<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549

                                   FORM 10-K

      [X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1996
                                       or
             [ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                          Commission File No. 33-44726

                        LIVING CENTERS OF AMERICA, INC.
             (Exact name of registrant as specified in its Charter)

          DELAWARE                                              74-2012902
(State or other Jurisdiction of                               (I.R.S. Employer
Incorporation or Organization)                               Identification No.)

15415 KATY FREEWAY, SUITE 800                                       77094
         HOUSTON, TEXAS                                          (Zip Code)
(Address of principal executive office)

                                 (281) 578-4600
              (Registrant's Telephone Number, Including Area Code)

           SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT
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<CAPTION>
                                                        Name of each exchange on
    Title of each class                                     which registered           
    -------------------                           --------------------------------------
<S>                                                      <C>
Common Stock, $.01 Par Value                             New York Stock Exchange
</TABLE>

       SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:  None

         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 the Form 10-K. [X]

         The aggregate market value of the outstanding Common Stock of the
registrant held by non-affiliates of the registrant as of November 25, 1996,
based on the closing sale price of the Common Stock on the New York Stock
Exchange on said date, was $369,851,000.  For purpose of the foregoing sentence
only, all directors and officers of the registrant are assumed to be
affiliates.

         There were 19,500,867 shares of Common Stock of the registrant
outstanding as of November 25, 1996.

                     DOCUMENTS INCORPORATED BY REFERENCE

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   INCORPORATED DOCUMENT                         PART OF FORM 10-K
   ---------------------                         -----------------
 <S>                                                 <C>
 Proxy Statement for the 1997                        Part III
Annual Meeting of Stockholders
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<TABLE>
<CAPTION>
                              TABLE OF CONTENTS
                                                                       PAGE
<S>                  <C>                                                <C>
PART I                                                                 
         ITEM 1.     BUSINESS                                            3
                                                                       
         ITEM 2.     PROPERTIES                                         13
                                                                       
         ITEM 3.     LEGAL PROCEEDINGS                                  15
                                                                       
         ITEM 4.     SUBMISSION OF MATTERS                             
                     TO A VOTE OF SECURITY HOLDERS                      15
                                                                       
         ITEM 4A.    EXECUTIVE OFFICERS OF THE REGISTRANT               16
                                                                       
PART II                                                                
         ITEM 5.     MARKET FOR REGISTRANT'S COMMON STOCK              
                     AND RELATED STOCKHOLDER MATTERS                    18
                                                                       
         ITEM 6.     SELECTED FINANCIAL DATA                            19
                                                                       
         ITEM 7.     MANAGEMENT'S DISCUSSION AND ANALYSIS              
                     OF FINANCIAL CONDITION AND RESULTS                
                     OF OPERATIONS                                      20
                                                                       
         ITEM 8.     FINANCIAL STATEMENTS AND                          
                     SUPPLEMENTARY DATA                                 26
                                                                       
         ITEM 9.     CHANGES IN AND DISAGREEMENTS WITH                 
                     ACCOUNTANTS ON ACCOUNTING AND                     
                     FINANCIAL DISCLOSURE                               50
                                                                       
PART III                                                               
         ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE           
                     REGISTRANT                                         51
                                                                       
         ITEM 11.    EXECUTIVE COMPENSATION                             51
                                                                       
         ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL          
                     OWNERS AND MANAGEMENT                              51
                                                                       
         ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED                 
                     TRANSACTIONS                                       51
                                                                       
PART IV                                                                
         ITEM 14.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES,          
                     AND REPORTS ON FORM 8-K                            52
                                                                       
SIGNATURES                                                              57
                                                                       
SCHEDULES                                                               59
                                                                       
EXHIBITS                                                                60
</TABLE>
<PAGE>   3
                                     PART I

ITEM 1.  BUSINESS

GENERAL DEVELOPMENT OF THE BUSINESS

         Living Centers of America, Inc. ("Living Centers", or the "Company")
is a Delaware corporation that primarily provides through its operating
subsidiaries, a diverse  range of health care services to senior citizens.
(All references to "Living Centers" or the "Company" is intended to include the
operating subsidiaries through which the services described herein are directly
provided.) One of the largest providers of long-term care in the United States,
Living Centers' operations are geographically concentrated and specifically
focused in key regional markets.  The Company's comprehensive continuum of
health care services includes skilled nursing care, rehabilitation services,
pharmaceutical services, assisted living services, subacute care, care for
individuals with Alzheimer's disease, hospice care, home health care, and
geriatric physician management services.  American Rehabilitation Services,
Inc. ("ARS"), Living Centers' rehabilitation subsidiary, through its
subsidiaries, provides contract rehabilitation services to long- term care
facilities, operates outpatient clinics, operates hospital rehabilitation
departments on a contract basis, and offers therapy program management to
long-term care providers. American Pharmaceutical Services, Inc. ("APS"), the
Company's pharmaceutical services subsidiary, provides medical supplies,
pharmaceuticals, and support services to subacute and long-term care providers.
By operating this integrated network of services, Living Centers provides cost-
effective services across the senior health care services continuum.

         The Company's subsidiaries are organized into three operational
business units -- the long-term care services group, the  rehabilitation
services group, and the institutional pharmaceutical services group. While each
group has its own distinct corporate structure and management team, each
reports to the Company's Chief Operating Officer and is supported by the
corporate group located in Houston, Texas.

LONG-TERM CARE SERVICES GROUP

         LONG TERM NURSING SERVICES.  Living Centers is one of the largest
operators of long-term health care facilities in the United States and is the
first or second largest provider of long-term care services in its key markets
of Texas, North Carolina and Colorado. The long term care group is organized
into three regionally concentrated operating units: The Southeast Area
(Alabama, Florida, Georgia, Louisiana, Mississippi, North Carolina, South
Carolina, and Virginia); the Texas Area; and the Rocky Mountain Area (Arizona,
Colorado, Nebraska, and Wyoming).

         Since becoming a public company in February 1992, the Company has made
two acquisitions which significantly increased its facility base.  First, in
October 1993, the Company consummated a merger transaction in which it acquired
the outstanding stock of Vari-Care, Inc. ("Vari-Care") which added a total of
22 centers and approximately 2,500 beds in Alabama, Arizona, Florida and Texas.
Second, in July 1995, the Company completed a transaction in which it acquired
the outstanding stock of The Brian Center Corporation and 16 related S
corporations (collectively the "BCC Entities", or "BCC"); the BCC acquisition
added a total of 51 centers and approximately 6,000 beds in Florida, Georgia,
North Carolina, South Carolina and Virginia. As of September 30, 1996, the
Company operated 206 centers with in excess of 23,500 licensed beds.

         Living Centers' facilities provide a continuum of care designed to
accommodate patients' and residents' needs as their acuity levels change.
Services provided include skilled nursing care, assisted living services, care
for individuals with Alzheimer's disease, subacute care, and hospice services,
although not all services are provided in all facilities.  All facilities must
meet comprehensive state licensing requirements, and those participating in
Medicare or Medicaid programs must also meet federal and state certification
standards (see "Government Regulation"). The Company's facilities are generally
equally distributed between urban and non-urban areas and typically compete
only with other facilities in their respective local markets.

         SPECIALTY CARE SERVICES. The Company is increasingly emphasizing
expansion and development of specialty care programs to better meet the
long-term care needs of the communities it serves. These programs and services,
none of which individually are material to the Company, are generally described
as follows:




                                     -3-
<PAGE>   4
         Assisted Living Centers. The Company provides assisted living services
in 35 of its long-term care centers and in four freestanding facilities with a
total of 1,350 beds to residents who need assistance with the basic activities
of daily living, but whose care needs have not yet reached a level that
requires 24-hour nursing care. The Company has developed a freestanding
assisted living center model in connection with the implementation of its
assisted living program.  During fiscal year 1996, Living Centers completed
construction of one 38 bed assisted living facility in the Lincoln, Nebraska
market.  Additionally, the company began construction on two facilities which
are expected to be completed in early fiscal year 1997 and further identified
nine sites for construction of new assisted living facilities.  The Company's
assisted living development program is focused on markets where Living Centers
has a skilled nursing facility presence so that as these residents' needs
change and require higher acuity services, they can be accommodated in one of
the Company's nursing facilities.  These newly constructed assisted living
facilities are intended to be exclusively private pay.

         Subacute Care Services. Since 1993, the Company has developed its
Progressive Care Centers program in which distinct units of certain designated
long-term care facilities are dedicated to subacute nursing care and
rehabilitation services for patients with higher acuity levels. At Progressive
Care Centers, specially trained staff offers care to patients with higher
acuity levels in a technologically advanced physical plant as an alternative to
more expensive patient treatment in the acute care hospital setting. Services
offered by the Company in  Progressive Care Centers include physical therapy,
occupational therapy, speech therapy, enteral therapy, IV therapy, respiratory
therapy, specialized wound management, ventilator care, and tracheostomy care,
although not all services are provided at all Progressive Care Center units.
The Company operates a total of approximately 250 beds in 14 facilities under
its Progressive Care Centers program.

         Alzheimer's Care Services. The Company believes that it is a leading
provider of long-term care to residents with Alzheimer's disease. Within
specially designated and designed portions of certain of its long-term care
centers, the Company operates over 60 units with approximately 1,700 beds
dedicated to addressing the problems of disorientation and perceptual confusion
typically experienced by residents with Alzheimer's disease. The Alzheimer's
care units also provide education and support to the residents' families. The
Company provides specially trained activity directors and nursing staffs to
these units and employs a Director of Alzheimer's Programming to supervise
program development and staff training. The Company intends to continue its
commitment to Alzheimer's care through implementation of Alzheimer's programs
in more of its long-term care facilities as well as in association with its
planned free-standing assisted living centers.

         Hospice Care.  Hospice care is increasingly recognized as a preferred
method of care for those patients diagnosed with a terminal illness and
certified with a life expectancy of less than six months.  Hospice services are
designed to provide comfort for the physical and emotional needs of terminally
ill patients.  Hospice services focus on maximizing the quality of life of
terminally ill patients as opposed to curing an illness; as a result, this
modality of care is typically a more cost-effective alternative to more
aggressive medical treatment.   An estimated four to eight percent of nursing
facility residents potentially require hospice services.  During fiscal year
1996 the Company expanded its hospice initiative by purchasing a 50 percent
interest in Heart of America Hospice ("Heart of America") of Kansas City,
Missouri.  Living Centers' existing hospice operation was combined with Heart
of America, which will become Living Centers' hospice provider. Subsequent to
September 30, 1996, Living Centers increased its ownership interest in Heart of
America to approximately 83 percent.

         Home Health Care.  Currently the Company provides home health care
through agencies in Tennessee (acquired as part of the 1995 Rehability
acquisition) and Corpus Christi, Texas.  The Company plans to expand its home
health care business through the acquisition and development of agencies in its
key markets. The expansion of home health complements the Company's initiative
to provide a complete continuum of senior health care in its targeted markets.
Additionally, these home care businesses will be potential customers for Living
Centers' rehabilitation therapy and pharmacy operations. At September 30, 1996,
the Company was negotiating a letter of intent to acquire Colorado HomeCare
which was executed subsequent to year end.  The locations of this home health
care provider's operations complement the Company's long-term care operations
in Colorado.

         Geriatric Physician Management Services.  Effective September 30, 1996
the Company purchased a 75 percent interest in American Geriatric Management
Services, Inc. ("AGMS"). AGMS is a management services organization created to
provide support services, record keeping, administrative management, budget
development, and managed care contracting services to geriatric and long-term
care physician group practices.  Geriatric and long-term care physicians whose
professional practices to be managed by AGMS make their professional medical
services available on-site at skilled nursing, nursing, subacute, hospice and
assisted living facilities. The Company expects that its association with AGMS
will assist in expanding the complex care capabilities of its facilities.
Living Centers intends to participate in the development of





                                     - 4 -
<PAGE>   5
several regionally concentrated management service organizations which will
provide services to long-term care physicians in the Company's key geographic
markets.  The Company believes that its association with AGMS will enable it to
expand physician coverage at its long-term care facilities, thereby increasing
the level and quality of services provided. This association should therefore
make the Company more attractive to managed care providers.

         Living Centers - DevCon Divestiture. In September 1996, Living Centers
divested its Living Centers - DevCon, Inc. subsidiary ("DevCon") which provided
training and habilitation services  to individuals with mental retardation and
developmental disabilities (see Note 2 to the Consolidated Financial
Statements).  DevCon operated over 80 centers and group homes with
approximately 400 beds in Florida and 1,750 beds in Texas and relied primarily
on Medicaid for reimbursement.  In recent years the revenues for this operation
had grown at a slower rate than those associated with the Company's skilled
nursing business.  This divestiture is consistent with the Company's strategy
of focusing on its senior health care services business.

         LONG-TERM CARE -- BUSINESS STRATEGY.  The Company's strategy is to
utilize its long-term care facilities as a platform to deliver a comprehensive
array of senior health care services. As a consequence, the Company seeks to
control the significant components of its care continuum, while diversifying
its sources of revenue and positioning itself to be responsive to a variety of
payors.   Through the provision of cost-effective quality care, the Company
believes that it can enhance profitability.  Several current focuses of the
long-term care group are as follows:

         Occupancy Level Increase.  During fiscal year 1996, the Company
significantly invested in the development of a Marketing and Managed Care
Department, led by a Corporate Vice President of Marketing,  to assist the
facility-based staff to increase the occupancy of Living Centers' long-term
facilities.   Several new systems, including a comprehensive facility level
training program and a demographic mapping system, are in the process of
implementation which will enhance census development and retention.  Due to the
significant fixed cost component within the Company's long-term care business,
marginal increases in a facility's occupancy are typically disproportionately
more profitable.

         Assisted Living Expansion.  Currently the Company has eleven assisted
living facilities in various phases of development.  This development is
targeted for markets where Living Centers already has a presence with skilled
nursing facilities.  The residents of these assisted living centers will have
the option to choose Living Centers' skilled nursing facilities when their
needs for care increase.  Additionally, these assisted living centers provide
an additional customer base for the Company's institutional pharmacy and
rehabilitation services businesses as well as for certain emerging service
lines such as home health and geriatric physician management services.

         Hospice Care Expansion.  A major initiative for the Company over the
next several years is to expand the coverage of its hospice care capabilities
within its key markets.  Currently, hospice services are provided at
approximately 140 of  the Company's facilities by more than 100 different
hospice providers. The Company's strategy is to offer Heart of America Hospice
services in Living Centers' targeted markets as an alternative provider to
these current third party providers.  The Company's objective is to capture a
meaningful portion of the hospice services provided within its long-term care
facilities by offering the availability of consistent, quality hospice services
to its residents.

         Complex Care Capability Enhancement.  Typically, higher acuity, more
complex services command higher fees and often times are more profitable.
Furthermore, the provision of these services in a skilled nursing facility can
be more cost-effective than in a hospital based acute care environment.  The
Company continually reviews its ancillary service offerings in an effort to
serve the complex care needs of the patient population within its service
areas.  Closely aligned with this objective is Living Centers' recent
acquisition of a controlling interest in American Geriatric Management
Services, which will enhance complex care capabilities.

         Managed Care Positioning.  Managed care payors require services for
their members that encompass Living Centers' service and business lines.  The
Company's Corporate Director of Managed Care is responsible for all aspects of
relationship management with this emerging payor including responsibility for
moving the managed care patient seamlessly along Living Centers' continuum of
care. The Company has increased its managed care contracting capabilities and
has created a system which allows the centralized case management of these
patients within targeted markets.  The Company is in the process of enhancing
its management information systems to better accommodate additional needs of
this payor; these enhancements will include the development and implementation
of patient outcome systems.





                                     - 5 -
<PAGE>   6
         Facility Portfolio Optimization.  The Company continuously reviews its
existing long-term franchise area for facility expansion opportunities
including the construction of new facilities.  Additionally, acquisition
opportunities within Living Centers existing geographic markets are analyzed.
Furthermore, Living Centers continuously reviews its portfolio of long-term
care centers for facilities which no longer meet the Company's operating,
financial, or strategic objectives.  During fiscal year 1996, the Company
divested or closed six long-term care facilities, not including the divestiture
of Living Centers - DevCon.  The Company prefers to own rather than lease its
long-term care facilities.  During fiscal year 1996, the Company converted five
leases to owned facilities.


REHABILITATION THERAPY SERVICES GROUP

         In June 1995, the Company acquired Rehability Corporation
("Rehability") which became the foundation for the rehabilitation services
group of the Company. In July 1995, the Company acquired MedTherapy
Rehabilitation Services, Inc., as part of its merger with The Brian Center
Corporation.  In August 1995, the Company acquired Therapy Management
Innovations, Inc. These three entities were subsequently combined to form the
Company's rehabilitation services group which operates through its subsidiaries
as American Rehabilitation Services, Inc. (including its subsidiaries "ARS").
During fiscal year 1996, Living Centers re-organized ARS into four distinct
operating divisions aligned along service lines as opposed to the previous
organization which was largely along geographic lines.  The ARS service
continuum includes nursing facility based rehabilitation, outpatient clinics,
hospital rehabilitation management, and therapy management consulting.  The
following describes these four operating divisions:

         American Therapy Services.   American Therapy Services ("ATS") employs
licensed therapists to provide physical, occupational, and speech therapy to
nursing facility residents through contracts with over 600 skilled nursing
facilities throughout the United States (approximately 500 of which are
unaffiliated with the Company).  The ultimate payor for these services is
typically Medicare; in some instances ATS invoices the skilled nursing facility
which in turn bills Medicare, in other instances ATS invoices Medicare
directly.

         Rehability Centers.  Rehability Centers operates approximately 134
outpatient rehabilitation clinics in 19 states and provides home health
services through its agencies located in Tennessee and Texas.  The primary
focus of the clinics is rehabilitation services related to occupational and
sports injuries. The primary payor for these services is typically private
employers (or their insurance carriers) for benefits associated with
occupational injuries or worker's compensation claims.

         Rehability Hospital Services.  Rehability Hospital Services manages
approximately 50 hospital rehabilitation departments on a contract basis.

         Therapy Management Innovations.  Therapy Management Innovations
("TMI") provides a variety of rehabilitation management consulting services to
subacute and long-term care facilities. These consulting services focus on
enhancing the quality of rehabilitation therapy and include supervision of
clinical procedures, documentation and billing protocols, as well as monitoring
of patient outcomes. Prior to the TMI acquisition, TMI managed substantially
all of the Company's rehabilitation therapy programs in its long-term care
services group.

REHABILITATION THERAPY SERVICES -- BUSINESS STRATEGY.  Concurrent with the
reorganization of ARS during 1996, ARS' financial and management information
systems were modified to support this service line configuration.  Several
current focuses of this business group are as follows:

         Clinic and Contract Therapy Performance Monitoring.   The enhanced
financial systems now in place provide management the capability to monitor the
financial and operating performance of  individual clinics and contract therapy
contracts.  Based upon this information, the Company can better manage its
portfolio of both outpatient clinics and therapy contracts.  During fiscal year
1996 ARS closed approximately 30 clinics that no longer met the Company's
financial or operating objectives.  Additionally, during the fiscal year, ARS
terminated over 100 nursing home contracts which did not meet the Company's
performance objectives.  This portfolio management process is ongoing.

         Overhead Reduction.  During the year, as part of the service line
re-alignment process,  ARS streamlined its operations.  This process resulted
in the elimination of approximately 325 full time equivalent employees,
representing 9% of ARS's work force.  Most of these eliminated positions were
non-revenue producing.  ARS is in the process of centralizing





                                     - 6 -
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its collection and billing functions; previously these functions were field
based at approximately 100 locations nationwide.  This process was completed
for the ATS division during the fourth quarter of fiscal year 1996 and is
expected to be completed for the balance of the ARS divisions during fiscal
year 1997.  The Company believes that this initiative will reduce overhead
costs and improve the receivable collection process.

         Therapist Productivity Improvement.  This tactical initiative has two
objectives.  First, ARS has  open positions for therapists, many of which
relate to additional available contracts with Living Centers' facilities, where
rehabilitation services are provided by third party contractors.  To address
therapist recruiting, ARS has significantly enhanced its capabilities and
intensified its recruiting activities.  Second, until late in fiscal year 1996
when new management information systems were introduced, the Company was unable
to monitor therapist productivity.  Currently, approximately 60% of Living
Centers' contract therapy needs are being serviced by ATS.  The Company's
objective for fiscal year 1997 is to further increase this internal
penetration.

         Third Party Sales Improvement.   With the realignment of ARS'
operations complete, the four business lines can refocus on marketing these
programs to nonaffiliated entities.  ARS continues to review and evaluate  its
continuum of rehabilitation services for service and product line development
opportunities.  The Company believes that there exists cross-selling
opportunities for its ancillary service lines. The same types of customers
procure services from the ATS and TMI divisions, and American Pharmaceutical
Services; however these customers are largely unrelated.


