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                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

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

                                   FORM 10-K/A

(MARK ONE)

[ X ]    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
         EXCHANGE ACT OF 1934

         For the Fiscal Year Ended December 31, 1999

                                       OR

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

         For the Transition Period From __________ to __________

                         COMMISSION FILE NUMBER 0-21752

                         NORTHSTAR HEALTH SERVICES, INC.
             ------------------------------------------------------
             (Exact name of registrant as specified in its charter)

             DELAWARE                                       25-1697152
---------------------------------                      -------------------
  (State or other jurisdiction                          (I.R.S. Employer
of incorporation or organization)                      Identification No.)

665 PHILADELPHIA STREET, INDIANA, PENNSYLVANIA                15701
----------------------------------------------              ---------
   (Address of principal executive offices)                 (Zip Code)

       Registrant's telephone number, including area code: (724) 349-7500

        Securities registered pursuant to Section 12(g) of the Act: None
                                                                   ------

                                                      Name of each exchange
         Title of each class                           on which registered
         --------------------                         ---------------------
   Common Stock-Par Value $.01 Per Share                         *

   *  Due to circumstances described herein, the Common Stock was delisted on
      May 31, 1996 and is currently quoted on the Over the Counter Bulletin
      Board.

         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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K/A or any
amendment to this Form 10-K/A. [ ]

         The aggregate market value of the voting stock held by non-affiliates
of the registrant, based on the closing sale price of such stock as of March 20,
2000 is set forth below:
                                       Aggregate Market Value of the Voting
         Class of Stock                    Stock held by Non-Affiliates
         ----------------              ------------------------------------
Common Stock, $.01 par value                          $6,722,352

The number of shares of Common Stock outstanding at March 20, 2000: 5,975,424

DOCUMENTS INCORPORATED BY REFERENCE:        PART OF FORM 10-K/A INTO WHICH
            None                            THIS DOCUMENT IS INCORPORATED:


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FORWARD LOOKING STATEMENTS

         From time to time, Northstar Health Services, Inc., ("Northstar" or the
Company") will publish forward looking statements relating to such matters as
anticipated financial performance, business prospects, and projected plans for
and results of its operations. The Private Securities Litigation Reform Act of
1995 provides a safe harbor for forward looking statements. In order to comply
with the terms of the safe harbor, the Company notes that a variety of factors
could cause the Company's actual results to differ materially from the
anticipated results or other expectations expressed in the Company's forward
looking statements. The risks and uncertainties that may affect the operations
and performance of the Company's business include the following: changes in
regulatory, governmental and payor policies regarding reimbursement;
competition, both directly in terms of other providers of physical therapy and
other services, and the competition for qualified personnel; the outcomes of the
current litigation involving the Company; potential defaults in borrowing
arrangements, potential defaults in bank financing, including an inability to
comply with various covenants in connection with such financing; the ability of
the Company to have its Common Stock relisted on a national market or exchange
and the uncertainties surrounding the healthcare industry in general.


ITEM 1.      BUSINESS

         In addition to other sections of this document, this Business section
contains the type of forward looking statements and projections discussed above
and must be read in connection with those disclosures.

GENERAL

         The Company, a Delaware corporation, is a regional provider of physical
rehabilitation and other health care services in Pennsylvania and adjacent
states, providing services at outpatient rehabilitation clinics and patient care
facilities to patients suffering from physical disabilities. The goals of
physical rehabilitation are to improve a patient's physical strength and range
of motion, reduce pain, prevent injury and restore the ability to perform basic
activities, including communication. The Company believes that physical
rehabilitation improves patient outcomes and shortens a patient's recovery time
and, as a result, has gained increasing recognition by payors as both a
clinically effective and a cost effective means to lower total healthcare
expenses.

         The Company's corporate and subsidiary operations are organized to
better position itself to efficiently manage existing and emerging opportunities
in its primary markets. As such, the Company has defined three operating
subsidiaries:

         o        KEYSTONE REHABILITATION SYSTEMS, INC. ("Keystone") provides
                  outpatient rehabilitation, primarily to ambulatory patients at
                  sixty-eight (68) outpatient sites specializing in orthopedics,
                  sports and neurologic rehabilitation. Keystone utilizes
                  physical therapists, occupational therapists and speech
                  therapists to provide its services. Keystone also contracts
                  with hospitals, nursing homes, home health agencies, personal
                  care homes and school districts to provide physical therapy,
                  occupational therapy, speech language pathology and athletic
                  training services. Keystone is one of the largest providers of
                  outpatient rehabilitation services in Pennsylvania.

         o        KEYSTONE REHABILITATION MANAGEMENT, INC. ("KRM") provides and
                  manages interdisciplinary therapy services to long term care
                  and subacute facilities, as well as hospitals, personal care
                  homes and home health care agencies on a contract basis. KRM
                  has the ability to supply experienced management personnel,
                  rehabilitation and related services to nursing homes and
                  hospitals through contractual arrangements.

         o        NORTHSTAR MEDICAL SERVICES, INC. ("NMS") is a subsidiary
                  corporation that was designed to develop and manage physician
                  practices. To date, the primary focus of this company has been
                  Penn Vascusonics, P.C., a radiology practice that provides
                  multiple mobile diagnostic services including mammography,
                  ultrasound and echocardiography to physicians, nursing



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                  homes and industries. Through this professional corporation,
                  hospital-quality testing was provided onsite in physician
                  offices and long term care facilities that provide for an
                  environment that makes the diagnostic experience less
                  stressful and more convenient for the patient. Mobile services
                  were provided through a fleet of customized vans equipped for
                  transporting equipment to physician office locations. The
                  Company closed all mobile diagnostic operations in August 1999
                  in keeping with its 1998 decision to focus its efforts on its
                  core rehabilitation business, it had decided to withdraw from
                  the mobile diagnostic industry. The related assets were sold
                  in October 1999.

         As of December 31, 1999, the Company had sixty-eight (68) outpatient
rehabilitation clinics and sixteen (16) contractual agreements with patient care
facilities. The Company continues to strive to expand its presence as a provider
of physical rehabilitation and related services in its geographic marketplace in
Pennsylvania and Ohio.

         As will be discussed in the Business Strategy section, the Company
continues to concentrate its efforts on strengthening operations and increasing
profitability in the outpatient therapy and rehabilitation business, its core
business and primary source of revenue. At the Corporate level, the Company has
consolidated certain regional management functions to contain costs and
streamline the services provided to operating subsidiaries.

OPERATIONS

         OUTPATIENT REHABILITATION CLINICS. As of December 31, 1999, The Company
owned and operated sixty-eight (68) outpatient rehabilitation clinics in
Pennsylvania and Ohio. The Company provides a wide range of outpatient
rehabilitation therapy services to patients who suffer from a variety of
physical ailments including muscular pain, loss of function, injury or
impairment. The Company provides services, prescribed by the patient's
physician, through licensed therapists, therapist assistants, aides and related
personnel, while coordinating the establishment and maintenance of patient
records, billings to third-party payors and management and operations of the
clinics. Northstar leases and purchases equipment for the outpatient clinics
and, although the amount and type of equipment for each clinic may vary, such
equipment typically includes whirlpools, electric stimulation and ultrasound
units, exercise machines and hot and cold pack units.

         The outpatient rehabilitation clinics are dependent upon patient
referrals from various sources within their communities, including
orthopaedists, internists, neurologists, physiatrists, chiropractors, hospital
discharge planners, community organizations and insurance company case managers.
Referrals also come from non-physician sources, including insurance companies,
managed care organizations, attorneys and employers. The Company's ability to
attract managed care and other third-party payor contracts in multiple locations
is aided by its large share of the geographic market, central billing and
collections services and direct marketing efforts to payors.

         CONTRACT REHABILITATION. As of December 31, 1999, the Company had
contractual arrangements with sixteen (16) patient care entities that the
Company considers to be of a significant nature based on the level of revenue
derived from these contractual agreements. Under these contracts, the patient
care facility generally furnishes the space for the delivery of rehabilitative
therapy treatments, and the Company provides all other necessary services,
including the appropriate rehabilitation therapies, on-site management, staff
recruitment, continuing education, and quality assurance. The Company provides
services that allow patient care facilities to offer advanced multidisciplinary
therapies that may not be available through their own in-house resources.
Northstar is compensated under such contracts on a fee-for-service basis and
typically collects payment for services directly from the patient care facility,
which in turn receives reimbursement from other third-party payors. Generally,
the Company enters into one-year or renewable contracts that typically can be
cancelled upon a notice of between thirty (30) to ninety (90) days.

INDUSTRY BACKGROUND

         The outpatient rehabilitation industry continues to experience
significant consolidation, due primarily to the highly fragmented nature of the
industry and the preference of managed care





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organizations to contract with regional providers offering comprehensive,
cost-effective programs. In recent years, due to regulatory considerations,
convenience and cost saving measures, there has been a trend away from hospital
based rehabilitation and toward outpatient rehabilitation services provided in
modern, accessible clinics and in long term care and subacute facilities.
Because the population age group aged fifty-five and older is expected to
increase dramatically over the next ten to fifteen years, this demographic shift
will affect those most intensively in need of rehabilitation services.

         Within the rehabilitation sector, the focus for growth is likely to be
in the outpatient segment as the trend toward cost containment continues. Under
the managed care environment, outpatient rehabilitation therapy is chosen as an
alternative to inpatient hospital care primarily as a result of the focus on
reducing patient stays and patient visits. Managed care organizations and
third-party payors are seeking to enter into contract relationships with
rehabilitation providers most capable of delivering a full continuum of care at
the lowest cost without sacrificing the quality or effectiveness of patient care
services. As a result, there has been increased demand for more comprehensive
and sophisticated physical rehabilitation services, particularly for services
already provided by the Company such as work reconditioning, aquatic therapy,
functional capacity evaluations and clinically oriented programs specific to
areas such as women's health, wellness/fitness, headache/TMJ and fibromyalgia.

         The Company believes that as the rehabilitation industry continues to
consolidate, it will be necessary to react to industry changes in order to
position the Company to stabilize its operations in its geographic marketplace.
Therefore, the Company will limit its entry into new contractual agreements in
patient care facilities and opening new outpatient centers to those contracts or
locations where the potential to achieve profitability appears reasonable. As
the outpatient industry achieves more growth resulting from, among other things,
earlier patient discharge from hospitals and other patient care facilities, the
Company believes it can sustain controlled growth by focusing on its core
rehabilitation business while forming strategic alliances with other entities or
providers to capitalize on what it believes are the inherent growth factors of
the rehabilitation industry. They are:

         o        THE EFFECTIVENESS OF PHYSICAL THERAPY. Physical therapy is
                  recognized by physicians and payors as a cost-effective method
                  to reduce future healthcare expenses, shorten the recuperation
                  time for injuries, reduce the likelihood of re-injury, and
                  enable patients to regain skills necessary to return to
                  independent living or the workplace. Additionally, physical
                  therapy may assist in containing healthcare expenses by
                  reducing or eliminating the need for ongoing inpatient
                  healthcare services and other related costs.

         o        INCREASING EMPHASIS ON PHYSICAL FITNESS AND THE TREATMENT OF
                  SPORTS INJURIES. The growing emphasis on wellness, physical
                  fitness, leisure sports, and conditioning, such as running and
                  aerobics, has led to increased injuries which require physical
                  therapy and increased awareness for injury prevention.

         o        DEMOGRAPHIC SHIFT TOWARD AN AGING POPULATION. The aging
                  population is expected to increase the demand for
                  rehabilitation services. As a person ages, he or she becomes
                  more susceptible to both neurologic and orthopaedic-related
                  ailments, including osteoporosis, which may result in the type
                  of injury or loss of function which can be aided by a
                  rehabilitation program that focuses on strengthening and
                  conditioning. Because the aging population chooses to remain
                  active well into later years, therapy programs can assist
                  individuals to sustain enjoyable activities and maintain an
                  active lifestyle.

         o        EARLIER PATIENT DISCHARGE FROM ACUTE CARE HOSPITALS TO
                  ALTERNATE SITES. The trends toward earlier patient discharge
                  from acute care hospitals to subacute sites, from patient care
                  facilities to outpatient care, and from hospital-based care to
                  clinic-based and home-based treatment programs, have combined
                  to increase the demand for all forms of rehabilitation
                  services.

          The Company believes that the demand for rehabilitation therapy
services will be favorably affected by the continued recognition of
rehabilitation as both a clinically and a cost-effective method of treating
certain types of disabilities. However, the Company also believes that this
market will be characterized by increased cost containment pressures and the
growing influence of managed care



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organizations, other third-party payors and state government mandated workers'
compensation programs in the selection of rehabilitation service providers. In
addition, federal and state governments and other entities, such as managed care
organizations and workers' compensation carriers, increasingly are converging to
contain healthcare costs by capping, or in some cases reducing, the
reimbursement rates for rehabilitation services. Consequently, rehabilitation
providers, including Northstar, are addressing this growing legislative and
payor pressure by seeking contract relationships and by providing services which
appeal to the demands of payors, such as work injury reconditioning, education
and prevention and other services which promote quality care at the lowest
possible cost.

          Overall, Northstar believes that the rehabilitation industry remains
highly fragmented. Changes within the healthcare environment are leading some
rehabilitation providers, including sole practitioners and owners of small
groups of outpatient rehabilitation clinics to sell such clinics and merge with
larger rehabilitation companies or establish networks of outpatient
rehabilitation clinics within a geographic area.

BUSINESS RISK

         The Company is currently experiencing certain financial conditions that
raise doubts about the ability of the Company to continue as a going concern.
Although the Company experienced a significant improvement in the results of its
core rehabilitation therapy businesses in 1998 and 1999, this was offset by
losses in the mobile diagnostics business until its closing in August 1999 and
the costs of refinancing the Company's senior debt. The Company has completed
negotiations with its principal creditors, including the holder of its senior
secured debt, to effectuate a restructuring of its payment obligations through
December 31, 2000 when this debt must be repaid. In addition, during 1996 the
Company's shares were delisted from the NASDAQ National Market, where they were
formerly traded, thus decreasing the Company's access to additional equity
capital. The Company's current financial condition will make it more difficult
for the Company to attract replacement financing, or for the Company to present
itself to possible purchasers as an attractive acquisition candidate. If the
Company is unable to effectuate a business combination with a financially
stronger entity or to raise replacement capital for a permanent restructuring of
its debt, the Company could be required to file a petition for relief under the
provisions of the Bankruptcy Code, or could have an involuntary petition
thereunder filed against it. Please also refer to the subsequent event discussed
in the liquidity and capital resources section of Item 7.

BUSINESS STRATEGY

         The Company's ability to strengthen its presence as a provider of
rehabilitation services in the Year 2000 is limited by its current financial
situation and senior debt covenants (See Item 7, Management's Discussion and
Analysis of Financial Condition and Results of Operations). Therefore, the
Company's strategy until the existing senior debt is refinanced is to
concentrate on internal mechanisms that do not require significant capital
resources to optimize existing operations. Key elements of the Company's
business strategy are summarized below.

         o        MAINTAIN REGIONAL PRESENCE. The Company provides both
                  inpatient and outpatient physical therapy and related services
                  and thus seeks to position itself as the preferred
                  rehabilitation provider for physicians, hospitals and managed
                  care organizations and other referral sources.

         o        EXPAND REFERRAL SOURCES. The Company seeks to expand the
                  referral base of the outpatient rehabilitation clinic by
                  aggressively marketing its rehabilitation services to local
                  and regional referral sources such as primary care physicians,
                  orthopaedic surgeons, private industry, insurance companies
                  and managed care organizations. As part of its strategy, the
                  Company has increased its emphasis on sales and marketing and
                  is targeting existing and new markets in order to gain
                  increased referrals.

         o        MAXIMIZE PAYOR REIMBURSEMENT. The Company has focused
                  attention on its payor mix in order to maximize its levels of
                  reimbursement under existing contracts and affiliations with
                  managed care organizations and other payors such as workers
                  compensation carriers, insurance companies and third party
                  payors. During 1999, the Company reduced its presence in
                  nursing facilities in response to unfavorable changes in
                  reimbursement levels.




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         o        EXPAND CONTRACTS WITH MANAGED CARE ORGANIZATIONS. As managed
                  care organizations become more prevalent in the marketplace,
                  outpatient rehabilitation service providers will need to
                  deliver a comprehensive range of services in a cost effective
                  manner with multiple locations within a metropolitan area or
                  region. The Company continues to market its services
                  aggressively to these organizations.

         o        EXPAND CONTRACTS WITH PATIENT CARE FACILITIES. The Company
                  continues to seek additional contracts with, as well as expand
                  the range of services it offers to personal care homes,
                  assisted living centers, hospitals, schools and home health
                  care agencies.

         o        INCREASE RANGE OF SERVICES. The Company provides a wide range
                  of services, including physical, occupational and speech
                  therapies, and continues to increase its more specialized
                  treatments such as hand therapy, aquatic therapy, sports
                  therapy, women's health programs, incontinence therapy,
                  neurological therapy, industrial rehabilitation, ankle and
                  foot therapy, arthritis programs, fibromyalgia program,
                  functional capacity evaluations and education/prevention
                  programs.

         o        RECRUIT AND RETAIN EXPERIENCED THERAPISTS AND KEY PERSONNEL.
                  The Company will continue to recruit and develop professional
                  therapists to staff its facilities and contract obligations
                  and offer competitive compensation and benefits packages.

         o        INCREASE EFFICIENCY OF OPERATIONS. The Company maintains
                  centralized accounting, payroll, accounts receivable/payable
                  and other administrative functions such as billing and
                  collection. Certain other functions, including regional
                  management, sales and marketing, and provider relations have
                  been centralized to contain costs and maximize efficiency.

          The Company believes that the success of its future business strategy
and profitability will depend upon several key issues. The Company is aware that
given its limited resources and existing bank covenants, it must focus its
efforts on its core rehabilitation business and avenues necessary to maximize
revenues in its existing outpatient facilities. In 1998, due to continued losses
in the mobile diagnostic division, the Company decided to withdraw from the
mobile diagnostic business and place the assets for sale. The mobile diagnostic
business was closed in August of 1999 and sold shortly thereafter. Future
results will not be burdened with operating and asset disposal costs of this
unit, as they were recorded in 1999. In conjunction with this strategy, the
Company realized the need to control costs and expenses and in 1999 has
implemented certain cost containment measures in order to reduce and/or
eliminate unessential costs. These measures include a reduction of staffing
levels, if appropriate, at all locations and the elimination of any costs not
necessary to operations. Management believes that additional expense reductions
implemented in 1999 have been successful and the full benefit will be realized
in the Year 2000 and beyond.

          In addition to cost containment measures, the Company will strive to
maximize the performance of its existing core physical therapy and
rehabilitation business. At the Corporate level, an administrative function that
encompasses sales, marketing and provider relations, was created in 1999 to
conduct an ongoing marketing and sales campaign that targets the key referral
sources of the Company in order to attract and expand existing business. The
Company expects much of its future success will rely on its ability to maximize
referrals from physicians, industries and managed care organizations.

          The Company continues to face financial difficulties, described in
more detail in the Management's Discussion and Analysis section, and management
continues to review its existing business in order to identify and eliminate
unprofitable facilities. In 1999, approximately three (3) contractual
arrangements with patient care facilities were terminated and five (5) new
contracts were implemented. In addition, one (1) outpatient facility in
Pennsylvania and one (1) in West Virginia, which were unprofitable, were closed.
Despite its limited available resources, the Company was able to open eight (8)
outpatient facilities in Pennsylvania and three (3) in Ohio in 1999 with minimal
capital investment. The Company believes that by the assessment and elimination
of unprofitable facilities, the sale of the mobile diagnostic business and the
strategic opening of low-cost, low-risk, new facilities, it can protect the core
rehabilitation business and improve its cash position. Overall, the Company
realizes that a business






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strategy aimed toward maximizing revenues and profitability from existing
operations is necessary to achieve financial results that could ultimately lead
to relisting of its common stock on a national market or exchange. However, the
Company does not believe that this will happen anytime in the foreseeable
future.

PATIENT CARE SERVICES

         The goals of physical rehabilitation are to improve a patient's
physical strength and range of motion, reduce pain, prevent injury and restore
the patient's ability to perform daily activities as functionally as possible.
The Company utilizes licensed therapists and therapist assistants to provide
physical, occupational and speech therapy to patients with musculoskeletal
injuries, physical disabilities associated with neurological disorders, and
post-surgical rehabilitation. The following is a brief description of
rehabilitation services offered by the Company:

         o        PHYSICAL THERAPY. Physical therapy is the evaluation and
                  treatment of physical disabilities designed to improve a
                  patient's physical strength, range of motion, coordination and
                  endurance. Treatments include exercise and the application of
                  modalities such as heat, cold, water, sound and electricity.

         o        OCCUPATIONAL THERAPY. Occupational therapy is the evaluation
                  and treatment of physical and cognitive deficiencies with the
                  goal of improving self-care, work and leisure skills.
                  Candidates for this treatment include people who have suffered
                  traumatic injuries, have disease related disabilities, or who
                  have underdeveloped physical and cognitive skills.
                  Occupational therapists use a variety of treatment techniques,
                  including using therapeutic exercises and activities,
                  designing and fabricating adaptive equipment (such as splints
                  and custom made handles for utensils) and teaching
                  compensatory techniques to help these individuals achieve
                  their potential for independent, productive living.

         o        SPEECH THERAPY. Speech therapy is the evaluation and treatment
                  of speech, language, voice and swallowing disorders arising
                  from strokes, head injuries, degenerative neurological
                  disorders, developmental deficits, cancer and hearing
                  impairment. Speech therapists use treatment techniques such as
                  thermal stimulation, muscle re-education and hearing and/or
                  speech aid through visual communication devices.

         o        WORK RECONDITIONING. Work reconditioning is a rehabilitation
                  program that simulates the specific job activities of an
                  injured worker in order to prepare the worker to return to
                  work and addresses issues of productivity, safety, physical
                  tolerances and worker behavior. The goal is to prepare the
                  patient to work a complete workday safely and without injury.
                  The Company utilizes a standardized industrial rehabilitation
                  program at all of its sites to improve both patient and payor
                  acceptance.

         o        FUNCTIONAL CAPACITY ASSESSMENT. Functional capacity assessment
                  is the evaluation of an existing or prospective employee's
                  physical condition and endurance and of the ability to meet
                  the requirements of employment. Employers, insurers and other
                  payors may use the assessment to estimate the extent of
                  rehabilitation treatment needed or as an objective method of
                  evaluating specific work capacity.

         o        PAIN MANAGEMENT. Pain management programs are used to assist
                  patients in the use of compensatory motor patterns and other
                  coping mechanisms to minimize or eliminate the debilitating
                  effects of acute and chronic pain.

         o        PREVENTIVE SERVICES. The Company also provides services
                  designed to prevent or avoid injuries in the workplace. These
                  preventive services, which may be performed at an employer's
                  work site, include programs to teach employees proper body
                  mechanics and techniques and detailed analysis of specific job
                  activities, such as lifting, with the goal of educating
                  employees to reduce or prevent workplace injuries.



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MERGERS, ACQUISITIONS AND JOINT VENTURES

         Keystone Rehabilitation Systems, Inc. ("Keystone")

         On November 15, 1995, NSK Merger Corp., a newly formed subsidiary of
the Company, was merged with and into Keystone (a Pennsylvania corporation) (the
"Merger"). See Note 3 to the Financial Statements.

         As consideration for the Merger, the shareholders of Keystone, Thomas
W. Zaucha and Alice L. Zaucha and the Zaucha Family Limited Partnership
(collectively, the "Shareholders"), received, in part, an aggregate of 944,352
shares of Common Stock, par value $.01 per share (the "Common Stock"), of the
Company (the "Stock Consideration"). The Company guaranteed the value of the
Stock Consideration to be at least $5,600,000 through certain periods ending no
later than December 31, 1997. Based on the weighted average trading volume of
the daily closing price per share for the ten consecutive trading days
immediately prior to the third business day prior to the determination date of
December 31, 1997, the Company's Common Stock was valued at $0.96 per share. The
Company has a contractual obligation to fund this shortfall in stock value
through a cash payment equal to the shortfall or, with shareholder approval,
through the issuance of additional shares to the Shareholders in an amount equal
to the shortfall. Based upon the above formula, the Company was obligated to
either make a cash payment of $4,693,423 or issue approximately 4,888,982
additional shares of stock. The Company does not currently have sufficient cash
to pay this obligation. This amount has been recorded as a liability in accrued
expenses at December 31, 1998 and 1999 (See Note 8 to the Financial Statements),
with the offset recorded to Additional Paid-In Capital. The Special Committee of
the Board of Directors has been charged with the authority to negotiate the
satisfaction of this obligation with the Shareholders, which could be done
through the payment of cash, issuance of stock, issuance of notes, or a
combination of any or all of these items. At the Company's Annual Meeting held
on June 11, 1998, the Company's stockholders approved the issuance of up to
4,888,982 shares of Common Stock in order to enable the Company to fully satisfy
the obligations of the Company under the guarantee in stock if deemed
appropriate by the Special Committee. As of December 31, 1999 the Guarantee
Conversion Option has not been exercised.

         The Company also agreed to make additional "earn-out" payments to the
Shareholders of $1,600,000 per year in the event that the Company's "EBITDA"
exceeds $2,500,000 in any year from 1996 to 2000, inclusive. EBITDA is defined,
generally, to mean the Company's earnings (including earnings from any
internally generated facility or contract but excluding earnings from any
facility or contract acquired from third parties) before interest, taxes,
depreciation and amortization. In the event an earn-out is not earned and
therefore not paid in any given year, the earn-out will be paid in the next year
if EBITDA in such next year exceeds the greater of $3,200,000 or $2,500,000 plus
the amount of the EBITDA shortfall in such prior year. The Shareholders are to
receive an earn-out of approximately $200,000 for 1995. The calculation for the
earn-out amounts for years 1996 through 2000 includes a reduction in the amount
due in the event that the current liabilities of Keystone at the date of the
Merger (other than permitted capital leases) exceeded $2,000,000. In addition,
such earn-out payments are to be reduced by 50% of such current liabilities up
to $2,000,000. Former management of the Company believed that, based on the
results of operations for 1996 as well as that management's interpretation of
the above-outlined adjustments, the 1996 earn-out computation resulted in no
amounts due to the Shareholders. The current Board of Directors appointed a
Special Committee to review these calculations and the issues in dispute. The
Special Committee and the Zaucha's have agreed that no earn-out will be paid for
1996, the earn-out for the year 1997 will be reduced by $504,725 and the
earn-out for the years 1998 through 2000 will be reduced by a minimum of
$192,800 per year. The earn-out payments for all years will accelerate and
become due within 90 days after any change in ownership or control of the
Company or a sale of the majority of the assets of the business. The Company has
determined that, based on the results of operations for 1997, there are no
amounts due to the Shareholders for the 1997 earn-out. However, the Company has
determined that the EBITDA for 1998 exceeds the greater of $3,200,000 or
$2,500,000 plus the amount of the EBITDA shortfall in 1997, and, therefore, in
accordance with the carryover provision above, there is an amount due to the
Shareholders in the amount of $1,095,275 for 1997. The Company has determined
that, based on the results of operations for 1998, there is an amount due to the
Shareholders in the amount of $1,407,200 for 1998. Accordingly, at December 31,
1998, the Company accrued the earn-out payments of $2,502,475 with an






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offsetting entry to goodwill. The Company has determined that, based on the
results of operations for 1999, there is an additional amount due to the
Shareholders in the amount of $1,407,200 for 1999. Accordingly, at December 31,
1999, the Company recorded a total earn-out liability of $3,909,675 with an
offsetting entry to goodwill. In the event of a change of control of the
Company, the earn out for the Year 2000 will become due.


         Penn Vascular Lab, P.C. ("PVL")

         On November 28, 1995, the Company acquired from PVL (a Pennsylvania
professional corporation) certain assets and the stock of Vascusonics, Inc. (a
Pennsylvania Corporation or "Vascusonics"). The agreement provided for a
management services contract whereby the Company would provide such services to
PVL for a period of two years in exchange for a fee equal to the excess of
collected revenue over the sum of $75,000 and PVL's business expenses. Although
the management services contract expired on November 28, 1997, it was renewable
annually at the mutual agreement of both parties. The purchase agreement also
provided the Company with the option to purchase the stock of PVL for one dollar
under certain circumstances, during the period one year after the management
services contract is terminated.

         As consideration, in part, for the above-mentioned items, the Company
promised to pay certain contingent payments to the principals of PVL. The
Company has determined that under the terms of this calculation, there are no
contingent payments due.

         In January 1997, the Company reached a settlement agreement with the
Seller of PVL regarding several disputes. In the terms of this agreement, the
Company reduced certain future payments due to the Seller from $100,000 to
$50,000, acquired ownership rights to disputed equipment, and reduced contingent
payment amounts.

         Under the purchase agreement, Ultrasonics, Inc. (Ultrasonics) took
ownership of PVL's and Vascusonics' accounts receivable assumed certain related
party leases for equipment used by the Company and entered into new lease terms
with the Company. In March 1998, the Company reached a settlement with the
related parties that resulted in mutual releases and no payments to either
party. The operations of Penn Vascusonics were closed in August 1999 and the
Company recorded a charge of $334,000 and $596,000 for related fixed asset and
goodwill impairments. The Penn Vascusonic operation and assets were sold in
October 1999, as further discussed in the Management Discussion and Analysis
section.

MARKETING OF FACILITIES AND SERVICES

         As of December 31, 1999, the Company had a sales and marketing staff of
eight (8) employees responsible for expanding its patient base in outpatient
rehabilitation clinics through referrals by physicians, industries, case
management companies and third party administrators through sales visits,
database marketing, advertising and public relations.

         The Company continues to emphasize its sales and marketing activities
at the local outpatient rehabilitation clinic and at the regional and corporate
levels, targeting hospitals, physicians, industries, insurance companies,
managed care organizations, workers' compensation carriers, and the general
public. The Company believes that due to continuing competition, the need for
emphasis on sales and marketing activities are vital to further penetrate target
markets, expand into new territories, increase patient flow and increase public
awareness.

         At the local outpatient rehabilitation clinic level, the facility
directors for each clinic are expected to maintain relationships with existing
referral sources and to establish relationships with new referral sources,
typically physicians, in that clinic's geographic area. Therapists interact with
referral sources on a regular basis in order to maintain personal relationships
and respond to their service needs. The Company believes that being responsive
to the needs of the referral sources enhance the Company's prospects of
obtaining additional referrals from such sources. Clinic personnel participate
in bonus programs based upon new patient referrals and increased patient visits.


                                       8
<PAGE>   10


         At the regional level (which are groups of related offices and
services), the Company has recognized the value of sales personnel in marketing
to larger regional referral sources (multi-physician practices, industries and
hospital-owned physicians and schools) that may be in a position to refer groups
of patients to the Company's facilities. Sales personnel can arrange for onsite
meetings between facility directors and referral sources and also meet with case
managers, employers and local community groups. Their marketing efforts are
responsible for developing and expanding business relationships with all
referral sources such as insurance companies, managed care organizations, and
industries as well as the physicians targeted by the clinical personnel.

         At the corporate level, the Company concentrates on establishing
contracts with multi-regional managed care organizations, insurance companies,
employers and long term care facilities. When appropriate, the Company may
consider service provider alliances in which two or more large rehabilitation
organizations enter into an arrangement such that, collectively, these two
organizations are able to secure a contract with a large referral source.
Corporate marketing programs are effective in establishing links with larger
employers and third party payors.

         The Company is aware of the growing importance of managed care
organizations in controlling patient referrals and their demand for high
quality, cost effective care from service providers with a regional presence.
Accordingly, both its corporate and regional sales personnel devote substantial
efforts to building relationships with these organizations. The Company has been
able to secure contracts and establish relationships with such organizations in
the past and believes that its sales and marketing efforts will allow it to
acquire additional contracts from, and establish additional relationships with,
managed care organizations and other referral sources in the future.

COMPETITION

         The rehabilitation industry is highly competitive and subject to
continual changes in the manner in which services are delivered and in which
providers are selected. The Company believes the most significant competitive
factors in the rehabilitation market are quality patient care, comprehensive
scope of services offered, treatment, alignment with physicians, outcome
measures, convenience of rehabilitation locations to patients, regional
dominance and the ability to develop and maintain relationships with referral
sources such as physicians, insurance companies, industries, managed care
organizations, lawyers and employers. The Company competes with many national,
local and regional providers of similar rehabilitation and related services,
including the outpatient rehabilitation operations of acute care hospitals,
managed care organizations and other long term care rehabilitation therapy
providers. Many of the Company's competitors have equal or longer histories of
operations and longer term relationships with therapists and referral sources
than the Company and possess greater financial, marketing, human and other
resources than the Company.

         The Company also competes with other healthcare companies in acquiring
rehabilitation providers. Several larger national companies with substantially
greater financial resources than the Company have been actively acquiring
rehabilitation providers. Certain of these companies, because of the size of
their stockholders' equity, may not be affected by present or future laws
limiting or prohibiting referrals by stockholders who may be referral sources.
Continued competition in this area may increase the valuation of rehabilitation
providers and limit the Company's ability to make future acquisitions.

         The Company also competes for the services of therapists with
hospitals, nursing homes, and other outpatient rehabilitation providers and
physicians' offices. Although the Company has not experienced significant
difficulties in attracting and retaining qualified therapists, during certain
periods the demand for qualified therapists exceeds the supply. A previous
supply shortage has abated, and expectations are that in future years there will
continue to be increasing numbers of available therapists. However, there can be
no assurance that the Company will continue to be able to attract or retain
sufficient therapists to meet its needs.

GOVERNMENTAL REGULATION

         General. The provision of physical therapy services and reimbursement
for such services is subject to a number of federal, state and local laws,
regulations and rules, some of which are very





                                       9
<PAGE>   11

complex. The various levels of regulatory activity affect the Company's business
activities by controlling its growth, requiring licensure or certification of
its facilities and controlling the reimbursement to the Company for services
provided.

         In the majority of states, outpatient rehabilitation facilities do not
require review or approval by state regulators. States with Certificate of Need
("CON") regulations place certain limits on the expansion and acquisition of
healthcare facilities. Therefore, acquisitions or expansion of existing
facilities in these states may require review by state regulators. Presently,
Pennsylvania (in which the majority of the Company's facilities are located)
does not have a CON requirement. Licensure and certification are both regulatory
activities mandated by either state or local agencies or a federal agency.
Compliance with the regulatory requirements is monitored by on-site inspections
by various representatives of governmental agencies. Although the Company
believes that it is currently in compliance with applicable laws, regulations
and rules, some of such laws, regulations and rules are broadly written and
subject to little or no interpretation by courts or administrative authorities.
Hence, there can be no assurance that a third-party or governmental agency will
not contend that certain aspects of the Company's operations or procedures are
not in compliance with such laws, regulations or rules or that state agencies or
courts would interpret such laws, regulations and rules in the Company's favor.
The sanctions for failure to comply with such laws, regulations or rules could
be denial of the right to conduct business, significant fines and/or criminal
penalties. Additionally, an increase in the complexity or substantive
requirements of such laws, regulations or rules could have a material adverse
effect on the business, financial condition and results of operations of the
Company.

         Fraud and Abuse Laws. The Social Security Act and certain provisions of
state law provide civil and criminal penalties for persons who knowingly and
willfully solicit, pay, offer or receive any remuneration, directly or
indirectly, as an inducement to make a referral of a patient for services or
items for which payment may be made under the Medicare programs. Often termed
"fraud and abuse" or "anti-kickback" laws, the provisions have been broadly
interpreted by the courts.

         The Officer of Inspector General of the Department of Health and Human
Services ("HHS") has issued guidelines specifying certain business arrangements
and payment practices involving providers or other entities, such as the
Company, which will not be considered prohibited activities. Commonly termed
"safe harbor regulations," the regulations set forth certain standards which, if
satisfied, will ensure that the arrangement will not be subject to criminal
prosecution or civil sanctions under the fraud and abuse laws. Failure to
satisfy the safe harbors in and of itself does not render an arrangement
illegal. However, there can be no assurance that enforcement agencies or courts
would determine that the Company is in compliance with the safe harbor
regulations applicable to its current operations.

         The Company takes measures to safeguard its compliance with
governmental rules and regulations by employing individuals at the corporate
level who maintain responsibility for identifying, creating and effecting the
appropriate policies with respect to compliance with the laws.

         One principal focus of the fraud and abuse laws has been on
arrangements in which profit distributions are made by a partnership or other
business venture for health-related items or services to persons making
referrals to the venture. Where such arrangements exist, a question is raised as
to whether the profit distributions are illegal payments in exchange for
referrals. Certain safe harbors set forth criteria which, if met, will ensure
that investors in business ventures for health-related items or services will
not be subject to scrutiny under the fraud and abuse laws.

         One safe harbor protects profit distributions to investors made by
publicly traded companies with tangible assets of more than $50 million. At
present, the Company does not satisfy the asset threshold for protection under
this safe harbor. Another safe harbor covers investment interests in small
entities. The criteria that must be satisfied for protection under this safe
harbor include, among other things, requirements that no more than 40% of the
investment interests of each class of investment interests in the entity may be
held by persons, or so-called "tainted investors," who are in a position to make
or influence referrals (including hospitals and physicians), furnish items or
services to the entity or otherwise generate business for the entity, and that
no more than 40% of the entity's gross revenues may come from referrals, items,
or services furnished, or business otherwise generated by "tainted investors."
Unless a large percentage of the Company's Common Stock is held by "tainted
investors," investments in





                                       10
<PAGE>   12

the Company should fall within the safe harbor for investment interests. None of
the Company's physical therapy activities are carried out through partnerships
or other investment vehicles which are owned in whole or in part by physicians
or other third parties which make referrals to, arrange for services by, or
recommend the services of such joint ventures.

         The laws involving fraud and abuse and the safe harbor regulations are
currently in a rapid state of development, and it is difficult to provide a
clear analysis of the risks in this area. There can be no assurance that
enforcement agencies or courts will determine that any existing arrangements
comply with all applicable laws and regulations.

         Stark II. The Omnibus Budget Reconciliation Act of 1993 enacted new
federal anti-referral legislation, more commonly known as "Stark II." Effective
January 1, 1995, Stark II bans referrals by physicians of Medicare patients to
entities for certain designated health services, including physical therapy
services, if a physician or immediate family member has a financial relationship
with the entity providing the service which does not meet any of the exceptions
set forth in Stark II. A financial relationship is generally defined as an
ownership or investment interest in or compensation arrangement with the entity,
subject to certain exceptions. One exception relates to ownership of investment
securities in publicly traded companies that had, at the end of its most recent
fiscal year, or on average during the previous three fiscal years, stockholder
equity exceeding $75 million. At present, the Company does not satisfy the asset
threshold and physicians may not make referrals of Medicare patients to the
Company where the physician or his or her immediate family member holds an
ownership or investment in the Company. Penalties for prohibited referrals
include nonpayment for services rendered pursuant to a prohibited referral,
civil money penalties, and fines and possible exclusion from the Medicare
programs. The Company believes it is currently in compliance with the
requirements of Stark II. However, there can be no assurance that enforcement
agencies or courts will determine that existing arrangements comply with all
applicable laws and regulations.

         The Practice of Physical Therapy. The laws and regulations of certain
states restrict the practice of medicine by corporate entities unless such
corporations are professional corporations, with all shareholders being members
of the profession. The continued viability of such restrictions varies among the
states. In many states the applicability of the restrictions has been
significantly reduced. In Pennsylvania, the state in which the majority of the
Company's operations are located, numerous exceptions have substantially eroded
the doctrine. Although the issue is not free from doubt, management does not
believe the doctrine would be applied to the Company's Pennsylvania operations.
The remainder of the Company's operations is in Ohio. Ohio does not restrict the
corporate practice of physical therapy. If such restrictions were imposed on the
Company, management believes that it could restructure its operations so as to
be in compliance. However, such restructuring could materially adversely affect
the Company and there can be no assurance that a satisfactory restructuring,
under such circumstances, could be accomplished.

         Other Legislative and Regulatory Actions. The Pennsylvania legislature
has enacted automobile insurance reforms which limit payments to providers for
non-emergency services rendered to patients who suffer injuries as a result of
automobile accidents. The Pennsylvania Legislature also enacted workers'
compensation legislation which limits payments to providers for services
rendered to patients with work-related injuries. The Pennsylvania Workers'
Compensation Act, among other things, altered the methodology for payment of
healthcare services to persons covered by workers' compensation, limiting
healthcare providers to payment of no greater than 113% of the applicable
governmentally imposed standard fees for medical services as determined
principally under the Medicare program. If such services do not fall under the
Medicare fee structure, the Pennsylvania Department of Labor and Industry
establishes rates, which may not be more than 80% of the prevailing rate for
such services in the area. The law also requires employees to obtain treatment
from designated providers for a specified period of time and contains
restrictions concerning patient referrals, similar to those established in the
Medicare fraud and abuse and Stark II laws, which are designed to prevent fraud
and abuse in the delivery of services to patients covered by workers'
compensation insurance.




                                       11
<PAGE>   13


REIMBURSEMENT

         The healthcare industry is generally experiencing a trend toward cost
containment as private and governmental payors seek to respond to rapidly
escalating healthcare costs. One means of cost containment has been to limit
reimbursement rates by capping or lowering fees or restricting the number of
treatments which will be reimbursed for any given condition. Pennsylvania, as
well as the other states, in which the Company operates, has fee schedules which
limit the reimbursement rates under workers' compensation programs. Another cost
reduction methodology is increased utilization management by third-party payors
through the use of physician "gatekeepers" and other pre-certification
mechanisms to control utilization of services. The Company expects that
legislation and payors' fee schedules and payment methodologies will continue to
limit the reimbursement of fees for various services and control access to
various services, including rehabilitation services, which may have a material
adverse effect on the business, financial position and results of operations of
the Company.

         The number of the Company's third-party payors who are adopting
prospective payment systems continues to increase. The Company has signed
provider contracts with managed care organizations, which emphasize utilization
control and cost containment, and the Company's business with these managed care
organizations is expected to continue to increase in the next few years. Managed
care organizations either directly transfer risk to healthcare providers though
capitation payment arrangements or pay for units of service on a steeply
discounted basis. These factors cause significant challenges to all providers,
including the Company.

         As a consequence, there can be no assurance that reimbursement for the
Company's services will remain at current levels. The reduction or limitation of
reimbursement levels for the Company's rehabilitation services could have a
material adverse effect on the business, financial condition, and results of
operations of the Company. In addition, such payors are expected to continue to
develop programs designed to control or reduce the cost of healthcare services,
which may have a material adverse effect on the business, financial condition
and results of operations of the Company.

         All billings directly to Medicare are being handled through one of six
certified rehabilitation agencies throughout Pennsylvania and Ohio. Any clinics
providing Medicare services throughout the Company have been certified as
extension sites of one of these agencies. In addition, patient care facilities
that contract with the Company for rehabilitation therapy services and which
bill Medicare directly for reimbursement of such services also must be
certified. The Company believes that all of its facilities are in compliance
with such certification requirements; however, the loss of the Company's
Medicare certification, or the Medicare certification of the patient care
facilities with which the Company contracts could materially adversely affect
the Company's ability to obtain Medicare reimbursement for services.

         Rehabilitation services provided in the Company's outpatient
rehabilitation clinics are reimbursed primarily from third-party payors, which
typically take longer to reimburse the Company than Medicare. Reimbursement from
third-party payors is dependent in large part on the Company's timely and
correct submission of claims in accordance with the varying requirements of
different payors. In addition, any future expansion beyond Pennsylvania and Ohio
might require the Company to seek payment from a larger number of payors, which
could result in longer collection cycles and increased costs of collection.

         For rehabilitation services provided in the Company's outpatient
rehabilitation clinics, most third-party payors, including Highmark Blue
Cross/Blue Shield, compensate the insured or a service provider, such as the
Company, for physical, occupational and speech therapy at fee levels that are
determined to be "reasonable and customary" for such services within a
geographic area. The determination of what is "reasonable and customary" is
based on "objective industry data." Reimbursement based on this criteria may be
substantially less than rates the Company customarily charges and may not cover
all of the Company's costs and expenses. As a result, the Company often will
seek the balance of such claims, if any, as well as the portion of the claims
not covered by third-party payors, directly from the patient. However, certain
third-party payor agreements may prohibit the Company from billing a patient for
any amount by which the Company's fees exceed those allowed by the payor.
Therefore, attempting to collect fees from patients may be uneconomical in light
of the associated costs, or may be prohibited by governmental regulations or
contractual arrangements with third-party payors, and may be unsuccessful.







                                       12
<PAGE>   14

Additionally, third-party payors could adopt more restrictive reimbursement
schedules, which may affect the Company's profitability.

         Prior to December 31, 1998, rehabilitation services provided in the
Company's outpatient rehabilitation clinics to Medicare patients were reimbursed
on a cost reimbursement methodology subject to cost limitations. The Company was
reimbursed for services at a tentative interim rate with final settlement
determined after submission of annual cost reports by the Company and audits
thereof by the Medicare fiscal intermediary.

         Effective January 1, 1999, Medicare began paying for services on a
fixed Fee Schedule. In the past, certain costs were subject to Medicare audit
adjustments. In 1999, the Company recorded audit adjustments of $995,000 related
to 1996 - 1998. Since Medicare reimbursements are now on a fixed schedule, no
significant reimbursement audit adjustments are expected in the future.

         The Balanced Budget Act of 1997 ("BBA") significantly modified the way
Medicare will pay for therapy services provided in a long-term care facility.
The BBA requires that each facility be reimbursed by Medicare for Part A
services under a comprehensive prospective payment system ("PPS") which includes
payment for therapy services in an all-inclusive per diem payment based upon the
acuity level of the patient. Contracted therapists or therapy companies may no
longer separately invoice Medicare and must instead contract directly with the
long term care facility to obtain compensation. As a result of this change, and
the amount of compensation certain long-term care facilities were willing or
able to pay for therapy services based upon their reimbursement by Medicare, the
Company has eliminated all but one of its contracts with long-term care
facilities.

EMPLOYEES

         As of December 31, 1999, the Company had 459 employees of whom two (2)
were executive officers of the Company; 215 were licensed therapists or
therapist assistants; and 10 were involved in marketing and business
development. The Company also has contracts with certain independent physical,
occupational and speech therapists that are utilized by the Company on an as
needed or minimum number of hour's per week basis.

         None of the Company's employees is represented by a labor union and the
Company is not aware of any activities seeking such organization. The Company
considers it relationships with its employees to be satisfactory.

          The Company's business is dependent on its ability to attract and
retain qualified therapists and therapist assistants. The Company employs a
variety of recruiting techniques, including employee referral, personal phone
contact and follow-up, advertising, convention attendance, direct mailing and
on-site college recruiting. The Company also maintains relationships with six
local physical therapy colleges and two physical therapy assistant schools. The
ability of the Company to attract and retain qualified physical, occupational
and speech therapists and therapist assistants is crucial to the Company's
operations, and competition for qualified, experienced therapists has been
intense in the recent past. Therapists may be attracted to hospitals and other
facilities that may provide predictable locations and work schedules in contrast
to the nature of the Company's services at patient care facilities, which
provide less predictable work schedules and changing locations. Although there
can be no assurance, the Company believes that it is able to compete effectively
for therapists due to its local Pennsylvania and Eastern Ohio presence near
several certified rehabilitation schools, provision for reimbursement for
continuing education, quality reputation and appropriate compensation and
benefits package. In addition, the Company believes that its management
philosophy appeals to many therapists because it encourages therapists to manage
the operations of their respective patient care facilities or outpatient
rehabilitation clinics on a semi-autonomous basis, including scheduling,
treatment approaches, facility financial performance, marketing and staff
retention. The Company also provides therapists with career advancement
opportunities beyond the individual facility level. To date, the Company has
been able to attract a sufficient number of physical, occupational and speech
therapists, either as employees or as independent contractors; although there
can be no assurance that this trend will continue. The Company believes its
future success will depend in part on its continued ability to attract and
retain highly skilled employees. If the Company is unable to attract and retain
a sufficient number of qualified therapists to





                                       13
<PAGE>   15

staff all of its facilities, the Company could be materially adversely affected.
The Company believes its annual turnover rate among therapists compares
favorably with that of its competitors.

         In most states, physical, occupational and speech therapists, therapist
assistants, certified occupational therapist assistants ("COTAs") and licensed
technicians must be state licensed clinicians with clinically specific
associate, baccalaureate or masters degrees. All therapists must pass a national
licensure exam administered by the states. A certified physical therapy
assistant provides therapy under the supervision of a physical therapist. In
order to be licensed, physical therapy assistants must have an associate degree
from an approved physical therapy assistant program. In addition, Pennsylvania
requires physical therapy assistants to successfully complete a statewide
written and practical examination. COTAs provide therapy under the supervision
of an occupational therapist. In order to be certified, COTAs must also have an
associate degree and have successfully completed a national certification
examination. All Company clinic personnel also undergo an initial orientation
program to familiarize themselves with the Company's policies and procedures.

LIABILITY INSURANCE

         The Company maintains professional malpractice liability insurance up
to $7,000,000 per incident and up to $7,000,000 in the aggregate on all of its
professional employees, in addition to coverage for the customary risks inherent
in the operation of healthcare facilities and businesses in general. The cost of
liability insurance coverage and the availability of such coverage have varied
in recent years with a trend toward higher cost. In an effort to control the
cost associated with such coverage, the Company has shifted from an occurrence
based policy to a claims made policy. While the Company believes its insurance
policies to be adequate in amount and coverage for its current operations, there
can be no assurance that its coverage will, in fact, be or continue to be
available in sufficient amounts and on reasonable terms, or at all.

ITEM 2.   PROPERTIES

         As of December 31, 1999, The Company leased approximately 13,000 square
feet as corporate office space at 665 Philadelphia Street, Indiana,
Pennsylvania, 15701, under lease agreements extending through November 15, 2005.
The Company also leased 68 outpatient rehabilitation clinics in Pennsylvania and
Ohio. A typical outpatient rehabilitation clinic encompasses 2,000-3,000 square
feet of space and it is leased for an average term of five (5) years. Monthly
rental payments range from approximately $300 to $15,000 per month, depending on
the location, size, and utilities and services provided. Management continually
reviews the size and adequacy of the leased properties and adjustments are made,
as office space needs change. In connection with its reorganization of regional
management in 1998, the Company closed three (3) regional management offices in
late 1998 and early 1999. In August of 1999, Northstar discontinued its mobile
diagnostic services business.

ITEM 3.   LEGAL PROCEEDINGS

         In the ordinary course of business, the Company may be subject to
claims and legal actions, from time to time, by patients and others. The Company
does not believe that any such pending actions, if adversely decided, would have
a material adverse effect on its financial condition.

         In January 1997, the Justice Department initiated an action against
Samuel Armfield, III, M.D. for claims amounting to $300,000 in connection with
Dr. Armfield's Medicare billings. Although such claims could be trebled if Dr.
Armfield is convicted, the Company believed that its exposure, through its
dealings with Vascusonics, would aggregate $50,000 to $100,000. In addition, the
Company had recourse against Dr. Armfield for any amounts assessed against the
Company, which the Company planned to aggressively pursue. A payment of $30,000
was made by the Company to Dr. Armfield in full settlement of all other issues
in March 2000.

         In March 1998, Robert J. Smallacombe, a former director, consultant and
employee of the Company filed a Writ of Summons against the Company and other
related parties. Mr. Smallacombe was terminated for cause in May 1997. See Note
15 to the Financial Statements. Mr. Smallacombe believes he is entitled to the
balance of his employment contract and certain stock options that may or may not





                                       14
<PAGE>   16



have been granted. The Company believes that it has counterclaims against Mr.
Smallacombe, and intends to vigorously defend itself against these claims.

         In 1998, Nicholas P. Horoszko filed a demand for arbitration against
the Company for alleged breach of contract. Horoszko is seeking damages of
approximately $225,000. This matter was settled in 1999.

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

         Not applicable.

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS

         On May 31, 1996, NASDAQ suspended trading in the Company's Common
Stock. Prior to its suspension the Company's Common Stock was traded on the
NASDAQ National Market under the symbol "NSTR". Since the suspension, the
Company's Common Stock is quoted on the Over The Counter Bulletin Board
("OTCBB") under the symbol NSTR. On March 20, 2000 the high and low sales prices
for the Common Stock of the Company as reported by OTCBB were $1.062 and $1.156,
respectively. Pursuant to current disclosure guidelines, the following table
sets forth the high and low sales prices for the Common Stock of the Company
during the calendar periods indicated, through December 31, 1999, as reported by
the OTCBB.

CALENDAR YEAR AND QUARTER           HIGH             LOW
-------------------------           ----             ---
1997          First Quarter         3.500            1.187
              Second Quarter        3.000            1.500
              Third Quarter         3.250            1.625
              Fourth Quarter        2.500            0.750

1998          First Quarter         1.125            0.625
              Second Quarter        1.187            0.593
              Third Quarter         1.687            0.500
              Fourth Quarter        1.282            0.500

1999          First Quarter         1.250            0.625
              Second Quarter        0.687            0.312
              Third Quarter         0.625            0.281
              Fourth Quarter        0.437            0.150


         As of December 31, 1999, the Company estimates that there are
approximately 1,000 holders of record, including those who hold in street name,
for its Common Stock.

         The Company has not paid nor does it expect to pay cash dividends on
its Common Stock in the foreseeable future.

         The Company's Registrar and Transfer Agent for its Common Stock is
Continental Stock Transfer and Trust Company, New York, New York.

ITEM 6.   SELECTED FINANCIAL DATA

         The information set forth below is provided for the five years ended
December 31, 1999, 1998,1997, 1996 and 1995.



                                       15
<PAGE>   17



         The following summarizes the activity for fiscal years 1999, 1998,
1997, 1996 and 1995 (dollars in thousands, except share data):

<TABLE>
<CAPTION>
                                                               As of December 31,
                              -----------------------------------------------------------------------------------
                              Restated          Restated           Restated
                              --------          --------           --------            -------            -------
BALANCE SHEET DATA:             1999              1998               1997               1996                1995
                              --------          --------           --------            -------            -------
<S>                           <C>               <C>                <C>                 <C>                <C>
Current Assets                 $ 4,930           $ 6,349            $ 7,098            $ 9,446            $14,603
Intangible Assets, net          19,477            19,811             19,221             21,132             23,947
Total Assets                    26,027            28,602             29,413             34,542             43,355
Current Liabilities             31,916            33,588             29,117             26,265             26,584
Long Term Debt                     306             1,051              2,039              4,901              6,288
Total Liabilities               32,293            34,694             31,212             31,350             32,988
Total Stockholders'
  (Deficit)/Equity              (6,266)           (6,092)            (1,799)             3,192             10,367

                                                      Twelve Months Ended December 31,
                              ------------------------------------------------------------------------------------
                              Restated          Restated           Restated           Restated
                              --------         ----------         ----------         ----------         ----------
INCOME STATEMENT DATA           1999              1998               1997               1996               1995
                              --------         ----------         ----------         ----------         ----------
Net Revenue                     26,622         $   30,664         $   31,655         $   37,872         $   15,771
Gross Profit                    14,145             15,522             14,331             19,083              5,131
Operating Income/(Loss)          1,946              1,764             (4,045)            (7,133)(A)        (11,962)
Non-Operating Expenses           1,934              1,481              2,228              2,226              1,041
Extraordinary Loss                  --                 --                 --                 --               (274)
Net Income/(Loss)                 (217)               401             (5,613)           (10,124)(A)        (13,101)
Net Income/(Loss)per Share
  (Basic and Diluted)            (0.04)              0.07              (0.95)             (1.63)(A)          (3.28)
Weighted Average Number
   of Common Shares          5,975,424          5,975,424          5,880,501          6,216,840          3,996,147
Cash Dividends
  Per Common Share                  --                 --                 --                 --                 --
</TABLE>


(A) The 1996 restatement of $1,177,000 relates to a PVL charge originally
recorded as a disproportionate dividend in Equity that has been corrected to be
recorded as additional compensation expense.

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
         RESULTS OF OPERATIONS

FORWARD LOOKING STATEMENTS

         From time to time, the Company will publish forward looking statements
relating to such matters as anticipated financial performance, business
prospects, and projected plans for and results of its operations. The Private
Securities Litigation Reform Act of 1995 provides a safe harbor for
forward-looking statements. In order to comply with the terms of the safe
harbor, the Company notes that a variety of factors could cause the Company's
actual results to differ materially from the anticipated results or other
expectations expressed in the Company's forward looking statements. The risks
and uncertainties that may affect the operations and performance of the
Company's business include the following: changes in regulatory, governmental
and payor policies regarding reimbursement; competition, both directly in terms
of other providers of physical therapy and other services, and the competition
for qualified personnel; the outcomes of the current litigation involving the
Company; potential and past defaults in borrowing arrangements, including an
inability to comply with various covenants in connection with such financing;
the ability of the Company to have its Common Stock relisted on a national
market or exchange; the uncertainties surrounding the healthcare industry in
general; and the ability of the Company to refinance its senior debt under
reasonable terms and conditions.

OVERVIEW

         The information presented in this Management's Discussion and Analysis
is of a summary nature; please refer to the Financial Statements, including
notes, which are included in this report.




                                       16
<PAGE>   18

         The consolidated financial statements include the accounts of the
Company, its wholly owned subsidiaries, and its majority interest in
partnerships and joint venture arrangements only for the period subsequent to
their acquisition. All significant intercompany balances and transactions have
been eliminated. The Company uses the equity method of accounting for entities
that it does not have majority ownership in.

         The financial statements for the years ended December 31, 1997, 1998
and 1999 have been restated to correct an error in recording the Company's 49%
ownership interest in an outpatient clinic partnership. The Company had
previously consolidated this partnership since the Company controlled the
operation of the Partnership. These statements have been corrected to reflect
the operations of the partnership using the Equity Method of Accounting. This
correction had no effect on Net Income or Shareholders' Equity of the Company.

         Management fee operating expenses have also been restated for better
presentation with no effect on operating or net income. Management fee expenses
had previously been reported on a separate line item in Operating Expenses.
These costs have now been more properly included in the appropriate expense
categories, primarily Cost of Service and Selling, general and administrative
expenses.

         The Company has recorded impairment charges during the three years
ended December 31, 1999. These charges have been restated and shown on a
separate line item in Operating Expenses. In 1997 and 1998, $707,000 and
$837,000, respectively, have been reclassified from Restructuring and other
non-recurring items to the restated Asset Impairment Charges line item. In 1999,
$938,000 was reclassified to this account with $9,000 from Restructuring and
other non-recurring items, $595,000 from Amortization of intangibles and
$334,000 from Other (income)/expense, net in Non-Operating Expenses. See Note 3
for a discussion of the nature of the items making up these charges. These
accounts were restated to more properly present the total impairment charges
incurred during the periods presented.

         The total of all restatements had no effect on net income/loss for any
of the years presented. However, total revenue decreased by $1,245,000,
$1,217,000 and $951,000 for the years 1999, 1998 and 1997, respectively. Total
operating expenses decreased by $535,000, $1,122,000 and $1,758,000 for the same
periods. Operating income and non-operating income for 1999 and 1998 decreased
by $631,000 and $386,000, respectively. The 1997 operating loss increased by
$104,000. As a result of the restatements non-operating expenses decreased by
$480,000, $189,000 and $51,000 in 1999, 1998 and 1997, respectively. Income
before income taxes in 1999 and 1998 decreased by $151,000 and $197,000,
respectively. Minority interest increased by the same amount for the respective
periods resulting in no effect on net income.

         The 1997 Loss before income taxes increased by $53,000 and minority
interest decreased by the same amount resulting in no effect on net income.



                                       17
<PAGE>   19



<TABLE>
<CAPTION>
                   CONDENSED SUMMARY OF RESTATEMENTS FOR 1999
                                        1999            1999            1999
(In thousands)                         AS FILED      RESTATEMENTS     RESTATED
<S>                                   <C>           <C>              <C>
TOTAL REVENUE                           27,867         (1,245)         26,622

GROSS PROFIT                            15,311         (1,166)         14,145

TOTAL OPERATING EXPENSES                12,734           (535)         12,199

OPERATING INCOME                         2,577           (631)          1,946

TOTAL NON-OPERATING EXPENSES             2,414           (480)          1,934

INCOME BEFORE MINORITY INTEREST            177           (151)             26

MINORITY INTEREST                          394           (151)            243

NET (LOSS)                                (217)            --            (217)
</TABLE>


<TABLE>
<CAPTION>
                   CONDENSED SUMMARY OF RESTATEMENTS FOR 1998
                                          1998           1998           1998
(In thousands)                          AS FILED      RESTATEMENTS    RESTATED
<S>                                    <C>           <C>               <C>
TOTAL REVENUE                            31,881         (1,217)         30,664

GROSS PROFIT                             17,030         (1,508)         15,522

TOTAL OPERATING EXPENSES                 14,880         (1,122)         13,758

OPERATING INCOME                          2,150           (386)          1,764

TOTAL NON-OPERATING EXPENSES              1,670           (189)          1,481

INCOME BEFORE MINORITY INTEREST             846           (197)            649

MINORITY INTEREST                           445           (197)            248

NET INCOME                                  401             --             401
</TABLE>


<TABLE>
<CAPTION>
                   CONDENSED SUMMARY OF RESTATEMENTS FOR 1997
                                         1997           1997            1997
(In thousands)                         AS FILED     RESTATEMENTS      RESTATED
<S>                                   <C>          <C>              <C>
TOTAL REVENUE                           32,606           (951)         31,655

GROSS PROFIT                            16,193         (1,862)         14,331

TOTAL OPERATING EXPENSES                20,134         (1,758)         18,376

OPERATING (LOSS)                        (3,941)          (104)         (4,045)

TOTAL NON-OPERATING EXPENSES             2,279            (51)          2,228

(LOSS) BEFORE MINORITY INTEREST         (5,450)           (53)         (5,503)
MINORITY INTEREST                          163            (53)            110

NET (LOSS)                              (5,613)            --          (5,613)
</TABLE>




                                       18
<PAGE>   20


RESULTS OF OPERATIONS

1999 COMPARED TO 1998

Total Revenue

         In 1999, the Company's total revenues declined by $4,042,000, or 13.2%,
from $30,664,000 for 1998 to $26,622,000 for 1999. Revenues decreased
approximately $2,830,000 as the result of the closure or termination of certain
clinics and contracts, and the termination of diagnostic services. A decline in
management fee revenues of approximately $706,000 is attributable to the
termination of all mobile diagnostic services effective August 13, 1999. The
Company opened new outpatient offices and entered into new contracts that
resulted in an increase in net patient service revenues of $912,000. Net patient
service revenue from continuing operating units decreased by $594,000. However,
this was more than offset from charges related to Medicare 1996-1998 Audit
adjustments of $995,000. No significant future audit adjustments are expected,
as Medicare began paying for services on a fixed fee basis effective January 1,
1999. Revenues from joint venture operations in nuclear imaging services
decreased approximately $824,000.

Costs of Service and Gross Profit

         Due to the decrease in total revenues and the continued stabilization
of the Company's workforce and revenue base, subcontracted services continue to
be reduced and direct labor costs declined, thereby decreasing the Company's
costs of service by $2,665,000 from $15,142,000 in 1998 to $12,477,000 in 1999,
or 17.6%. As a percentage of net patient service revenue, costs of service
decreased from 52% in 1998 to 48.4% in 1999. As a result of the decrease in net
patient service revenue in 1999, gross profit decreased $1,377,000, from
$15,522,000 in 1998 to $14,145,000 in 1999. As a percentage of total revenue,
gross profit increased, from 50.6% of revenue in 1998 to 53.1% in 1999.

Selling, General and Administrative (SG&A) Expense

         Total SG&A expenses for the year declined $1,403,000 from $10,752,000
in 1998 to $9,349,000 in 1999. Included in this net decrease was a reduction of
administrative and clerical salaries of $725,000. In addition, favorable legal
settlements increased by $272,000 from 1998 to 1999. The net decrease in SG&A
expense is the result of reduced expenses due to the cost reductions begun in
1998 and more fully implemented in 1999. In addition, the 1999 settlement of
substantially all litigation related to the Keystone acquisition and consent
solicitation issues more fully discussed in Item 13. The Company continues to be
committed to reductions in overhead expenses wherever possible by evaluation of
administrative expenses for necessity and value giving consideration to current
operating levels and planned growth.

Bad Debt Expense

         The Company incurred bad debt expense of $342,000 or approximately 1.3%
of net patient service revenue during 1999 versus $365,000 or approximately 1.3%
during 1998. In 1999, bad debt expense without any recoveries of previous
written-off amounts would have been 2.5% of net patient service revenue.

Restructuring and Non-Recurring Items

         During 1998, the Company continued to incur significant legal,
restructuring fees and related costs from the continuing reorganization of the
Company. As a result of the resolution of substantially all of these matters by
the end of 1999, the expenses deemed non-recurring decreased during 1999 to
$50,000 compared to $1,114,000 for 1998.

Depreciation and Amortization

         Operating expenses include amortization of intangibles arising from
past acquisitions, depreciation and other deferred charges, including financing
costs. Amortization of intangibles for 1999 was $880,000 a decrease of $49,000
from $929,000 in 1998. This includes a $151,000 charge for





                                       19
<PAGE>   21

deferred financing costs for the Senior Debt that was refinanced in 1999. The
Company expects that amortization of intangibles will continue to decrease in
2000 as a result of additional intangible asset write-offs that occurred during
1999 (see note below) for impaired goodwill associated with the Company's mobile
diagnostic business that was closed in 1999.

Impairment Charge for PVL

         In August 1999, the Company terminated the remaining operations of its
Penn Vascular Lab, P.C. (PVL) mobile diagnostics business and recorded a related
charge of $929,000 in the third quarter, for goodwill and fixed asset
impairment, related to the closing of this business. The amount of the charge
was determined by calculating the difference between the sale proceeds of PVL
with the net book value of PVL's goodwill and fixed assets. The Business was
sold in October 1999.

Interest and Other Non-Operating Expenses

         Interest expense was $2,050,000 for 1999 compared to $1,934,000 for
1998. The increase can be attributed to a .5% increase in the Company's weighted
average interest rate from 1998 to 1999. This was primarily due to increases in
the interest rates charged by the Company's senior lender and as a result of
increases in the prime rate during 1999. The Company reported net other
non-operating expense of $29,000 in 1999 compared to net other non-operating
income of $263,000 in 1998. The income for 1998 includes $190,000 for gains that
resulted from the sale of two joint venture interests.

Income Taxes

         The Company has recorded a tax benefit of $14,000 for 1999 versus a
benefit of $366,000 during 1998. The benefit in 1998 is a result of the
amendment of prior year tax returns for loss carry backs that resulted in a
federal refund of $272,000 that was received in February 1999. As a result of
the losses experienced in prior years, the Company does not anticipate any
significant taxable income for federal or state income tax purposes in 1999 or
2000.

Net Income

         The Company reported a net loss for the year ended December 31, 1999 of
$217,000 compared to net income of $401,000 for the same period in 1998. This
decrease in profitability can be attributed primarily to costs associated with
the Company's mobile diagnostic business, which was sold in 1999. These costs
included 1999 operating losses of $408,000, as well as a charge for the
impairment of related fixed assets and goodwill of $334,000 and $596,000,
respectively. The Company also recorded charges of $995,000 related to Medicare
audit adjustments for the years 1996 - 1998. These costs were partially offset
by a $236,000 decrease in restructuring and other non-recurring items in 1999 as
compared to 1998.

1998 COMPARED TO 1997

Total Revenue

         In 1998, the Company's total revenues declined by $991,000, or 3.1%,
from $31,655,000 for 1997 to $30,664,000 for 1998. Revenues decreased
approximately $2,811,000 as the result of the closure or termination of certain
clinics and contracts, including $370,000 for the termination of a sub-acute
contract in Illinois, and the termination of diagnostic services in Ohio.
Management fee revenues related to diagnostic services decreased approximately
$232,000 and the Company opened new outpatient offices and entered into new
contracts that resulted in an increase in net patient service revenues of
$1,004,000. Net patient service revenue from continuing operating units
increased $944,000 as a result of the Company's expanded sales and marketing
efforts that contributed to an increase in the number of patient referrals in
1998 and due to a revision in the Company's fee schedule effective February 1,
1998, that positively affected net reimbursement from certain payors. Revenues
from joint venture operations in nuclear imaging services increased
approximately $104,000.




                                       20
<PAGE>   22


Costs of Service and Gross Profit

         Due to the decrease in total revenues and the continued stabilization
of the Company's workforce and revenue base, subcontracted services were
significantly reduced and direct labor costs declined, thereby decreasing the
Company's costs of service by $2,182,000 from $17,324,000 in 1997 to $15,142,000
in 1998, or 12.6%. As a percentage of net patient service revenue, costs of
service decreased from 58% in 1997 to 52% in 1998. As a result of the decrease
in costs, gross profit increased $1,191,000, from $14,331,000 in 1997 to
$15,522,000 in 1998. As a percentage of total revenue, gross profit also
increased, from 45.3% of revenue in 1997 to 50.6% in 1998.

Selling, General and Administrative (SG&A) Expense

         Total SG&A expenses for the year declined $1,369,000 from $12,121,000
in 1997 to $10,752,000 in 1998. The expense for 1997 includes a provision of
approximately $441,000 for professional fees compensated with warrants and the
expense for 1998 was reduced by approximately $289,000 for the resolution of a
legal matter for less than the accrual that had been previously booked.
Excluding these items, selling, general and administrative expenses in 1998
decreased $12,000, or less than 1.0%. This slight decrease is the result of
reduced expenses due to the cost reductions implemented in 1998 offset by
increased expenses due to the expansion of corporate services in 1998 in the
areas of sales, marketing, and provider relations that has contributed to the
increased revenues in continuing operations.

Bad Debt Expense

         The Company incurred bad debt expense of $365,000 or approximately 1.3%
of net patient service revenue during 1998 versus $1,965,000 or approximately
6.6% during 1997. The decrease in bad debt expense was accomplished through
increased billing efficiency, the use of a new collection agency in 1998 that
has increased the rate of bad debt recoveries, and recoveries of contract
billings deemed uncollectible in prior years. The expense in 1997 included a bad
debt reserve of $400,000 directly attributed to a sub-acute contract in Illinois
that had been determined to be uncollectible. Without this specific reserve, bad
debt expense would have been approximately 5.2% of net patient service revenue
in 1997. In 1998, bad debt expense without any recoveries would have been 2.8%
of net patient service revenue, which is a more likely level of bad debt expense
that can be expected in the future, after the catch-up effect of the new
collection procedures is fully realized and the full recovery of the contract
billings that are now being paid.

Restructuring and Non-Recurring Items

         During 1998, the Company continued to incur additional legal and other
professional fees resulting from the continuing reorganization of the Company
and litigation both against and on behalf of the Company in various matters. As
a result of the resolution of a majority of these matters by the end of 1997,
the expenses deemed non-recurring decreased during 1998 to $277,000 compared to
$1,871,000 for 1997.

Depreciation and Amortization

         Other operating costs include amortization of intangibles arising from
past acquisitions, depreciation and other deferred charges, primarily financing
costs. Amortization of intangibles for 1998 of $929,000 declined by $188,000
from the 1997 total, reflecting (1) intangible asset write-offs in 1997 and (2)
completion of the amortization period for certain assets acquired during
previous acquisitions by the Company. The Company expects that amortization of
intangibles will continue to decrease in 1999 as a result of additional
intangible asset write-offs that occurred during 1998.

Interest and Other Non-Operating Expenses

         Interest expenses were $1,934,000 for 1998 compared to $2,229,000 for
1997. The decrease can be attributed to a decrease in the Company's weighted
average interest rate from 1997 to 1998. This was primarily due to decreases in
the interest rates charged by the Company's senior lender as a result of
decreases in the prime rate during 1998. The Company reported net other
non-operating income of





                                       21
<PAGE>   23

$263,000 in 1998 compared to net other non-operating expenses of $50,000 in
1997. The income for 1998 includes $190,000 for gains that resulted from the
sale of two joint venture interests, while the expense for 1997 included $66,000
of expense related to the disposal of fixed assets.

Income Taxes

         The Company has recorded a benefit of $366,000 for 1998 versus a
benefit of $770,000 during 1997. The benefit in 1997 is a result of the
amendment of prior year tax returns for loss carry backs that resulted in
significant federal and state income tax refunds that were received in 1997. The
benefit in 1998 is a result of the amendment of prior year tax returns for loss
carry backs that resulted in a federal refund of $272,000 that was received in
February 1999. As a result of the losses experienced in both 1997 and prior
years, the Company does not anticipate any significant taxable income for
federal or state income tax purposes in 1998 or 1999.

Net Income

         The Company reported net income for 1998 of $401,000 compared to a loss
of $5,613,000 for the same period in 1997. This significant increase in
profitability can be attributed to the improved efficiency of operations, the
decrease in the amount of restructuring and other non-recurring expenses and the
decline in bad debt expense.

LIQUIDITY AND CAPITAL RESOURCES

         In 1999, the Company successfully negotiated with its senior debtor to
obtain an Amended and Restated Credit Agreement with Cerberus Capital
Management, LLC through December 31, 2000. There can be no assurance that the
Company will be able to fully comply with the repayment schedule through the
Year 2000 and to obtain a restructuring of the remaining debt, at December 31,
2000. In addition, the Company has other obligations, including obligations
incurred in the Keystone merger with the Zaucha's and professional fees with
legal and other professional services firms that it is currently unable to fully
pay. The Company has reached payment agreements related to the fees of these
parties; however, there is no assurance that the Zaucha's will continue to
forbear on the amounts that are due.

         During 1999, the cash provided by operations was $1,037,000 versus
$1,868,000 during 1998. This decrease in cash provided from operations can be
attributed to a number of items, but is primarily the result of the reductions
in accrued expense liabilities in 1999.

         The net cash used in investing activities was $273,000 in 1999 as
compared to $240,000 in 1998, primarily related to capital expenditures for both
years. During 1999, the Company made payments on long-term debt of $1,544,000,
which were primarily scheduled debt and lease payments, as compared to payments
of $1,079,000 in 1998. In addition, the Company paid approximately $227,000 to
minority interest holders in companies controlled by Northstar and $131,000
under contractual obligations with certain employees. During 1999, the Company
entered into capital lease arrangements to finance approximately $281,000 of
capital equipment purchases, but did not make any additional material borrowings
under any other debt arrangements. The Company holds ownership interest in
several partnerships (Minority Interests) that it controls ranging from 49% -
85%. Distribution payments are made on a regular basis to the partners based
upon performance of the individual partnerships and their respective percentage
of ownership. The timing of such distributions recognizes the cash flow from
their operations and does not adversely effect liquidity. During 1999, the
Company made distribution payments to partners in profitable partnerships of
$227,000, composed to $236,000 for 1998.

         On March 15, 2000, the Company signed a definitive agreement to become
a wholly owned subsidiary of Benchmark Medical, Inc. of Malvern, PA. Benchmark
is a newly formed, privately held company funded by Wind Point Partners, a
private equity investment firm based in Chicago, IL.

         The agreement calls for Benchmark to acquire all of the outstanding
shares and certain options and warrants of Northstar stock at $1.50 per share.
The options and warrants are triggered upon the occurrence of specified events
set forth in the option and warrant agreements.



                                       22
<PAGE>   24


         The total consideration is approximately $36 million, which includes
payments to stockholders and repayment or assumption of certain obligations of
the Company. The transaction is subject to certain closing conditions including
expiration of the Hart-Scott Rodino waiting period. The transaction is expected
to close during the second calendar quarter of this current year.

         A copy of the Agreement and Plan of Merger was attached as Exhibit 2.1
to the Company Form 8-K filing on March 20, 2000.

SUMMARY OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

         The Company is presently experiencing certain liquidity difficulty as a
result of the expenses related to the contest for corporate control in 1997; the
investigation and litigation expenses arising out of certain actions taken by
the Company's pre-1996 management; prior year's operating losses; and prior
obligations to buy out profit-sharing interests in several of the Company's key
clinics. As a result of these circumstances, the Company's access to the capital
and debt markets has been severely impaired. If it is unable to raise additional
capital and/or effect a more permanent restructuring of the terms of its
outstanding senior long-term debt obligations at December 31, 2000, the Company
could be required to file a petition for relief under the provisions of the
Bankruptcy Code.

         In response to these developments, the Company continues to focus its
efforts on improving the performance of its core physical therapy and
rehabilitation businesses. The Company has been successful in selling its mobile
diagnostic business. The Company is also continuing to review all expenses in an
effort to reduce costs wherever possible, and to seek additional sources of
revenues. The Company's Chairman has indicated that he will not demand immediate
reimbursement of all amounts currently due to him and his family partnership.

         There can be no assurance that the Company will be successful in
raising additional equity or other capital, or that it will be in a position to
do so on terms that will not significantly dilute the equity interest of the
Company's existing stockholders. The Company is not currently eligible to
utilize Form S-3 to register offerings of securities under the Securities Act of
1933, and its shares are not currently listed on either the NASDAQ National
Market or the NASDAQ Small Cap Market. These circumstances could adversely
affect the Company's ability to attract additional equity capital.

RECENT ACCOUNTING PRONOUNCEMENTS

         During 1999, the Company adopted SFAS No. 133, No. 134, No. 135, No.
136 and No. 137. SFAS No. 133 as amended by SFAS No. 137 "Accounting for
Derivatives and Hedges" establishes standards for the reporting of these
instruments in the financial statements. Since the Company does not have any
significant derivatives or hedges, this pronouncement has had no impact on the
financial statements. SFAS No. 134, 135 and 136 refer to matters not directly
related to Company operations.

YEAR 2000 ISSUE

         The Company suffered no significant impacts from the changing of the
calendar year to the Year 2000. The Company's operations were not interrupted.
The Company has continued to conduct business with no noticeable difficulty
since the beginning of the calendar year 2000. While effects of the Year 2000
may not be noticed until a later time, the Company believes that it has taken
appropriate measures to mitigate any future risk. The Company also believes
there are no significant continuing contingencies related to customers or
vendors. Costs incurred by the Company related to this issue were not
significant and all such costs have been expensed as incurred in the Company's
consolidated statements of income.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT
         MARKET RISK SENSITIVE INSTRUMENTS

         The Company currently does not invest excess funds in derivative
financial instruments or other market risk sensitive instruments for the purpose
of managing its foreign currency exchange rate risk or for any other purpose.




                                       23
<PAGE>   25

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

         This information is set forth as exhibits beginning on page F-1.

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
         AND FINANCIAL DISCLOSURE - Not applicable.





                                       24
<PAGE>   26




ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

(a)      Identification of Directors

<TABLE>
<CAPTION>
             Name            Age                 Position                     Held Since
             ----            ---                 --------                     ----------
<S>                         <C>      <C>                                     <C>
Michael S. Delaney*           50      Secretary and Assistant Treasurer       March 1997
James R. Martin               53      Executive Vice-President, Chief         October 1999
                                      Financial Officer, Treasurer and
                                      Director
Lawrence F. Jindra, M.D.      41      Director                                March 1997
James H. McElwain             54      Director                                March 1997
Mark G. Mykityshyn            42      Director                                March 1997
Roger J. Reschini             62      Director                                March 1997
David B. White                44      Director                                March 1997
Thomas W. Zaucha              54      Chairman of the Board of                November 1995
                                      Directors, President and Chief
                                      Executive Officer
</TABLE>

* Mr. Delaney is not an employee of the Company or its sudsidiaries.

         THOMAS W. ZAUCHA (54) is the Chairman of the Board of Directors,
President and Chief Executive Officer of the Company and has been a Director of
the Company since December 1995. His term as a Director is for 1998 - 1999. He
will stand for re-election at the next Annual Meeting. Mr. Zaucha, founder of
Keystone Rehabilitation Systems, Inc., served as its Chairman, President and
Chief Executive Officer until Keystone merged with Northstar in 1995. Mr. Zaucha
became Chairman of the Board and Chief Executive Officer of Northstar in March
1996. Mr. Zaucha has approximately thirty (30) years of experience in the health
care and physical therapy related industries. He currently serves on the State
Board of Physical Therapy and is a member of the Pennsylvania Physical Therapy
Association and the American Physical Therapy Association. Mr. Zaucha was the
recipient of the Entrepreneur of the Year Award (Health Care) in 1992 and was
named Civic Leader of the Year in 1996. Mr. Zaucha is a member of numerous
community and civic organizations. His business address is that of the Company's
address.

         JAMES R. MARTIN (53) joined the Company on November 1, 1999 as
Executive Vice President, Chief Financial Officer and Treasurer. Mr. Martin was
also appointed to the Company's Board of Directors and will stand for
re-election at the next Annual Meeting. He is involved in strategic financial
planning decisions for the Company including debt financing alternatives and
financial reporting. Prior to joining the Company, Mr. Martin served as
Treasurer of Glenshaw Glass in Pittsburgh, Pennsylvania from 1997 - 1999 with
additional domestic and international responsibilities for Glenshaw's parent
company, G&G Investments. Mr. Martin headed his own CPA and Consulting firm from
1993 - 1997, prior to that he served as Controller at the Rochester & Pittsburgh
Coal Company. He began his public accounting experience with Price Waterhouse
Coopers LLP and Arthur Andersen LLP in Pittsburgh. Mr. Martin received his
undergraduate and MBA degrees from Duquesne University and he is an actively
licensed Certified Public Accountant in Pennsylvania and is a member of PICPA,
AICPA and Financial Executives Institute. Mr. Martin's business address is that
of the Company's address.

         LAWRENCE F. JINDRA, M.D. (41) has served as a Director of the Company
since March 1997 and is Chairman of the Special Committee and a member of the
Compensation & Nominating Committee of the Board of Directors. His term as a
Director of the Company is for 1998-1999. He will stand for re-election at the
next Annual Meeting. Dr. Jindra currently serves as the President of Floral Park
Ophthalmology, PC, and on the adjunct faculty of the Department of Ophthalmology
of the College of Physicians and Surgeons of Columbia University. Dr. Jindra has
also served as the Assistant Chief of Ophthalmology of Northport Veterans
Affairs Medical Center and as the Founder and Director of the Glaucoma
Consultation Unit since 1994 and 1989, respectively. From 1992 to 1993, Dr.
Jindra served as a White House Fellow as a member of the Office of Science &
Technology Policy and as a member of the President's Task Force for National
Health Care Reform. Dr. Jindra received a Master's Degree in Public
Administration (Medicine, Science and






                                       25
<PAGE>   27

Technology Concentration) from Harvard University and a Master of Science Degree
in Management from Oxford University. His business address is 5 Covert Avenue,
Floral Park, New York.

         JAMES H. MCELWAIN (54) has served as a Director of the Company since
March 1997 and is Chairman of the Audit Committee of the Board of Directors. His
term as a Director of the Company is for 1998-1999. He will stand for
re-election at the next Annual Meeting. Mr. McElwain has served as the Chief
Operating Officer of S.W. Jack Drilling Company since 1995. From September 1988
until December 1994, he served as the Vice President of Finance of Keystone
Rehabilitation Systems, Inc., which merged with the Company in 1995. His
business address is 57 South Ninth Street, Indiana, Pennsylvania.

         MARK G. MYKITYSHYN (42) has served as a Director of the Company since
March 1997 and is Chairman of the Compensation & Nominating Committee and a
member of the Special Committee of the Board of Directors. His term as a
Director of the Company is for 1998-1999. He will stand for re-election at the
next Annual Meeting. Mr. Mykityshyn has served as Managing Director of Centaurus
Ventures, LLC, since August 1998. He has served as Technical and Financial
Consultant with High Technology Venture Finance since 1995. He has also served
as President of Strategy Partners, Inc. from 1993 to 1998, a Management and
Technology Consultant with Booz Allen & Hamilton, Inc. from 1993 to 1997, and
was an Adjunct Professor of Aeronautics at The George Washington University from
1994 to 1995. Prior to 1993, Mr. Mykityshyn served as an aviator in the United
States Marine Corps (1982-1989) and earned the Degree of Engineer of
Aeronautical and Astronautical Engineering and the Degree of Master of Science
in Aeronautical and Astronautical Engineering from the Massachusetts Institute
of Technology and a Masters Degree in Public Administration (Science and
Technology Policy concentration) from Harvard University (1990-1993). His
business address is 1705 Patriots Way, Atlanta, Georgia.

         ROGER J. RESCHINI (62) has served as a Director of the Company since
March 1997 and is a member of the Compensation & Nominating Committee and the
Audit Committee of the Board of Directors. His term as a director of the Company
is for 1998-1999. He will stand for re-election at the next Annual Meeting. Mr.
Reschini founded the Reschini Agency, Inc., a multiple line insurance agency, in
1979 and founded TFID, Inc., a real estate development company, in 1984. Mr.
Reschini has also been the recipient of a Benjamin Rush Award and a Paul Harris
Fellowship. His business address is 922 Laurel Place, Indiana, Pennsylvania.

         DAVID B. WHITE (44) has served as a Director of the Company since March
1997 and is a member of the Compensation & Nominating Committee and the Audit
Committee of the Board of Directors. His term as a Director of the Company is
for 1998-1999. He will stand for re-election at the next Annual Meeting. Mr.
White is a partner in the law firm of Burns, White & Hickton (Pittsburgh, PA).
Mr. White was admitted to the practice of law in 1982, and he is currently a
member of the Allegheny County, Pennsylvania and American Bar Associations; the
Hospital Association of Pennsylvania; the National Order of Barristers; and the
Academy of Trial Lawyers. Mr. White's principal practice areas are general and
commercial litigation, insurance law and health care law. His business address
is Burns, White & Hickton, 2400 Fifth Avenue Place, 120 Fifth Avenue,
Pittsburgh, Pennsylvania.

         MICHAEL S. DELANEY (50) has served as Corporate counsel to the Company
since November 1995, and as its Secretary and Assistant Treasurer since March
1997. Mr. Delaney has also served as Corporate counsel to Keystone
Rehabilitation Systems, Inc. from 1981 to 1995. Mr. Delaney is in private
practice (Indiana, PA). Mr. Delaney was admitted to the practice of law in 1977,
and is currently a member of the Indiana County, Pennsylvania and American Bar
Associations. His business address is 936 Philadelphia Street, Indiana,
Pennsylvania.

         Directors of the Company hold office until the next annual meeting of
stockholders and until their successors are elected. Executive officers are
elected annually by, and serve at the discretion of, the Board of Directors.
There are no arrangements or understandings known to the Company between any of
the Directors or executive officers of the Company and any other person pursuant
to which any of such persons was elected as a director or an executive officer,
except various employment agreements between the Company and certain executive
officers. (See Executive Compensation, Employment Agreements)





                                       26
<PAGE>   28


SECTION 16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

         Under the Exchange Act, the Company's directors and executive officers,
and any persons holding more than ten percent (10%) of the outstanding shares of
Common Stock are required to report their initial ownership of Common Stock and
any subsequent changes in that ownership to the Securities and Exchange
Commission (the "Commission"). Specific due dates for these reports have been
established by the Commission, and the Company is required to disclose any
failure by such persons to file these reports in a timely manner during the 1999
fiscal year. Based solely upon the Company's review of copies of such reports
furnished to it, the Company believes that since January 1, 1999 through
December 31, 1999, the Company's current executive officers and directors and
the holders of more than ten percent (10%) of the outstanding Common Stock
complied with all reporting requirements of Section 16(a) under the Exchange
Act.

         ITEM 11.   EXECUTIVE COMPENSATION

         The following table shows, for the fiscal years ended December 1999,
1998 and 1997, the cash compensation paid by the Company and its subsidiaries,
as well as certain other compensation paid or accrued for those years, to (i)
any person who served as the Chief Executive Officer during fiscal year 1999,
and (ii) the other most highly compensated executive officers of the Company to
the extent such person's total annual salary and bonus exceeded $100,000 in 1999
(the "Named Executive Officers") in all capacities in which they served.


                           SUMMARY COMPENSATION TABLE

<TABLE>
<CAPTION>
                                                  Annual Compensation                  Long Term
                                                                                     Compensation
                                                                                      Securities
          Name and                                                Other Annual        Underlying       All Other
     Principal Position           Year       Salary       Bonus   Compensation (1)    Options (#)   Compensation (2)
     ------------------           ----       ------       -----   ----------------   ------------   ----------------
<S>                              <C>      <C>            <C>     <C>                <C>            <C>
Thomas W. Zaucha                  1999      $121,555 (3)    $0           $0                0               $300
Chairman, President               1998       $40,200 (3)    $0           $0                0               $300
And CEO                           1997      $125,000 (3)    $0           $0                0               $300

Lisa S. Guarino (Former)          1999       $79,679 (4)    $0           $0               5,000          $1,738
Executive Vice President,         1998      $125,000 (4)    $0           $0              15,000            $300
CFO and Treasurer                 1997      $134,445 (4)    $0           $0              15,000            $300

James R. Martin, CFO              1999       $16,880 (5)    $0           $0             100,000             $0
Executive Vice President,
Treasurer and Director
</TABLE>

(1)      The aggregate amount of all perquisite compensation was less than the
         lesser of $50,000 or 10% of the total annual salary and bonus reported
         for each Named Executive Officer for fiscal years ended December 31,
         1999, 1998 and 1997.

(2)      All dollar amounts listed in this column represent the Company's
         contributions made on behalf of the Named Executive Officers pursuant
         to the Keystone Rehabilitation System's Inc. 401(k) Retirement Savings
         Plan, a qualified plan for the Company's employees pursuant to Section
         401(k) of the Internal Revenue Code of 1986, as amended (the "401(k)
         Plan"). The 401(k) Plan calls for certain annual matching contributions
         up to prescribed limits of fifty percent (50%) of the employee
         contribution with a maximum of $300 per employee. Employees can defer
         up to twenty percent (20%) of their salary. The Named Executive
         Officers were limited to a maximum deferral of $10,000 for 1998 and
         1999, and $9,500 for 1997. The 401(k) Plan also provides that the
         Company can


                                       27
<PAGE>   29

         make discretionary contributions; however, no such contributions were
         made by the Company during the year ended December 31, 1999. During the
         year ended December 31, 1999, the Named Executives were eligible for
         medical benefits under the Company's group insurance policy, including
         disability and life insurance benefits, which are equivalent to such
         benefits, paid to all other full-time employees.

(3)      During 1999, 1998, and 1997, Mr. Zaucha received annual cash
         compensation in the amount of $125,000, $40,200 and $125,000,
         respectively, which consisted entirely of salary pursuant to his
         employment contract which is summarized herein. In 1998, Mr. Zaucha
         voluntarily reduced his salary from $125,000 per year to $12,500 per
         year for the period April 1, 1998 to December 31, 1998. Mr. Zaucha also
         receives funds from the Company in the form of lease payments, note
         payments and other related-party transactions that relate to the merger
         with Keystone. See, "Certain Relationships and Related Transactions."
         Lease payments to Mr. Zaucha for 1999 were $484,986 and $470,360 for
         1998 and 1997. In conjunction with the merger with Keystone, the
         Company is required to make earn out payments to Mr. Zaucha, Alice
         Zaucha and the Zaucha Family Limited Partnership in certain events,
         none of which have been made to this date. The Company also paid
         $87,423 in 1999, $86,920 in 1998, and $80,404 in 1997 for real estate
         maintenance, housekeeping and leasehold improvement construction
         services to Impulse Development Corporation, a company controlled by
         Mr. Zaucha.

(4)      Included within Ms. Guarino's salary for 1997 was a severance payment
         in the amount of $61,285 and consulting fees in the amount of $39,506,
         which she received for services rendered between May 8, 1997, and
         August 31, 1997, during which time she was not an employee of the
         Company. Ms. Guarino's position with the Company was terminated on
         September 30, 1996 and she was reinstated to her position in September
         1997 as a result of the Consent Solicitation (defined and discussed
         below). Effective June 4, 1999 Ms. Guarino resigned as Chief Financial
         Officer of the Company and continued her employment with the Company on
         a part-time hourly basis through October 31, 1999. Subsequent to Ms.
         Guarino's employment with the Company, she has provided consulting
         services on an hourly basis totaling $1,437.50 through December 31,
         1999 included in all other compensation. Ms. Guarino was granted 5,000
         stock options on May 7, 1999 that expired on November 30, 1999 due to
         her resignation.

(5)      On November 1, 1999, James R. Martin joined the Company as Executive
         Vice President and Chief Financial Officer at a salary base of $125,000
         annually and entered into an Employment Agreement for a term of three
         (3) years which such term will automatically extend for an additional
         one (1) year period unless terminated by the Company with ninety (90)
         days prior written notice. Mr. Martin was also appointed as a director
         to the Company's Board of Directors on October 27, 1999.

OPTION/SAR GRANTS IN FISCAL YEAR 1999

         The following table sets forth information as of December 31, 1999
concerning individual grants of options to purchase Common Stock made to Named
Executive Officers during 1999.
<TABLE>
<CAPTION>
                                                                                                   Potential Realizable
                                                                                                 Value at Assumed Annual
                        # Securities         % of Total                                            Rates of Stock Price
                         Underlying         Options/SARS        Exercise                        Appreciation for Option Term
                        Options/SARS         Granted to         or Base      Expiration         ----------------------------
           Name           Granted             Employees           Price         Date                 5%            10%
           ----         ------------        ------------        --------     ----------              --            ---
<S>                    <C>                 <C>                 <C>          <C>                <C>              <C>
Lisa S. Guarino              5,000                 2.90%          .50          11/30/99            $ 691         $1,526
James R. Martin            100,000 (1)            57.97%          .16          11/12/04           $4,310         $9,524
</TABLE>

(1) Mr. Martin's options shall become exercisable immediately in the event
    of a change of control.




                                       28
<PAGE>   30


AGGREGATED OPTION/SAR EXERCISES IN FISCAL YEAR 1999 AND FISCAL YEAR END 1999
OPTION/SAR VALUES

         The following table sets forth information regarding the exercise of
Options by Named Executive Officers during 1999. The table also shows the number
and value of unexercised Options that were held by the Named Executive Officers
as of December 31, 1999.

<TABLE>
<CAPTION>
                                                                   Number of Securities
                                                                  Underlying Unexercised           Value of Unexercised
                            Number of Shares                              Options                  In-the-Money Options
                              Acquired on           Value              Exercisable/                    Exercisable/
         Name                   Exercise           Realized            Unexercisable                  Unexercisable
         ----               -----------------      --------       ----------------------           --------------------
<S>                        <C>                    <C>             <C>                              <C>
Lisa S. Guarino                    0                  $0                 10,000/0                          0/0
James R. Martin                    0                  $0              100,000/75,000                   $3,100/9,300
</TABLE>

COMPENSATION OF DIRECTORS

         In 1999 and 1998, each Director who was not an employee of the Company
received a quarterly retainer fee of $3,000 and attendance fees of $1,000 for
each Board of Director meeting at which he was present in person or via
telephone means. For the period January 1 through April 14, 1998, each Director
who was not an employee of the Company received an attendance fee of $1,000 for
each committee meeting at which he was present in person or via telephone means.
Subsequent to April 14, 1998, the committee meeting fee was reduced to $500 per
meeting. In addition, Directors were granted options on July 31, 1998, to
purchase 25,000 shares, at market value. No additional options were granted to
Directors in 1999.

EMPLOYMENT AGREEMENTS

Thomas W. Zaucha

         In November 1995, the Company and Thomas W. Zaucha, President and Chief
Executive Officer of the Company entered into an employment agreement for a term
of five years. The agreement specifies Mr. Zaucha's position and duties,
compensation and benefits, and termination provisions. The agreement also
contains a non-competition provision and a confidentiality provision.

         Under the terms of his employment agreement, Mr. Zaucha serves as the
President and Chief Executive Officer of the Company. Mr. Zaucha is entitled to
an annual base salary of $125,000 which may be increased but not decreased by
the Board at any time based on Mr. Zaucha's contribution to the success of the
Company and such other factors as the Board may deem appropriate. In 1998, Mr.
Zaucha voluntarily reduced his salary from $125,000 per year to $12,500 per year
for the time period April 1, 1998 through December 31, 1998. Mr. Zaucha is also
entitled to insurance and health benefit plans available generally to employees
of the Company and is eligible to participate in and receive grants under stock
option or bonus plans, profit sharing or similar plans and certain other
benefits generally available to employees of the Company. In addition, Mr.
Zaucha is entitled to a company car.

         The agreement with Mr. Zaucha also provides that if his employment is
terminated due to illness or disability, he will continue to receive all
payments when due under the agreement. If Mr. Zaucha's employment with the
Company is terminated by reason of his death, he will receive all payments under
the agreement when due as of the time of his death. If the Company terminates
Mr. Zaucha for cause, Mr. Zaucha will only be entitled to accrued and unpaid
salary.

Lisa S. Guarino

         In September 1997, the Company and Lisa S. Guarino, former Executive
Vice President and Chief Financial Officer of the Company, entered into an
employment agreement for a term of one year which such term was to automatically
extend for additional one year periods unless terminated by the Company with
ninety days prior written notice. The term of this agreement automatically
extended for one year on the first anniversary and was to be effective through
August 31, 1999. Upon a change of control of the Company (as defined in the
agreement) the term of the agreement would automatically extend for one year
from the date of





                                       29
<PAGE>   31

the change of control. In the event of a change of control, Ms. Guarino would
have the option of remaining with the Company or any surviving company or being
paid six months salary as severance.

         Under the terms of the agreement, Ms. Guarino served as the Executive
Vice President and Chief Financial Officer and reported directly to the Chief
Executive Officer. