
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 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 trial materials for Phase I through IV
clinical trials, as well as bioequivalency studies of generic products. 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 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.



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       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 drug master files, analysis of standard operating procedures, review
of production records, and observation of operations to ensure SOPs 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.

       CLINICAL TRIAL STUDIES

       The Company opened a 48-bed clinical trial facility at its Research
Triangle Park location in the third quarter of 1996. 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 has expanded its Phase I clinical trial capabilities and
added the ability to conduct Phase II-A studies and multi-center trials focused
in niche therapeutic areas, including hepatic disease, chemotherapeutics and
hormone replacement therapy. L.A.B.'s Neu-Ulm operations include a 120-bed
facility for conducting Phase I and II-A clinical trial studies, as well as
bioequivalency studies.

INTERNAL DRUG AND TECHNOLOGY DEVELOPMENT

       The Company intends to dedicate 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 intend to 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 generic product
applications filed with the FDA. Certain of these products have been licensed or
sold. The internal development program has also resulted in patents covering
drug technology and pending patent applications. L.A.B. also engaged in an
internal product development program with goals similar to those of the Company.
At the time it was acquired by the Company, L.A.B. had numerous products then
licensed to clients and new products in development, targeted primarily for
regulatory approval and licensing in Europe.

       Since 1993, the Company has significantly increased its investment in its
internal drug and technology 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 drug and technology development efforts. The Company anticipates
that licensing revenue, including royalties and milestone payments, from
internal drug and technology development will represent a larger proportion of
its revenue, although there can be no assurance that internal development
projects will yield products that will be approved by the appropriate regulatory
authorities or will be attractive to potential clients. In 1996, the FDA
approved a generic product licensed by the Company to a client which is the
first approved generic version of a branded product that had over $100 million
in sales in 1995. The Company began to recognize royalties on this product in
the fourth quarter of 1996. 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
potentially exceed the margins on standard fee-for-service engagements.

       INTERNAL DRUG DEVELOPMENT

       In 1993, the Company began allocating a significant portion of its
technical resources and operating capacity to internal development of generic
drugs. The U.S. generic drug market has expanded sales from approximately $3.5
billion in 1990 to approximately $6.4 billion in 1994. Generic drugs accounted
for an estimated 38% of prescriptions dispensed in the United States in 1994.
The Company anticipates that the growth in the generic drug market will continue
as


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managed care organizations pursue policies favoring generic substitution and as
patents on many high revenue products expire over the next several years.

       The Company's research and development committee, composed of
representatives from the formulations development, finance, marketing and legal
departments, identifies potential generic 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.

       The first group of products in the Company's internal product development
program involved generic versions of certain hormone products. 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 development contract with Endeavor to
continue product development and clinical supply manufacture. AAI currently owns
approximately 40% of the fully diluted common equity of Endeavor, and the
Company's net sales to Endeavor were approximately $6.2 million, $3.5 million
and $2.0 million in 1996, 1995 and 1994, respectively. Endeavor is currently
developing two products in multiple dosage strengths, although there can be no
assurance that such products will ultimately be approved by the FDA.

       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 generic products. AAI recognized net sales to Aesgen of $4.7
million and $5.6 million in 1996 and 1995, respectively. In June 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 of products which are currently in
development. The terms of the license agreements vary as to amounts of initial
and 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 sponsor the approved ANDA, the Company has
made ANDA submissions for internally developed products in its own name which
are currently under review at the FDA.

       Continuing to leverage its development capabilities, the Company is
moving beyond generic drug 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
therapeutic indices, reduced side effects, improved bioavailability and improved
pharmacokinetics. Because considerable toxicity data already exist for the
marketed product, the Company believes that new compound modifications or
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 this type of compound.

       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 which meets
quarterly 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.

       The Company's technology 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


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oral absorption of a number of non-steroidal anti-inflammatory drugs or NSAIDs,
such as ibuprofen, 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. In June
1996, the Company assigned to a third party certain of its patented technology
for the production of a high-purity active ingredient for a generic drug
product. The Company is seeking licensing partners for its other recently
developed technologies.

