<PAGE>   1
 
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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                             ---------------------
 
                                   FORM 10-K
                                      FOR
                         ANNUAL AND TRANSITION REPORTS
                                  PURSUANT TO
                            SECTIONS 13 OR 15(D) OF
                      THE SECURITIES EXCHANGE ACT OF 1934
 
<TABLE>
<C>               <S>
   (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, 1997

                                               OR

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

                  FOR THE TRANSITION PERIOD FROM ____________ TO ____________
</TABLE>
 
                       COMMISSION FILE NUMBER: 001-13037
 
                             SERVICE EXPERTS, INC.
             (Exact Name of Registrant as Specified in Its Charter)
 
<TABLE>
<S>                            <C>
          DELAWARE                         62-1639458
(State or Other Jurisdiction            (I.R.S. Employer
     of Incorporation or              Identification No.)
        Organization)

111 WESTWOOD PLACE, SUITE 420                37027
    BRENTWOOD, TENNESSEE                   (ZIP CODE)
    (ADDRESS OF PRINCIPAL
     EXECUTIVE OFFICES)
</TABLE>
 
       Registrant's Telephone Number, Including Area Code: (615) 371-9990
 
          Securities registered pursuant to Section 12(b) of the Act:
 
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<S>                                                <C>
   COMMON STOCK, $.01 PAR VALUE PER SHARE                    NEW YORK STOCK EXCHANGE
           (Title of Each Class)                   (Name of Each Exchange on Which Registered)
</TABLE>
 
          Securities registered pursuant to Section 12(g) of the Act:
                                      NONE
                                (Title of Class)
 
     Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.  Yes [X]  No [ ]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  [ ]
 
     The aggregate market value of the shares of Common Stock (based upon the
closing sale price of these shares as reported on the New York Stock Exchange on
March 12, 1998) of the registrant held by non-affiliates on March 12, 1998, was
approximately $382,194,329.
 
     As of March 12, 1998, 15,827,993 shares of the registrant's Common Stock
were outstanding.
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                      DOCUMENTS INCORPORATED BY REFERENCE
 
     Documents incorporated by reference and the part of Form 10-K into which
the document is incorporated:
 
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<S>                                                           <C>
Portions of the Company's Proxy Statement relating to its
  Annual Meeting of Stockholders to be held on May 1,
  1998......................................................  Part III
</TABLE>
 
                                     PART I
 
ITEM 1.  BUSINESS
 
GENERAL
 
     Service Experts, Inc. (the "Company") is one of the leading providers of
residential heating, ventilating and air conditioning ("HVAC") services and
replacement equipment in the United States, and management believes that the
Company will continue to be a leading consolidator of the fragmented HVAC
service and replacement industry. The Company currently operates 63 HVAC service
and replacement businesses ("Service Centers") in 28 states and owns Contractor
Success Group, Inc., a company that provides HVAC businesses proprietary
products, as well as marketing, management, educational and advisory services
("CSG"). The Service Centers install, service and maintain central air
conditioners, furnaces and heat pumps, primarily in existing homes. Management
estimates that approximately 80% of the Company's pro forma net revenue in 1997,
giving effect to all completed and pending acquisitions, was related to
replacing, maintaining and servicing HVAC equipment at existing residences, and
to the sale of ancillary products such as indoor air quality ("IAQ") devices and
services.(1) The Company focuses on the service and replacement segment of the
HVAC industry rather than the new construction segment because management
believes that the service and replacement segment offers higher margins and
exposes the Company to less credit risk. The service and replacement segment
offers more attractive pricing because of customers' demands for immediate,
convenient and reliable service.
 
     Management intends to develop a national presence through acquisitions and
a national reputation for superior, high quality service which will enable the
Company to appeal to a large number of customers. The Company has implemented an
aggressive acquisition strategy, acquiring 71 HVAC businesses (the "1997
Acquired Companies") during 1997 with aggregate annualized residential HVAC
service and replacement revenue for the year ended December 31, 1997 of
approximately $162.0 million. Subsequent to December 31, 1997, the Company has
acquired ten HVAC businesses with aggregate annualized HVAC service and
replacement revenue of approximately $22.8 million (the "1998 Acquired
Companies"). The Company currently has agreements in principle to acquire during
the first six months of 1998 four additional HVAC businesses (the "Pending
Acquisitions") with aggregate revenue in 1997 of approximately $7.8 million. The
Company's 1997 pro forma net revenue, giving effect to the acquisition of the
1997 Acquired Companies, the 1998 Acquired Companies and the companies included
in the Pending Acquisitions, was approximately $321.3 million.
 
HVAC SERVICE AND REPLACEMENT INDUSTRY
 
     The HVAC industry consists of the installation, replacement, maintenance,
service and repair of HVAC systems at existing residences and commercial
businesses and the installation of HVAC systems at newly constructed homes and
businesses. The Company primarily provides installation and replacement services
to existing homes and small to medium-sized businesses.
 
     According to Air Conditioning, Heating and Refrigeration News, there are
approximately 43 million central air conditioners, 54 million furnaces and nine
million heat pumps in operation in homes in the United States. Management
estimates, based on industry information, that the market for the service and
replace-
 
---------------
 
(1) All references herein to the Company's 1997 pro forma results assume the
    completion as of January 1, 1997 of the acquisitions being discussed.
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ment of HVAC systems in existing homes is approximately $24 billion annually.
The installation and replacement segment of the industry has increased in size
as a result of the aging of the installed base of residential systems, the
introduction of new, energy efficient systems and the upgrading of existing
homes to central air conditioning. According to the Air Conditioning and
Refrigeration Institute, over 61 million central air conditioners have been
installed in the United States since 1975. Many of the units installed from the
mid-1970s to the mid-1980s are reaching the end of their useful lives, thus
providing a growing replacement market. In addition, in recent years, increased
governmental regulation restricting the use of ozone depleting refrigerants in
HVAC systems has contributed to the growing replacement market. See
"Regulation."
 
     According to Air Conditioning, Heating, and Refrigeration News, over 30,000
HVAC contractors are currently operating in the United States. Management
believes that HVAC businesses are typically closely held, single-center
operations that serve a limited geographic area and are heavily dependent upon
referrals to generate business. Management believes that, in many cases, these
businesses are operated by former service technicians who lack the business and
marketing expertise to expand their businesses, increase their profitability and
compete effectively with larger operators. Management believes that larger
companies are able to operate more efficiently, offer customers a broader array
of products and services and provide a higher level of customer service than
smaller operators. Management believes that these competitive advantages are the
result of greater managerial and financial resources as well as economies of
scale in purchasing and marketing expenses. Management believes that these
factors will continue to promote a trend toward consolidation in the industry
and present an opportunity for well-capitalized operators to acquire additional
businesses on favorable terms.
 
ACQUISITIONS
 
     The Company's goal is to become the leading provider of residential HVAC
services and replacement equipment in the United States through the acquisition
of HVAC businesses in new markets, the integration of HVAC businesses in
existing markets and the continued revenue and profit growth of its Service
Centers.
 
  Strategy
 
     The Company has implemented an aggressive acquisition program utilizing a
"hub and spoke" strategy for expansion into new geographic areas and further
penetration into existing markets. The U.S. residential HVAC service industry is
currently highly fragmented. Management believes that many HVAC businesses,
which lack the capital necessary to expand operations and the ability to exit
their business profitably, will desire to affiliate with the Company because the
Company will provide (i) business and marketing systems that enable a company to
operate more profitably, (ii) the opportunity to increase the operator's focus
on customer service rather than administration, (iii) the potential for national
name recognition and (iv) the opportunity for the owner to gain liquidity while,
in some cases, continuing to manage the operations of the business. By expanding
geographically, management hopes that the Company will be able to offset to some
extent seasonal and economic trends that affect different regions of the country
periodically.
 
     Expanding Geographic Presence through Hub Acquisitions.  The Company plans
to continue to make "hub" acquisitions of existing HVAC businesses in new
markets that are not being served by the Company. Management targets for
acquisition HVAC businesses that operate successfully in the Company's targeted
markets. Typically, these businesses have annual net revenue ranging from $1.0
million to $10.0 million. In evaluating such acquisitions, the Company considers
candidates that are in attractive markets, financially stable, experienced in
the industry and characterized by strong management.
 
     Expanding Market Penetration of Hubs through the Acquisition of Other HVAC
Businesses.  The Company expects to increase market share through "spoke"
acquisitions of other HVAC businesses that have large customer bases and that
present opportunities to reduce overhead or dispose of fixed assets to improve
profitability. When acquired, the operations of such businesses will be
integrated into the operations of existing hubs, enabling the Company to reduce
overhead costs, sell redundant assets and consolidate operations within existing
areas served by the Company.
 
                                        3
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  Recent and Pending Acquisitions
 
     During 1997, the Company acquired 71 HVAC businesses. The consideration
paid by the Company for the 1997 Acquired Companies was approximately $102.2
million, consisting of approximately 2.5 million shares of Common Stock, $43.1
million in cash and warrants to purchase 200,000 shares of Common Stock. Five of
the transactions (collectively, the "1997 Pooled Companies"), were accounted for
using the pooling of interests method of accounting, and the remainder were
accounted for using the purchase method. The 1997 Pooled Companies together with
Custom Air Conditioning, Inc. and Freschi Air Systems, Inc., two companies
acquired in 1996 and accounted for using the pooling of interests method, are
sometimes referred to collectively as the "Pooled Companies." One-time expenses
associated with the 1997 Pooled Companies were $263,000. Of the consideration
paid for the 1997 Acquired Companies, $73.9 million was allocated to intangible
assets which are to be amortized over a 40-year period. On a pro forma basis,
these companies, excluding the Pooled Companies, contributed revenue in 1997 of
approximately $121.6 million and contributed operating income of approximately
$8.6 million.
 
     The Company currently has agreements in principle to acquire four HVAC
businesses. The Pending Acquisitions are expected to close during the first six
months of 1998. The consideration to be paid by the Company for these businesses
is approximately $6.1 million, consisting of approximately 224,000 shares of
Common Stock and approximately $200,000 cash. All of these transactions are
expected to be accounted for using the purchase method. Approximately $4.9
million of the consideration to be paid is expected to be allocated to
intangible assets which are to be amortized over a 40-year period. On a pro
forma basis, these companies generated revenue in 1997 of approximately $7.8
million. The acquisitions are subject to customary conditions, and there can be
no assurance that the Company will be able to consummate all of the acquisitions
or to successfully integrate the businesses of the acquired companies.
 
     The Company's acquisitions during 1997 expanded the geographic coverage of
the Company by providing entry to the Connecticut, Idaho, Illinois, Iowa,
Kentucky, Maryland, Massachusetts, Nebraska, North Carolina, Ohio, Utah and West
Virginia markets and increasing the Company's market presence in Arkansas,
California, Florida, Georgia, Indiana, Louisiana, New York, Oklahoma, Tennessee
and Texas. The Company now operates 63 Service Centers in 28 states.
 
OPERATING STRATEGY
 
     Management believes that successful implementation of the Company's
operating strategy will enable it to establish a national reputation for
superior, high quality service. By developing a national reputation, management
believes the Company will appeal to a large number of customers who are familiar
with and rely upon a large, national company. The Company's operating strategy
incorporates the successful methods developed by CSG and capitalizes on the
operating efficiencies resulting from the integration of the operations of its
Service Centers. The key elements of the Company's operating strategy are as
follows:
 
     Providing Superior, High Quality Service in a Professional Manner.  The
Service Centers seek to provide high quality service at a competitive price and
in a friendly, professional manner. In order to provide such service, service
technicians, maintenance technicians and installers employed by the Company
complete comprehensive training programs designed to teach employees the
Company's operating procedures. These procedures are described in CSG's training
manuals which provide detailed instructions in areas such as residential
replacement sales, residential installation, preventive maintenance agreements,
service and routine maintenance. The Company has standardized policies and
operating procedures intended to result in a uniform level of professional, high
quality service, including installation and maintenance procedures, random
drug-testing of employees, the technician's appearance and the use of "Carpet
Saver" shoe coverings when inside a customer's home. Substantially all of the
Service Centers utilize a flat rate billing system that advises the customer of
the cost of service before work begins and charges the quoted price regardless
of the actual time necessary to repair the system. The Service Centers are
generally open for business from 8:00 a.m. to 8:00 p.m. on weekdays, and most
are open on Saturday from 8:00 a.m. to 4:00 p.m. Management believes that by
providing evening and Saturday service, in addition to 24 hour emergency
service, the Service Centers are able to better accommodate customers than most
of their competitors.
 
                                        4
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     Increasing Revenue at Service Centers.  The Company actively promotes its
maintenance agreements to both new and existing customers. See "Service
Centers -- Maintenance and Service Agreements." The sale of maintenance
agreements not only generates recurring revenue through the payment of fees, but
also helps the Company develop a committed, loyal customer base and provides the
opportunity for cross-marketing of the Company's other services and products.
The Company offers a wide assortment of financing packages designed to enable
customers to purchase equipment and services from the Company in the most
convenient and cost-effective manner possible. Certain Service Centers also
offer their customers a Professional Courtesy credit card solely for use in
purchasing equipment and services from the Company. This financing, including
the Professional Courtesy credit card, is offered through a number of third
party lenders. Pursuant to its arrangements with such financing companies, the
Company receives an origination fee based on the amount financed, but does not
bear any credit risk from such financing.
 
     The Service Centers utilize a variety of local print advertising and
targeted marketing promotions designed by CSG, including maintenance technician
referrals, service technician referrals, yellow page advertising and direct mail
campaigns followed up by telemarketing. During the off-peak spring and fall
months, the Service Centers aggressively market products and services which
generate revenue during such months and help to offset increased demand
historically experienced in the summer and winter months. In 1997, advertising
and marketing expenditures (net of marketing expenditures by manufacturers) were
3.4% as a percentage of the Company's net revenue.
 
     As technology has improved, HVAC businesses have begun to utilize equipment
that monitors the levels of certain harmful substances in the air of a
customer's home. The Company's Service Centers offer a number of services and
products that are not available from most HVAC contractors. The Company offers
and actively promotes a variety of IAQ services designed to detect and correct
unhealthy air quality. Among these services are duct cleaning, fresh air
ventilation and heat recovery systems, ultraviolet light processes and the sale
and installation of ozonators. According to industry sources, the market for IAQ
products and services in the United States was estimated to be $1.8 billion in
1994 and is expected to double by the year 2000 as public awareness of indoor
air pollution, which the U.S. Environmental Protection Agency now ranks as one
of the top five environmental health threats, continues to grow.
 
     Achieving Operating Efficiencies.  Manufacturers of HVAC equipment have
historically offered more favorable prices and rebates to high volume
purchasers. Since the Company's initial public offering (the "IPO"), the Company
has achieved increased operating efficiencies by consolidating certain functions
at the corporate level, including the purchase of insurance, the provision of
legal support and the utilization of corporate trainers in the areas of
marketing and IAQ. The Company intends to review the desirability of
consolidating other functions at the corporate level, including the purchasing
and leasing of service vehicles and national marketing. A portion of any
operating efficiencies will be offset by increased general and administrative
expenses at the Company's corporate headquarters.
 
     Since the IPO, the Company has implemented a uniform system of budgets,
forecasts, reports and financial controls, including an electronic mail system,
for its Service Centers. In addition, each of the Service Centers generates and
provides to the Company a daily management report of revenue and expense
information and certain billing and collection data.
 
     Attracting and Retaining Quality Employees.  Management believes the
Service Centers attract and retain quality employees by providing (i) an
environment that emphasizes professionalism and customer satisfaction, (ii)
extensive training that allows employees to advance to higher-earning positions
and (iii) stability of income because the Service Centers do not experience the
cyclical lay-offs typically found in the HVAC industry. The Company has
established a bonus program for each Service Center pursuant to which managers
may earn bonuses based on the performance of the Service Center and the Company
relative to established goals set by the Service Center's general manager and
the Company. The Service Centers generally are operated by managers who are
trained in the CSG operating methods and procedures and who management believes
are better educated than a typical HVAC service business operator.
 
     Potential employees of most Service Centers must pass extensive interviews
and background checks, where permitted, as well as technical tests prior to
being hired. Service technicians, maintenance technicians
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and installers employed by the Company are required to complete training
programs designed to teach employees the Company's operating procedures. These
training programs are conducted both at the Service Centers and at CSG sponsored
seminars. Since the IPO, the Company has implemented training programs relating
to marketing and IAQ products that are conducted at Service Centers by the
Company's corporate trainers. Management believes that these policies have
resulted in a low rate of employee turnover. See "Contractor Success Group."
 
