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, 1997

               [ ] 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, 1997 were
$5,878,000.

  The aggregate  market value of voting common stock held by non  affiliates was
$8,206,240  on February  27,  1998,  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 February 27, 1998,
2,984,380 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 1998 Annual Meeting of  Shareholders
are incorporated by reference in Part III.6

            Transitional Small Business Disclosure Format: Yes__ No X .


<PAGE>



                                TABLE OF CONTENTS
                            FORM 10-KSB ANNUAL REPORT
                      FOR THE YEAR ENDED DECEMBER 31, 1997


Item                                                                 Page
----                                                                 ----

PART I

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                        28

                                    PART III

9.     Directors, Executive Officers, Promoters and Control
         Persons; Compliance with Section 16 (a) of
         the Exchange Act                                              28

10.    Executive Compensation                                          29

11.    Security Ownership of Certain Beneficial Owners
         and Management                                                29

12.    Certain Relationships and Related Transactions                  29

13.    Exhibits and Reports on Form 8-K                                29

       Signatures                                                      32




<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


                                     PART I
                                     ------

ITEM 1.  DESCRIPTION OF BUSINESS.

The Company -

  Avalon Community Services,  Inc., is a Nevada 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,  Texas, Missouri, and Nebraska with plans to significantly expand into
additional  states.  Avalon's  business  strategy is designed to escalate Avalon
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 corrections industry.

  The private correctional services industry has experienced  significant growth
in recent years.  During 1995 there were 3.8 million individuals on probation or
parole.  This  population  is expected to increase to over 7 million by the year
2005.  Annual  correction  industry growth rates have been  approximately 7 to 8
percent per year. This growth rate exceeds the general population growth because
of increasing crime rates,  higher conviction rates and longer prison sentences.
Avalon  contracts  with  various   government   agencies  to  provide  community
corrections  services.  Studies have  documented  a 10 to 30 percent  savings to
government  agencies as a result of utilizing private  corrections  providers to
build and  operate  correctional  facilities.  Avalon  management  believes  its
background and abilities to build and operate community correctional  facilities
and provide correctional  programing position the Company for substantial future
growth in the corrections industry.

  Avalon currently owns and operates 805 private community corrections beds. The
Company owns and operates three  minimum-security  correctional  facilities (655
beds) in Oklahoma and one  medium-security  correctional  facility (150 beds) 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 also provides  intensive  substance abuse treatment services to inmates
in six  medium  security  correctional  facilities  in  Nebraska  and one medium
security  correctional  facility  in  Missouri.   Intensive  programming  is  an
essential part of community  based  corrections.  Avalon has provided  substance
abuse programs in facilities for over thirteen (13) years.  Avalon's  management
has been  engaged in the  business of providing  private  correctional  services
since 1985.

  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  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 3, 1998.

<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               Ownership and                               Corrections
                                    Management

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

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

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

Nebraska State Penitentiary,        Program Management            30 Clients    Substance Abuse
     Lincoln, NE                                                                Treatment Services

The Lincoln Correctional            Program Management            50 Clients    Substance Abuse
     Center, Lincoln, NE                                                        Treatment Services

The Omaha Correctional              Program Management            25 Clients    Substance Abuse
     Center, Omaha, NE                                                          Treatment Services

The Nebraska Community              Program Management            30 Clients    Substance Abuse
    Corrections Center,                                                         Treatment Services
     Lincoln,  NE

Community Correctional              Program Management            45 Clients    Substance Abuse
    Center, Lincoln, NE                                                         Treatment Services

Community Correctional              Program Management            30 Clients    Substance Abuse
    Center, Omaha, NE                                                           Treatment Services

Ozark Correctional Center,          Program Management            650 Clients   Substance Abuse
      Jefferson City, MO                                                        Treatment Services

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


                                     Page 2
<PAGE>
                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


Correctional Services -

  Avalon owns and operates four  correctional  centers,  Carver  Center,  Avalon
Correctional  Center,  Turley  Correctional  Center  and  El  Paso  Intermediate
Sanction  Facility.  The  correctional  centers  provide  complete  correctional
administration,   correctional   officer  staffing,   housing,   food  services,
vocational assistance,  transportation, and rehabilitation services. Avalon also
provides  intensive  substance abuse treatment services to inmates in six medium
security   correctional   facilities   in  Nebraska  and  one  medium   security
correctional facility in Missouri.

  Oklahoma.  Avalon's  contracts  with the Oklahoma  Department  of  Corrections
extend  through June 30, 1998.  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,  including
renewal options.

  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 built 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.  The  Company is  developing  plans to  construct a new
facility on this site and  increase  the  facility's  capacity to 180 beds.  The
construction is scheduled for completion during the fourth quarter of 1998.

  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.

  Nebraska.  Avalon was awarded a contract in February  1996,  with the State of
Nebraska  Department  of  Correctional   Services  to  provide  substance  abuse
treatment services. The Nebraska contract had an initial fifteen-month term with
two (2), one year renewal  options.  The contract is to provide  substance abuse
treatment services in six prisons: the Nebraska State Penitentiary,  the Lincoln
Correctional  Center,  the Omaha  Correctional  Center,  the Nebraska  Community
Corrections Center at Lincoln, the Community Correctional Center in Lincoln, and
the Community  Correctional Center in Omaha. Avalon began providing the contract
services in March 1996.

  Missouri.  Avalon  was  awarded a four year  contract  in March  1997 with the
Missouri  Department of Corrections.  The contract is to provide substance abuse
services in the Ozark  Correctional  Center, a 650 bed medium security prison in
Fordland,  Missouri.  Avalon began providing  services in the Ozark Correctional
Center on May 1, 1997.

                                     Page 3
<PAGE>

                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


  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.

Competition -

  Corrections. The trend in the United States toward privatization of government
services and  functions  has  increased  as  governments  have faced  continuing
pressure to control  costs and improve  the  quality of  services.  Governmental
agencies  responsible for the operation of detention  facilities are privatizing
facilities and contracting  with private  contractors for services in an attempt
to address  these  pressures.  Fiscal  pressures  have  forced  some  government
agencies  to  limit  public  services  and  seek  more  cost-effective  means of
providing  the  remaining  services.  Many  do not  have  the  readily-available
resources  to make the  changes  to meet such  mandates  and are  utilizing  the
services of private providers.

