SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                   FORM 10-KSB

              [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                   For the Fiscal Year Ended December 31, 1998

               [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF
                       THE SECURITIES EXCHANGE ACT OF 1934
                       For the transition period from_ to_

                         Commission File Number: 0-20307
                         AVALON COMMUNITY SERVICES, INC.
                 (Name of small business issuer in its charter)

                     Nevada                    13-3592263
             (State of Incorporation) (I.R.S. Employer I.D. Number)

               13401 Railway Drive, Oklahoma City, Oklahoma 73114
               (Address of Principal executive offices) (Zip Code)

                    Issuer's telephone number (405) 752-8802

      Securities registered under Section 12(b) of the Exchange Act: None

                Securities registered under Section 12(g) of the
                                 Exchange Act:

                 Shares of Class A Common Stock, par value $.001
                                (Title of class)

         The issuer has (1) filed all reports required to be filed by Section 13
or 15(d) of the Exchange Act during the past 12 months (or such shorter  period
as the registrant  was required to file such reports),  and (2) has been subject
to such filing requirements for the past 90 day: Yes X No ___

         Disclosure of  delinquent  filers in response to Item 405 of Regulation
S-B is not contained in this form, and no disclosure  will be contained,  to the
best of Registrant's  knowledge,  in definitive proxy or information  statements
incorporated  by reference  in Part III of this Form 10-KSB or any  amendment to
this form 10-KSB. [ X ]

         Revenues for continuing operations for the year ended December 31, 1998
were $7,686,000.

         The  aggregate  market  value  of  voting  common  stock  held  by  non
affiliates  was  $4,880,375 on March 5, 1999,  based on the average high and low
prices of such stock as  reported  by the  National  Association  of  Securities
Dealers  Automated  Quotations  Systems  ("NASDAQ")  on that day. As of March 5,
1999,  4,668,138  shares of the issuer's  common  stock,  par value $.001,  were
issued and outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE:
     Portions  of  the  Proxy   Statements   for  the  1999  Annual  Meeting  of
Shareholders are incorporated by reference in Part III.6

            Transitional Small Business Disclosure Format: Yes_ No X.


<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                                TABLE OF CONTENTS
                            FORM 10-KSB ANNUAL REPORT
                      FOR THE YEAR ENDED DECEMBER 31, 1998




                                     PART I
Item                                                                 Page
----                                                                 ----

1.   Description of Business                                           1

2.   Description of Property                                           5

3.   Legal Proceedings                                                 6

4.   Submission of Matters to a Vote of Security Holders               6

                                     PART II

5.   Market for Common Equity and Related
          Stockholder Matters                                          6

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

7.   Financial Statements                                              9

8.   Changes in and Disagreements with Accountants
          on Accounting and Financial Disclosure                       29

                                    PART III

9.   Directors, Executive Officers, Promoters and Control
          Persons; Compliance with Section 16(a) of
          the Exchange Act                                             29

10.  Executive Compensation                                            31

11.  Security Ownership of Certain Beneficial Owners
          and Management                                               31

12.  Certain Relationships and Related Transactions                    31

13.  Exhibits and Reports on Form 8-K                                  31

     Signatures                                                        34




<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


                                     PART I
ITEM 1.  DESCRIPTION OF BUSINESS.

The Company -

     Avalon Community  Services,  Inc., is an Oklahoma based Corporation  owning
and operating private correctional  facilities.  Avalon Community Services, Inc.
and its wholly owned  subsidiaries  ("Avalon" or the  "Company")  specialize  in
operating  private  community  correctional  facilities and providing  intensive
correctional  programming.  Avalon  currently  operates  facilities  and manages
programs  in  Oklahoma  and  Texas,  with  plans to  significantly  expand  into
additional  states.  Avalon's  business strategy is designed to grow the Company
into a dominant role as a provider of community correctional services.  Avalon's
development plan is to expand operations through new state and Federal contracts
and selective  acquisitions  to capitalize on the current rapid growth trends in
the private correctional service industry.

     The private correctional  services industry growth continues to demand more
beds. As of the second quarter 1997, 1.73 million  individuals were incarcerated
in this  country's  prisons and jails,  an increase of 5.9% from the prior year.
The total prison and jail  population  has grown 6.0%  annually  during the last
five  years.  It is  estimated  that the weekly  need for new  corrections  beds
remains between 1,500 and 2,000 beds. Avalon contracts with various governmental
agencies to provide community corrections operations and services.  Studies have
documented a 10 to 30 percent  savings to  government  agencies  when  utilizing
private  corrections  providers  to build and operate  correctional  facilities.
Avalon  management  believes its  background  and abilities to build and operate
correctional  facilities  and provide  correctional  programming  positions  the
Company for substantial growth in the corrections industry.  The number of adult
correctional  beds operated by private  managers has grown an astounding  2,200%
over the past 10 years.  According to University of Florida data,  approximately
107,000  beds were  privately  operated  at  year-end  1997,  up from  85,000 at
year-end 1996. The number of privately operated corrections beds is projected to
triple over the next five years.

     Avalon  currently  owns  and  operates  1,185  private   corrections  beds,
including 300 beds currently  being  constructed.  The Company owns and operates
three  minimum-security  correctional  facilities  (655 beds) in  Oklahoma,  one
medium  security  juvenile  facility (80 beds) in Oklahoma,  one medium security
correctional  facility (150 beds) in Texas,  and an  additional  medium-security
correctional facility (300 beds) is currently being constructed in Texas. Avalon
believes it is the largest private provider of community  correctional  services
in Oklahoma.  The Avalon  facilities  provide  numerous  programs for  offenders
generally  serving  the  last six  months  of their  sentence.  Avalon  provides
contract  agencies the basic  services  relating to the security,  detention and
care  of  inmates,  and a broad  range  of  rehabilitative  programs  to  reduce
recidivism.  The provided  programming  includes  substance  abuse treatment and
counseling,  vocational  training,  work  release  programs,  basic  educational
programs, job and life skill training, and reintegration services.

     Avalon's  management  made the  decision  to  divest  all non  correctional
services at the end of 1996 to allow management to focus  exclusively on private
corrections.   Avalon  is  aggressively   developing  its  private  correctional
operations  through  selective   acquisitions  and  responding  to  requests  of
governmental agencies.

     Avalon's  management made the decision to change the Company name to Avalon
Correctional Services,  Inc., to reflect the Company's focus on the correctional
industry.  This name change is subject to approval  of the  stockholders  at the
annual meeting.

     Avalon's  corporate  office is located at 13401  Railway  Drive in Oklahoma
City,  Oklahoma.  Avalon's  common stock is traded on the NASDAQ SmallCap Market
with the symbol "CITY".







                                     Page 1

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES




Facilities -

     The  following  table  summarizes  certain   information  with  respect  to
facilities and programs managed by Avalon at March 5, 1999.
<TABLE>
<CAPTION>

Facility Name
And Location                        Company Role                  Capacity               Facility/Program Type
---------------------------         ------------------------      -----------            ---------------------                    
<S>                                 <C>                           <C>                    <C>    
                                                           
Carver Center,                      Complete Facility             250 Beds               Community  Security
     Oklahoma City, OK              Sighting, Design,                                    Corrections
                                    Construction, Ownership,
                                    and Management

Avalon Correctional Center,         Complete Facility             255 Beds               Community  Security
     Tulsa, OK                      Sighting, Design,                                    Corrections
                                    Construction, Ownership,
                                    and Management

Turley Correctional Center,         1997 Acquisition              150 Beds               Community  Security
     Tulsa, OK                      Complete Facility                                    Corrections
                                    Ownership and
                                    Management

El Paso Intermediate                1996 Acquisition
    Sanction Facility,              Complete Facility             150 Beds               Medium Security
    El Paso, TX                     Ownership and                                        Correctional Facility
                                    Management

Union City Juvenile Center,         Complete Facility             80 Beds                Medium Security Juvenile
    Union City, OK                  Sighting, Design,                                    Facility
                                    Construction, Ownership,
                                    and Management

El Paso Multi Purpose               Complete Facility             300 Beds               Medium Security
    Facility,                       Sighting, Design,                                    Correctional Facility
    El Paso, TX                     Construction, Ownership,
                                    and Management

Avalon Corporate Office,            Corporate Headquarters        N/A                    Administrative
    Oklahoma City, OK
</TABLE>


Correctional Services -

     Avalon owns and operates six correctional  centers,  Carver Center,  Avalon
Correctional Center,  Turley Correctional Center, Union City Juvenile Center, El
Paso  Intermediate  Sanction  Facility,  and the El Paso Multi Purpose  Facility
currently  being   constructed.   The  correctional   centers  provide  complete
correctional  administration,   correctional  officer  staffing,  housing,  food
services, vocational assistance, transportation, and rehabilitation services.



                                     Page 2

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


     Oklahoma.  Avalon's  contracts with the Oklahoma  Department of Corrections
extend  through June 30, 1999.  The  contracts  with the Oklahoma  Department of
Corrections are bid every three years.  The structure of the Oklahoma  contracts
is based upon three one year contract  periods.  Avalon has contracted  with the
State of  Oklahoma  pursuant  to  similar  contracts  since  1985.  The State of
Oklahoma's performance under the contracts is subject to annual appropriation by
the legislature.  Avalon also provides  services  pursuant to a Federal contract
obtained in connection with the acquisition of the Turley Correctional Center in
October 1997. The five year contract  extends through April 30, 1999.  

     Carver Center is a 250 bed minimum security  correctional  facility located
in Oklahoma  City,  Oklahoma.  Carver  Center has been expanded from its initial
capacity of 25 beds in 1985, to its current  capacity of 250 beds to accommodate
the increasing needs of the Oklahoma Department of Corrections.

     Avalon  Correctional  Center  is a 255 bed  minimum  security  correctional
facility located in Tulsa, Oklahoma. The Avalon Correctional Center was sighted,
designed, and constructed by Avalon and opened in July 1995.

     Turley  Correctional  Center  is a 150 bed  minimum  security  correctional
facility  located  in  Tulsa,  Oklahoma.  The  Turley  Correctional  Center  was
purchased by Avalon in October 1997.

     Union  City  Juvenile  Center  is  an  80  bed  medium  security   juvenile
correctional  facility located in Union City, Oklahoma.  The Union City Juvenile
Center was sighted,  designed,  and constructed by the Company.  Construction of
the Union City  Juvenile  Center was  completed  and the Center began  receiving
offenders in February 1999.

     Carver Center,  Avalon  Correctional  Center and Turley Correctional Center
are  accredited  by the  American  Correctional  Association  ("ACA")  as  Adult
Community Correctional Facilities. ACA accreditation or candidacy is required to
contract  with the State of  Oklahoma  for  correctional  services.  The ACA,  a
private not-for-profit  organization,  was established to develop uniformity and
industry standards for the operation of correctional facilities and provision of
inmate care.

     Texas.  Avalon purchased the El Paso  Intermediate  Sanction Facility in El
Paso, Texas in August 1996. The facility has a capacity of 150 beds. The Company
signed a fifteen year contract to provide  services in the facility for the West
Texas Community Supervision and Corrections Department in July 1996. Avalon also
signed a three year  contract with the Texas  Department of Criminal  Justice in
November  1996,  to provide  services  for up to 50 male  parole  and  mandatory
supervision releases in the facility.