CONTRACTOR SUCCESS GROUP
 
     CSG, a wholly-owned subsidiary of the Company, was formed in 1991 to offer
HVAC companies proprietary products and marketing, management, educational and
advisory services not available from industry trade associations. Currently,
there are approximately 265 members of CSG serving distinct market areas in the
United States and Canada defined primarily by zip codes. CSG offers its members
a competitive edge over other contractors in the market by providing useful
management and technical skills, training programs and proprietary products. In
exchange, CSG members pay an initial fee upon joining CSG and a quarterly fee
thereafter. In 1997, CSG collected fees totaling approximately $2.5 million. CSG
members are granted exclusive rights to the territory in which they operate.
Although the Company has acquired 54 CSG members since its formation, other HVAC
companies have joined CSG. The Company intends to continue to build and expand
the membership of CSG.
 
     CSG licenses to its members copyrighted training manuals that cover in
specific detail the aspects of owning and operating an HVAC service and
replacement company, including residential replacement sales, residential
maintenance, service contracts, residential installation, business planning and
service dispatch. In addition, CSG members receive materials containing, and
attend conferences discussing, methods and procedures for the operation of an
efficient, profitable company, including (i) daily report forms designed to
provide accurate and timely sales and cost information essential to determining
the performance of an HVAC business, (ii) "Scorecard," a monthly report
distributed to CSG members comparing top producers among members, (iii)
contracts and forms, including non-competition agreements for employees, sales
and service contracts, (iv) marketing promotions that are tested and proven with
specific instructions on how to tailor advertising for the member's market and
(v) quarterly projects introducing to CSG members new products and services
designed to increase productivity.
 
  Seminars and Services
 
     Potential CSG subscribers are invited to attend an informational seminar
where they are introduced to the CSG concept and are invited to join the
organization. Upon paying the initial fee, CSG subscribers attend "Boot Camp"
which is an intensive four-day workshop conducted by CSG three times each year.
At Boot Camp, HVAC contractors are educated on all aspects of operating an HVAC
service and replacement business. Attendees receive presentations and materials
that explain in specific detail the methods and procedures successfully utilized
by CSG members. Topics covered include administration, sales, service,
advertising, direct marketing, maintenance, service contracts, acquisitions and
accounting. CSG members may also attend "Success Convention," which is a
quarterly two-day convention of CSG members designed to allow the members to
compare ideas and projects and at which quarterly projects are presented, and
"Sales Extravaganza," which is an annual convention designed to encourage and
motivate a member's salespeople, selling technicians and telemarketers.
 
  Future University
 
     In connection with the acquisition of its Service Centers, the Company has
acquired approximately 39% of the issued and outstanding common stock of Future
University, Inc. ("Future University(R)"). The remaining shares of Future
University's Common Stock are held by a number of CSG members and their
shareholders. Future University is a corporation formed in 1991 that offers to
CSG members, for an additional enrollment fee, technical and operational
educational programs designed to improve the profitability of the CSG member's
business. The technical programs offer installers and technicians a combination
of classroom and on-the job-training during one and two week sessions.
Technicians receive skills training that will enable
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them to effectively analyze customer problems and offer efficient solutions. In
the maintenance training classes, for example, technicians are trained to
maximize the operating efficiency of HVAC systems, assure safe operation of
systems and reduce the chances of future breakdowns. In the sales training
classes, technicians are trained to deal with customer expectations, use and
promote various products and services, develop leads, explain financing programs
and improve on various customer relations skills. In sending technicians to the
Future University program, CSG members are able to develop a high level of
commitment in their employees. The technical programs are held in Little Rock,
Arkansas under an exclusive licensing arrangement with Hardwick Air Masters,
Inc., one of the Company's Service Centers. Pursuant to the current licensing
arrangement, Hardwick Air Masters, Inc. receives 70% of the revenue from the
technical programs and Future University receives 30% of such revenue. The
operational programs offer general managers and salespeople a variety of classes
covering residential sales training, replacement sales, marketing and
promotions, telemarketing and general operations. These programs are held in
Houston, Texas.
 
SERVICE CENTERS
 
  General
 
     Management estimates that during 1997 the Service Centers' service and
maintenance technicians responded to over 600,000 maintenance, repair and
service calls. The services offered by each Service Center include (i) the sale
of replacement central air conditioners, furnaces and heat pumps, (ii) the
maintenance and repair of HVAC units, (iii) diagnostic analysis of the condition
of existing units and (iv) the sale of ancillary products such as IAQ devices
and monitors. Most of the Service Centers employ an in-house sales force that
sells replacement units, installation technicians who install replacement
equipment in existing homes, service technicians who service and maintain the
equipment, and an administrative staff to perform dispatching, purchasing and
other administrative functions. In addition, some of the Service Centers offer
plumbing services. Management believes that in 1997 the installation and
servicing of plumbing systems represented less than 1% of the Company's pro
forma net revenue. The Company anticipates that these Service Centers will
continue to offer, and that Service Centers acquired in the future may offer,
plumbing services, but currently does not intend to expand this business.
 
     Most of the Service Centers' technicians are trained to promote the
Company's preventive maintenance agreements and to cross-market IAQ equipment
and other ancillary services and products offered by the Company. Service
technicians are trained to perform service and maintenance in a professional
manner, to identify problems with existing HVAC systems and to offer customers
the most practical, cost-effective solution to their problem, whether that
involves repairing the existing system or suggesting a replacement system or
part. Often this involves providing customers with information on products to
upgrade their system and improve efficiency as well as informing them about the
advantages and disadvantages of a particular product or service. Maintenance
technicians perform routine maintenance examinations of HVAC systems in an
effort to keep the systems in working order and to identify potential problems
before they become too costly to correct.
 
     Management believes that most HVAC contractors charge the cost of the
materials and the hourly rate for the actual time it takes to install or repair
the system. In contrast, the Company utilizes a flat rate pricing system that
advises the customer of the cost of service for the particular job before work
begins and charges the quoted price regardless of the time necessary to repair
the system. While this may result in parts, labor and other costs incurred in
repairing a customer's system exceeding the quoted price from time to time, the
Company is able to alter its pricing on a per job basis. The Company's
experience is that customers generally prefer this pricing method because it
eliminates surprise or hidden costs. This pricing method also creates an
incentive for the Company to hire quality technicians and to provide them with
the training necessary to service customer needs efficiently.
 
  Sale of Replacement Units
 
     The replacement market for residential HVAC equipment is dependent upon the
base of installed units, the mechanical life and usage of the equipment and
technological advances in the efficiency of newer units.
 
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Management believes the replacement market for HVAC units offers the potential
for high growth and profitability in the future given the potential number of
HVAC systems that will need replacement in the coming years and the Company's
ability to effectively service that need. The market for replacement units is
highly fragmented, with no single manufacturer dominating the market. In order
to service the replacement market, the Company maintains relationships with
several national, regional and local manufacturers of replacement units in order
to offer a wide variety of products to its customers. The Company has recently
implemented a preferred vendor program (the "Preferred Vendor Program") pursuant
to which the Company has established strategic relationships with selected
vendors. The Company encourages its Service Centers to use these preferred
vendors which offer discounts and rebates to the Service Centers.
 
     At the time of sale, a customer is offered a wide assortment of financing
packages by the Service Center. A Service Center's installers and technicians,
in addition to the salespeople, are trained to educate customers as to the
financing options available, assist the customer in completing the credit
application forms and determine whether the customer's financing is approved.
The Company also offers its customers a Professional Courtesy credit card solely
for use in purchasing equipment and services from the Company. Such financing,
including the Professional Courtesy credit card, is offered through a number of
third party lenders. Pursuant to its arrangements with such financing companies,
the Company receives an origination fee based on the amount financed, but does
not bear any credit risk from such financing.
 
  Maintenance and Service Agreements
 
     The Company currently has approximately 115,000 maintenance agreements with
customers. These agreements are for a term of one to three years and generally
provide for two diagnostic and precision maintenance visits during the year at
an average cost to the customer of approximately $135 per year. The sale of
maintenance agreements not only generates recurring revenue through the payment
of fees, but also helps the Company develop a committed, loyal customer base and
provides the opportunity for cross-marketing of the Company's other services and
products. Management believes that customers with maintenance agreements are
among the Company's most satisfied customers because of the many benefits
offered by these agreements, including (i) energy savings resulting from a more
efficient HVAC system, (ii) fewer and less costly emergency repairs, (iii)
longer useful life for the HVAC system, (iv) discounted rates for service and
(v) guaranteed same-day service in the event of an emergency repair. Maintenance
agreements also allow the Company to more fully utilize its technicians during
the historically slower spring and fall months by scheduling maintenance
appointments during such time. Because systems under maintenance agreements are
less likely to require emergency repairs, the Service Centers are able to
provide more prompt service to emergency and new service calls.
 
     The Company's service agreements are generally for a term of one year and
provide for the repair of any problem with the customer's system at no
additional cost to the customer. Pursuant to the terms of the service
agreements, if the cost of repair exceeds the value of the customer's HVAC
system, the Company is not required to repair the system and the customer
receives a discount if he purchases a replacement unit from the Company. In some
states, warranties provided for in the Company's service agreements may be
deemed insurance contracts by applicable state insurance regulatory agencies
thereby subjecting the Company and the service agreements to the insurance laws
and regulations of any such state. In such states, the Company insures its
service agreements through licensed insurers. Management believes that the
Company has made adequate provision for potential claims under these agreements.
See "Regulation."
 
  Commercial Service and Replacement
 
     Some of the Service Centers offer HVAC services to small and medium-sized
businesses. In 1997, non-residential revenue generated from the provision of
services and sale of products, including those related to commercial, electrical
and plumbing services and products, represented approximately 20% of the
Company's pro forma net revenue. The Service Centers target restaurants, small
office buildings, warehouses and theaters as potential prospects for their
commercial services. The Company's commercial sales representatives receive
extensive training designed to enable the representatives to promote the
Company's services and products effectively. The services offered to commercial
customers are generally the same as services offered to
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residential customers, including the analysis, maintenance and repair of
existing HVAC systems, the sale of replacement systems and the sale of ancillary
products, including IAQ devices and services. While management does not plan to
develop further its commercial HVAC business beyond existing operations given
the potential for growth in the residential service and replacement market, the
Company intends to continue to provide, and may acquire Service Centers that
provide, commercial HVAC services.
 
SERVICES AND OPERATIONS
 
     The Company provides management, financial and accounting services for all
of the Service Centers' operations, as well as insurance and certain marketing
and legal support. Management provides certain financial control support,
including budgets, forecasts and reports, while allowing each general manager of
a Service Center to manage its day-to-day operations. Since the IPO, the Company
has added various corporate management and staff personnel to provide support
services for its Service Centers and to facilitate its acquisition of additional
HVAC businesses.
 
     The Company provides the following services:
 
     Purchasing
 
          Each Service Center generally purchases the HVAC units, parts and
     supplies it uses from distributors. The Company's Preferred Vendor Program
     allows the Service Centers to purchase these items at a lower cost through
     discounts and rebates available from the vendors participating in the
     program. The principal manufacturers participating in the Company's
     Preferred Vendor Program include The Trane Company, Lennox Industries, Inc.
     and Amana. The Service Centers generally maintain less than a 30-day supply
     of inventory.
 
     Management Information Systems
 
          The Service Centers currently utilize various compatible management
     and financial information systems. The Company intends to convert the
     majority of the Service Centers' current systems to an integrated system
     within the next 12 to 18 months. The implementation of an integrated system
     will allow the Company to maintain greater control over the operations of
     its Service Centers. The Company tracks important data related to the
     Service Centers' operations and financial performance and monitors all
     advertising expenditures. In addition, the Service Centers generate and
     provide to the Company a daily management report of revenue information and
     certain billing and collection data.
 
     Employee Screening and Training
 
          Prior to employment, potential employees of the Company are tested to
     determine their technical expertise. In addition, as permitted by local
     law, employees of the Company are required to pass a drug test prior to
     employment and are thereafter subject to random drug testing. Failure to
     take or pass a drug test may result in immediate termination of employment.
     Once hired, employees of the Company generally complete various training
     programs covering technical skills and communication and sales techniques.
     In addition, employees periodically attend educational seminars and
     conventions conducted by CSG. See "Contractor Success Group." The Company
     has established training programs relating to marketing and IAQ products
     that are conducted at the Company's Service Centers by two corporate
     trainers.
 
     Advertising and Marketing
 
          The Company's advertising and marketing programs are designed to
     attract new customers and to stimulate increased demand from existing
     customers. Each Service Center, utilizing materials produced by CSG,
     develops customized marketing programs tailored to meet the needs of its
     local customer base. Emphasizing superior, high quality service, the
     Service Centers market directly to prospective and existing customers
     through various means, including local print advertising, yellow page
     advertising and direct mail campaigns followed up by telemarketing. In
     1997, advertising and marketing expenditures
                                        9
<PAGE>   10
 
     (net of marketing expenditures by manufacturers) were 3.4% as a percentage
     of the Company's net revenue. The Company intends, over time, to develop
     the Service Experts name as a key element of its marketing strategy. As a
     part of this strategy, management intends gradually to integrate the
     Company's name and logo in advertising while continuing to utilize
     established local brand names.
 
REGULATION
 
     HVAC systems are subject to various environmental statutes and regulations,
including, but not limited to, laws and regulations implementing the Clean Air
Act, as amended (the "Clean Air Act"), relating to minimum energy efficiency
standards of HVAC systems and the production, servicing and disposal of certain
ozone depleting refrigerants used in such systems. In connection with the entry
into new markets, the Company may become subject to compliance with additional
regulations. Although, there can be no assurance that the regulatory environment
in which the Company operates will not change significantly in the future,
compliance with existing regulatory requirements has not had a material effect
on the Company.
 
     Various local, state and federal laws and regulations, including, but not
limited to, laws and regulations implementing the Clean Air Act, impose
licensing standards on technicians who service heating and air conditioning
units. While the installers and technicians employed by the Service Centers are
duly certified by applicable local, state and federal agencies and have been
able to meet or exceed such standards to date, there can be no assurance that
they will be able to meet stricter future standards. In addition, installers
must comply with local building codes when installing HVAC units in residences
and commercial buildings.
 
     In some states, warranties provided for in the Company's service agreements
may be deemed insurance contracts by applicable state insurance regulatory
agencies, thereby subjecting the Company and the service agreements to the
insurance laws and regulations of any such state.
 
TRADEMARKS
 
     "Service Experts" is registered as a federal trademark with the United
States Patent and Trademark Office. The Company currently licenses the Service
Experts name and logo to two companies that are members of CSG. The Company owns
and licenses numerous proprietary products used by the Service Centers and other
CSG members. See "Contractor Success Group." In addition, the Company owns
approximately 39% of the issued and outstanding common stock of "Future
University," which is registered as a federal trademark with the United States
Patent and Trademark Office. See "Contractor Success Group -- Future
University." The Company regards its trademarks as having significant value and
being an important factor in the development and marketing of its operations.
The Company's policy is to pursue registration of its trademarks whenever
possible and to oppose vigorously any infringement of its trademarks.
 
COMPETITION
 
     The HVAC service and replacement industry is highly competitive in each of
the markets in which the Company operates. The Company's Service Centers compete
with utility companies and other full-service HVAC businesses primarily on the
basis of quality, reliability, customer service and price. Some of these
companies have access to capital, personnel, marketing and technological
resources that are equal to or greater than those of the Company. Because of the
fragmented nature of the industry and relative low barriers to entry, additional
competitors, including companies that offer other home improvement services in
addition to HVAC services, may emerge that have greater access than the Company
to capital, personnel and technological resources. Certain of these companies
are pursuing a consolidation strategy in the industry and compete with the
Company for potential acquisitions as well as for customers.
 
EMPLOYEES
 
     Management estimates that the Company currently has approximately 3,200
employees, all but approximately 40 of who are employed at Service Centers. None
of the Company's employees is represented by a collective bargaining agreement.
 
                                       10
<PAGE>   11
 
INSURANCE
 
     The Company maintains general liability, workers compensation and property
insurance. The costs of insurance coverage varies, and the availability of
certain coverage has fluctuated in recent years. As of February 1, 1997, the
Company consolidated the purchase of insurance for its operations under a single
policy, excluding major medical insurance. This coverage resulted in savings
from the amounts previously paid by the Company's subsidiaries. While management
believes, based upon its claims experience, that the Company's present insurance
coverage is adequate for its current operations, there can be no assurance that
the coverage is sufficient for all future claims or will continue to be
available in adequate amounts or at reasonable rates.
 
ITEM 2.  PROPERTIES
 
     The Company currently occupies the building and underlying real estate on
which all but four of its Service Centers are located pursuant to leases with
terms generally ranging from five to ten years on terms the Company believes to
be commercially reasonable. Total rental expense for the Company's leased
centers, including certain leased vehicles and equipment, in 1997 was
approximately $2.9 million. The Company purchased the building and underlying
real estate on which four of its Service Centers are located. The Company
generally plans to continue to lease rather than purchase space for the Service
Centers to maximize the Company's available capital.
 
     The Company's corporate headquarters are located in approximately 6,580
square feet of space in Brentwood, Tennessee. The remaining term of the lease on
this office space is approximately four years, and the Company pays annual rent
of $115,200. Subsequent to year-end, the Company entered into a new lease
agreement for its corporate headquarters. This operating lease is for
approximately 20,800 square feet of space and for a term of five years
commencing on May 1, 1998, pending completion of the construction of the new
building. The minimum annual lease commitments are $361,000 for the first year
and increase annually during the term of the lease to $425,000 in the fifth
year. As a result of this agreement, the Company will cancel its current lease
obligation but will not incur any fees or penalties associated with such
cancellation.
 
ITEM 3.  LEGAL PROCEEDINGS
 
     The Company does not have pending any litigation that, separately or in the
aggregate, if adversely determined, would have a material adverse effect on the
Company. The Company and its Service Centers may, from time to time, be parties
to litigation or administrative proceedings which arise in the normal course of
their businesses.
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
     No matters were submitted to a vote of the stockholders during the fourth
quarter ended December 31, 1997.
 
                                       11
<PAGE>   12
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     The following table sets forth the reported high and low sales prices of
the Common Stock for the quarters indicated as reported on the Nasdaq National
Market and the New York Stock Exchange. The Company completed its IPO on August
16, 1996 at a price per share of $13.00. The Common Stock was traded on the
Nasdaq National Market under the symbol "SERX" from the Company's IPO on August
16, 1996 until June 6, 1997. The Common Stock is currently traded on the New
York Stock Exchange under the symbol "SVE."
 
<TABLE>
<CAPTION>
                                                               HIGH     LOW
                                                              ------   ------
<S>                                                           <C>      <C>
1996
Third Quarter (beginning August 16, 1996)                     $20.25   $13.75
Fourth Quarter..............................................   28.50    19.00
1997
First Quarter...............................................  $28.25   $21.25
Second Quarter..............................................   30.25    21.25
Third Quarter...............................................   30.38    24.38
Fourth Quarter..............................................   30.38    24.63
1998
First Quarter (through March 12, 1998)......................  $29.31   $25.50
</TABLE>
 
     On March 12, 1998, the last reported sale price of the Common Stock was
$26.13 per share. As of March 12, 1998, there were approximately 323 holders of
record of the Company's Common Stock.
 
     Since the IPO, the Company has not declared or paid dividends on its Common
Stock. The Company expects that future earnings will be retained to finance the
growth and development of the Company's business and, accordingly, does not
intend to declare or pay any dividends on the Common Stock for the foreseeable
future. The declaration, payment and amount of future dividends, if any, will be
subject to the discretion of the Company's Board of Directors and will depend
upon the future earnings, results of operations, financial condition and capital
requirements of the Company, among other factors. Under Delaware law, the
Company is prohibited from paying any dividends unless it has capital surplus or
net profits available for this purpose. In addition, the Company's credit
facilities impose restrictions on the ability of the Company to pay dividends.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."
 
ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA
 
     The following table presents selected consolidated financial data of the
Company. The Company was incorporated on March 27, 1996. On August 21, 1996 and
simultaneously with the closing of the Company's IPO, the Company acquired 12
HVAC companies and CSG (collectively, the "Predecessor Companies") in exchange
for shares of Common Stock and cash (the "Combination"). The acquisitions of the
Predecessor Companies have been accounted for using the historical cost basis of
the Predecessor Companies in accordance with Securities and Exchange Commission
("Commission") Staff Accounting Bulletin No. 48 ("SAB 48"). In accordance with
the provisions of the Commission's Staff Accounting Bulletin No. 97 ("SAB 97"),
the historical financial statements of the Company for periods prior to August
21, 1996 are the combined financial statements of AC Service & Installation Co.,
Inc. and Donelson Air Conditioning Company, Inc. (collectively, the "Acquiring
Company"). In addition, the historical financial statements of the Company for
all periods presented include the financial statements of the Pooled Companies,
which were acquired effective December 1996, May 1997 and September 1997 in
business combinations accounted for as poolings of interests, and the operations
of all other acquired companies are included from their respective effective
dates of acquisition. The Pooled Companies are Custom Air Conditioning, Inc.,
Freschi Air Systems, Inc., C. Iapaluccio Company, Inc., Parrott Mechanical,
Inc., TML, Inc. and MT Partnership, Hawk Heating
 
                                       12
<PAGE>   13
 
& Air Conditioning, Inc. and McAlister Heat & Air, Inc. The following should be
read with the historical consolidated financial statements and notes thereto
appearing elsewhere herein.
 
     The selected consolidated financial data for the fiscal years ended
December 31, 1993, 1994, 1995, 1996 and 1997 have been derived from the
financial statements of either the Company or the Acquiring Company and the
Pooled Companies.
 
<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                  ------------------------------------------------
                                                   1993      1994      1995      1996       1997
                                                  -------   -------   -------   -------   --------
                                                       (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                               <C>       <C>       <C>       <C>       <C>
STATEMENT OF OPERATIONS DATA:
Net revenue.....................................  $35,151   $47,545   $49,748   $74,913   $238,692
Cost of goods sold..............................   26,934    36,369    38,227    52,628    154,598
                                                  -------   -------   -------   -------   --------
Gross margin....................................    8,217    11,176    11,521    22,285     84,094
Selling, general and administrative expenses....    7,716     9,240    11,185    17,384     60,219
                                                  -------   -------   -------   -------   --------
Income from operations..........................      501     1,936       336     4,901     23,875
Other income (expense)..........................      (59)     (199)     (359)      (26)       580
                                                  -------   -------   -------   -------   --------
Income (loss) before federal and state income
  taxes.........................................      442     1,737       (23)    4,875     24,455
Provision for income tax expense................       46       251       146     1,136      9,189
                                                  -------   -------   -------   -------   --------
Net income (loss)...............................  $   396   $ 1,486   $  (169)  $ 3,739   $ 15,266
                                                  =======   =======   =======   =======   ========
Net income (loss) per share:
  Basic.........................................  $   .19   $   .70   $  (.08)  $   .74   $   1.07
                                                  =======   =======   =======   =======   ========
  Diluted.......................................  $   .19   $   .70   $  (.08)  $   .74   $   1.06
                                                  =======   =======   =======   =======   ========
Weighted average shares outstanding:
  Basic.........................................    2,132     2,132     2,132     5,022     14,305
                                                  =======   =======   =======   =======   ========
  Diluted.......................................    2,132     2,132     2,132     5,051     14,453
                                                  =======   =======   =======   =======   ========
</TABLE>
 
<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                  ------------------------------------------------
                                                   1993      1994      1995      1996       1997
                                                  -------   -------   -------   -------   --------
                                                                   (IN THOUSANDS)
<S>                                               <C>       <C>       <C>       <C>       <C>
BALANCE SHEET DATA:
Working capital.................................  $ 2,025   $ 1,460   $   395   $12,878   $ 27,945
Total assets....................................   10,778    13,522    16,833    80,170    194,810
Total debt......................................    3,715     3,603     7,614     6,083     15,937
Stockholders' equity............................    3,177     3,886     3,321    55,319    142,402
</TABLE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
 
     The following discussion should be read in conjunction with the information
contained in the Company's consolidated financial statements, including the
notes thereto.
 
OVERVIEW
 
     Simultaneous with the IPO in August 1996, the Company acquired the
Predecessor Companies in the Combination. Prior to the Combination, the Company
had no operations. The consideration paid by the Company for the Predecessor
Companies was approximately $77.5 million, consisting of approximately 4.5
million shares of Common Stock and approximately $18.7 million in cash. No
intangible assets were recorded as a result of the Combination because of the
accounting treatment in accordance with SAB 48.
 
     As of December 31, 1997, the Company had acquired 88 HVAC businesses and
one consulting business (the "Acquired Companies") since the IPO, of which 51
are Service Centers. The consideration paid by the Company for the Acquired
Companies was approximately $147.5 million, consisting of approximately 5.0
million shares of Common Stock, warrants to purchase 200,000 shares of Common
Stock and approximately $46.7 million in cash. Seven of the transactions were
accounted for using the pooling of interests method of
 
                                       13
<PAGE>   14
 
accounting, and the remainder were accounted for using the purchase method.
Approximately $107.0 million of the consideration paid by the Company was
allocated to intangible assets which are to be amortized over a 40-year period.
 
FINANCIAL STATEMENT PRESENTATION
 
     Since the IPO, the financial presentation of the Company has changed. The
Combination was accounted for using the historical cost basis of the Predecessor
Companies in accordance with SAB 48. On July 31, 1996, SAB 97 was adopted to
replace SAB 48 for certain combination transactions. In accordance with the
provisions of SAB 97, the presentation of financial information for the Company
reflects the Acquiring Company as the acquiror of the other Predecessor
Companies. Prior financial statements of the combined Predecessor Companies are
not included in the Company's historical financial presentation. The operation
of the Predecessor Companies and other Acquired Companies (except for the Pooled
Companies) have been included in the Company's financial statements from their
respective effective dates of acquisition.
 
     The Acquired Companies historically have been managed as independent
private companies and, as such, their results of operations reflect different
tax structures which have influenced, among other things, their historical
levels of owner's compensation. Owners and certain key employees of the Acquired
Companies have agreed to certain reductions in their compensation in connection
with the acquisitions.
 
COMPONENTS OF INCOME
 
     Net revenue of the Acquired Companies has been derived primarily from the
installation, service and maintenance of central air conditioners, furnaces and
heat pumps in existing homes. Net revenue and associated income from operations
are subject to seasonal fluctuations resulting from increased demand for the
Company's services during warmer weather in the summer months and during colder
weather in winter months, particularly in the beginning of each season. Cost of
goods sold primarily consists of purchased materials such as replacement air
conditioning units and heat pumps and the labor associated with both
installations and repair orders. The main components of selling, general and
administrative expenses include administrative salaries, insurance expense and
promotion and advertising expenses.
 
PREFERRED VENDOR PROGRAM
 
     The Company's Preferred Vendor Program was designed with flexibility to
ensure competitive prices and services at the local level and at the same time
reduce certain administrative and operational costs in the system. The Preferred
Vendor Program will also help to offset corporate costs. At each Service Center,
the Company's managers have the freedom to determine the best source(s) of
products for their customers' needs. The Company has developed a strategic
relationship with several vendors and requests that the Service Centers support
them when possible and practical. The benefits available to the Service Center
by utilizing this select list of vendors are significant and although the
programs are voluntary, they are widely used in almost every Service Center.
Included in the Preferred Vendor Program are recognized national brands in
manufacturing including The Trane Company, Lennox Industries, Inc. and Amana,
and distribution channels including Watsco, Inc., Pameco Corp. and Hughes
Supply, Inc.
 
RESULTS OF OPERATIONS
 
     Because of the significant effect of the Combination, the acquisitions of
the Acquired Companies and the anticipated effect of pending acquisitions on the
Company's results of operations, the Company's historical results of operations
and period-to-period comparisons will not be indicative of future results and
may not be meaningful. The Company plans to continue acquiring Service Centers
in the future. The integration of acquired Service Centers and the addition of
management personnel to support existing and future acquisitions may positively
or negatively affect the Company's results of operations during the period
immediately following acquisition.
 
                                       14
<PAGE>   15
 
     The following table sets forth certain selected financial data as a
percentage of net revenue for the periods indicated:
 
<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                              -----------------------
                                                              1995     1996     1997
                                                              -----    -----    -----
<S>                                                           <C>      <C>      <C>
Net revenue.................................................  100.0%   100.0%   100.0%
Cost of goods sold..........................................   76.8     70.3     64.8
                                                              -----    -----    -----
Gross margin................................................   23.2     29.7     35.2
Selling, general and administrative expenses................   22.5     23.2     25.2
                                                              -----    -----    -----
Income from operations......................................    0.7%     6.5%    10.0%
                                                              =====    =====    =====
</TABLE>
 
  Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
 
     Net Revenue.  Net revenue increased $163.8 million, or 218.6%, from $74.9
million for the year ended December 31, 1996 to $238.7 million for the year
ended December 31, 1997. This increase is primarily attributable to the
inclusion of the Predecessor Companies and the 13 companies acquired in December
1996 for a full year and the acquisition of 66 HVAC businesses during 1997.
 
     Cost of Goods Sold.  Cost of goods sold increased $102.0 million, or
193.8%, from $52.6 million for the year ended December 31, 1996 to $154.6
million for the year ended December 31, 1997. As a percentage of net revenue,
cost of goods sold decreased from 70.3% for the year ended December 31, 1996 to
64.8% for the year ended December 31, 1997. The decrease as a percentage of net
revenue was primarily attributable to an emphasis on more profitable products,
the inclusion of the Predecessor Companies and the December 1996 acquisitions
for the full year, the inclusion of 66 companies acquired in 1997 and a $1.8
million decrease in the cost of equipment and supplies as a result of the
Preferred Vendor Program.
 
     Gross Margin.  Gross margin increased $61.8 million, or 277.4%, from $22.3
million for the year ended December 31, 1996 to $84.1 million for the year ended
December 31, 1997. As a percentage of net revenue, gross margin increased from
29.7% for the year ended December 31, 1996 to 35.2% for the year ended December
31, 1997. The increase in gross margin as a percentage of net revenue is
primarily attributable to the inclusion of 66 companies acquired in 1997 that
operated at higher margins than the 1997 Pooled Companies and the reduction in
costs from the Preferred Vendor Program.
 
     Selling, General and Administrative Expenses.  Selling, general and
administrative expenses increased $42.8 million, or 246.4%, from $17.4 million
for the year ended December 31, 1996 to $60.2 million for the year ended
December 31, 1997. This increase is attributable to the inclusion of 66
companies acquired in 1997, a $1.8 million increase in amortization expense and
an increase in management personnel during the year. As a percentage of net
revenue, selling, general and administrative expenses increased from 23.2% for
the year ended December 31, 1996 to 25.2% for the year ended December 31, 1997.
 
     Income from Operations.  Income from operations increased $19.0 million
from $4.9 million for the year ended December 31, 1996 to $23.9 million for the
year ended December 31, 1997. Income from operations as a percentage of net
revenue increased from 6.5% in 1996 to 10.0% in 1997 as a result of the factors
mentioned above.
 
  Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
 
     Net Revenue.  Net revenue increased $25.2 million, or 50.6%, from $49.7
million for the year ended December 31, 1995 to $74.9 million for the year ended
December 31, 1996. This increase is primarily attributable to the acquisition of
the Predecessor Companies in August 1996 and the December 1996 acquisitions.
 
     Cost of Goods Sold.  Cost of goods sold increased $14.4 million, or 37.7%,
from $38.2 million for the year ended December 31, 1995 to $52.6 million for the
year ended December 31, 1996. As a percentage of net revenue, cost of goods sold
decreased from 76.8% for the year ended December 31, 1995 to 70.3% for the year
ended December 31, 1996. The decrease as a percentage of net revenue was
primarily attributable to an
                                       15
<PAGE>   16
 
emphasis on more profitable products, improved employee training, an improvement
in the operations of a 1997 Pooled Company and the inclusion of the Predecessor
Companies following the Combination.
 
     Gross Margin.  Gross margin increased $10.8 million, or 93.4%, from $11.5
million for the year ended December 31, 1995 to $22.3 million for the year ended
December 31, 1996. As a percentage of net revenue, gross margin increased from
23.2% for the year ended December 31, 1995 to 29.7% for the year ended December
31, 1996.
 
     Selling, General and Administrative Expenses.  Selling, general and
administrative expenses increased $6.2 million, or 55.4%, from $11.2 million for
the year ended December 31, 1995 to $17.4 million for the year ended December
31, 1996. This increase is attributable to the inclusion of the acquisition of
the Predecessor Companies in August 1996 and the December 1996 acquisitions and
an increase in management personnel since the IPO. As a percentage of net
revenue, selling, general and administrative expenses increased from 22.5% for
the year ended December 31, 1995 to 23.2% for the year ended December 31, 1996.
 
     Income from Operations.  Income from operations increased $4.6 million from
$0.3 million for the year ended December 31, 1995 to $4.9 million for the year
ended December 31, 1996. Income from operations as a percentage of net revenue
increased from 0.7% in 1995 to 6.5% in 1996.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The Company's principal capital needs arise from the acquisition of new
HVAC businesses and the costs associated with such expansion. Cash used in
investing activities was primarily attributable to the acquisition of HVAC
businesses.
 
     The Company's ability to acquire new HVAC businesses will depend on a
number of factors, including the ability of management of the Company to
identify favorable target businesses and to negotiate favorable acquisition
terms, the availability of adequate financing and other factors, many of which
are beyond the control of the Company. In addition, there can be no assurance
that the Company will be successful in identifying and acquiring Service
Centers, that the Company can integrate such new Service Centers into the
Company's operations or that the Company's new Service Centers will generate
sales revenue or profit margins consistent with those of the Company's existing
Service Centers.
 
     On August 21, 1996, the Company completed the IPO at $13.00 per share. The
proceeds to the Company, net of expenses and underwriting discounts and
commissions, were approximately $28.1 million. Of the net proceeds, $18.7
million was used to pay the cash portion of the consideration for the
Predecessor Companies, including $1.2 million which was used to repay certain
indebtedness arising from the Combination. The Company used the remaining
proceeds for working capital and capital expenditures, including the acquisition
of additional HVAC replacement and service businesses.
 
     On March 18, 1997, the Company completed a secondary offering of 1,850,000
shares of its Common Stock at $22.00 per share. The proceeds to the Company, net
of expenses and underwriters' discounts and commissions, were approximately
$38.0 million. The Company used the proceeds for planned capital expenditures,
acquisitions and general corporate purposes.
 
     The Company has a $50.0 million unsecured revolving credit facility with a
banking syndication available through September 3, 1999 (the "Credit Facility").
Borrowings under the Credit Facility bear interest at either (i) the higher of
the agent's base lending rate or the federal funds rate plus one-half of one
percent per annum or (ii) a variable rate equal to the 30, 60 or 90-day LIBOR,
as such rates change from time to time, plus a variable margin of from 75 to 150
basis points depending on the Company's funded debt to EBIA ratio determined on
a quarterly basis, at the election of the Company. All of the Company's
subsidiaries have guaranteed the repayment of indebtedness under the Credit
Facility. The Credit Facility contains covenants with respect to the maintenance
of certain financial ratios and specified net worth and limiting the incurrence
of additional indebtedness, the sale of substantial assets, consolidations or
mergers by the Company and the payments of dividends.
 
                                       16
<PAGE>   17
 
     The Company currently has on file with the Commission a shelf Registration
Statement on Form S-4 (Registration No. 333-12319) (the "Shelf Registration
Statement") covering securities with a collective aggregate offering price of
$50.0 million for use in the acquisition of HVAC businesses. Under the Shelf
Registration Statement, the Company may issue shares of Common Stock, warrants
to purchase Common Stock and debt securities in connection with acquisitions.
 
     Management believes that the Company's existing cash balances, cash
generated from operations, and additional borrowings will be sufficient to fund
the Company's operating needs, planned capital expenditures and debt service
requirements for the next 12 months. Management continually evaluates potential
strategic acquisitions as part of the Company's growth strategy. To date, such
acquisitions have been predominantly funded by issuing shares of Common Stock,
although future acquisitions could be effected using greater amounts of cash.
Although the Company believes that its financial resources will enable it to
consider potential acquisitions, should the Company's actual results of
operations fall short of, or its rate of expansion significantly exceed, its
plans, or should its costs or capital expenditures exceed expectations, the
Company may need to seek additional financing in the future. In negotiating such
financing, there can be no assurance that the Company will be able to raise
additional capital on terms satisfactory to the Company. Failure to obtain
additional financing on reasonable terms could have a negative effect on the
Company's plans to acquire additional HVAC businesses.
 
  Newly Issued Accounting Standards
 
     In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement No. 130, "Reporting Comprehensive Income" ("Statement 130"). Statement
130 establishes standards for reporting and displaying comprehensive income and
its components in a full set of general purpose financial statements. Statement
130 is effective for interim and annual periods in 1998. Comprehensive income
encompasses all changes in stockholders' equity (except those arising from
transactions with owners) and includes net income, net unrealized capital gains
or losses on available for sale securities and foreign currency translation
adjustments. Management of the Company does not expect the adoption of Statement
130 to have a material impact on the Company's financial statements.
 
     In June 1997, the FASB issued Statement No. 131, "Disclosures about
Segments of an Enterprise and Related Information" ("Statement 131"). Statement
131 establishes standards for the way public business enterprises are to report
information about operating segments in annual financial statements and requires
these enterprises to report selected information about operating segments in
interim financial reports issued to shareholders. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. Statement 131 is effective for fiscal years beginning after December
15, 1997. Management of the Company is currently reviewing the impact of
Statement 131. The Company will adopt Statement 131 on December 31, 1998 and
will report interim information effective in the first quarter of 1999.
 
  Impact of Year 2000
 
     The Year 2000 issue is the result of computer programs written using two
digits rather than four digits to define the applicable year. Any of the
Company's computer programs that have time-sensitive software may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result in
a system failure or miscalculations causing disruptions of operations,
including, among other things, a temporary inability to process transactions,
send invoices or engage in similar normal business activities.
 
     Based on a recent assessment, the Company determined that it will be
required to modify or replace portions of its software so that its computer
systems will function properly with respect to dates in the year 2000 and
thereafter. The Company believes that with modifications to existing software
and conversions to new software, the Year 2000 issue will not pose significant
operational problems for its computer systems. However, if such modifications
and conversions are not made, or are not completed timely, the Year 2000 issue
could have a material effect on the operations of the Company.
 
     The Company has initiated formal communications with all of its significant
suppliers to determine the extent to which the Company's interface systems are
vulnerable to those third parties' failure to remediate
                                       17
<PAGE>   18
 
their own Year 2000 Issues. The Company's total Year 2000 project cost and
estimates to complete include the estimated costs and time associated with the
impact of third party Year 2000 issues based on currently available information.
However, there can be no guarantee that the systems of other companies on which
the Company's systems rely will be timely converted and would not have an
adverse effect on the Company's systems. The Company has determined it has no
exposure to contingencies related to the Year 2000 issue for the products it has
sold.
 
     The Company will utilize both internal and external resources to reprogram,
or replace, and test the software for Year 2000 modifications. The Company
anticipates completing the Year 2000 project no later than March 31, 1999, which
is prior to any anticipated impact on its operating systems. The total cost of
the Year 2000 project is estimated at $600,000 and is being funded through
operating cash flows. Of the total project cost, approximately $400,000 is
attributable to the purchase of new software which will be capitalized. The
remaining $200,000, which will be expensed as incurred, is not expected to have
a material effect on the results of operations. To date, the Company has
incurred approximately $100,000 related to the assessment of, and preliminary
efforts on, its Year 2000 project and the development of a modification plan,
purchase of new systems and systems modifications.
 
     The costs of the project and the date on which the Company believes it will
complete the Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events, including
the continued availability of certain resources, third party modification plans
and other factors. However, there can be no guarantee that these estimates will
be achieved and actual results could differ materially from those anticipated.
Specific factors that might cause such material differences include, but are not
limited to, the availability and cost of personnel trained in this area, the
ability to locate and correct all relevant computer codes and similar
uncertainties.
 
                                       18
<PAGE>   19
 
                                  RISK FACTORS
 
     This report contains forward-looking statements regarding the business and
industry of the Company, including those regarding the successful integration of
the businesses of its subsidiaries, the effective implementation of the
Company's strategy, the availability of additional HVAC businesses for
acquisition, the adequacy of the Company's capital resources and other
statements regarding trends relating to the HVAC industry and various revenue
and expense items. Many factors, including the Company's limited operating
history on a combined basis, its aggressive acquisition strategy and the
uncertainty that acquisitions can be completed and integrated as planned, the
fact that many of the Company's operating and information systems are in the
development or implementation phase, competition, labor availability, regulatory
developments and other uncertainties, could cause actual results to differ
materially from those discussed in the forward-looking statements made in this
report.
 
LIMITED COMBINED OPERATING HISTORY
 
     The Company was incorporated in March 1996 and, simultaneously with the
closing of the Company's IPO on August 21, 1996, consummated the acquisition of
the Predecessor Companies in exchange for shares of Common Stock and cash. Since
the IPO, the Company has acquired numerous additional Service Centers. Because
of the limited operating history of the Company as a combined entity, there can
be no assurance that the Company will be able to integrate successfully the
businesses of its subsidiaries or to operate profitably. There can be no
assurance that the Company's management will be able to manage effectively the
combined entity and implement effectively the Company's operating and
acquisition strategies. Failure to integrate successfully the Company's
subsidiaries and to implement successfully the Company's operating and
acquisition strategies could have a material adverse effect on the Company's net
revenue and earnings.
 
RISKS ASSOCIATED WITH ACQUISITION STRATEGY AND FINANCING
 
     The success of the Company's acquisition strategy will depend on a number
of factors, including (i) the Company's ability to locate and successfully
negotiate the acquisition of HVAC businesses and to successfully integrate the
operations of acquired Service Centers into the Company's operations and (ii)
the availability of adequate financing to develop or acquire additional HVAC
businesses. In addition, the Company competes with other HVAC and residential
service companies for desirable acquisition candidates. Some of these companies
may have access to capital, personnel and other resources equal to or greater
than those of the Company. The Company expects that its capital needs over the
next several years, primarily for acquisitions, will exceed capital generated
from operations. The Company plans to incur indebtedness and to issue, from time
to time, additional debt or equity securities. In the event that the Common
Stock does not maintain a sufficient market value, or potential acquisition
candidates are unwilling to accept Common Stock as part of the consideration for
the sale of their businesses, the Company may be required to utilize more of its
cash resources, if available, in order to maintain its acquisition program.
There can be no assurance that the Company's acquisition strategy will be
successful, that modifications to the Company's strategy will not be required,
that the Company will be able to manage effectively and enhance the
profitability of additional Service Centers or that the Company will be able to
obtain adequate financing on reasonable terms to develop or acquire additional
HVAC service businesses.
 
RISKS ASSOCIATED WITH DEVELOPMENT, IMPLEMENTATION, AND INTEGRATION OF OPERATING
SYSTEMS AND POLICIES
 
     As a rapidly growing provider of HVAC services, the Company is faced with
the development, implementation and integration of Company-wide policies and
systems related to its operations. Each of the subsidiaries of the Company and
companies to be acquired may need, to some extent, to modify or adopt certain
systems and policies they have utilized historically in order to implement the
Company's systems and policies, which management is continuing to formulate. The
Company is implementing a uniform computer system and electronic mail system at
each of the Service Centers. The Company plans to implement and integrate
certain other information and operating systems and procedures for the Service
Centers including, but not limited to, uniform purchasing programs and certain
centralized marketing programs. The Company
 
                                       19
<PAGE>   20
 
may experience delays, complications and expenses in implementing, integrating
and operating such systems, any of which could have a material adverse effect on
the Company's operations, net revenue and earnings.
 
COMPETITION
 
     The HVAC service and replacement industry is highly competitive. The
Company's Service Centers compete with other full-service HVAC businesses
primarily on the basis of quality, reliability, customer service and price.
Several companies have been organized to pursue the acquisition of businesses
that offer HVAC services. Some of these competitors have access to capital,
personnel, marketing and technological resources that are equal to or greater
than those of the Company. In certain markets, the Company competes with utility
companies which have access to capital, personnel, marketing and technological
resources that are equal to or greater than those of the Company. Because of the
fragmented nature of the industry and relatively low barriers to entry,
additional competitors, including companies that offer other home improvement
services in addition to HVAC services, may emerge with greater access than the
Company to capital, personnel and technological resources. There can be no
assurance that the Company will be able to compete successfully or that such
competition will not make it more difficult to acquire HVAC businesses on terms
beneficial to the Company.
 
DEPENDENCE ON KEY PERSONNEL
 
     The success of the Company is dependent upon the continued services of the
Company's senior management, particularly upon its Chairman, President and Chief
Executive Officer, Alan R. Sielbeck. The loss of the services of Mr. Sielbeck or
any of the Company's senior management would have a material adverse effect upon
the Company's business and prospects.
 
LABOR AVAILABILITY
 
     The timely provision of high-quality service by the Service Centers
requires an adequate supply of skilled labor. In addition, the operating costs
of each Service Center may be adversely affected by high turnover in skilled
positions. Accordingly, the Company's ability to increase productivity and net
earnings is limited to a degree by its ability to employ the skilled laborers
necessary to meet the Company's service requirements. There can be no assurance
that the Company will be able to maintain an adequate skilled labor force
necessary to operate efficiently its Service Centers or that the Company's labor
expenses will not increase as a result of a shortage in the supply of skilled
workers.
 
SEASONAL NATURE OF THE INDUSTRY
 
     The HVAC service industry generally experiences increased demand during the
summer and winter months. The Company may, in certain periods, be affected by
these seasonal trends. Extended periods of unseasonably mild or wet weather can
have an adverse affect on the business of the Company. There can be no assurance
that the HVAC service and replacement industry will not experience future
declines or that such declines will not have a material adverse effect on the
Company.
 
CONTROL BY MANAGEMENT AND PRINCIPAL STOCKHOLDERS
 
     As of March 12, 1998, directors, officers and 5% stockholders of the
Company beneficially owned approximately 7.7% of the outstanding Common Stock.
Accordingly, these persons have substantial influence over the affairs of the
Company, including the ability to influence the election of directors and other
matters requiring stockholder approval.
 
REGULATION
 
     HVAC systems are subject to various environmental statutes and regulations,
including, but not limited to, laws and regulations implementing the Clean Air
Act, relating to minimum energy efficiency standards of HVAC systems and the
production, servicing and disposal of certain ozone depleting refrigerants used
in such systems. In connection with the entry into new markets, the Company may
become subject to compliance
                                       20
<PAGE>   21
 
with additional regulations, and there can be no assurance that the regulatory
environment in which the Company operates will not change significantly in the
future.
 
     Various local, state and federal laws and regulations, including those
implementing the Clean Air Act, impose licensing standards on technicians who
service heating and air conditioning units. While the installers and technicians
employed by the Service Centers are duly certified by applicable local, state
and federal agencies and have been able to meet or exceed such standards to
date, there can be no assurance that they will be able to meet future standards.
 
     In some states, warranties provided for in the Company's service agreements
may be deemed insurance contracts by applicable state insurance regulatory
agencies thereby subjecting the Company and the service agreements to the
insurance laws and regulations of such state.
 
CERTAIN ANTI-TAKEOVER PROVISIONS
 
     Certain provisions of the Company's Restated Certificate of Incorporation
("Restated Certificate") and Bylaws and Delaware law may make a change in the
control of the Company more difficult to effect, even if a change in control
were in the stockholders' interest. Section 203 of the Delaware General
Corporation Law would prevent an "interested stockholder" (defined in Section
203, generally, as a person owning 15% or more of the Company's outstanding
voting stock) from engaging in a "business combination" (as defined in Section
203) with the Company for three years following the date such person became an
interested stockholder unless certain conditions, including approval by the
Company's Board of Directors, are met. The Company's Restated Certificate and
Bylaws include certain super-majority voting requirements. The Restated
Certificate also allows the Board to determine the terms of preferred stock
which may be issued by the Company without approval of the holders of the Common
Stock. The ability of the Company to issue preferred stock in this manner could
enable the Board to prevent changes in management and control of the Company.
The Board of the Company is divided into three classes of directors, with
directors being elected for staggered three-year terms. Such staggered terms may
affect the ability of the holders of the Common Stock to change control of the
Company. In addition, certain provisions of the employment agreements between
the Company and the executive officers of the Company may make a change of
control more difficult. Pursuant to these employment agreements, upon a change
in control of the Company, each executive officer is to be paid as severance pay
such officer's base salary for the remaining term of the employment agreement.
 
VOLATILITY OF MARKET PRICE
 
     From time to time, there may be significant volatility in the market price
of the Common Stock. Quarterly operating results of the Company, changes in
earnings estimated by analysts, changes in general conditions in the economy or
the financial markets or other developments affecting the Company could cause
the market price of the Common Stock to fluctuate substantially. In addition, in
recent years the stock market has experienced extreme price and volume
fluctuations. This volatility has had a significant effect on the market prices
of securities issued by many companies for reasons unrelated to their operating
performance.
 
ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
 
     No disclosure required.
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
     See Appendix A.
 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
     None.
 
                                       21
<PAGE>   22
 
                                    PART III
 
ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
EXECUTIVE OFFICERS AND KEY EMPLOYEES
 
     Information with respect to the executive officers of the Company is
incorporated by reference to the information contained under the caption
"Executive Compensation -- Executive Officers of the Company" included in the
Company's Proxy Statement relating to its Annual Meeting of Stockholders to be
held on May 1, 1998.
 
DIRECTORS
 
     Information with respect to the Company's directors is incorporated by
reference to the information contained under the caption "Election of Directors"
included in the Company's Proxy Statement relating to its Annual Meeting of
Stockholders to be held on May 1, 1998.
 
COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT
 
     Information with respect to compliance with Section 16(a) of the Securities
Exchange Act of 1934 is incorporated by reference to the information contained
under the heading "Compliance with Reporting Requirements of the Exchange Act"
included in the Company's Proxy Statement relating to its Annual Meeting of
Stockholders to be held on May 1, 1998.
 
ITEM 11.  EXECUTIVE COMPENSATION
 
     This information is incorporated by reference to the information contained
under the heading "Executive Compensation" included in the Company's Proxy
Statement relating to its Annual Meeting of Stockholders to be held on May 1,
1998, except that the Comparative Performance Graph and the Compensation
Committee Report on Executive Compensation included in the Proxy Statement are
expressly not incorporated herein by reference.
 
ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     This information is incorporated by reference to the information contained
under the caption "Voting Securities and Principal Holders Thereof" included in
the Company's Proxy Statement relating to its Annual Meeting of Stockholders to
be held on May 1, 1998.
 
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     This information is incorporated by reference to the information contained
under the caption "Certain Relationships and Related Transactions" included in
the Company's Proxy Statement relating to its Annual Meeting of Stockholders to
be held on May 1, 1998.
 
                                       22
<PAGE>   23
 
                                    PART IV
 
ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
     (a) Index to Consolidated Financial Statements, Financial Statement
Schedules and Exhibits:
 
          (1) CONSOLIDATED FINANCIAL STATEMENTS: See Item 8 herein.
 
             The Consolidated Financial Statements of the Company required to be
        included in Part II, Item 8, are indexed on Page A-1 and submitted as a
        separate section of this report.
 
          (2) CONSOLIDATED FINANCIAL STATEMENT SCHEDULES:
 
             All schedules are omitted, because they are not applicable or not
        required, or because the required information is included in the
        consolidated financial statements or notes thereto.
 
          (3) EXHIBITS
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER         DESCRIPTION OF EXHIBITS
-------        -----------------------
<C>       <C>  <S>
   3.1     --  Restated Certificate of Incorporation of the Registrant(a)
   3.2     --  Bylaws of the Registrant(a)
   4       --  Form of Common Stock Certificate(b)
  10.1     --  Registrant's 1996 Incentive Stock Plan(a)
  10.2     --  Registrant's 1996 Non-Employee Director Stock Option Plan(a)
  10.3     --  Registrant's 1996 Employee Stock Purchase Plan(a)
  10.4     --  Registrant's 1997 Nonqualified Stock Option Plan(c)
  10.5     --  Registrant's 1997 Nonqualified Stock Purchase Plan(c)
  10.6     --  Employment Agreement, dated June 16, 1996, between the
               Registrant and Alan R. Sielbeck(a)
  10.7     --  Employment Agreement, dated June 16, 1996, between the
               Registrant and James D. Abrams(a)
  10.8     --  Employment Agreement, dated June 16, 1996, between the
               Registrant and Anthony M. Schofield(a)
  10.9     --  Employment Agreement, dated August 1, 1997, between the
               Registrant and Alfred W. Taylor III
  10.10    --  Employment Agreement, dated October 1, 1997, between the
               Registrant and Ronald L. Smith
  10.11    --  Form of Equitable Securities Corporation Stock Purchase
               Warrant(a)
  10.12    --  Amended and Restated Credit Agreement, dated September 18,
               1997, between the Registrant and SunTrust Bank, Nashville,
               N.A., as agent for the lenders
  10.13    --  First Amendment to Amended and Restated Credit Agreement,
               dated December 16, 1997, between the Registrant and SunTrust
               Bank, Nashville, N.A., as agent for the lenders
  10.14    --  Form of Combination Agreement by and among each of the
               Predecessor Companies, each of its respective stockholders
               and the Registrant(a)
  10.15    --  Form of Agreement and Plan of Merger among certain of the
               Registrant's subsidiaries, a wholly-owned subsidiary of the
               Registrant and the Registrant(c)
  10.16    --  Form of Combination Agreement between certain of the
               Registrant's subsidiaries and the Registrant(c)
  10.17    --  Form of Stock Purchase Agreement between the former
               stockholders of certain of the Registrant's subsidiaries and
               the Registrant
</TABLE>
 
                                       23
<PAGE>   24
 
<TABLE>
<CAPTION>
EXHIBIT
NUMBER         DESCRIPTION OF EXHIBITS
-------        -----------------------
<C>       <C>  <S>
  21       --  List of subsidiaries of the Registrant
  23       --  Consent of Ernst & Young LLP
  27       --  Financial Data Schedule (for SEC use only)
</TABLE>
 
---------------
 
(a)  Incorporated by reference to the exhibits filed with the Registrant's
     Registration Statement on Form S-l, Registration No. 333-07037.
(b)  Incorporated by reference to the exhibits filed with the Registrant's
     Registration Statement on Form 8-A, File No. 000-21173.
(c)  Incorporated by reference to the exhibits filed with the Registrant's
     Registration Statement on Form S-4, File No. 333-12319.
(d)  Incorporated by reference to the exhibits filed with the Registrant's
     Registration Statement on Form S-1, Registration No. 333-21971.
 
                                       24
<PAGE>   25
 
                 EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS
 
     The following is a list of all executive compensation plans and
arrangements filed as exhibits to this Annual Report on Form 10-K:
 
          1. Registrant's 1996 Incentive Stock Plan (filed as Exhibit 10.1)
 
          2. Registrant's 1996 Non-Employee Director Stock Option Plan (filed as
     Exhibit 10.2)
 
          3. Registrant's 1996 Employee Stock Purchase Plan (filed as Exhibit
     10.3)
 
          4. Registrant's 1997 Nonqualified Stock Option Plan (filed as Exhibit
     10.4)
 
          5. Registrant's 1997 Nonqualified Stock Purchase Plan (filed as
     Exhibit 10.5)
 
          6. Employment Agreement, dated June 26, 1996, between the Company and
     Alan R. Sielbeck (filed as Exhibit 10.6)
 
          7. Employment Agreement, dated June 26, 1996, between the Company and
     James D. Abrams (filed as Exhibit 10.7)
 
          8. Employment Agreement, dated June 26, 1996, between the Company and
     Anthony M. Schofield (filed as Exhibit 10.8)
 
          9. Employment Agreement, dated August 1, 1997, between the Registrant
     and Alfred W. Taylor III (filed as Exhibit 10.9)
 
          10. Employment Agreement, dated October 1, 1997, between the
     Registrant and Ronald L. Smith (filed as Exhibit 10.10)
 
     (b) Reports on Form 8-K
 
     The Company filed a Current Report on Form 8-K on October 15, 1997
reporting the acquisition of Parrott Mechanical, Inc. ("Parrott") pursuant to
Item 2 of Form 8-K. The Company also filed a Current Report on Form 8-K on
November 24, 1997 reporting combined operating results for the month of October
1997 for the Company and Hawk Heating & Air Conditioning, Inc., TML, Inc. and MT
Partnership (collectively, "TML"), Parrott and McAlister Heat & Air, Inc.
pursuant to Item 5 of Form 8-K. The Company also filed a Current Report on Form
8-K on November 26, 1997 containing the financial statements of TML and pro
forma financial statements pursuant to Item 5 of Form 8-K.
 
                                       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, in the City of
Nashville, State of Tennessee, on March 12, 1998.
 
                                          SERVICE EXPERTS, INC.
 
                                          By:     /s/ ALAN R. SIELBECK
                                            ------------------------------------
                                                      Alan R. Sielbeck
                                                  Chairman, President and
                                                  Chief Executive Officer
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed by the following persons on behalf of the Registrant in
the capacities and on the date indicated.
 
<TABLE>
<CAPTION>
                        NAME                                        TITLE                    DATE
                        ----                                        -----                    ----
<C>                                                    <S>                              <C>
 
                /s/ ALAN R. SIELBECK                   Chairman, President and          March 12, 1998
-----------------------------------------------------    Chief Executive Officer
                  Alan R. Sielbeck                       (principal executive officer)
 
              /s/ ANTHONY M. SCHOFIELD                 Chief Financial Officer,         March 12, 1998
-----------------------------------------------------    Secretary and Treasurer
                Anthony M. Schofield
 
                                                       Director
-----------------------------------------------------
                   James D. Abrams
 
                                                       Director
-----------------------------------------------------
                 Raymond J. De Riggi
 
               /s/ NORMAN T. ROLF, JR.                 Director                         March 12, 1998
-----------------------------------------------------
                 Norman T. Rolf, Jr.
 
                 /s/ WILLIAM G. ROTH                   Director                         March 12, 1998
-----------------------------------------------------
                   William G. Roth
 
               /s/ TIMOTHY G. WALLACE                  Director                         March 12, 1998
-----------------------------------------------------
                 Timothy G. Wallace
</TABLE>
 
                                       26
<PAGE>   27
 
                         INDEX TO FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                              PAGE
                                                              ----
<S>                                                           <C>
SERVICE EXPERTS, INC. -- AUDITED FINANCIAL STATEMENTS
  YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
Report of Independent Auditors..............................  A-2
Consolidated Balance Sheets.................................  A-3
Consolidated Statements of Operations.......................  A-5
Consolidated Statements of Stockholders' Equity.............  A-6
Consolidated Statements of Cash Flows.......................  A-7
Notes to Consolidated Financial Statements..................  A-8
</TABLE>
 
                                       A-1
<PAGE>   28
 
                         REPORT OF INDEPENDENT AUDITORS
 
The Stockholders
Service Experts, Inc.
 
     We have audited the accompanying consolidated balance sheets of Service
Experts, Inc. (see Note 1) as of December 31, 1996 and 1997, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
 
     We conducted our audits 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 provide a reasonable basis for our opinion.
 
     In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position of
Service Experts, Inc. (see Note 1) at December 31, 1996 and 1997, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997, in conformity with generally
accepted accounting principles.
 
                                                    ERNST & YOUNG LLP
 
Nashville, Tennessee
February 23, 1998
 
                                       A-2
<PAGE>   29
 
                             SERVICE EXPERTS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              ------------------
                                                               1996       1997
                                                              -------   --------
                                                                (IN THOUSANDS)
<S>                                                           <C>       <C>
                                     ASSETS
Current assets:
  Cash and cash equivalents.................................  $10,806   $ 11,192
  Accounts receivable:
     Trade, net of allowance for doubtful accounts of
      $773,000 in 1996 and $1,550,000 in 1997...............   13,405     29,129
     Related party..........................................      130        202
     Employee...............................................      114        365
     Other..................................................      208      2,099
                                                              -------   --------
                                                               13,857     31,795
  Inventories...............................................    5,245     11,570
  Costs and estimated earnings in excess of billings........      525      1,805
  Prepaid expenses and other current assets.................      785      2,458
  Current portion of notes receivable -- related parties....       14         14
  Current portion of notes receivable -- other..............      294        284
  Deferred income taxes.....................................    1,918      3,896
                                                              -------   --------
          Total current assets..............................   33,444     63,014
Property, buildings and equipment:
  Land......................................................    1,198      1,365
  Buildings.................................................    1,649      3,252
  Furniture and fixtures....................................    1,737      5,900
  Machinery and equipment...................................    3,290      5,718
  Vehicles..................................................    7,078     14,754
  Leasehold improvements....................................    1,277      2,477
                                                              -------   --------
                                                               16,229     33,466
Less accumulated depreciation and amortization..............   (4,976)    (8,986)
                                                              -------   --------
                                                               11,253     24,480
Notes receivable -- related parties, net of current
  portion...................................................      352        338
Notes receivable -- other, net of current portion...........      679        591
Goodwill, net of accumulated amortization of $72,000 in 1996
  and $1,883,000 in 1997....................................   33,038    105,158
Other assets................................................    1,404      1,229
                                                              -------   --------
          Total assets......................................  $80,170   $194,810
                                                              =======   ========
</TABLE>
 
                            See accompanying notes.
 
                                       A-3
<PAGE>   30
 
                             SERVICE EXPERTS, INC.
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              ------------------
                                                               1996       1997
                                                              -------   --------
                                                                (IN THOUSANDS)
<S>                                                           <C>       <C>
                      LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Line of credit and short-term debt........................  $ 1,477   $     --
  Trade accounts payable and accrued liabilities............    7,696     17,821
  Cash consideration payable................................    1,495         --
  Accrued compensation......................................    1,933      6,129
  Accrued warranties........................................    1,076      2,139
  Income taxes payable......................................    1,724        608
  Deferred revenue..........................................    3,685      6,816
  Billings in excess of costs and estimated earnings........      798      1,282
  Current portion related party notes.......................       24         --
  Current portion of long-term debt and capital lease
     obligations............................................      658        274
                                                              -------   --------
          Total current liabilities.........................   20,566     35,069
Related party notes, net of current portion.................        9         --
Long-term debt and capital lease obligations, net of current
  portion...................................................    3,915     15,663
Deferred income taxes.......................................      361      1,676
Commitments (Note 11)
Stockholders' equity:
  Common stock $.01 par value; 30,000,000 shares authorized;
     11,621,847 and 15,422,269 shares issued and outstanding
     at December 31, 1996 and 1997, respectively............      116        154
  Preferred stock, $.01 par value; 10,000,000 shares
     authorized, no shares issued and outstanding...........       --         --
  Additional paid-in capital................................   50,459    122,673
  Retained earnings.........................................    4,759     19,575
  Equity notes receivable...................................      (15)        --
                                                              -------   --------
          Total stockholders' equity........................   55,319    142,402
                                                              -------   --------
 
          Total liabilities and stockholders' equity........  $80,170   $194,810
                                                              =======   ========
</TABLE>
 
                            See accompanying notes.
 
                                       A-4
<PAGE>   31
 
                             SERVICE EXPERTS, INC.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                                YEAR ENDED DECEMBER 31,
                                                              ----------------------------
                                                               1995      1996       1997
                                                              -------   -------   --------
                                                                     (IN THOUSANDS,
                                                                 EXCEPT PER SHARE DATA)
<S>                                                           <C>       <C>       <C>
Net revenue.................................................  $49,748   $74,913   $238,692
Cost of goods sold..........................................   38,227    52,628    154,598
                                                              -------   -------   --------
Gross margin................................................   11,521    22,285     84,094
Selling, general and administrative expenses................   11,185    17,384     60,219
                                                              -------   -------   --------
Income from operations......................................      336     4,901     23,875
Other income (expense):
  Interest expense..........................................     (610)     (613)      (688)
  Interest income...........................................       66       361        775
  Other income..............................................      185       226        493
                                                              -------   -------   --------
                                                                 (359)      (26)       580
                                                              -------   -------   --------
Income (loss) before federal and state income taxes.........      (23)    4,875     24,455
Provision (benefit) for income taxes:
  Current...................................................      102     2,677      9,642
  Deferred..................................................       44    (1,541)      (453)
                                                              -------   -------   --------
                                                                  146     1,136      9,189
                                                              -------   -------   --------
  Net income (loss).........................................  $  (169)  $ 3,739   $ 15,266
                                                              =======   =======   ========
Net income (loss) per share:
  Basic.....................................................  $  (.08)  $   .74   $   1.07
                                                              =======   =======   ========
  Diluted...................................................  $  (.08)  $   .74   $   1.06
                                                              =======   =======   ========
Weighted average shares outstanding:
  Basic.....................................................    2,132     5,022     14,305
                                                              =======   =======   ========
  Diluted...................................................    2,132     5,051     14,453
                                                              =======   =======   ========
</TABLE>
 
                            See accompanying notes.
 
                                       A-5
<PAGE>   32
 
                             SERVICE EXPERTS, INC.
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                           COMMON STOCK     ADDITIONAL                EQUITY
                                          ---------------    PAID-IN     RETAINED     NOTES
                                          SHARES   AMOUNT    CAPITAL     EARNINGS   RECEIVABLE    TOTAL
                                          ------   ------   ----------   --------   ----------   --------
                                                                  (IN THOUSANDS)
<S>                                       <C>      <C>      <C>          <C>        <C>          <C>
Balance at January 1, 1995..............   2,133    $ 21     $  1,196    $ 2,669       $ --      $  3,886
  Capital distributions.................      --      --           --       (584)        --          (584)
  Capital contributions.................      --      --          188         --         --           188
  Net loss..............................      --      --           --       (169)        --          (169)
                                          ------    ----     --------    -------       ----      --------
Balance at December 31, 1995............   2,133      21        1,384      1,916         --         3,321
  Change in retained earnings due to
     conversion of Pooled Company to
     calendar year-end..................      --      --           --         (4)        --            (4)
  Issuance of stock at initial public
     offering...........................   2,588      26       28,087         --         --        28,113
Predecessor companies (see Note 3)
  Issuance of stock.....................   4,832      48        6,462         --        (15)        6,495
  Capital distributions.................      --      --      (18,699)        --         --       (18,699)
Issuance of stock for acquired companies
  (see Note 4)..........................   2,069      21       32,475         --         --        32,496
  Capital distributions.................      --      --           --       (892)        --          (892)
  Capital contributions.................      --      --          750         --         --           750
  Net income............................      --      --           --      3,739         --         3,739
                                          ------    ----     --------    -------       ----      --------
Balance at December 31, 1996............  11,622     116       50,459      4,759        (15)       55,319
Issuance of stock at secondary
  offering..............................   1,850      19       38,029         --         --        38,048
Issuance of stock Employee Stock
  Purchase Plan.........................      23      --          250         --         --           250
Issuance of stock for acquired companies
  (see Note 4)..........................   1,927      19       33,905         --         --        33,924
  Capital distributions.................      --      --           --       (450)        --          (450)
  Capital contributions.................      --      --           30         --         15            45
  Net income............................      --      --           --     15,266         --        15,266
                                          ------    ----     --------    -------       ----      --------
  Balance at December 31, 1997..........  15,422    $154     $122,673    $19,575       $ --      $142,402
                                          ======    ====     ========    =======       ====      ========
</TABLE>
 
                            See accompanying notes.
 
                                       A-6
<PAGE>   33
 
                             SERVICE EXPERTS, INC.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                                 YEAR ENDED DECEMBER 31,
                                                              -----------------------------
                                                               1995       1996       1997
                                                              -------   --------   --------
                                                                     (IN THOUSANDS)
<S>                                                           <C>       <C>        <C>
OPERATING ACTIVITIES
Net income (loss)...........................................  $  (169)  $  3,739   $ 15,266
Adjustments to reconcile net income (loss) to net cash
  provided by (used in) operating activities:
  Depreciation..............................................    1,158      1,186      4,278
  Amortization..............................................       --         72      1,810
  Provision (benefit) for deferred income taxes.............       44     (1,541)      (453)
  Loss (gain) on asset disposals............................      (51)       (44)       151
  Provision for loss on accounts receivable.................      213        391        385
  Changes in operating assets and liabilities:
    Receivables.............................................     (674)    (1,132)    (8,587)
    Inventories.............................................     (200)      (365)    (1,229)
    Prepaid expenses and other current assets...............        3       (318)      (631)
    Trade accounts payable and accrued liabilities..........      143     (1,594)     2,740
    Accrued compensation....................................       32       (713)     2,324
    Accrued warranties......................................       59        150        237
    Deferred revenue........................................       56        435       (288)
    Income taxes payable....................................     (207)       287     (2,040)
    Costs and estimated earnings in excess of billings and
     billings in excess of costs and estimated earnings.....     (436)        37       (501)
                                                              -------   --------   --------
        Net cash flow provided by (used in) operating
        activities..........................................      (29)       590     13,462
INVESTING ACTIVITIES
Payments (advances) on notes receivable.....................       --       (250)       378
Purchase of property, buildings, and equipment..............   (2,472)    (1,033)    (9,886)
Proceeds from sale of property, buildings, and equipment....       93        273        553
Cash acquired through acquisitions..........................       --      3,961      3,995
Payment of cash for acquired companies......................      (25)   (18,699)   (46,568)
Increase (decrease) in other assets.........................      (89)      (334)       775
                                                              -------   --------   --------
        Net cash used in investing activities...............   (2,493)   (16,082)   (50,753)
FINANCING ACTIVITIES
Increase (decrease) in short-term debt......................    2,350     (1,341)    (1,477)
Proceeds from notes payable to shareholders and related
  parties...................................................       --         59         --
Payments on notes payable to shareholders and related
  parties...................................................       (9)      (900)    (1,495)
Issuance of stock at secondary offering, net of issuance
  costs.....................................................       --     28,113     38,048
Issuance of stock, Employee Stock Purchase Plan.............       --         --        250
Proceeds of long-term debt and capital leases...............    1,426      2,424     15,500
Payments of long-term debt and capital leases...............     (681)    (2,270)   (12,744)
Cash contributions received.................................      163        320         45
Distributions paid..........................................     (584)      (892)      (450)
                                                              -------   --------   --------
        Net cash provided by financing activities...........    2,665     25,513     37,677
                                                              -------   --------   --------
Increase in cash and cash equivalents.......................      143     10,021        386
Cash and cash equivalents at beginning of period............      739        882     10,806
Change in cash and cash equivalents due to conversion of
  Pooled Company to calendar year-end.......................       --        (97)        --
                                                              -------   --------   --------
Cash and cash equivalents at end of period..................  $   882   $ 10,806   $ 11,192
                                                              =======   ========   ========
SUPPLEMENTAL CASH FLOW INFORMATION
Interest paid...............................................  $   562   $    613   $    528
                                                              =======   ========   ========
Income tax paid.............................................  $    99   $  1,907   $ 11,036
                                                              =======   ========   ========
Fair value of land contributed by stockholders..............  $    --   $    430   $     --
                                                              =======   ========   ========
DISTRIBUTION OF ASSETS TO STOCKHOLDERS
Book value of assets distributed............................  $    --   $  1,324   $     --
                                                              -------   --------   --------
Long-term debt assumed by stockholders......................  $    --   $    488   $     --
                                                              -------   --------   --------
Notes payable to stockholders retired.......................  $    --   $    343   $     --
                                                              =======   ========   ========
</TABLE>
 
                            See accompanying notes.
 
                                       A-7
<PAGE>   34
 
                             SERVICE EXPERTS, INC.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
REPORTING ENTITY
 
     Service Experts, Inc. (the "Company") was incorporated on March 27, 1996.
As a result of the adoption of Securities and Exchange Commission ("Commission")
Staff Accounting Bulletin No. 97 ("SAB 97") on July 31, 1996, the historical
financial statements of the Company for periods prior to August 21, 1996 are the
combined financial statements of AC Service & Installation Co., Inc. and
Donelson Air Conditioning Company, Inc. (collectively, the "Acquiring Company")
and seven subsequent acquisitions accounted for as poolings of interests (see
Note 2). AC Service & Installation Co., Inc. and Donelson Air Conditioning
Company, Inc. were under common control prior to August 21, 1996. On August 21,
1996 and simultaneous with the closing of its initial public offering, the
Company acquired in separate transactions, 12 heating, ventilating and air
conditioning ("HVAC") replacement and service businesses and Contractor Success
Group, Inc. (collectively, the "Predecessor Companies") in exchange for shares
of the Company's Common Stock and cash (the "Combination"). The Acquiring
Company was treated as the acquiror entity in this transaction in accordance
with SAB 97. The operations of the Predecessor Companies have been included in
the Company's financial statements from the date of acquisition. The
above-mentioned acquisitions have been accounted for using the historical cost
basis of the acquired companies in accordance with Commission Staff Accounting
Bulletin No. 48 ("SAB 48"). The Company operates in one industry segment and is
primarily engaged in the replacement and servicing of HVAC units for residential
and commercial customers. The Company has Service Centers located in cities
across the United States.
 
PRINCIPLES OF CONSOLIDATION
 
     The consolidated financial statements of Service Experts, Inc. include the
accounts of the Company and its subsidiaries. All material intercompany
transactions have been eliminated in consolidation. Investments in affiliates
less than 50.0% owned are generally recorded on the equity method.
 
RECOGNITION OF REVENUE
 
     Revenue on all of the Company's heating and air conditioning installation
contracts for commercial buildings is recognized on the percentage of completion
method in the ratio that total incurred costs bear to total estimated costs.
Revenue on all of the Company's residential heating and air conditioning
installation, service and maintenance jobs is recognized upon completion of the
services, which is usually within one to two days.
 
     Earnings and estimated costs on contracts are reviewed throughout the terms
of the contracts, and any required adjustments are reflected in the periods in
which they first become known. When estimates indicate a probable loss on a
contract, the full amount thereof is accrued in the period in which it is first
determined. Most contracts are completed within six to 18 months.
 
     Trade accounts receivable includes billings and billed retainage on
contracts. Also included in trade accounts receivable are unbilled retainage
amounts of $718,000 and $1,376,000 at December 31, 1996 and 1997, respectively.
The Company classifies these amounts as current assets because all balances are
expected to be collected in the current year. Concentrations of credit risk with
respect to trade receivables are limited due to the large number of customers
comprising the Company's customer base, and their dispersions across many
different industries and geographies.
 
     The asset, "costs and estimated earnings in excess of billings," represents
revenue recognized in excess of amounts billed on in-progress contracts. The
liability, "billings in excess of costs and estimated earnings," represents
billings in excess of revenue recognized on in-progress contracts.
 
                                       A-8
<PAGE>   35
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
FAIR VALUE OF FINANCIAL INSTRUMENTS
 
  Cash and Cash Equivalents
 
     The carrying amounts reported in the consolidated balance sheets for cash
and cash equivalents approximate fair value.
 
  Accounts Receivable, Notes Receivable, Accounts Payable and Accrued
Liabilities
 
     The carrying amounts reported in the consolidated balance sheets for
accounts receivable, notes receivable, accounts payable and accrued liabilities
approximate fair value. Accounts receivable and notes receivable are usually
unsecured.
 
  Long-Term Debt and Related Party Notes Payable
 
     Based upon the borrowing rates currently available to the Company, the
carrying amounts reported in the consolidated balance sheets for long-term debt
and related party notes payable approximate fair value.
 
CONCENTRATIONS OF CREDIT RISK
 
     At times, cash balances in the Company's accounts may exceed FDIC insurance
limits. The Company primarily purchases HVAC units that are manufactured by four
companies: Amana, Carrier Air Conditioning, Inc., Lennox Industries, Inc. and
The Trane Company. Total purchases of equipment and parts from these
manufacturers during 1997 totaled approximately $35.4 million.
 
CASH EQUIVALENTS
 
     The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.
 
ALLOWANCE FOR DOUBTFUL ACCOUNTS
 
     During the years ended December 31, 1995, 1996 and 1997 amounts charged to
bad debts expense and accounts written off, net of recoveries, were as follows:
 
<TABLE>
<CAPTION>
                                  BALANCE AT    CHARGED TO   CHARGED TO                  BALANCE AT
                                 BEGINNING OF   COSTS AND      OTHER                       END OF
YEAR ENDED                          PERIOD       EXPENSES     ACCOUNTS     DEDUCTIONS      PERIOD
----------                       ------------   ----------   ----------    ----------    ----------
                                                           (IN THOUSANDS)
<S>                              <C>            <C>          <C>           <C>           <C>
December 31, 1995..............      $259          $213         $ --          $170(1)      $  302
December 31, 1996..............      $302          $391         $390(2)       $310(1)      $  773
December 31, 1997..............      $773          $385         $569(2)       $177(1)      $1,550
</TABLE>
 
---------------
 
(1) Uncollectible accounts written off, net of recoveries.
(2) Allowance for bad debts of acquired companies.
 
INVENTORIES
 
     Inventories are stated at cost, which is not in excess of market. Cost is
determined by the first-in, first-out (FIFO) method for all inventories.
 
                                       A-9
<PAGE>   36
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
PROPERTY, BUILDINGS AND EQUIPMENT
 
     Property, building and equipment are stated on the basis of cost.
Depreciation and amortization are provided on the straight-line and
declining-balance methods over the following useful lives:
 
<TABLE>
<CAPTION>
                                                              YEARS
                                                              -----
<S>                                                           <C>
Buildings...................................................  31.5
Furniture and fixtures......................................     5
Machinery and equipment.....................................     5
Vehicles....................................................     5
Leasehold improvements......................................  7-30
</TABLE>
 
     Assets acquired upon the acquisition of businesses are depreciated and
amortized over the shorter of the respective assets' remaining useful lives or
the above useful lives for new acquired assets.
 
GOODWILL
 
     Goodwill consists of the excess of purchase price over the fair value of
acquired tangible and identifiable intangible assets. Excess cost over the fair
value of net assets acquired (or goodwill) is amortized on a straight-line basis
over 40 years.
 
LONG-LIVED ASSETS
 
     Statement of Financial Accounting Standards No. 121, "Accounting for the
Impairment of Long-lived Assets and for Long-lived Assets to be Disposed Of"
requires that companies consider whether indicators of impairment of long-lived
assets held for use are present. If such indicators are present, companies
determine whether the sum of the estimated undiscounted future cash flows
attributable to such assets is less than their carrying amount, and if so,
companies recognize an impairment loss based on the excess of the carrying
amount of the assets over their fair value. Accordingly, management periodically
evaluates the ongoing value of property, buildings, equipment and goodwill and
has determined that there were no indications of impairment as of December 31,
1996 and 1997.
 
DEFERRED REVENUE
 
     The Company pre-sells maintenance contracts in the form of extended service
agreements ("ESA"). ESA revenue is recorded as deferred revenue and recognized
as income when the service is performed.
 
PREFERRED STOCK
 
     Preferred stockholders are entitled to such preferences to the Common Stock
as to dividends and distributions of assets of the Company on dissolution as
determined by the Board of Directors. The Board of Directors has the power and
authority to establish preferences related to dividends, redemptions, payment on
liquidation, conversion privileges and voting rights. As of December 31, 1997,
the Company had no shares of preferred stock issued and outstanding.
 
WARRANTIES
 
     The Company provides the retail customer with a warranty ranging from one
to ten years on parts and labor from the date of installation of the HVAC unit.
This warranty generally runs concurrent with the manufacturer's warranty on
parts and labor for the first year. The Company provides an accrual for future
warranty costs based upon the relationship of prior years' sales to actual
warranty costs. It is the Company's practice to classify the entire warranty
accrual as a current liability.
 
                                      A-10
<PAGE>   37
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
USE OF ESTIMATES
 
     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
 
INCOME TAXES
 
     The Company, in general, uses the liability method of accounting for
federal and state income taxes as provided by SFAS No. 109, "Accounting for
Income Taxes." Under the liability method, the deferred tax liability or asset
is based on temporary differences between the financial statement and income tax
bases of assets and liabilities, measured at tax rates that will be in effect
when the differences reverse.
 
ADVERTISING COSTS
 
     The Company expenses advertising costs as incurred. During 1995, 1996 and
1997, the Company expensed $916,000, $1,782,000 and $8,183,000, respectively.
 
INCOME PER SHARE
 
     In 1997, the Financial Accounting Standards Board ("FASB") issued Statement
No. 128, "Earnings Per Share" ("Statement 128"). Statement 128 replaced the
calculation of primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options, warrants and convertible
securities. Diluted earnings per share is very similar to the previously
reported fully diluted earnings per share, and uses the treasury stock method in
calculating dilution. All earnings per share amounts for all periods have been
presented and restated to conform to Statement 128 requirements.
 
NEWLY ISSUED ACCOUNTING STANDARDS
 
     In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive
Income" ("Statement 130"). Statement 130 establishes standards for reporting and
displaying comprehensive income and its components in a full set of general
purpose financial statements. Statement 130 is effective for interim and annual
periods beginning in 1998. Comprehensive income encompasses all changes in
stockholders' equity (except those arising from transactions from owners) and
includes net income, net unrealized capital gains or losses on available for
sale securities and foreign currency translation adjustments. Management of the
Company does not expect the adoption of Statement 130 to have a material impact
on the Company's financial statements.
 
     In June 1997, the FASB issued Statement No. 131, "Disclosures about
Segments of an Enterprise and Related Information" ("Statement 131"). Statement
131 establishes standards for the way public business enterprises are to report
information about operating segments in annual financial statements and requires
these enterprises to report selected information about operating segments in
interim financial reports issued to shareholders. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. Statement 131 is effective for fiscal years beginning after December
15, 1997. Management of the Company is currently reviewing the impact of
Statement 131. The Company will adopt Statement 131 on December 31, 1998 and
will report interim information effective in the first quarter of 1999.
 
2.  BUSINESS COMBINATIONS
 
     In December 1996, the Company completed business combinations with Custom
Air Conditioning, Inc. ("Custom") and Freschi Air Systems, Inc. ("Freschi")
through the exchange of 230,049 and 177,765 shares of the Company's Common
Stock, respectively. These business combinations were accounted for as poolings
                                      A-11
<PAGE>   38
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
of interest and, accordingly, the consolidated financial statements were
restated in 1996 to include the accounts of these pooled companies. The Company
completed a business combination with C. Iapaluccio Company, Inc. ("Iapaluccio")
through the exchange of 92,553 shares of the Company's Common Stock in May 1997.
The Company also completed business combinations with Parrott Mechanical, Inc.,
including real property operations used by the company ("Parrott Mechanical et
al."), TML, Inc. and MT Partnership (collectively, "TML"), Hawk Heating & Air
Conditioning, Inc. ("Hawk") and McAlister Heat & Air, Inc. ("McAlister") through
the exchange of 171,230, 240,526, 34,426 and 32,786 shares, respectively, of the
Company's Common Stock in September 1997.
 
     These five business combinations have been accounted for as poolings of
interests and, accordingly, the consolidated financial statements for the
periods presented have been restated to include the accounts of these pooled
companies. The following is a summary of results of operations of the separate
pooled entities acquired in 1997 for periods prior to the business combinations.
 