  A combination of factors in many states (i.e., decreasing revenues, increasing
prison population,  litigation  arising from substandard prison conditions,  and
overcrowding)  has  led to a  revamping  of  the  corrections'  processes  and a
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.
Private  operated  correctional  management  companies  are able to provide high
quality services at a lower cost. Private  correctional  facilities operating as
contractors for government agencies, pursuant to court order or otherwise, exist
in  virtually  every  state.  The private  correctional  services  industry  has
experienced rapid growth in recent years. The industry is very early in its life
cycle.  Private companies manage approximately 5 percent of the beds in the U.S.
prison system.

  The area of community corrections, like that of all other corrections sectors,
has experienced  substantial growth over the past decade.  Community corrections
includes providing 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.  Offenders in a community  corrections facility receive programming to
prepare them for re-entry into the community.  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 correctional  services including:  a) a thirteen-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
programming  will be the basis for the Company  becoming the dominant company in
the community corrections industry.



                                     Page 4

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


  Avalon  contracts  with the State of  Oklahoma  to provide  services at Carver
Center,  Avalon Correctional Center and Turley Correctional 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 and Oklahoma
contracts during 1997 comprised  approximately  83% of total revenues.  Revenues
from contracts with the Oklahoma  Department of Corrections  represented  52% of
1997 revenues.

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  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 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 March 2, 1998, Avalon had approximately 158 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.

  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  Company  is  developing  plans to
construct a new building on the Turley Correctional Center property in 1998. The
new building  will replace six of the  existing  structures  on the property and
increase  the  capacity  of the  facility to 180 beds.  The Turley  Correctional
Center was purchased in October 1997.


                                     Page 5

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


  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.

  Avalon owns a recently  remodeled  60,000 square foot building  located in Elk
City,  Oklahoma.  The building is zoned for the operation of a residential  care
facility or an assisted living center.  This building is under contract for sale
as of March 2, 1998.

  Avalon Corporate Office is located in Oklahoma City, Oklahoma, in a commercial
building at 13401 Railway Drive,  Oklahoma City,  Oklahoma  73114.  The 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 Company
debt. See Note 5 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, 1997.

                                     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 1996
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, 1996                        2 1/2           2
      June 30, 1996                         7 5/8           2 1/2
      September 30, 1996                    5 7/8           4 1/8
      December 31,1996                      4 3/4           3 7/8
      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

  Avalon had approximately 830 holders of record of its common stock as of March
11, 1998. No dividends  were declared  during 1996 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 $4.25 per share on February 27, 1998.


                                     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. This strategy was implemented in
the  fourth  quarter  of  1996.  Since  the  fourth  quarter  of  1996,  all non
correctional  operations have been discontinued and all related assets have been
sold or are under letters of intent or contract to sell.  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.  The
Company  expects  the  1998  earnings  to  include  only  correctional  facility
operations.

  Working capital at December 31, 1997 was $875,000 representing a current ratio
of 1.47.  Warrants and options were exercised in 1997 generating net new capital
of $146,000,  used primarily for operating needs. Capital expenditures were $2.3
million in 1997,  compared  to $171,000 in 1996.  The  significant  expenditures
during  1997  were the  purchase  of the  Turley  Correctional  Center in Tulsa,
Oklahoma,  and  investment in equipment.  Proceeds  from asset  dispositions  of
$196,000  were  primarily  a  result  of the  sale  of  assets  associated  with
discontinued  operations.  Proceeds from asset  dispositions were used to retire
debt.

  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  Class A
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's revolving bank line of credit is currently  $500,000.  Long-term
debt  borrowed  during  1997  totaled  $2.5  million  primarily   consisting  of
refinancing the Avalon Correctional Center in Tulsa,  Oklahoma.  The refinancing
resulted in reducing  the  interest  rate from 10% to 8.95% on the $1.6  million
mortgage. Additional financing was utilized to fund equipment purchases.

  The Company has cash reserves of $1.96  million 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.  Additional sources of
funding may be required on a project  funding  basis.  The Company is  currently
negotiating  with  financial  institutions  to  obtain a line of  credit to fund
future growth.  The Company is also evaluating equity sources of financing.  The
Company may receive  equity from the  exercise of stock  options,  warrants,  or
conversion of debentures in 1998.

Results of Operations -

Year Ended December 31, 1997 Compared to the Year Ended December 31, 1996-

  Total revenues from continuing  operations increased by 77% to $5.9 million in
1997 from $3.3 million in 1996. The increase was a result of the  acquisition of
the Turley Correctional Facility in Tulsa, Oklahoma, a contract award to provide
substance  abuse  counseling  in Fordland,  Missouri,  a new  contract  award to
provide services to the Texas Department of Criminal Justice in El Paso,  Texas,
and a full year of  operations  under a contract  with the West Texas  Community
Supervision  and  Corrections  Department at the El Paso  Intermediate  Sanction
Facility acquired by the Company in August 1996.


                                     Page 7

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


  Revenues  in 1997 were  enhanced  by the  following:  the Turley  Correctional
Facility provided $353,000 of revenues;  the Fordland,  Missouri substance abuse
counseling  contract  provided  $514,000 of revenues;  the Texas  Department  of
Criminal  Justice  contract  provided  $427,000  of  revenues;  the  West  Texas
Community Supervision and Corrections  Department contract increased revenues by
$733,000 due to a full year of operations in 1997;  and the Avalon  Correctional
Facility in Tulsa,  OK,  increased  revenues by $556,000 due to increased inmate
census.

  The  Company's  net loss from  continuing  operations  was  $1,853,000 in 1997
compared  to  $60,000  in 1996.  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.