     The Company  was awarded a contract in June 1998 with the Texas  Department
of Criminal Justice to provide 250  multi-purpose  beds in El Paso, Texas. A new
300 bed facility is being constructed  adjacent to the existing El Paso Facility
and is expected to be completed and operational in the second quarter of 1999.

     Avalon is evaluating additional correctional projects in several states.

Discontinued Operations-

     Avalon  previously  provided  mental  health  services and assisted  living
services in Oklahoma  and  Colorado.  Avalon's  management  made the decision to
divest all non  correctional  services at the end of 1996 to allow management to
focus exclusively on private  corrections.  The remaining assets at December 31,
1998,  consists  of an  investment  in one  assisted  living  center  which  was
reclassified  as an asset held for sale in 1998.  The  Company  has  entertained
various  offers  to sell  this  investment,  and  management  believes  that the
facility will be sold in 1999.




                                     Page 3

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


Competition -

     Corrections.  The  trend  in the  United  States  toward  privatization  of
government  services and  functions  continues to increase as  governments  have
faced continuing  pressure to control costs and improve the quality of services.
Governmental  agencies responsible for the operation of correctional  facilities
are privatizing and contracting  with private  providers for services to address
these pressures.

     A  combination  of factors in many  states  has led to a  revamping  of the
corrections' processes (i.e., decreasing revenues, increasing prison population,
litigation  arising  from  substandard   prison   conditions,   and  substantial
overcrowding) in addition to reallocation of limited prison  resources.  Private
correctional  services  provide a  substantial  economic  savings  allowing  the
contracting governmental agency to comply with legislative and judicial pressure
to  improve  prison  conditions.   Privately  operated  correctional  management
companies  are able to provide  high  quality  services at lower  cost.  Private
correctional  facilities  operating  as  contractors  for  government  agencies,
pursuant to court order or otherwise, exist in virtually every state.

     Avalon's primary focus is the area of community corrections.  Comparable to
other corrections  sectors,  community  corrections has experienced  substantial
growth  over  the  past  decade.  Community  corrections  provides  services  to
individuals still in the correctional  system and individuals  granted parole or
sentenced to probation.  Offenders  are often placed in a community  corrections
facility  for the  last  six to  twelve  months  of  their  sentence.  Community
corrections  facilities  enable  offenders  to remain  employed and even upgrade
their job skills. The inmates also contribute to society by paying taxes, paying
court costs, paying victim restitution,  and paying for a portion of the cost of
their   incarceration.   Community   corrections   facilities  have  the  lowest
re-imprisonment  rate  among  the  various  types  of  incarceration.  Community
corrections  facilities  generate revenue for local  communities,  are more cost
effective  than  building  additional  jail  cells,  and help  reduce the prison
overcrowding  problem. The community  corrections market segment is estimated at
$4 billion annually and includes approximately 5,000 providers.

     Contracts for correctional  services are awarded by government agencies and
are generally based upon competitive  bidding and quality of services  provided.
Avalon  management  believes the Company has several  competitive  advantages in
contracting for community  correctional  services including:  a) a fourteen-year
history of providing quality services to the Oklahoma Department of Corrections;
b) a geographic location allowing for lower administrative overhead charges when
bidding against  competitors for regional  contracts;  c)  accreditation  by the
American  Correctional  Association  since 1990 and  certification as a drug and
alcohol provider since 1985; and d) a high quality and cost-effective  corporate
infrastructure  for  management,   marketing,  financial  management,  financial
reporting, quality assurance, and providing support services.

     Avalon  has  developed  a  broad  range  of  programs  designed  to  reduce
recidivism,  including  substance  abuse  treatment and  counseling,  vocational
training,  work release programs, GED classes, job and life skills training, and
reintegration services in addition to providing fundamental residential services
for adult inmates.  The management services offered by Avalon range from project
consulting for the design and development of new correctional facilities, to the
complete turnkey development of siting, designing,  constructing,  and operating
correctional  facilities.  Avalon management believes its experience and success
in  owning  and  operating  community  correctional   facilities  and  providing
successful  programming  will be the basis for becoming the dominant  company in
the community corrections industry.

     Avalon  contracts with the State of Oklahoma to provide  services at Carver
Center,  Avalon  Correctional  Center,  Turley Correctional Center and the Union
City Juvenile Center.  Avalon also provides services pursuant to a contract with
the Federal Bureau of Prisons at Turley  Correctional  Center.  Avalon contracts
with West Texas Community  Supervision and Correctional  Department and with the
Texas  Department of Criminal  Justice Parole  Department to provide services in
the El Paso Intermediate  Sanction  Facility.  Revenues generated from the Texas
contracts during 1998 comprised  approximately  26% of total revenues.  Revenues
from contracts with the Oklahoma  Department of Corrections  represented  49% of
1998 revenues.


                                     Page 4

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


Insurance -

     Avalon maintains  insurance  coverage for general  liability,  property and
contents, automobile physical damage and liability,  workers' compensation,  and
directors  and  officers.  Avalon  believes its existing  insurance  coverage is
adequate.

Regulations -

     Avalon's  adult  correctional  facilities in Oklahoma are accredited by the
American Correctional Association ("ACA"), an independent organization comprised
of professionals in the corrections industry.  The ACA utilizes compliance audit
teams  to  rigorously  examine  all  aspects  of the  Company's  facilities  and
operations.  The Company  recognizes the importance of maintaining  high quality
management and operations at its facilities.  Accreditation is generally granted
for a three-year  period.  Carver Center has been  accredited  since 1990 and is
currently  accredited through 1999. Avalon Correctional Center was accredited in
1996 and is accredited through 1999. Turley  Correctional  Center was accredited
in 1997 and is accredited through 2000. The application for accreditation of the
Union City Juvenile Center will be submitted during 1999.

     The corrections industry is subject to federal, state and local regulations
administered by a variety of regulatory  authorities.  The correctional services
offered by Avalon in various states are subject to regulations  and oversight by
the  various  government  agencies.   Management  believes  its  operations  are
currently in  compliance  with all  applicable  laws and  regulations  affecting
Avalon's business.

Employees -

     At February 23, 1999,  Avalon had  approximately  261 full-time  employees,
including  directors and officers.  Avalon has not  experienced a work stoppage,
and management considers its employee relations to be good.

ITEM 2.   DESCRIPTION OF PROPERTY.

     Carver Center is a 250 bed minimum security  correctional  facility located
in Oklahoma  City,  Oklahoma.  The facility is located on five acres of land and
includes five buildings.  Avalon  constructed a new 16,000 square foot dormitory
at Carver  Center in the second  quarter of 1995.  The  Carver  Center  facility
contains approximately 35,000 square feet of building space.

     Avalon  Correctional  Center  is a 255 bed  minimum  security  correctional
facility  located on  approximately  two acres of land in Tulsa,  Oklahoma.  The
construction of the approximately  36,000 square foot facility was completed and
opened by the Company in July 1995. The Avalon Correctional Center was sighted,
designed, and constructed by the Company.

     Turley  Correctional  Center  is a 150 bed  minimum  security  correctional
facility  located in Tulsa,  Oklahoma.  The facility is located on a thirty-five
acre tract of land and includes seven buildings.  The Turley Correctional Center
was purchased by the Company in October 1997.

     El  Paso  Intermediate  Sanction  Facility  is a 150  bed  medium  security
correctional  facility  located on seven  acres of land in El Paso,  Texas.  The
facility was constructed as an intermediate sanction facility. The 36,000 square
foot facility was purchased by the Company in 1996.

     Union  City  Juvenile  Center  is  an  80  bed  medium  security   juvenile
correctional  facility  located  on 20 acres of land in  Union  City,  Oklahoma.
Construction  of the 45,000  square foot  facility was  completed and the Center
began  receiving  offenders in February 1999. The Union City Juvenile Center was
sighted, designed, and constructed by the Company.


                                     Page 5

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


     El Paso Multi Purpose  Facility is a 300 bed medium  security  correctional
facility being  constructed on seven acres of land purchased in 1998 in El Paso,
Texas. The 54,000 square foot facility is scheduled for completion in the second
quarter of 1999.

     Avalon  Corporate  Office is  located  in  Oklahoma  City,  Oklahoma,  in a
commercial  building at 13401 Railway Drive,  Oklahoma City, Oklahoma 73114. The
Company owned building  contains  approximately  21,000 square feet of warehouse
space including approximately 8,000 square feet of office space.

     Substantially  all property owned by Avalon is pledged as collateral on the
Company's  credit  facilities.   See  Note  6  to  the  Consolidated   Financial
Statements.


ITEM 3.  LEGAL PROCEEDINGS.

     Avalon is a party to  litigation  arising in the normal course of business.
Management  believes that the ultimate  outcome of these matters will not have a
material effect on Avalon's financial condition or results of operations.


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

     No matters  were  submitted to a vote of Avalon's  stockholders  during the
quarter ended December 31, 1998.


                                     PART II

ITEM 5.   MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

     Avalon's  common stock trades on the NASDAQ SmallCap Market with the symbol
"CITY".  The following table reflects the range of high and low sales prices, as
reported by the National  Quotation Bureau for each quarterly period during 1998
and 1997. The prices represent inter-dealer prices, without retail mark up, mark
down,  or  commission  and may not  represent  actual  transactions.  Trading in
Avalon's  common stock is limited and may not be an  indication  of the value of
the common stock.

Quarterly Period Ended                High                       Low
-------------------------------------------------------------------------
March 31, 1997                        5 1/2                      3 15/16
June 30, 1997                         4 7/8                      3 1/2
September 30, 1997                    5                          3 7/8
December 31,1997                      5 5/16                     3 3/4
March 31, 1998                        4 3/4                      3 7/8
June 30, 1998                         4 11/16                    3 7/8
September 30, 1998                    4 1/4                      3 1/4
December 31, 1998                     4                          2 3/4

     Avalon had  approximately  830 holders of record of its common  stock as of
March 5, 1999. No dividends were declared  during 1998 and 1997.  Avalon's Board
of Directors  presently intends to retain all earnings in the foreseeable future
for use in  Avalon's  business.  Payment of  dividends  on the  Common  Stock is
restricted by certain credit facilities.

     The  average  high and low price for the Common  Stock,  as reported on the
NASDAQ SmallCap Market System was $2.50 per share on March 5, 1999.



                                     Page 6

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES



ITEM 6.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

Liquidity and Capital Resources -

     The  Company's  business  strategy is to focus on the  private  corrections
industry,  expanding its operations into  additional  states through new Federal
and state contracts and selective acquisitions. The successful implementation of
the  Company's  growth  plan has  created  the need for  additional  capital and
financing.  The  Company  has been  successful  in  securing  $37 million of new
capital and credit facilities since September 1997.

     Working capital at December 31, 1998 was $8,643,000  representing a current
ratio of 3.04:1,  compared to working capital of $875,000 and a current ratio of
1.47:1 at December 31, 1997.  The increase in working  capital from December 31,
1997 is primarily due to the $15 million private placement  completed  September
16,  1998.  Capital  expenditures  were $5.0  million in 1998,  compared to $2.3
million in 1997.  The capital  expenditures  consist  primarily of  construction
costs for the Union City Juvenile  Center  completed in February  1999,  and the
construction of the El Paso Multi Purpose  Facility  scheduled for completion in
the second quarter of 1999.

     The Company issued $4.15 million of convertible  subordinated debentures in
1997 through a private placement. The debentures bear interest at 7.5% per annum
and mature in 2007. The  debentures  can be converted into the Company's  common
stock at $3.00 per share at any time  prior to their  maturity.  The  debentures
proceeds were utilized to complete an  acquisition  and provide  capital for new
contracts and acquisitions.  The Company acquired the Turley Correctional Center
in Tulsa,  Oklahoma in October 1997.  The purchase price of  approximately  $1.4
million was funded with debenture proceeds.

     The Company  had  approximately  $11.1  million of cash  available  for new
projects at  December  31,  1998.  The Company  believes  it has  adequate  cash
reserves and cash flow from  operations  to meet its current cash  requirements.
The Company expects current contracts to generate  sufficient income to increase
cash reserves, while minimizing income taxes through the utilization of tax loss
carryforwards.  The Company  secured an $18 million senior credit  facility with
Fleet Capital  Corporation in February  1999. The credit  facility and available
cash  balance  will  enable  the  Company  to  expand  its  operations   through
acquisitions and development.

     Since the fourth quarter of 1996, all non correctional operations have been
discontinued  and all related  assets have been sold or are being held for sale.
Losses  associated  with  discontinued  operations  and  disposal of the related
assets in 1997 are  reflected  as losses  from  discontinued  operations  in the
Statement  of  Operations.  1998  earnings  include only  correctional  facility
operations, except for $91,000 recorded for losses on facilities held for sale.


Results of Operations -

Year Ended December 31, 1998 Compared to the Year Ended December 31, 1997-

     Total revenues from continuing  operations increased by 31% to $7.7 million
in 1998 from $5.9 million in 1997. The increase was a result of the a full years
operation at the Turley  Correctional  Facility in Tulsa,  Oklahoma  acquired in
October 1997, a new community  transition  program contract awarded in June 1998
at the Ozark Correctional Facility in Fordland, Missouri, and increased revenues
from the Company's El Paso operations.

     The  Company's  net loss from  continuing  operations  was $376,000 in 1998
compared  to  $1,853,000  in 1997.  The 1997 loss  included a non cash charge of
$1,819,000  resulting from a discount on the  convertible  debentures  issued in
September 1997.  Excluding the effect of the $1,819,000  discount on convertible
debentures in 1997, the loss from continuing operations was $34,000.

                                     Page 7

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES



     The Company  incurred a net loss in 1998 of $450,000 or $.13 per share,  as
compared to a net loss in 1997 of  $2,581,000  or $.88 per share.  The  majority
(98.7%) of the loss in 1997 resulted from the accounting treatment of a discount
from issuance of convertible debentures of $1,819,000, a non cash expense, and a
loss of $728,000 from discontinued  operations.  The discount on the convertible
debentures  was the result of the market  value of the  Company's  common  stock
exceeding the conversion price of the debentures at the date the debentures were
issued.  The  debenture  discount was  accounted  for by a charge to expense and
credit to paid in capital,  resulting in no change of  liabilities,  cash or net
equity.

     Corrections.  Operating income, before interest,  depreciation,  and income
taxes, increased  approximately 23% in 1998 to $1,449,000 compared to $1,175,000
for 1997.  The average daily inmate census  increased to 496 in 1998 from 425 in
1997,  an increase of 17%.  The census  increase  was a result of a full year of
operation at the Turley Correctional  Facility in Tulsa,  Oklahoma,  acquired in
October 1997.

     Direct operating expenses increased by 27% in 1998 over 1997,  primarily as
a result of the full operations in 1997 of the Turley Correctional  Facility and
the contract award for a community transition program at Fordland, Missouri.

     Discontinued  Operations.  The Company made the decision to discontinue all
non  correctional  operations  in the  fourth  quarter  of 1996.  The  Company's
strategy is to focus on opportunities in the corrections industry. Revenues from
discontinued operations were $0 and $50,000, in 1998 and 1997 respectively.  The
losses on the disposal of assets related to discontinued  operations were $0 and
$728,000, in 1998 and 1997, respectively.

     Corporate.  General and administrative expenses increased in 1998 by 16% to
$1,091,000 from $943,000. The majority of this increase was related to increased
staffing.

     The increase in interest  expense of $475,000 in 1998  resulted from a full
year  interest on the  convertible  debentures  issued in  September  1997,  and
interest on the $10,000,000 subordinated note placed in September 1998.

     The Company is aware of the risk of computer  error in the year 2000.  Such
errors could cause  computers  to recognize  the year 2000 as 1900 and cause the
computer  to fail in  calculation  or  function.  As a result,  the  Company has
reviewed its computer  operations  and has  identified all computers and systems
that are not year 2000 compliant  (y2k).  The Company's  primary exposure to y2k
problems is in its  financial  reporting  area.  The company has  purchased  and
ordered computer equipment and software to become fully y2k compliant.  The cost
of this equipment,  including testing and implementation to become y2k compliant
is expected to be approximately $15,000. The Company will test and implement the
new equipment and software before July 1, 1999.


                                     Page 8

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


                                                                           Page
ITEM 7.  FINANCIAL STATEMENTS.                                             ----
                                                                  
Index to Financial Statements:
                                                                                
Report of Independent Certified Public Accountants                          10

Consolidated Balance Sheets                                                 11

Consolidated Statements of Operations                                       12

Consolidated Statements of Stockholders' Equity                             13

Consolidated Statements of Cash Flow                                        14

Notes to Consolidated Financial Statements                                  16


                                     Page 9

<PAGE>




               REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS






To the Board of Directors of
Avalon Community Services, Inc.

We have audited the accompanying consolidated balance sheets of Avalon Community
Services,  Inc. and  subsidiaries  (the  "Company")  as of December 31, 1998 and
1997,  and the related  consolidated  statements  of  operations,  stockholders'
equity, and cash flows for the years then ended.  These  consolidated  financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is  to  express  an  opinion  on  these  consolidated  financial
statements based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material  respects,  the consolidated  financial  position of the
Company as of December 31, 1998 and 1997, and the consolidated  results of their
operations  and their cash flows for the years  then  ended in  conformity  with
generally accepted accounting principles.

As  discussed  in Note 17 to the  financial  statements,  during the year ending
December 31, 1998,  the Company  adopted the provisions of Statement of Position
98-5 " Reporting on Costs of Start Up  Activities"  which  changed its method of
accounting for deferred development and new facility opening costs.


                                                        GRANT THORNTON, LLP

Oklahoma City,  Oklahoma
February 19, 1999, except 
for the second paragraph of 
Note 6 and Note 18 as to 
which date is February 25, 1999


                                     Page 10

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>


                                                                                      December 31,

                                                                             1998                       1997
                                                                       ------------------------------------------
ASSETS
Current assets:
<S>                                                                    <C>                       <C>    
   Cash and cash equivalents                                           $    5,181,000            $    1,458,000
   Investment in short term U.S. treasury bills                             5,919,000                       ---
   Short term certificate of deposit                                         ---                        500,000
   Accounts receivable, net                                                 1,348,000                   673,000
   Current maturities of notes receivable                                     322,000                    16,000
   Prepaid expenses and other                                                 100,000                   107,000
                                                                       ------------------------------------------
         Total current assets                                          $   12,870,000            $    2,754,000
                                                                       ------------------------------------------
Property and equipment, net                                            $   13,644,000            $    9,212,000
Notes receivable, net of  current maturities                                      ---                   318,000
Other assets                                                                2,251,000                 1,111,000
                                                                       ------------------------------------------
         Total assets                                                  $   28,765,000            $   13,395,000
                                                                       ==========================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable, accrued liabilities and other                     $    2,026,000            $    1,030,000
   Current maturities of long-term debt                                     2,201,000                   849,000
                                                                       ------------------------------------------
         Total current liabilities                                     $    4,227,000            $    1,879,000
                                                                       ------------------------------------------
Long-term debt, less current maturities                                $   14,348,000            $    5,129,000
                                                                       ------------------------------------------
Convertible debentures                                                 $    3,850,000            $    4,150,000
                                                                       ------------------------------------------
Redeemable Class A Common Stock, $.001 par value
     1,622,448  shares issued and outstanding in 1998                  $    4,124,000            $          ---
                                                                       ------------------------------------------
Stockholders' equity:
      Common Stock - par value $.001;  20,000,000  shares    
           authorized; 4,664,598 and 2,982,170 shares issued
           and outstanding in 1998 and 1997, respectively,
           less 1,662,448 and no shares subject to repurchase          
           in 1998 and 1997, respectively                              $        3,000            $        3,000
 
   Preferred stock; par value $.001; 1,000,000
           shares authorized; none issued                                         ---                       ---
   Paid-In capital                                                          6,618,000                 6,189,000
   Accumulated deficit                                                     (4,405,000)               (3,955,000)
                                                                      ------------------------------------------
         Total stockholders' equity                                    $    2,216,000            $    2,237,000
                                                                      ------------------------------------------
         Total liabilities and stockholders' equity                    $   28,765,000            $   13,395,000
                                                                      ==========================================
</TABLE>

       These accompanying notes are an integral part of these consolidated
                             financial statements.

                                     Page 11

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>


                                                                    Year Ended December 31,

                                                               1998                        1997
                                                      ---------------------------------------------
<S>                                                   <C>                       <C>    
Revenues                                              $       7,686,000         $         5,878,000
Costs and expenses:
   Direct operating                                           4,692,000                   3,698,000
   General and administrative                                 1,091,000                     943,000
   Development costs                                            336,000                      62,000
   Losses from property held for sale                            91,000                         ---
   Depreciation and amortization expense                        628,000                     460,000
   Discount on convertible debentures                               ---                   1,819,000
   Interest expense                                           1,224,000                     749,000
                                                      ---------------------------------------------
Loss from continuing operations
     before income tax expense                        $        (376,000)        $        (1,853,000)
   Income tax expense                                               ---                         ---
                                                      ---------------------------------------------
Loss from continuing operations                       $        (376,000)        $        (1,853,000)
                                                      ---------------------------------------------
Discontinued operations:
   Loss on disposal, net of income tax benefit of
     $0 and 1997                                      $             ---         $          (728,000)
                                                      ---------------------------------------------
         Loss from discontinued operations            $             ---         $          (728,000)
                                                      ---------------------------------------------
Net Loss before cumulative effect of
     change in accounting principles                  $        (376,000)        $        (2,581,000)               
                                                      ---------------------------------------------
Cumulative effect of change in
     accounting principles                            $         (74,000)        $               ---
                                                      ---------------------------------------------

Net loss                                              $        (450,000)        $        (2,581,000)
                                                      =============================================


Basic and diluted loss per share:
   Continuing operations                              $           (0.11)        $             (0.63)
   Discontinued operations                                          ---                       (0.25)
   Cumulative effect of change in
      accounting principles                                       (0.02)                        ---
                                                      ---------------------------------------------
         Net loss per share:                          $           (0.13)        $             (0.88)
                                                      =============================================
Weighted average number of common
   shares outstanding, basic and diluted                      3,499,403                   2,935,369
                                                      =============================================
</TABLE>

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

                                     Page 12

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>


                                             Common Stock                                                 
                                                                                                   Total
                                    Class A     Class A   Class B      Paid-In    Accumulated   Stockholders'
                                    Shares      Amount     Shares      Capital      Deficit        Equity
                                ------------------------------------------------------------------------------
<S>                                <C>          <C>      <C>         <C>          <C>            <C>
Balance, January 1, 1997           2,927,135    $ 3,000   3,410,000  $ 4,066,000  $ (1,374,000)  $ 2,695,000
Net loss                                 ---        ---         ---          ---    (2,581,000)   (2,581,000)
Stock options exercised               22,035        ---         ---       36,000           ---        36,000
Class B shares retired                   ---        ---  (3,410,000)         ---           ---           ---
Issuance of warrants                     ---        ---         ---      158,000           ---       158,000
Discount on issuance of
    convertible debentures               ---        ---         ---    1,819,000           ---     1,819,000
Warrants exercised, net of
    issuance costs                    33,000        ---         ---      110,000           ---       110,000
                                ------------------------------------------------------------------------------
Balance, December 31, 1997         2,982,170    $ 3,000         ---  $ 6,189,000  $ (3,955,000)  $ 2,237,000

Net loss                                 ---        ---         ---          ---      (450,000)     (450,000)
Stock options exercised               17,480        ---         ---       29,000           ---        29,000
Issuance of warrants                     ---        ---         ---      266,000           ---       266,000
Issuance of redeemable
    common stock                   1,622,448        ---         ---          ---           ---           ---
Warrants exercised, net of
    issuance costs                    42,500        ---         ---      134,000           ---       134,000
                                ------------------------------------------------------------------------------
Balance, December 31, 1998         4,664,598    $ 3,000         ---  $ 6,618,000  $ (4,405,000)  $ 2,216,000
                                ==============================================================================
</TABLE>















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

                                     Page 13

<PAGE>



                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOW
<TABLE>
<CAPTION>

                                                                           Year ended December 31,

                                                                       1998                    1997
                                                                  ----------------------------------------
OPERATING ACTIVITIES:
  <S>                                                             <C>                   <C>    
  Net loss                                                        $     (450,000)       $     (2,581,000)
  Adjustments to reconcile net loss to
     net cash provided by (used for) operating activities
       Amortization of discount on investments                           (47,000)                    ---
       Depreciation and amortization                                     628,000                 460,000
       Amortization of debt issue costs                                   55,000                     ---
       Discount on convertible debentures                                    ---               1,819,000
       Loss  on sale of property                                          18,000                  71,000
       Write down of property                                             17,000                  59,000
       Cumulative effect of change in accounting principles               74,000                     ---
       Changes in operating assets and liabilities:
         Decrease (increase) in -
           Accounts receivable                                          (675,000)               (331,000)
           Due to / from  affiliates                                     (97,000)                120,000
           Prepaid expenses and other assets                               7,000                  40,000
           Increase (decrease) in accounts payable and other            (335,000)                609,000
                                                                  ----------------------------------------
  Net cash provided by operations                                 $     (805,000)       $        266,000

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

INVESTING ACTIVITIES:
  Purchase of short term investments                              $   (5,872,000)       $       (500,000)
  Proceeds from maturity of certificate of deposit                       500,000                     ---
  Capital expenditures                                                (3,737,000)               (941,000)
  Payment for purchase of business                                           ---              (1,400,000)
  Funding of note receivable                                              (4,000)                (25,000)
  Proceeds from payments on notes receivable                              16,000                   1,000
  Proceeds from disposition of property                                   16,000                  45,000
  Proceeds from disposition of discontinued operations                   280,000                 151,000
                                                                  ----------------------------------------
  Net cash used in investing activities                           $   (8,801,000)       $     (2,669,000)
                                                                  ----------------------------------------

</TABLE>





























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

                                     Page 14

<PAGE>



                                                         


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOW



<TABLE>
<CAPTION>


                                                                            Year ending December 31,

                                                                        1998                     1997
                                                                  ----------------------------------------
FINANCING ACTIVITIES:
  <S>                                                             <C>                   <C>  
  Proceeds from convertible debenture issue                       $          ---        $      4,150,000
  Proceeds from borrowing                                             16,515,000               5,210,000
  Repayment of borrowing                                              (6,532,000)             (5,612,000)
  Payment of debt issue costs                                         (1,452,000)                    ---   
  Proceeds from warrant and option exercise                              163,000                 146,000
  Payment of warrant & debenture issue costs                                 ---                (346,000)
  Proceeds from issuance of Redeemable Common Stock                    4,635,000                     ---
                                                                  ---------------------------------------- 
Net cash provided by  financing activities                        $   13,329,000        $      3,548,000
                                                                  ----------------------------------------


Net increase in cash
  and cash equivalents                                            $    3,723,000        $      1,145,000
                                                                  ----------------------------------------  

 Cash and cash equivalents,
  beginning of period                                             $    1,458,000        $        313,000
                                                                  ----------------------------------------
 Cash and cash equivalents
  end of period                                                   $    5,181,000        $      1,458,000
                                                                  ========================================
</TABLE>

<TABLE>
<CAPTION>

SUPPLEMENTAL CASH FLOW INFORMATION:
<S>                                                               <C>                   <C>    
Cash paid during the year for:
         Interest                                                 $    1,286,000        $        668,000
         Income taxes                                                        ---                     ---

</TABLE>


Non cash investing and financing activities:

     The Company has approximately  $1,231,000  relating to construction  costs,
and $100,000  relating to debt issue costs financed  through accounts payable at
December 31, 1998.  During 1998,  the company issued  warrants of  approximately
$266,000 in exchange for financial advisory services.






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

                                     Page 15

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



NOTE 1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business -

     Avalon Community Services,  Inc. (the "Company" or "Avalon") is an Oklahoma
based  corporation  specializing  in operating  private  community  correctional
facilities  and  providing  intensive  correctional  programming.   The  Company
currently operates in Oklahoma and Texas with plans to significantly expand into
additional states. The Company owns and operates 1,185 private  corrections beds
including 300 beds currently being constructed.

Principles of Consolidation -

     The consolidated  financial  statements include the accounts of the Company
and its wholly-owned subsidiaries after elimination of all material intercompany
balances and transactions.

Use of Estimates -

     The preparation of the consolidated  financial  statements requires the use
of management's  estimates and assumptions in determining the carrying values of
certain  assets  and  liabilities  and  disclosures  of  contingent  assets  and
liabilities  at the  date  of the  consolidated  financial  statements  and  the
reported amounts for certain revenues and expenses during the reporting  period.
Actual results could differ from those estimated.

Cash and Cash Equivalents -

     The  Company   considers  all  highly  liquid   investments  with  original
maturities  of three months or less when  purchased and money market funds to be
cash equivalents.

Investments -

     The Company  accounts for certain  investments  in debt  securities  in the
following  manner.  Debt  securities  that the Company has a positive intent and
ability to hold to maturity are  classified as  held-to-maturity  securities and
are  reported  at  amortized  cost.  Debt  securities  that are  bought and held
principally  for the  purpose  of  selling  in the near term are  classified  as
trading  securities and reported at fair value, with unrealized gains and losses
included in earnings.  Debt securities not classified as either held-to-maturity
securities or trading securities are classified as available-for-sale securities
and  reported  at fair  value,  with  unrealized  gains and  losses,  net of tax
effects,  excluded from earnings and reported in other comprehensive income. The
Company has classified its entire debt securities  portfolio as held-to-maturity
securities.

     Declines in the fair value of individual securities below cost or amortized
cost that are other than temporary  result in write-downs  included in earnings.
The  specific  identification  method is  followed  in  determining  the cost of
securities sold.

Concentrations of Credit Risk -

     Financial instruments  potentially subjecting the Company to concentrations
of credit risk consist  principally  of  temporary  cash  investments,  accounts
receivable  and  notes  receivable.   The  Company  places  its  temporary  cash
investments  with high credit quality  financial  institutions  and money market
funds and limits the amount of credit  exposure to any one  institution or fund.
The Company had a significant  portion of its cash  equivalents in United States
treasury bills at December 31, 1998.  Concentrations of credit risk with respect
to accounts receivable are limited due to the fact that a significant portion of
the Company's receivables are from state governments.  Approximately 75% and 44%
of total accounts receivable at December 31, 1998 and 1997,  respectively,  were


                                     Page 16

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



due from the  Oklahoma  Department  of  Corrections.  The Company  maintains  an
allowance for doubtful  accounts for potential credit losses.  The allowance for
doubtful  accounts  at  December  31,  1998  and  1997 was  $9,000  and  $8,000,
respectively.  Actual bad debt expenses have not been material. Credit risk on a
note receivable by the Company is partially  mitigated by the  collateralization
of the note by second lien on real estate.

Property and Equipment -

     Property  and  equipment  are  recorded  at cost.  Expenditures  for  major
additions  and   improvements  are   capitalized,   while  minor   replacements,
maintenance  and repairs are charged to expense as incurred.  When  property and
equipment is retired or otherwise disposed of, the cost and related  accumulated
depreciation  are removed from the accounts  and any  resulting  gain or loss is
reflected   in  current   operations.   Depreciation   is  provided   using  the
straight-line method over the following estimated useful lives:

           Buildings and Improvements                     40 Years
           Furniture and Equipment                    5 to 7 Years
           Transportation Equipment                  3 to 15 Years


     Impairment  losses are recorded on  long-lived  assets when  indicators  of
impairment are present and the undiscounted cash flows estimated to be generated
by those assets are less than the assets' carrying  amounts.  Impairment  losses
are recognized based upon the estimated fair value of the asset when required.

Income Taxes -

     Deferred  income taxes are  recognized for the tax  consequences  in future
years of differences  between the tax bases of assets and  liabilities and their
financial  reporting  amounts at each  year-end  based on  enacted  tax laws and
statutory  tax rates  applicable  to the  period in which  the  differences  are
expected to affect taxable income.  Valuation  allowances are  established  when
necessary to reduce  deferred tax assets to the amount  expected to be realized.
Income tax expense is the tax  payable for the period and the change  during the
period in deferred tax assets and liabilities.

Revenue Recognition -

     The Company  recognizes  revenues as services  are  provided.  Revenues are
earned  based upon the  number of  inmates on a per diem basis at the  Company's
correctional  facilities.  Revenues are earned on a monthly  contract  basis for
substance  abuse  treatment  services.  All  correctional  and  substance  abuse
revenues are received monthly from various governmental agencies.

Deferred Development Costs -

     Prior to 1998,  development costs that could be directly associated with an
anticipated  contract were  capitalized,  and, if the  recoverability  from that
contract was probable,  they were deferred  until the  anticipated  contract had
been awarded.  The  development  costs of sucessful  proposals were deferred and
amortized  over the  anticipated  life of the  contract  (including  option  and
renewal  periods),  while costs of  unsuccessful  or  abandoned  contracts  were
charged to expense when their  recovery was not  considered  probable.  Facility
costs were incurred (after a contract is awarded) in connection with the opening
of new  facilities  under the contract,  and were  capitalized  from the date of
award until  commencement of operations and amortized on a  straight-line  basis
over the term of the contract.  As of January 1, 1998, the Company, pursuant to
Statement  of Position  98-5  "Reporting  on the Costs of Start Up  Activities",
expensed development and new facility opening costs.