PHARMACEUTICAL SERVICES GROUP

         American Pharmaceutical Services ("APS"), the institutional
pharmaceutical services group of the Company, specializes in meeting the needs
of health care providers in subacute and long-term care settings by providing
pharmaceutical supplies and programs.  APS and its subsidiaries provide
services and products to approximately 1,000 long-term care centers (800 of
which are unaffiliated with Living Centers) with  more than 100,000 long-term
care beds through 31 full-service institutional pharmacies. APS provides
pharmacy dispensing, infusion therapy and specialty patient care products such
as urologicals, wound care products and other ancillary supplies.  APS also
offers a comprehensive array of services and supplies to meet the needs of
patients with higher acuity levels, such as intravenous (IV) and enteral
therapy.  In 1996, APS expanded its product line to include respiratory therapy
and orthotic supplies and services.  In addition, APS provides pharmacy
consulting services, specializing in long-term care drug regimen reviews,
medication procedures and regulatory monitoring. APS provides full clinical
support for its products through long-term care facility staff education and
quality assurance programs.

         PHARMACEUTICAL SERVICES -- BUSINESS STRATEGY.  APS is the fastest
growing of Living Centers' three business groups.  Revenue increases have been
derived from both internally generated sales as well as through acquisitions.
Internally generated sales include adding new customer accounts as well as
selling additional products and services to existing customers.  Approximately
25% of APS's revenue base is derived from Living Centers' facility base with
the balance associated with non-affiliated third party customers.
Correspondingly, APS has effectively penetrated Living Center's long-term care
facility franchise, fulfilling approximately 90% of its pharmaceutical service
requirements.  While APS' franchise area covers 21 states, its operations are
concentrated largely in the same states where Living Centers operates
facilities.  The Company believes that APS is the largest long-term care
institutional pharmacy provider in the states of Arizona, Colorado, Florida,
Texas and North Carolina.  Several current focuses of this business unit are as
follows:

         Acquisition Integration.  Since September 1994, when APS became a
wholly-owned subsidiary of the Company, APS has acquired 12 institutional
pharmacy-related businesses with 22 branch operations, six of which were added
through the acquisition of Allied Pharmacy Management in September 1996.
During fiscal year 1997, APS will continue to integrate the operations added in
fiscal 1996 in order to realize operating efficiencies.

         Internal Growth Continuation.  APS will continue to focus on internal
growth by expanding product lines and adding new accounts.

         Purchasing Power and Overhead Leverage.  APS purchases significant
volumes of pharmaceutical products and has initiated a centralized purchasing
program designed to lower its product procurement costs.  APS has also
developed and is implementing a preferred drug list (formulary) primarily
directed at the geriatric population it serves.  This program





                                     - 7 -
<PAGE>   8
is expected to assist APS reduce its product procurement cost.  Furthermore,
as APS continues to grow its revenues, there exists opportunities to more
efficiently leverage overhead costs.

         Targeted Acquisitions.  The Company expects to continue to grow
externally through acquisition and continuously reviews institutional pharmacy
and pharmacy-related acquisition candidates.  These potential opportunities
could be within markets where APS already has a presence, or within new markets
not currently served by the Company.  APS' strategy is to be a significant
provider in the markets in which it operates as an institutional pharmacy
provider.


SOURCES OF REVENUE

         The Company derives its net revenues from Medicaid, Medicare and
private pay sources. As of September 30, 1996, distinct part units in 191 of
the Company's 206 long-term care centers were certified to participate in the
Medicare program.

         The Company classifies as private pay revenue all of the payments and
receivables from individuals who pay directly for services without governmental
assistance and revenues from managed care companies, commercial insurers,
health maintenance organizations and other charge-based contracted payment
sources. Veterans Administration payments are also included in private pay
revenue and are received pursuant to renewable contracts negotiated
periodically.

         For a summary of the approximate percentages of total resident
revenues derived from the various sources of payment, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations".

GOVERNMENT REGULATION

         Various aspects of the Company's business are regulated by the federal
government and by the states where the Company has operations.  Regulatory
activities affect the Company's business activities by controlling its growth,
requiring licensure and certification for its facilities and health care
services, and controlling reimbursement for services provided.  The Company
believes it is in substantial compliance with these regulatory requirements,
but there can be no assurance that the Company will be able to maintain such
compliance, or will not be required to expend significant amounts to do so.

         MEDICARE AND MEDICAID.  The Medicare program was enacted in 1965 to
provide a nationwide, federally funded health insurance program for the
elderly.  The program is divided into Part A and Part B, each of which has
separate rules and requirements and separate funding sources.  Medicare Part A,
the Hospital Insurance Program (42 U.S.C.  Section 1395c et seq.) Is financed
primarily through mandatory taxes on workers' wages.  Part A pays for hospital,
skilled nursing, home health agency, hospice, and dialysis services determined
to be medically necessary for the individual patient.  Medicare Part B, the
Supplementary Medical Insurance program (42 U.S.C. Section 1395j et seq.), is a
voluntary medical benefits plan in which eligible individuals can enroll to
receive benefits in addition to those available under Part A.  Under Part B,
each beneficiary must pay a monthly premium, meet a deductible towards the cost
of covered items and services determined to be medically necessary, and pay 20
percent of the Medicare allowable charge as coinsurance on most covered items.
Non-institutional services, including physician services, outpatient hospital
services, durable medical equipment, and laboratory services, among others, are
paid under Medicare Part B.

         The Medicare program is administered by the Health Care Financing
Administration (HCFA) of the U.S. Department of Health and Human Services
(HHS).    HCFA adopts regulations, and issues interpretive memoranda and
program manuals providing detailed explanation of the Medicare program.  The
payment operations of the Medicare program are handled by intermediaries (under
Part A) and carriers (under Part B) who are insurance companies and Blue
Cross/Blue Shield plans which contract with the Secretary of HHS to make
Medicare payments to providers in a particular geographic region.  Individual
intermediaries and carriers issue transmittals, bulletins, notices, and general
instructions to providers and suppliers in their respective areas to facilitate
the administration of the Medicare program, but are required to follow the
Medicare statute, HCFA regulations, HCFA transmittals, and the program manuals.

         Within these requirements, intermediaries and carriers are granted
broad discretion to establish particular guidelines and procedures for making
Medicare coverage determinations and payments, including prior approval,
utilization limits, and specific documentation.





                                     - 8 -
<PAGE>   9
         The Medicaid program is a joint federal-state cooperative arrangement
established for the purpose of enabling states to furnish medical assistance on
behalf of aged, blind, or disabled individuals, or members of families with
dependent children, whose income and resources are insufficient to meet the
costs of necessary medical services.  The federal and state governments share
the costs of such aid pursuant to statutory formulae.  The Secretary of HHS has
primary federal responsibility for administering the Medicaid program.  The
responsibility has been delegated to HCFA, whose Medicaid Bureau carries out
this delegation.  States are not required to participate in the Medicaid
program.  States which choose to participate, however, must administer their
Medicaid programs in accordance with federal law, the implementing regulations
and policies of the Secretary and their approved state plans.    A state
becomes eligible to receive federal funds by submitting to the Secretary a
state plan for medical assistance.  The federal Medicaid statute establishes
minimum standards for state plans in such areas as administration, eligibility,
coverage of services, quality and provision of services, and payment for
services.  States have significant latitude, within these standards, to
determine the mix of services and structure of their state Medicaid programs.
The state plan must be amended by appropriate submission to the Secretary
whenever necessary to reflect changes in federal statutes, regulations,
policies, court decisions, or material changes in any phase of state law,
policy, or operations.

         All of the Company's nursing facilities, assisted living facilities,
home health and hospice agencies, pharmacies, and rehabilitation clinics, and
rehabilitation clinics are licensed under applicable state law and are
certified or approved (other than its assisted living facilities) as providers
or suppliers under one or more of the Medicare or Medicaid programs, as
applicable.  Licensure and certification standards may vary from jurisdiction
to jurisdiction, but generally focus upon physical environment and plant
safety, administration, staffing and personnel, professional and support
services, patient rights, and quality.  Once a facility or service provider
becomes licensed and certified, it must continue to comply with federal, state
and local license requirements in addition to local building and life-safety
codes.

         Long term care facilities must comply with certain requirements to
participate either as a skilled nursing facility under Medicare or a nursing
facility under Medicaid.  Regulations effective October 1, 1990, pursuant to
the Omnibus Budget Reconciliation Act of 1987, obligate facilities to
demonstrate compliance with requirements relating to resident rights, resident
assessment, quality of care, quality of life, physician services, nursing
services, pharmacy services, dietary services, rehabilitation services,
infection control, physical environment, and administration.  Survey,
certification, and enforcement procedures to be used by state and federal
survey agencies to determine facilities' level of compliance with the
participation requirements for Medicare and Medicaid were adopted by HCFA
regulations effective July 1, 1995.  The requirements include (I) that surveys
focus on residents' outcomes of care and (ii) that all deviations from
participation requirements will be considered deficiencies, but that all
deficiencies will not constitute noncompliance.  The regulations identify
alternative remedies against facilities and specify the categories of
deficiencies for which they will be applied.  These remedies include: temporary
management; denial of payment for new admissions; denial of payment for all
residents; civil money penalties of $50 to $10,000 per day of violation;
facility closure and/or transfer of residents in emergencies; directed plans of
correction; and directed in- service training.

         The facilities and service providers operated by the Company's
subsidiaries in the normal course of business are subject to annual inspections
and complaint investigations.   The Company has developed a management system
to test compliance with the various standards and requirements, including
training on regulatory requirements, and initiating and maintaining on-going
quality assessment and improvement programs.  The Company believes that its
facilities and service providers are in substantial compliance with applicable
regulatory requirements.  From time to time, however, the Company receives
notice of noncompliance with various requirements for Medicare/Medicaid
participation or state licensure.  The Company reviews such notices for factual
correctness, and based on such review, either takes appropriate corrective
action or challenges the stated basis for the allegation of noncompliance.  In
most cases, the Company and the reviewing agency will agree upon the measure to
be taken to bring the facility or provider service into compliance.  Under
certain circumstances, however, such as repeat violations or perceived severity
of the violations, the federal and/or state agencies have the authority to take
adverse actions against a facility or provider, including the imposition of
monetary fines, or the threatened decertification of a facility or provider
from participation in the Medicare and/or Medicaid programs, or licensure
revocation.  While in certain instances facilities or providers have been
fined, decertified, or had licensure sanctions imposed, the Company has been
able to reinstate the certifications and satisfactorily resolve the fines and
licensure sanctions.  No such enforcement action against a facility or provider
has had a material adverse impact on the Company.  In all cases during fiscal
year 1996, cited deficiencies were remedied before any facilities or providers
were decertified or threatened licensure sanctions became effective.





                                     - 9 -
<PAGE>   10
         Medicare and Medicaid reimbursements are generally determined from
annual cost reports filed by the Company which are subject to audit by the
respective agency administering the programs.  The Company believes that
adequate provisions for loss have been recorded to reflect any adjustments
which could result from audits to these cost reports.  Adjustments to the
Company's cost reports have not had a material adverse effect on the Company's
operating results.

         The Medicare and Medicaid anti-kickback statute, 42 U.S.C. Section
1320a-7(b), prohibits the knowing and willful solicitation or receipt of any
remuneration "in return for" referring an individual, or for recommending or
arranging for the purchase, lease, or ordering of any item or service for which
payment may be made under Medicare or a state health care program.  In
addition, the statute prohibits the offer or payment of remuneration "to
induce" a person to refer an individual, or to recommend or arrange for the
purchase, lease, or ordering of any item or service for which payment may be
made under the Medicare or state health care programs.  The statute contains
exceptions for certain discounts, group purchasing organizations, employment
relationships, waivers of coinsurance by community health centers, health
plans, and practices defined in regulatory safe harbors.  Pursuant to the
"Health Insurance Portability and Accountability Act of 1996", effective
January 1997, Congress has expanded the sanctions applicable to health care
fraud.

         False claims are prohibited pursuant to criminal and civil statutes.
Criminal provisions at 42 U.S.C. Section 1320a-7b prohibit filing false claims
or making false statements to receive payment or certification under Medicare
or Medicaid, or failing to refund overpayments or improper payments; offenses
for violation are felonies punishable by up to five years imprisonment, and/or
$25,000 fines.  Civil provisions at 31 U.S.C. Section  3729 prohibit the
knowing filing of a false claim or the knowing use of false statements to
obtain payment; penalties for violations are fines of not less than $5,000 nor
more than $10,000, plus treble damages, for each claim filed.

         The Ethics in Patient Referrals Act, ("Stark I"), effective January 1,
1992, generally prohibited physicians from referring Medicare patients to
clinical laboratories for testing, if the referring physician (or a member of
the physician's immediate family) had a "financial relationship", through
ownership or compensation, with the laboratory.  The Omnibus Budget
Reconciliation Act of 1993 contains provisions ("Stark II") expanding Stark I
by prohibiting physicians from referring Medicare and Medicaid patients to an
entity for the furnishing of a list of "designated health services" including
physical therapy, occupational therapy, home health services, and others.  If
such a financial relationship exists, the entity is generally prohibited from
claiming payment for such services under the Medicare or Medicaid programs.
Compensation arrangements are generally exempted from the Stark provisions if,
among other things, the compensation to be paid is set in advance, does not
exceed fair market value and is not determined in a manner that takes into
account the volume or value of any referrals or other business generated
between the parties.

         Other provisions in the Social Security Act authorize other penalties,
including exclusion from participation in Medicare and Medicaid, for various
billing-related offenses.  HHS can also initiate permissive exclusion actions
for such improper billing practices as submitting claims "substantially in
excess" of the provider's usual costs or charges, failure to disclose ownership
and officers, or failure to disclose subcontractors and suppliers.  Executive
Order 12549 prohibits any corporation or facility from participating in federal
contracts if it or its principals have been disbarred, suspended or are
ineligible, or have been voluntarily excluded, from participating in federal
contracts.  A principal has been defined as an officer, director, owner,
partner, key employee or other person with primary management or supervisory
responsibilities.
         The Company expects that business practices of providers and financial
relationships between providers will be subject to increased scrutiny as health
care reform efforts continue at federal and state levels.  Although the Company
has contractual arrangements with some health care providers, the Company
believes that its practices are not in violation of these federal and state
prohibitions.  The Company cannot reasonably predict whether enforcement
activities will increase at the federal or state level or the effect of any
such increase on its business.

         In the summer of 1995, a major anti-fraud demonstration project,
"Operation Restore Trust", was announced by the OIG.  A primary purpose for the
project is to scrutinize the activities of health care providers who are
reimbursed under the Medicare and Medicaid programs.  Initial investigative
efforts have focused on skilled nursing facilities, home health and hospice
agencies, and durable medical equipment suppliers in Texas, Florida, New York,
Illinois, California, and Louisiana.  With the exception of Louisiana, the
states were targeted because they collectively compromise 40% of Medicare and
Medicaid beneficiaries.  The OIG has issued, and will continue to issue,
special Fraud Alert bulletins identifying "suspect" characteristics of
potentially illegal practices by providers, and illegal arrangements between
providers.  The bulletins contain Hot Line numbers and encourage Medicare
beneficiaries, health care company employees, competitors,





                                     - 10 -
<PAGE>   11
and others to call to report suspected violations.  The OIG has indicated it is
specifically looking for evidence of excessive services to residents in nursing
home, "drop shipments" of supplies for a resident that has not been properly
assessed, billing for services not rendered, billing for equipment or supplies
which were not used, the use of untrained staff, falsified plans of care,
forged physician signatures, and kickbacks.  Identified problems will result in
increased audit scrutiny, letter inquiries or subpoenas for data and records,
and onsite investigations.  Enforcement actions could include criminal
prosecutions, or suit for civil penalties, and/or Medicare program exclusion.
While the Company does not believe that it is in violation of any such laws or
is the target of any such investigation, there can be no assurance that
substantial amounts will not be expended to cooperate with any such
investigation or to defend allegations arising therefrom.  If it were found
that any of the Company's practices failed to comply with the anti- fraud
provisions, the Company could be materially adversely affected.  The Company is
unable to predict the effect of future administrative or judicial
interpretations of these laws, or whether other legislation or regulations on
the federal or state level in any of these areas will be adopted, what form
such legislation or regulations may take, or their impact on the Company.
There can be no assurance that such laws will ultimately be interpreted in a
manner consistent with the Company's practices.

         CERTIFICATE OF NEED.  Certificate of Need ("CON") statutes and
regulations control the development and expansion of health care services and
facilities in certain states.  The CON process is intended to promote quality
health care at the lowest possible cost and to avoid the unnecessary
duplication of services, equipment and facilities.  CON or similar laws
generally require that approval must be obtained from the designated state
health planning agency for certain acquisitions and capital expenditures, and
determine that a need exists prior to the expansion of existing facilities,
construction of new facilities, addition of beds, acquisition of major items of
equipment or introduction of new services.  State approvals are generally
issued for a specified maximum expenditure and require implementation of the
proposal within a specified period of time.  Failure to obtain the necessary
state approval can result in the inability to provide the service, to operate
the facility, to complete the acquisition, addition or other change, and can
also result in the imposition of sanctions or adverse action on the facility's
license and adverse reimbursement action. Most  states in which the Company
operates have adopted CON or similar laws that regulate the locations operated
by the Company's subsidiaries, and/or the services provided.   Some states,
however, including, but not limited to Colorado, Texas, and Wyoming, do have
other state laws which control the addition of nursing facility beds in a
service area.  CONs or other approvals may be required in connection with the
Company's future acquisitions and/or expansions.  There can be no assurance
that the Company will be able to obtain the CONs or other approvals necessary
for any or all such projects.

         ENVIRONMENTAL LAWS. Certain federal and state laws govern the handling
and disposal of medical, infectious and hazardous waste. Failure to comply with
those laws or the regulations promulgated thereunder could subject an entity
covered by these laws to fines, criminal penalties and other enforcement
actions. The Company has developed policies with respect to the handling and
disposal of medical, infectious and hazardous waste to assure compliance by
each of its centers with those laws and regulations. The Company believes that
it is in material compliance with applicable laws and regulations governing
medical, infectious and hazardous waste.

         OSHA.  Federal regulations promulgated by the Occupational Safety and
Health Administration impose additional requirements on the Company with regard
to protecting employees from hazards in the workplace, including exposure to
blood-borne pathogens. The Company cannot predict the frequency of compliance
monitoring or enforcement actions that it may be subject to by governing
agencies and there can be no assurance that the regulations will not adversely
affect the operations of the Company and other long-term care providers.

         WORK OPPORTUNITY CREDIT.  The targeted jobs credit expired on December
31, 1994.  The 1996 Small Business Act (P.L. 104-188), Section 1201, replaced
the targeted jobs credit under Section 51 with the work opportunity credit.
The credit is available on an elective basis for employers hiring individuals
from one or more of eight targeted groups, and generally, is equal to 35% of
qualified first-year wages.  However, no credit is allowed for wages paid
unless the individual is employed by the employer for at least 180 days or 400
hours.  In addition, the individual is not treated as a member of a targeted
group unless certification requirements are met.  The credit is available for
wages paid or incurred to a qualified individual who begins work for an
employer after September 30, 1996, and before October 1, 1997.

COMPETITION

         The long-term health care industry is segmented into a variety of
competitive areas which market similar services. These competitors include
nursing homes, hospitals, extended care centers, retirement centers and
communities, and home





                                     - 11 -
<PAGE>   12
health and hospice  agencies. The Company's centers historically have competed
on a local basis with other long-term care providers, and the Company's
competitive position has varied from center to center within the various
communities it serves. During fiscal year 1996, however, the Company  invested
in the development of a Marketing and Managed Care Department, led by a Company
Vice President of Marketing to assist facilities-based staffs increase the
occupancies of the Company's long-term care centers.  Several new systems are
in the process of implementation which are designed to enhance census
development and retention. Significant competitive factors include the quality
of care provided, reputation, location and physical appearance of the long-term
care centers and, in the case of private pay residents, charges for services.
Since there is little price competition with respect to Medicaid and Medicare
residents, the range of services provided by the Company's centers that is
covered by Medicaid and Medicare and the location of the centers significantly
affect a center's competitive position in its market. Competition in the
institutional pharmaceutical and the rehabilitation services markets ranges
from small local operators to companies which are national in scope and
distribution capability.  The Company cannot assure that its marketing
initiative and the implementation of marketing systems will result in
significant increases in census at its long-term care centers.

CAUTIONARY STATEMENTS

         Information provided herein by the Company contains, and from time to
time the Company may disseminate materials and make statements which may
contain "forward-looking" information, as that term is defined by the Private
Securities Litigation Reform Act of 1995 (the "Act").  These cautionary
statements are being made pursuant to the provisions of the Act and with the
intention of obtaining the benefits of the "safe harbor" provisions of the Act.

         The Company cautions investors that any forward-looking statements
made by the Company are not guarantees of future performance and that actual
results may differ materially from those in the forward-looking statements as a
result of various factors, including, but not limited to, the following:

         (i) In recent years, an increasing number of legislative proposals
have been introduced or proposed by Congress and in some state legislatures
which would effect major changes in the healthcare system.  However, the
Company cannot predict the form of healthcare reform legislation which may be
proposed or adopted by Congress or by state legislatures.  Accordingly, the
Company is unable to assess the effect of any such legislation on its business.
There can be no assurance that any such legislation will not have a material
adverse impact on the future growth, revenues and net income of the Company.