ENDEAVOR

       The Company owns shares of convertible preferred stock of Endeavor,
representing approximately 40% of the fully diluted common equity. AAI also
provides development services to Endeavor at terms that the Company believes are
no less favorable than terms that would be obtained from an unrelated third
party.

       Endeavor has submitted ANDAs for two products in multiple dosage
strengths and has received notice from the FDA citing certain major
deficiencies with the applications. Endeavor is pursuing both ANDAs. Endeavor
does not market any products, has not received approval of any product and
there can be no assurance that the FDA will approve any of its products.
Endeavor's revenues are dependent upon approval of its products, and continued
product development by Endeavor is dependent upon it obtaining product
approvals or additional capital funding. The Company believes that Endeavor
intends to market its products through licensing to third parties.

INFORMATION TECHNOLOGY

       The Company has made significant investments in information technology.
The Company's LTS system tracks laboratory workflow and enables the Company to
effectively 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 approximately 125
analytical instruments with multiple software architectures permitting automated
data capture. In addition, the Company is currently conducting a pilot test of a
system allowing certain domestic and international clients secured access to
review in-progress laboratory data. This system will allow a client to
efficiently monitor the immediate status of the project and make changes to the
scope and format of its project.

       The Company believes that superior 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. The Company has begun to
develop a database of client information integrating data, documents, electronic
messages, and reference services. The Company intends to make this database
available with secured on-line access through the Internet which would permit
client access to data on its projects at any location worldwide and facilitate
regulatory on-line access to the extensive data necessary to support the
chemistry, manufacturing and control section of a regulatory application. The
Company also believes that this service will allow clients to avoid delays
currently incurred in regulatory staff audits of paper-copy data stored at the
Company's or clients' facilities.



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CLIENTS

       Over the past six years, the Company has provided services to 24 of the
top 25 pharmaceutical companies in the world as ranked by 1994 research and
development spending. In 1996, the Company provided services under contracts to
hundreds of clients, including some of the largest U.S., European and Japanese
drug companies.

       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. During 1996, Endeavor and Aesgen accounted
for 10% or more (approximately 15% and 11% respectively) of the Company's net
sales. 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 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, 1996, backlog was approximately $20.3
million, as compared to $19.7 million at December 31, 1995.



<PAGE>   10



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. The largest competitor offering these services is Covance Inc.
(formerly known as Corning Pharmaceutical Services, Inc., a subsidiary of
Corning, Inc.). Certain of the Company's competitors, including Covance Inc.,
may have significantly greater resources than the Company. Competitive
conditions for service areas vary.

       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. 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 GMP by the Company in a project
could result in disqualification of data collected by the Company in the
project. Material violation of GMP requirements could result in additional
regulatory sanctions,



<PAGE>   11



and in severe cases 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 GMP 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, 1996, the Company, including L.A.B., had approximately
750 full-time equivalent employees, of which approximately 75 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 U.S.-based employees is
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, professional commitment
and work productivity and provide an incentive for employees to remain with the
Company. In addition, the Company operates a 65-child, employee day-care
facility at its Wilmington, North Carolina campus as a benefit to its employees
and is expanding this facility. 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.



<PAGE>   12



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., 47, is Chairman of the Board of Directors and
President of the Company. With more than 20 years' experience in the
pharmaceutical industry, Dr. Sancilio worked with Burroughs-Wellcome Co.,
Schering-Plough Corporation, and Hoffmann-LaRoche, Inc. before founding the
Company in 1979. 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.

William H. Underwood, 49, has served as Chief Operating Officer since 1995, as
Executive Vice President of the Company since 1992, as Vice President from 1986
to 1992, and as a director since January 1996. He has held positions in the
pharmaceutical and cosmetic industries for more than 17 years, in positions
including Director of Quality Assurance and Director of Manufacturing at Mary
Kay Cosmetics, Inc. and Group Leader of Bacteriological Quality Control at
Burroughs-Wellcome Co.

Anthony F. Arato, 49, joined AAI in 1981 and currently serves as Vice President
of Manufacturing and Engineering. Over the past decade he has served in numerous
capacities and management positions. Prior to joining AAI, Mr. Arato was
employed for eight years as a field engineer for Perkin-Elmer Corporation.