<TABLE>
<CAPTION>
                                                        YEAR ENDED       THREE MONTHS    NINE MONTHS
                                                       DECEMBER 31,         ENDED           ENDED
                                                     -----------------    MARCH 31,     SEPTEMBER 30,
                                                      1995      1996         1997           1997
                                                     -------   -------   ------------   -------------
                                                                                 (UNAUDITED)
                                                                      (IN THOUSANDS)
<S>                                                  <C>       <C>       <C>            <C>
Net revenue
  Service Experts..................................  $24,876   $46,856     $33,355        $144,153
  Iapaluccio.......................................    1,756     2,591         536             N/A
  Parrott..........................................   12,383    14,607         N/A          12,908
  TML..............................................    8,182     8,064         N/A           8,082
  Hawk.............................................    1,041     1,206         N/A           1,077
  McAlister........................................    1,510     1,589         N/A           1,353
                                                     -------   -------     -------        --------
  Combined.........................................  $49,748   $74,913     $33,891        $167,573
                                                     =======   =======     =======        ========
Net income (loss)
  Service Experts..................................  $   708   $ 3,110     $ 1,827        $  9,742
  Iapaluccio.......................................       27        84          17             N/A
  Parrott..........................................   (1,371)      360         N/A             816
  TML..............................................      380        38         N/A             596
  Hawk.............................................       19        26         N/A             166
  McAlister........................................       68       121         N/A             195
                                                     -------   -------     -------        --------
  Combined.........................................  $  (169)  $ 3,739     $ 1,844        $ 11,515
                                                     =======   =======     =======        ========
</TABLE>
 
3.  RECAPITALIZATION, INITIAL PUBLIC OFFERING AND SECONDARY OFFERING
 
     On August 21, 1996, the Company completed an initial public offering
("IPO") of 2,587,500 shares of Common Stock at $13.00 per share. Simultaneously
with the closing of the IPO, the Company issued 3,369,538 shares of Common Stock
and distributed $18,699,000 in cash (exclusive of 1,153,098 shares issued and
$5,027,947 cash distributed to the former stockholders of the Acquiring Company)
in exchange for the capital stock of the Predecessor Companies. The exchange is
being accounted for utilizing the historical cost basis in accordance with SAB
48 with the stock being valued at the historical cost of the net assets
exchanged. Cash consideration given in these acquisitions is treated for
accounting purposes as a dividend from the Company.
 
     On March 18, 1997, the Company completed a secondary public stock offering,
which involved a sale to the public of 1,850,000 shares of Common Stock at
$22.00 per share which resulted in $38.0 million in net proceeds to the Company.
A portion of the net proceeds was used to pay the cash portion of the
consideration
 
                                      A-12
<PAGE>   39
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
for acquisitions and to repay certain indebtedness arising from acquisitions.
The remaining proceeds were used to fund the Company's capital expenditures,
acquisitions and for general corporate purposes.
 
4.  ACQUISITIONS
 
     On November 18, 1996, the Company filed a shelf Registration Statement on
Form S-4 (the "Shelf Registration Statement") covering securities with a
collective aggregate offering price of $50.0 million for use in acquisitions.
The following table sets forth certain information regarding acquisitions in
1996 and 1997:
 
<TABLE>
<CAPTION>
                                  SERVICE      TOTAL       TOTAL
                                  CENTERS    COMPANIES    SHARES         CASH            TOTAL
                                  ACQUIRED   ACQUIRED     ISSUED     CONSIDERATION   CONSIDERATION
                                  --------   ---------   ---------   -------------   -------------
                                                                            (IN THOUSANDS)
<S>                               <C>        <C>         <C>         <C>             <C>
1996
Fourth Quarter...................    13         17       2,498,000      $ 2,983         $44,038

1997
First Quarter....................     7         13         772,000       15,126          28,287
Second Quarter...................     9         18         470,000       10,788          21,625
Third Quarter....................    10         20         717,000       10,252          30,254
Fourth Quarter...................    12         20         540,000        6,949          22,612
</TABLE>
 
     The Company established an escrow account equal to 10% of the purchase
price for each acquisition, subject to final closing adjustments. The purchase
price was allocated to the acquired assets based on the fair values of those
assets as determined by the Company as set forth below for the acquisitions
accounted for under the purchase method:
 
<TABLE>
<CAPTION>
                                                               1996        1997
                                                              -------    --------
                                                                (IN THOUSANDS)
<S>                                                           <C>        <C>
Current assets..............................................  $ 7,032    $ 23,622
Property, buildings and equipment...........................    2,593      11,106
Other assets................................................      392       1,665
Goodwill....................................................   32,337      73,930
Liabilities assumed.........................................   (6,787)    (20,494)
                                                              -------    --------
          Purchase price....................................  $35,567    $ 89,829
                                                              =======    ========
</TABLE>
 
     The Company has four purchase agreements which provide for contingent
payments based on the four acquired companies achieving specified levels based
on earnings before income taxes, depreciation and amortization (EBITDA), pretax
income or net income during the 12 month period subsequent to the acquisition.
The maximum additional consideration under these earn-out agreements is
approximately $5.9 million. Any such payments will be capitalized as goodwill.
 
     In connection with the acquisitions, the Company incurred $148,000 in costs
associated with the termination of acquired companies' 401(k) plans. These
amounts were capitalized as a part of the purchase price.
 
                                      A-13
<PAGE>   40
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
OTHER INFORMATION REGARDING ACQUISITIONS
 
     All of the foregoing acquisitions were accounted for using the purchase
method of accounting. The allocation of the purchase price associated with the
acquisitions has been determined by the Company based upon available
information and is subject to further refinement. The operating results of the
acquired companies have been included in the accompanying consolidated
statements of operations from the respective dates of acquisition. The
following unaudited pro forma results of operations give effect to the
operations of the entities acquired as if the respective transactions had
occurred as of the first day of the fiscal year immediately preceding the year
of the transactions. The pro forma results of operations do not purport to
represent what the Company's results of operations would have been had such
transactions in fact occurred at the beginning of the years presented or to
project the Company's results of operations in any future period.
 
<TABLE>
<CAPTION>
                                                                 YEAR ENDED DECEMBER 31,
                                                              ------------------------------
                                                                1995       1996       1997
                                                              --------   --------   --------
                                                                  (IN THOUSANDS, EXCEPT
                                                                     PER SHARE DATA)
<S>                                                           <C>        <C>        <C>
Net revenue.................................................  $136,928   $257,429   $286,024
Net income..................................................     4,360     12,165     15,845
Income per common share:
  Basic.....................................................  $    .38   $    .90   $   1.05
  Diluted...................................................  $    .38   $    .90   $   1.04
</TABLE>
 
     Subsequent to December 31, 1997, the Company completed the acquisition of
eight Service Centers by issuing approximately 321,000 shares of Common Stock
and paying cash consideration of approximately $6.0 million. The following
unaudited pro forma results of operations give effect to the operations of the
entities acquired during 1997 and subsequent to December 31, 1997 as if the
respective transactions had occurred as of the first day of the fiscal year
immediately preceding the year of the transactions. The pro forma results of
operations do not purport to represent what the Company's results of operations
would have been had such transactions in fact occurred at the beginning of the
years presented or to project the Company's results of operations in any future
period.
 
<TABLE>
<CAPTION>
                                                                   YEAR ENDED
                                                                  DECEMBER 31,
                                                              ---------------------
                                                                1996        1997
                                                              ---------   ---------
                                                              (IN THOUSANDS, EXCEPT
                                                                 PER SHARE DATA)
<S>                                                           <C>         <C>
Net revenue.................................................  $282,300    $313,454
Net income..................................................    13,091      16,984
Income per common share:
  Basic.....................................................  $    .96    $   1.12
  Diluted...................................................  $    .96    $   1.11
</TABLE>
 
                                      A-14
<PAGE>   41
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
5.  CONTRACTS IN PROCESS
 
     Information relative to contracts in process is as follows:
 
<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              -------------------
                                                               1996        1997
                                                              -------    --------
                                                                (IN THOUSANDS)
<S>                                                           <C>        <C>
Contracts on the percentage-of-completion method:
  Expenditures on uncompleted contacts......................  $ 6,944    $ 19,974
  Estimated earnings........................................    2,348       7,127
                                                              -------    --------
                                                                9,292      27,101
Less applicable billings....................................   (9,565)    (26,578)
                                                              -------    --------
                                                              $  (273)   $    523
                                                              =======    ========
Included in the accompanying consolidated balance sheets
  under the following captions:
  Costs and estimated earnings in excess of billings........  $   525    $  1,805
  Billings in excess of costs and estimated earnings........     (798)     (1,282)
                                                              -------    --------
                                                              $  (273)   $    523
                                                              =======    ========
</TABLE>
 
     Progress billings on contracts bear a relation to costs incurred, but are
not indicative of the ultimate profit or loss on a contract.
 
6.  NOTES RECEIVABLE
 
     Notes receivable are accepted from members of Contractor Success Group,
Inc. who desire to finance a portion of their initial membership fee. The
original principal balance generally does not exceed $15,000 and the notes
typically involve a three-year term, accrue interest at 18.0% and are payable in
equal monthly installments. The notes are periodically reviewed for
collectibility and reserves are established at the time it appears that
collectibility is uncertain.
 
     Also included in notes receivable is a note receivable with a balance of
$181,000 and $174,000 at December 31, 1996 and 1997, respectively, which bears
interest at 9.0% and is due in monthly installments with all unpaid principle
due and payable as a balloon payment on July 1, 2009.
 
                                      A-15
<PAGE>   42
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
7.  LEASES
 
     Total rental expense for all operating leases was $254,000, $574,000 and
$2,863,000 for 1995, 1996 and 1997, respectively. The Company leases office and
warehouse space from various stockholders of the Company. These lease agreements
expire at various dates through 2006. The major facilities' leases are for terms
of two to ten years and generally provide renewal options for terms up to five
additional years. In addition, some leases contain purchase options. Management
expects that in the normal course of business, most leases that expire will be
renewed or replaced by other leases. Related party rental expense for 1995, 1996
and 1997 was $215,000, $362,000 and $1,513,000, respectively. The Company leases
certain vehicles and office and warehouse facilities under terms of
non-cancelable operating lease agreements which expire at various dates through
2006. Minimum rental commitments at December 31, 1997 under operating leases
having an initial non-cancelable term of one year or more are as follows:
 
<TABLE>
<CAPTION>
                                                       CAPITAL   OPERATING   RELATED
                                                       LEASES     LEASES      PARTY    TOTAL
                                                       -------   ---------   -------   ------
                                                                   (IN THOUSANDS)
<S>                                                    <C>       <C>         <C>       <C>
1998.................................................     59         652      1,951     2,662
1999.................................................     55         569      1,910     2,534
2000.................................................     26         546      1,819     2,391
2001.................................................     --         433      1,584     2,017
2002.................................................     --         192        625       817
Thereafter...........................................     --         109        648       757
                                                        ----       -----      -----    ------
                                                         140       2,501      8,537    11,178
                                                                   =====      =====    ======
Less amounts representing interest...................     19
                                                        ----
Present value of net minimum rentals (including $50
  classified as current).............................   $121
                                                        ====
</TABLE>
 
     The carrying value of assets under capital leases, which are included with
owned assets in the accompanying consolidated balance sheets is $154,000 at
December 31, 1996 and $120,000 at December 31, 1997.
 
     Amortization of the assets under capital leases is included in depreciation
expense.
 
8.  LONG-TERM DEBT
 
     Long-term debt consists of the following:
 
<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              -----------------
                                                               1996      1997
                                                              ------    -------
                                                               (IN THOUSANDS)
<S>                                                           <C>       <C>
Line of credit and short-term debt..........................  $1,477    $15,500
Mortgage notes payable......................................   1,167         --
Installment and equipment notes.............................     207        316
Other.......................................................   3,076         --
                                                              ------    -------
                                                               5,927     15,816
Less current portion........................................   2,111        224
                                                              ------    -------
                                                              $3,816    $15,592
                                                              ======    =======
</TABLE>
 
     At December 31, 1996, the Company had a Revolving Line of Credit agreement
with a Nashville, Tennessee bank for up to $10.0 million to be used for working
capital purposes and acquisitions and a Discretionary Line of Credit agreement
with a Nashville, Tennessee bank for up to $10.0 million to be used
 
                                      A-16
<PAGE>   43
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
for acquisitions or such other purposes as may be approved by the bank. Any
principal amounts outstanding on the Lines of Credit were due on September 10,
1998. At December 31, 1996, there were no amounts outstanding under the above
Lines of Credit.
 
     During September 1997, the Company terminated its $20.0 million Lines of
Credit and entered into a $50.0 million revolving credit facility with a banking
syndication available through September 3, 1999 (the "Credit Facility"). In
addition to a revolving credit loan, the Credit Facility provides for a swing
line commitment in the principal amount of up to $2.0 million. The Credit
Facility also provides stand by letters of credit of up to $5.0 million in the
aggregate. The maximum total amount available to be advanced under the revolving
credit loan, swing line commitment and letters of credit is $50.0 million. The
Company may make principal payments under the revolving credit notes at any
time, subject to minimum repayment amounts, for non-LIBOR advances and at the
end of the interest period for LIBOR advances.
 
     Borrowings under the revolving credit loan bear interest, at the Company's
option, (i) the higher of the Banks' base rate or the federal funds rate plus
 .5% or (ii) a 30, 60 or 90-day LIBOR plus a variable margin of from 75 to 150
basis points depending on the Company's funded debt to EBIA ratio determined on
a quarterly basis. Advances under the swing line bear interest at the banks'
base rate. All of the Company's subsidiaries have guaranteed the repayment of
indebtedness under the Credit Facility. The Credit Facility requires an annual
commitment fee, ranging from 20 to 37.5 basis points, of the average unused
portion of the revolving credit loan.
 
     The Credit Facility contains covenants with respect to the maintenance of
certain financial ratios, maintaining a specified minimum net worth, limiting
the incurrence of additional indebtedness, the sale of substantial assets,
consolidations or mergers by the Company and the payments of dividends. At
December 31, 1997, the Company was in compliance with all covenants. There were
no amounts outstanding under letters of credit at December 31, 1996 and 1997.
 
     The Company had a mortgage note payable to Free Will Baptist, Inc. that was
secured by the Company's office building and related land. The loan required
monthly installments of $8,400, including fixed principal and imputed interest.
The mortgage was transferred to the former shareholders of the Acquiring Company
on June 30, 1996 (see Note 13). The Company also had various mortgage notes
payable to various lenders which were secured by real estate. These notes were
paid off during 1997. In addition, the Company also had a $1.5 million line of
credit. The line of credit bore interest of a variable rate of the lender's
prime rate of interest plus 1.75% (9.875% at December 31, 1996). The line of
credit was secured by approximately $4.5 million of the accounts receivable and
inventory. At December 31, 1996, there was $1,477,000 outstanding under this
line of credit. The Company terminated this line of credit during 1997.
 
     The Company has various installment and equipment loans to various lenders
which are secured by vehicles and equipment. These loans bear interest at
various fixed rates ranging from 8.25% to 15.50% per annum with maturity dates
through 2000.
 
     As of December 31, 1997, the aggregate amounts of annual principal
maturities of long-term debt are as follows (in thousands):
 
<TABLE>
<S>                                                           <C>
1998........................................................  $   224
1999........................................................   15,569
2000........................................................       23
                                                              -------
                                                              $15,816
                                                              =======
</TABLE>
 
                                      A-17
<PAGE>   44
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
9. STOCKHOLDERS' EQUITY AND STOCK PLANS
 
INCENTIVE STOCK OPTION PLAN
 
     The Company has elected to follow Accounting Principles Board Opinion No.
25, "Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FASB
Statement No. 123, "Accounting for Stock-Based Compensation" ("Statement 123"),
requires use of option valuation models that were not developed for use in
valuing employee stock options. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying stock
on the date of grant, no compensation expense is recognized. Had compensation
expense for the stock option plans been determined consistent with the
provisions of Statement 123, the Company's net income and income per share would
have been as follows:
 
<TABLE>
<CAPTION>
                                                         YEAR ENDED DECEMBER 31,
                                                -----------------------------------------
                                                      1996                    1997
                                                -----------------      ------------------
                                                   AS       PRO           AS        PRO
                                                REPORTED   FORMA       REPORTED    FORMA
                                                --------   ------      --------   -------
                                                  (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                             <C>        <C>         <C>        <C>
Net income....................................   $3,739    $3,618      $15,266    $14,648
Income per common share:
  Basic.......................................   $  .74    $  .72      $  1.07    $  1.02
  Diluted.....................................   $  .74    $  .72      $  1.06    $  1.01
</TABLE>
 
     The resulting pro forma disclosures may not be representative of that to be
expected in future years.
 
     The fair value of these options was estimated at the date of the grant
using the Black-Scholes option pricing model with the following range of
assumptions used for the option grants which occurred during 1996 and 1997.
 
<TABLE>
<CAPTION>
                                                          YEAR ENDED DECEMBER 31,
                                                         --------------------------
                                                            1996           1997
                                                         -----------    -----------
<S>                                                      <C>            <C>
Volatility.............................................  .25 and .55        .34
Interest rate..........................................  5.97%-6.34%    5.37%-5.71%
Expected life (years)..................................       3              3
Dividend yields........................................     0.0%           0.0%
</TABLE>
 
     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 employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
 
     Under the Company's stock option plans, non-qualified and incentive stock
options to purchase Common Stock may be granted to officers, employees and
directors. Stock options are exercisable over a period determined by the Board
of Directors, but no longer than ten years after the date of the grant. The
Company has reserved 1.3 million shares of Common Stock under the Company's 1996
Incentive Stock Option Plan (the "Incentive Plan").
 