  The Company  incurred a net loss in 1997 of $2,581,000  or $.88 per share,  as
compared to a net loss in 1996 of  $1,034,000  or $.38 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 67% in 1997 to $1,175,000  compared to $705,000
for 1996.  The  substantial  increase  in  operating  income was a result of the
Company's focus on private corrections and obtaining new contracts and acquiring
additional facilities.  The average daily inmate census increased to 425 in 1997
from 268 in 1996,  an increase of 59%.  The census  increase was a result of the
acquisition  of the  Turley  Correctional  Facility  in Tulsa,  Oklahoma,  a new
contract award to provide  services to the Texas  Department of Criminal Justice
in El Paso,  Texas, and a full year of operations under a contract with the West
Texas  Community   Supervision  and  Corrections   Department  at  the  El  Paso
Intermediate Sanction Facility acquired by the Company in August, 1996.

  Direct operating expenses  increased by 89% in 1997 over 1996,  primarily as a
result  of the  full  operations  in 1997 of the El Paso  Intermediate  Sanction
Facility,  the  contract  award  for  substance  abuse  counseling  services  at
Fordland,  Missouri,  and the acquisition of the Turley  Correctional  Center in
Tulsa, Oklahoma. The profit margin decreased slightly to 37% in 1997 from 41% in
1996.  This was primarily due to lower profit  margins  generated from substance
abuse counseling  services in prisons in Nebraska and Missouri.  Substance abuse
programs  profit  margins  are  typically   lower  than  margins   generated  by
residential correctional facilities.

  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.  The net  loss  from
discontinued  operations was $649,000, net of income tax allocations,  for 1996.
Revenues from  discontinued  operations  were $50,000 and $493,000,  in 1997 and
1996 respectively.  The losses on the disposal of assets related to discontinued
operations were $728,000 and $325,000, in 1997 and 1996, respectively.

  Corporate.  General and  administrative  expenses  increased in 1997 by 53% to
$990,000  from  $646,000.  The  majority  of this  increase  was a result of the
overhead reimbursement received from discontinued  operations in 1996. The gross
overhead reimbursement  received by the Company from discontinued  operations in
1996  was  $398,000.  The  Company  incurred  minimal  additional  costs in 1997
associated with additional staffing,  increased legal and professional expenses,
and an increase in promotional  costs.  These additional costs resulted from the
Company's  focus on corrections  and  implementing a strategy for growth through
new contracts and acquisitions.

  The increase in interest expense of $330,700 in 1997 resulted from interest on
the convertible  debentures and a full year interest on indebtedness  assumed in
1996  with  the  acquisition  of the El  Paso  Intermediate  Sanction  Facility.
Depreciation  and  amortization  expense have  increased  commensurate  with the
growth of the correctional operations.


                                     Page 8

<PAGE>




                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


ITEM 7.  FINANCIAL STATEMENTS.

         Index to Financial Statements:
                                                                     Page

         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, 1997 and
1996,  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, 1997 and 1996, and the consolidated  results of their
operations  and their cash flows for the years  then  ended in  conformity  with
generally accepted accounting principles.


                                                             GRANT THORNTON, LLP

Oklahoma City, Oklahoma
February 27, 1998  (except for Note 16, as to which the date is March 3, 1998)


                                     Page 10

<PAGE>



                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS


                                                              December 31,
                                                            1997        1996
                                                        -----------  ----------
ASSETS
Current assets:
 Cash and cash equivalents                              $ 1,458,000  $  313,000
 Short term certificate of deposit                          500,000         ---
 Accounts receivable, net of allowance for
  doubtful accounts of $8,000 and $5,000, respectively      673,000     401,000
 Current maturities of notes receivable                      16,000         ---
 Due from affiliates                                            ---     120,000
 Prepaid expenses and other                                 107,000     311,000
------------------------------------------------------- -----------  ----------
   Total current assets                                   2,754,000   1,145,000
------------------------------------------------------- -----------  ----------
Property and equipment, net                               9,212,000   8,312,000
Notes receivable, net of  current maturities                318,000         ---
Other assets                                              1,111,000      66,000
------------------------------------------------------- -----------  ----------
   Total assets                                         $13,395,000  $9,523,000
======================================================= ===========  ==========

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accounts payable, accrued liabilities and other        $ 1,030,000  $  448,000
 Current maturities of long-term debt                       849,000     519,000
------------------------------------------------------- -----------  ----------
   Total current liabilities                              1,879,000     967,000
------------------------------------------------------- -----------  ----------
Long-term debt, less current maturities                   5,129,000   5,861,000
Convertible debentures                                    4,150,000         ---
Commitments and contingencies                                   ---         ---

Stockholders' equity:
 Common stock:
  Class A - par value $.001;  20,000,000  shares
   authorized;  2,982,170 and 2,927,135 shares issued
   and outstanding in 1997 and 1996, respectively             3,000       3,000
  Class B - no par 4,000,000 shares authorized; none
   and 3,410,000 shares issued and outstanding
   in 1997 and 1996, respectively                               ---         ---
  Preferred stock; par value $.001; 1,000,000
   shares authorized; none issued                               ---         ---
   Paid-In capital                                        6,189,000   4,066,000
   Accumulated deficit                                   (3,955,000) (1,374,000)
------------------------------------------------------- -----------  ----------
   Total stockholders' equity                             2,237,000   2,695,000
------------------------------------------------------- -----------  ----------
   Total liabilities and stockholders' equity           $13,395,000  $9,523,000
======================================================= ===========  ==========

  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


                                                     Year Ended December 31,
                                                       1997           1996
                                                   ------------    ------------

Revenues                                           $ 5,878,000     $ 3,313,000
Costs and expenses
 Direct operating                                    3,713,000       1,962,000
 General and administrative                            990,000         646,000
 Depreciation and amortization expense                 460,000         307,000
 Discount on convertible debentures                  1,819,000             ---
 Interest expense                                      749,000         419,000
-----------------------------------------------    ------------    ------------
Loss from continuing operations
 before income tax expense                          (1,853,000)        (21,000)
 Income tax expense                                        ---          39,000
-----------------------------------------------    ------------    ------------
Loss from continuing operations                     (1,853,000)        (60,000)
-----------------------------------------------    ------------    ------------
Discontinued operations:
 Loss on operations, net of income tax
  benefit of $0 in 1997 and 1996                           ---        (649,000)
 Loss on disposal, net of income tax benefit of
  $0 in 1997 and $120,000 in 1996                     (728,000)       (325,000)
-----------------------------------------------    ------------    ------------
  Loss from discontinued operations                   (728,000)       (974,000)
-----------------------------------------------    ------------    ------------
Net loss                                           $(2,581,000)    $(1,034,000)
===============================================    ============    ============