<PAGE>   13





Mark P. Colonnese, 41, joined AAI in 1993 and currently serves as Vice
President, Chief Financial Officer and Treasurer. Prior to joining AAI, Mr.
Colonnese worked as a financial executive at Schering-Plough Corporation for ten
years, most recently as Senior Director of Planning and Business Analysis.

Martin S. Hunicutt, 46, joined AAI in 1994 as Vice President of Marketing and
Sales. Prior to joining AAI, Mr. Hunicutt worked for 19 years in a variety of
capacities for Burroughs-Wellcome Co. Mr. Hunicutt's experience includes service
as marketing project director for a major pharmaceutical product, director of
marketing with responsibilities for both marketed and pre-launch products, and
product manager with commercial management responsibilities.

James Swarbrick, Ph.D., 63, joined the Company in 1993 as Vice President of
Research and Development. Prior to joining the Company, Dr. Swarbrick was
Professor and Chairman of the Division of Pharmaceutics and Director of Graduate
Studies in the School of Pharmacy at the University of North Carolina at Chapel
Hill. Dr. Swarbrick serves on the FDA's Generic Drugs Advisory Committee and
serves as Chairman of the Pharmaceutical Research and Manufacturers Association
Foundation's Pharmaceutics Advisory Committee and is a member of that
organization's Scientific Advisory Committee. Dr. Swarbrick has published
extensively in areas of pharmaceutics and product development with more than 60
research publications to date and is co-author of Physical Pharmacy, a graduate
text, and senior co-author of the Encyclopedia of Pharmaceutical Technology,
which is used throughout the pharmaceutical industry.

R. Forrest Waldon, 34, has served as the Company's General Counsel and Secretary
since 1989 and as a Vice President since 1993. Prior to joining AAI, Mr. Waldon
was a corporate attorney with the Atlanta, Georgia law firm of Thrasher &
Whitley, P.C.

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 over 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
Stuttgart and Munich, Germany; Paris, France; London, England; Arnheim,
Netherlands and Budapest, Hungary. The Company maintains sales offices in
Raleigh, North Carolina; Chicago, Illinois; Boston, Massachusetts; San Diego and
San Francisco, California; Elmwood Park, New Jersey; San Juan, Puerto Rico;
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 is party to lawsuits and administrative proceedings
incidental to the normal course of its business. 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.



<PAGE>   14




         The Company is currently appealing a judgment in an action, Kurtzman v.
Applied Analytical Industries, Inc., involving a claim by a former management
employee for damages arising from his termination of employment. In such matter,
the former employee alleged that a contract of employment existed between him
and the Company for a term of years. In 1995, a judgment for approximately
$363,000 was entered against the Company following a jury trial. The Company has
recorded the full amount of such judgment as an expense in its 1995 financial
statement. In January 1997, the North Carolina Court of Appeals denied the
Company's appeal of the judgment and overturned the trial court's denial of
pre-judgment interest on the award. The Company has requested the North Carolina
Supreme Court to hear arguments on both of these issues.

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

         None

                                     PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
        MATTERS.

The information required by Item 5 is included on page 27 of the Annual Report
and is incorporated herein by reference.

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 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

The information required by Item 8 is included on pages 17 through 27 of the
Annual Report and is incorporated herein by reference.

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
pages 2 and 3 of the Company's Notice of Annual Meeting of Stockholders, dated
approximately April 8, 1997 (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."



<PAGE>   15





ITEM 11. EXECUTIVE COMPENSATION.

A description of the compensation of the Company's executive officers is set
forth on pages 6 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 4 and 5 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 12 and 14 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, 1996 and 1995, and
related consolidated statements of income, cash flows and stockholders' equity
for each of the three years in the period ended December 31, 1996 and the
related notes to financial statements, together with the report of independent
accountants thereon of Price Waterhouse LLP, dated February 21, 1997 appearing
on pages 17 through 26 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 and 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 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:

         The Company filed a report on Form 8-K, dated January 15, 1997, to
report the L.A.B. acquisition as of December 31, 1996. Such report, as amended
on March 17, 1997, included the financial statements of L.A.B. listed below.