                                      A-18
<PAGE>   45
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
NONQUALIFIED STOCK OPTION PLAN
 
     In May 1997, the Company adopted the Service Experts, Inc. 1997
Nonqualified Stock Option Plan (the "Nonqualified Option Plan") to award options
to employees of the Company and certain others who provide significant services
to the Company. Under the Nonqualified Option Plan options granted at any time
by the Compensation Committee may not exceed that number of shares which equals
the sum of (i) 9.5% of the total number of outstanding shares of Common Stock at
that time, minus (ii) the number of shares of Common Stock that are authorized
for issuance under the Incentive Plan. At December 31, 1997 no options had been
issued under this plan.
 
NON-EMPLOYEE DIRECTOR STOCK OPTION PLAN
 
     The Company has a Non-Employee Director Stock Option Plan that provides for
a maximum issuance of 100,000 shares of Common Stock for grant to non-management
members of the Board of Directors.
 
     Options to purchase a total of 15,000 and 3,000 shares of Common Stock with
an exercise price of $13.00 and $26.00 per share were issued during 1996 and
1997, respectively. Each option is exercisable in full upon receipt and shall
expire ten years after the grant date.
 
     Information regarding the option plans for 1996 and 1997 are summarized
below:
 
<TABLE>
<CAPTION>
                                                                                      WEIGHTED
                                                                                      AVERAGE
                                                           STOCK     OPTION PRICE     EXERCISE
                                                          OPTIONS      PER SHARE       PRICE
                                                          -------    -------------    --------
<S>                                                       <C>        <C>              <C>
Balance, January 1, 1996................................       --         --               --
Granted.................................................  517,811    $13.00-$17.25     $16.92
Exercised...............................................       --         --               --
Cancelled...............................................       --         --               --
                                                          -------
Balance, December 31, 1996..............................  517,811    $13.00-$17.25     $16.92
Granted.................................................  220,000    $25.75-$27.00     $26.19
Exercised...............................................       --         --               --
Cancelled...............................................  (72,415)   $13.00-$17.25     $16.92
                                                          -------
Balance, December 31, 1997..............................  665,396    $13.00-$27.00     $19.96
                                                          =======
</TABLE>
 
<TABLE>
<CAPTION>
                                                                1996        1997
                                                              --------    --------
<S>                                                           <C>         <C>
Weighted average fair value of options granted during the
  year......................................................  $   4.27    $   7.91
Weighted average remaining contractual life of options......       8.7(1)      9.4
Options available for grant.................................   182,189     634,604
</TABLE>
 
---------------
 
(1) 1996 has been restated to reflect the cancellation of options during 1997.
 
EMPLOYEE STOCK PURCHASE PLANS
 
     In June 1996, the Company adopted an Employee Stock Purchase Plan (the
"Employee Purchase Plan"). A total of 200,000 shares of Common Stock have been
reserved for issuance under the Employee Purchase Plan. Employees are eligible
to participate in the Employee Purchase Plan if they are employed by the Company
or a participating subsidiary for at least 20 hours a week and more than five
months in any calendar year and have been employed for at least six months since
their last date of hire. The Employee Purchase Plan allows participants to
purchase shares of Common Stock in connection with option periods commencing on
January 1 of each year and ending the following December 31.
 
                                      A-19
<PAGE>   46
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     In June 1997, the Company adopted a nonqualified stock purchase plan (the
"Nonqualified Purchase Plan"). The Company has reserved 100,000 shares of Common
Stock for issuance under the Nonqualified Purchase Plan. Participation in the
Nonqualified Purchase Plan is generally limited to individuals who were not
employed by the Company or one of its subsidiaries on January 1 of a calendar
year and, accordingly, were not eligible to receive an option under Employee
Purchase Plan. The Nonqualified Purchase Plan allows participants to purchase
shares of Common Stock in connection with option periods commencing on July 1 of
each year and ending the following December 31. The Employee Purchase Plan and
the Nonqualified Purchase Plan are referred to collectively as the "Purchase
Plans."
 
     Each Purchase Plan permits eligible employees of the Company and certain of
its subsidiaries to purchase shares of Common Stock through payroll deductions,
which may not exceed 10% of the employee's base compensation, at a price equal
to 85% of the fair market value of the shares of Common Stock at the beginning
of the option period or at the end of the option period, whichever is lower.
During 1997, the Company issued 22,355 shares under the Employee Purchase Plan.
The Company expects to issue in 1998 approximately 54,000 shares under the
Purchase Plans for the 1997 plan year.
 
WARRANTS
 
     In connection with the Company's IPO, Equitable Securities Corporation
received warrants to purchase 82,391 shares of the Company's Common Stock at an
exercise price of $13.00 per share. The warrants are exercisable for a period of
five years. The Company also issued warrants in connection with its acquisition
of ProAir Services, L.P. to purchase 200,000 shares of the Company's Common
Stock at an exercise price of $22.00 per share. These warrants are exercisable
for a period of five years. At December 31, 1997, no warrants had been
exercised.
 
INCOME (LOSS) PER SHARE
 
     The following table sets forth the computation of basic and diluted income
per share:
 
<TABLE>
<CAPTION>
                                                               YEAR ENDED DECEMBER 31,
                                                              -------------------------
                                                               1995     1996     1997
                                                              ------   ------   -------
                                                              (IN THOUSANDS, EXCEPT PER
                                                                     SHARE DATA)
<S>                                                           <C>      <C>      <C>
Numerator:
  Net income (loss).........................................  $ (169)  $3,739   $15,266
                                                              ------   ------   -------
  Numerator for basic income (loss) per share--income (loss)
     available to common stockholders.......................    (169)   3,739    15,266
                                                              ------   ------   -------
  Numerator for diluted income (loss) per share--income
     (loss) available to common stockholders after assumed
     conversions............................................  $ (169)  $3,739   $15,266
Denominator:
  Denominator for basic income (loss) per
     share--weighted-average shares.........................   2,132    5,022    14,305
  Effect of dilutive securities:
     Employee stock options.................................      --       21       111
     Warrants...............................................      --        8        37
                                                              ------   ------   -------
  Dilutive potential common shares..........................      --       29       148
     Denominator for diluted income (loss) per
      share--adjusted weighted-average shares and assumed
      conversions...........................................   2,132    5,051    14,453
                                                              ======   ======   =======
Basic income (loss) per share...............................  $ (.08)  $  .74   $  1.07
                                                              ======   ======   =======
Diluted income (loss) per share.............................  $ (.08)  $  .74   $  1.06
                                                              ======   ======   =======
</TABLE>
 
                                      A-20
<PAGE>   47
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
10.  EMPLOYEE BENEFIT PLANS
 
     The Company has defined-contribution employee benefit plans incorporating
provisions of section 401(k) of the Internal Revenue Code and the Davis-Bacon
Act. Generally, employees of the Company must have one year of service and work
500 hours during the plan year to be eligible. Under the plans' provisions, a
plan member may make contributions, on a tax-deferred basis, from 1.0% to 20.0%
of total compensation not to exceed the maximum established annually by the
Internal Revenue Service. Under the plans matching contributions are made by the
Company in amounts ranging from 1.0% to 50.0% of total contributions by a plan
member, to a maximum of between 2.0% and 6.0% of the employee's total calendar
year compensation. The Company's matching contributions totaled $358,000,
$309,000 and $576,000 as of December 31, 1995, 1996 and 1997, respectively.
 
11.  COMMITMENTS AND CONTINGENT LIABILITIES
 
     The Company is a party to a number of legal proceedings arising in the
ordinary course of its business. In the opinion of management, the resolution of
these proceedings will not have a material adverse effect on the financial
position or results of operations of the Company.
 
     The Company maintains general liability insurance coverage and an umbrella
policy to ensure itself against any liabilities occurring in the normal course
of business. The Company believes that its insurance coverage is adequate.
 
12.  INCOME TAXES
 
     Income tax expense consists of the following:
 
<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                              -----------------------
                                                              1995    1996      1997
                                                              ----   -------   ------
                                                                  (IN THOUSANDS)
<S>                                                           <C>    <C>       <C>
Current:
  Federal...................................................  $ 56   $ 2,214   $7,539
  State.....................................................    46       463    2,103
                                                              ----   -------   ------
                                                               102     2,677    9,642
Deferred:
  Federal...................................................    --    (1,299)    (219)
  State.....................................................    44      (242)    (234)
                                                              ----   -------   ------
                                                                44    (1,541)    (453)
                                                              ----   -------   ------
Provision for income taxes..................................  $146   $ 1,136   $9,189
                                                              ====   =======   ======
</TABLE>
 
                                      A-21
<PAGE>   48
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     Significant components of the deferred tax assets and liabilities are as
follows:
 
<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                              ---------------
                                                               1996     1997
                                                              ------   ------
                                                              (IN THOUSANDS)
<S>                                                           <C>      <C>
Deferred tax liabilities:
  Contract billings.........................................  $  168   $  255
  Accounts receivable.......................................      33       --
  Inventory.................................................       9       20
  Depreciation and amortization.............................     378    1,714
  Other -- net..............................................      71       --
                                                              ------   ------
Deferred tax liabilities....................................     659    1,989
Deferred tax assets:
  Accounts receivable.......................................     268      553
  Warranty reserves.........................................     355      786
  Deferred revenue..........................................   1,045    2,683
  Accrued expenses..........................................     369      150
  Accounts payable..........................................      19       --
  Prepaid expenses..........................................      11       --
  Carryforwards, net........................................      44       37
  Other -- net..............................................     105       --
                                                              ------   ------
Total gross deferred tax assets.............................   2,216    4,209
                                                              ------   ------
          Net deferred tax assets...........................  $1,557   $2,220
                                                              ======   ======
</TABLE>
 
     Management has evaluated the need for a valuation allowance for all or a
portion of the deferred tax assets and believes that the deferred tax assets
will be more likely than not realized. Accordingly, no valuation allowance has
been recognized.
 
<TABLE>
<CAPTION>
                                                                   DECEMBER 31,
                                                              ----------------------
                                                              1995    1996     1997
                                                              ----   ------   ------
                                                                  (IN THOUSANDS)
<S>                                                           <C>    <C>      <C>
Tax provision at statutory rate (34% in 1995 and 1996 and
  35% in 1997)..............................................  $ (8)  $1,661   $8,559
State income tax less applicable federal tax benefit........    59      146    1,215
Adjustments to eliminate S corporations.....................    --     (218)    (469)
Less benefit of graduated tax rates.........................    95     (257)      --
Less benefit recognized upon termination of Subchapter S
  election for
  AC Service & Installation Co., Inc........................    --     (236)      --
Goodwill amortization.......................................    --       --      525
Other -- net................................................    --       40     (641)
                                                              ----   ------   ------
                                                              $146   $1,136   $9,189
                                                              ====   ======   ======
</TABLE>
 
     The termination of S corporation status occurred on August 21, 1996 for AC
Service and Installation Co., Inc., and a deferred tax asset of $236,000 was
recorded. The effect of recognizing the deferred tax asset was included in the
provision for income taxes.
 
13.  RELATED PARTY TRANSACTIONS
 
     In addition to the lease agreements with related parties in Note 7, the
Company has the following related party transactions.
 
                                      A-22
<PAGE>   49
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The Company has one outstanding note receivable from a stockholder of the
Company totaling $366,000 and $352,000 at December 31, 1996 and 1997,
respectively. The note is payable in 180 monthly installments of $3,905 and
bears annual interest of 9.0%.
 
     On June 30, 1996, the Company distributed land, buildings, accounts
receivable and other assets with a net book value of $1,096,000 in satisfaction
of mortgage notes payable of $488,000, shareholder notes payable of $343,000,
and accrued compensation of $365,000 to the former shareholders of the Acquiring
Company.
 
     James D. Abrams, a director and former chief operating officer of the
Company, and John R. Young, an employee and stockholder of the Company, are
principal stockholders of Service Now, Inc. ("Service Now"). Service Now is a
48% stockholder of SuccessWare, Inc. ("SuccessWare"), a corporation that
provides management and financial information systems software to the Company.
In 1996 and 1997, the Company and its subsidiaries made aggregate payments to
SuccessWare of approximately $50,000 and $450,000, respectively.
 
     Mr. Abrams and Mr. Young are the sole stockholders of Fusion Filters, Inc.
("Fusion"), which licenses air filters and other products from manufacturers and
sublicenses them to HVAC contractors, including certain of the Company's
subsidiaries. The Company has not entered into any definitive agreements with
Fusion, but certain Service Centers purchase filters from Fusion from time to
time. In 1996 and 1997 the Company's Service Centers made aggregate payments to
Fusion of approximately $450,000 and $895,000, respectively. The Company and
many its subsidiaries also utilize, from time to time, the services of Travel
Now, Inc., a travel agency, of which Mr. Abrams and Mr. Young are principal
stockholders.
 
     The Company owns approximately a 39% interest in Future University, Inc.
("Future University"). Fees paid to Future University for training during 1996
and 1997 totaled approximately $75,000 and $260,000, respectively.
 
14.  QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
 
     Quarterly financial information for the years ended December 31, 1996 and
1997 are summarized below:
 
<TABLE>
<CAPTION>
                                                                    1996
                                                    -------------------------------------
                                                                   QUARTER
                                                    -------------------------------------
                                                      1ST       2ND       3RD       4TH
                                                    -------   -------   -------   -------
                                                    (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                 <C>       <C>       <C>       <C>
Net revenue.......................................  $11,269   $14,676   $20,916   $28,052
Gross profit......................................    3,188     4,256     6,178     8,663
Income before income taxes........................      224       322     1,899     2,430
Net income........................................      235       432     1,628     1,444
Income per share
  Basic...........................................  $   .11   $   .20   $   .30   $   .14
  Diluted.........................................  $   .11   $   .20   $   .30   $   .14
</TABLE>
 
<TABLE>
<CAPTION>
                                                                    1997
                                                    -------------------------------------
                                                                   QUARTER
                                                    -------------------------------------
                                                      1ST       2ND       3RD       4TH
                                                    -------   -------   -------   -------
                                                    (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                                 <C>       <C>       <C>       <C>
Net revenue.......................................  $41,963   $60,140   $65,470   $71,119
Gross profit......................................   14,444    20,587    24,264    24,799
Income before income taxes........................    3,394     7,304     7,566     6,191
Net income........................................    2,177     4,589     4,749     3,751
Income per share
  Basic...........................................  $   .18   $   .33   $   .32   $   .25
  Diluted.........................................  $   .18   $   .32   $   .32   $   .24
</TABLE>
 
                                      A-23
<PAGE>   50
                             SERVICE EXPERTS, INC.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The quarterly information for 1996 and the first two quarters of 1997 have
been restated to reflect the results of the 1997 Pooled Companies.
 
     The 1996 and first three quarters of 1997 earnings per share amounts have
been restated to comply with Statement of Financial Accounting Standards No.
128, Earnings per share.
 
15.  SUBSEQUENT EVENTS
 
     Subsequent to December 31, 1997, the Company has acquired ten HVAC
businesses, of which eight are Service Centers, for an aggregate of
approximately $6.8 million cash and approximately 321,000 shares of Common
Stock. Additionally, the Company currently has agreements in principle to
acquire four HVAC businesses (the "Pending Acquisitions"). The Pending
Acquisitions are expected to close during the first six months of 1998. The
consideration to be paid by the Company for these businesses is approximately
$6.1 million, consisting of approximately 224,000 shares of Common Stock and
approximately $200,000 cash. All of these transactions are expected to be
accounted for using the purchase method. Of the purchase price, $4.9 million is
expected to be allocated to intangible assets which are to be amortized over a
40-year period. On a pro forma basis, these companies generated revenue in 1997
of approximately $7.8 million. The acquisitions are subject to customary
conditions, and there can be no assurance that the Company will be able to
consummate all of the acquisitions or to successfully integrate the businesses
of the acquired companies.
 
     Subsequent to year-end, a new lease agreement was entered into for the
Company's corporate headquarters. This operating lease is for a term of five
years commencing on May 1, 1998, pending completion of the construction of the
new building. The minimum annual lease commitments are $361,000 for the first
year and increases annually during the term of the lease to $425,000 in the
fifth year. As a result of this agreement, the Company will cancel its current
lease obligation but will not incur any fees or penalties associated with such
cancellation.
 
     On February 3, 1998, warrants issued in connection with the acquisition of
ProAir Services, L.P. were exercised. The holder of the Warrants purchased
34,634 shares of common stock at an exercise price of $22.00 per share.
 
     In March 1998, the Company adopted the Service Experts, Inc. Service Center
Stock Option Plan (the "Service Center Option Plan") to award options to
employees of the Company who are not executive officers or subject to Section
16(b) of the Securities Exchange Act of 1934, as amended. A total of 214,697
shares of Common Stock have been reserved for issuance under the Service Center
Option Plan. No options have been issued under the Service Center Option Plan.
 
                                      A-24