                                     Page 17

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



Net Loss Per Common Share -

     Basic loss per share has been  computed  on the basis of  weighted  average
shares  outstanding  during each  period.  Diluted loss per share is the same as
basic loss per share because the assumed  exercise of options and warrants (Note
9), the assumed redemption of 1,622,448 shares of common stock (Note 6), and the
conversion of debentures (Note 7), would be anti-dilutive.

Reclassifications-

     Certain  reclassifications  have been made to the 1997 financial statements
to conform to the 1998 presentation.


NOTE 2.  INVESTMENTS

     The amortized cost of debt  securities,  together with thier estimated fair
value, are summarized as follows as of December 31, 1998.
<TABLE>
<CAPTION>


                                    Cost /                Gross                Gross
                                   Amortized            Unrealized           Unrealized              Estimated
    Type of Investment               Cost                 Gains                Losses               Fair Value
--------------------------      ---------------       --------------      ----------------        ---------------
<S>                                 <C>                    <C>                  <C>                   <C> 
U.S. Treasury Bills                 $ 5,919,000            ---                  ---                   $ 5,919,000
</TABLE>


     At December 31, 1998, the entire  investment in U.S. treasury bills are due
within one year.  The Company had no sale or  maturities of  investments  during
1998 or 1997.



NOTE 3.  PROPERTY AND EQUIPMENT

     The elements of property and equipment and related accumulated depreciation
as of December 31, 1998 and 1997 are as follows:

                                                              
                                                            Accumulated 
                                          Cost              Depreciation
                                     -------------------------------------
December 31, 1998:
     Land                           $   1,388,000          $        ---
     Buildings and Improvements         7,586,000               758,000
     Furniture and Equipment              933,000               533,000
     Transportation Equipment           1,086,000               258,000
     Construction in Progress           4,200,000                   ---
                                    -------------          ------------
                                     $ 15,193,000          $  1,549,000
                                    =============          ============





                                     Page 18

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



                                                           Accumulated        
                                      Cost                 Deprciation
                                    -----------------------------------
December 31, 1997:
    Land                            $   1,092,000          $        ---
   Buildings and Improvements           7,544,000               513,000
   Furniture and Equipment                784,000               424,000
   Transportation Equipment               883,000               154,000
                                    -------------          ------------
                                    $  10,303,000          $  1,091,000
                                    =============          ============



NOTE 4.  ACCOUNTS PAYABLE, ACCRUED LIABILITIES AND OTHER

     The  elements  of accounts  payable,  accrued  liabilities  and other as of
December 31, 1998 and 1997 are as follows:


                                                    1998             1997
                                             -----------------------------------

                                                                               
     Trade accounts payable                   $ 1,450,000            $   303,000
     Accrued interest payable                     154,000                140,000
     Accrued salary and benefits                  168,000                115,000
     Discontinued operations liabilities              ---                157,000
     Other accrued liabilities                    254,000                315,000
                                             ------------           ------------
                                              $ 2,026,000            $ 1,030,000
                                             ============           ============




NOTE 5.  CORRECTIONAL CONTRACTS


     The  Company  contracts  with  various  governmental  agencies  to  provide
correctional  services.  The  contracts  generally  specify  for the  Company to
provide  correctional  services  including  complete  residential  services  and
programming in the Company's  facilities  ("Residential  Services") or specified
correctional  programming  services  in  the  governmental  agency's  facilities
("Programming  Services").  Compensation  paid to the  Company  for  Residential
Services is generally based on a per person, per day basis. Compensation paid to
the  Company  for  Programming  Services  is  generally  based upon the units of
service provided.  Contract revenues from significant  contracts as a percentage
of total Company revenue for the years ending December 31, are as follows:

                                                       1998          1997 
                                                    -----------   -----------

Oklahoma Department of Corrections                      49%           52%

West Texas Community Supervision and Corrections        18%           31%

Missouri Department of Corrections                      13%           ---




                                     Page 19

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



     The Company has a fifteen (15) year Residential Services contract with West
Texas  Community  Supervision  and  Corrections   Department  and  a  four  year
Residential  Services  contract with the Texas  Department  of Criminal  Justice
Parole Department to provide  correctional  services in El Paso, Texas extending
through August 31, 2011 and August 31, 1999, respectively. The Company's current
Residential  Services  contracts  with the Oklahoma  Department  of  Corrections
extend  through June 30, 1999. The Company has a Programming  Services  contract
with the State of Missouri extending through February 28, 1999.



NOTE 6.  LONG-TERM DEBT

     Long-term debt consists of the following:
<TABLE>
<CAPTION>


                                                                      December 31,
                                                                 1998            1997 
                                                            ------------------------------
<S>                                                         <C>              <C>   
Revolving bank line of credit, 
  collateralized by accounts
  receivable,  with  interest at 
  1% over  prime  (effective  rate 
  of  9.25% at December 31, 1998); 
  due June 1999                                             $     724,000    $     167,000 
   
Notes payable to banks, collateralized by
  equipment due in installments through
  July 1999 with interest at 7.99%.                                 2,000           89,000

Notes payable to banks, collateralized
  by transportation equipment, due in
  installments through March 2012
  with interest ranging from 4.90% to 9.49%.                      676,000          621,000

Notes payable to banks, collateralized
  by land, buildings and improvements
  due in installments due in installments
  through June 2012 with interest
  ranging from 8.95% to 11%.                                    4,631,000        4,941,000

Note payable to an individual, uncollateralized,
  with interest at 8.5%, due in full April 1999.                  160,000          160,000

Note payable to an investment company, unsecured
  with interest at 12.5%, due in four installments
  beginning in 2005, including original issue premium          10,356,000              ---
                                                            -------------    -------------
                                                            $  16,549,000    $   5,978,000
Less - current maturities                                   $   2,201,000    $     849,000
                                                            -------------    -------------
                                                            $  14,348,000    $   5,129,000
                                                            =============    =============
</TABLE>





                                     Page 20

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



     The  Company   completed  a  senior  credit  facility  with  Fleet  Capital
Corporation on February 25, 1999. The Company utilized existing cash reserves in
February 1999 to retire $5,053,000 in existing  indebtedness upon the completion
of the senior credit  facility.  The aggregate  maturities of long-term debt for
each of the next five years after the retirement of indebtedness are as follows:
1999: $537,000;  2000: $404,000;  2001: $436,000; 2002: $468,000; 2003: $495,000
and $14,206,000 thereafter.

     The Company  completed a $15,000,000  private  placement of debt and equity
with an investment  company on September 16, 1998.  Pursuant to the terms of the
agreement, the Company tendered an unsecured subordinated note with a face value
of  $10,000,000  bearing  interest of 12.5% with  interest  payable in quarterly
installments until December 31, 2005, when the first of four quarterly principal
installments  are due. The Company also tendered  1,622,448 shares of redeemable
common stock to the investment  company.  These shares are subject to repurchase
by the  Company,  at the  holders  option,  after  five  years  from the date of
issuance  at  the  fair  value  as  defined  in  the  agreement   under  certain
circumstances if the Company is unable to meet certain covenants required by the
agreement.  The financial covenants require the Company,  among other things, to
maintain certain earnings and debt coverage ratios.

     The Company  obtained an independent  fair value  appraisal of the debt and
equity instruments reflecting a fair value allocation of the debt of $10,365,000
and the fair value allocation of the redeemable common stock of $4,635,000.  The
original  issue  premium of $365,000 will be accreted as a reduction of interest
expense  over the term of the debt  instrument.  Debt issue costs of  $1,654,000
(including $266,000  representing the fair value of warrants issued to financial
advisors) has been allocated to the debt and redeemable  common stock based upon
their fair values.  Costs of $511,000  allocated to the redeemable  common stock
have reduced its book value to $4,124,000.  Costs of $1,143,000 allocated to the
debt  instrument are included in other assets and amortized to interest  expense
over the life of the debt instrument using the effective interest method.


NOTE 7.  CONVERTIBLE DEBENTURES

     The Company  completed a private  placement of  $4,150,000  of  convertible
debentures on September 12, 1997. The  convertible  debentures  bear interest at
7.5% and  mature on  September  12,  2007.  The  convertible  debentures  may be
redeemed  by the  Company at any time after  May,  2001 at 106.5% of  principal,
declining to 100% at maturity.  The convertible  debentures are convertible into
common  stock  at  $3.00  per  share  at any  time  until  their  maturity.  The
convertible debenture holders signed agreements to subordinate the debentures to
the  $10,000,000  face value note  issued on  September  16,  1998.  The Company
redeemed $300,000 of convertible debentures at face value in September 1998.



NOTE 8.  STOCKHOLDERS' EQUITY

     The  Company  has  outstanding  275,100  Class  B stock  purchase  warrants
providing for the purchase of the Company's common stock at a price of $6.00 per
share. The warrants may be exercised at any time until their expiration at March
26,  1999.  The warrants may be redeemed by the Company at any time for $.01 per
share, with the exception of certain warrants relating to 1,600 shares of common
stock.

     The Company  completed a private  placement  in August  1994,  of 1,000,000
shares of common  stock and  1,000,000  Class C stock  purchase  warrants and an
additional  100,000  shares of common stock and 100,000  Class C stock  purchase
warrants were reserved for underwriters. The Company issued an additional 25,000
and 165,000 Class C stock purchase warrants, respectively, in 1997 and 1996. The
Company has issued 452,500 shares of common stock upon the exercise of the Class
C stock purchase  warrants  through December 31, 1998 and has a total of 837,500
Class C stock purchase warrants outstanding.




                                     Page 21

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



     The  Class C stock  purchase  warrants  provide  for  the  purchase  of the
Company's  common stock at any time until their expiration at December 30, 1999.
The exercise price of the Class C stock purchase  warrants is $3.19 per share as
of December 31,  1998.  The warrants may be redeemed by the Company upon certain
events, for $.01 per share.

     The Company issued 200,000 Class D stock purchase  warrants in August 1996,
in  connection  with  the  acquisition  of the  El  Paso  Intermediate  Sanction
Facility.  The Class D stock purchase  warrants  provide for the purchase of the
Company's common stock at any time until their expiration at August 2, 2001. The
exercise  price of the class D warrants  is $4.20 per share as of  December  31,
1998.  The warrants may be redeemed by the Company upon certain  events for $.01
per share.

     The Company  issued  Class E Warrants to purchase  79,000  shares of Common
Stock in September 1997, in connection with the private placement of convertible
debentures. The Company recognized $148,000 of cost based upon the difference in
the exercise  price of the Class E warrants and the current  market price of the
common stock on the date of issuance.  This cost was recorded as debenture issue
costs and is  classified  in other assets on the balance  sheet.  The  debenture
issue cost is amortized to expense over the term of the convertible debentures.
 The Class E stock purchase  warrants  provide for the purchase of the Company's
common stock at a price of $3.00 per share at any time until their expiration at
August 2, 2001.  The warrants may be redeemed by the Company upon certain events
for $.01 per share.