<PAGE>   16

ADDITIONAL FINANCIAL DATA

                                                               Page

Applied Analytical Industries, Inc. for years ended
  December 31, 1996, 1995 and 1994:
      Report of Independent Accountants                         F-1
      Financial Statement Schedule:
      Schedule II - Valuation and Qualifying Accounts           F-2

L.A.B., financial statements for the years ended
  December 31, 1996 and 1995:
      Report of Independent Accountants                         F-3
      Consolidated Balance Sheet                                F-4
      Consolidated Statement of Operations                      F-5
      Consolidated Statement of Cash Flows                      F-6
      Notes to Financial Statements                     F-7 to F-10

Pro Forma Financial Information:
      Pro Forma Condensed Statement of Operations,
        reflecting the pro forma combination of
        AAI and L.A.B. for the year ended
        December 31, 1996                                      F-11
      Notes to Pro Forma Financial Information                 F-12

<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    President                       March 31, 1997
-------------------------------  (Principal Executive Officer)
  Frederick D. Sancilio, Ph.D.


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             President and Director             March 31, 1997
------------------------------------------    (Principal Executive Officer)
            Frederick D. Sancilio, Ph.D.

      /s/    MARK P. COLONNESE                Vice President and Chief           March 31, 1997
------------------------------------------    Financial Officer (Principal
             Mark P. Colonnese                Financial Officer)


       /s/    STEPHEN F. RIZZO                Vice President and                 March 31, 1997
------------------------------------------    Controller (Principal
              Stephen F. Rizzo                Accounting Officer)


     /s/    WILLIAM H. UNDERWOOD              Executive Vice President           March 31, 1997
------------------------------------------    and Director
            William H. Underwood

     /s/    JOSEPH H. GLEBERMAN               Director                           March 31, 1997
------------------------------------------
            Joseph H. Gleberman

    /s/   CHARLES D. MOSELEY, JR.             Director                           March 31, 1997
------------------------------------------
          Charles D. Moseley, Jr.

         /s/    JOHN M. RYAN                  Director                           March 31, 1997
------------------------------------------
                John M. Ryan

       /s/    JAMES L. WATERS                 Director                           March 31, 1997
------------------------------------------
              James L. Waters
</TABLE>


<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 February 21, 1997 appearing in the 1996 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
February 21, 1997




                                       F-1




<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

        1994                         $ 92            114            81 (1)         $125

        1995                         $125             23            78 (1)         $ 70

        1996                         $ 70              4             1 (1)         $ 73
</TABLE>



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







                                     F-2
<PAGE>   20


Report of Independent Accountants

To the Owners of
L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co.

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

Effective December 31, 1996, Applied Analytical Industries, Inc. acquired L.A.B.

PRICE WATERHOUSE GmbH
Stuttgart, Germany
February 21, 1997





















                                       F-3



<PAGE>   21



        L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co.
                           Consolidated Balance Sheet
                          (In thousand Deutsche marks)

<TABLE>
<CAPTION>
                                                                  December 31,
                                                                  ------------
                                                              1996           1995
                                                              ----           ----
<S>                                                         <C>             <C>
                               ASSETS
Current assets:
Cash                                                            341             577
Accounts receivable                                           2,440           4,165
Work-in-progress                                              6,711           9,364
Prepaid and other current assets                              1,363           1,913
                                                            -------         -------
     Total current assets                                    10,855          16,019
                                                            -------         -------

Property and equipment:
Buildings and improvements                                       27              27
Machinery and equipment                                      14,558          14,007
                                                            -------         -------
                                                             14,585          14,034
Less, accumulated depreciation                               11,221          10,256
                                                            -------         -------
                                                              3,364           3,778

Other assets                                                    559             258
                                                            -------         -------
     Total assets                                            14,778          20,055
                                                            =======         =======