         (ii) The Company derives substantial portions of its revenues from
third-party payors, including government reimbursement programs such as
Medicare and Medicaid, and some portions of its revenues from nongovernmental
sources, such as commercial insurance companies, health maintenance
organizations and other charge-based contracted payment sources.  Both
government and non government payors have undertaken cost-containment measures
designed to limit payments to healthcare providers.  There can be no assurance
that payments under governmental and nongovernmental payor programs will be
sufficient to cover the costs allocable to patients eligible for reimbursement.
The Company cannot predict whether or what proposals or cost-containment
measures will be adopted or, if adopted and implemented, what effect, if any,
such proposals might have on the operations of the Company.

         (iii) The Company is subject to extensive federal, state and local
regulations governing licensure, conduct of operations at existing facilities,
construction of new facilities, purchase or lease of existing facilities,
addition of new services, certain capital expenditures, cost-containment and
reimbursement for services rendered.  The failure to obtain or renew required
regulatory approvals or licenses, the delicensing of facilities owned, leased
or operated by the Company or the disqualification of the Company from
participation in certain federal and state reimbursement programs could have a
material adverse effect upon the operations of the Company.

         (iv) There can be no assurance that the Company will be able to
continue its substantial growth or be able to fully implement its strategy to
develop and its business strategies for its long-term care, pharmaceutical, or
rehabilitation therapy services groups.





                                     - 12 -
<PAGE>   13
EMPLOYEES

         The Company employs approximately 29,000 individuals, including
approximately 5,000 registered and licensed practical nurses, 10,000 nursing
assistants, over 2,000 therapists, 200 pharmacists and 1,500 employees who work
at the corporate and field offices.

ITEM 2.               PROPERTIES

         As of  September 30, 1996, Living Centers operated 206 long-term care
and assisted living centers with 23,746 licensed beds in 13 states. The
Company's lease arrangements for its long-term care centers are generally
"triple net" leases, as is typical in the industry, whereby the Company rather
than the landlord is responsible for all property taxes, insurance coverages
and maintenance on the property. The average remaining life of the leases,
including renewal options exercisable solely by the Company, is 11.8 years. The
Company considers its properties to be in good operating condition and suitable
for the purposes for which they are being used. The centers are generally
refurbished or remodeled on a five to seven-year cycle.

         The following table lists, at September 30, 1996 by state, the total
number of licensed beds and the number of centers owned, leased and managed by
the Company. Licensed beds represent the number of beds for which a license has
been issued and may vary from the actual beds available for use.

<TABLE>
<CAPTION>
                             OWNED            LEASED            MANAGED               TOTAL
                        --------------    --------------     --------------      --------------
STATE                   CENTERS   BEDS    CENTERS   BEDS     CENTERS   BEDS      CENTERS   BEDS
<S>                      <C>    <C>       <C>      <C>         <C>     <C>        <C>     <C>
Texas                      51    5,854      42     4,656         1     120         94     10,630
North Carolina             29    3,429       3       458         1      91         33      3,978
Colorado                   18    1,902       8       819        --      --         26      2,721
Louisiana                  --       --       6     1,260        --      --          6      1,260
Georgia                     2      270       6       706        --      --          8        976
Alabama                     7      820      --        --        --      --          7        820
Arizona                     2      215       5       545        --      --          7        760
Nebraska                    7      612      --        --        --      --          7        612
Florida                     2      295       1       266         1      51          4        612
Wyoming                     3      385       2       140        --      --          5        525
South Carolina              2      265      --        --         1     120          3        385
Virginia                   --       --       5       343        --      --          5        343
Mississippi                 1      124      --        --        --      --          1        124
                         ----   ------      --     -----       ---     ---        ---     ------
        Total            124    14,171      78     9,193         4     382        206     23,746
                         ===    ======      ==     =====       ===     ===        ===     ======
</TABLE>


Certain of the above properties serve as collateral for various mortgage debt
instruments or capitalized lease obligations.  See Note 5 to the Consolidated
Financial Statements.  The Company regularly reviews its portfolio of
properties and intends to divest those centers which it believes do not meet
patient care or financial performance standards.





                                     - 13 -
<PAGE>   14
In addition to long-term care centers, at September 30, 1996 the Company
operated 134 outpatient rehabilitation clinics in 19 states and 31
institutional pharmacies in 11 states, as follows:



<TABLE>
<CAPTION>
                                                           OUTPATIENT INSTITUTIONAL
                             STATE                          CLINICS    PHARMACIES
             <S>                                               <C>         <C>
             Alabama  . . . . . . . . . . . . . . . . .        --           1
             Arizona  . . . . . . . . . . . . . . . . .         1           2
             California . . . . . . . . . . . . . . . .         5          --
             Colorado . . . . . . . . . . . . . . . . .        --           2
             Connecticut  . . . . . . . . . . . . . . .         3          --
             Florida  . . . . . . . . . . . . . . . . .        15           9
             Georgia  . . . . . . . . . . . . . . . . .         1           1
             Illinois . . . . . . . . . . . . . . . . .        --           1
             Indiana  . . . . . . . . . . . . . . . . .        --           1
             Iowa . . . . . . . . . . . . . . . . . . .         1          --
             Kansas . . . . . . . . . . . . . . . . . .        11          --
             Kentucky . . . . . . . . . . . . . . . . .         1          --
             Louisiana  . . . . . . . . . . . . . . . .         6           2
             Maryland . . . . . . . . . . . . . . . . .         3          --
             Mississippi  . . . . . . . . . . . . . . .         8          --
             Nevada . . . . . . . . . . . . . . . . . .         1          --
             New Jersey . . . . . . . . . . . . . . . .        --           1
             North Carolina . . . . . . . . . . . . . .        21           2
             South Carolina . . . . . . . . . . . . . .        10          --
             Tennessee  . . . . . . . . . . . . . . . .        10          --
             Texas  . . . . . . . . . . . . . . . . . .        28           9
             Virginia . . . . . . . . . . . . . . . . .         7          --
             Washington . . . . . . . . . . . . . . . .         1          --
             Wyoming  . . . . . . . . . . . . . . . . .         1          --
                                                               --          --
                 Total  . . . . . . . . . . . . . . . .        134         31
                                                               ===         ==
</TABLE>

         Substantially all of the Company's outpatient rehabilitation clinics
and institutional pharmacy facilities are leased under "triple net" leases. The
Company considers its properties to be in good operating condition and suitable
for the purposes for which they are being used. In connection with the
Rehability acquisition, the Company adopted a restructuring plan in which it
expects to close a total of 30 outpatient rehabilitation centers prior to March
31, 1997.  See Note 9 to the Consolidated Financial Statements.

         Certain of the above properties serve as collateral for various
mortgage debt instruments or capitalized lease obligations.  See Note 5 to the
Consolidated Financial Statements.  The Company regularly reviews its portfolio
of properties and intends to divest those clinics and/or pharmacies which it
believes do not meet quality or financial performance standards.





                                     - 14 -
<PAGE>   15
ITEM 3.               LEGAL PROCEEDINGS

         As is typical in the health care industry, the Company is subject to
claims that its services have resulted in resident injury  or other adverse
effects, the risks of which are greater for higher acuity residents receiving
services from the Company than for other long-term care residents. The Company
has, from time to time, been subject to such negligence claims and other
litigation.  In addition, resident, visitor, and employee injuries also subject
the Company to risk of litigation.  While the Company believes that the
ultimate resolution of pending legal proceedings will not have a material
adverse effect on the Company's business or financial condition, there can be
no assurance that any current or future claims will not have a material adverse
effect on the Company's business or financial condition.  Although the Company
maintains insurance with coverages it deems appropriate in respect of such
potential liabilities, there can be no assurance that such insurance will
continue to be available at acceptable rates or that claims in excess of the
current insurance coverages or claims not covered by insurance will not be
asserted against the Company.  Moreover, insurance coverage in certain states
is not available to cover punitive damages, and proceedings involving claims of
punitive damages are pending in certain of those states.  See "Liquidity and
Capital Resources" included in Management's Discussion and Analysis of
Financial Condition and Results of Operations.

         An attorney in the Civil Division of the United States Department of
Justice has advised Living Centers that a complaint under the Civil False
Claims Act has been filed, under seal, against BCC and one of its subsidiaries,
MedTherapy Rehabilitation Services, Inc. ("MedTherapy"), in the federal
district court for the Western District of North Carolina. The Department of
Justice has reviewed the sealed complaint and advised counsel for BCC and
MedTherapy that the plaintiff alleges, in general, that BCC and MedTherapy
caused certain therapists to make improper therapy record entries with respect
to therapy screening services and that any claims filed with Medicare for
payments which are based upon such improper record entries should be viewed as
false claims under the Civil False Claims Act. Under the Civil False Claims
Act, any person who knowingly files false claims is liable for treble damages
and penalties ranging from $5,000 to $10,000 for each false claim. Because the
complaint is under seal, Living Centers does not know the number of claims
alleged or the specific factual allegations set forth in the complaint. The
Department of Justice has the right to intervene and pursue the claim on behalf
of the plaintiff, but has not made a decision on intervention as of the date
hereof. If the Department of Justice does not intervene, the plaintiff may
continue to pursue the claim individually.  BCC and MedTherapy have advised the
Department of Justice that, based upon the information disclosed thus far by
the Department of Justice, they dispute, and will vigorously contest, the
claims of the plaintiff. Although the Company believes, based on discussions
with counsel, that the plaintiff's claims are merit less, no assurances can be
given that, if the plaintiff were to prevail in his claim, the resulting
judgment would not have a material adverse effect upon the Company. Moreover,
in connection with the Company's acquisition of BCC, the primary stockholder
(Donald C.  Beaver) agreed to indemnify and hold harmless Living Centers from
and against any and all loss, expense, damage, penalty and liability which
could result from this claim, subject to further adjustment.  Mr. Beaver's
indemnity requires any payment to the Company to be in the form of shares of
Common Stock.


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

         Not applicable.





                                     - 15 -
<PAGE>   16
ITEM 4A.         EXECUTIVE MANAGEMENT OF THE REGISTRANT

         The following table sets forth certain information concerning
executive officers of the Company:

<TABLE>
<CAPTION>
NAME                                                        AGE                    OFFICE HELD
<S>                                                          <C>  <C>
Edward L. Kuntz . . . . . . . . . . . . . . . . . . . .      51   Chairman, Chief Executive Officer, President and
                                                                    Director
Leroy D. Williams . . . . . . . . . . . . . . . . . . .      55   Executive Vice President, Chief  Operating Officer
                                                                    and Director
Charles B. Carden . . . . . . . . . . . . . . . . . . .      51   Executive Vice President and Chief Financial
                                                                    Officer
Donald C. Beaver  . . . . . . . . . . . . . . . . . . .      56   Vice Chairman
Pauline Bonner  . . . . . . . . . . . . . . . . . . . .      47   Area President, Long Term Care Group
Sydney K. Boone, Jr.  . . . . . . . . . . . . . . . . .      51   Vice President, Acquisitions and Development
David W. Budke  . . . . . . . . . . . . . . . . . . . .      33   Vice President, Program Development
James P. Dorn . . . . . . . . . . . . . . . . . . . . .      49   Vice President, Human Resources
Boyd P. Gentry  . . . . . . . . . . . . . . . . . . . .      37   Vice President, Investor Relations and Treasurer
Kelly R. Gill . . . . . . . . . . . . . . . . . . . . .      41   President, Therapy Services Group
Laura Kislowski . . . . . . . . . . . . . . . . . . . .      42   Vice President, Marketing
William R. Korslin  . . . . . . . . . . . . . . . . . .      47   President, Pharmaceutical Services Group
Keith Krein, M.D. . . . . . . . . . . . . . . . . . . .      44   Medical Director and Vice President, Professional
                                                                    Services
John D. Lee, III  . . . . . . . . . . . . . . . . . . .      50   Area President, Long Term Care Group
James L. Martin, Jr.  . . . . . . . . . . . . . . . . .      38   Vice President, Purchasing
Kenneth Morgan  . . . . . . . . . . . . . . . . . . . .      53   Area President, Long Term Care Group
Karuppanna Muthuswamy . . . . . . . . . . . . . . . . .      51   Vice President, Information Services
Susan Thomas Whittle  . . . . . . . . . . . . . . . . .      48   Vice President, General Counsel and Secretary
</TABLE>



    There are no family  relationships existing among any of the above listed
officers. Officers are elected annually and serve at the discretion of the
Board of Directors. Each of the executive officers has employment agreements
that provide for annual salaries ranging from $113,000 to $500,000 for periods
of employment up to 36 months and severance payments of up to 36 months of
salary plus certain benefits.  The severance arrangements also provide for an
additional 12 months of compensation and benefits in the event of a change in
control of the Company.

    Mr. Kuntz became Chief Executive Officer and a Director in December 1991,
Chairman in January 1992 and President in November 1993.  He served as
President until February 1996.   He joined Living Centers as Executive Vice
President in February 1985. Prior to joining the Company, Mr. Kuntz was
employed by ARA since 1978 and was general counsel to ARA Living Centers (the
predecessor of Living Centers).

    Mr. Williams became Executive Vice President in December 1991 and a
Director in January 1992. He was appointed Chief Operating Officer in August
1995, and President in February 1996.   He joined Living Centers in 1978 as
Regional Controller of Living Centers--Eastern Region. From May 1983 to
February 1985, Mr. Williams was Financial Vice President for Living
Centers--Texas. In March 1985, he was appointed Vice President--Finance and
became Senior Vice President--Finance in January 1991.

    Mr. Carden was appointed Executive Vice President and Chief Financial
Officer effective October 1996.  Previously, he was Chief Financial Officer of
Leaseway Transportation Corp. where he was employed for fourteen years.  He
also has had various supervisory and analytical positions in corporate finance
with Ford Motor Company.

    Mr. Beaver was appointed Vice Chairman concurrent with the acquisition by
the Company of the outstanding stock of The Brian Center Corporation in July
1995.  Previously, Mr. Beaver had been the sole shareholder of The Brian Center
Corporation.





                                     - 16 -
<PAGE>   17
    Ms. Bonner became Area President, for the Rocky Mountain Area, in February
1996.  She has held various operational positions since joining the Company in
1980, including District Director of Operations and Area Vice President for the
Rocky Mountain Area.

    Mr. Boone became Vice President, Acquisitions and Development and Associate
General Counsel in November 1993. He had served as Assistant General Counsel
since joining the Company in May 1989. Previously, he was in private law
practice.

    Mr. Budke became Vice President, Program Development in November 1993. He
previously held various marketing and public relation positions at the Company
since joining the Company in September 1987.

    Mr. Dorn became Vice President, Human Resources in March 1996. Previously,
he was Vice-President - Human Resources for Curtin Matheson Scientific, and has
held human resources management positions for over twenty years.

    Mr. Gentry became Vice President, Investor Relations and Treasurer in
August 1995. Previously, Mr. Gentry was a Senior Vice President of NationsBank.
Mr. Gentry served NationsBank and its predecessors in a variety of corporate
finance and corporate banking positions for over 12 years prior to joining the
Company.

    Ms. Kislowski became Vice President, Marketing in August 1995.  Previously,
Ms. Kislowski had significant experience in long-term care sales and marketing
positions, most recently with Regency Health Services.

    Mr. Korslin has served as President of APS since May 1994. Mr. Korslin
joined APS in July 1987 as General Manager, Enteral Services. From 1989 through
1992, he served as Eastern Area Vice President of APS and, from 1992 to 1994,
Mr.  Korslin was Senior Vice President in charge of all field operations of
APS. He was appointed as a Vice President of Living Centers in September 1995.

    Mr. Lee became Area President, for the Southeast Area in February 1996.  He
previously held the position of Area Vice President for the Southeast Area
since joining the Company in May 1994.  Previously, Mr. Lee had held Senior
Management positions with long-term care companies located in the Eastern and
Southeastern United States.

    Mr. Martin became Vice President, Purchasing in May 1996.   Mr. Martin
joined the Company through the acquisition of The Brian Center Corporation in
July 1995, where he had been Controller.

    Mr. Morgan became Area President, for the Texas Area in February 1996.  He
previously held the position of Area Vice President for the Texas Area since
joining the Company in January 1995.  Previously, Mr. Morgan had owned and
operated long-term care facilities, and held Senior Management positions with
long-term care companies located in Texas and the Midwestern United States.

    Dr. Krein became Medical Director and Vice President, Professional Services
in November 1989. Previously, he was regional medical director for Spectrum
Emergency Care, Inc. (a subsidiary of ARA) from September 1984 until he joined
the Company in November 1989.

    Mr. Muthuswamy became Vice President, Information Services in January 1991.
Previously, he was Director of Operation Services Development for ARASERVE (an
ARA business sector) from March 1978 until he joined the Company in May 1989.

    Ms. Whittle became Vice President, General Counsel and Secretary in
September 1993. Previously, she was a partner with the law firms of Clark,
Thomas & Winters of Austin, Texas and Wood, Lucksinger & Epstein, a national
health care law firm.





                                     - 17 -
<PAGE>   18
                                    PART II

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

PRINCIPAL MARKETS AND SALES PRICES OF COMMON EQUITY SECURITIES

         The Company's common stock is traded on the New York Stock Exchange
under the symbol "LCA."  The high and low sales prices for each quarter for the
last two fiscal years is presented in the table below:

<TABLE>
<CAPTION>
                                          Fiscal Year 1996                        Fiscal Year 1995     
                                       -----------------------                --------------------------
                                       High              Low                  High                 Low
            Quarter Ended
            -------------
            <S>                        <C>              <C>                   <C>                 <C>
            December 31                35               25 1/2                34 1/4              29 1/4

            March 31                   41               31 1/2                38 1/4              32 3/4

            June 30                    39 1/4           32 5/8                37 1/2              25 1/4

            September 30               28 1/8           20 3/4                34 7/8              267/16
</TABLE>

NUMBER OF STOCKHOLDERS

         As of November 25, 1996 there were approximately 512 owners of record
of the Company's common stock.

DIVIDENDS

         The Company has not paid any cash dividends on its common stock since
inception and it does not currently anticipate paying any such dividends on the
common stock.  The Company's Bank Credit Facility and various other note
agreements contain covenants which effectively limited the payment of cash
dividends as of September 30, 1996 to $24.4 million.  See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources" and Note 5 to the Consolidated Financial
Statements.





                                     - 18 -
<PAGE>   19
ITEM 6.  SELECTED FINANCIAL INFORMATION

     The following selected financial data are derived from the Company's
Consolidated Financial Statements, which have been audited by Ernst & Young
LLP, independent auditors. The Consolidated Financial Statements give
retroactive effect to the acquisition of BCC as though the transaction occurred
on September 30, 1990; such transaction has been accounted for using the
pooling of interests method of accounting. The information set forth below is
qualified by reference to, and should be read in conjunction with, the
Consolidated Financial Statements and the Notes thereto, and "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this filing. All dollar amounts are presented in
thousands, except per share amounts.

<TABLE>
<CAPTION>
                                                                                YEARS ENDED SEPTEMBER 30,
                                                   ------------------------------------------------------------------------------
                                                      1996             1995                1994            1993            1992
<S>                                                <C>             <C>                 <C>             <C>             <C>
INCOME STATEMENT DATA: (1)
   Net revenues..............................      $ 1,114,491     $   893,869         $  708,873      $  576,140      $  511,838  
   Income from operations....................           89,556          57,005(2)          49,468          38,464          30,868  
      Interest expense, net..................           12,461          10,817             10,894           8,998          11,001  
      Equity earnings/minority interests.....             (156)           (204)             1,603           1,582           1,210  
      Net Income.............................           43,180          24,234             26,616          20,899          14,249  
   Pro forma taxes(4)........................               --             599                899             899             726  
   Pro forma net income(4)...................           43,180          23,635             25,717          20,000          13,523  
   Earnings per share........................      $      2.13     $      1.27(3)      $     1.56      $     1.32      $     0.92  
   Pro forma earnings per share(4)...........      $      2.13     $      1.24(3)      $     1.51      $     1.26      $     0.87  
   Weighted average number of shares                                                                                               
       outstanding (in thousands)............           20,315          19,034             17,080          15,824          15,551  
OPERATING STATISTICS:                                                                                                              
   Number of centers (end of period).........              206             294                288             267             261  
   Average occupancy rate....................             83.9%           85.1%              85.2%           84.3%           84.3%  
   Percentage of patient revenues from:                                                                                            
      Private................................             31.9%           25.5%              23.7%           24.0%           25.2%  
      Medicare...............................             25.5            23.9               17.5            13.6             9.9  
      Medicaid...............................             42.6            50.6               58.8            62.4            64.9  
   Percentage operating margin...............              8.0%            6.4%(2)            7.0%            6.7%            6.0%  
</TABLE>

<TABLE>
<CAPTION>
                                                                                       SEPTEMBER 30,
                                                   ------------------------------------------------------------------------------
                                                      1996             1995                1994            1993            1992
<S>                                                <C>             <C>                 <C>             <C>             <C>
BALANCE SHEET DATA:
   Working capital...........................      $ 101,091       $  34,631           $  14,955       $  15,960       $  17,258  
   Total assets..............................        821,734         730,708             525,639         376,248         354,974  
   Long term debt, including current portion         276,448         216,910             206,097         135,409         145,956  
   Stockholders' equity......................        329,315         303,596             172,018         119,432         105,521  
   Total capitalization......................        605,763         520,506             378,115         254,841         251,477  
</TABLE>

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

(1)      Years prior to 1994 have been restated to reflect the implementation
         of SFAS 109.
(2)      Includes $14.3 million of non-recurring merger and acquisition and
         related costs associated with the BCC merger. Excluding these
         non-recurring merger and acquisition and related costs, the percentage
         operating margin would have been 8.0%.
(3)      Excluding non-recurring merger and acquisition and related costs in
         the amount of $14.3 million, earnings per share and proforma earnings
         per share would have been $1.93 and $1.90, respectively.
(4)      A pro forma income tax provision has been provided to reflect the
         estimated federal and state income taxes as if all BCC S corporations
         were taxable entities. See Note 1 to Consolidated Financial
         Statements.