Basic and diluted loss per share:
 Continuing operations                             $     (0.63)    $     (0.02)
 Discontinued operations                                 (0.25)          (0.36)
-----------------------------------------------    ------------    ------------
  Net loss per share:                              $     (0.88)    $     (0.38)
===============================================    ============    ============

Weighted average number of common
 shares outstanding, basic and diluted               2,935,369       2,745,879
===============================================    ============    ============




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

                                     Page 12

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


                                              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, 1996              2,496,905  $ 3,000    1,210,000   $ 2,678,000       (340,000)     $ 2,341,000
Net loss                                    ---      ---          ---           ---     (1,034,000)      (1,034,000)
Stock options exercised                   3,230      ---          ---         5,000            ---            5,000
Class B shares issued                       ---      ---    2,200,000           ---            ---              ---
Stock and warrants issued for
purchase of El Paso Facility             50,000      ---          ---       200,000            ---          200,000
Warrants exercised, net of
    issuance costs                      377,000      ---          ---     1,183,000            ---        1,183,000
                                     ----------  -------  ------------  ------------   ------------   --------------
Balance, December 31, 1996            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
                                     ==========  =======  ============  ============   ============   ==============
</TABLE>


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

                                     Page 13

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


                                                                          Year ended December 31,
                                                                        1997               1996
                                                                    ---------------    ------------
OPERATING ACTIVITIES:
<S>                                                                  <C>               <C>
 Net loss                                                            $(2,581,000)      $(1,034,000)
 Adjustments to reconcile net loss to
 net cash provided by (used for) operating activities
  Depreciation and amortization                                          460,000           382,000
  Discount on convertible debentures                                   1,819,000               ---
  Deferred income taxes                                                      ---           (89,000)
  Loss  on sale of property                                               71,000            14,000
  Write down of property                                                  59,000           318,000
  Changes in operating assets and liabilities:
   Decrease (increase) in -
    Accounts receivable                                                 (331,000)         (118,000)
    Due to / from  affiliates                                            120,000           (11,000)
    Prepaid expenses and other assets                                     40,000          (129,000)
   Increase (decrease) in accounts payable and other                     609,000           (27,000)
---------------------------------------------------------------     ---------------   -------------
  Net cash provided by (used in) operations                              266,000          (694,000)
---------------------------------------------------------------     ---------------   -------------

INVESTING ACTIVITIES:
 Purchase of short term investments                                     (500,000)              ---
 Capital expenditures                                                   (941,000)         (172,000)
 Payment for purchase of business                                     (1,400,000)         (200,000)
 Funding of note receivable                                              (25,000)              ---
 Proceeds from payments on notes receivable                                1,000               ---
 Proceeds from disposition of property                                    45,000            46,000
 Proceeds from disposition of discontinued operations                    151,000               ---
---------------------------------------------------------------     ---------------    ------------
  Net cash used in investing activities                               (2,669,000)         (326,000)
---------------------------------------------------------------     ---------------    ------------

FINANCING ACTIVITIES:
 Proceeds from convertible debenture issue                             4,150,000               ---
 Proceeds from borrowing                                               5,210,000         3,445,000
 Repayment of borrowing                                               (5,612,000)       (3,451,000)
 Proceeds from warrant and option exercise                               146,000         1,324,000
 Payments of warrant & debenture issue costs                            (346,000)         (106,000)
---------------------------------------------------------------    ----------------    ------------
  Net cash provided by  financing activities                           3,548,000         1,212,000
---------------------------------------------------------------    ----------------    ------------
Net Increase in Cash
 And Cash Equivalents                                                $ 1,145,000       $    192,000
---------------------------------------------------------------    ----------------    ------------
Cash and Cash Equivalents,
 Beginning of Period                                                 $   313,000       $    121,000
---------------------------------------------------------------    ----------------    ------------
Cash and Cash Equivalents
 End of Period                                                       $ 1,458,000       $    313,000
===============================================================    ================    ============

</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


                                                     Year ended December 31,
                                                    1997               1996
                                                ---------------    ------------
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid during the year for:
         Interest                               $   668,000       $    482,000
         Income Taxes                                   ---              4,000


  The Company sold assets  associated with the  discontinued  operations in July
1997. The Company  accepted a $310,000 note receivable as partial  proceeds from
the sale.

  The Company  acquired  property and equipment of  $3,681,000,  assumed debt of
$2,974,000  and  liabilities  of  $307,000,  and issued  common  stock and stock
purchase  warrants  with a fair  value of  $200,000  with the  acquisition  of a
correctional facility in August 1996.

  The Company  applied  $29,000 of deferred  warrant  costs against the proceeds
received upon the exercise of certain stock purchase warrants during 1996.

















  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 1997 AND 1996



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 correctional facilities and
providing intensive correctional programming.  The Company currently operates in
Oklahoma,  Texas, Missouri, and Nebraska with plans to significantly expand into
additional  states.  The Company owns and operates four  community  correctional
facilities  and  provides   substance   abuse   services  in  seven   additional
correctional facilities.

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.

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.
However,  the Company had a significant  portion of its cash  equivalents in one
money  market fund and the short term  certificate  of deposit at one  financial
institution at December 31, 1997.  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.  The Company maintains an
allowance for doubtful  accounts for potential  credit  losses.  Actual bad debt
expenses have not been material.  Credit risk on a note  receivable 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


                                     Page 16

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996





  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.  When  required,
impairment  losses are  recognized  based upon the  estimated  fair value of the
asset

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 -

  Deferred  development  costs consist of costs that can be directly  associated
with an anticipated  contract and, if the  recoverability  from that contract is
probable, they are deferred until the anticipated contract has been awarded. The
development  costs are deferred  until the  commencement  of  operations  of the
facility or  contract  period and  amortized  over the  anticipated  life of the
contract  (including  option and  renewal  periods).  Costs of  unsuccessful  or
abandoned contracts are charged to expense when their recovery is not considered
probable.  Facility  costs  are  incurred  (after  a  contract  is  awarded)  in
connection with the opening of new facilities  under the contract.  These costs,
which  are  required  under  the  contract,  to  the  extent  recoverable,   are
capitalized  from the date of award until  commencement of operations,  at which
time they are amortized on a straight-line basis over the term (including option
periods) ranging from one to five year periods of the government contracts.