     The Company  issued  3,900,000  shares of Class B common stock from 1995 to
1997 in connection with the CEO's personal guarantee of debt. Class B shares are
voting rights only,  are  non-transferable  and have no  liquidation or dividend
rights.  The Company  canceled all Class B common stock and the  certificate  of
designation  creating  the stock on August  25,  1997,  pursuant  to a Change of
Control Agreement between the Company and the Company's CEO.

     The Company issued 200,539 stock purchase warrants to financial advisors in
September 1998, in connection with the $15,000,000 private placement.  The stock
purchase  warrants provide for the purchase of the Company's common stock at any
time until  their  expiration  in  September  2002.  The  exercise  price of the
warrants is $3.75 per share as of December 31,1998. The warrants may be redeemed
by the Company  upon  certain  events for $.01 per share.  The fair value of the
warrants was  allocated  between the proceeds the debt and equity issues as debt
issue cost and a reduction in redeemable common stock.

     A 1994 agreement provided for the issuance of 750,000 common stock purchase
warrants to purchase  common stock at $1.50 per share for each dollar of Company
debt  guaranteed by the  Company's  CEO. The warrants will have a five year term
from the date of issuance. Management believes that the warrants had no economic
value  when  granted,  and  accordingly,  no amount  has been  assigned  to such
warrants in the financial statements.


NOTE 9.  STOCK OPTION PLAN

     The Company  adopted a stock  option plan (the  "Plan")  providing  for the
issuance of 250,000  shares of Class A common stock  pursuant to both  incentive
stock  options,  intended to qualify under  Section 422 of the Internal  Revenue
Code,   and  options   that  do  not   qualify  as   incentive   stock   options
("non-statutory").  The  Option  Plan was  registered  with the  Securities  and
Exchange  Commission  in  November  1995.  The purpose of the Plan is to provide
continuing incentives to the Company's officers,  key employees,  and members of
the Board of Directors.





                                     Page 22

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



The  options  generally  vest over a four or  five-year  period  with a ten year
expiration  period.  The Company  amended  its stock  option plan on December 1,
1996,  increasing  the  number of shares  available  under the Plan to  600,000.
Non-statutory  options have been granted  providing  for the issuance of 492,900
shares of Class A common  stock at exercise  prices  ranging from $1.50 to $4.25
per share. Options providing for the issuance of 216,690 shares were exercisable
at December 31, 1998.

     The Company uses the intrinsic value method to account for its stock option
plan in which compensation is recognized only when the fair value of each option
exceeds its exercise price at the date of grant.  Accordingly,  no  compensation
cost has been  recognized for the options  issued.  Had  compensation  cost been
determined  based on the fair  value of the  options  at the  grant  dates,  the
Company's net loss per share would have been  increased to the pro forma amounts
indicated below.


                                         1998                          1997
                                  ----------------              ----------------
Net loss
   As reported                       $  (450,000)                 $  (2,581,000)
   Pro forma                            (760,400)                    (2,880,000)
Loss per share, basic and diluted
   As reported                       $     (0.13)                 $       (0.88)
   Pro forma                               (0.22)                         (0.98)

     These pro forma  amounts may not be  representative  of future  disclosures
because they do not take into effect pro forma  compensation  expense related to
grants made before  1995.  The fair value of each grant is estimated on the date
of grant  using  the  Black-Scholes  options pricing  model  with the  following
weighted-average assumptions used for grants in 1998 and 1997, respectively:  no
expected  dividends;  expected volatility of 85% and 85%; riskfree interest rate
of 5.9% and 5.8%; and expected lives of ten years.

     The  Black-Scholes  options  valuation  model  was  developed  for  use  in
estimating  the fair value of traded  options with no vesting  restrictions  and
that are fully transferable. Option valuation models require the input of highly
subjective  assumptions  including  the  expected  stock price  volatility.  The
Company's employee stock options have  characteristics  significantly  different
from those of traded options,  and changes in the subjective  input  assumptions
can materially affect the fair value estimate.  It is management's  opinion that
the existing models do not necessarily  provide a reliable single measure of the
fair value of its employee stock options.

     A summary of the status of the  Company's  stock option plan as of December
31,  1998 and  1997,  and  changes  during  the years  ending on those  dates is
presented below.


                                     Page 23

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997

<TABLE>
<CAPTION>


                                                       1998                                    1997
                                         ----------------------------------      ---------------------------------

                                                             Weighted                                Weighted
                                                              average                                 average
                                            Shares        exercise price            Shares        exercise price
                                         ---------------- -----------------      ---------------  ----------------
<S>                                        <C>               <C>                     <C>             <C>    
Outstanding at beginning of year           477,330           $   3.11                469,770         $   2.93
        
   Granted                                  85,830               3.11                 71,400             3.80

   Exercised                               (17,480)              1.67                (22,035)            1.63

   Forfeited                               (52,780)              2.95                (41,805)            3.02
                                          ----------         ---------              ----------       ---------
Outstanding at end of year                 492,900               3.18                477,330             3.11
Options exercisable at year end            216,690               2.64                 83,850             1.71
                                          ----------         ---------              ----------       ---------
Weighted average fair value of
    options granted during the year                          $   3.29                                $   3.00
                                                             =========                               =========
</TABLE>
                                                         


     The following table summarizes  information about fixed-price stock options
outstanding at December 31, 1998:
<TABLE>
<CAPTION>


                                              Options outstanding                          Options exercisable
                                --------------------------------------------------    -------------------------------

                                                      Weighted         Weighted                          Weighted
                                   Number             average          average           Number          average
                                outstanding at       remaining         exercise        exercisable       exercise
                                  12/31/98        contractual life      price          at 12/31/98        price
                                ----------------  ------------------ -------------    ---------------  --------------
Range of exercise prices
   <S>                             <C>                  <C>             <C>              <C>              <C>    
   $1.50 to $2.25                  164,400              6.63            $ 1.70           125,065          $ 1.69
   $3.75 to $4.25                  328,500              7.85              3.92            91,625            3.92
                                ----------------  ------------------ -------------    ---------------  --------------
   $1.50 to $4.25                  492,900                                               216,690
                                   =======                                               =======
</TABLE>


NOTE 10.  ACQUISITIONS AND CONTRACT AWARDS

     The Company acquired the Turley Correctional Facility in Tulsa, Oklahoma on
October 2, 1997. The Turley Correctional Facility is a 150 bed adult residential
community  corrections  facility located on approximately  thirty-five  acres of
real estate.  The  acquisition  was accounted  for under the purchase  method of
accounting.  The  purchase  price  was  approximately  $1,400,000  and  included
approximately $445,000 attributable to specific intangible items. The intangible
costs are  included in other assets and are being  amortized on a straight  line
method over three to twenty  years.  Revenues  and expenses  generated  from the
facility  subsequent  to October 1, 1997,  are  included in 1997  operations.  A
subsidiary of the Company,  Southern Corrections Systems,  Inc., has assumed the
annual  contracts with the Oklahoma  Department of  Corrections  and the Federal
Bureau of Prisons.







                                     Page 24

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



     The following unaudited pro forma summary presents the consolidated results
of  operations  of the Company for the year ending  December 31, 1997, as if the
business combination had occurred on January 1, 1997.

            Revenues                                    $   6,886,000
            Net Loss                                       (2,592,000)
            Loss per share, basic and diluted           $       (0.88)

     The above amounts are based upon certain  assumptions  and estimates  which
the Company  believes are  reasonable.  The pro forma results do not necessarily
represent  results  which would have  occurred if the business  combination  had
taken place at the date and on the basis assumed above.

     The  Company  was  awarded  a five  year  contract  in March  1998 with the
Oklahoma Office of Juvenile Affairs.  The contract is to sight,  design,  build,
and  operate a facility to provide  services  for 80  youthful  delinquent  male
offenders ages 13 to 19. The contract is expected to generate  monthly  revenues
of approximately  $300,000  beginning in the first quarter of 1999. The contract
is expected to generate  revenues of  $18,800,000  over a five year period.  The
Company  completed  construction of the facility and commenced  operations under
this contract in the first quarter of 1999.

     The  Company  was  awarded  a new  contract  in July  1998  with the  Texas
Department of Criminal  Justice for an additional 200 adult male offenders.  The
Company has sighted,  designed,  and begun  construction of a new 300 bed secure
facility in El Paso,  Texas.  The  contract  is  expected  to  generate  monthly
revenues of approximately $200,000 beginning in the second quarter of 1999.


NOTE 11.  DISCONTINUED OPERATIONS

     The Company  discontinued  all non  correctional  operations  in the fourth
quarter of 1996.  Revenues from  discontinued  operations for 1997 were $50,000.
Operating losses from discontinued operations of $535,000 and a loss on disposal
of assets utilized in discontinued operations of $193,000 were incurred in 1997.
Approximately  $541,000 of these losses were  recorded in the fourth  quarter of
1997.

     The  remaining  assets at December 31, 1998,  consist of an  investment  of
approximately $95,000 in one assisted living center. The Company has entertained
various offers and management believes that the facility will be sold in 1999.

     The net assets and liabilities of the discontinued  operations  included as
accounts payable, accrued liabilities and other in the accompanying consolidated
balance sheet at December 31, 1997, are as follows:


Assets
  Property and equipment, net                       $     298,000

Liabilities

  Accounts payable and accrued liabilities               (157,000)
  Note payable                                           (298,000)
                                                    --------------
Net liabilities of discontinued operations          $    (157,000)
                                                    ==============





                                     Page 25

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



NOTE 12.  FAIR VALUE OF FINANCIAL INSTRUMENTS

     The carrying values of cash, cash equivalents, investments in U.S. treasury
bills and short term certificates of deposit  approximate their fair values, due
to the short term nature and  stability of market  interest  rates in 1998.  The
fair values of the Company's debt maturing within one year, the revolving credit
facility  and other  long-term  debt  approximate  the carrying  values,  due to
variable interest rates, the stability of market interest rates in 1998, and the
fact that rates on the debt  approximate  the  Company's  incremental  borrowing
rate. The convertible  debentures approximate fair value due to the stability of
market interest rates in 1998. All the Company's financial  instruments are held
for purposes other than trading.


NOTE 13.  INCOME TAX

     The difference  between the tax basis of assets and  liabilities  and their
financial  reporting amounts that give rise to significant  portions of deferred
income  tax  assets  and  liabilities  are:  assets - net  operating  loss carry
forwards, excess tax basis in property and equipment, and nondeductible accruals
and  allowances;  liabilities,  accelerated  tax  depreciation.  The Company has
approximately  $2,646,000 of net operating  loss carry  forwards at December 31,
1998, expiring through 2013.