                                     - 19 -
<PAGE>   20
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS

OVERVIEW

     The Company provides a diverse range of services in the health care
continuum including long-term health care, rehabilitation therapy, and
pharmaceutical services. Services provided at the Company's long-term care
facilities, which comprise approximately 70% of the Company's total revenue,
include long-term nursing services and specialty care services including
assisted living services, subacute care, and care for individuals with
Alzheimer's disease. The Company is currently expanding or developing
additional specialty care services such as hospice care, geriatric physician
management services and home health care. See Business - Long-Term Care
Services Group. The Company's rehabilitation therapy group provides services to
over 600 skilled nursing and other health care facilities, offers therapy
program management services to long-term health care companies, and operates
approximately 134 outpatient clinics. The pharmaceutical group operates 31
institutional pharmacies and provides services to more than 100,000 long-term
health care beds through its various product lines.

     When the Company began its operations as a separate, publicly-traded
company in 1992, it provided primarily long-term nursing services. From fiscal
year 1992 through fiscal year 1995 it grew rapidly through acquisitions, adding
specialty care services, rehabilitation therapy, and pharmaceutical services,
as well as additional long-term care facilities. During this period the
Company's net revenue increased from $351 million to $894 million and its net
income, adjusted for non-recurring merger and acquisition costs in 1995,
increased from $10.5 million to $36.1 million. During the fiscal year ending
September 30, 1995 the Company completed several significant acquisitions
including The Brian Center Corporation ("BCC"), Rehability, and TMI.
Accordingly, the fiscal year ended September 30, 1996 was the first year that
fully reflected the financial results from all of the Company's major
acquisitions. The Company's net revenue for the fiscal year ended September 30,
1996 increased to $1.1 billion and net income, excluding non-recurring items,
increased to $45.0 million.

     During the fiscal year ended September 30, 1996, the Company turned its
focus to integrating the BCC, Rehability, and TMI operations and divesting its
DevCon subsidiary, which provided training and habilitation services to
individuals with mental retardation and developmental disabilities. During
fiscal year 1996, the Company finalized a plan originating in June 1995 to
restructure the operations and exit certain activities of ARS, including
closing or downsizing unprofitable clinics and offsite contracts. See Note 9 to
the Consolidated Financial Statements. The divestiture of DevCon was completed
in September 1996 through the recapitalization and subsequent sale of the
majority of DevCon's stock for $47.5 million in cash. The Company's results for
the fiscal year ended September 30, 1996 and prior years reflect the inclusion
of the DevCon operations. DevCon's net revenue and income from operations for
fiscal year 1996 were $47.6 million and $5.7 million, respectively. The Company
expects its reported earnings to reflect the effects of this divestiture until
the proceeds from the divestiture are reinvested.

     The Company's strategy is to utilize its core long-term care facilities as
a platform to deliver a comprehensive array of senior health care services. As
a consequence, the Company seeks to control the significant components of its
care continuum, while diversifying its sources of revenue and positioning
itself to be responsive to a variety of payors. Through the provision of
cost-effective quality care, the Company believes that it can enhance
profitability. However, future operating performance will continue to be
affected by the issues facing the senior health care industry including quality
of care, occupancy levels, availability of nursing, therapy and other
personnel, adequacy of funding of federal and state reimbursement programs in
addition to the Company's continued expansion of its non-nursing home
operations and its ability to control costs.





                                     - 20 -
<PAGE>   21
RESULTS OF OPERATIONS

     The following table sets forth data from the statement of income expressed
as a percentage of net revenues:


<TABLE>
<CAPTION>
                                                      YEARS ENDED SEPTEMBER 30,
                                                     --------------------------
                                                      1996       1995      1994
<S>                                                  <C>        <C>       <C>  
Net Revenues:
     Nursing home                                     69.7%      82.6%     94.3%
     Non-nursing home:
        Pharmacy                                      11.4       10.4       4.0
        Therapy                                       18.5        6.6       1.1
        Other                                           .4         .4        .5
                                                    ------     ------    ------
                                                     100.0      100.0     100.0
                                                    ------     ------    ------
Costs and Expenses:
     Salaries and wages                               40.9       40.3      42.0
     Employee benefits                                 8.7        9.1      11.7
     Nursing, dietary, and other supplies              5.4        6.3       6.6
     Ancillary services                               16.9       16.6      11.2
     General and administrative                       15.1       15.1      17.5
     Depreciation and amortization                     3.5        3.5       3.7
     Provision for bad debts                           1.5        1.3        .4
     Life insurance proceeds                           (.2)        --        -- 
     Gain on sale                                     (2.0)        --        -- 
     Impairment of long-lived assets                   2.3         --        -- 
     Other                                              .3         --        -- 
     Mergers and acquisition cost                       --        1.4        -- 
                                                    ------     ------    ------

Income from operations                                 7.6        6.4       7.0
Interest expense, net                                  1.1        1.2       1.5
                                                    ------     ------    ------

Income before income taxes and equity earnings/
    minority interest                                  6.5        5.2       5.5
Provision for income taxes                             2.8        2.4       1.9
                                                    ------     ------    ------

Income before equity earnings/minority interest        3.7        2.8       3.6
Equity earnings/minority interest                       --         .1        .2
                                                    ------     ------    ------

Net income                                             3.7        2.8       3.8
Pro forma taxes (unaudited)                             --         .1        .1
                                                    ------     ------    ------

Pro forma net income (unaudited)                       3.7%       2.1%      3.7%
                                                    ======     ======    ======
</TABLE>




                                      -21-
<PAGE>   22

     Nursing home revenues are derived from two basic sources: routine services
$(630.7 million or 81.2 % in fiscal year 1996) and ancillary services $(145.8
million or 18.8 % in fiscal year 1996) and are a function of occupancy rates in
the long-term care facilities and the payor mix. Occupancy rates, as identified
in the following table, decreased in fiscal year 1996 partially due to an
increase in hospital-operated skilled units in key markets. The Company has
invested in the marketing and managed care areas and has implemented an
aggressive marketing program to increase census and improve quality mix. Years
Ended September 30,

<TABLE>
<CAPTION>
                                              Years Ended September 30,  
                                          ---------------------------------
                                          1996          1995         1994
<S>                                       <C>           <C>          <C>
Weighted licensed bed count               25,498        26,355       26,617

Total average residents                   21,405        22,428       22,669

Average occupancy                           83.9%         85.1%        85.2%
</TABLE>


     Payor mix is the source of payment for the services provided and consists
of private pay, Medicare and Medicaid. Private pay includes revenue from
individuals who pay directly for services without governmental assistance,
managed care companies, commercial insurers, health maintenance organizations,
and Veteran's administration contractual payments. Managed care as a payor
source to health care providers is expected to increase over the next several
years. The Company has increased its managed care contracting capabilities and
has created a system which allows the centralized case management of these
patients within targeted markets. However, the impact to the Company of this
increasing payor source can not be determined at this time.

     Reimbursement rates from government sponsored programs, such as Medicare
and Medicaid, are strictly regulated and subject to funding appropriations from
federal and state governments. To the extent unfavorable changes in economic
conditions impact payments under governmental or third-party payor programs,
the Company would be adversely affected. See Business - Government Regulation.
Revenues derived from the Company's pharmacy and therapy groups are also
influenced by payor mix. The table below presents the approximate percentage of
the Company's net patient revenues derived from the various sources of payment
for the periods indicated:

<TABLE>
<CAPTION>
                                              Years Ended September 30,  
                                           ------------------------------
                                           1996         1995         1994
<S>                                        <C>          <C>          <C>
Private pay                                31.9%        25.5%        23.7%

Medicare                                   25.5%        23.9%        17.5%

Medicaid                                   42.6%        50.6%        58.8%
</TABLE>


     The increasing trend in the percentage of revenues derived from private
pay and Medicare sources is attributable primarily to the growth in the
Company's pharmacy and therapy operations. The revenue from these operations,
which is generated primarily from private pay and Medicare sources, results in
a reduction of the percentage of net revenue derived from the Medicaid program.
In addition, average reimbursement rates for Medicare patients have increased
more rapidly than for Medicaid residents due primarily to the higher
reimbursement rates associated with the increase in acuity levels. Although
cost reimbursement for Medicare residents generates a higher level of revenue
per patient day, profitability is not proportionally increased due to the
additional costs associated with the required higher level of care and other
services for such residents.

     The administrative procedures associated with the Medicare cost
reimbursement program generally preclude final determination of amounts due the
Company until cost reports are audited or otherwise reviewed and settled with
the applicable administrative agencies. The Company does not expect any
differences between revenue recorded and as finally determined to have a
significant effect on the Company's results of operations or financial
position. See Note 1 to the Consolidated Financial Statements.



                                     - 22 -

<PAGE>   23



     Costs and expenses, excluding depreciation and amortization, primarily
consist of salaries, wages, and employee benefits. Various federal, state, and
local regulations impose, depending on the services provided, a variety of
regulatory standards for the type, quality and level of personnel required to
provide care or services. These regulatory requirements have an impact on
staffing levels, as well as the mix of staff, and therefore impact total costs
and expenses. See Business-Government Regulation. The cost of ancillary
services, which includes pharmaceuticals, is also affected by the level of
service provided and patient acuity. General and administrative expenses
include the cost of the Company's various insurance programs, except worker's
compensation. See Note 12 to the Consolidated Financial Statements.

     FISCAL 1996 COMPARED TO FISCAL 1995. Net revenues comprising nursing home
and non-nursing home operations totaled $1.1 billion for the year ended
September 30, 1996, an increase of $220.6 million or 24.7%, as compared to
fiscal 1995. Nursing home operations contributed $38.1 million of the increase
which included rate increases of $37.2 million and higher ancillary service
billings resulting from the improvement in patient mix, primarily Medicare, of
$22.6 million. Divesture of nursing home operations decreased revenue $19.6
million and lower census reduced revenue by $7.6 million. Non-nursing home
operations contributed $182.5 million of the increase, consisting of $34.6
million from pharmacy operations, $146.5 million from therapy services and $1.4
million from medical supplies. Acquisitions, primarily Rehability, provided
$177.0 million of the $182.5 million increase in non-nursing home revenue.

     Costs and expenses, including non-recurring items totaled, $1.0 billion
for the year ended September 30, 1996, an increase of $188.1 million or 22.5%,
as compared to fiscal 1995. Acquisitions, primarily Rehability and TMI, were
$171.0 million of the increase and divestitures reduced total expenses by $24.3
million. Other increases include payroll and related $(15.8 million) and
ancillary services $(28.4 million). The increase in ancillary services
corresponds to the increase in ancillary revenue and the higher level of
patient acuity as well as an increase in the cost of pharmaceuticals related to
higher pharmacy services revenue.

     Non-recurring items reduced total costs and expenses in fiscal year 1996
by $1.1 million compared to the $12.4 million of merger and acquisition costs
from the BCC purchase in fiscal 1995. Non-recurring items included a $2.0
million gain from the receipt of life insurance proceeds on the former
President of the Rehabilitation Services Group. In addition the Company
recognized a $22.5 million gain in September 1996 on the sale of its DevCon
operations, which provided training and habilitation services to individuals
with mental retardation and developmental disabilities, through the
recapitalization and subsequent sale of the majority of DevCon's stock for
$47.5 million. The Company also recorded non-recurring charges of $2.9 million
primarily related to the closure of its medical supplies business and the
write-off of unamortized loan acquisition costs related to the Second Amended
and Restated Credit Agreement.

     Non-recurring items also included an impairment loss of $20.5 million
related to nursing facilities with current period operating losses and certain
other nursing facilities and goodwill where management believed an impairment
existed as a result of the regulatory or competitive environment. Management
estimated the undiscounted cash flows to be generated by each of these assets
and compared them to their carrying value. If the undiscounted future cash flow
estimates were less than the carrying value of the asset then the carrying
value was written down to estimated fair value. Fair value was estimated based
on either management's estimate of fair value, present value of future cash
flows, or market value less estimated cost to sell for certain facilities to be
disposed. See Note 8 to the Consolidated Financial Statements.

     Net interest expense totaled $12.5 million for the year ended September
30, 1996, an increase of $1.6 million or 15.2%, as compared to the same period
for fiscal 1995. The increase reflects a full year of interest expense for
fiscal 1996 versus three months of interest expense for fiscal 1995 on the
additional debt incurred to acquire Rehability.

     The provision for income taxes increased $12.0 million in fiscal year 1996
but resulted in a lower effective tax rate of 43.8% compared to 47.1% in fiscal
year 1995. The decrease in non-deductible merger and acquisition costs reduced
the effective tax rate by 7.2% while the elimination of the Targeted Jobs Tax
Credit, increased non-deductible goodwill amortization, and other items
resulted in an increase of 3.9%.



                                     - 23 -

<PAGE>   24



     FISCAL 1995 COMPARED TO FISCAL 1994. Net revenues totaled $893.9 million
for the year ended September 30, 1995, an increase of $185.0 million or 26.1%,
as compared to fiscal 1994. Nursing home operations contributed $69.7 million
of the increase, which includes $18.7 million of acquisitions and approximately
$32.4 million in rate increases and improvements in patient mix over the prior
period (primarily in the area of Medicaid and Medicare services). Ancillary
revenue in the nursing home operations increased approximately $29.7 million
due to higher acuity levels and an increase in Medicare patients. Nursing home
revenues were lower by $11.1 million due to divestitures. Non-nursing home
operations contributed $115.3 of the increase, which includes $68.0 million of
pharmacy acquisitions, primarily APS, and $51.2 million in therapy services,
primarily Rehability and TMI.

     Costs and expenses totaled $836.9 million for the year ended September 30,
1995, an increase of $177.5 million or 26.9%, as compared to the same period
for fiscal 1994. Acquisitions contributed $125.3 million of the increase, which
includes acquisitions, primarily APS$(60.0 million), Rehability $(41.2
million), TMI $(5.3 million) and nursing homes $(18.8 million). Other major
expense increases included $22.5 million in payroll related expenses, $3.0
million in nursing dietary and other supplies, $19.1 million in ancillary
services (primarily from the higher resident acuity level and the increase in
the number of Medicare residents in the Company's nursing home operations),
$2.4 million in general and administrative expenses and $2.0 million in bad
debt expense. All fiscal 1995 expense categories expressed as a percentage of
revenues reflect a significant change from fiscal 1994. This percentage shift
in expense categories is attributable to the inclusion of APS's cost of
products sold in the expense category "operating and administrative" and, to a
lesser extent, the lower labor intensity of the APS operation. Non-recurring
merger and acquisition and related costs were $14.3 million due to the
acquisition of Rehability. Also, divestitures decreased total expenses by $11.1
million.

     Net interest expense totaled $10.8 million for the year ended September
30, 1995, a decrease of $.01 million or .7%, as compared to the same period for
fiscal 1994. Interest income from the Company's insurance subsidiary increased
and the Company used the proceeds from the February 1995 public offering of
Common Stock to retire existing debt. However, the effects of the common stock
offering were partially offset by additional debt incurred to acquire
Rehability.

     Equity earnings/minority interests incurred a loss of $.2 million for the
year ended September 30, 1996, a decrease of $1.8 million, as compared to the
same period for fiscal 1994. This decrease is the result of APS recorded as a
fully consolidated subsidiary for fiscal 1995 as opposed to an unconsolidated
equity investment (49% ownership) for fiscal 1994.

     Net income totaled $24.2 million for the year ended September 30, 1995, a
decrease of $2.4 million, or 8.9%, as compared to the same period for fiscal
1994. The decrease reflects the impact of the nonrecurring merger and
acquisition and related costs of $14.3 million, most of which is non-deductible
for federal income tax purposes. Excluding non-recurring merger and acquisition
and related costs, net income would have increased $7.8 million or 27.0% from
fiscal 1994.

SEASONALITY

     The Company's revenues and operating income generally fluctuate from
quarter to quarter. This seasonality is related to a combination of factors
which include the timing of Medicaid rate increases, the number of work days in
the period, and seasonal census cycles.

LIQUIDITY AND CAPITAL RESOURCES

     Cash and cash equivalents were $21.4 million at September 30, 1996, a $3.5
million increase from September 30, 1995 and working capital was $101.0
million, an increase of $66.5 million during fiscal year 1996. Cash provided by
operations was $31.8 million or $34.6 million less than fiscal year 1995. Net
income of $43.1 million, non-cash items totaling $44.9 million and an increase
in accrued expenses of $17.5 million contributed to the cash provided by
operations. The increase in income taxes payable is primarily the taxes due on
the gain on the sale of DevCon stock which will be paid in the first quarter of
fiscal year 1997. These items were offset by the reduction in accounts payable
of $13.8 million due to the timing of payments and an increase in receivables
of $69.6 million. The increase in receivables was primarily attributable to
acquisitions $(15.6 million), timing of collections on Medicare cost reports
and other rate adjustments $(13.1 million), receivables due to LCA Insurance
Company, Ltd. (see Note 12 to the Consolidated Financial Statements) from
third-party insurance companies $(11.7 million), and an increase in average
days outstanding, net of allowance, $(13.0 million).


                                     - 24 -

<PAGE>   25



     Excluding the $47.5 million in proceeds from the disposition of DevCon,
cash used in investing activities was $114.2 million in fiscal 1996 compared to
$139.9 million in fiscal year 1995. Investing activities in fiscal year 1996
included six pharmacy related acquisitions $(60.3 million), conversion of five
previously leased long-term care facilities to an ownership position $(14.8
million), construction of five assisted living facilities and expansion of
existing facilities $(13.3 million), the acquisition of a 50% interest in a
hospice operation $(2.8 million), and routine capital expenditures. Capital
commitments on four assisted living facilities remaining under construction and
expansion of existing long-term care facilities totaled $9.6 million at
September 30, 1996. These commitments are expected to be funded by cash from
operations or the Bank Credit Facility.

     Financing activities provided $38.4 million during fiscal 1996. During the
fourth quarter the Company entered into an amended bank credit facility (the
"Bank Credit Facility") with a group of banks pursuant to which the banks
agreed to provide $500 million to the Company. A complete description of the
Bank Credit Facility is included in Note 5 to the Consolidated Financial
Statements. Total debt increased $57.4 million as funds were used in investing
activities and the purchase of $20.0 million of the Company's common stock in
accordance with a share repurchase program. The shares are to be utilized over
the next several years to fulfill the Company's obligations under its various
employee benefit programs.

     In October 1996 the Company entered into a leasing program, initially
totaling $70.0 million, which will be used as the primary funding mechanism for
future assisted living and skilled nursing facility construction, lease
conversions, and other facility acquisitions. The company's long-term strategy
in managing working capital is to maintain substantial available commitments
under bank credit agreements or other financial agreements to finance
short-term capital requirements in excess of internally generated cash.

IMPACT OF INFLATION

     The health care industry is labor intensive. Wages and other labor-related
costs are especially sensitive to inflation. Increases in wages and other
labor-related costs as a result of inflation, or the increase in minimum wage
requirements effective October 1996, without a corresponding increase in
Medicaid and Medicare reimbursement rates would adversely impact the Company.





                                     - 25 -

<PAGE>   26
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



REPORT OF INDEPENDENT AUDITORS

To the Stockholders and Board of Directors of Living Centers of America, Inc.

     We have audited the accompanying consolidated balance sheets of Living
Centers of America, Inc. and subsidiaries as of September 30, 1996 and 1995 and
the related consolidated statements of income, stockholders' equity and cash
flows for each of the three years in the period ended September 30, 1996. Our
audits also included the financial statement schedule listed in the index at
Item 14. These consolidated financial statements and schedule are the
responsibility of the management of Living Centers of America, Inc. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.

     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the 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 Living Centers of America, Inc. and subsidiaries at September 30, 1996 and
1995 and the consolidated results of their operations and their cash flows for
each of the three years in the period ended September 30, 1996 in conformity
with generally accepted accounting principles. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.

     As discussed in Note 1 to the consolidated financial statements, in the
fourth quarter of 1996 the Company changed its method of accounting for
impairment of long-lived assets in accordance with the adoption of SFAS 121.




/s/ ERNST & YOUNG LLP


Houston, Texas
November 25, 1996


                                     - 26 -
<PAGE>   27
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                  (dollars in thousands, except share amounts)


<TABLE>
<CAPTION>
                                                                          September 30,
                                                                    ------------------------
<S>                                                                 <C>           <C>       
                            ASSETS                                     1996          1995
CURRENT ASSETS:
   Cash and cash equivalents                                        $   21,394    $   17,886
   Receivables (less allowances of $22,783 and $16,500)                204,462       151,969
   Notes receivable, net                                                 3,756         3,403
   Receivable from affiliates                                               --         2,698
   Supplies                                                             16,582        13,264
   Prepaid expenses                                                      6,450        10,503
   Deferred income taxes                                                19,644        17,264
   Other (including patient trust funds of $3,768 and $4,506)            9,273         9,865
                                                                    ----------    ----------
          TOTAL CURRENT ASSETS                                         281,561       226,852

PROPERTY AND EQUIPMENT:
   Land, buildings and improvements                                    359,137       356,725
   Furniture, fixtures and equipment                                   104,363        92,996
   Leased property under capital leases                                 12,551        13,465
                                                                    ----------    ----------
                                                                       476,051       463,186
   Less accumulated depreciation                                       186,333       169,815
                                                                    ----------    ----------
                                                                       289,718       293,371

GOODWILL, NET                                                          188,508       145,402
RESTRICTED INVESTMENTS                                                  31,040        36,622
INVESTMENT IN UNCONSOLIDATED AFFILIATE                                   3,016           205
NOTES RECEIVABLE, NET                                                   10,780        10,781
OTHER ASSETS                                                            17,111        17,475
                                                                    ----------    ----------
                                                                    $  821,734    $  730,708
                                                                    ==========    ==========

                LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
   Notes payable and current maturities of long-term debt           $   13,746    $   34,981
   Accounts payable                                                     60,210        73,076
   Accrued payroll and related expenses                                 60,089        55,957
   Accrued property taxes                                                4,995         5,131
   Patient trust funds                                                   3,768         4,506
   Accrued income taxes payable                                         16,921         4,534
   Other accrued expenses                                               20,741        14,036
                                                                    ----------    ----------
          TOTAL CURRENT LIABILITIES                                    180,470       192,221

LONG-TERM DEBT, NET OF CURRENT MATURITIES                              262,702       181,929

LONG-TERM INSURANCE RESERVES                                            26,093        22,986

MINORITY INTERESTS                                                         289           604

DEFERRED INCOME TAXES AND OTHER NONCURRENT LIABILITIES                  22,865        29,372

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
   Preferred stock, par value $ .01; 4,650,000 shares authorized;
      none issued                                                           --            --
   Series A - Junior participating preferred stock, par
     value $.01; 350,000 authorized and
     reserved; none issued                                                  --            --
   Common stock, par value $ .01; 75,000,000 and 35,000,000
      shares authorized; 20,267,920 shares issued                          203           203
   Capital surplus                                                     228,171       227,099
   Retained earnings                                                   120,733        77,553
   Unrealized loss on securities available-for-sale                        (18)           --
   Treasury stock at cost - 767,053 and 77,109 shares                  (19,774)       (1,259)
                                                                    ----------    ----------
          TOTAL STOCKHOLDERS' EQUITY                                   329,315       303,596
                                                                    ----------    ----------
                                                                    $  821,734    $  730,708
                                                                    ==========    ==========
</TABLE>


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

                                     - 27 -

<PAGE>   28
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
                       CONSOLIDATED STATEMENTS OF INCOME
                    (in thousands, except per share amounts)


<TABLE>
<CAPTION>
                                                    Years Ended September 30,
                                            --------------------------------------
                                               1996          1995          1994
<S>                                         <C>           <C>           <C>       
NET REVENUES
   Nursing home revenue:
     Net patient services                   $  767,747    $  724,924    $  656,493
     Other                                       8,799        13,556        12,306
   Non-nursing home revenue:
     Pharmacy services                         127,439        92,843        28,574
     Therapy services                          205,785        59,278         7,934
     Medical supplies and other                  4,721         3,268         3,566
                                            ----------    ----------    ----------
                                             1,114,491       893,869       708,873
COSTS AND EXPENSES:
   Salaries and wages                          455,702       360,571       297,509
   Employee benefits                            96,716        82,007        83,231
   Nursing, dietary and other supplies          60,427        55,991        46,505
   Ancillary services                          188,937       148,746        79,195
   General and administrative                  168,333       134,697       123,771
   Depreciation and amortization                39,214        31,158        26,072
   Provision for bad debts                      16,666        11,220         3,122
   Non-recurring items:
       Life insurance proceeds                  (2,015)           --            --
       Gain on sale                            (22,451)           --            --
       Impairment of long-lived assets          20,489            --            --
       Other                                     2,917            --            --
       Merger and acquistion costs                  --        12,474            --
                                            ----------    ----------    ----------
                                             1,024,935       836,864       659,405
                                            ----------    ----------    ----------

          INCOME FROM OPERATIONS                89,556        57,005        49,468

INTEREST EXPENSE, NET:
   Interest expense                             20,128        18,322        16,043
   Interest income                              (7,667)       (7,505)       (5,149)
                                            ----------    ----------    ----------
                                                12,461        10,817        10,894
                                            ----------    ----------    ----------
          INCOME BEFORE INCOME TAXES
             AND EQUITY EARNINGS/MINORITY
             INTEREST                           77,095        46,188        38,574

PROVISION FOR INCOME TAXES                      33,759        21,750        13,561
                                            ----------    ----------    ----------
          INCOME BEFORE EQUITY EARNINGS/
             MINORITY INTEREST                  43,336        24,438        25,013

EQUITY EARNINGS/MINORITY INTEREST                 (156)         (204)        1,603
                                            ----------    ----------    ----------
NET INCOME                                  $   43,180    $   24,234    $   26,616
                                            ==========    ==========    ==========
PRO FORMA DATA (UNAUDITED):
     INCOME BEFORE PRO FORMA TAXES          $   43,180    $   24,234    $   26,616
     PRO FORMA TAXES                                --           599           899
                                            ----------    ----------    ----------
          PRO FORMA NET INCOME              $   43,180    $   23,635    $   25,717
                                            ==========    ==========    ==========
WEIGHTED AVERAGE COMMON AND
   COMMON EQUIVALENT SHARES
   OUTSTANDING                                  20,315        19,034        17,080
                                            ==========    ==========    ==========
EARNINGS PER SHARE                          $     2.13    $     1.27    $     1.56
                                            ==========    ==========    ==========
PRO FORMA EARNINGS PER SHARE                $     2.13    $     1.24    $     1.51
                                            ==========    ==========    ==========
</TABLE>





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

                                     - 28 -

<PAGE>   29
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                       (dollars and shares in thousands)

<TABLE>
<CAPTION>
                                                                                                
                                              Common Stock                          Unrealized    Treasury  Stock            
                                            ---------------   Capital    Retained     Loss on     ----------------
                                             Shares  Amount   Surplus    Earnings    Securities   Shares   Amount    Total     
                                             ------  ------  --------   ---------    ----------   ------   ------    ------
<S>                                          <C>    <C>      <C>        <C>           <C>         <C>      <C>      <C>
BALANCE, SEPTEMBER 30, 1993                  15,941  $ 159   $ 93,058   $  30,591        -         274     $(4,376) $ 119,432    
                                                                                                                                 
Issuance of stock as partial consideration                                                                                       
   of Vari-Care merger transaction            1,193     12     25,492                                                  25,504    
                                                                                                                                 
Transaction costs associated with Vari-Care                                                                                      
   merger transaction                                            (349)                                                   (349)   
                                                                                                                                 
Net income                                                                 26,616                                      26,616    
                                                                                                                                 
Transfer S corporation earnings, net of                                                                                          
   distributions                                                   (9)          9                                           0    
                                                                                                                                 
Stockholder distributions                                                  (2,414)                                     (2,414)   
                                                                                                                                 
Funding of employee benefit                                                                                                      
   plans                                                          274                              (55)        870      1,144    
                                                                                                                                 
Funding of options exercised                                                                                                     
   under 1992 Employee Stock                                                                                                     
   Option Plan, net of tax                                        103                              (44)        708        811    
                                                                                                                                 
Issuance of warrants in APS purchase                                                                                             
   transaction                                                  1,274                                                   1,274    
                                             ------  -----   --------   ---------      ----        ---    -------   --------- 
BALANCE, SEPTEMBER 30, 1994                  17,134    171    119,843      54,802        -         175      (2,798)   172,018    
                                                                                                                                 
Net income                                                                 24,234                                      24,234    
                                                                                                                                 
Transfer S corporation earnings, net of                                                                                          
   distributions                                                 (898)        898                                           0    
                                                                                                                                 
Stockholder distributions                                                  (2,381)                                     (2,381)   
                                                                                                                                 
Proceeds from additional public offering      2,875     29     99,032                                                  99,061    
                                                                                                                                 
Issuance of stock as consideration for                                                                                           
   TMI merger transaction                       258      3      8,320                                                   8,323    
                                                                                                                                 
Funding of employee benefit                                                                                                      
   plans                                                          656                              (44)        678      1,334    
                                                                                                                                 
Funding of options exercised                                                                                                     
   under 1992 Employee Stock                                                                                                     
   Option Plan, net of tax                                        146                              (54)        861      1,007    
                                             ------  -----   --------   ---------      ----        ---    -------   --------- 
BALANCE, SEPTEMBER 30, 1995                  20,267    203    227,099      77,553        -          77      (1,259)   303,596    
                                                                                                                                 
Net income                                                                 43,180                                      43,180    
                                                                                                                                 
Funding of employee benefit                                                                                                      
   plans                                                          736                              (46)        846      1,582    
                                                                                                                                 
Funding of options exercised                                                                                                     
   under 1992 Employee Stock                                                                                                     
   Option Plan, net of tax                                        336                              (40)        639        975    
                                                                                                                                 
Purchase of treasury stock                                                                         776     (20,000)   (20,000)   
                                                                                                                                 
Unrealized loss on securities                                                                                                    
   available-for-sale                                                                     (18)                            (18)   
                                             ------  -----   --------   ---------        ----      ---     -------  --------- 
BALANCE, SEPTEMBER 30, 1996                  20,267  $ 203   $228,171   $ 120,733        $(18)     767    $(19,774) $ 329,315 
                                             ======  =====   ========   =========        ====      ===     =======  ========= 
</TABLE>

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


                                     - 29 -

<PAGE>   30

            LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           SUPPLEMENTAL CONSOLIDATED STATEMENTS OF CASH FLOWS
                         (dollars in thousands)


<TABLE>
<CAPTION>
                                                                           Years Ended September 30,
                                                                  --------------------------------------
                                                                     1996          1995          1994 
<S>                                                               <C>           <C>           <C>       
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income                                                     $   43,180    $   24,234    $   26,616
   Adjustments to reconcile net income to net cash
     provided by operating activities:
          Depreciation and amortization                               39,214        31,158        26,072
          Income taxes deferred                                       (9,141)       (3,429)       (9,409)
          Equity earnings/minority interest                              156           204        (1,603)
          Provision for bad debts                                     16,666        11,220         3,122
          Gain on sale                                               (22,451)           --            -- 
          Impairment of long-lived assets                             20,489            --            -- 
          Additions to asset valuation reserve                            --            --         4,998
   Changes in noncash working capital:
          Receivables                                                (69,634)      (35,387)      (16,729)
          Receivable from affiliates                                   2,698          (844)        1,925
          Supplies                                                      (519)          258          (863)
          Prepayments, including insurance                             4,053        (4,106)          175
          Other current assets                                          (221)       (2,073)       (1,923)
          Accounts payable                                           (13,774)       34,194         4,706
          Accrued expenses and other current liabilities              17,465         8,860        (1,241)
   Changes in other noncurrent liabilities, primarily insurance        2,694           756         7,999
   Other                                                                 933         1,389         1,588
                                                                  ----------    ----------    ----------
NET CASH PROVIDED BY OPERATING ACTIVITIES                             31,808        66,434        45,433

CASH FLOWS USED IN INVESTING ACTIVITIES:
   Acquisitions and investments                                      (68,710)      (87,602)      (91,216)
   Purchases of property and equipment                               (53,366)      (38,946)      (23,473)
   Proceeds from sale of DevCon                                       47,500            --            -- 
   Disposals of property, equipment and
          other assets                                                 2,690         7,022         8,533
   Restricted investments                                              5,564       (19,822)      (16,200)
   Additions to notes receivable                                      (1,519)       (3,488)      (22,507)
   Collections on notes receivable                                       981         3,173        21,905
   Other                                                                 209          (198)       (2,862)
                                                                  ----------    ----------    ----------
NET CASH USED IN INVESTING ACTIVITIES                                (66,651)     (139,861)     (125,820)

CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from long-term debt                                        1,469       219,342       120,835
   Net draws under credit line                                       194,615         1,955        10,000
   Repayment of long-term debt                                      (138,708)     (247,461)      (66,466)
   Proceeds from additional public offering                               --        99,061            -- 
   Issuance of warrants for APS purchase                                  --            --         1,274
   Issuance of common stock for Vari-Care merger                          --            --        25,152
   Purchase of treasury stock                                        (20,000)           --            -- 
   Shareholder distributions                                              --        (2,381)       (2,414)
   Funding of options under 1992 employee stock
          purchase plan and employee benefit plans                       975         1,007         1,152
                                                                  ----------    ----------    ----------
NET CASH PROVIDED BY FINANCING ACTIVITIES                             38,351        71,523        89,533
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                       3,508        (1,904)        9,146
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                        17,886        19,790        10,644
                                                                  ----------    ----------    ----------
CASH AND CASH EQUIVALENTS, END OF PERIOD                          $   21,394    $   17,886    $   19,790
                                                                  ==========    ==========    ==========
</TABLE>



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

                                 - 30 -
<PAGE>   31
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

BASIS OF PRESENTATION

     Living Centers of America, Inc. (the "Company" or "Living Centers"),
engages in the operation of long-term care facilities, specialty health care
services, pharmacy and rehabilitation services through its operating
subsidiaries. The Company's operations are geographically concentrated and
specifically focused in key markets, including Texas, North Carolina, and
Colorado. The accompanying consolidated financial statements include the
accounts of the Company and its subsidiaries and exclude all significant
intercompany transactions.

     In February 1995, the Company issued an additional 2,875,000 shares of its
common stock in an additional public offering. The net proceeds of the
transaction, approximately $99.1 million, were used to retire existing debt and
for working capital and general corporate purposes.

     Effective July 31, 1995, the Company issued approximately 6,479,000
additional shares of its common stock in a merger transaction with The Brian
Center Corporation and 16 related S corporations (collectively the "BCC
Entities"). The merger was accounted for using the pooling of interests
methodology and the accompanying financial statements have been restated to
include the accounts of the BCC Entities as though the transaction occurred on
September 30, 1992. See Note 3.

CASH MANAGEMENT

     The Company maintains a centralized cash management system in which cash
receipts are transferred daily from facility and ancillary company depository
accounts to a cash concentration account. Cash is then used to provide for
normal working capital requirements, including reduction of the outstanding
credit lines or placement of excess funds in commercial grade investments. To
the extent that cash transferred from the facility and ancillary company
depository accounts is not sufficient to provide for cash disbursement
requirements, a cash advance is obtained from the Bank Credit Facility. See
Note 5. Cash equivalents consist of temporary investments with original
maturities of three months or less.

NOTES RECEIVABLE, NET

     Notes receivable, net, aggregating $14.5 million and $14.2 million at
September 30, 1996 and 1995, respectively, consist primarily of notes which
arose from divestitures of certain operating facilities. These notes, which are
generally collateralized by long-term care facilities, have interest rates
ranging generally from 5% to 12.25% and maturities through 2012, including
approximately $12.5 million due after 1999. Notes receivable, net at September
30, 1996 and 1995, include reserves for potential uncollectible amounts of $3.5
million. Management believes the collateral values are sufficient to recover
the net carrying amount of these notes in the event of default.

RECEIVABLE FROM AFFILIATES

     Included in the merger with the BCC Entities (see Note 3) were receivables
from various related corporations (which were not part of the merger
transaction) and the major stockholder of the BCC Entities. Such receivables
originated from services or products provided by the BCC Entities to such
corporations or the major stockholder and were repaid during fiscal year 1996.

SUPPLIES

     Supplies, consisting principally of pharmaceutical and medical supplies,
are valued at the lower of cost (first-in, first out) or market.


                                     - 31 -

<PAGE>   32
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS----(CONTINUED)


PROPERTY AND EQUIPMENT

     Property and equipment are stated at cost and include interest on funds
borrowed to finance construction. Capitalized interest was $.2 million for 1996
and none in 1995 or 1994. Maintenance and repairs are charged to operations
currently and replacements and significant improvements are capitalized.
Depreciation and amortization are provided over the estimated useful lives of
the assets on a straight-line basis as follows:

<TABLE>
     <S>                                          <C>
     Buildings ..............................     25-40 years    
     Building improvements ..................     10-15 years
     Furniture, fixtures and equipment.......      3-15 years
</TABLE>

GOODWILL, NET

     Goodwill represents primarily an allocation from the Company's previous
parent as a result of a management buyout transaction which is amortized on a
straight-line basis over 40 years and the excess of purchase price over fair
market value of assets acquired in various purchase transactions which is
amortized on a straight line basis over 30 years. Accumulated amortization at
September 30, 1996 and 1995 was $11.7 million and $5.5 million, respectively.
Amortization of goodwill charged to expense was $5.6 million, $2.8 million and
$1.2 million for the three years ended September 30, 1996, 1995 and 1994,
respectively.

IMPAIRMENT OF LONG-LIVED ASSETS

     In September 1996 the Company adopted Statement of Financial Accounting
Standards No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of" (SFAS 121). SFAS 121 requires impairment
losses to be recognized for long-lived assets when indicators of impairment are
present and the undiscounted cash flows are not sufficient to recover the
assets' carrying amount. Goodwill is also evaluated for recoverability by
estimating the projected undiscounted cash flows, excluding interest, of the
related business activities. The impairment loss of these assets, including
goodwill, is measured by comparing the carrying amount of the asset to its fair
value with any excess of carrying value over fair value written off. Fair value
is based on market prices where available, an estimate of market value, or
determined by various valuation techniques including discounted cash flow. See
Note 8.

     Prior to adoption of SFAS 121 the Company performed its analyses of
impairment of long-lived assets by consideration of the projected undiscounted
cash flows on an entity-wide basis.

RESTRICTED INVESTMENTS

     Restricted investments represent cash and other investments that have been
designated to pay insurance claims of the Company's wholly-owned insurance
subsidiary. The invested funds restricted to pay insurance claims have been
classified as available-for-sale securities in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt and Equity Securities" and are recorded at their estimated market value.
See Note 4.

INVESTMENT IN UNCONSOLIDATED AFFILIATE

     Investment in unconsolidated affiliate at September 30, 1996 primarily
consists of a 50% owned interest in Heart of America Hospice, LLC, a
Kansas-based hospice. This investment is recorded under the equity method of
accounting.

                                     - 32 -

<PAGE>   33


                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     Investment in unconsolidated affiliate at September 30, 1995 consists of a
50% owned interest in Charlotte/Advance, Inc. (a corporation which partially
owns and operates three long-term care facilities), which is recorded using the
equity method. This investment was sold during fiscal year 1996. At September
30, 1995, the Company also held minority interests in an institutional pharmacy
and a joint venture operation in American Rehabilitation Services, Inc.
("ARS"). Both were recorded using the equity method of accounting.

     Prior to September 30, 1994, the Company owned a 49% interest in American
Pharmaceutical Services, Inc. ("APS"), which was recorded using the equity
method. APS provides nutritional and infusion therapy services, as well as
pharmacy services, at selected Company facilities. See Note 3. The Company's
equity earnings in APS's net income for fiscal year 1994 was $1.7 million and
is reflected as equity earnings in the Consolidated Statements of Income. On
September 30, 1994, the Company acquired the remaining 51% of the outstanding
stock of APS and the investment in unconsolidated affiliate was eliminated as
part of the purchase allocation.

INCOME TAXES

     Noncurrent deferred income taxes arise primarily from timing differences
resulting from using accelerated depreciation for tax purposes and reserves for
uninsured losses not deductible in the current period. Current deferred income
taxes result from timing differences in the recognition of revenues and
expenses for tax and financial reporting purposes which are expected to reverse
within one year. See Note 10.

     The Company filed a consolidated federal income tax return the year ended
September 30, 1995 which included pre-merger (non BCC) operations and will
continue to file on a consolidated basis for subsequent years. Federal and
state income tax payments made (including the BCC Entities) during fiscal 1996,
1995 and 1994 were $31.5 million, $21.2 million and $16.4 million,
respectively.

     The various corporations (exclusive of the S corporations) included in the
BCC Entities filed consolidated tax returns through the date of the merger. For
state income tax purposes, each corporation within the federal consolidated
group filed a separate income tax return. The S corporations included in the
merger are not subject to income taxes as their attributes flow through to
their individual stockholders; accordingly, the accompanying consolidated
financial statements do not include a provision for income taxes with respect
to the earnings of these entities through July 31, 1995. A pro forma income tax
provision has been provided to reflect the estimated federal and state income
taxes as if all of the S corporations were taxable entities. This estimate is
based on the maximum effective federal and state income tax rates in effect
during the years presented. Effective August 1, 1995, all of these corporations
became taxable entities and the operations of these companies are included in
the consolidated tax return of Living Centers.

 TREASURY STOCK

     During fiscal year 1996, the Company acquired 775,740 shares of treasury
stock on the open market for a total cost of $20.0 million. The shares
repurchased are primarily intended to be used as part of a plan to fund the
employer's contribution to the Company's 401(k) Plan and Deferred Retirement
Incentive Plan and to fund employee purchases made under the Company's Employee
Stock Purchase Plan. See Note 16.

NET REVENUES

     Revenues are recorded in the period in which services are provided at
established rates whether or not collection in full is anticipated. Contractual
adjustments and the results of other arrangements for providing services at
less than established rates are reported as deductions to arrive at net
revenues. Contractual adjustments include differences between established
billing rates and amounts estimated by management as reimbursable under various
cost reimbursement formulas or contracts in effect. An appropriate provision
for bad debt expense is included as an operating expense and a corresponding
reserve for doubtful accounts is reflected in net receivables to reduce gross
receivables to an amount actually expected to be collected.

                                     - 33 -

<PAGE>   34


                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)



     The administrative procedures associated with the Medicare cost
reimbursement program generally preclude final determination of amounts due the
Company until cost reports are audited or otherwise reviewed and settled with
the applicable administrative agencies. Normal estimation differences between
final settlements and amounts recorded in previous years are generally reported
as current year contractual adjustments. The Company does not expect any
differences between revenue recorded and as finally determined to have a
significant effect on the Company's results of operations or financial
position. Medicare revenues represented 26%, 24% and 18% and Medicaid revenues
represented 43%, 51%, 59% of net revenue for fiscal years 1996, 1995 and 1994,
respectively.

STOCK-BASED COMPENSATION

     The Company grants stock options for a fixed number of shares to employees
with an exercise price equal to the fair value of the shares at the date of
grant. The Company accounts for stock option grants in accordance with APB
Opinion 25 "Accounting for Stock Issued to Employees" and, accordingly,
recognizes no compensation expense for the stock option grants.

     In October 1995 the Financial Accounting Standards Board adopted Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123). SFAS 123 allows companies the option to retain the
current accounting approach for recognizing stock-based expense in the
financial statements or to adopt a new accounting method based on the estimated
fair value of the employee stock options. Companies that do not follow the new
fair value based method will be required to provide pro-forma disclosures of
net income and earnings per share as if the fair-value method of accounting had
been applied. The Company is required to adopt SFAS 123 for the year ending
September 30, 1997. As the Company expects to retain their current accounting
method, SFAS 123 will not have an impact on the Company's results of operation
or financial position.

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. Although these estimates are based on management's
knowledge of current events, they may ultimately differ from actual results.

OTHER

     Certain prior year amounts have been reclassified to conform with the 1996
presentation.

NOTE 2.  DIVESTITURES

     In September 1996, the Company completed the divestiture of its DevCon
operations, which provided training and habilitation services to individuals
with mental retardation and developmental disabilities, through the
recapitalization and subsequent sale of the majority of DevCon's stock for
$47.5 million in cash. The Company will retain a small ownership interest in
the recapitalized company. Proceeds from the divestiture were utilized to
reduce debt related to various acquisitions.



                                     - 34 -

<PAGE>   35


                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


NOTE 3.  ACQUISITIONS

FISCAL YEAR 1996 ACQUISITIONS

     In May 1996, the Company acquired a 50% interest in Heart of America
Hospice, a Kansas based hospice company, for $2.8 million in cash.

     In June 1996, the Company acquired certain assets of Lahr Pharmacy, Inc.
and related companies for $13.4 million in cash. An additional $3.5 million may
be paid in connection with this acquisition if certain predetermined earnings
targets are achieved during the subsequent three years. If paid, this
additional consideration will be included in goodwill. The Company has not
completed the evaluations necessary to determine the final purchase price
allocation related to this acquisition.

     Effective September 1, 1996, the Company acquired the stock of Allied
Pharmacy Management, Inc., which operates five institutional pharmacies and a
home health care business in Florida, for $29.6 million in cash. The Company
has not completed the evaluations necessary to determine the final purchase
price allocation related to the this acquisition.

     The Company also acquired other previously leased long-term care
facilities, institutional pharmacies, and therapy operations as part of several
smaller transactions, primarily for cash. All such acquisitions were recorded
using the purchase method of accounting.

FISCAL YEAR 1995 ACQUISITIONS

     On June 30, 1995, Living Centers completed a merger with Rehability
Corporation in which it acquired all of the outstanding stock of the company
through a cash tender offer of $11.50 per share. In the transaction, the
Company paid approximately $88.1 million in cash for the stock and various
transaction costs and assumed approximately $36 million in debt. The name of
the acquired company was subsequently changed to American Rehabilitation
Services, Inc. ("ARS" or "Rehability"). The transaction was recorded using the
purchase method of accounting. The allocation of purchase price includes
approximately $81.9 million of goodwill which will be amortized over a 30-year
period.

     Effective August 1, 1995 the Company issued approximately 258,000 shares
of its common stock valued at $8.3 million in exchange for all of the capital
stock of Therapy Management Innovations, Inc. and related entities ("TMI"). The
transaction was recorded using the purchase method of accounting. The
allocation of purchase price includes approximately $7.9 million of goodwill
which will be amortized over a 30-year period.

     The following information presents the results of operations on a pro
forma basis as though the APS, Rehability and TMI transactions all occurred on
October 1, 1993. Information is presented for informational purposes only and
may not be indicative of actual operating results that would have been
achieved. All amounts are in thousands, except per share amounts.

<TABLE>
<CAPTION>
                                                 Years Ended September 30, 
                                                ---------------------------
                                                   1995             1994
<S>                                             <C>              <C>       
     Net revenues ..........................    $1,041,228       $  941,297
     Net Income ............................        26,893(a)        25,296
     Earnings per share ....................    $     1.37(a)    $     1.46
     </TABLE>

-----------

(a) Excluding non-recurring merger and acquisition and other related costs of
    $14.3 million, net income and earnings per share would have been $38.8
    million and $2.02, respectively.



                                     - 35 -
<PAGE>   36
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     On July 31, 1995, the Company acquired all of the outstanding stock of The
Brian Center Corporation and 16 related S corporations (collectively the "BCC
Entities") in exchange for approximately 6,479,000 shares of its common stock
in a merger transaction which was accounted for as a pooling of interests. In
addition, the Company paid $3.7 million in cash to acquire various minority
interests associated with several of the BCC affiliates. The Company used a
portion of its bank credit facility to retire approximately $70.0 million of
existing debt of BCC. The retained earnings of the S corporations $(1.8 million
at July 31, 1995 and $2.6 million at September 30, 1994 and 1993) have been
reclassified to Capital Surplus. Financial statements for periods prior to the
merger have been restated to reflect the financial position and results of
operations of the combined companies as if they had merged on September 30,
1992.

         Separate results of operations of the companies prior to the
acquisition are summarized below (in thousands):

<TABLE>
<CAPTION>
                                                      Ten Months     Year
                                                    Ended July 31,   Ended
                                                        1995      September 30,
                                                     (unaudited)     1994
<S>                                                   <C>          <C>     
              Net Revenues:
                   Living Centers ...............     $529,405     $498,633
                   The BCC Entities .............      183,127      210,240
                                                      --------     --------
                   Combined .....................     $712,532     $708,873
                                                      ========     ========

              Income From Operations(a):
                   Living Centers ...............     $ 37,310     $ 33,269
                   The BCC Entities .............       10,004       16,199
                                                      --------     --------
                   Combined .....................     $ 47,314     $ 49,468
                                                      ========     ========

              Net Income:
                   Living Centers ...............     $ 20,110     $ 18,718
                   The BCC Entities .............        2,109        7,898
                                                      --------     --------
                   Combined .....................     $ 22,219     $ 26,616
                                                      ========     ========

              Pro Forma Net Income:
                   Living Centers ...............     $ 20,110     $ 18,718
                   The BCC Entities .............        1,510        6,999
                                                      --------     --------
                   Combined .....................     $ 21,620     $ 25,717
                                                      ========     ========
     </TABLE>

-------------
     (a) Includes merger and acquisition expenses of $4.5 million for Living
         Centers and $1.3 million for BCC Entities.

     In addition to the above, the Company has acquired other long-term care
facilities and five separate pharmaceutical operations as part of several
smaller transactions, primarily for cash. All such acquisitions were recorded
using the purchase method of accounting.



                                     - 36 -
<PAGE>   37
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


FISCAL YEAR 1994 ACQUISITIONS

     On September 30, 1994, the Company completed a transaction in which it
acquired the remaining 51% of the common stock of Abbey Pharmaceutical
Services, Inc. The name of the acquired company was subsequently changed to
American Pharmaceutical Services, Inc. ("APS"). In the transaction, the Company
paid $20.5 million in cash and issued warrants to purchase 250,000 shares of
common stock of the Company at $35 per share. The Company valued the warrants,
which can be exercised anytime within seven years after the transaction closing
date, at $1.3 million. The purchase agreement also contemplates the Company's
preparing, upon request by Abbey Healthcare Group, Inc. (the previous 51% owner
of APS), one registration statement for its resale of such shares. Any such
registration statement is to become effective ten days after the filing by the
Company of its next annual or quarterly report required to be filed with the
Securities and Exchange Commission after such request, and is to remain
effective for 60 days. Financing for the transaction was provided through the
Company's Bank Credit Facility. The transaction was recorded using the purchase
method of accounting. The allocation of purchase price includes approximately
$24.8 million of goodwill which will be amortized over a 30-year period.

NOTE 4.  RESTRICTED INVESTMENTS

     Restricted investments at September 30, 1996 and 1995 included the
following:

<TABLE>
<CAPTION>
                                                Gross      Gross      Estimated
                                  Amortized   Unrealized Unrealized      Market
September 30, 1995                  Cost        Gains      Losses        Value 
------------------                 -------     -------     -------      -------
<S>                               <C>         <C>          <C>           <C>
U. S. Treasury Notes               $14,187     $   122     $  (186)     $14,123
Asset-backed securities              5,859          21         (32)       5,848
Corporate debt securities            2,691          25         (27)       2,689
Mortgage-backed securities           1,401          59          --        1,460
Repurchase Pooling Arrangement       5,892          --          --        5,892
Cash                                 1,028          --          --        1,028
                                   -------     -------     -------      -------
Total                              $31,058     $   227     $  (245)     $31,040
                                   =======     =======     =======      =======

</TABLE>



<TABLE>
<CAPTION>
                                                Gross      Gross      Estimated
                                  Amortized   Unrealized Unrealized      Market
September 30, 1995                  Cost        Gains      Losses        Value 
------------------                 -------     -------     -------      -------
<S>                               <C>         <C>          <C>           <C>
U. S. Treasury Notes               $15,135     $   432        (605)     $14,962
Asset-backed securities              6,400          59          (7)       6,452
Corporate debt securities            2,701          43         (16)       2,728
Mortgage-backed securities           1,382          94          --        1,476
Repurchase Pooling Arrangement       5,600          --          --        5,600
Cash                                 5,404          --          --        5,404
                                   -------     -------     -------      -------
Total                              $36,622     $   628     $  (628)     $36,622
                                   =======     =======     =======      =======
</TABLE>


     Proceeds from sales and maturities of investments were $14.5 million, $3.7
million and none in fiscal years 1996, 1995 and 1994, respectively. Gross gains
of $0.1 million, $0.1 million, and none were realized during fiscal years 1996,
1995 and 1994.



                                     - 37 -

<PAGE>   38
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     The amortized cost and estimated market value of debt securities at
September 30, 1996 by contractual maturity are shown below. Expected maturities
may differ from contractual maturities because borrowers may have the right to
call or repay obligations with or without call or prepayment penalties.

<TABLE>
<CAPTION>
                                                       Estimated
                                          Amortized     Market
                                            Cost        Value 
                                           -------     -------
<S>                                        <C>         <C>
Due after one year through five years      $ 9,664     $ 9,748
Due after five years through ten years       7,216       7,064
                                           -------     -------
                                            16,880      16,812
Cash                                         1,028       1,028
Repurchase Pooling Arrangement               5,892       5,892
Mortgage-backed securities                   1,401       1,460
Asset-backed securities                      5,859       5,848
                                           -------     -------
Total                                      $31,058     $31,040
                                           =======     =======
</TABLE>


     The Repurchase Pooling Arrangement is subject to market risk associated
with changes in the value of the underlying financial instruments as well as
the risk of loss of appreciation if a counter party fails to perform.

NOTE 5.  DEBT

     Long-term debt at September 30, 1996 and 1995 is summarized in the
following table (in thousands):

<TABLE>
<CAPTION>
                                                                      September 30,
                                                               ----------------------------
                                                                 1996                1995
<S>                                                            <C>                 <C>
Bank Credit Facility....................................       $225,315            $168,950   
SouthTrust Bank of Alabama, NA..........................         20,000              20,000   
Variable Annuity Life Insurance Company.................         10,000              10,000   
NationsBank of Texas, NA................................         10,000                  --   
Mortgage notes (6% to 10.75% due                                                              
         through 2014)..................................          1,444               1,795   
Other notes payable (8% to 10% due                                                            
         through 2008)..................................          5,688              11,202   
                                                               --------            --------
                                                                272,447             211,947   
Obligations under capital leases........................          4,001               4,963   
                                                               --------            --------
                                                                276,448             216,910   
Less short-term notes payable and current portion ......        (13,746)            (34,981)  
                                                               --------            --------
Total long-term debt....................................       $262,702            $181,929   
                                                               ========            ========
</TABLE>

     Interest paid on the above debt was $19.3 million, $17.7 million and $15.8
million during fiscal years 1996, 1995 and 1994, respectively.

     In February 1992, the Company entered into an agreement (the "Bank Credit
Facility") with several banks in which the banks provided financing to the
Company. During the last several years, the Bank Credit Facility has been
amended and/or restated to provide financing for various purchase transactions.
In August, 1996, the Company entered into a Third Amended and Restated Credit
Agreement (the "1996 Bank Credit Facility"), pursuant to which the banks agreed
to provide $500 million to Living Centers, including a $350 million five-year
revolving credit and competitive advance facility (Tranche

                                     - 38 -

<PAGE>   39


                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


A) and a $150 million 364-day revolving credit facility with a four-year term
out (Tranche B). The Company recorded a non-recurring charge of $0.9 million
for the write-off of unamortized deferred financing costs related to the Second
Amended and Restated Credit Agreement. See Note 8. The 1996 Bank Credit
Facility allows Living Centers to borrow at the base rate in effect at
NationsBank of Texas, N.A. or at LIBOR plus an applicable margin ranging from
0.25% to 0.65% and also provides for a facility fee of 0.15% to 0.225%. The
applicable margin and facility fee are subject to adjustment depending on
Living Centers' leverage ratio at the quarter end immediately preceding the
borrowing.

     Living Centers may prepay borrowings made under Tranche A at any time, but
all amounts drawn must be repaid by August 19, 2001 with a provision for
earlier extension if the Company and banks agree. If not extended prior
thereto, the balance of Tranche B at August 18, 1997 will be converted to a
term note and repaid in equal quarterly installments beginning October 1, 1997.
The 1996 Bank Credit Facility is an unsecured credit facility and contains
various financial covenants similar to those in the original Bank Credit
Facility. Balances available under the 1996 Bank Credit Facility and
predecessor agreements at September 30, 1996 and 1995 (after giving
consideration to outstanding letters of credit of $4.7 million) were $270.0
million and $84.6 million, respectively. As of September 30, 1996 and 1995, the
announced base rate of NationsBank was 8.25% and 8.75%, respectively.

     The Company has entered into interest rate swap agreements to reduce the
impact of changes in interest rates on its floating rate long-term debt. At
September 30, 1996, the Company had outstanding three interest rate swap
agreements with commercial banks having a total notional principal amount of
$60 million. These agreements effectively changed the Company's interest rate
exposure on $60 million under the 1996 Bank Credit Facility to approximately
6.8% through 2005. The Company receives floating rates on these swaps which are
based on LIBOR.

     The Company's use of swap agreements and reverse swap agreements did not
have a material effect on the weighted-average borrowing rate of reported
interest expense during the years ended September 30, 1996, 1995, and 1994 and
the Company is not exposed to credit loss on these swaps. See Note 13 for fair
value disclosures. The difference between amounts paid and received on swap
agreements is recorded on an accrual basis as an adjustment to net interest
over the periods covered by the agreements. The related amount receivable from
or payable to counter parties is included in other receivables or payables,
respectively. The fair values of the swap agreements and changes thereto are
not recognized in the consolidated financial statements.

     On October 1, 1993, the Company borrowed $20 million from SouthTrust Bank
of Alabama, NA which was used to repay debt that was assumed in the Vari-Care
merger transaction. The note is unsecured and bears interest at the rate of
6.95%, payable semi-annually. The principal is repayable in five annual
payments of $4 million beginning October 1, 1998. The Company also assumed
approximately $6.3 million of existing Vari-Care notes and capital lease
obligations under substantially the same terms that existed prior to the
merger.

     In January 1994, the Company issued, in a private placement, a $10 million
note to American General Insurance Company that was later sold to The Variable
Annuity Life Insurance Company ("Variable Annuity Life") at a fixed rate of
interest of 7.79%. The note is unsecured and will mature in a single payment
due in ten years. The note agreement contains restrictions similar to other
unsecured debt of the Company.

     In May 1994, the Company executed a promissory note (payable on demand or
by June 29, 1997) with NationsBank of Texas, N.A. in the principal amount of
$10 million. Subject to the Bank's prior approval of any request for an
advance, the Company may borrow, repay and reborrow principal amounts in
increments such that the unpaid principal balance at anytime shall not exceed
$10 million. The interest rate on each advance is quoted separately based on
market conditions that exist at that time. At September 30, 1996, there was
$10.0 million outstanding under the note agreement.



                                     - 39 -
<PAGE>   40
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     Long-term debt maturing in the next five fiscal years is presented below
(in thousands):

<TABLE>
<CAPTION>
                                                  September 30, 1996
                                                  ------------------
                      <S>                             <C>
                      1997.....................       $ 13,746  
                      1998.....................          3,813  
                      1999.....................          5,149  
                      2000.....................          4,833  
                      2001.....................        230,214  
</TABLE>

     The covenants governing the 1996 Bank Credit Facility and the notes with
SouthTrust Bank and Variable Annuity Life provide for the maintenance of
various financial ratios. The Company is in compliance with the terms of all
such covenants. These covenants also limit the Company's ability to pay
dividends. At September 30, 1996 and 1995, these restrictions effectively
limited dividend payments to no more than $24.4 million and $16.7 million,
respectively. Even though the covenants of the 1996 Bank Credit Facility permit
the payment of dividends as described above, the Company does not presently
intend to pay any such dividends.

NOTE 6.   EMPLOYEE RETIREMENT PLANS

     The Company's employees are eligible to participate in defined
contribution retirement plans sponsored by the Company. Company contributions
to these plans represents a matching percentage of certain employee
contributions which is subject to management's discretion based upon
consolidated financial performance. The employees of ARS are also covered by a
defined contribution plan which provides for Company contributions in cash of
up to 50% of certain employee contributions. Total combined expense recognized
by the Company under both of these plans was $2.2 million, $1.8 million and
$1.1 million in fiscal years 1996, 1995 and 1994, respectively.

     The Company does not provide post-retirement health care or life insurance
benefits to employees. Accordingly, the Company is not subject to the
requirements of Statement of Financial Accounting Standards No. 106,
"Employers" Accounting for Post Retirement Benefits Other Than Pensions."

NOTE 7.   LIFE INSURANCE PROCEEDS

     The Company recorded a non-taxable gain of $2.0 million from the receipt
of insurance proceeds on Don W. Wortley, former President of TMI and the
Rehabilitation Services Group.

NOTE 8.   IMPAIRMENT OF LONG-LIVED ASSETS AND OTHER NON-RECURRING ITEMS

     The Company recorded an impairment loss of $20.5 million upon adoption of
SFAS 121 which is included in the Statement of Income as Impairment of
long-lived assets. This loss is related to nursing facilities with current
period operating losses, facilities where management believed an impairment
existed as a result of the regulatory or competitive environment, and goodwill,
primarily TMI. The impairment of TMI goodwill is primarily a result of the
death of its former President (see Note 7). Management estimated the
undiscounted cash flows to be generated by each of these assets and compared
them to their carrying value. If the undiscounted future cash flow estimates
were less than the carrying value of the asset then the carrying value was
written down to their estimate of fair value. Fair value was estimated based on
either management's estimate of fair value or present value of future cash
flows. In addition, this impairment loss included a reduction to fair value of
certain nursing facilities to be replaced or expected to be disposed of. Fair
value for facilities to be replaced or disposed of was calculated based on
either management's estimate of fair value or market value less estimated cost
to sell. Facilities to be disposed of had a carrying value of $4.8 million at
September 1996 and are expected to be divested in fiscal year 1997.


                                     - 40 -
<PAGE>   41
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     The Company also recorded non-recurring charges of $2.9 million primarily
related to the closure of its medical supplies business and the write-off of
unamortized loan acquisition costs related to the Second Amended and Restated
Credit Agreement.

NOTE 9.  RESTRUCTURING PLAN

     During fiscal year 1996, the Company finalized a plan originating in June
1995 to restructure the operations and exit certain activities of ARS. This
plan includes centralization of billing and collection, closing or downsizing
unprofitable clinics and offsite contracts, and staff reductions of
approximately 300 employees in both corporate overhead and field management.
This plan resulted in an increase to the original purchase price of the
acquisition by $10.1 million which included an accrual for estimated exit costs
of $8.6 million. The increase in purchase price includes the following:

<TABLE>
<S>                                                     <C>
Termination/severance for displaced employees           $ 4,394
Future lease costs for abandoned real property            4,176
Write off of abandoned tangible and intangible
    assets at closed locations                            1,532
                                                        -------
Total                                                   $10,102
                                                        =======
</TABLE>

     The Company has charged $1,038 against the accrual for
termination/severance for approximately 200 displaced employees and $309
against the accrual for future lease costs. At September 30, 1996, the Company
believes that the remaining accruals for the restructuring plan are adequate.
The restructuring is expected to be completed during the second quarter of
fiscal 1997.

NOTE 10. INCOME TAXES

         The provision for income taxes is presented in the table below (in
thousands):

<TABLE>
<CAPTION>
                                           Years Ended September 30,
                                    --------------------------------------
                                      1996           1995           1994
<S>                                 <C>            <C>            <C>     
     Current:
          Federal ............      $ 38,326       $ 21,982       $ 14,476
          State & Local ......         5,141          4,237          2,978
                                    --------       --------       --------
                                      43,467         26,219         17,454
     Deferred:
          Federal ............        (8,276)        (3,698)        (3,373)
          State & Local ......        (1,432)          (771)          (520)
                                    --------       --------       --------
                                      (9,708)        (4,469)        (3,893)
                                    --------       --------       --------
              Total ..........      $ 33,759       $ 21,750       $ 13,561
                                    ========       ========       ========
     </TABLE>


                                     - 41 -
<PAGE>   42
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     The provision for income taxes varies from the amount determined by
applying the Federal statutory rate to pre-tax income as a result of the
following:

<TABLE>
<CAPTION>
                                                             Years Ended September 30,
                                                          -----------------------------
                                                            1996       1995       1994
<S>                                                         <C>        <C>        <C>  
Federal statutory income tax rate .....................     35.0%      35.0%      35.0%
Increase (decrease) in taxes resulting from:
    State & local taxes, net of federal tax benefit ...      3.4        4.9        4.0
    Permanent book/tax differences, primarily
        resulting from goodwill .......................      7.0        2.0        1.2
    Targeted job tax credits ..........................       --       (2.7)      (4.0)
    Non-deductible merger and acquisition cost ........       --        7.2         -- 
Other, net ............................................     (1.6)       0.7       (1.0)
                                                          ------     ------     ------
Effective tax rate ....................................     43.8%      47.1%      35.2%
                                                          ======     ======     ======
</TABLE>

     The components of deferred income taxes are as follows (in thousands):

<TABLE>
<CAPTION>
                                           Years Ended September 30,
                                       ---------------------------------
                                         1996        1995        1994
<S>                                    <C>         <C>         <C>      
Reserves for potential claims ......   $ (2,134)   $ (1,984)   $ (1,840)
Purchase accounting ................     (1,749)     (1,828)     (1,435)
FAS 121 asset valuation ............     (4,030)         --          -- 
Tax depreciation under book ........     (1,822)     (1,023)       (147)
Bad debts ..........................     (1,295)       (761)       (342)
Texas Occupational Injury accrual ..      1,847         835         568
Net operating losses ...............       (262)         --       1,116
Other, net .........................       (525)        292      (1,352)
Changes in valuation allowance .....        262          --        (461)
                                       --------    --------    --------
                  TOTAL ............   $ (9,708)   $ (4,469)   $ (3,893)
                                       ========    ========    ========
</TABLE>



                                     - 42 -
<PAGE>   43
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     The components of the net deferred tax liability are as follows (in
thousands):

<TABLE>
<CAPTION>
                                                       September 30,
                                                 ---------------------
                                                   1996        1995
<S>                                              <C>         <C>      
Deferred tax liabilities:
-------------------------
Amounts relating to property and equipment ...   $(34,773)   $(36,905)
Abbey equity accounting ......................         --        (883)
Other ........................................     (1,596)     (1,105)
                                                 --------    --------
Total deferred tax liabilities ...............    (36,369)    (38,893)
                                                 --------    --------

Deferred tax assets:
--------------------
Financial reserves not yet deductible for
    tax purposes:
     Asset valuation .........................      4,243       2,564
     Insurance ...............................      8,524       7,562
     Notes receivable allowance ..............        821         821
     Payroll and benefits ....................      4,884       4,460
     Bad debts ...............................      6,572       5,355
     Restructuring reserve ...................      3,159          -- 
     NOL carryforwards .......................      1,785       1,293
     Other miscellaneous .....................      5,243       6,276
     Timing differences in Medicare ..........      1,592         899
                                                 --------    --------
Total deferred tax assets ....................     36,823      29,230
Less valuation allowances ....................     (1,785)       (808)
                                                 --------    --------
Net deferred tax liability ...................   $ (1,331)   $(10,471)
                                                 ========    ========
</TABLE>

     The net change in the valuation allowance for deferred tax assets was an
increase of $977 at September 30, 1996 and a nominal increase at September 30,
1995.

NOTE 11. COMMITMENTS AND CONTINGENCIES

     Certain of the Company's facilities are held under operating or capital
leases. All capital leases will expire by 2009. Certain of these leases also
contain provisions allowing the Company to purchase the leased assets during
the term or at the expiration of the lease, at fair market value. Facilities
operating under capital leases are summarized as follows (in thousands):

<TABLE>
<CAPTION>
                                                              September 30,
                                                          --------------------
                                                            1996        1995
<S>                                                       <C>         <C>     
         Centers operating under capital leases .......   $ 12,551    $ 13,465
         Less accumulated amortization ................     (5,084)     (4,473)
                                                          --------    --------
                                                          $  7,447    $  8,992
                                                          ========    ========
</TABLE>

     Rental expense, net of sublease rent income, for all operating leases was
$44.2 million, $36.9 million and $31.8 for fiscal years 1996, 1995 and 1994,
respectively. Certain leases also contain increases based on the Consumer Price
Index, Medicaid reimbursement rates, or at amounts specified in the lease
agreement. Sublease rent income was $6.9 million, $6.1 million and $5.9 million
for fiscal years 1996, 1995 and 1994 respectively. Contingent rent based
primarily on revenues was $1.6 million, $1.4 million and $1.2 million for
fiscal years 1996, 1995 and 1994, respectively.


                                     - 43 -
<PAGE>   44
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     The table below presents a schedule of the future minimum rental
commitments and sublease income under all noncancellable leases as of September
30, 1996 (in thousands):


<TABLE>
<CAPTION>
                                                                          September 30, 1996
                                                             ---------------------------------------------
                                                                                 Sublease
                                                             Operating            Income           Capital
         <S>                                                 <C>                 <C>              <C>
         1997...........................................     $ 38,576            $ 6,545          $  1,249  
         1998...........................................       33,478              6,429               969  
         1999...........................................       28,223              5,552               645  
         2000...........................................       21,127              2,342               634  
         2001...........................................       18,897              2,348               647  
         Subsequent years...............................      100,142              9,992               982  
                                                             --------            -------          --------
         Total minimum rental obligations...............     $240,443            $33,208             5,126  
                                                             ========            =======
         Less amount representing interest..............                                            (1,125) 
                                                                                                  --------
         Present value of capital leases................                                             4,001  
         Less current portion...........................                                            (1,007) 
                                                                                                  --------
         Long-term obligations under capital leases.....                                          $  2,994  
                                                                                                  ======== 
</TABLE>

     The Company is a party to various legal proceedings in the normal course
of business. The Company takes every legal claim seriously and investigates
and, where appropriate, defends such allegations vigorously. Such claims are
generally covered by insurance, or the Company has provided reserves which it
believes are adequate for any potential losses which may result from such
claims. The Company believes that the results of any such proceedings, if
determined unfavorably to the Company, will not have a material adverse effect
on its consolidated financial position or its results of operations.

     An attorney in the Civil Division of the United States Department of
Justice has advised Living Centers that a complaint under the Civil False
Claims Act has been filed, under seal, against BCC and one of its subsidiaries,
MedTherapy Rehabilitation Services, Inc. ("MedTherapy"), in the federal
district court for the Western District of North Carolina. The Department of
Justice has reviewed the sealed complaint and advised counsel for BCC and
MedTherapy that the plaintiff alleges, in general, that BCC and MedTherapy
caused certain therapists to make improper therapy record entries with respect
to therapy screening services and that any claims filed with Medicare for
payments which are based upon such improper record entries should be viewed as
false claims under the Civil False Claims Act. Under the Civil False Claims
Act, any person who knowingly files false claims is liable for treble damages
and penalties ranging from $5,000 to $10,000 for each false claim. Because the
complaint is under seal, Living Centers does not know the number of claims
alleged or the specific factual allegations set forth in the complaint. The
Department of Justice has the right to intervene and pursue the claim on behalf
of the plaintiff, but has not made a decision on intervention as of the date
hereof. If the Department of Justice does not intervene, the plaintiff may
continue to pursue the claim individually. BCC and MedTherapy have advised the
Department of Justice that, based upon the information disclosed thus far by
the Department of Justice, they dispute, and will vigorously contest, the
claims of the plaintiff. Although the Company believes, based on discussions
with counsel, that the plaintiff's claims are merit less, no assurances can be
given that, if the plaintiff were to prevail in his claim, the resulting
judgment would not have a material adverse effect upon the Company. Moreover,
in connection with the Company's acquisition of BCC, the primary stockholder
(Donald C. Beaver) agreed to indemnify and hold harmless Living Centers from
and against any and all loss, expense, damage, penalty and liability which
could result from this claim, subject to further adjustment. Mr. Beaver's
indemnity requires any payment to the Company to be in the form of shares of
Common Stock.


                                     - 44 -
<PAGE>   45
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


NOTE 12. INSURANCE COVERAGES

     The Company insures auto, general, and professional liability and workers'
compensation risks through insurance policies with third parties. Some of these
third-party policies subsequent to February 21, 1994 are subject to reinsurance
agreements between the insurer and LCA Insurance Company, Ltd., a wholly-owned
subsidiary of the Company that was formed during 1994. The liabilities for
incurred losses are estimated by independent actuaries on an undiscounted
basis. Cash reserves of LCA Insurance Company, Ltd. have been designated as
restricted investments to pay for future claims experience applicable to policy
periods subsequent to February 21, 1994. Restricted investments at September
30, 1996 and 1995 designated to pay such claims were $31.0 million and $36.6
million, respectively.

     In 1992, the Company elected under Texas law to decline to participate in
the Texas workers' compensation insurance program. As part of the election, the
Company implemented an employee benefit plan providing for employer-paid
benefits comparable to those provided under the Texas workers' compensation
program and obtained insurance that limits the Company's exposure for any
individual injury. During 1994, the Company established a trust in which to
fund the amount applicable to actuarially determined claims to be incurred for
fiscal year 1994 and subsequent years.

     The BCC Entities are insured for current and past workers' compensation
claims under various types of insurance and financial plans, certain of which
are loss-sensitive in nature and design, which subject the Companies to
additional future premiums for losses incurred in a prior year but paid in a
subsequent fiscal period, as losses develop. The BCC Entities have recorded
expenses under these plans based upon actual and estimated losses based on the
available incurred loss structure.

     Additionally, certain of these loss-sensitive workers' compensation plans
in which the Companies have participated were organized as pools or funds, with
joint and several or pro rata liability ascribed to its members. Such plans may
lead to the potential of future loss assessments for the BCC Entities; however,
the amount of such additional potential assessments, if any, is not
determinable at this time. It is the opinion of management that any additional
assessments will not have a material adverse effect on the financial position
or results of operations of the Companies.

NOTE 13. DISCLOSURES REGARDING FAIR VALUE OF FINANCIAL INSTRUMENTS

     The following methods and assumptions were used to estimate the fair value
of each class of financial instruments for which it is practicable to estimate
that value:

     CASH AND CASH EQUIVALENTS

     The carrying amount approximates fair value because of the short maturity
of those instruments.

     NOTES RECEIVABLE

     Fair value for each significant note receivable was estimated based on the
net present value of cash flows that would be received on each note over the
remaining note term using current market interest rates rather than stated
interest rates. The discount factor was the estimated rate for long-term debt
in effect at September 30, 1996 and 1995. Further adjustments were made to the
value of the notes based on management's opinion of the credit risk of the note
obligee.

     LONG-TERM DEBT

     Since the Company recently renegotiated its Bank Credit Facility, the
Company believes that the fair value of the long-term debt is properly
reflected at current carrying amounts except for certain fixed rate debt
instruments. Fair values for each significant fixed rate debt instrument was
estimated based on the net present value of cash flows that would be paid on
each note over the remaining note term using the Company's current incremental
borrowing rate rather than the stated interest rates on the notes. See Note 5.



                                     - 45 -
<PAGE>   46
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


     INTEREST RATE SWAP AGREEMENTS

     Fair values for the Company's various interest rate swap agreements were
estimated based on quoted amounts from the issuers which would be required to
terminate the agreement. See Note 5.

     The estimated values of the Company's financial instruments as of
September 30, 1996 and 1995 are as follows (in thousands):

<TABLE>
<CAPTION>
                                                                           SEPTEMBER 30,
                                                    ----------------------------------------------------------
                                                              1996                              1995
                                                    -------------------------        -------------------------
                                                    CARRYING           FAIR          CARRYING           FAIR
                                                     AMOUNT            VALUE          AMOUNT            VALUE
     <S>                                            <C>              <C>             <C>              <C>
     Cash and cash equivalents...............       $ 21,394         $ 21,394        $ 17,886         $ 17,886  
     Notes receivable........................         14,536           15,517          14,184           14,562  
     Restricted investments..................         31,040           31,040          36,622           36,622  
     Long-term debt..........................        276,448          277,413         216,910          216,985  
     Interest rate swap agreements...........             --              341              --           (1,575)  
</TABLE>

NOTE 14. RELATED PARTY TRANSACTIONS

     The Company purchases services and medical supplies from APS at current
market prices under certain service and supply agreements and all significant
intercompany purchases have been eliminated for the years ended September 30,
1996 and 1995. Prior to acquiring the remaining 51% of APS on September 30,
1994, the Company also purchased services and supplies from APS which amounted
to approximately $4.8 million which is included in the accompanying
Consolidated Statement of Income for fiscal year 1994. See Note 3. The Company
also purchases therapy services from ARS and TMI at current market prices under
certain service agreements. The total purchases from these companies prior to
their acquisition by the Company on June 30, 1995 and August 1, 1995,
respectively amounted to $1.5 million and $0.9 million in 1995 and 1994,
respectively for ARS and $1.9 million and $1.8 million 1995 and 1994,
respectively for TMI. All significant intercompany purchases from these two
subsidiaries since their acquisition have been eliminated.

NOTE 15. EARNINGS PER COMMON SHARE

     The table below presents a reconciliation of the number of weighted
average common shares used in computing primary earnings per share (in
thousands):

<TABLE>
<CAPTION>
                                                                            Years Ended September 30,
                                                                    ----------------------------------------
                                                                     1996             1995             1994
<S>                                                                 <C>              <C>              <C>
Common shares outstanding, end of period.....................       19,501           20,190           10,481    
Issuance of shares in connection with the BCC                                                                   
    Entities merger..........................................           --               --            6,479    
Effect of using weighted average shares  outstanding.........          623           (1,340)             (37)   
Effect of using treasury stock method on                                                                        
  stock options..............................................          191              184              157    
                                                                    ------           ------           ------
Shares used in computing earnings per share..................       20,315           19,034           17,080    
                                                                    ======           ======           ======                     
</TABLE>

     In February 1995, the Company issued an additional 2,875,000 shares of its
common stock in an additional public offering. The net proceeds of the
transaction, approximately $99.1 million, were used primarily to retire
existing debt. Assuming the transaction had occurred on October 1, 1994, net
income and earnings per share for the year ended September 30, 1995 would have
been $25.5 million and $1.27, respectively.


                                     - 46 -

<PAGE>   47
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


NOTE 16. EMPLOYEE STOCK OPTION AND STOCK PURCHASE PLANS

     The Company established an Employee Stock Option Plan in 1992 which
authorizes the granting of incentive stock options, nonqualified options, or
any combination of the foregoing to purchase up to 1,400,000 shares of the
Company's common stock. The exercise price per share of common stock with
respect to each incentive stock option is the fair market value of a share of
common stock (defined as the closing price per share of the common stock on the
New York Stock Exchange) on the date such option is granted while the exercise
price per share of common stock with respect to a nonqualified option is the
fair market value of a share of common stock on the date such option is granted
or on a subsequent date or as otherwise provided in any agreement with the
recipient, but in no event will the exercise price with respect to a
nonqualified option be less than 50% of the fair market value of a share of
common stock on the date of the grant. The options have a term as fixed by the
Stock Option Committee, but, in no event, longer than ten years after the date
of grant. Options are exercisable only by the optionee and only while the
optionee is an employee or nonemployee director of the Company or, unless such
optionee's employment is terminated for cause, within three months after the
optionee ceases to be an employee or director of the Company. Options are
exercisable for 12 months after the death or permanent disability of an
optionee. The option exercise price must be paid in cash or, at the discretion
of the Stock Option Committee, may be paid in whole or in part in shares of
common stock valued at fair market value on the date of exercise. As of
September 30, 1996 and 1995, there were 1,259,548 and 779,625, respectively,
options granted and outstanding. The following is a summary of the stock option
activity under the plan:

<TABLE>
<CAPTION>
                                                                                 Years Ended September 30,
                                                                   ------------------------------------------------
                                                                          1996             1995             1994
         <S>                                                       <C>              <C>              <C>
         Options outstanding a beginning of period...........            779,625          597,775          542,300
         Options granted.....................................            691,540          334,250          189,975
         Options exercised...................................            (39,434)         (54,010)         (44,770)
         Options forfeited...................................           (172,183)         (98,390)         (89,730)
                                                                       ---------          -------          ------- 
         Options outstanding at end of period................          1,259,548          779,625          597,775
                                                                       =========          =======          =======
                                                                                                                  
         Options exercisable at end of period................            317,011          207,280          146,780
                                                                       =========          =======          =======
                                                                                                                  
         Option price range..................................      $13.25-$38.75    $13.25-$35.50    $13.25-$28.75
                                                                   =============    =============    =============
</TABLE>

     The Company established an Employee Stock Purchase Plan in 1993. The plan
authorizes the purchase of up to 120,000 shares of the Company's common stock
by eligible employees. The provisions of the plan include eligibility for all
full time employees who have completed one year of service, employee
contributions equal to the lesser of 10% of base salary or $10,000, the
purchase price being equal to the lesser of the fair market value of the stock
on the first or the last day of the plan year, and an option to purchase shares
of stock or withdraw all payroll deductions plus interest at the end of the
plan year. As of September 30, 1995 and 1996, a total of 32,006 shares and
43,160 shares, respectively, had been issued under the plan.



                                    - 47 -
<PAGE>   48
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


NOTE 17. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

     The table below sets forth summarized quarterly financial data for the
years ended September 30, 1996 and 1995 (in thousands, except per share
amounts):


<TABLE>
<CAPTION>
                                                 Fourth           Third         Second        First
                                                 Quarter         Quarter        Quarter      Quarter
<S>                                              <C>             <C>            <C>          <C>      
1996
Net revenues ................................   $ 284,838       $ 281,217      $ 278,056    $ 270,380
Income from operations ......................      21,172(a)       22,951(a)      24,110       21,323
Income before income taxes and equity
       earnings/minority interests ..........      17,700          20,038         21,154       18,203
Equity earnings/minority interests ..........         (87)            122           (189)          (2)
Net income ..................................   $   7,053       $  12,816      $  12,412    $  10,899
                                                =========       =========      =========    =========

Earnings per share ..........................   $    0.35       $    0.63      $    0.61    $    0.54
                                                =========       =========      =========    =========

Weighted average common and common
       equivalent shares outstanding ........      19,913          20,501         20,503       20,360
                                                =========       =========      =========    =========
</TABLE>

(a)      Includes $2.0 million income and $0.9 million expense of non-recurring
         items in the third and fourth quarters, respectively (or $.10 per
         share income and $0.19 per share expense after tax, respectively)

<TABLE>
<S>                                             <C>             <C>             <C>             <C>      
1995                                     
Net revenues ................................   $ 267,793       $ 215,851       $ 208,081       $ 202,144
Income from operations ......................      15,170(b)       12,835(b)       14,793(b)       14,207
Income before income taxes and equity
       earnings/minority interests ..........      11,807          11,111          12,339          10,931
Equity earnings/minority interests ..........        (112)            (43)            (30)            (19)
Net income ..................................       4,474           5,208           7,692           6,860
Pro forma tax expense .......................          50             166             165             218
Pro forma net income ........................   $   4,424       $   5,042       $   7,527       $   6,642
                                                =========       =========       =========       =========

Earnings per share:

       Primary ..............................   $    0.22       $    0.26       $    0.41       $    0.40
                                                =========       =========       =========       =========
       Pro forma ............................   $    0.22       $    0.25       $    0.40       $    0.39
                                                =========       =========       =========       =========

Weighted average common and common
       equivalent shares outstanding ........      20,265          20,089          18,718          17,179
                                                =========       =========       =========       =========
</TABLE>

--------------
(b)      Includes $0.6 million, $4.7 million and $7.1 million of mergers and
         acquisitions cost in second, third and fourth quarters, respectively
         (or $.03, $0.23 and $0.29 per share, respectively)



                                     - 48 -
<PAGE>   49
                LIVING CENTERS OF AMERICA, INC. AND SUBSIDIARIES
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-----(CONTINUED)


NOTE 18. STOCKHOLDER RIGHTS PLAN

     Since November 17, 1994, when the Company's Board of Directors declared a
dividend of one right for each outstanding share of the Company's common stock,
each share of the Company's outstanding common stock carries with it such
right. Each right entitles the holder to purchase from the Company one
one-hundredth of a share of Series A Junior Participating Preferred Stock, par
value $.01 per share, for an exercise price of $160, subject to adjustment. The
rights expire on November 17, 2004. Such rights will not be exercisable nor
transferable apart from the Common Stock until such time as a person or group
acquires 15% of the Company's Common Stock or initiates a tender offer or
exchange offer that will result in ownership of 15% of the Company's Common
Stock. In the event that the Company is merged, and its Common Stock is
exchanged or converted, the rights will entitle the holders to buy shares of
the acquiror's common stock at a 50% discount. Under certain other
circumstances, the rights can become rights to purchase the Company's Common
Stock at a 50% discount. The rights may be redeemed by the Company for one cent
per right at any time until 10 days following the first public announcement of
a 15% acquisition of beneficial ownership of the Company's Common Stock.



                                     - 49 -
<PAGE>   50
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE


     In November 1994, the Company engaged Ernst & Young LLP as independent
certified public accountants to audit the Company's financial statements for
the fiscal year ending September 30, 1995. At that time, the Company chose not
to renew the engagement of Arthur Andersen LLP, who previously served as the
Company's independent certified public accountants. The decision to change
accountants was approved by the Company's Board of Directors. The Company also
engaged Ernst & Young LLP to audit the Company's financial statements for the
fiscal year ended September 30, 1994 which is presented under the pooling of
interests method of accounting for the BCC acquisition.

     In connection with the audit of the Company's financial statements for the
two fiscal years ended September 30, 1994 and during the interim period
following September 30, 1994 through the date of dismissal of Arthur Andersen
LLP, there were no disagreements with Arthur Andersen LLP on any matters of
accounting principles or practice, financial statement disclosure or auditing
scope or procedure which, if not resolved to its satisfaction, would have
caused Arthur Andersen LLP to make reference thereto in connection with its
report. Arthur Andersen LLP's report on the Company's financial statements for
the fiscal year ended September 30, 1994 contained no adverse opinion or
disclaimer of opinion and was not qualified or modified as to uncertainty,
audit scope or accounting principles.




                                     - 50 -
<PAGE>   51
                                    PART III


ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     Information on directors of the registrant appears in the Company's Proxy
Statement for the 1997 annual meeting of stockholders expected to be held
February 6, 1997, which is to be filed with the Securities and Exchange
Commission, and is incorporated herein by reference. Information required by
this item for the Company's executive officers is contained in Part I of this
report.


ITEM 11. EXECUTIVE COMPENSATION

     Information on executive compensation appears in the Company's Proxy
Statement for the 1997 annual meeting of stockholders expected to be held
February 6, 1997, which is to be filed with the Securities and Exchange
Commission, and is incorporated herein by reference.


ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     Information on security ownership of certain beneficial owners appears in
the Company's Proxy Statement for the 1997 annual meeting of stockholders
expected to be held February 6, 1997, which is to be filed with the Securities
and Exchange Commission, and is incorporated herein by reference.


ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     Information on certain relationships and related transactions appears in
the Company's Proxy Statement for the 1997 annual meeting of stockholders
expected to be held February 6, 1997, which is to be filed with the Securities
and Exchange Commission, and is incorporated herein by reference.





                                     - 51 -
<PAGE>   52
                                    PART IV



ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K

FINANCIAL STATEMENTS



         The following reports, financial statements and schedule are filed
herewith on the pages indicated: 


<TABLE>
<CAPTION>
                                                                            Page
                                                                            ----
         <S>                                                                 <C>
         Report of Independent Auditors                                      26

         Consolidated Balance Sheets at September 30, 1995 and 1996          27

         Consolidated Statements of Income for Fiscal 
           Years 1994, 1995 and 1996                                         28

         Consolidated Statements of Stockholders' Equity 
           for Fiscal Years 1994, 1995 and 1996                              29

         Consolidated Statements of Cash Flows for Fiscal 
           Years 1994, 1995 and 1996                                         30

         Notes to Consolidated Financial Statements                          31


FINANCIAL STATEMENT SCHEDULE

         Schedule II - Valuation and Qualifying Accounts and Reserves        59
</TABLE>


         All other schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are not
required under the related instructions or are inapplicable, and, therefore,
have been omitted.




                                    - 52 -
<PAGE>   53
                                 EXHIBIT INDEX

<TABLE>
<CAPTION>
  Exhibit No.            Document
  -----------            --------
     <S>          <C>
     *2.1         Stock Purchase Agreement by and between Abbey Healthcare
                  Group, Incorporated and Living Centers of America, Inc. with
                  respect to the sale of Abbey Pharmaceutical Services, Inc.
                  (filed as Exhibit 99.2 to Registrant's 8-K dated October 14,
                  1994 and incorporated herein by reference).

     *2.2         Schedule 14D-1 Tender Offer Statement for Rehability
                  Corporation filed on May 23, 1995.

     *2.3         Amended and Restated Agreement and Plan of Merger dated March
                  27, 1995 among Living Centers of American, Inc., and Living
                  Centers/Brian Care Company and The Brian Center Corporation,
                  The Beaver Property Entities and Donald C. Beaver, as amended
                  (filed as Exhibit 2.1 of the Fourth Amendment to Registrant's
                  Registration Statement on Form S-4, Registration No. 33-90676
                  and incorporated herein by reference).

     *2.4         Agreement of Purchase and Exchange among Living Centers of
                  America, Inc. and Living Centers Specialty Care Services,
                  Inc. and Cason, Inc., Don W. Wortley, Don W. Wortley Trust,
                  Mary Ann Wortley Trust, and 726 Cottonwood, Ltd. dated as of
                  August 1, 1995 (filed as Exhibit 10.1 in Registrant's
                  Registration Statement on Form S-3, Registration No.
                  33-97616, and incorporated herein by reference).

     *2.5         Form of Registration Rights Agreement between Donald C.
                  Beaver and Living Centers of America, Inc., (filed as Exhibit
                  2.2 to Registrants' Registration Statement on Form S-4,
                  Registration Number 33-90676 and incorporated herein by
                  reference).

     *2.6         Form of Registration Covenant between Donald C. Beaver and
                  Living Centers of America, Inc. (filed as Exhibit 2.3 to
                  Registrant's Registration Statement on Form S-4, Registration
                  Number 33-90676 and incorporated herein by reference).

     2.7          Recapitalization Agreement, as amended, by and among Living 
                  Centers of America, Inc., DevCon Holding Company, Living 
                  Centers-DevCon, Inc., and Golder, Thoma, Cressey, Rauner 
                  Fund IV, L.P.

     *3.1         Restated Certificate of Incorporation of Living Centers of
                  America, Inc. (filed as Exhibit 4.1 to the Registrant's Form
                  S-8 on August 7, 1996, Registration No. 333-09707, and
                  incorporated herein by reference).

     *3.2         By-laws of Living Centers of America, Inc. (filed as Exhibit
                  3.2 to the Registrant's Registration Statement on Form S-1,
                  Registration No. 33-44726, and incorporated herein by
                  reference).

     *4.1         Restated Certificate of Incorporation of Living Centers of
                  America, Inc. (filed as Exhibit 3.1 hereto).

     *4.2         By-laws of Living Centers of America, Inc. (filed as Exhibit
                  3.2 hereto).

     *4.3         Certificate of Designations of Series A Junior Participating
                  Preferred Stock of Living Centers of American, Inc. (filed as
                  Exhibit 4.1 to Registrant's Form 10-Q for the quarter ended
                  December 31, 1994, Commission File Number 33-44726 and
                  incorporated herein by reference).

     *4.4         Rights Agreement dated as of November 17, 1994 between the
                  Registrant and Chemical Bank, as Rights Agent, specifying the
                  terms of the rights to purchase the Company's Series A Junior
                  Participating Preferred Stock, and the exhibits thereto
                  (filed as Exhibit 1 to the Company's Registration Statement
                  on Form 8-A dated November 17, 1994), as amended by Loan
                  Agreement dated October 1, 1993 between Living Centers of
                  America, Inc. and SouthTrust Bank of Alabama, N.A. (filed as
                  Exhibit 4(d) to Registrant's Form 8-K dated October 15, 1993
                  and incorporated herein by reference).
</TABLE>

                                     - 53 -
<PAGE>   54
<TABLE>
<CAPTION>
  Exhibit No.            Document
  -----------            --------
     <S>          <C>
     *4.5         Amendment to Loan Agreement dated October 1, 1993 between
                  Living Centers of America, Inc. and SouthTrust Bank of
                  Alabama, N.A. (filed as Exhibit 99.7 to Registrant's Form 8-K
                  dated October 14, 1994 and incorporated herein by reference).

     *4.6         Senior Note Purchase Agreement among Living Centers of
                  America, Inc. and the purchasers listed in the Schedule of
                  Purchasers attached thereto as ANNEX I, dated January 21,
                  1994 (filed as Exhibit 4 to Registrant's Form 10-Q for the
                  quarter ended December 31, 1993, Commission File Number
                  33-44726, and incorporated herein by reference), as amended
                  by Amendment Number 1 to Senior Note Purchase Agreement dated
                  January 21, 1994 among Living Centers of America, Inc. and
                  Purchaser (filed as Exhibit 4.1 to Registrant's Form 10-Q for
                  the quarter ended March 31, 1994, Commission File Number 33-
                  44726, and incorporated herein by reference) by Second
                  Amendment and Consent to Senior Note Purchase Agreement
                  between Living Centers of America, Inc. and the Variable
                  Annuity Life Insurance Company (filed as Exhibit 4.2 to
                  Registrant's Form 10-Q for the quarter ended June 30, 1994,
                  Commission File Number 33-44726 and incorporated herein by
                  reference), and by Third amendment to Senior Note Purchase
                  Agreement between Living Centers of America, Inc. and the
                  Variable Annuity Life Insurance Company (filed as Exhibit
                  99.8 to Registrant's 8-K dated October 14, 1994 and
                  incorporated herein by reference).

     4.7          Third Amended and Restated Credit Agreement, dated as of
                  August 19, 1996 among Living Centers of America, Inc., the
                  banks named therein, Chase Securities Inc., Toronto Dominion
                  (Texas), Inc. and NationsBank of Texas, N.A.

     +*10.1       Employment Agreement between Living Centers of America, Inc.
                  and Edward L. Kuntz (filed as Exhibit 10.1 to Registrant's
                  Registration Statement on Form S-4, Registration No.
                  33-66588, and incorporated herein by reference.)

     +10.2        Extension and Ratification of Employment Agreement
                  between Living Centers of America, Inc. and Edward L. Kuntz.

     +*10.3       Employment Agreement between Living Centers of America, Inc.
                  and Leroy D. Williams (filed as Exhibit 10.3 to Registrant's
                  Registration Statement on Form S-4, Registration No.
                  33-66588, and incorporated herein by reference.)

     + 10.4       Extension and Ratification of Employment Agreement
                  between Living Centers of America, Inc. and Leroy D.
                  Williams.

     + 10.5       Employment Agreement between Living Centers of America,
                  Inc. and Charles B. Carden.

     +*10.6       Employment Agreement between Living Centers of America, Inc.
                  and Donald C. Beaver (filed as Exhibit 2.2 to Registrant's
                  Registration Statement on Form S-4, Registration Number
                  33-90676 and incorporated herein by reference).

     + 10.7       Employment Agreement between Living Centers of America,
                  Inc. and Pauline Bonner.

     +*10.8       Employment agreement between Living Centers of America, Inc.
                  and Sydney K. Boone, Jr. (filed as Exhibit 10.4 to the
                  Registrant's Form 10-K for the fiscal year ended September
                  30, 1993, Commission File Number 33-44726 and incorporated
                  herein by reference).

     +*10.9       Employment Agreement between Living Centers of America, Inc.
                  and David W. Budke (filed as Exhibit 10.5 to the Registrant's
                  Form 10-K for the fiscal year ended September 30, 1993,
                  Commission File Number 33-44726, and incorporated herein by
                  reference).
</TABLE>


                                     - 54 -
<PAGE>   55
<TABLE>
<CAPTION>
  Exhibit No.            Document
  -----------            --------
     <S>          <C>
     +*10.10      Employment Agreement between Living Centers of America, Inc.
                  and Boyd P. Gentry (filed as Exhibit 10.7 to the Registrant's
                  Form 10-K for the fiscal year ended September 30, 1995,
                  Commission File Number 33-44726, and incorporated herein by
                  reference).

     +*10.11      Employment Agreement between Living Centers of America, Inc.
                  and Kelly R. Gill (filed as Exhibit 10 to the Registrant's
                  Form 10-Q for the quarter ended December 31, 1995, Commission
                  File Number 33- 44726, and incorporated herein by reference).

     +*10.12      Employment Agreement between Living Centers of America, Inc.
                  and Laura Kislowski (filed as Exhibit 10.8 to the
                  Registrant's Form 10-K for the fiscal year ended March 31,
                  1996, Commission File Number 33-44726, and incorporated
                  herein by reference).

     +*10.13      Employment Agreement between Living Centers of America, Inc.
                  and William R. Korslin (filed as Exhibit 10 to the
                  Registrant's Form 10-Q for the quarter ended December 31,
                  1995, Commission File Number 33-44726, and incorporated
                  herein by reference).

     +*10.14      Employment Agreement between Living Centers of America, Inc.
                  and Keith Krein, M.D. (filed as Exhibit to Registrant's
                  Registration Statement on Form S-4, Registration No.
                  33-66588, and incorporated herein by reference.)

     + 10.15      Employment Agreement between Living Centers of America,
                  Inc. and John D. Lee, III.

     +*10.16      Employment Agreement between Living Centers of America, Inc.
                  and James L. Martin, Jr. (filed as Exhibit 10.1 to the
                  Registrant's Form 10-Q for the quarter ended June 30, 1996,
                  Commission File Number 33-44726, and incorporated herein by
                  reference).

     + 10.17      Employment Agreement between Living Centers of America,
                  Inc. and Kenneth Morgan.

     +*10.18      Employment Agreement between Living Centers of America, Inc.
                  and Karuppanna Muthuswamy (filed as Exhibit 10.10 to
                  Registrant's Registration Statement on Form S-4, Registration
                  No. 33-66588, and incorporated herein by reference.)

     +*10.19      Employment Agreement between Living Centers of America, Inc.
                  and Susan Thomas Whittle (filed as Exhibit 10.10 to the
                  Registrant's Form 10-K for the fiscal year ended September
                  30, 1993, Commission File Number 33-44726, and incorporated
                  herein by reference).

     +*10.20      1992 Stock Option Plan of Living Centers of America, Inc.,
                  as amended (filed as Exhibit 10.1 to Registrant's Form S-8 on
                  August 7, 1996, Registration No. 333-09707, and incorporated
                  herein by reference).

     +*10.21      Deferred Retirement Incentive Plan of Living Centers of
                  America, Inc. (filed as Exhibit 10.4 to Registrant's Annual
                  Report on Form 10-K for the fiscal year ended September 30,
                  1992, File No. 33-44726, and incorporated herein by
                  reference).

     *10.22       Indemnification Agreement dated as of February 21, 1992
                  between Living Centers of America, Inc. and The ARA Group,
                  Inc. (filed as Exhibit 10.4 to the Registrant's Registration
                  Statement on Form S-1, Registration No. 33-44726, and
                  incorporated herein by reference).

     *10.23       Assignment Agreement dated as of February 21, 1992 between
                  Living Centers of America, Inc. and The ARA Group, Inc.
                  (filed as Exhibit 10.6 to the Registrant's Registration
                  Statement on Form S-1, Registration No. 33-44726, and
                  incorporated herein by reference).
</TABLE>


                                     - 55 -

<PAGE>   56

<TABLE>
<CAPTION>
  Exhibit No.            Document
  -----------            --------
     <S>          <C>
     +*10.24      Management Incentive Bonus Plan of Living Centers of America,
                  Inc. (filed as Exhibit 10.8 to Registrant's Annual Report on
                  Form 10-K for the fiscal year ended September 30, 1992, File
                  No. 33- 44726, and incorporated herein by reference).

     +*10.25      Employee Stock Purchase Plan of Living Centers of America,
                  Inc. (filed as Exhibit 10.2 to the Registrant's Quarterly
                  Report on Form 10-Q for the quarter ended March 31, 1993,
                  File No. 33-44726, and incorporated herein by reference).

     11           Statement regarding computation of per share earnings.

     21           Subsidiaries of the Registrant.

     23           Consent of Ernst & Young LLP

     24           Powers of Attorney

     27           Financial Data Schedule
</TABLE>

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

          *    Incorporated by reference as indicated.

          +    Represents management contracts or compensatory plans or
               arrangements required to be filed as exhibits to this Annual
               Report by Item 601(b)(10)(iii) of Regulation S-K.

         The Company will furnish a copy of any exhibit described above to any
beneficial holder of the Company's securities upon receipt of a written request
therefor provided that such request sets forth a good faith representation that
as of December 16, 1996, the date of record for the Company's 1997 annual
stockholder's meeting, such beneficial owner is entitled to vote at such
meeting, and provided further that such holder pays to the Company a fee
compensating the Company for its reasonable expenses in furnishing such
exhibits.

REPORTS ON FORM 8-K

There were no reports filed on Form 8-K during the quarter ended September 30,
1996.



                                     - 56 -
<PAGE>   57
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.



                              LIVING CENTERS OF AMERICA, INC.
                              (Registrant)



                              By: /s/ Susan Thomas Whittle
                                  ---------------------------------------------
                                  Susan Thomas Whittle
                                  Vice President, General Counsel and Secretary



Date: December 16, 1996





                                     - 57 -
<PAGE>   58



         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of Living
Centers of America, Inc. and in the capacities and on the date indicated.


<TABLE>
<CAPTION>
Signature                                   Title
<S>                                     <C>

   /s/ Edward L. Kuntz                  Chairman, Chief Executive Officer, and
------------------------------          Director (Principal Executive Officer)
Edward L. Kuntz                         


   /s/ Leroy D. Williams                President, Chief Operating Officer and
------------------------------          Director
Leroy D. Williams                       


   /s/ Charles B. Carden                Executive Vice President and Chief 
------------------------------          Financial Officer (Principal Financial 
Charles B. Carden                       Officer)


               *                        Vice Chairman and Director
------------------------------
Donald C. Beaver


               *                        Director
------------------------------
Roger J. Bulger, M.D. FACP


               *                        Director
------------------------------
Anthony M. Frank


               *                        Director
------------------------------
Eddy J. Rogers, Jr.


               *                        Director
------------------------------
Robert H. Hurlbut


   /s/ Ronald W. Fleming                Controller and Chief Accounting Officer
------------------------------          (Principal Accounting Officer)
Ronald W. Fleming                       

</TABLE>


     *    Executed on behalf of the aforementioned directors by Susan Thomas
          Whittle pursuant to the powers of attorney included in Exhibit 24.


                                              /s/ Susan Thomas Whittle
                                             ------------------------------
                                             Susan Thomas Whittle


Date: December 16, 1996



                                     - 58 -
<PAGE>   59
                                  SCHEDULE II
                 VALUATION AND QUALIFYING ACCOUNTS AND RESERVES
                        LIVING CENTERS OF AMERICA, INC.
                             (DOLLARS IN THOUSANDS)


<TABLE>
<CAPTION>
                                         Balance,                     Deduction     Additions     Balance,
                                        Beginning     Charged           From          From         End of
                                        of Period    to Income         Reserve     Acquisitions    Period
                                        ----------   ----------       ----------   ------------  ----------
<S>                                     <C>          <C>              <C>           <C>          <C>       
Fiscal Year 1996:

  Allowance for doubtful accounts ...   $   16,500   $   16,666       $  (12,492)   $    2,109   $   22,783
                                        ==========   ==========       ==========    ==========   ==========

  Notes receivable reserves .........   $    3,550   $        0       $      (34)   $       --   $    3,516
                                        ==========   ==========       ==========    ==========   ==========

Fiscal Year 1995:

  Allowance for doubtful accounts ...   $    6,632   $   10,520       $  (11,071)   $   10,419   $   16,500
                                        ==========   ==========       ==========    ==========   ==========

  Notes receivable reserves .........   $    2,850   $      700       $       --    $       --   $    3,550
                                        ==========   ==========       ==========    ==========   ==========

Fiscal Year 1994:

  Allowance for doubtful accounts ...   $    3,781   $    3,122       $   (2,978)   $    2,707   $    6,632
                                        ==========   ==========       ==========    ==========   ==========

  Notes receivable reserves .........   $    5,424   $   (2,416)(a)   $     (158)   $       --   $    2,850
                                        ==========   ==========       ==========    ==========   ==========
</TABLE>


(a)  Includes reversal of reserves based on collections of notes previously
     considered doubtful.





                                     - 59 -