                      LIABILITIES AND OWNERS' EQUITY

Current liabilities:
Loan obligations                                              5,972           5,570
Accounts payable                                              5,675           6,204
Accrued wages and benefits                                    2,710           2,221
Customer advances                                            10,862          13,489
AAI advance                                                   1,364            --
Rent payable                                                  3,367           2,817
Other accrued liabilities                                     8,849           6,519
                                                            -------         -------
     Total current liabilities                               38,799          36,820
                                                            -------         -------
Long-term debt                                                 --             6,910
Commitments and contingencies
Owners' equity:
  Stated capital                                              2,000           2,000
  Contributed capital                                         2,890            --
  Accumulated deficit                                       (28,911)        (25,675)
                                                            -------         -------
     Total owners' equity                                   (24,021)        (23,675)
                                                            -------         -------
     Total liabilities and owners' equity                    14,778          20,055
                                                            =======         =======
</TABLE>

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


                                       F-4



<PAGE>   22


        L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co.
                      Consolidated Statement of Operations
                          (In thousand Deutsche marks)


<TABLE>
<CAPTION>
                                                         For the years ended
                                                            December 31,
                                                        -----------------------
                                                          1996           1995
                                                         ------         ------
<S>                                                      <C>             <C>
Net sales                                                27,425          32,895

Operating costs and expenses:
   Cost of sales                                         23,535          25,475
   Selling                                                2,670           1,991
   General and administrative                             6,263           5,905
   Research and development                               2,280           1,180
                                                        -------         -------
                                                         34,748          34,551
                                                        -------         -------
Loss from operations                                     (7,323)         (1,656)

Other (income) expense:
   Interest                                               1,245           1,499
   Other                                                   (275)           (342)
                                                        -------         -------
                                                            970           1,157
                                                        -------         -------

Loss before income taxes and extraordinary item          (8,293)         (2,813)
Provision for income taxes                                  943             852
                                                        -------         -------
Loss before extraordinary item                           (9,236)         (3,665)
Extraordinary item - gain on forgiveness of debt          6,000            --
                                                        -------         -------
         Net Loss                                        (3,236)         (3,665)
                                                        =======         =======
</TABLE>



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




                                       F-5



<PAGE>   23



        L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co.
                      Consolidated Statement of Cash Flows
                          (In thousand Deutsche marks)

<TABLE>
<CAPTION>
                                                                       For the years ended
                                                                          December 31,
                                                                          ------------
                                                                     1996             1995
                                                                     ----             ----
<S>                                                                  <C>            <C>
Cash flows from operating activities:
Net loss                                                             (3,236)        (3,665)
Adjustments to reconcile net loss to net cash
  provided (used) by operating activities:
     Depreciation and amortization                                      985            965
     Extraordinary gain                                              (6,000)          --
     Changes in assets and liabilities:
       Accounts receivable                                            1,725           (325)
       Work-in-progress                                               2,653            223
       Prepaid and other assets                                         550            468
       Accounts payable                                                (529)         1,704
       Accrued wages and benefits                                       489            512
       Customer advances                                             (2,627)        (3,653)
       AAI advance                                                    1,364           --
       Rent payable                                                   3,440            794
       Other accrued liabilities                                      2,330           (439)
                                                                     ------         ------
Net cash provided (used) by operating activities                      1,144         (3,416)
                                                                     ------         ------

Cash flows from investing activities:
Proceeds from sale of property and equipment                            242             94
Purchase of property and equipment                                     (813)        (2,564)
Other                                                                  (301)           (24)
                                                                     ------         ------
Net cash used by investing activities                                  (872)        (2,494)
                                                                     ------         ------

Cash flows from financing activities:
Proceeds from borrowings                                                402          6,848
Payments on borrowings                                                 (910)        (2,541)
Capital contribution                                                   --            1,500
                                                                     ------         ------
Net cash provided (used) by financing activities                       (508)         5,807
                                                                     ------         ------
Net increase (decrease) in cash                                        (236)          (103)
Cash, beginning of period                                               577            680
                                                                     ------         ------
Cash, end of period                                                     341            577
                                                                     ------         ------

Supplemental information, cash paid for:
  Interest                                                              197            125
  Income taxes                                                          722             30
</TABLE>


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

                                       F-6



<PAGE>   24



        L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co.
                   Notes to Consolidated Financial Statements


1. Business and Significant Accounting Policies

Description of business

L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH & Co. (the "Company"
or "L.A.B."), is a limited partnership operating as a European contract research
and development organization headquartered in Neu-Ulm, Germany with operational
units in Neu-Ulm, Stuttgart and Munich, Germany as well as limited liability
subsidiaries in France, Netherlands, England and Hungary.