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 assumed exercise of options and warrants (see note 7) would be
anti-dilutive.













                                     Page 17

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996




NOTE 2.  PROPERTY AND EQUIPMENT
-------------------------------

  The elements of property and equipment and related accumulated depreciation as
of December 31, 1997 and 1996 are as follows:

                                                              Accumulated
                                         Cost                Depreciation
                                      -------------------------------------
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
                                      =============          ==============

December 31, 1996:
     Land                             $    619,000           $         ---
     Buildings and Improvements          7,591,000                 384,000
     Furniture and Equipment               717,000                 320,000
     Transportation Equipment              156,000                  67,000
                                      -------------          --------------
                                      $  9,083,000           $     771,000
                                      =============          ==============


  The  Company  changed  its'  estimate  of the useful  lives of  buildings  and
improvements  from 25 to 40 years during 1996. The change resulted in a decrease
in net loss,  net of income tax  expense of $28,000,  for 1996 of  approximately
$55,000 or $.02 per share


NOTE 3.  ACCOUNTS PAYABLE, ACCRUED LIABILITIES AND OTHER
--------------------------------------------------------

  The elements of accounts payable, accrued liabilities and other as of December
31, 1997 and 1996 are as follows:


                                               1997                 1996
                                          ---------------------------------
  Trade accounts payable                  $   303,000           $   80,000
  Accrued interest payable                    140,000               36,000
  Accrued salary and benefits                 115,000               89,000
  Discontinued operations liabilities         157,000               12,000
  Other accrued liabilities                   315,000              231,000
                                          ------------          -----------
                                          $ 1,030,000           $  448,000
                                          ============          ===========


                                     Page 18

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996




NOTE 4.  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.  Revenues generated from Residential  Services during 1997 and
1996 comprised 91% and 88%,  respectively,  of total Company revenues.  Contract
revenues from the Oklahoma Department of Corrections  represented 52% and 58% of
total Company revenues in 1997 and 1996, respectively.

  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.  The
Company's current Residential Services contracts with the Oklahoma Department of
Corrections  extend  through  June 30,  1998.  The Company  has two  Programming
Services  contracts with the Nebraska  Department of Correctional  Services with
terms extending  through  September 30, 1999,  including  renewal  options.  The
Company has a Programming Services contract with the State of Missouri extending
through June 30, 1998, with renewal options extending to June 30, 2000.



NOTE 5.  LONG-TERM DEBT
-----------------------

  Long-term debt consists of the following:
                                                             December 31,
                                                        1997           1996
                                                    --------------------------
Revolving bank line of credit                       $   167,000    $    38,000

Notes payable to banks, collateralized by
 equipment due in installments through
 July 1999 with interest from 7.99% to 8.5%              89,000        137,000

Notes payable to banks, collateralized
 by transportation equipment, due in
 installments through March 2012
 with interest ranging from 7.99% to 9.49%.             621,000         71,000

Notes payable to banks, collateralized
 by land, buildings and improvements
 due in installments through June 2012
 with interest ranging from 8.5% to 11%               4,941,000      5,584,000

Note payable to an individual, uncollateralized,
 with interest at 8.5%, due in full April 1998          160,000            ---

Note payable to corporation collateralized by
 buildings, with interest at 8.5%
 with principal due in full January 1998                    ---        550,000
                                                    -----------    -----------
                                                      5,978,000      6,380,000
Less - current maturities                               849,000        519,000
                                                    -----------    -----------
                                                    $ 5,129,000    $ 5,861,000
                                                    ===========    ===========





                                     Page 19

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996



  The aggregate maturities of long-term debt for each of the next five years are
as follows:  1998:  $849,000;  1999: $926,000;  2000: $765,000;  2001: $506,000;
2002: $ 540,000;  thereafter:  $2,392,000.  Substantially  all notes payable and
long-term debt has been personally guaranteed by the Company's CEO.

  The revolving bank line of credit provides for aggregate maximum borrowings of
$500,000 and bears interest at 1% over national prime,  (effective rates of 9.5%
and 9.2%,  at December  31, 1997 and 1996,  respectively)  The line of credit is
collateralized by the Company's Federal and state contract revenues.  Payment of
dividends is restricted by terms of the Company's revolving credit facility. The
revolving bank line of credit matures April 5, 1998.


NOTE 6.  CONVERTIBLE DEBENTURES
-------------------------------

  The  Company  completed  a private  placement  of  $4,150,000  of  convertible
debentures  on September  12, 1997.  The  debentures  bear  interest at 7.5% and
mature on September 12, 2007.  The  debentures may be redeemed by the Company at
any time after May, 2001 at 106.5% of principal,  declining to 100% at maturity.
The debentures are convertible into common stock  immediately  after issuance at
$3.00 per share.

  The  difference  between the  conversion  price of the debentures and the fair
value of the  Company's  common stock as evidenced by the quoted market price of
the common stock  multiplied  by the number of shares into which the  debentures
are  convertible  at the date of issue has been  recorded as a discount on debt.
This  discount is to be  amortized  from the period of issuance to the date that
the security is first  convertible.  This  discount was  immediately  charged to
current year earnings,  since the debentures are immediately  convertible  after
issuance. The recognition of this charge did not affect cash flow, the Company's
assets or liabilities,  or total  stockholder's  equity. The discount charge did
impact current year operations and accumulated deficit, offset by an increase to
paid in capital. The discount charge of $1,819,000 is reflected in the statement
of operations.



NOTE 7.  STOCKHOLDERS' EQUITY
-----------------------------

  The Company has outstanding  275,100 Class B stock purchase warrants providing
for the purchase of the  Company's  Class A 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.

                                     Page 20

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996




  The Company  completed a private  placement of 1,000,000  shares of its common
stock  and  1,000,000  Class C stock  purchase  warrants  in  August  1994.  The
placement  provided for 100,000 shares of common stock and 100,000 Class C stock
purchase warrants  reserved for  underwriters.  The Company issued an additional
165,000 Class C stock purchase warrants in 1996. Twenty five thousand additional
Class C stock  purchase  warrants  were issued in 1997.  The Company  recognized
$10,000 of cost based upon the  difference in the exercise  price of the Class C
warrants  and the  current  market  price  of the  common  stock  on the date of
issuance.  The  Company  has  issued  410,000  shares of common  stock  upon the
exercise of the Class C stock purchase  warrants  through December 31, 1997. The
Company  currently  has 880,000  Class C stock  purchase  warrants  outstanding,
including the 100,000 warrants reserved for underwriters.

  The Class C stock purchase  warrants provide for the purchase of the Company's
Class A common  stock at any time until their  expiration  at December 30, 1999.
Anti-dilution  provisions  of the warrant  agreement  have  reduced the exercise
price from $3.50 to $3.33 per share as of December 31, 1997.  The warrants  were
issued in connection  with a 1994 offering,  therefore the reduction of exercise
price from  anti-dilution  provisions  had no effect on the Company's  financial
statements. The warrants may be redeemed by the Company upon certain events, for
$.01 per share.

  The Company issued Class D Warrants in August 1996, to purchase 200,000 shares
of Common Stock in connection with the  acquisition of the El Paso  Intermediate
Sanction  Facility.  The warrants were issued along with 50,000 shares of common
stock.  The Company  valued the  warrants and the stock at $200,000 and recorded
this amount as part of the  purchase  price of the asset,  with a  corresponding
credit to paid in capital. This valuation was based upon the market price of the
stock at the date of  issuance  and the fair value of the assets  received.  The
Class D stock purchase  warrants provide for the purchase of the Company's Class
A common stock at a price of $5.125 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 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  will be  amortized  to  expense  over the  term of the  convertible
debentures.  The Class E stock purchase warrants provide for the purchase of the
Company's  Class A common  stock at a price of $3.00 per share at any time until
their  expiration  at September  12,  2002.  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 on August  25,  1997,
pursuant to a Change of Control  Agreement between the Company and the Company's
CEO. The Company has no Class B shares  outstanding  and has no plans to reissue
these shares.

  A 1994  agreement  provided for the issuance of 750,000  common stock purchase
warrants to purchase  Class A 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.





                                     Page 21

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996



NOTE 8.  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.  The options  generally  vest over a four or  five-year
period with a ten year  expiration  period.  On  December  1, 1996,  the Company
amended its stock option plan,  increasing the number of shares  available under
the Plan to 600,000.  Non-statutory  options have been granted providing for the
issuance of 477,330  shares of Class A common stock at exercise  prices  ranging
from $1.50 to $4.00 per share.  Options  providing  for the  issuance  of 83,850
shares were exercisable at December 31, 1997.

  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 and basic loss per share would have been increased to the pro
forma amounts indicated below.

                                      1997                 1996
                                  -------------        -------------
     Net loss
      As reported                 $ (2,581,000)        $ (1,034,000)
      Pro forma                     (2,880,000)          (1,375,000)

     Loss per share
      As reported                 $      (0.88)        $      (0.38)
      Pro forma                          (0.98)               (0.50)

  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 1997 and 1996, respectively:  no
expected dividends;  expected volatility of 85% and 96%; risk-free interest rate
of 5.8% and 5.7%; and expected lives of ten years.

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









                                     Page 22

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996



  A summary of the status of the Company's  stock option plan as of December 31,
1997 and 1996,  and changes  during the years ending on those dates is presented
below.

<TABLE>
<CAPTION>

                                                   1997                             1996
                                         ---------------------------      ---------------------------


                                                       Weighted                          Weighted
                                                        average                           average
                                           Shares     exercise price       Shares      exercise price
                                         ----------   --------------      ----------   --------------
<S>                                      <C>          <C>                 <C>          <C>
Outstanding at beginning of year           469,770       $ 2.93             229,900       $  1.71
   Granted                                  71,400         3.80             259,600          3.93
   Exercised                               (22,035)        1.63              (3,230)         1.62
   Forfeited                               (41,805)        3.02             (16,500)         1.78
                                         ----------   --------------      ----------   --------------
Outstanding at end of year                 477,330         3.11             469,770          2.93
Options exercisable at year end             83,850         1.71              57,005          1.63
Weighted average fair value of
 options granted during the year                         $ 3.00                           $  3.70
                                                      ==============                   ==============
</TABLE>


  The following table summarizes  information  about  fixed-price  stock options
outstanding at December 31, 1997:
<TABLE>
<CAPTION>

                                             Options outstanding                    Options exercisable
                                ----------------------------------------------    ------------------------
                                                  Weighted            Weighted                   Weighted
                                  Number          average             average     Number         average
                                outstanding at    remaining           exercise    exercisable    exercise
                                  12/31/97        contractual life    price       at 12/31/97    price
                                --------------    ----------------    --------    -----------    ---------
<S>                             <C>               <C>                 <C>         <C>            <C>
Range of exercise prices
   $1.50 to $2.25                  177,330            7.20             $ 1.70       82,600         $ 1.68
   $3.26 to $4.00                  300,000            8.63               3.95        1,250           3.80
                                --------------    ----------------    --------    -----------    ---------
   $1.50 to $4.00                  477,330                                          83,850
                                ==============                                    ===========
</TABLE>


NOTE 9.  ACQUISITIONS
---------------------

  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. These 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.  Pro forma
financial information for the acquisition is not presented because historical

                                     Page 23

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996



financial information of the acquired operations is not available.  A subsidiary
of the  Company,  Southern  Corrections  Systems,  Inc.,  has assumed the annual
contracts  with the Oklahoma  Department of  Corrections.  The Company is in the
final stages of  completing  the necessary  requirements  to assume the contract
with the Federal Bureau of Prisons.

  The Company acquired the El Paso  Intermediate  Sanction  Facility in El Paso,
Texas from Secure  Corrections,  Inc. in August,  1996. The facility is 150 bed,
36,000 square foot medium security  correctional facility on approximately seven
acres of real estate. The purchase price was approximately  $3,681,000 including
the  assumption of certain  liabilities.  A subsidiary of the Company,  Southern
Corrections Systems,  Inc., entered into a fifteen (15) year contract to provide
services  in  the  facility  for  the  West  Texas  Community   Supervision  and
Corrections Department.


NOTE 10.  DISCONTINUED OPERATIONS
---------------------------------

  The Company discontinued all non correctional operations in the fourth quarter
of 1996. Revenues from discontinued operations for the years ended 1997 and 1996
were $50,000 and $493,000, with a net discontinued loss from operations,  net of
income tax benefit,  of $649,000 for 1996.  The Company  estimated a loss on the
disposal  of all non  correctional  operations  of  $325,000  (net of income tax
benefit of $120,000) in 1996. This included a provision of approximately $48,000
for expected  operating  losses during the phase out period beginning during the
fourth quarter of 1996. All such expected  losses were incurred in 1996.  Actual
operating losses incurred during 1997 and expected  operating losses through the
estimated  disposal date of  approximately  $535,000,  and an additional loss on
disposal of  approximately  $193,000 were estimated in 1997.  Accordingly,  1997
includes an additional loss of $728,000.  Approximately $541,000 of these losses
were recorded in the fourth quarter of 1997.

  The  remaining  assets at December  31,  1997,  consist of one building and an
investment in one assisted  living center.  The Company has executed  letters of
intent for their sale and  management  believes  such sales will be concluded in
the quarter ended June 30, 1998.

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

                                                         December 31,
                                                     1997           1996
                                                   ----------     ---------
Assets
 Property and equipment, net                       $ 298,000      $ 328,000

Liabilities
 Accounts payable and accrued liabilities           (157,000)       (25,000)
 Note payable                                       (298,000)      (315,000)
                                                   ----------     ----------
Net liabilities of discontinued operations         $(157,000)     $ (12,000)
                                                   ==========     ==========








                                     Page 24

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996




NOTE 11.  FAIR VALUE OF FINANCIAL INSTRUMENTS
---------------------------------------------

  The carrying values of cash, cash equivalents,  and short term certificates of
deposit  approximate  their  fair  values,  due to the  short  term  nature  and
stability of market  interest  rates in 1997. The notes  receivable  approximate
fair value since the notes  receivable  were negotiated in proximity to December
31, 1997.  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  1997,  and the  fact  that  rates  on the  debt  approximate  the  Company's
incremental  borrowing rate. The convertible  debentures  approximate fair value
since the convertible  debentures were issued in proximity to December 31, 1997.
All the  Company's  financial  instruments  are held  for  purposes  other  than
trading.


NOTE 12.  INCOME TAX
--------------------

  The  components of the provision for (benefit from) income taxes for the years
ended December 31, 1997 and 1996 from continuing operations were as follows:


                                Federal            State           Total
                                -------           -------         -------

 1997 -
   Current                      $   ---           $   ---         $   ---
   Deferred                         ---               ---             ---
                                -------           -------         -------
                                $   ---           $   ---         $   ---
                                =======           =======         =======


1996 -
  Current                       $ 7,000           $ 1,000         $ 8,000
  Deferred                       26,000             5,000          31,000
                                -------           -------         -------
                                $33,000           $ 6,000         $39,000
                                =======           =======         =======


  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
carryforwards,  excess tax basis in property and  equipment,  and  nondeductible
accruals and allowances; liabilities - accelerated tax depreciation. The Company
has  approximately  $1,133,000 of net operating  loss carry forwards at December
31, 1997, expiring through 2012.

  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, 1997
and 1996:








                                     Page 25

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996



                                                           December 31,
                                                        1997           1996
                                                    -----------     -----------
Provision for (benefit from) income taxes
 at statutory rate                                  $ (630,000)     $  (7,000)
Nondeductible expenses                                 624,000          3,000
State income taxes                                     (73,000)         6,000
Change in valuation allowance                           68,000         13,000
Change in prior year estimate                           11,000         24,000
                                                    ------------    -----------
  Total provision for (benefit from) income taxes   $        ---    $  39,000
                                                    ============    ===========

         Deferred tax assets and liabilities are as follows:

Deferred tax assets
 Net operating loss carry forward                   $  453,000      $ 314,000
 Property & equipment                                  144,000        120,000
 Shareholder contributed property                       46,000         46,000
 Nondeductible accruals and allowances                 214,000          9,000
 Other                                                   1,000          1,000
                                                    ------------    -----------
                                                       858,000        490,000
 Less: Valuation allowance                            (637,000)      (353,000)
                                                    ------------    -----------
  Deferred tax assets                                  221,000        137,000
                                                    ------------     ----------
Deferred tax liabilities:
 Property and equipment                               (155,000)       (71,000)
                                                    ------------    -----------
  Deferred tax liabilities                            (155,000)       (71,000)
                                                    ------------    -----------
   Net deferred tax asset                           $   66,000      $  66,000
                                                    ============    ===========


  The valuation  allowance on tax assets increased $284,000 in 1997 and $312,000
in 1996, including $68,000 and $13,000 related to continuing  operations in 1997
and  1996,   respectively.   The  tax  effects  of  approximately   $618,000  of
nondeductible  expenses  relate to the  allocation of proceeds from  convertible
debentures (see Note 6) charged to operations in 1997.


NOTE 13.  RELATED PARTY TRANSACTIONS
------------------------------------

  The Company's initial operations were formed by acquiring existing  operations
from the Company's CEO in 1992 and 1993. Certain existing  agreements related to
providing  management,  administrative  and  accounting  services  and leases of
buildings were continued, resulting in related party transactions.

  The Company charged $398,000 to affiliated  entities controlled by the CEO for
management,  administrative,  and accounting  services in 1996.  Such amount has
been  reflected  as a reduction  of general and  administrative  expenses in the
Consolidated Statement of Operations.

                                     Page 26

<PAGE>


                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        FOR THE YEARS ENDED 1997 AND 1996



  The balance due from  affiliates  at December 31, 1996,  resulted from charges
for administrative and accounting  services,  as well as net cash advances made.
The outstanding  balance related to residential  care operations was included in
discontinued operations in 1996.

  The Company managed the operations of a residential  care operation and leased
a building to an affiliated  entity in 1996.  The Company also leased  equipment
from an affiliated  entity in 1996. The leases  resulted in net lease expense of
$4,000 in 1996.

  The Company issued  3,900,000  shares of Class B common stock to the Company's
CEO from 1995 to 1997,  pursuant  to a 1994  debt  guarantee  agreement  for his
personal  guarantee  of debt.  The Company  canceled all Class B common stock in
August 1997,  pursuant to a Change of Control  Agreement between the Company and
the Company's CEO.

  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 1998.
The Company  guaranteed  the debt of both  facilities  in 1996 and  continues to
guarantee  the  debt  of  one  of the  facilities  at  December  31,  1997.  The
outstanding balance of the guaranteed debt was $2,012,000 at December 31, 1997.


NOTE 14.  COMMITMENTS AND CONTINGENCIES
---------------------------------------

  Total  lease  expense was  $57,000  and  $118,000  for 1997 and 1996 under all
operating  leases.  The future  minimum  lease  payments are as follows:  1998 -
$42,000, 1999 - $13,000, 2000 - $7,000 , 2001 - $6,000, and 2002 - $2,000.

  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.


NOTE 15.  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 16.  SUBSEQUENT EVENTS
---------------------------

  The Company was awarded a five year  contract in March 1998 with the  Oklahoma
Office of Juvenile Affairs.  The contract is to provide services for 80 youthful
delinquent  male  offenders  ages 13 to 19. The Company will  design,  build and
operate a new medium  security  facility  to  provide  for  housing,  education,
program and recreation  areas for these  offenders.  The contract is expected to
generate annual  revenues of  approximately  $3,600,000  beginning in the fourth
quarter of 1998.  The contract is expected to generate  revenues of  $18,800,000
over a five year period.  The Company  will  complete  the  construction  of the
facility and commence operations under this contract in December 1998.


                                     Page 27

<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.  During the two most recent fiscal years and the three interim  periods
subsequent to December 31, 1995,  and through the date of dismissal,  there have
been no disagreements with Coopers & Lybrand, L.L.P. on any matter of accounting
principles or practices,  financial  statement  disclosure or auditing  scope or
procedure or any reportable event.

  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 ...............  45       Chief Executive Officer, Director
    Jerry M. Sunderland ...........  61       President, Director
    Gary D.  Parsons...............  54       Vice President of Operations
    Randall J.  Wood ..............  40       Corporate Secretary
    Tiffany Wright.................  30       Public Information Officer
    Paul D.  Voss .................  30       Vice President of Finance
    Robert O. McDonald ............  59       Director
    Mark S.  Cooley ...............  40       Director


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 above-name 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, residential care, mental
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.

  Jerry M.  Sunderland  has served as President of Avalon since June,  1995. Mr.
Sunderland  served  as  an  Correctional   Administrator  for  the  Company  and
affiliates since 1988. Mr.  Sunderland also serves as a Director of Avalon's and
its  subsidiaries.  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.

                                     Page 28

<PAGE>



                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


  Gary D. Parsons was  appointed as Vice  President  of  Operations  in December
1997.  Mr.  Parsons has over 24 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
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.

  Randall J. Wood 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 Wright serves as Public  Information  Officer and assistant  Corporate
Secretary for the Company. Ms. Wright served for four years as marketing manager
for Eagle Picher Industries,  a New York Stock Exchange listed company, prior to
joining  Avalon  in 1994.  Ms.  Wright  has  developed  and is  responsible  for
directing the Company's public relations  department and implementing  marketing
strategies. Ms. Wright is the primary contact for the Company's shareholders and
investors.  Ms. Wright received a Bachelors  Degree in Business  Administration,
Marketing and Management from Missouri Southern State College.

  Paul D. Voss was appointed  Vice  President of Finance in January,  1998.  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, holds CPA licenses in
Oklahoma  and Texas and is a member of both the  American  Institute of CPAs and
the Oklahoma Society of CPAs.

  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,  subject
to shareholder approval at the 1998 annual meeting. 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.

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, 1997.


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                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES



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)
             vi    Certificate  of  Corporate  Resolutions,  dated  December 13,
                   1993,  regarding  authorization  of Class B Common  Stock and
                   Amendment to Articles (5)

         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, 1998 (6)
             ii    Contract between Southern Corrections  Systems,  Inc. and the
                   Oklahoma  Department of Corrections  for public works inmates
                   for the year ended June 30, 1998 (6)
             iii   Contract between Southern Corrections  Systems,  Inc. and the
                   Oklahoma Department of Corrections for halfway house services
                   for the year ended June 30, 1998. (6)
             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    Acquisition   Agreement   dated   August  2,   1996   between
                   Registrant, Kensington Capital Plc, and RECOR, Inc. (7)
             vii   Change of  Control  Agreement  between  Donald  E.  Smith and
                   Avalon Community Services, Inc. dated August 25, 1997. (7)
             viii  Employement  Agreement  with Donald E. Smith dated  August 8,
                   1997. (7)
             ix    Employment Agreement with Jerry M. Sunderland dated August 8,
                   1997 (7)
             x     Letter of Acceptance  and Notice of Award dated  February 24,
                   1997 to Avalon  Community  Services,  Inc.  from the Missouri
                   Department of Corrections. (7)
             xi    Commercial Contract to Buy and Sell Real Estate dated October
                   2, 1997 between Avalon Community  Services,  Inc. and Freedom
                   Ranch, Inc. (9)
             xii   Notice of Award dated  March 3, 1998 to Southern  Corrections
                   Systems,  Inc. from the Oklahoma Office of Juvenile  Affairs.
                   (11)

        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.

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.

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<PAGE>



                AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES


             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.
             11)   Incorporated herein by reference to the Registrant's Form 8-K
                   dated March 19, 1998.

                                                 Page 31

<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, 1998


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, 1998



By:   s\ Jerry M. Sunderland
------------------------------------
Jerry M. Sunderland
President and Director                                     Dated: March 26, 1998



By:   s\ Robert O. McDonald
------------------------------------
Robert O. McDonald
Director                                                   Dated: March 26, 1998



By:   s\ Paul Voss
------------------------------------
Paul Voss
Vice President of  Finance                                 Dated: March 26, 1998


                                     Page 32