     The  following is a  reconciliation  of the  provision  for (benefit  from)
income  taxes from  continuing  operations  computed  by  applying  the  Federal
statutory  rate of 34% and the  effective  income  tax rate for the years  ended
December 31, 1998 and 1997:

<TABLE>
<CAPTION>

                                                                       December 31,

                                                                 1998                 1997
                                                           ----------------     ---------------
<S>                                                        <C>                  <C>    
Provision for (benefit from) income taxes
   at statutory rate                                       $      (128,000)     $     (630,000)
Nondeductible expenses                                               9,000             624,000
State income taxes                                                 (18,000)            (73,000)
Change in valuation allowance                                      118,000              68,000
Change in prior year estimate                                       19,000              11,000
                                                           ---------------      ---------------
   Total provision for (benefit from) income taxes         $           ---      $          ---
                                                           ===============      ===============

     Deferred tax assets and liabilities are as follows:

Deferred tax assets
   Net operating loss carry forward                        $     1,058,000      $      453,000
   Property & equipment                                                ---             144,000
   Shareholder contributed property                                    ---              46,000
   Nondeductible accruals and allowances                           338,000             214,000
   Other                                                             1,000               1,000
                                                           ---------------      ---------------
                                                           $     1,397,000      $      858,000
Less: Valuation allowance                                  $    (1,058,000)     $     (637,000)
                                                           ---------------      ---------------

</TABLE>

                                     Page 26

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



   
<TABLE>
<S>                                                        <C>                  <C>    
     Deferred tax assets                                   $       339,000      $      221,000
                                                           ----------------     ---------------
Deferred tax liabilities:
   Property and equipment                                  $      (273,000)     $     (155,000)
                                                           ----------------     ---------------
Deferred tax liabilities                                          (273,000)           (155,000)
                                                           ----------------     ---------------
Net deferred tax asset                                     $        66,000      $       66,000
                                                           ================     ===============

</TABLE>

     The  valuation  allowance  on tax  assets  increased  $421,000  in 1998 and
$284,000  in  1997,   including  $396,000  and  $68,000  related  to  continuing
operations  in 1998 and 1997,  respectively.  The tax  effects of  approximately
$618,000 of  nondeductible  expenses  relate to the  allocation of proceeds from
convertible  debentures charged to operations in 1997. The increase in valuation
allowance for 1998 was a result of an increase in prior year operating losses of
$188,000 and increase in the historic tax basis of assets of $63,000


NOTE 14.  RELATED PARTY TRANSACTIONS

     The Company entered into  agreements  with affiliated  entities in 1995 and
1996 to develop and manage two assisted living centers.  The Company  received a
15% equity  interest in each assisted living center and funded start up costs of
approximately  $357,000 for these centers in 1996. The Company sold one facility
in 1997 and plans to sell its  remaining  interest in one facility  during 1999.
Facility debt of $1,990,000 was guaranteed by the Company at December 31, 1998.


NOTE 15.  COMMITMENTS AND CONTINGENCIES

     Total   lease   expense   was  $58,000  and  $57,000  for  1998  and  1997,
respectively,  under all operating leases. The future minimum lease payments are
as follows: 1999 - $48,000, 2000 - $41,000, 2001 - $32,000 , 2002 - $14,000, and
2003 - $4,000.

     The Company executed  three-year  employment  agreements with the Company's
CEO and President in 1997. The  agreements  provide for  compensation  at a base
rate  and  increases  to be  determined  on an  annual  basis  by the  Board  of
Directors.  The  agreements  also  contain  provisions  for  severance  pay  and
disability  payments,  as well as non-compete  agreements  preventing  them from
engaging in a business deemed similar to that of the Company.

     The  Company  entered  into a  construction  contract  with  Oscar J. Boldt
Construction  for  construction of the Union City Juvenile Center in Union City,
Oklahoma.  The total contract  amount is $4,115,000 and the total amount paid to
the  contractor  as of December  31,  1998 is  $2,055,000.  Construction  of the
facility was completed in the first quarter of 1999.


                                     Page 27

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1998 AND 1997



     The  Company  entered  into  a  construction   contract  with  C.F.  Jordan
Commercial L.P. for  construction of a 300 bed facility in El Paso,  Texas.  The
total contract  amount is $3,960,000 and the amount paid to the contractor as of
December 31, 1998 is $298,000.  Construction  is expected to be completed in the
second quarter of 1999.

     Effective September 1, 1998 the Company established a deferred compensation
plan for certain  officers or key executives of the Company.  The plan currently
has a monthly committment or $5,400.

     Capitalized interest on construction projects totaled approximately $71,000
for the year ending December 31, 1998.

NOTE 16.  LITIGATION

     The  Company  is a party to  litigation  arising  in the  normal  course of
business.  Management  believes that the ultimate  outcome of these matters will
not have a material  effect on the Company's  financial  condition or results of
operations.


NOTE 17.  CHANGE IN ACCOUNTING PRINCIPLE

     During the fourth quarter of 1998 the Company elected to adopt,  for all of
1998 and future years, the provision of Statement of Position 98-5 "Reporting on
Costs of Start Up Activities".  Development  and new facility  opening costs had
been  deferred and amortized  over the life of the contract  prior to January 1,
1998. As a result of the adoption of the new  pronouncement,  deferred  costs of
approximately  $74,000 were  charged to  operations  and reported as  cumulative
effect of change in accounting principle,  effective January 1, 1998. The effect
of the change in 1998 was to increase the net loss before the cumulative  effect
of change in accounting Principles by approximately $207,000 or $0.06 per share.
Pursuant  to  the  pronouncement,  presentation  of the  pro  forma  effects  of
retroactive application are not required.


NOTE 18.  SUBSEQUENT EVENTS

     The  Company   completed  a  senior  credit  facility  with  Fleet  Capital
Corporation on February 25, 1999. The four year revolving  credit  facility will
be utilized to finance the expansion of the Company's business.

     The credit  facility  provides  for an $18 million  senior  revolving  debt
facility secured by substantially all assets of the Company. The credit facility
is subject to a 1/2% unused line fee and  interest  on  outstanding  balances at
Prime plus .25% to .50% or LIBOR  plus 2.0% to 3.0%.  The  maturity  date of the
credit facility is February 25, 2003.

     The Company has not needed to utilize the credit  facility.  Existing  cash
reserves  were  utilized  to retire debt that was  collateralized  by assets now
pledged pursuant to the credit  facility.  The Company expects to borrow amounts
under the facility in 1999 to finance new projects and acquisitions.



                                     Page 28

<PAGE>



                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


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

     The  Company  dismissed  Coopers  &  Lybrand,   L.L.P.,   the  Registrant's
independent auditors, on February 25, 1997, and appointed the accounting firm of
Grant Thornton,  LLP as independent  accountants for fiscal year ended 1996. The
dismissal  and  appointment  were  approved  by the  Board of  Directors  of the
Company.  There have been no  disagreements  with Coopers & Lybrand,  L.L.P.  or
Grant  Thornton  LLP  on any  matter  of  accounting  principles  or  practices,
financial statement  disclosure or auditing scope or procedure or any reportable
event  during the two most recent  fiscal  years and the three  interim  periods
subsequent to December 31, 1995, and through the date of dismissal.

     The reports on the financial  statements of the Company rendered by Coopers
& Lybrand, L.L.P. did not contain an adverse opinion or disclaimer of opinion or
qualification  or modification as to uncertainty,  the scope of audit performed,
or accounting principles. The Company had not consulted with Grant Thornton, LLP
prior to their appointment with respect to any matters of accounting  principles
or practices, financial statement disclosure, auditing scope or procedure or any
disagreement  with the  Company.  There  have been no  disagreements  with Grant
Thornton, L.L.P. on any matter of accounting principles or practices,  financial
statement disclosure or auditing scope or procedure or any reportable event.


PART III

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

MANAGEMENT -

        Name                       Age        Position(s) with the Company
   --------------------            ---    --------------------------------------
   Donald E. Smith ............... 46     Chief Executive Officer, Director
   Jerry M. Sunderland ........... 62     President, Director
   Gary D.  Parsons............... 54     Senior Vice President of Operations
   Tim West ...................... 50     Senior Vice President of Operations
   Randall J.  Wood .............. 40     Corporate Secretary
   Tiffany Smith ................. 30     Vice President of  Corporate 
                                          Communications
   Paul D.  Voss ................. 31     Vice President of Finance
   Shawn Sunderland............... 35     Vice President of Business Development
   Robert O. McDonald ............ 60     Director
   Mark S.  Cooley ............... 41     Director
   James A. Wilson ............... 42     Director-elect


Directors and Officers of the Company -

     The following is a brief description of the business  experience during the
past five years of each of the abovename persons:

     Donald E. Smith is the founder of the Company's corrections  operations and
has served as the Chief Executive  Officer of Avalon and its subsidiaries  since
their inception.  Mr. Smith has owned, managed and developed a number of private
corporations  since 1985 to provide private  corrections,  health care and other
related  services.  Mr. Smith received a Bachelor of Science degree in 1974 from
Northwestern State College.  Mr. Smith was employed by Arthur Andersen & Co. for
seven years prior to founding  the  Company. 




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                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


     Jerry M. Sunderland  joined the Company in 1988 and has served as President
of Avalon since June 1995.  Mr.  Sunderland  also serves as a Director of Avalon
and its subsidiaries.  Mr. Sunderland has in excess of 38 years of experience in
developing and operating  quality  programs and facilities for adult  offenders.
Mr.  Sunderland  was  employed by the Oklahoma  Department  or  Corrections  for
sixteen years  including  ten years as warden of maximum  security  prison.  Mr.
Sunderland   also  served  as  an  agent  for  the  Oklahoma   State  Bureau  of
Investigation  for  twelve  years.  Mr.  Sunderland  has a  Bachelors  degree in
Sociology and a Masters degree in Corrections. 

     Gary D. Parsons  joined Avalon as Vice  President of Operations in December
1997 and was promoted to Senior Vice  President of Operations in February  1999.
Mr.  Parsons has in excess of 25 years of experience in developing and operating
quality programs and facilities for adult offenders. Mr. Parsons was employed by
the Oklahoma  Department of  Corrections  for twenty four years.  Mr. Parsons is
jointly responsible for Avalon's correctional operations,  including recruitment
and  training  of   personnel,   maintaining   accreditation   by  the  American
Correctional  Association,  and compliance with  contractual  requirements.  Mr.
Parsons  received a Bachelors  degree in Business  Administration  and a Masters
degree in Business Administration from the University of Central Oklahoma.

     Tim West joined Avalon as Vice  President of Operations in May 1998 and was
promoted to Senior Vice  President of Operations in February  1999. Mr. West has
in  excess  of 25 years  of  experience  designing,  developing,  and  operating
correctional  institutions.   Mr.  West  is  jointly  responsible  for  Avalon's
correctional  operations,  including  recruitment  and  training  of  personnel,
maintaining  accreditation  by  the  American  Correctional   Association,   and
compliance  with  contractual  requirements.  Mr.  West has  served in  numerous
capacities in the Texas  criminal  justice  system,  most recently as the Senior
Warden at the Mark W. Stiles Unit in Huntsville,  Texas. Mr. West also served as
the project director for the "Michael Prototype" in the Texas prison system. Mr.
West received a Bachelors and Masters Degree in  Contemporary  Corrections  from
the Institute for  Contemporary  Corrections and the Behavioral  Sciences at Sam
Houston University.