Basis of presentation

The consolidated financial statements include the accounts of L.A.B. and its
subsidiaries. All material intercompany transactions have been eliminated.

Revenue recognition

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

Income taxes

The Company does not have the ability to consolidate its operations for income
tax purposes and is subject to income taxes separately by subsidiary.

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 12 years for building improvements and 3 to 10 years for equipment.

Other assets

Other assets include a 50% joint venture in China entered into in November
1996. The investment is reported at original cost and is accounted for using the
equity method. There was no significant impact on 1996 operating results from
this investment.




                                       F-7



<PAGE>   25



Distributions

Distributions, under German law, are payable to the owners only when retained
earnings are not in a deficit position. Taxable income or loss passes directly
to the partners of L.A.B. since it is a limited partnership.

Translation of foreign currencies

The functional currency for the Company is the Deutsche mark. The financial
statements for international operations were translated into marks at year-end
exchange rates, including the statement of operations. Adjustments which would
have resulted from financial statement translations at average exchange rates
and be included in owners' equity as cumulative translation adjustments were not
material. Gains and losses resulting from foreign currency transactions are
included in operating results.

Fair value of financial instruments

The carrying value of cash and cash equivalents, accounts receivable, current
liabilities and loans approximate fair value.

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. Change in Control of L.A.B.

Applied Analytical Industries, Inc. ("AAI") exercised its option to acquire
L.A.B., effective as of December 31, 1996, through two wholly-owned German
subsidiaries. This change in control of L.A.B. is expected to have a significant
impact on the Company as described in the following footnotes.


3. Extraordinary Item

In contemplation of the acquisition of L.A.B. by AAI, certain creditors of the
Company have waived, as of December 30, 1996, their demands for DM6 million in
loan obligations prior to such acquisition. This forgiveness of liability has
been recognized in the consolidated financial statements as an extraordinary
item. There are no income taxes related to this transaction.




                                       F-8



<PAGE>   26




4. Loan Obligations (in thousand Deutsche marks):

<TABLE>
<CAPTION>
                                                           December 31,
                                                           ------------
                                                        1996          1995
                                                        ----          ----

<S>                                                    <C>           <C>
Banking institutions                                    5,972        11,632
Landlord loan                                            --             848
                                                       ------        ------
                                                        5,972        12,480
Less current maturities                                 5,972         5,570
                                                       ------        ------
Long-term debt                                           --           6,910
                                                       ------        ------
</TABLE>


The banking institutions' loan obligations represent interest bearing
lines-of-credit extended to the Company. The amounts at December 31, 1996 have
been reduced by the extraordinary item described above. Two of the three banking
institutions have withdrawn their credit lines for the Company and have
requested payment of their outstanding balances in January 1997. The remaining
bank has not requested immediate payment and has informally continued a
line-of-credit for DM1.3 million. The weighted average interest rate for the
loan obligations to banking institutions was 5.5% in 1996 and 8.7% in 1995.

The landlord loan represents unpaid rental payments, prior to 1994, related to
the Company's Neu-Ulm facility which were converted to a loan obligation at the
end of 1993. This loan has been paid through monthly installments of
approximately DM26,000, including interest at 8%.


5. Related Party Transactions

In 1995, the owner of the Company's leased facility in Neu-Ulm acquired 75%
ownership of L.A.B. through a capital contribution of DM1.5 million. The Company
has not made rental payments related to this facility for 1995 and 1996. In
contemplation of the acquisition of L.A.B. by AAI, this majority-owner of the
Company, as of December 30, 1996, has waived all claims against L.A.B., except
for approximately DM2.9 million of the rental payments discussed above. This
forgiveness of liability of approximately DM2.9 million has been recognized as a
contribution of capital by this partner to owners' equity.

In 1996, AAI advanced DM1.5 million to L.A.B. as a prepayment for work to be
performed by the Company. As of December 31, 1996, there was approximately DM1.4
million remaining in customer advances. L.A.B. performed approximately DM100,000
of work for AAI in 1996.

