<PAGE>   1
                     U.S. SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                   FORM 10-KSB

(Mark One)

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

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

                         COMMISSION FILE NUMBER 0-20791

                           AMARILLO BIOSCIENCES, INC.
                 (NAME OF SMALL BUSINESS ISSUER IN ITS CHARTER)

               TEXAS                                     75-1974352
    (State of other jurisdiction of                   (I.R.S. Employer
     incorporation or organization)                  Identification No.)

  800 WEST 9TH AVENUE, AMARILLO, TEXAS                     79101
(Address of principal executive offices)                 (Zip Code)

         ISSUER'S TELEPHONE NUMBER, INCLUDING AREA CODE: (806) 376-1741


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

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

                          Common Stock, Par Value $.01
                                (Title of class)

         Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such
shorter period that the registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days. 
Yes  X   No
    ---     ---

         Check if there is no disclosure of delinquent filers in response to
Item 405 of Regulation S-B 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 its most recent fiscal year were $222,289

         As of March 9, 1999, there were outstanding 5,414,232 shares of the
registrant's common stock, par value $.01, which is the only class of common or
voting stock of the registrant. As of that date, the aggregate market value of
the shares of common stock held by nonaffiliates of the registrant (based on the
closing price for the common stock on the NASDAQ SmallCap Market) was
approximately $6,458,412.


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                                     PART I

         The following contains forward-looking statements that involve risks
and uncertainties. The Company's actual results could differ materially from
those discussed in the forward-looking statements as a result of certain
factors, including those set forth in "Management's 1999 Plan of Operations" as
well as those discussed elsewhere in this Form 10-KSB. The following discussion
should be read in conjunction with the Financial Statements and the Notes
thereto included elsewhere in this Form 10-KSB.

ITEM 1.       DESCRIPTION OF BUSINESS.

GENERAL

         Amarillo Biosciences, Inc. (the "Company" or "ABI"), a
development-stage company incorporated in 1984, is engaged in developing
biologics for the treatment of human and animal diseases. The Company is
currently focusing its research on human health indications for the use of low
dose oral natural interferon alpha (IFN[alpha]), particularly for the treatment
of Sjogren's syndrome, fibromyalgia, hepatitis B, hepatitis C and oral warts in
HIV+ patients. The Company believes that significant worldwide opportunities
exist for the development of low dose oral natural IFN[alpha] as a cost
effective, non-toxic, efficacious alternative to the treatment of disease by
injection of high doses of IFN[alpha]. In addition, the Company believes that
low dose oral natural IFN[alpha] will be an effective treatment for diseases or
conditions for which current therapies are inadequate.

         The Company owns or licenses 19 United States patents relating to low
dose oral natural IFN[alpha]. Since 1992, the Company has filed with the U.S.
Food and Drug Administration ("FDA"), and there now are in effect, eight
Investigational New Drug ("IND") Applications covering indicated uses for low
dose oral IFN[alpha], including treatment of Sjogren's syndrome and
fibromyalgia. The Company is seeking regulatory approvals in certain foreign
countries to test low dose oral IFN[alpha] in the treatment of hepatitis B and
C.

         The Company's objective is to exploit its proprietary technology to
become a leader in the field of low dose oral IFN[alpha] applications. The
Company's business strategy is to pursue those indications for low dose oral
IFN[alpha] treatment for which initial clinical research has indicated the
treatment is efficacious and which, in the opinion of the Company, have the
greatest commercial potential and are most likely to be approved by the FDA. To
the extent possible, the Company will attempt to minimize the cost to the
Company of obtaining FDA approval by utilizing forms of IFN[alpha] already
approved (in other dosage forms and for different indications) by the Japanese
Ministry of Health and Welfare for human use. The Company believes that cost
savings will result. The Company will attempt to gain market share for approved
products by forming alliances with strong marketing partners.

         The Company has 10 full-time employees and three part-time employees.
The Company makes extensive use of consultants in business and research and
development.



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HUMAN HEALTH APPLICATIONS

Sjogren's Syndrome. Sjogren's syndrome is a chronic autoimmune disorder
characterized by dryness of the eyes and mouth. It can exist as a primary
disorder or in association with other autoimmune diseases such as rheumatoid
arthritis, systemic lupus erythematosus and scleroderma. Patients with primary
Sjogren's syndrome may have clinical signs such as rash, arthritis, pneumonitis
and nephritis. Typical symptoms include the sensation of burning in the eyes,
dryness of the mouth, skin, nose and vagina, difficulty swallowing, painful
throat and fatigue. Oral candidiasis (a fungus infection of the mouth) may also
arise as a result of reduced saliva flow. Although Sjogren's syndrome is not
life threatening, it can cause extreme discomfort and seriously impair quality
of life.

         The Sjogren's Syndrome Foundation, Inc. estimates that there are 
approximately two to four million people in the United States who suffer from
Sjogren's syndrome. The Company believes that the incidence of Sjogren's
syndrome worldwide is similar to its incidence in the United States. Women
constitute 90% of Sjogren's patients.

         Topical use of artificial tears is the prevailing treatment for the dry
eye symptom of the disease. Artificial tears must be used on a regular basis.
Intensive oral hygiene is prescribed to prevent progressive oral problems that
may develop as a result of the disease. Topical and systemic means of increasing
salivary flow may provide transient relief of symptoms.

         The Company believes that oral IFN[alpha] therapy helps to relieve the
dryness associated with Sjogren's syndrome, improves secretory function, and may
effectively supplement, or be used in lieu of, existing treatments. In a study
conducted by the Company from October 1994 to January 1996 at two universities,
the Company found that oral IFN[alpha] therapy administered to Sjogren's
syndrome patients led to increased saliva production in six of 14 patients. The
Company has filed, and there is now in effect, an IND for the use of oral
IFN[alpha] to treat Sjogren's syndrome.

         A Phase II trial was completed in late 1997. At the end of 12 weeks,
ninety patients who took placebo or interferon were evaluable. Patients given
150 IU three times per day had a significant (p<0.014) increase in stimulated
saliva production. Subjective measures of relief of dryness also favored the
same interferon group. A Phase III pivotal trial was approved and launched in
November 1998. A total of 500 patients will be given either 150 IU oral
IFN[alpha] or placebo for a 24 week period. Endpoints will be significant relief
of oral dryness and increased saliva output.

Hepatitis C. The Company is conducting a clinical trial in Canada to evaluate
oral IFN[alpha] pre-treatment as a means of increasing the effectiveness of
parenteral IFN[alpha] therapy in hepatitis C patients. An estimated 40 million
worldwide chronic cases of HCV are believed by the Company to be candidates for
this treatment.

HIV. ABI is continuing an open label trial in California of HIV+ patients with
persistent oral warts. A number of patients have shown marked improvement, with
regression of the warts and without relapse. Further studies are planned to
confirm and extend these encouraging results.

Fibromyalgia. A second Phase II trial in fibromyalgia patients is ongoing. A
total of 120 patients will be enrolled to receive interferon or placebo in an
effort to reproduce the positive effects noted in our previous study and to
define further the most effective dose schedule.

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STRATEGIC ALLIANCE WITH HBL

         Hayashibara Biochemical Laboratories, Inc. ("HBL") was established in
1970 to engage in biotechnical research and development. It is a subsidiary of
Hayashibara Company, Ltd., a privately-owned Japanese holding corporation with
diversified subsidiaries. For more than 100 years the Hayashibara Company, Ltd.
and its predecessors have been applying microbiological technology in the starch
industry for the production of maltose and other sugars.

         In 1981, HBL established the Fujisaki Institute to accelerate
development of industrial methods for the production of biologics and to sponsor
clinical trials for such products. In 1985, HBL built the Fujisaki Cell Center
to support basic research. In 1987, HBL successfully accomplished the mass
production of human cells in an animal host by producing human cells in
hamsters. This made it possible to economically produce a natural form of human
IFN[alpha] and other biologics. HBL also has developed and obtained patents for
technology relating to the production of IFN[alpha]-containing lozenges by which
the stability of the IFN[alpha] activity can be maintained for up to 18 months
at room temperature and up to three years if the product is refrigerated. The
Company believes that the use of such lozenges gives it advantages over
competitive technologies in terms of cost, taste and ease of handling.

         In September 1997, HBL and ABI entered license agreements granting
exclusive rights to ABI to develop interferon gamma for oral use in humans and
for all routes of administration in animals, and tumor necrosis factor alpha for
oral and topical uses in humans and for all routes of administration in animals;
the rights were granted worldwide, except Japan. The Company is dependent on HBL
as the sole supplier of products in human health.

AGREEMENTS

         In October 1989, the Company entered into a Manufacturing and Supply
Agreement with Interferon Sciences, Inc. ("ISI"), under which ISI granted to the
Company an exclusive worldwide license to market ISI IFN[alpha] for oral use in
animals and agreed to supply ISI IFN[alpha] for such use exclusively to the
Company. Pursuant to the agreement, ISI receives a specified price for ISI
IFN[alpha] sold to the Company. ISI is also entitled to receive royalties on net
sales as well as a percentage of any license fee, option fee or other payment,
except royalty or specific research or patent expense reimbursements, which the
Company receives for the assignment or sublicense of the Company's rights under
the license agreement.

         Since 1994, the Company has been required to expend a minimum of
$50,000 per year toward development of products under the Manufacturing and
Supply Agreement in order to keep it in force. The Company has done so, and
currently intends to continue to make such expenditures. The Manufacturing and
Supply Agreement will continue for seven years after the Company's first
purchase order for Manufactured Products under the Agreement, and will be
automatically renewed for successive three-year terms thereafter, subject to
termination by the Company, with or without cause, and subject to termination by
ISI at any time after the first renewal term if net sales for a calendar year do
not exceed $100,000. The seven-year term has not yet commenced, since the
Company has not yet placed an order with ISI for Manufactured Products.
"Manufactured Products" is defined in the

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agreement as ISI IFN[alpha], packaged in accordance with FDA approved dosage
forms. The FDA has not yet approved any dosage form within the meaning of the
agreement.

         In October 1989, the Company and ISI entered into a license agreement
pursuant to which the Company granted to ISI a license (co-exclusive with the
Company) of the Company's patented technology for the use and sale of
IFN[alpha]-containing products for use in humans worldwide, except for Japan
(where the Company has granted to HBL an exclusive license), for a royalty on
net sales of licensed products made during the term of the agreement. The
original term of the license agreement was to expire on October 20, 1994, but
ISI extended its term as therein permitted. As amended in April 1995, the
agreement will continue in force for the life of the licensed patents, subject
only to ISI's right to terminate the agreement with or without cause (in which
case ISI must cease any use or sale of the licensed products), and the Company's
right to terminate for breach of the agreement by ISI, or upon certain other
events.

         In April 1995, in connection with the settlement of certain patent and
infringement litigation brought by the Company in New Zealand against Fernz
Corporation Limited, Pharma Pacific Management Pty. Ltd. ("PPM") and certain
other companies and certain opposition proceedings brought by PPM against the
Company and certain of the Company's licensors in Australia and Europe, the
Company entered into a non-exclusive license agreement with PPM. Pursuant to
such agreement, the Company licenses to PPM worldwide, except in Japan, the
right to use the Company's patented technology for the use and sale of
IFN[alpha]-containing products in humans and PPM is obligated to pay the Company
a royalty based on sales of the product in countries where any of the licensed
patents has issued. To the Company's knowledge, PPM is not selling products
covered by the license in any such country. PPM also paid to the Company
$500,000 as a reimbursement of a portion of the Company's research and expenses
related to the licensed technology and a $50,000 license fee to be credited
against future royalties. In connection with the settlement, ISI and the Company
agreed to an amendment of ISI's license from the Company pursuant to which ISI
granted back to the Company any right to sublicense the licensed technology
(except that ISI retained the right to sublicense such technology in connection
with the use and sale of ISI IFN[alpha] products) and the Company purchased
312,500 shares of the common stock of ISI, a public company, for $625,000.
Following a 4:1 reverse split in March 1997, the Company sold 65,000 shares of
ISI stock, leaving a balance of 13,125 shares at December 31, 1998.

         On October 13, 1998, the Company engaged Trust Company of the South
(TCOS) to act as its Executive Advisor. TCOS's services in connection with this
engagement will include assisting the Company, in (1) Preparation of a corporate
profile suitable for use with brokers and investors (research, write, design,
print and distribute), (2) Designing and implementation of a plan for both the
short and long term promotion of investor interest in the Company, (3)
Interfacing with the investment community on behalf of the Company and publicly
promoting investor interest in the Company, (4) Preparation of press releases,
upon request, and introduction of the Company to appropriate financial writers
and media persons, (5) Enlistment of additional market makers for the Company's
stock, (6) Development of a list of key brokers that can be cultivated on behalf
of the Company and its stock, and seek to enhance the interest of these brokers
in the Company, (7) Assistance, when requested, in the preparation of
presentations to broker and investor groups, (8) Development, with Company's
officers of an ongoing in-house program for investor relations, (9) Coordination
with management and other board members in the selection of additional outside
board members, (10) Evaluation of the benefits of listing the Company's
securities on the American Stock

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Exchange when and if appropriate, (11) Evaluation and recommendations regarding
utilizing personal and corporate trust services provided by TCOS.

         The Company agrees to promptly reimburse TCOS for all expenses incurred
by TCOS pursuant to this engagement. Such expenses shall include but not be
limited to, transportation, lodging, mileage, meals, parking, tips, copying,
printing, telephone, overnight delivery, computer research, postage, telecopy
and other miscellaneous items. The Company shall have the right to pre-approve
expense charges which would exceed $7,500 in one calendar month.

         The term of this Engagement will be through October 12, 2003; however,
the Company may terminate the Engagement prior to the expiration of said term by
giving written notice of termination to TCOS at least ten days prior to any six
months anniversary of the letter agreement. At the inception of the Engagement
TCOS received 112,000 options at $1 3/4 and will be paid $6,000 per month in
fees each month thereafter.

PATENTS AND PROPRIETARY RIGHTS

         In July 1997, ABI and Hoffmann-La Roche (HLR) entered a license
agreement whereby ABI was granted patent rights to make, have made, use and sell
natural interferon alpha in the USA, under US Patent No. 4,503,035, owned by
HLR. This license will require ABI to pay a royalty to HLR on sales in the USA
until March 2002.

         Three patents issued in October and December, 1998 with claims valid
until the year 2015. Those patents are "Treatment of Bacterial Infection with
Oral Interferon-Alpha" (US Patent No. 5,817,307), "Treatment of Neoplastic
Disease with Oral Interferon" (US Patent No. 5,824,300) and "Treatment of
Autoimmune Disorders with Oral Interferon" (US Patent No. 5,846,526). Another
patent (US Patent No. 5,830,056) issued November 3, 1998 entitled "Treatment of
Viral Disease with Oral Interferon-Alpha"; because of a terminal disclaimer,
this patent has claims valid until May 28, 2008.

         A Notice of Allowance of Claims was received in November 1998 on US
Patent Application Serial No. 07/875/630 filed April 28, 1992; claims were
granted with a terminal disclaimer such that claims will be valid until December
13, 2002.

COMPETITION

         The pharmaceutical industry is an expanding and rapidly changing
industry characterized by intense competition. The Company believes that its
ability to compete will be dependent in large part upon its ability to
continually enhance and improve its products and technologies. In order to do
so, the Company must effectively utilize and expand its research and development
capabilities and, once developed, expeditiously convert new technology into
products and processes which can be commercialized. Competition is based
primarily on scientific and technological superiority, technical support,
availability of patent protection, access to adequate capital, the ability to
develop, acquire and market products and processes successfully, the ability to
obtain governmental approvals and the ability to serve the particular needs of
commercial customers. Corporations and institutions with greater resources than
the Company may, therefore, have a significant competitive advantage. The
Company's potential competitors include entities that develop and produce
therapeutic agents for

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treatment of human and animal disease. These include numerous public and private
academic and research organizations and pharmaceutical and biotechnology
companies pursuing production of, among other things, biologics from cell
cultures, genetically engineered drugs and natural and chemically synthesized
drugs. Almost all of these potential competitors have substantially greater
capital resources, research and development capabilities, manufacturing and
marketing resources and experience than the Company. The Company's competitors
may succeed in developing products or processes that are more effective or less
costly than any that may be developed by the Company, or that gain regulatory
approval prior to the Company's products. The Company also expects that the
number of its competitors and potential competitors will increase as more
IFN[alpha] products receive commercial marketing approvals from the FDA or
analogous foreign regulatory agencies. Any of these competitors may be more
successful than the Company in manufacturing, marketing and distributing its
products. There can be no assurance that the Company will be able to compete
successfully.

GOVERNMENT REGULATION

         The Company's research and development activities are subject to
comprehensive regulation by numerous governmental authorities in the United
States and other countries. If the Company is able to produce and market
products, such production and marketing will place the Company under continued
regulation. Among the applicable regulations in the United States,
pharmaceutical products are subject to the Federal Food, Drug and Cosmetic Act,
the Public Health Service Act, other federal statutes and regulations, and
certain state and local regulations. These statutes and regulations govern the
development, testing, formulation, manufacture, labeling, storage, record
keeping, quality control, advertising, promotion, sale, distribution and
approval of pharmaceutical products. Failure to comply with applicable
requirements can result in fines, recall or seizure of products, total or
partial suspension of production, refusal by the government to approve marketing
of the product and criminal prosecution.

         A new drug may not be legally marketed for commercial use in the United
States without FDA approval. In addition, upon approval, a drug may only be
marketed for the indications, in the formulations and at the dosage levels
approved by the FDA. The FDA also has the authority to withdraw approval of
drugs in accordance with applicable statutes and regulations. Analogous foreign
regulators impose similar approval requirements relating to commercial marketing
of a drug in their respective countries and may impose similar restrictions and
limitations after approval.

         In order to obtain FDA approval of a new product, the Company and its
strategic partners, if any, must submit proof of safety, efficacy, purity, and
stability, and the Company must demonstrate validation of its manufacturing
process. The testing and application process is expensive and time consuming,
often taking years to complete. There is no assurance that the FDA will act
favorably or quickly in reviewing applications. With respect to patented
products, processes or technologies, delays imposed or caused by the
governmental approval process may materially reduce the period during which the
Company will have the exclusive right to exploit them. Delays could also affect
the commercial advantages derived from proprietary processes. There is no
assurance that the regulatory agencies will find present or future submissions
of the Company to be adequate.

         The FDA approval process for a pharmaceutical product such as oral
IFN[alpha] includes review of (i) preclinical laboratory and animal studies to
enable FDA review of an Investigational New Drug

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("IND") or Investigational New Animal Drug ("INAD") applications, (ii) initial
clinical studies to define safety and dose parameters and (iii) well-controlled
clinical trials to demonstrate product efficacy and safety, followed by
submission and FDA approval of a Product License Application ("PLA") concerning
biologics and a New Drug Application ("NDA") with respect to drugs. FDA approval
of the NDA and/or PLA is required prior to any commercial sale or shipment of
the product, except as to certain exports.

         Preclinical studies involve laboratory evaluation of product
characteristics and animal studies to assess the safety of the product. The
results of the preclinical tests are submitted to the FDA as part of the IND or
INAD application and are reviewed by the FDA. Unless the FDA objects to an IND,
the application will become effective 30 days following its receipt by the FDA.
INADs need only be filed prior to the shipment of the drug or biologic for
testing. There can be no certainty that the FDA will not object to the
commencement of clinical studies concerning any drug or biologic.

         Human clinical trials are typically conducted in three sequential
phases with some amount of overlap allowed. Phase I trials normally consist of
testing the product in a small number of patient volunteers for establishing
safety (adverse effects), dosage tolerance, metabolism, distribution, excretion
and clinical pharmacology. In Phase II, the continued safety and initial
efficacy of the product are evaluated in a somewhat larger patient population,
and appropriate dosage amounts and treatment intervals are determined. Phase III
trials typically involve more definitive testing of the appropriate dose for
safety and clinical efficacy in an expanded patient population at multiple
clinical testing centers. A clinical plan, or "protocol," accompanied by the
approval of the institution participating in the trials, must be submitted to
the FDA prior to commencement of each clinical trial. Each clinical study must
be conducted under the auspices of an Institutional Review Board ("IRB") at the
institution performing the clinical study. An IRB may require changes in a
protocol, and there can be no assurance that an IRB will permit any given study
to be initiated or completed. In addition, the FDA may order the temporary or
permanent discontinuation of clinical trials at any time. In light of this
process, the Company must necessarily rely on other persons and institutions to
conduct studies. The Company cannot guarantee that such persons and institutions
will conduct studies properly. There also can be no assurance that Phase I,
Phase II and Phase III testing of the Company's products will be completed
successfully within any specified time period, if at all.

         All the results of the preclinical and clinical studies on a
pharmaceutical product are submitted to the FDA in the form of a PLA or NDA, for
approval to commence commercial distribution. Submission of a PLA or NDA does
not assure FDA approval for marketing. The application review process takes more
than two years on average to complete. However, the process may take
substantially longer if the FDA has questions or concerns about a product or
studies regarding the product. In general, the FDA requires at least two
adequate and well-controlled clinical studies demonstrating efficacy with
sufficient levels of statistical assurance. However, additional support may be
required. The FDA also may request additional information relating to safety or
efficacy, such as long-term toxicity studies. In responding to a PLA or NDA, the
FDA may grant marketing approval, require additional testing and/or information
or deny the application. Accordingly, there can be no assurance about any
specific time frame for approval, if any, of products by the FDA. The FDA also
may require post-marketing testing and surveillance to monitor the safety record
of a product and its continued compliance with regulatory requirements.


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<PAGE>   9


         The facilities of each pharmaceutical manufacturer must be registered
with and approved by the FDA as compliant with the agency's good manufacturing
practice regulations ("GMP"). For biologics, except certain well-characterized
ones, this requires the filing of an establishment license application ("ELA")
that must be approved by the FDA for the facility in which the product is
maintained. While the ELA and PLA are separate documents, they must be submitted
at the same time and both documents must be approved before the sale of the
biologic. Continued registration also requires compliance with the FDA's GMP
regulations. Products must be formulated in accordance with the FDA's GMP
requirements and preclinical tests must be conducted by laboratories that comply
with FDA regulations governing the testing of drugs in humans and animals. In
order to comply with GMP, manufacturers must continue to expend time, money and
effort in production, record keeping and quality control. In addition,
manufacturers must comply with regulations promulgated by the United States Drug
Enforcement Administration and similar state and local regulatory authorities if
they handle controlled substances, and they must be registered with the United
States Environmental Protection Agency and similar state and local regulatory
authorities if they generate toxic or dangerous waste streams. The Company
asserts that the manufacture or use of IFN[alpha] does not pose an environmental
hazard. Other regulatory agencies, such as the Occupational Safety and Health
Administration, also monitor manufacturing facilities for compliance with
workplace safety regulations. Each of these organizations conducts periodic
establishment inspections to confirm continued compliance with its regulations.
Failure to comply with any of these regulations could mean fines, interruption
of production and even criminal prosecution.

         For foreign markets, a pharmaceutical company is subject to regulatory
requirements, review procedures and product approvals which, generally, may be
as extensive, if not more extensive, as those in the United States. Although the
technical descriptions of the clinical trials are different, the trials
themselves are often substantially the same as those in the United States.
Approval of a product by regulatory authorities of foreign countries must be
obtained prior to commencing commercial product marketing in those countries,
regardless of whether FDA approval has been obtained. The time and cost required
to obtain market approvals in foreign countries may be greater than required for
FDA approval and may be subject to delay. There can be no assurance that
regulatory authorities of foreign countries will grant approval.

RESEARCH AND DEVELOPMENT

         During the years ended December 31, 1998 and 1997, the Company incurred
expenses of $1,372,850 and $1,650,415, respectively, resulting from
Company-sponsored research and development activities. Research and development
is expected to remain a significant component of the Company's business. The
Company has arranged for others to perform substantially all of its clinical
research and intends to continue to do so while utilizing its staff for
monitoring such research. See also ITEM 6, "MANAGEMENT'S 1999 PLAN OF OPERATIONS
- Research and Development".



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<PAGE>   10


ITEM 2.           DESCRIPTION OF PROPERTY.

         The Company's executive and administrative offices are located at 800
West 9th Avenue, Amarillo, Texas in a 5,200 square foot facility owned by the
Company. The building contains offices, meeting rooms and a biologic storage
area. The Company believes that the facility is adequate for its present and
anticipated use. The facility is insured against hazards in the amount of its
market value.

ITEM 3.           LEGAL PROCEEDINGS.

         None.

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

         None.




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                                     PART II

ITEM 5.           MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER
                  MATTERS

         Since August 8, 1996, the Company's common stock has traded on the
NASDAQ SmallCap Market under the symbol AMAR. The range of high and low sales
prices as quoted on the NASDAQ SmallCap Market for each quarter of 1998 and 1997
are as follows:

<TABLE>
<CAPTION>

                                 1998                      1997
                         --------------------       -------------------
           Quarter        High           Low         High          Low
           -------       -----          -----       -----         -----
<S>                      <C>            <C>         <C>           <C>  
            First        5.500          3.000       9.875         3.750
            Second       5.375          2.750       4.500         3.375
            Third        4.000          1.000       4.250         3.500
            Fourth       2.250           .313       6.500         3.250
</TABLE>

         As of March 5, 1999, the Company had 310 shareholders of record and
approximately 594 beneficial shareholders.

ITEM 6.           MANAGEMENT'S 1999 PLAN OF OPERATIONS

         The Company's Management has developed a Plan of Operations for 1999.
As a development stage company, the Company continues to engage in research and
development activities focused on developing biologics for the treatment of
human and animal diseases. The Company has not commenced any significant product
commercialization and, until such time as it does, will not generate significant
product revenues. The Company's accumulated deficit has continued to grow, from
$9,045,000 at December 31, 1997, to $11,378,000 at December 31, 1998. Operating
losses are expected to continue for the foreseeable future and until such time
as the Company is able to attain sales levels sufficient to support its
operations.

         In 1999 the Company will continue its research and development
activities, as well as the activities necessary to develop commercial
partnerships and licenses. The Company's expenditure of financial resources in
1999 will fall principally into six broad categories, as follows: Research and
Development; Personnel; Consulting and Professional (other than legal and
accounting); Legal; Public Relations, Investor Relations, and Shareholder
Relations; and Liquidity Needs. The Company's expectations and goals with
respect to these categories are addressed separately below, by category:

RESEARCH AND DEVELOPMENT

         Until it achieves commercial product sales, the Company's business is
research and development, and this is the area where the Company's principal
efforts will be expended in 1999. The Company has budgeted approximately $5.2
million for expenditure in 1999 on research and development, inclusive of
amounts to be expended on the Company's Phase III Sjogren's syndrome clinical
trial, which commenced at the end of 1998. A contract research organization is
managing the study.


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         The budgeted amount for Research and Development in 1999 includes
approximately $250,000 for fibromyalgia studies, and approximately $100,000 for
other human clinical trials, which includes some final costs relating to
completed studies. Other indications which will receive attention by the Company
in 1999 are hepatitis B and the treatment of oral warts in HIV-infected
patients.

PERSONNEL

         In addition to its intellectual property, the Company's principal
assets are its personnel. The Company has been successful in controlling its
personnel costs, both by maintaining its principal location in Amarillo, Texas,
and by ensuring maximum efficiency and utilization of existing personnel.
Important new management team members have been hired to complete the
progression from a research and development organization to a company with
commercially viable products. The Company has budgeted approximately $1 million
for personnel expenses in 1999, including salaries, payroll taxes, worker's
compensation insurance, directors and officers general liability insurance, and
group life, health, dental, and liability insurance.

         At the present time, the President and CEO of the Company, Joseph M.
Cummins, is also serving as the Company's Chief Financial Officer. Management
foresees a need to recruit a qualified individual to serve the company in the
finance and accounting areas. The Company's 1999 personnel budget therefore
includes salary and fringe benefits for such a person.

CONSULTING AND PROFESSIONAL (EXCEPT LEGAL AND ACCOUNTING)

         The Company has budgeted approximately $150,000 for expenditure on
professional consultants in 1999. Consulting fees are expected to be paid to the
Company's scientific advisory board; to certain directors who perform specific
consulting tasks at the Company's request; and to a number of independent
consultants, in connection with the operation of the Company. The Company will
continue to use the services of consultants to complement the Company's small
full-time staff, where such is a more efficient utilization of the Company's
resources.

LEGAL AND ACCOUNTING

         Although the Company is not involved in litigation, it has budgeted
legal expenses of approximately $180,000 in 1999. Almost 40% of the Company's
legal expenditures will be for preparation and filing of patents and for
maintenance of existing patents in a number of countries. Other legal expenses
will be related to compliance with laws and regulations affecting public
companies, licensing and contracting, and general corporate matters. The Company
does not presently have an in-house legal staff, nor does it intend to put such
a staff in place in 1999. The Company will maintain Ernst & Young as its
auditors.

PUBLIC RELATIONS, INVESTOR RELATIONS AND SHAREHOLDER RELATIONS

         The Company recognizes that its ability to raise capital will depend,
to some extent, upon its relations with both potential future investors and its
existing shareholders. In turn, such relationships are built upon the foundation
of adequate, timely, and comprehensible communications. Accordingly, the Company
has budgeted approximately $125,000 for expenditure on these items in 1999. The
expenditures will include payments to the Company's public relations
consultants, as well as the

                                       12

<PAGE>   13


Company's expenses in attending a number of meetings with analysts and
institutional investors. The Company has also budgeted sufficient amounts to
maintain its comprehensive web site (www.amarbio.com).

LIQUIDITY NEEDS

         The principal budget items discussed above, along with other
miscellaneous costs and expenses, will cause the Company to expend approximately
$6.8 million in 1999, including the substantial expense of the Company's Phase
III Sjogren's syndrome trial, and the additional personnel costs referred to
under "Personnel", above. At December 31, 1998, the Company had available cash
of $4,776,000. The Company will need to raise additional funds in order to
completely execute its 1999 Plan. Should a commitment for additional funds not
be obtained during the second quarter of 1999, the Company will take steps to
curtail clinical trial expenditures and to reduce staff and administrative
expenses. Management believes that based on the Company's ability to curtail
clinical trial expense and to reduce staff and administration expenses,
available funds are sufficient to meet its anticipated cash requirements for at
least the next twelve months.

THE YEAR 2000 ISSUE

ABI'S STATE OF READINESS

IT Systems. The Company owns relatively few information technology ("IT")
systems, consisting of approximately twelve (12) computers. The basic
input/output system ("BIOS") of each computer has been checked using publicly
available utilities designed for that purpose. With one exception, the BIOS of
each computer was found to be Year 2000 compliant. The non-compliant computer
was brought into compliance with software, and in a subsequent test, proved to
be Year 2000 compliant.

         The software used on the computers owned by ABI is all commercially
available, off-the-shelf software; ABI does not own any custom-made software.
The Year 2000 compliance of each of the programs has been verified with the
vendors of those programs, and all software used by the Company is either Year
2000 compliant or compliant with minor issues.

Non-IT Systems. The Company does not own any machines (other than the computers
mentioned above) that contain microprocessors or microcontrollers. Therefore,
the Company does not need to assess or plan for Year 2000 issues pertaining to
non-IT systems.

Third Parties. The Company is investigating the Year 2000 preparedness of those
third parties with which it has a material relationship. As the principal
business of the Company is testing the effectiveness of new drugs, the Company
sees two categories of third-party Year 2000 issues.

         First, the Company is investigating those third parties who are
essential in the production, packaging, and delivery of the test drugs
("clinical supplies") to the clinical trial sites. If any steps along the chain
of production of the drugs were interrupted by a Year 2000 issue, then the
supply of the clinical supplies to the clinical trial sites could be
interrupted. This would delay the clinical trials, and consequently delay
ultimate FDA approval for the drugs. The Company is in the 


                                       13

<PAGE>   14


process of investigating the Year 2000 preparedness of each of the companies
that plays a key role in the production, packaging, and distribution of the
drug.

         Second, the Company is taking steps to insure that clinical trial data
is not lost due to a Year 2000 issue. This requires an investigation of the
company that is managing the clinical trial, as well as the procedures used at
the various clinical trial sites, and the process by which the clinical data is
stored and transmitted back to the Company. We have already had initial contact
with PPD Pharmaco, the clinical trial manager, and they assure us that they
expect full Year 2000 compliance by the end of the first quarter of 1999.

         The Company has employed a consultant, Mr. James Corti, who is
responsible for assessing the Year 2000 preparedness of those third parties with
which the Company has a material relationship. While the responsiveness of those
third parties to our inquires is beyond the Company's control, we estimate that
Mr. Corti will conclude his Year 2000 assessment by the end of April, 1999.

         The Company has not yet encountered any actual Year 2000 problems,
except for one computer BIOS (see "IT Systems", above), which was corrected with
publicly available shareware at no cost to the Company. The Company therefore
has not spent any money on remediation. All of the costs incurred to date have
been related to the investigation of potential Year 2000 issues. All of the Year
2000 related costs should be incurred before the end of April, 1999. We
anticipate that these costs will not exceed $10,000.

THE RISK OF THE COMPANY'S YEAR 2000 ISSUES

         There are two ways in which the Company would be adversely affected by
a worst-case Year 2000 scenario.

         First, Year 2000 problems could interrupt the supply of clinical
supplies to clinical testing sites. If clinical supplies became corrupted and
had to be replaced, or if the supplies otherwise became temporarily unavailable,
this would cause a 3-6 month delay in the clinical trial. Such a delay would
delay the ultimate profits to the Company from sales of the drug by the same
amount of time.

         Second, a Year 2000 problem could result in damage to the clinical
trial data. Because the data is originally entered on hardcopy, that is, actual
pieces of paper, and because that hardcopy data is not destroyed, clinical trial
data can never by completely lost due to a Year 2000 problem. At most, the
computer data could be lost due to a Year 2000 problem, and the Company would
incur additional expense and delay to have the data re-entered from the original
hardcopies. The same is true for the study codes that reveal which trial
subjects used placebo: if a code were lost due to a computer error, then the
clinical trial data could be reconstructed from the hardcopies of the code kept
at the Company.

CONTINGENCY PLANS

Drug Supply. The Company has only one supplier for the drug itself, but does
have a second source for the processing and packaging of the drug into a usable
clinical trial form. The Company 

                                       14

<PAGE>   15


plans to establish a stockpile of each drug before beginning clinical trials.
This will provide a buffer against any possible interruption of supply due to a
Year 2000 problem. But stockpiling alone is not enough to guarantee a supply of
the drug during the clinical trials. In order to afford the greatest amount of
stability, clinical study supplies are refrigerated. Conceivably, a Year 2000
problem could cause the failure of the refrigeration system and ruin the supply
of the drug. Central storage of clinical supplies will be temporary only,
pending distribution to study sites, and will be at a location with adequate
backup systems, meaning those with the capability to generate electrical power
with fossil fuel fired generators, though the individual clinical trial sites
may not have these precautions. In the event of loss of trial supplies at one or
more trial sites, the Company will have the capability to replace such supplies,
within certain limits. Specifically, the Company orders 10% more of all clinical
supplies than will be required for conduct of the study, assays, and other
requirements. By way of example, the Company's Phase III Sjogren's syndrome
trial will involve 50 separate trial sites. Accordingly, the Company will have
sufficient clinical supplies to replace lost clinical supplies at five of those
trial sites. If the losses of clinical supplies exceeded that amount, the
Company would then be dependent upon its suppliers to replace such trial
supplies. If such suppliers had also experienced interruptions in their
manufacturing capability, the commencement of the trials at certain sites could
be delayed.

Data Integrity. Clinical trial data and the study codes used in the study will
be stored both in hardcopy form and on diskette. While the hardcopies should
provide the ultimate in data safety, the diskettes should also be safe from any
Year 2000 harm. The diskettes will provide a less expensive way of restoring
lost clinical trial data and study codes in the event of a Year 2000 problem.

FORWARD-LOOKING STATEMENTS

         Certain statements made in this Plan of Operations and elsewhere in
this report are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995 (the "Act"). Forward-looking statements
include, without limitation, any statement that may predict, forecast, indicate
or imply future results, performance, achievements, costs or expenses and may
contain words such as "believe", "anticipate", "expect", "estimate", "project",
"budget", or words or phrases of similar meaning. Forward-looking statements
involve risks and uncertainties which may cause actual results to differ
materially from those projected in the forward-looking statements. Such risks
and uncertainties are detailed from time to time in reports filed by the Company
with the SEC, including Forms 8-K, 10-QSB and 10-KSB, and include among others
the following: promulgation and implementation of regulations by the U.S. Food
and Drug Administration ("USFDA"); promulgation and implementation of
regulations by foreign governmental instrumentalities with functions similar to
those of the USFDA; costs of research and development and clinical trials,
including without limitation, costs of clinical supplies, packaging and inserts,
patient recruitment, trial monitoring, trial evaluation, and publication; and
possible difficulties in enrolling a sufficient number of qualified patients for
certain clinical trials. The Company is also dependent upon a broad range of
general economic and financial risks, such as possible increases in the costs of
employing and/or retaining qualified personnel and consultants, possible Year
2000 issues, and possible inflation which might affect the Company's ability to
remain within its budget forecasts. The principal uncertainties to which the
Company is presently subject are its inability to ensure that the results of the
Sjogren's syndrome Phase III trial, or any other trials performed by the
Company, will be sufficiently favorable to ensure eventual regulatory approval
for commercial sales, and its inability to accurately budget at 

                                       15

<PAGE>   16


this time the possible costs associated with hiring and retaining of additional
personnel to assist the Company both with its finance and accounting functions.

         The risks cited here are not exhaustive. Other sections of this report
may include additional factors which could adversely impact the Company's
business and future prospects. Moreover, the Company is engaged in a very
competitive and rapidly changing industry. New risk factors emerge from time to
time and it is not possible for management to predict all such risk factors, nor
can it assess the impact of all such risk factors on the Company's business, or
the extent to which any factor or combination of factors may cause actual
results to differ materially from those projected in any forward-looking
statements. Given these risks and uncertainties, investors should not place
undue reliance on forward-looking statements as a prediction of actual future
events.

ITEM 7.           FINANCIAL STATEMENTS.

         The financial statements of the Company are set forth beginning on page
F-1 immediately following the signature page of this report.

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

         None.

                                    PART III

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

         As of March 8, 1999, the directors and executive officers of the
Company were as follows:

<TABLE>
<CAPTION>

NAME                                                        AGE         POSITION
---------------------------------------------------        -----        ---------------------------------
<S>                                                     <C>            <C>                                          
Joseph Cummins, DVM, PhD (1)(3)....................         56          Chairman of the Board, President,
                                                                        Chief Executive Officer, Chief
                                                                        Financial Officer and Director

Stephen Chen, PhD (2)(4)...........................         49          Director

James Cook (1)(3)(5)...............................         64          Director

Thomas D'Alonzo (1)(2).............................         55          Director

Katsuaki Hayashibara (3)(4)(5).....................         55          Director

Brian McLean, MD (3)(5)............................         39          Director

Dennis Moore, DVM (1)(4)(5)........................         52          Director

James Page, MD (1)(2)(5)...........................         72          Director

Kathleen L. Kelleher...............................         51          Chief Operating Officer, Vice
                                                                        President Business Development
</TABLE>


                                       16

<PAGE>   17

<TABLE>
<CAPTION>

NAME                                                        Age         Position
---------------------------------------------------        ----         ----------------------------------
<S>                                                     <C>           <C>
The following are not executive officers, but are expected by the Company to make a
significant contribution to the business:

Philip C. Fox, DDS.................................         51          Director Research and Development

John M. Smith......................................         62          Director of Marketing and
                                                                        International Business Development

Martin J. Cummins..................................         32          Clinical Projects Director
</TABLE>

(1)   Member of the Executive Committee.
(2)   Member of the Compensation Committee.
(3)   Member of the Finance Committee.
(4)   Member of the Audit Committee.
(5)   Member of the Stock Option Plans Administration Committee.

         Joseph Cummins has been the Chairman of the Board of the Company since
he founded it in June 1984. Dr. Cummins has also served as President of the
Company since December 1994, and as Chief Financial Officer since October 1998.
He received a PhD degree in microbiology from the University of Missouri in 1978
and a doctor of veterinary medicine degree from Ohio State University in 1966.
Dr. Cummins has been conducting research concerning IFN since 1969.

         Stephen Chen has been a director of the Company since February 1996. He
has been President and Chief Executive Officer of STC International, Inc., a
health care investment firm, since May 1992. From August 1989 to May 1992 he was
Director of Pharmaceutical Research and Development for the Ciba Consumer
Pharmaceuticals Division of Ciba-Geigy.

         James Cook has been a director of the Company since 1988. He has been
President and Chief Executive Officer of the First National Bank of Arvada since
January 1992 and from April 1987 to December 1991 he was Executive Vice
President of First National Bank of Amarillo.

         Thomas D'Alonzo has been a director of the Company since 1997. He has
been President of Pharmaceutical Product Development, Inc., a global clinical
research organization, since 1996, was President of GENVEC, Inc., from 1993 to
1996, and was President of Glaxo, Inc. from 1983 to 1993.

         Katsuaki Hayashibara has been a director of the Company since 1994. 
Mr. Hayashibara was named Director of the Overseas Business Development Division
of Hayashibara Company, Ltd. in January 1997. Prior to 1997, Mr. Hayashibara
served as Director of Research and Development for HBL.

         Brian McLean has been a director of the Company since September 1996. 
Dr. McLean is an M.D. and received an MBA degree from UCLA in 1992. He is a
partner in a venture capital firm in New York City.

         Dennis Moore has been a director of the Company since 1986. Dr. Moore 
has been a doctor of veterinary medicine since 1972 and was in private practice
from 1972 to 1995. Since 1995, Dr. Moore has been involved in managing his
personal investments.


                                       17

<PAGE>   18




         James Page has been a director of the Company since February 1996.
Prior to retiring in 1991 as a Vice President with Adria Laboratories, Inc., a
pharmaceutical company specializing in therapy given to cancer and AIDS
patients, Dr. Page held various upper management level positions with Carter
Wallace, Inc., Merck Sharpe & Dohme Research Laboratories and Wyeth
Laboratories.

         Kathleen Kelleher has been an officer of the Company since January 
1999. Ms. Kelleher holds a Bachelor's Degree and a Master's Degree in Biology.
In addition, she holds a MBA from the University of Chicago. Ms. Kelleher has
spent the last twenty years working in the pharmaceutical and biopharmaceutical
industry. She has held senior management positions in marketing, business
development, licensing, product planning, strategic marketing, strategic
planning and operations. Most recently, Ms. Kelleher was employed as senior
director of licensing at G.D. Searle, the pharmaceutical division of Monsanto.

         Philip Fox joined Amarillo Biosciences as Director, Research and
Development in January 1999. Prior to that, he was at the National Institutes of
Health, National Institute of Dental and Craniofacial Research since 1976.
During his NIH tenure, he served as Clinical Director of the Intramural Research
Program, and Chief of the Clinical Investigations Section, Gene Therapy and
Therapeutics Branch. Dr. Fox is an oral/maxillofacial surgeon and a diplomate of
the American Board of Oral Medicine.

         John Smith has been an officer of the Company since December 1998.
During a long career in pharmaceutical marketing, he has held senior
marketing/business development positions with Pfizer and Bristol-Myers Squibb as
well as small companies in the U.S., Europe, Indonesia, China and Hong Kong.

         Martin Cummins has held several positions within Amarillo Biosciences
since joining the Company full-time in June 1992. Mr. Cummins currently oversees
all research studies involving human participants as Clinical Project Director.

         The Company's directors are elected at the annual meeting of
shareholders to hold office until the annual meeting of shareholders for the
ensuing year or until their successors have been duly elected and qualified. The
Company pays directors who are not employees of the Company a fee of $1,000 per
regularly scheduled Board meeting attended, or $250 for participation in a
regularly scheduled Board meeting by conference telephone. The Company
reimburses all directors for their expenses in connection with their attendance
at such meetings.

         Officers are elected annually by the Board of Directors and serve at
the discretion of the Board.

COMPLIANCE WITH SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

         Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act") requires directors and officers of the Company and persons who
own more than 10 percent of the Company's common stock to file with the
Securities and Exchange Commission (the "Commission") initial reports of
ownership and reports of changes in ownership of the common stock. Directors,
officers and more than 10 percent shareholders are required by the Exchange Act
to furnish the Company with copies of all Section 16(a) forms they file.

                                       18

<PAGE>   19

         To the Company's knowledge, based solely on a review of the copies of
such reports furnished to the Company and written representations that no other
reports were required during the year ended December 31, 1998, all filings
applicable to its directors, officers and more than 10 percent beneficial owners
were timely filed.

ITEM 10.          EXECUTIVE COMPENSATION.

         The following table sets forth for the three years ended December 31,
1998 compensation paid by the Company to its Chairman of the Board, President
and Chief Executive Officer; to its former Executive Vice-President and Chief
Financial Officer and to its Director of Marketing and International Business
Development. None of the Company's other executive officers had annual salary
and bonus in excess of $100,000 for services rendered during any of the three
years ended December 31, 1998.

                                            SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                                             Annual Compensation
                                                         ------------------------------------------------------------
  NAME AND PRINCIPAL POSITION                  YEAR           SALARY               BONUS         OTHER COMPENSATION
------------------------------------------     ----      -----------------       ------------    --------------------
<S>                                            <C>       <C>                     <C>            <C>
Dr. Joseph Cummins, Chairman                                                                                   --
     of the Board, President and                                                                 
     Chief Executive Officer..............     1998      $         120,000       $         --    $
                                               1997                120,000             20,000               12,000(3)
                                               1996                120,000                 --              252,000(4)
Charles Hughes, Executive Vice-                                                                                       
     President and Chief Financial                                                                                    
     Officer (1)..........................     1998                     --                 --                   --
                                               1997                147,435 (2)             --               10,333(3)
                                               1996                 75,000             10,000              157,575(5)
John Smith, Director of Marketing              
     and International Business
     Development..........................     1998                100,000                  -                   --
</TABLE>

(1)  Mr. Hughes terminated his employment with the Company on September 8, 1997.
(2)  Includes both 1997 salary and severance payments.
(3)  Represents a Company contribution to the Simplified Employee Pension Plan.
(4)  Represents the value of 30,000 shares of common stock issued at $5.00 per
     share and payment of withholding tax requirements in settlement of
     restricted stock grants and a Company contribution of $12,000 to the
     Simplified Employee Pension Plan.
(5)  Represents the value of 19,000 shares of common stock issued at $5.00 per
     share and payment of withholding tax requirements in settlement of
     restricted stock grants and a Company contribution of $7,500 to the
     Simplified Employee Pension Plan.




                                       19

<PAGE>   20

                              OPTION GRANTS IN 1998

        The following table sets forth certain information relating to options
granted in 1998 to the executive officers named above, to purchase shares of
common stock of the Company.

<TABLE>
<CAPTION>

                                               NUMBER OF                                                 
                                               SHARES OF                                                 
                                              COMMON STOCK          % OF TOTAL                                
                                               UNDERLYING        OPTIONS GRANTED     EXERCISE OR                             
                                                OPTIONS            TO EMPLOYEES       BASE PRICE    EXPIRATION
  NAME                                         GRANTED(#)            IN 1997            ($/SH)         DATE
-----------------------------------------     ------------       ---------------     -----------    ----------
<S>                                          <C>               <C>                  <C>           <C>    
John Smith...............................        40,000               67.8%           $1.75 (1)     09/13/2008
</TABLE>

(1) The fair market value of the common stock on the date of the grant.

                AGGREGATED OPTION EXERCISES AT DECEMBER 31, 1998
                           AND YEAR-END OPTION VALUES

        The following table sets forth information for the executive officers
named above, regarding the exercise of options during 1998 and unexercised
options held at the end of 1998.

<TABLE>
<CAPTION>

                                                                NUMBER OF SHARES OF        VALUE OF UNEXERCISED
                                                             COMMON STOCK UNDERLYING          IN-THE-MONEY
                                  SHARES                     UNEXERCISED OPTIONS AT            OPTIONS AT
                                 ACQUIRED ON     VALUE         DECEMBER 31, 1998(#)      DECEMBER 31, 1998($)(1)
NAME                             EXERCISE(#)   REALIZED($)  EXERCISABLE/UNEXERCISABLE   EXERCISABLE/UNEXERCISABLE
------------------------------- -------------  ------------ -------------------------   -------------------------
<S>                            <C>           <C>            <C>                         <C>
Joseph Cummins                       --             --         5,500    /    9,000         None    /      None
John Smith                            -             -            -      /    40,000        None    /      None
</TABLE>

(1)  Calculated based on the closing price of the common stock ($1.25) as
     reported by NASDAQ on December 30, 1998.

                   DIRECTOR COMPENSATION FOR LAST FISCAL YEAR

<TABLE>
<CAPTION>

                                                                         Cash Compensation                      Security Grants
                                                                  ------------------------------------          ---------------
                                                                                                                   NUMBER OF
                                                                                                                  SECURITIES
                                                                    MEETING                CONSULTING             UNDERLYING
                        NAME                                        FEES(1)                  FEES(2)                OPTIONS
-----------------------------------------------------             -----------             ------------          -------------
<S>                                                               <C>                     <C>                         <C>  
Stephen Chen, PhD                                                 $     2,000             $     45,950                5,000
James Cook                                                              2,000                    3,000                5,000
Thomas D'Alonzo                                                         2,000                        -                5,000
Katsuaki Hayashibara                                                    2,000                       --                5,000
Brian McLean, MD                                                        2,000                       --                5,000
Dennis Moore, DVM                                                       2,000                    4,500                5,000
James Page, MD                                                          1,000                    1,200                5,000
</TABLE>

(1)  Each director receives a fee of $1,000 for in-person attendance at each
     regular directors' meeting.

(2)  Each director receives $1,200 per day for employment on special projects or
     assignments.

                                       20

<PAGE>   21




ITEM 11.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
                  MANAGEMENT.

        As of December 31, 1998, there were 5,414,232 shares of the Company's
common stock outstanding. The following table sets forth as of December 31,
1998, the beneficial ownership of each person who owns more than 5% of such
outstanding common stock:

<TABLE>
<CAPTION>

NAME AND ADDRESS                                            NUMBER OF SHARES      PERCENT OF TOTAL
-----------------------------------------------             ----------------      ----------------
<S>                                                        <C>                  <C>
Hayashibara Biochemical Laboratories, Inc.                                                     
2-3 Shimoishii 1-chome                                                                                                   
Okayama 700, Japan                                              1,232,856                  22.8
Dr. Joseph Cummins                                                                         
800 West 9th Avenue                                                                                                      
Amarillo, Texas 79101                                             676,814(1)               12.5
Mesa Operating Limited Partnership                                                             
P.O. Box 2009                                                                                                            
Amarillo, Texas 79189-2009                                        315,120                   5.8
Mochida Pharmaceutical Co., Ltd.                                  
7, Yotsuya 1-chome
Shinjuku-Ku
Tokyo 160, Japan                                                  300,000                   5.5
</TABLE>

(1)   Includes an aggregate of 337,668 shares of common stock held by Joseph
      Cummins as trustee under certain trusts for the benefit of his children
      and 10,590 shares owned by Dr. Cummins' wife.

        The following table sets forth the beneficial ownership of the Company's
stock as of December 31, 1998 by each director, and by all executive officers
and directors as a group:

<TABLE>
<CAPTION>

DIRECTORS                                           NUMBER OF SHARES         PERCENT OF TOTAL
---------------------------------------------       ----------------         ----------------
<S>                                                 <C>                      <C> 
Joseph Cummins                                           676,814(1)               12.5
Dennis Moore                                             149,616                   2.8
James Cook                                                66,600(2)                1.2
Katsuaki Hayashibara                                      48,240                   1.0
Stephen Chen                                               7,900                     *
Thomas D'Alonzo                                            3,000                     *
Brian McLean                                                  --                    --
James Page                                                    --                    --
Total Group (all directors and                           952,170                    17.5
executive officers - 8 persons)
</TABLE>

*    Less than 1%
(1)  Includes an aggregate of 337,668 shares of common stock held by Joseph
     Cummins as trustee under certain trusts for the benefit of his children and
     10,590 shares owned by Dr. Cummins' wife.
(2)  All of such shares are owned jointly with Mr. Cook's wife.

                                       21

<PAGE>   22

ITEM 12.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         The Company has relied significantly on HBL, the largest shareholder of
the Company, for a substantial portion of its capital requirements. From 1989 to
1996, HBL has provided an aggregate of $9,000,000 of funding pursuant to the
Development Agreement, purchased from the Company an aggregate of 661,620 shares
of common stock for a total purchase price of $2,444,300 and made loans to the
Company aggregating $3,600,000, of which $1,000,000 loaned after March 31, 1996
was repaid simultaneously with the consummation of the IPO. As of December 31,
1998, the outstanding amount of the Company's indebtedness to HBL (including
accrued interest) was $2,808,356. HBL owns 1,232,856 shares, approximately 23%
of the Company's common stock. In addition to the Development Agreement, HBL and
the Company are parties to various license and manufacturing and supply
agreements pursuant to which the Company licenses certain technology to or from
HBL and HBL supplies formulations of its IFN[alpha] to the Company.

         Pursuant to a Stock Purchase Agreement entered into in September 1987
between the Company and Mesa, Inc. ("Mesa"), which owns 315,120 shares of common
stock, the Company has agreed that for as long as Mesa is a shareholder of the
Company, the Company shall not without the prior written approval of Mesa engage
in any repurchase or redemption of its issued and outstanding shares of common
stock, unless such repurchase or redemption is offered, pro rata, to all then
existing shareholders.

         During the years ended December 31, 1998 and 1997, the Company paid
$74,000 and $88,000, respectively, for legal services rendered by Morris, Moore,
Moss and Douglass, P.C. Edward Morris, the Secretary of the Company, is a member
of such firm.

         Although the Company believes that the foregoing transactions were on
terms no less favorable to the Company than would have been available from
unaffiliated third parties in arm's length transactions, there can be no
assurance that this is the case. All future transactions and loans between the
Company and its officers, directors and 5% shareholders will be on terms no less
favorable to the Company than could be obtained from independent third parties.
There can be no assurance, however, that future transactions or arrangements
between the Company and its affiliates will be advantageous, that conflicts of
interest will not arise with respect thereto or that if conflicts do arise, that
they will be resolved in favor of the Company.



                                       22

<PAGE>   23




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

EXHIBIT INDEX

<TABLE>
<CAPTION>

 NUMBER           DESCRIPTION
--------------    ---------------------------------------------------------------------------
<S>               <C>                                                  
3.1*              Restated Articles of Incorporation of the Company.

3.2*              Articles of Amendment of Restated Articles of Incorporation of the Company.

3.3*              Bylaws of the Company.

4.1*              Specimen Common Stock Certificate.

4.2*              Form of Underwriter's Warrant.

10.1*             Agreement dated as of April 1, 1984 between University Patents, Inc. and the
                  Company.

10.2*             License Agreement dated as of March 22, 1988 between the Company and The Texas
                  A&M University System.

10.3*             License Agreement dated October 20, 1989 between the Company and ISI.

10.4*             Manufacturing and Supply Agreement dated October 20, 1989 between the Company
                  and ISI.

10.5*             Joint Development and Manufacturing/Supply Agreement dated March 13, 1992
                  between the Company and HBL, as amended.

10.6*             Amended and Restated Agreement dated as of November 24, 1992 between Mitsubishi
                  and the Company.

10.7*             Japan Animal Health License Agreement dated January 20, 1993 between the
                  Company and HBL.

10.9*             Employment Agreement dated as of March 4, 1994 between the Company and Dr.
                  Joseph M. Cummins, as amended.

10.11*            Manufacturing/Supply Agreement dated June 1, 1994 between the Company and
                  HBL. 

10.12*            Settlement Agreement dated April 27, 1995 among the Company, ISI,
                  Pharma Pacific
                  Management Pty. Ltd. ("PPM"), Pharma Pacific Pty. Ltd., Pharma Pacific Ltd., and
                  Fernz Corporation Limited.

10.13*            Amendment of ACC/ISI License Agreement dated April 27, 1995 between the
                  Company and ISI.

10.14*            PPM/ACC Sub-license Agreement dated April 27, 1995 between PPM and the
                  Company.

10.15*            License and Supply Agreement dated July 10, 1995 between Veldona Africa, Inc.
                  ("VAF") and Innovative Therapeutics, Ltd. ("ITL").

10.16*            Pricing Amendment, dated December 5, 1995 between VAF and ITL.

10.18*            Form of Consulting Agreement between the Company and the Underwriter.

10.19*            Research Agreement dated March 25, 1996 between the Company and Ajinomoto Co.,
                  Inc.

10.20             1996 Employee Stock Option Plan, Amended and Restated as of September 12, 1998.

10.21             Outside Director and Advisor Stock Option Plan, Amended and Restated as of
                  September 12, 1998.
</TABLE>


                                       23

<PAGE>   24


<TABLE>
<CAPTION>

 NUMBER           DESCRIPTION
--------------    ---------------------------------------------------------------------------
<S>               <C>                                                                                
10.22*            Form of Indemnification Agreement between the Company and officers and directors
                  of the Company.

10.23*            Indemnification Agreement between HBL and the Company.

10.24*            Stock Purchase Agreement dated as of September 21, 1987 between Mesa Operating
                  Limited Partnership and the Company.

10.26**           License Agreement dated July 22, 1997, between Hoffmann-La Roche Inc., and the
                  Company.

10.27**           Distribution Agreement dated January 12, 1998, between Global Damon
                  Pharmaceutical and the Company.

10.28**           Distribution Agreement dated September 17, 1997, between HBL and the Company
                  (TNF-A).

10.29**           Distribution Agreement dated September 17, 1997, between HBL and the Company
                  (IFN-G).

10.30             Amendment No. 1 dated September 28, 1998 to License Agreement of March 22,
                  1988, between The Texas A&M University System and the Company.

10.31             Employment Agreement dated as of November 29, 1998 between the Company and
                  Kathleen L. Kelleher.

10.32             Employment Agreement dated as of September 14, 1998 between the Company and
                  Dr. Philip C. Fox.

10.33             Employment Agreement dated as of September 14, 1998 between the Company and
                  John Smith.

10.34             Engagement Agreement dated as of October 15, 1998 between Trust Company of the
                  South and the Company.

21.               Subsidiaries of the Company. The following sets forth the name
                  and jurisdiction of incorporation of each subsidiary of the
                  Company. All of such subsidiaries are wholly-owned by the
                  Company.
</TABLE>

<TABLE>
<CAPTION>
                       NAME                                      JURISDICTION OF INCORPORATION
                       -----------------------------             -----------------------------
<S>                                                            <C>
                       VANGUARD BIOSCIENCES, INC.                            TEXAS
                       VELDONA USA, INC.                                     TEXAS
                       VELDONA AFRICA, INC.                                  TEXAS
                       VELDONA POLAND, INC.                                  TEXAS
                       ABI TAIWAN, INC.                                      TEXAS
                       AMARILLO CELL OF CANADA, INC.                         TEXAS

27.                    Financial Data Schedule
</TABLE>

*The Exhibit is incorporated by reference to the exhibit of the same number to
the Company's Registration Statement on Form SB-2 filed with and declared
effective by the Commission (File No. 333-4413) on August 8, 1996. 
**The Exhibit is incorporated by reference to the Company's 1997 Annual Report
on Form 10-KSB filed with the Commission on or before March 31, 1998.

                                       24

<PAGE>   25




                               REPORTS ON FORM 8-K

         No reports on Form 8-K have been filed for the quarter ended December
31, 1998.



                                       25

<PAGE>   26



                                   SIGNATURES

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


                                AMARILLO BIOSCIENCES, INC.


                                By: /s/ JOSEPH M. CUMMINS
                                   --------------------------------------------
                                   Joseph M. Cummins, Chairman of the Board,
                                   President, Chief Financial Officer and Chief
                                   Executive Officer

Date:  March 26, 1999 
      -------------------------

Pursuant to the requirements of 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.

<TABLE>
<CAPTION>

Signature                                                          Title                                      Date
---------                                                          -----                                      ----
<S>                                                         <C>                                  <C>
/s/ JOSEPH M. CUMMINS                                                                                March 26, 1999 
---------------------------------------                       Chairman of the Board,                ------------------------------
Joseph M. Cummins                                             President, Chief Financial
                                                              Officer, Director and
                                                              Chief Executive Officer
/s/ JAMES COOK                                                                                       March 26, 1999 
---------------------------------------                       Director                              ------------------------------
James Cook
/s/ DENNIS MOORE                                                                                     March 26, 1999 
---------------------------------------                       Director                              ------------------------------
Dennis Moore
/s/ JAMES PAGE                                                                                       March 26, 1999 
---------------------------------------                       Director                              ------------------------------
James Page
/s/ BRIAN MCLEAN                                                                                     March 26, 1999 
---------------------------------------                       Director                              ------------------------------
Brian McLean
</TABLE>
<PAGE>   27
                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

                        Consolidated Financial Statements

                          Year ended December 31, 1998



                                    CONTENTS


<TABLE>
<CAPTION>

<S>                                                              <C>
Report of Independent Auditors ...................................F-1


Audited Consolidated Financial Statements


Consolidated Balance Sheets ......................................F-2

Consolidated Statements of Operations.............................F-3

Consolidated Statements of Stockholders' Equity (Deficit).........F-4

Consolidated Statements of Cash Flows ............................F-7

Notes to Consolidated Financial Statements........................F-9
</TABLE>



<PAGE>   28




                         Report of Independent Auditors



The Board of Directors
Amarillo Biosciences, Inc.

We have audited the accompanying consolidated balance sheets of Amarillo
Biosciences, Inc. and subsidiaries (companies in the development stage) as of
December 31, 1998 and 1997, and the related consolidated statements of
operations, stockholders' equity (deficit) and cash flows for the years then
ended. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits. The financial statements for the period June 25,
1984, (inception) through December 31, 1991, were audited by other auditors
whose report dated July 12, 1992, which has been furnished to us, expressed an
unqualified opinion on those statements. The financial statements for the period
June 25, 1984, (inception) through December 31, 1991, include total revenues and
net loss of $643,566 and $3,901,236, respectively. Our opinion on the statements
of operations, stockholders' equity (deficit), and cash flows for the period
June 25, 1984, (inception) through December 31, 1998, insofar as it relates to
amounts for prior periods through December 31, 1991, is based solely on the
report of other auditors.

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

In our opinion, based on our audits and the report of other auditors, the
financial statements referred to above present fairly, in all material respects,
the consolidated financial position of Amarillo Biosciences, Inc. and
subsidiaries as of December 31, 1998 and 1997, and the consolidated results of
their operations and their cash flows for the years then ended, and the period
from June 25, 1984 (inception) through December 31, 1998, in conformity with
generally accepted accounting principles.




                                                               ERNST & YOUNG LLP

Dallas, Texas
February 11, 1999


                                       F-1

<PAGE>   29




                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

                           Consolidated Balance Sheets

<TABLE>
<CAPTION>

                                                                          DECEMBER 31,
                                                               ------------------------------
                                                                   1998              1997
<S>                                                            <C>               <C>         
ASSETS
Current assets:
   Cash and cash equivalents                                   $  4,776,328      $    879,170
   Marketable securities                                               --           6,007,182
   Other current assets                                              43,415            70,779
                                                               ------------      ------------
Total current assets                                              4,819,743         6,957,131

Property and equipment, net                                         116,761           125,179
Patent license, net of accumulated amortization of $81,177
   and $73,824 in 1998 and 1997, respectively                        43,823            51,176
Organizational costs, net of accumulated amortization of
   $6,084 and $4,962 in 1998 and 1997, respectively                    --               1,122
Investment in ISI common stock                                        5,735           114,023
                                                               ------------      ------------
Total assets                                                   $  4,986,062      $  7,248,631
                                                               ============      ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Accounts payable                                            $     88,920      $     74,754
   Accrued interest expense                                         208,356            91,356
   Accrued legal expense                                              1,609            28,341
   Accrued vacation                                                  19,000            19,000
   Other accrued expense                                                113               617
                                                               ------------      ------------
Total current liabilities                                           317,998           214,068

Notes payable                                                     2,600,000         2,600,000
                                                               ------------      ------------
Total liabilities                                                 2,917,998         2,814,068

Commitments and contingencies

Stockholders' equity
   Common stock, $.01 par value:
   Authorized shares -10,000,000
   Issued shares- 5,414,232 in 1998 and 1997                         54,142            54,142
   Additional paid-in capital                                    13,392,138        13,392,138
   Deficit accumulated during the development stage             (11,378,216)       (9,045,415)
   Accumulated other comprehensive income                              --              33,698
                                                               ------------      ------------
Total stockholders' equity                                        2,068,064         4,434,563
                                                               ------------      ------------
Total liabilities and stockholders' equity                     $  4,986,062      $  7,248,631
                                                               ============      ============
</TABLE>

See accompanying notes.

                                       F-2

<PAGE>   30




                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

                      Consolidated Statements of Operations

<TABLE>
<CAPTION>

                                                                                CUMULATIVE
                                                                               FROM JUNE 25,
                                                                                   1984
                                                                               (INCEPTION)
                                            YEAR ENDED        YEAR ENDED         THROUGH
                                            DECEMBER 31,      DECEMBER 31,      DECEMBER 31,
                                               1998               1997             1998
                                            ------------      ------------      ------------ 
<S>                                         <C>               <C>               <C>         
Revenues:
   Contract revenues                        $       --        $       --        $  9,000,000
   Interferon sales                                 --                 396           420,974
   Interest income                               296,819           411,700         1,414,637
   Sublicense fees                                  --                --             113,334
   Royalty income                                   --                --              31,544
   Gain (loss) on sale of ISI stock              (74,590)          188,562           113,972
   Other                                              60            52,000           604,431
                                            ------------      ------------      ------------ 
                                                 222,289           652,658        11,698,892
Expenses:
   Research and development expenses           1,372,850         1,650,415        11,352,444
   Selling, general, and administrative
      expenses                                 1,065,240         1,355,435        10,872,720
   Interest expense                              117,000           118,060           816,944
                                            ------------      ------------      ------------ 
                                               2,555,090         3,123,910        23,042,108

                                            ------------      ------------      ------------ 
Loss before income taxes                      (2,332,801)       (2,471,252)      (11,343,216)
Income tax expense                                  --                --              35,000
                                            ------------      ------------      ------------ 
Net loss                                    $ (2,332,801)     $ (2,471,252)     $(11,378,216)
                                            ============      ============      ============

Basic and diluted net loss per share        $      (0.43)     $      (0.46)
                                            ============      ============

Weighted average shares outstanding            5,414,232         5,414,232
                                            ============      ============
</TABLE>


See accompanying notes.



                                       F-3

<PAGE>   31



                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

            Consolidated Statements of Stockholders' Equity (Deficit)
      Cumulative from June 25, 1984 (Inception) through December 31, 1998


<TABLE>
<CAPTION>

                                                                                                                       DEFICIT
                                                                                                                     ACCUMULATED
                                                                           COMMON STOCK            ADDITIONAL        DURING THE
                                                       ISSUANCE     -------------------------       PAID IN          DEVELOPMENT
                                                        PRICE           SHARES       AMOUNT         CAPITAL             STAGE
                                                     ----------     ----------     ----------     ------------      --------------
<S>                                                  <C>                <C>        <C>            <C>               <C>           
1984
Initial issuance for cash                            $     0.29         84,000     $      840     $     23,660      $       --    
Initial issuance in exchange for legal fees                0.29         30,000            300            8,450              --    
Initial issuance in exchange for services
   research and development costs and                      0.01      1,086,000         10,860           (9,955)             --    

1985
Issuance for cash                                          0.83        102,000          1,020           83,980              --    
Issuance in exchange for professional fees
   salaries and research services                          0.83         10,800            108            8,892              --    

1986
Issuance in exchange for professional fees
   salaries and services                                   0.83         22,800            228           18,772              --    
Treasury stock purchase; 11,040 shares at cost                            --             --               --                --    
Issuance for cash                                     0.83-1.25        182,352          1,824          154,626              --    
Issuance in exchange for professional fees
   salaries and research services                          0.83         19,020            190           15,660              --    

1987
Issuance for cash                                     1.25-2.08        309,648          3,096          445,974              --    
Treasury stock purchase; 2,400 shares at cost                             --             --               --                --    

1988
Issuance for cash                                          1.88        120,972          1,210          225,613              --    

1989
Issuance for cash                                          2.08          2,568             26            5,324              --    
Issuance for cash                                          2.50        227,748          2,277          567,093              --    

1990
Issuance for cash                                     1.72-2.50        592,584          5,926        1,108,634              --    
Issuance for cash                                          4.17        174,000          1,740          723,260              --    
Issuance in exchange for note receivable from
   stockholder                                             2.50         54,540            545          135,805              --    

1991
Repayment of note receivable from stockholder                             --             --               --                --    
Net loss and total comprehensive loss cumulative
   from June 25, 1984 (inception) through
   December 31, 1991                                                      --             --               --          (3,901,236) 


<CAPTION>


                                                                           
                                                                           NOTE                                        
                                                        UNREALIZED      RECEIVABLE                              TOTAL
                                                        GAIN (LOSS)        FROM             TREASURY          STOCKHOLDERS'
                                                       ON INVESTMENT    STOCKHOLDER          STOCK              EQUITY
                                                       -------------    -----------       ----------        ---------------
<S>                                                    <C>              <C>               <C>               <C>         
1984
Initial issuance for cash                              $       --       $       --        $       --        $     24,500
Initial issuance in exchange for legal fees                    --               --                --               8,750
Initial issuance in exchange for services
   research and development costs and                          --               --                --                 905

1985
Issuance for cash                                              --               --                --              85,000
Issuance in exchange for professional fees
   salaries and research services                              --               --                --               9,000

1986
Issuance in exchange for professional fees
   salaries and services                                       --               --                --              19,000
Treasury stock purchase; 11,040 shares at cost                 --               --             (22,500)          (22,500)
Issuance for cash                                              --               --                --             156,450
Issuance in exchange for professional fees
   salaries and research services                              --               --                --              15,850

1987
Issuance for cash                                              --               --                --             449,070
Treasury stock purchase; 2,400 shares at cost                  --               --              (3,500)           (3,500)

1988
Issuance for cash                                              --               --                --             226,823

1989
Issuance for cash                                              --               --                --               5,350
Issuance for cash                                              --               --                --             569,370

1990
Issuance for cash                                              --               --                --           1,114,560
Issuance for cash                                              --               --                --             725,000
Issuance in exchange for note receivable from
   stockholder                                                 --           (136,350)             --                --

1991
Repayment of note receivable from stockholder                  --            136,350              --             136,350
Net loss and total comprehensive loss cumulative
   from June 25, 1984 (inception) through
   December 31, 1991                                           --               --                --          (3,901,236)
</TABLE>


                                       F-4

<PAGE>   32



                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

            Consolidated Statements of Stockholders' Equity (Deficit)
      Cumulative from June 25, 1984 (Inception) through December 31, 1998

<TABLE>
<CAPTION>

                                                                                                                       DEFICIT
                                                                                                                     ACCUMULATED
                                                                           COMMON STOCK             ADDITIONAL        DURING THE
                                                      ISSUANCE      --------------------------       PAID IN          DEVELOPMENT
                                                        PRICE         SHARES         AMOUNT          CAPITAL             STAGE
                                                     ----------     ----------     -----------    -------------      --------------
<S>                                                  <C>                <C>        <C>            <C>               <C>           
1992
Net loss and total comprehensive loss for year
    ended December 31, 1992                                                --        $     --     $      --         $   (505,558) 
                                                                     ---------       ---------    -------------     ------------
Balance at December 31, 1992                                         3,019,032          30,190        3,515,788       (4,406,794) 

1993
Net loss and total comprehensive loss for year
    ended December 31, 1993                                                --              --             --            (108,363) 
                                                                     ---------       ---------    -------------     ------------
Balance at December 31, 1993                                         3,019,032          30,190        3,515,788       (4,515,157) 

1994
Net loss and total comprehensive loss for year
    ended December 31, 1994                                                --             --              --            (129,239) 
Adjustment to unrealized loss on investments                               --             --              --               --     
                                                                                                                                  
Total comprehensive loss
                                                                     ---------       ---------    -------------     ------------
Balance at December 31, 1994                                         3,019,032          30,190        3,515,788       (4,644,396) 

1995
Issuance for stock grant                                   2.50         29,640             297           73,803            --     
Net loss for year ended December 31, 1995                                  --             --              --            (311,579) 
Adjustment to unrealized loss on investments                               --             --              --               --     
                                                                                                                                  
Total comprehensive loss                                                                                                          
                                                                     ---------       ---------    -------------     ------------
Balance at December 31, 1995                                         3,048,672          30,487        3,589,591       (4,955,975) 

1996
Issuance for cash                                           5.00     2,300,000          23,000        9,354,502            --     
Issuance for stock grant                                    5.00        79,000             790          394,210            --     
Warrants issued for cash                                                   --             --                200            --     
Cancellation of treasury stock                                         (13,440)           (135)         (25,865)           --     
Net loss for year ended December 31, 1996                                  --             --              --          (1,618,188) 
Adjustment to unrealized loss on investments                               --             --              --               --     
                                                                                                                                  
Total comprehensive loss                                                                                                          
                                                                     ---------       ---------    -------------     ------------
Balance at December 31, 1996                                         5,414,232          54,142       13,312,638       (6,574,163) 

1997
Net loss for year ended December 31, 1997                                  --             --              --          (2,471,252) 
Adjustment to unrealized gain (loss) on investment                         --             --              --               --     
                                                                                                                                  
Total comprehensive loss                                                                                                          
                                                                                                                                  
Options issued for professional services                                   --             --             79,500            --     
                                                                     ---------       ---------    -------------     ------------
Balance at December 31, 1997                                         5,414,232       $  54,142    $  13,392,138     $ (9,045,415) 
                                                                     =========       =========    =============     ============


<CAPTION>

                                                                           NOTE                                        
                                                        UNREALIZED      RECEIVABLE                              TOTAL
                                                        GAIN (LOSS)        FROM             TREASURY          STOCKHOLDERS'
                                                       ON INVESTMENT    STOCKHOLDER          STOCK              EQUITY
                                                       -------------    -----------       ----------        ---------------
<S>                                                    <C>              <C>               <C>               <C>         
1992
Net loss and total comprehensive loss for year
    ended December 31, 1992                            $      --        $      --         $      --         $      (505,558)
                                                       ---------        ---------         ---------         ---------------
Balance at December 31, 1992                                  --               --           (26,000)               (886,816)

1993
Net loss and total comprehensive loss for year
    ended December 31, 1993                                   --               --                --                (108,363)
                                                       ---------        ---------         ---------         ---------------
Balance at December 31, 1993                                  --               --           (26,000)               (995,179)

1994
Net loss and total comprehensive loss for year
    ended December 31, 1994                                   --               --                --                (129,239)
Adjustment to unrealized loss on investments             (57,316)              --                --                 (57,316)
                                                                                                            ---------------
Total comprehensive loss                                                                                           (186,555)
                                                       ---------        ---------         ---------         ---------------
Balance at December 31, 1994                             (57,316)              --           (26,000)             (1,181,734)

1995
Issuance for stock grant                                      --               --                --                  74,100
Net loss for year ended December 31, 1995                     --               --                --                (311,579)
                                                            
Adjustment to unrealized loss on investments              57,316               --                --                  57,316
                                                                                                            ---------------
Total comprehensive loss                                                                                           (254,263)
                                                       ---------        ---------         ---------         ---------------
Balance at December 31, 1995                                  --               --           (26,000)             (1,361,897)

1996
Issuance for cash                                             --               --                --               9,377,502
Issuance for stock grant                                      --               --                --                 395,000
Warrants issued for cash                                      --               --                --                     200
Cancellation of treasury stock                                --               --            26,000                      --
Net loss for year ended December 31, 1996                     --               --                --              (1,618,188)
Adjustment to unrealized loss on investments              (3,500)              --                --                  (3,500)
                                                                                                            ---------------
Total comprehensive loss                                                                                         (1,621,688)
                                                       ---------        ---------         ---------         ---------------
Balance at December 31, 1996                              (3,500)              --                --               6,789,117

1997
Net loss for year ended December 31, 1997                     --               --                --              (2,471,252)
Adjustment to unrealized gain (loss) on investment        37,198               --                --                  37,198
                                                                                                            ---------------
Total comprehensive loss                                                                                         (2,434,054)
                                                                                                            ---------------
Options issued for professional services                      --               --                --                  79,500
                                                       ---------        ---------         ---------         ---------------
Balance at December 31, 1997                           $  33,698        $      --         $      --         $     4,434,563
                                                       =========        =========         =========         ===============

</TABLE>



                                       F-5

<PAGE>   33



                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

            Consolidated Statements of Stockholders' Equity (Deficit)
      Cumulative from June 25, 1984 (Inception) through December 31, 1998

<TABLE>
<CAPTION>
                                                                                                                       DEFICIT
                                                                                                                     ACCUMULATED
                                                                           COMMON STOCK             ADDITIONAL        DURING THE
                                                      ISSUANCE        -----------------------       PAID IN          DEVELOPMENT
                                                        PRICE           SHARES       AMOUNT          CAPITAL             STAGE
                                                     ----------       ----------   ----------     --------------    --------------
<S>                                                  <C>           <C>            <C>            <C>               <C>           
Net loss for year ended December 31, 1998                                   -- $   $      --      $         --      $   (2,332,801)
Adjustment to unrealized gain (loss) on investment                          --            --                --                --  
                                                                                                                                  
Total comprehensive loss                                              ---------    ----------     --------------    --------------
Balance at December 31, 1998                                          5,414,232    $   54,142     $   13,392,138    $  (11,378,216)
                                                                      =========    ==========     ==============    ==============
<CAPTION>

                                                                           NOTE                                        
                                                        UNREALIZED      RECEIVABLE                              TOTAL
                                                        GAIN (LOSS)        FROM             TREASURY          STOCKHOLDERS'
                                                       ON INVESTMENT    STOCKHOLDER          STOCK              EQUITY
                                                       -------------    -----------       ----------        ---------------
<S>                                                    <C>              <C>               <C>               <C>         
Net loss for year ended December 31, 1998              $          --    $        --       $       --        $     (2,332,801)
Adjustment to unrealized gain (loss) on investment           (33,698)            --               --                (33,698)
                                                                                                            ---------------
Total comprehensive loss                                                                                         (2,366,499)
                                                       -------------    -----------       ----------        ---------------
Balance at December 31, 1998                           $          --    $        --       $       --        $     2,068,064
                                                       =============    ===========       ==========        ===============
</TABLE>

See accompanying notes.


                                       F-6

<PAGE>   34




                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

                      Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>

                                                                                        CUMULATIVE
                                                                                        FROM JUNE 25,
                                                                                           1984
                                                                                        (INCEPTION)
                                                  YEAR ENDED         YEAR ENDED           THROUGH
                                                  DECEMBER 31,      DECEMBER 31,         DECEMBER 31,
                                                     1998              1997                 1998
                                                 -------------      -------------      ------------- 
<S>                                              <C>                <C>                <C>           
OPERATING ACTIVITIES
Net loss                                         $  (2,332,801)     $  (2,471,252)     $ (11,378,216)
Adjustments to reconcile net loss to
   net cash used in operating activities:
   Loss on impairment of ISI stock                      74,590               --               74,590
   Depreciation                                         19,486             21,388            190,466
   Amortization                                          8,475              7,648             92,217
   Discount on investment in ISI                          --             (125,325)            24,675
   Recognition of deferred sub-license
     fees                                                 --                 --              (32,844)
   Organization costs                                     --               (1,087)           (11,040)
   Gain (loss) on sale of assets                          --                1,002             (7,373)
   Common stock issued for stock grant                    --                 --              469,100
   Common stock issued for services                       --                 --               53,505
   Options issued for services                            --               79,500             79,500
Changes in operating assets and liabilities:
   Other current assets                                 27,364             36,756            (43,415)
   Accounts payable                                     14,166            (63,544)            88,920
   Accrued expenses                                     89,764           (199,339)           229,078
                                                 -------------      -------------      ------------- 
Net cash used in operating activities               (2,098,956)        (2,714,253)       (10,170,837)

INVESTING ACTIVITIES
Sale (purchase) of marketable
   securities                                        6,007,182            (22,812)              --
Capital expenditures                                   (11,068)           (12,688)          (322,925)
Proceeds from sale of equipment                           --                9,626             23,071
Purchase of patent license                                --                 --             (125,000)
Sale of (investment in) ISI common
   stock                                                  --              520,000           (105,000)
                                                 -------------      -------------      ------------- 
Net cash used in investing activities            $   5,996,114      $     494,126      $    (529,854)
</TABLE>


                                       F-7

<PAGE>   35




                           Amarillo Biosciences, Inc.
                                and Subsidiaries
                      (companies in the development stage)

                Consolidated Statements of Cash Flows (continued)

<TABLE>
<CAPTION>

                                                                                CUMULATIVE
                                                                                FROM JUNE 25,
                                                                                  1984
                                                                                (INCEPTION)
                                          YEAR ENDED          YEAR ENDED         THROUGH
                                          DECEMBER 31,       DECEMBER 31,       DECEMBER 31,
                                              1998               1997               1998
                                          -------------     -------------      -------------
<S>                                       <C>               <C>                <C>          
FINANCING ACTIVITIES
Receipt of sub-license fees               $        --       $        --        $      32,844
Proceeds from notes payable                        --             300,000          2,600,000
Repayment of note receivable from
   stockholder for purchase of common
   stock                                           --                --              136,350
Issuance of common stock                           --                --           12,733,825
Acquisition of treasury stock                      --                --              (26,000)
                                          -------------     -------------      -------------
Net cash provided by financing
   activities                                      --             300,000         15,477,019
                                          -------------     -------------      -------------
Net increase (decrease) in cash and
   cash equivalents                           3,897,158        (1,920,127)         4,776,328
Cash and cash equivalents at
   beginning of period                          879,170         2,799,297               --
                                          -------------     -------------      -------------
Cash and cash equivalents at end of
   period                                 $   4,776,328     $     879,170      $   4,776,328
                                          =============     =============      =============

SUPPLEMENTAL INFORMATION
Cash paid for income taxes                $        --       $        --        $      37,084
                                          =============     =============      =============

Cash paid for interest                    $        --       $        --        $       6,466
                                          =============     =============      =============
</TABLE>

See accompanying notes.



                                       F-8

<PAGE>   36



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

                   Notes to Consolidated Financial Statements

                                December 31, 1998



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTS POLICIES

ORGANIZATION

Amarillo Biosciences, Inc. (the Company), is a development stage company,
developing and marketing within the United States and internationally
applications of low dose oral IFN[alpha] in both humans and animals. The Company
is currently conducting clinical studies as part of the process of obtaining
regulatory approval from the United States Food and Drug Administration (FDA),
so that commercial marketing can begin in the United States.

The Company's viability is dependent upon successful commercialization of
products resulting from its research and product development activities. All of
the Company's products will require significant additional development,
laboratory and clinical testing and investment prior to obtaining regulatory
approval to commercially market its product(s). Accordingly, for at least the
next few years, the Company will continue to incur research and development and
general and administrative expenses and likely will not generate sufficient
revenues from product sales to support its operations.

The Company has been dependent upon financing from its stockholders. The
Company's development-stage-through-1991 activities were financed primarily
through the issuance of common stock. From 1991 to August 1996, such activities
were financed under an agreement (described in Note 4) with a major stockholder.
In August 1996, the Company completed its initial public offering receiving net
proceeds of approximately $9,378,000.

The Company's 1999 Plan of Operations calls for the Company to expend
approximately $6.8 million in 1999, including the substantial expense of the
Company's Phase III Sjogren's syndrome trial (see "Management's 1999 Plan of
Operations" elsewhere herein). At December 31, 1998, the Company had available
cash of $4,776,000. The Company will need to raise additional funds in order to
completely execute its 1999 Plan. The Company is presently negotiating with a
major investor in an attempt to raise additional funds. Should a commitment for
additional funds not be obtained during the second quarter of 1999, the Company
will take steps to curtail clinical trial expenditures and to reduce staff and
administrative expenses. Management believes that based on the Company's ability
to curtail clinical trial expense and to reduce staff and administration
expenses, available funds are sufficient to meet its anticipated cash
requirements for at least the next twelve months.

The Company has no current arrangements with respect to further sources of
financing and there can be no assurance that any of its officers, directors or
stockholders (including the major stockholder) will provide any portion of the
Company's future financing requirements.

                                       F-9

<PAGE>   37



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTS POLICIES (CONTINUED)

The possible inability to obtain further financing would have a material adverse
effect on the Company, including possibly requiring the Company to cease
operations.

PRINCIPLES OF CONSOLIDATION

The accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries, Amarillo Cell of Canada, Inc.,
Veldona Africa, Inc., Veldona Poland, Inc., Veldona USA, Inc., Vanguard
Biosciences, Inc. and ABI Taiwan, Inc. (all Texas corporations). All significant
intercompany balances and transactions have been eliminated in consolidation.
The effect of translation of foreign currencies is not material.

MARKETABLE SECURITIES AND INVESTMENT IN ISI COMMON STOCK

Marketable securities and the investment in ISI common stock are classified as
held-to-maturity and available-for-sale, respectively. Held-to-maturity
securities are carried at amortized cost and matured in September 1998.
Available-for-sale securities are carried at fair value, with any unrealized
gain or loss reported as a separate component of stockholders' equity.

CONCENTRATION OF CREDIT RISK

At December 31, 1998, the Company's cash equivalents were invested principally
in money market accounts, a substantial portion of which are uninsured.

CASH AND CASH EQUIVALENTS

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost. Depreciation is calculated using
methods that approximate the declining balance method over the estimated useful
lives of the assets.

PATENT LICENSE

The patent license represents payments made under one of the license agreements
described in Note 5. The agreement remains in effect over the life of the
underlying patents. Accordingly, the patent license fee is being amortized over
17 years using the straight-line method.

                                      F-10

<PAGE>   38



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTS POLICIES (CONTINUED)

INCOME TAXES

The Company files a consolidated income tax return with its domestic
subsidiaries, Amarillo Cell of Canada, Inc., Veldona Africa, Inc., Veldona
Poland, Inc., Veldona USA, Inc., Vanguard Biosciences, Inc. and ABI Taiwan, Inc.

On January 1, 1993, the Company changed its method of accounting for income
taxes from the deferred method to the liability method required by Statement of
Financial Accounts Standards No. 109, Accounting for Income Taxes (Statement No.
109). As permitted by the new rules, prior years' financial statements have not
been restated. The effect of adopting Statement No. 109 was not material.

REVENUE RECOGNITION

Contract revenue for research and development performed under the manufacturing
and supply agreement with Hayashibara Biochemical Laboratories, Inc. (HBL) (see
Note 4) was recorded as earned based on research and administrative costs
incurred. Amounts received in advance of services to be performed were recorded
as deferred revenue until expenses were incurred. The remaining balance of all
contract revenue received from HBL was recorded as earned in 1996.

RESEARCH AND DEVELOPMENT

Research and development costs are expensed as incurred.

USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.

STOCK SPLIT

In May 1993, the Company approved a ten-for-one stock split for all issued and
outstanding shares. As described in Note 7, during 1996 a six-for-five stock
split was effected. All references to common stock and per share data have been
restated to give effect to these splits.

                                      F-11

<PAGE>   39



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTS POLICIES (CONTINUED)

STOCK-BASED COMPENSATION

The Company accounts for stock-based compensation utilizing Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB
25). In October 1996, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards Number 123, Accounting for Stock Based
Compensation (SFAS 123). Under the provisions of SFAS 123, the Company has
elected to continue to apply the provisions of APB 25 to its stock-based
compensation arrangements and provide supplementary financial statement
disclosures as required under SFAS 123.

BASIC AND DILUTED NET LOSS PER SHARE

Net loss per share is based on the number of weighted average shares
outstanding. The effect of warrants and options outstanding (see Note 7) is
anti-dilutive.

COMPREHENSIVE INCOME

As of January 1, 1998, the Company adopted Financial Accounting Standards Board
Statement No. 130 (Statement 130), Reporting Comprehensive Income. Statement 130
establishes new rules for the display of comprehensive income and its
components; however, the adoption of this Statement had no impact on the
Company's results of operations or shareholders' equity. Statement 130 requires
unrealized gains or losses on the Company's available-for-sale securities, which
prior to adoption were reported separately in shareholders' equity, to be
included in other comprehensive income. Prior year financial statements have
been reclassified to conform to the requirements of Statement 130.

2. PROPERTY AND EQUIPMENT

Property and equipment are stated at cost and consist of the following:

<TABLE>
<CAPTION>

                                       DECEMBER 31,
                                  ---------------------
                                     1998         1997
<S>                               <C>          <C>     
Land                              $  8,000     $  8,000
Building                            94,532       94,532
Furniture and equipment            128,157      117,943
Automobile                          13,688       13,688
                                  --------     --------
                                   244,377      234,163
Less accumulated depreciation      127,616      108,984
                                  --------     --------
                                  $116,761     $125,179
                                  ========     ========
</TABLE>

                                      F-12

<PAGE>   40

                  Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)


3. NOTES PAYABLE

In September 1991 the Company borrowed $1,000,000 under a note payable agreement
with HBL. In September 1992, the Company borrowed an additional $1,000,000 under
a similar note agreement with HBL. The $1,000,000 note plus accrued interest of
$300,000 due September 25, 1996 was renewed in a new note to HBL for $1,300,000
due September 25, 2001 which accrues interest at the rate of 4 1/2%. The
$1,000,000 note plus accrued interest of $300,000 due September 16, 1997 was
renewed in a new note to HBL for $1,300,000 due September 16, 2002 which accrues
interest at the rate of 4 1/2%. Each of the notes provide that the principal and
accrued interest be paid only from 10% of the Company's gross revenues from
sales of interferon. All payments are to be applied first to accrued interest.
As repayment of the notes is dependent on future sales, management is unable to
estimate the fair value of the notes at December 31, 1998. Because material
amounts of sales are not expected in the next twelve months, the notes continue
to be classified as non-current liabilities.

4. MANUFACTURING AND SUPPLY AGREEMENTS

The Company was a party to the following manufacturing and supply agreements at
December 31, 1998:

On March 13, 1992, the Company entered into a Joint Development and
Manufacturing/Supply Agreement with HBL (the Development Agreement), a major
stockholder (see Note 7) under which HBL will formulate, manufacture, and supply
HBL interferon for the Company or any sub-licensee. In exchange, HBL is entitled
to receive a transfer fee, specified royalties and a portion of any payment
received by the Company for sub-license of rights under this agreement. The
agreement further provides that the Company sub-license to HBL the right to
market HBL interferon for oral use in humans and in non-human, warm-blooded
species in Japan, in exchange for the Company receiving a royalty fee based on
net sales. On June 1, 1994, the Company entered into an additional agreement
with HBL to make the Company HBL's exclusive agent for the development of HBL
interferon for non-oral use in humans and in non-human, warm-blooded species in
North America. In exchange, HBL is entitled to receive a transfer fee based on
units of interferon supplied.

Under the Development Agreement, HBL provided $9,000,000 in research funding to
the Company. The agreement also provides that a royalty fee be paid to HBL. The
initial term of the agreement is for seven years, but it will be renewed
automatically for successive three-year terms subject to prior written
agreement. HBL can terminate the agreement at any time after the end of the
first renewal term if certain conditions are not met.



                                      F-13

<PAGE>   41



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



4. MANUFACTURING AND SUPPLY AGREEMENTS (CONTINUED)

On October 20, 1989, the Company entered into a manufacturing and supply
agreement with Interferon Sciences, Inc. (ISI), then a 1% stockholder of the
Company under which ISI will manufacture and utilize ISI interferon to formulate
and supply interferon-containing compositions to the Company for use in
non-human species. Under the Agreement, ISI is entitled to receive certain
transfer fees, manufacturing and supply fees, and a portion of any payments
received by the Company related to the use of ISI interferon. The agreement will
be in force for seven years after ISI's receipt of the first purchase order from
the Company and thereafter as long as net sales of such products by the Company
meet certain levels. As of December 31, 1998, the Company has not submitted a
purchase order to ISI.

5. LICENSE AND SUBLICENSE AGREEMENTS

The Company holds patent rights for which the Company has paid certain license
fees under three license agreements. Under these agreements, the Company will
pay the licensor a portion of any sub-license fee received by the Company with
respect to the manufacturing, use or sale of a licensed product, as well as a
royalty fee based on the net selling price of licensed products, subject to a
minimum annual royalty. The Company has also entered into various sub-license
agreements under which the Company is entitled to receive royalties based on the
net sales value of licensed products.

6. RESEARCH AGREEMENTS

The Company contracts with third parties throughout the world to conduct
research including studies and clinical trials. These agreements are generally
less than one year in duration. At December 31, 1998, the Company had
commitments to provide additional funding of approximately $192,000 under these
agreements.

7. COMMON STOCK

In May 1993, the stockholders of the Company approved an amendment to the
Articles of Incorporation to increase the total number of authorized shares of
common stock of the Company from one million shares to ten million shares. The
stockholders also approved a ten-for-one stock split for the currently issued
and outstanding shares of the Company. Since 1984, the Company has issued common
stock in exchange for various professional, research, and consulting services.
The stock issued for non-cash consideration was assigned a value based on the
fair value of the services received.


                                      F-14

<PAGE>   42



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



7. COMMON STOCK (CONTINUED)

In December 1989, the Company issued 218,400 shares of stock to HBL for $2.50
per share. In February 1990, an additional 174,000 shares were issued to HBL for
$4.17 per share, and in November 1990, an additional 69,120 shares were issued
to HBL for $2.50 per share. These shares, combined with purchases from various
other stockholders and the 200,100 shares purchased by HBL in the public
offering, give HBL control of 23% of the outstanding common stock, or 1,232,856
shares at December 31, 1998.

In July 1992, the Board of Directors approved restricted stock grants to three
employees which allowed the Company to issue, under certain conditions, up to
180,000 shares of its authorized but unissued shares of common stock. In May
1994 the Board of Directors approved restricted stock grants to an additional
employee which allowed the Company to issue, under certain conditions, up to
30,000 shares of its authorized but unissued shares of common stock. In January
1995, 29,640 shares of common stock (net of required federal withholdings of
12,360 shares) were issued to a former employee under a Contract Termination and
Severance Agreement. The issuance and withholding were in full satisfaction of
the employee's original 84,000 shares in stock grants. In August 1996, 79,000
shares of common stock (net of required federal withholdings of 47,000 shares)
were issued to the other three employees. The issuance and withholding were in
full satisfaction of the three employees original 126,000 shares in stock
grants. Total charges to compensation expense recognized by the Company
cumulative from June 25, 1984 (inception) through December 31, 1998 was
$735,000.

In August 1996, the Company completed its initial public offering and issued
5,300,000 shares of common stock resulting in net proceeds of approximately
$9,377,702.

In addition to stock options discussed in Note 8, the Company has 200,000 shares
of Common Stock reserved for issuance upon exercise of warrants granted to the
Company's Underwriter (exercisable through August 2000 at $8.10 per share).

During 1997, the Company granted 30,000 options to outside professionals for
services which vested immediately at an exercise price of $4.25 (fair market
value of the common stock at the date of the grant). The Company recognized
$79,500 (representing the fair value of the options) in expense relating to
these grants.

Under a stock purchase agreement with a stockholder. Mesa. Inc. (Mesa), the
Company is prohibited from repurchasing or redeeming any of its issued and
outstanding shares without the prior written approval of Mesa unless such
redemption or repurchase is offered pro rata to all stockholders.


                                      F-15

<PAGE>   43



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



8. STOCK OPTION PLAN

The Company has elected to follow APB 25 and related interpretations in
accounting for its stock-based compensation. Under APB 25, because the exercise
price of the Company's stock options has been equal to or greater than the
market price of the underlying stock on the date of grant, no compensation
expense has been recognized.

During 1996, the Company introduced two stock option plans: the 1996 Employee
Stock Option Plan (Employee Plan) and the Outside Director and Advisor Stock
Option Plan (Director Plan). The Employee Plan has authorized the grant of
options to employees for up to a maximum of 390,000 shares of the Company's
common stock. All options granted have five to ten year terms and become
exercisable over a four to five year period. The option price is equal to 100%
to 110% of the fair value of the common stock on the date of grant depending on
the percentage of common stock owned by the optionee on the grant date. The
Director Plan allows options to purchase a maximum of 210,000 shares of the
Company's common stock to be granted to outside directors and scientific
advisors to the Company at an exercise price equivalent to 100% of the fair
market value of the common stock on the date of grant. The ten year options
become exercisable over a period of five years.

Supplemental information regarding net loss and net loss per share is required
by SFAS 123 and has been determined as if the Company had accounted for its
stock options under the fair value method of that Statement. The fair value for
these options was estimated at the date of grant using the Black-Scholes option
pricing model with the following weighted average assumptions for 1998 and 1997,
respectively: risk-free interest rate of 5.55% and 6.61%; dividend yield of 0%
and 0%; volatility factors of the expected market price of the Company's common
stock of .822 and .692; and a weighted-average expected life of the option of
3.2 and 4.9 years.

The Black-Scholes option 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 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 stock options.

For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period and the expense for
1998 and 1997 are not necessarily indicative of the effects on reported net
income (loss) for future years. The Company's pro forma information as of
December 31, is as follows:

                                      F-16

<PAGE>   44



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



8. STOCK OPTION PLAN (CONTINUED)

<TABLE>
<CAPTION>

                                                         1998                1997
                                                   --------------      ------------- 
<S>                                                <C>                 <C>           
Pro forma net loss                                 $   (2,358,342)     $  (2,544,335)
Pro forma basic and diluted net loss per share     $        (0.44)     $       (0.47)
</TABLE>

Based on the Black-Scholes method, the fair value of the options granted as of
December 31, is as follows:


<TABLE>
<CAPTION>

                                                               1998            1997
                                                           -----------     -----------
<S>                                                       <C>              <C>   
Number of options issued at fair market value of stock         104,000          66,000
Weighted-average fair value of options                     $      1.12     $      2.48
Weighted-average exercise price of options                 $      1.92     $      3.94

Number of options issued in excess of fair                        --             7,000
   market value of stock
Weighted average fair value of options                            --       $      2.11
Weighted average exercise price of options                        --       $      4.27
</TABLE>

A summary of the Company's stock option activity, and related information for
the year ended December 31, is as follows:


<TABLE>
<CAPTION>

                                                 1998                             1997
                                        ------------------------          -------------------------
                                                      WEIGHTED                          WEIGHTED
                                                      AVERAGE                           AVERAGE
                                                      EXERCISE                          EXERCISE
                                        OPTIONS        PRICE              OPTIONS         PRICE
                                        -------       ----------          -------       -----------
<S>                                     <C>         <C>                   <C>          <C>         
Outstanding, beginning of year          188,500     $       4.64          135,500      $       5.10
Granted                                 104,000             1.92           73,000              3.97
Expired, unexercised                       --               --            (20,000)             5.25
Exercised                                  --               --               --                --
                                        -------                           -------
Outstanding, end of year                292,500     $       3.68          188,500      $       4.64
                                        =======                           =======

Exercisable at end of year               62,900     $       4.80           23,875      $       5.08
                                        =======                           =======
</TABLE>

Exercise prices for options outstanding as of December 31, 1998 ranged from
$1.75 to $5.50. The weighted-average remaining contractual life of those options
is 8.75 years.



                                      F-17

<PAGE>   45



                   Amarillo Biosciences, Inc. and Subsidiaries
                      (companies in the development stage)

             Notes to Consolidated Financial Statements (continued)



9. EMPLOYEE BENEFIT PLAN

The Company has a Simplified Employee Pension Plan (the Plan) which is a
contributory plan that covers all employees of the Company. Contributions to the
Plan are at the discretion of the Company. The plan expense for the years ended
December 31, 1998 and 1997, and cumulative from June 25, 1984 (inception)
through December 31, 1998 was $0, $49,131 and $200,857, respectively.

10. INCOME TAXES

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax reporting purposes. Significant
components of the Company's deferred tax liabilities and assets are as follows
at December 31:


<TABLE>
<CAPTION>

                                                              1998             1997
                                                          -----------      -----------
<S>                                                       <C>              <C>        
Deferred tax liability:
    Prepaid expenses                                      $    14,287      $    24,065
Deferred tax assets:
    Net operating loss and AMT carryforward                 3,332,332        2,599,564
    Accrued interest and note payable                         256,683          235,061
    Depreciation and amortization                             159,410          116,520
    Other                                                      72,572           67,509
                                                          -----------      -----------
                                                            3,820,997        3,018,654
Valuation allowance for deferred tax assets                (3,806,710)      (2,994,589)
                                                          -----------      -----------
Total deferred tax assets, net of valuation allowance          14,287           24,065
                                                          -----------      -----------
Net deferred taxes                                        $      --        $      --
                                                          ===========      ===========
</TABLE>

At December 31, 1998, the Company has net operating loss carryforwards of
approximately $9,695,000 for federal income tax purposes expiring in 2006. The
ability of the Company to utilize these carryforwards may be limited should
changes in stockholder ownership occur in the future.

At December 31, 1998, the Company had approximately $36,000 of alternative
minimum tax credits which may be carried forward indefinitely.

The difference between the reported income tax provision and the benefit
normally expected by applying the statutory rate to the loss before income taxes
results primarily from the inability of the Company to recognize its tax losses.


                                      F-18

<PAGE>   46



11. CONTINGENCIES

The Company is not a party to any litigation and is not aware of any pending
litigation or unasserted claims or assessments as of December 31, 1998.

12. RELATED PARTY TRANSACTIONS

In the ordinary course of business, the Company has and expects to have
transactions with related parties, including stockholders. In addition to the
transactions disclosed elsewhere in these financial statements, such related
party transactions included legal fees of approximately $74,000 and $88,000 paid
to Morris, Moore, Moss and Douglass, P.C., a member of which is an officer and
stockholder of the Company, in 1998 and 1997, respectively. The Company also
employs various stockholders as researchers and consultants and pays fees based
on contractual agreements.

13. SETTLEMENT OF LITIGATION

Commencing in 1993, the Company was the plaintiff in litigation involving a
patent infringement action in New Zealand. In May 1996, a settlement was reached
whereby the Company: (1) amended its manufacturing and supply agreement with ISI
to allow the sub-license of certain products previously exclusively licensed to
ISI and purchased 312,500 shares of ISI common stock for $625,000, or $2 per
share, representing the quoted market price of ISI stock at that time; and (2)
received $550,000 cash from the defendant in the lawsuit, comprising $50,000 in
exchange for a sub-license of the technology that was the subject of the lawsuit
and $500,000 as a payment toward research and development costs incurred by the
Company.

As a result of restrictions on the sale by the Company of its ISI stock until
August 1997, the Company discounted the ISI stock (quoted price $1.66 per share
at December 31, 1996) to a carrying value of $471,500 at December 31, 1996 and
during 1995 charged $150,000 to selling, general and administrative expenses and
charged $3,500 to unrealized loss on marketable securities in 1996.

During 1997, after a four for one reverse stock split, the Company sold 65,000
shares of ISI stock for $580,850 and realized a gain on the sale of $188,562.

At December 31, 1998, the Company determined that its investment in ISI common
stock had permanently declined in value and accordingly recognized a loss on the
ISI stock of $74,590, representing the difference between the Company's cost
basis in the ISI common stock and its quoted market price at December 31, 1998.



                                      F-19

<PAGE>   47

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
 
 EXHIBIT
 NUMBER           DESCRIPTION
--------------    ---------------------------------------------------------------------------
<S>               <C>                                                  
 3.1*             Restated Articles of Incorporation of the Company.

 3.2*             Articles of Amendment of Restated Articles of Incorporation of the Company.

 3.3*             Bylaws of the Company.

 4.1*             Specimen Common Stock Certificate.

 4.2*             Form of Underwriter's Warrant.

10.1*             Agreement dated as of April 1, 1984 between University Patents, Inc. and the
                  Company.

10.2*             License Agreement dated as of March 22, 1988 between the Company and The Texas
                  A&M University System.

10.3*             License Agreement dated October 20, 1989 between the Company and ISI.

10.4*             Manufacturing and Supply Agreement dated October 20, 1989 between the Company
                  and ISI.

10.5*             Joint Development and Manufacturing/Supply Agreement dated March 13, 1992
                  between the Company and HBL, as amended.

10.6*             Amended and Restated Agreement dated as of November 24, 1992 between Mitsubishi
                  and the Company.

10.7*             Japan Animal Health License Agreement dated January 20, 1993 between the
                  Company and HBL.

10.9*             Employment Agreement dated as of March 4, 1994 between the Company and Dr.
                  Joseph M. Cummins, as amended.

10.11*            Manufacturing/Supply Agreement dated June 1, 1994 between the Company and
                  HBL. 

10.12*            Settlement Agreement dated April 27, 1995 among the Company, ISI,
                  Pharma Pacific
                  Management Pty. Ltd. ("PPM"), Pharma Pacific Pty. Ltd., Pharma Pacific Ltd., and
                  Fernz Corporation Limited.

10.13*            Amendment of ACC/ISI License Agreement dated April 27, 1995 between the
                  Company and ISI.

10.14*            PPM/ACC Sub-license Agreement dated April 27, 1995 between PPM and the
                  Company.

10.15*            License and Supply Agreement dated July 10, 1995 between Veldona Africa, Inc.
                  ("VAF") and Innovative Therapeutics, Ltd. ("ITL").

10.16*            Pricing Amendment, dated December 5, 1995 between VAF and ITL.

10.18*            Form of Consulting Agreement between the Company and the Underwriter.

10.19*            Research Agreement dated March 25, 1996 between the Company and Ajinomoto Co.,
                  Inc.

10.20             1996 Employee Stock Option Plan, Amended and Restated as of September 12, 1998.

10.21             Outside Director and Advisor Stock Option Plan, Amended and Restated as of
                  September 12, 1998.
</TABLE>



<PAGE>   48


<TABLE>
<CAPTION>

 EXHIBIT
 NUMBER           DESCRIPTION
--------------    --------------------------------------------------------------------------------
<S>               <C>                                                                                
10.22*            Form of Indemnification Agreement between the Company and officers and directors
                  of the Company.

10.23*            Indemnification Agreement between HBL and the Company.

10.24*            Stock Purchase Agreement dated as of September 21, 1987 between Mesa Operating
                  Limited Partnership and the Company.

10.26**           License Agreement dated July 22, 1997, between Hoffmann-La Roche Inc., and the
                  Company.

10.27**           Distribution Agreement dated January 12, 1998, between Global Damon
                  Pharmaceutical and the Company.

10.28**           Distribution Agreement dated September 17, 1997, between HBL and the Company
                  (TNF-A).

10.29**           Distribution Agreement dated September 17, 1997, between HBL and the Company
                  (IFN-G).

10.30             Amendment No. 1 dated September 28, 1998 to License Agreement of March 22,
                  1988, between The Texas A&M University System and the Company.

10.31             Employment Agreement dated as of November 29, 1998 between the Company and
                  Kathleen L. Kelleher.

10.32             Employment Agreement dated as of September 14, 1998 between the Company and
                  Dr. Philip C. Fox.

10.33             Employment Agreement dated as of September 14, 1998 between the Company and
                  John Smith.

10.34             Engagement Agreement dated as of October 15, 1998 between Trust Company of the
                  South and the Company.

21.               Subsidiaries of the Company. The following sets forth the name
                  and jurisdiction of incorporation of each subsidiary of the
                  Company. All of such subsidiaries are wholly-owned by the
                  Company.
</TABLE>

<TABLE>
<CAPTION>

                       NAME                                      JURISDICTION OF INCORPORATION
                       -----------------------------             -----------------------------
<S>                                                              <C>
                       VANGUARD BIOSCIENCES, INC.                            TEXAS
                       VELDONA USA, INC.                                     TEXAS
                       VELDONA AFRICA, INC.                                  TEXAS
                       VELDONA POLAND, INC.                                  TEXAS
                       ABI TAIWAN, INC.                                      TEXAS
                       AMARILLO CELL OF CANADA, INC.                         TEXAS

27.               Financial Data Schedule
</TABLE>

*The Exhibit is incorporated by reference to the exhibit of the same number to
the Company's Registration Statement on Form SB-2 filed with and declared
effective by the Commission (File No. 333-4413) on August 8, 1996. 

**The Exhibit is incorporated by reference to the Company's 1997 Annual Report
on Form 10-KSB filed with the Commission on or before March 31, 1998.