     Randall J. Wood joined Avalon in 1995 and serves as Corporate Secretary and
General  Counsel for the  Company.  Prior to joining  the  Company in 1996,  Mr.
Wood's  practice  was  focused  primarily  in the  field  of real  property  and
commercial litigation.  Mr. Wood practiced with the firm of Stack & Barnes, P.C.
for ten  years,  and was  with  the firm of  Hammons,  Vaught & Conner  prior to
joining the Company. Mr. Wood is a member of the Oklahoma Bar Association and is
authorized  in Oklahoma  Federal  Courts and the Tenth Circuit Court of Appeals.
Mr. Wood is responsible for the duties of the Corporate Secretary, management of
legal matters,  and compliance with  government  regulations for the Company and
its  subsidiaries.  Mr.  Wood  received  his law degree from the  University  of
Oklahoma in 1983.

     Tiffany Smith joined the Company in 1994 as the Public Information  Officer
and was promoted to Assistant Corporate Secretary for the Company in 1997 and to
Vice  President of Corporate  Communications  in 1999. Ms. Smith served for four
years as  marketing  manager  for  Eagle  Picher  Industries,  a New York  Stock
Exchange listed company, prior to joining Avalon. Ms. Smith has developed and is
responsible  for  directing the Company's  corporate  communications  and public
relations  department and implementing  marketing  strategies.  Ms. Smith is the
primary contact for the Company's shareholders and investors. Ms. Smith received
a Bachelors  Degree in Business  Administration,  Marketing and Management  from
Missouri Southern State College.  Ms. Smith is the spouse of Donald Smith, Chief
Exective Officer.

     Paul D. Voss  joined the  Company as Vice  President  of Finance in January
1998. Mr. Voss is primarily  responsible  for financial  reporting and corporate
administration  for the Company.  Mr. Voss was Controller at Magic Circle Energy
from 1994 to 1996.  Mr. Voss was a senior  auditor for Grant  Thornton  for five
years and more recently an accounting  manager for Finley & Cook,  P.L.L.C.  Mr.
Voss  received  a  degree  in  Business  Administration  from the  Angelo  State
University in 1989.

     Shawn  Sunderland  joined  the  Company  in 1997 and was  promoted  to Vice
President of Business  Development  in February  1999.  Mr  Sunderland  has been
engaged in the corrections  and law enforcement  industry for more than 9 years.
Mr.   Sunderland  is  responsible   for  project   development   including  site
development,  lease  negotiation,  proposal  development,  facility design,  and
program  implementation.   Mr.  Sunderland  is  the  son  of  Jerry  Sunderland,
President.



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                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


     Robert O. McDonald was appointed as a Director of Avalon in October,  1994.
Mr.  McDonald is Chairman of the Board of Directors  of Capital West  Securities
and its parent holding company,  Affinity Holding Corp. Mr. McDonald started his
investment  career  in 1961  with  Allen  and  Company  and left in 1967 to form
McDonald  Bennahum and Co., which later joined with  Ladenburg  Thalmann and Co.
where Mr. McDonald was a Senior Partner.  Mr. McDonald joined Planet Oil Mineral
Corporation  in 1971 and became  president  in 1973.  From 1975 until 1993,  Mr.
McDonald was affiliated  with Stifel Nicolaus & Company and headed its municipal
syndicated effort. Mr. McDonald received a Bachelor's Degree in Finance from the
University  of  Oklahoma  in 1960.  He also  served as an  Officer in the United
States Army and Army Reserve.

     Mark S. Cooley was appointed as a Director of Avalon in January  1998.  Mr.
Cooley is a Principal  of Cooley & Company and Pro Trust  Equity  Partners.  Mr.
Cooley was with Citicorp and Chemical  Bank for twelve years in their  Corporate
Finance  Divisions in New York and Denver.  Mr.  Cooley  received his  Bachelors
degree in Economics  from DePauw  University  and an MBA in Finance from Indiana
University.

     James P. Wilson was  appointed as a  Director-elect  of Avalon in September
1998, subject to shareholder  approval at the 1999 annual meeting. Mr. Wilson is
a managing  partner in the investment  firm of Rice,  Sangalis,  Toole & Wilson.
Prior  to  founding  Rice,  Sangalis,  Toole &  Wilson,  Mr.  Wilson  was a vice
president with First Texas Merchant Banking Group, and was also an audit manager
with  Arthur  Young & Co.  Mr.  Wilson  received  a BBA  degree  from  Texas A&M
University, and is a Certified Public Accountant.


ITEMS 10, 11 and 12.

     The information  required by these Items has been incorporated by Reference
from the  Company's  definitive  proxy  statement  which  will be filed with the
Commission not later than 120 days after December 31, 1998.


ITEM 13.  EXHIBITS AND REPORTS ON FORM 8-K.

   (a) Exhibits:

   3.     i       Articles of Incorporation (1)
          ii      Bylaws (1)
          iii     Articles of Amendment to  Registrant's  Articles of  
                  Incorporation (2)
          iv      Amendment  to  Registrant's  Articles of  Incorporation  dated
                  December 31,  1995  
          v       Unanimous Consent of Board of Directors authorizing extension
                  of expiration dates of  Class "B" Redeemable Warrants (3)

   4.     i       Form of Stock Certificate (1)
          ii      Form of Class "B" Redeemable Warrant (1)
          iii     Form of Class "B" Warrant Agreement (1)
          iv      Form of Class "C" Redeemable Warrant (6)
          v       Form of Class "C" Warrant Agreement (6)
          vi      Form of Class "D" Redeemable Warrant (7)
          vii     Form of Class "D" Warrant Agreement (7)
          viii    Form of Class "E" Warrant Agreement (10)
          ix      Form of Convertible Debenture Agreement (10)

   10.    i       Contract between Southern Correction Systems, Inc. and the 
                  Oklahoma Department of Corrections for halfway house services 
                  for the year ended June 30, 1999 (13)
          ii      Contract between Southern Corrections Systems, Inc. and the 

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<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


                  Oklahoma Department of Corrections for public works inmates 
                  for the year ended June 30, 1999 (13)
          iii     Contract between Southern Corrections Systems, Inc.  and the 
                  Oklahoma Department of  Corrections for halfway house services
                  for the year ended June 30, 1999.(13)
          iv      Stock Option Plan adopted by Board of Directors on August 16,
                  1994 (6)
          v       Placement Agent Agreement dated May 15, 1994, between 
                  Registrant and Westminster Securities Corporation (6)
          vi      Change of Control Agreement between Donald E.  Smith and 
                  Avalon Community Services, Inc. dated August 25, 1997.  (7)
          vii     Employment  Agreement with Donald E. Smith dated August 8, 
                  1997. (7)
          viii    Employment  Agreement with Jerry M. Sunderland dated August 8,
                  1997 (7) 
          ix      Letter of Acceptance and Notice of Award dated February 24,
                  1997 to Avalon Community  Services, Inc.  from the Missouri 
                  Department of Corrections.  (7)
          x       Commercial Contract to Buy and Sell Real Estate dated 
                  October 2, 1997 between Avalon Community Services, Inc.  
                  and Freedom Ranch, Inc.  (9)
          xi      Notice of Award dated March 3, 1998 to Southern Corrections 
                  Systems, Inc.  from the Oklahoma Office of Juvenile 
                  Affairs.(11)
          x       Contract between Southern Corrections Systems, Inc. and the 
                  Texas Department of Criminal Justice dated June 18, 1998. (13)
          xi      Financing agreement between Avalon Community Services, Inc.
                  and Rice, Salgalis, Toole and Wilson dated 
                  September 16, 1998. (12) 
          xii     Financing agreement between Avalon Community Services, Inc,
                  and Fleet Capital Corporation dated February 25, 1999. (14)

   16.    i       Letter re: Change in Certified Accountant (8)


    21.   i       Subsidiaries of Registrant (5)

   b)     Reports on Form 8-K.
          i       Form 8-K dated October 17, 1997 re: Acquisition of Assets from
                  Freedom Ranch, Inc.
          ii      Form 8-K dated March 19, 1998 re: Award from the Oklahoma 
                  Office of Juvenile Affairs.
          iii     Form 8-K dated October 1, 1998 re: Financing agreement with 
                  Rice, Sangalis, Toole & Wilson.
          ix      For 8-K dated March 10, 1999 re; Financing agreement with
                  Fleet Capital Corporation.

Footnotes:
          1)      Incorporated   herein  by   reference   to  the   Registrant's
                  Registration Statement on Form S-18 dated March 26, 1991.
          2)      Incorporated   herein  by   reference   to  the   Registrant's
                  Post-Effective  Amendment No. 1 to  Registration  Statement on
                  Form S-18 dated August 3, 1992.
          3)      Incorporated   herein  by   reference   to  the   Registrant's
                  Post-Effective  Amendment No. 2 to  Registration  Statement on
                  Form S-18 dated October 26, 1992.
          4)      Incorporated  herein by reference to the Registrant's Form 8-K
                  dated January 13, 1994.
          5)      Incorporated  herein by  reference  to the  Registrant's  Form
                  10-KSB for the fiscal year ended  December  31, 1993 and dated
                  March 24, 1994.
          6)      Incorporated   herein  by   reference   to  the   Registrant's
                  Registration  Statement on Form SB-2 dated  September 13, 1995
                  and amended.
          7)      Incorporated   herein  by   reference   to  the   Registrant's
                  Registration  Statement  on Form S-2  Amendment  No. 1,  dated
                  April 16, 1996 and amended.
          8)      Incorporated herein by reference to the Registrant's Form 8-K 
                  dated March 4, 1997.
          9)      Incorporated herein by reference to the Registrant's Form 8-K 
                  dated October 17, 1997.
          10)     Incorporated herein by reference to the Registrant's Form S-2 
                  dated December 22, 1997.

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<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


          11)     Incorporated herein by reference to the Registrant's Form 8-K 
                  dated March 19, 1998.
          12)     Incorporated herein by reference to the Registrant's Form 8-K 
                  dated October 1, 1998.
          13)     Incorporated  herein by reference to the Registrant's Form S-2
                  dated December 2, 1998.
          14)     Incorporated herin by reference to the Registrant's 8-K dated
                  March 10, 1999.
         

                                     Page 33

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES

                                   SIGNATURES

     In accordance  with 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.

                                            AVALON COMMUNITY SERVICES, INC.


                                            By:    s\  Donald E. Smith
                                               --------------------------
                                            Donald E. Smith
                                            Chief Executive Officer and Director

                                            Dated: March 26, 1999


In accordance  with the  Securities  Exchange Act of 1934,  this report has been
signed below by the  following  persons on behalf of the  Registrant  and in the
capacities and on the dates indicated.



By:   s\  Donald E. Smith
   ------------------------------
Donald E. Smith
Chief Executive Officer and Director                       Dated: March 26, 1999



By:   s\ Jerry M. Sunderland
   ------------------------------
Jerry M. Sunderland
President and Director                                     Dated: March 26, 1999



By:   s\ Robert O. McDonald
   ------------------------------
Robert O. McDonald
Director                                                   Dated: March 26, 1999



By:   s\ Mark S. Cooley
   ------------------------------
Mark S. Cooley
Director                                                   Dated: March 26, 1999


By:   s\ Paul Voss
   ------------------------------
Paul Voss
Vice President of  Finance                                 Dated: March 26, 1999


                                     Page 34