6. Income Taxes

The provision for income taxes relates to taxable income of subsidiary
companies. The main operating company in Germany has had losses for both 1996
and 1995 which accrued to the existing partners; therefore, no tax loss
carryforwards will be available for AAI. Tax loss carryforwards available to AAI
at the non-German operations would have a 100% valuation allowance given the
historical operating losses at such operations.


                                       F-9



<PAGE>   27




7. Commitments and Contingencies

The Company leases land, buildings and equipment under renewable lease
arrangements classified as operating leases. Lease expense recognized under such
agreements totaled DM5.1 million and DM4.0 million for the years ended December
31, 1996 and 1995, respectively. Included in both the 1996 and 1995 amounts was
approximately DM1.5 million which was ultimately forgiven.

Future minimum rentals due under lease agreements as of December 31, 1996 are
DM2.2 million - 1997; DM1.7 million - 1998; DM1.5 million - 1999; DM1.7 million
- 2000; DM1.5 million - 2001 and none thereafter.


8. Going Concern

L.A.B.'s current liabilities exceed its current assets at both December 31, 1996
and 1995, and given its financial resource availability described in footnote 4,
there would exist substantial doubt regarding the Company's ability to continue
as a going concern; however, this situation is alleviated by the AAI acquisition
and AAI's ability and intent to make financing available to fund L.A.B.'s
operations for the next year.












                                       F-10



<PAGE>   28



                       Applied Analytical Industries, Inc.
                         Pro Forma Financial Information

The following unaudited pro forma financial information is presented to reflect
the acquisition of L.A.B. Gesellschaft fur pharmakologische Untersuchungen mbH &
Co. ( "L.A.B.") by Applied Analytical Industries, Inc. ("AAI" or the "Company")
as if it had occured at the beginning of 1996. This pro forma financial
information is presented for informational purposes and is not necessarily
indicative of the consolidated results that would have been achieved had the
acquisition been consummated at the beginning of the period presented. A pro
forma balance sheet is not presented as of December 31, 1996, since the L.A.B.
transaction is reflected in such consolidated balance sheet of AAI.

                   Pro Forma Condensed Statement of Operations
                      (In thousands, except per share data)
                                   (Unaudited)

<TABLE>
<CAPTION>
                                          Historical       Historical        Pro forma        Pro forma
Year ended December 31, 1996                 AAI             L.A.B.         adjustments        combined
----------------------------                 ---             ------         -----------        --------
<S>                                         <C>              <C>                <C>            <C>
Net sales                                   $42,162          $18,223            $ --           $60,385

Operating costs and expenses:
   Cost of sales                             17,621           15,638             (840)          32,419
   Selling                                    6,357            1,774             (112)           8,019
   General and administrative                 8,908            4,161              359           13,428
   Research and development                   4,216            1,515                             5,731
   Unusual item                               6,600                                              6,600
                                            -------          -------            -----          -------
                                             43,702           23,088             (593)          66,197
                                            -------          -------            -----          -------
Income (loss) from operations                (1,540)          (4,865)             593           (5,812)
Other income (expense), net                     494             (645)             219               68
                                            -------          -------            -----          -------
Income (loss) before income taxes            (1,046)          (5,510)             812           (5,744)
Provision for income taxes                    2,102              627                             2,729
                                                             -------            -----          -------
Net income (loss)                           $(3,148)         $(6,137)           $ 812          $(8,473)
                                            -------          -------            -----          -------

Earnings (loss) per share                   $ (0.23)                                           $ (0.63)
                                            -------                                            -------
Weighted average shares                      13,440                                             13,440
                                            -------                                            -------
</TABLE>


                 The accompanying notes are an integral part of
                     this pro forma financial information.




                                       F-11



<PAGE>   29



                       Applied Analytical Industries, Inc.
                    Notes to Pro Forma Financial Information
                                   (Unaudited)


1. AAI Historical Information

The historical AAI information reflects the write-off of certain in-process
research and development costs with an appraised value of approximately $6.6
million, in connection with the L.A.B. acquisition on the unusual item line.

2. L.A.B. Historical Information.

The historical L.A.B. information used in the pro forma statement of operations
does not include the extraordinary items reported in 1996. Additionally, it has
been translated from Deutsche marks to U.S. dollars using an exchange rate of
1.505 marks per dollar, which was calculated using monthly exchange rates for
1996 published by the Federal Reserve. The Company believes this is a reasonable
representation to what actual exchange rates may have been.

3. Pro Forma Adjustments.

The pro forma adjustments include the following:

Amortization of intangibles ($737,000) and depreciation on assets ($56,000)
where the allocated purchase price is greater than the historical L.A.B. value.

A reduction in rental expense ($1,120,000) related to the Neu-Ulm facility to
reflect the accrued amounts forgiven by the landlord to be more in-line with
future rent.

A reduction in general and administrative expenses for L.A.B. merger related
costs ($266,000) incurred during 1996.

A reduction in interest expense ($219,000) related to L.A.B. forgiven bank debt.











                                      F-12



<PAGE>   30




                       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. 333-05535))

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.
              333-05535))

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. 333-05535))

10.2        - Applied Analytical Industries, Inc. 1995 Restricted Stock Award
              Plan (incorporated by reference to Exhibit 10.2 to the Company's
              Registration Statement on Form S-1 (Registration No. 333-05535))

10.3        - 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. 333-05535))

10.4        - 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. 333-05535))




<PAGE>   31






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. 333-05535))

10.6        - Preferred Stock Purchase 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 and James L. Waters (incorporated by reference to
              Exhibit 10.6 to the Company's Registration Statement on Form S-1
              (Registration No. 333-05535))

10.7        - Loan Agreement dated as of December 21, 1992 between
              NationsBank, N.A. and the Company, together with the First
              Amendment and Second Amendment thereto and agreement extending the
              term thereof (incorporated by reference to Exhibit 10.7 to the
              Company's Registration Statement on Form S-1 (Registration No.
              333-05535))

10.8        - Loan Agreement dated as of November 1, 1988 between the Company
              and The New Hanover County Industrial Facilities and Pollution
              Control Financing Authority (incorporated by reference to Exhibit
              10.8 to the Company's Registration Statement on Form S-1
              (Registration No. 333-05535))

10.9        - Letter of Credit Reimbursement Agreement dated November 1, 1988
              between NationsBank, N.A. (formerly, NCNB National Bank of North
              Carolina) and the Company, as amended (incorporated by reference
              to Exhibit 10.9 to the Company's Registration Statement on Form
              S-1 (Registration No. 333-05535))

10.10       - 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. 333-05535))

10.11       - Lease Agreement dated as of December 23, 1993 between I-40
              Properties, as landlord, and the Company, as tenant (incorporated
              by reference to Exhibit 10.11 to the Company's Registration
              Statement on Form S-1 (Registration No. 333-05535))

10.12       - 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. 333-05535))




<PAGE>   32






10.13       - 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. 333-05535))

10.14       - Loan Agreement dated as of December 30, 1996 between
              NationsBank, N.A. and the Company

10.15       - Letter dated August 22, 1996 from NationsBank, N.A. to the
              Company extending the maturity of certain indebtedness
              (incorporated by reference to Exhibit 10.15 to the Company's
              Registration Statement on Form S-1 (Registration No. 333-05535))

10.16       - Registration Rights Agreement dated as of November 17, 1996
              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.
              333-05535))

10.17       - 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)

10.18       - Option Agreement between Applied Analytical Industries, Inc. and
              My Asset Management GmbH and Friedrich Herzog von Wurttemberg.
              (incorporated by reference to Exhibit 2.1 to the Company's
              Current Report on Form 8-K dated December 31, 1996)

10.19       - Purchase and Assignment Agreement between Friedrich Herzog von
              Wurttemberg and My Asset Management GmbH (incorporated by
              reference to Exhibit 2.2 to the Company's Current Report on
              Form 8-K dated December 31, 1996)

13          - 1996 Annual Report to Shareholders

21          - Subsidiaries of Applied Analytical Industries, Inc.

27          - Financial Data Schedule (for SEC use only)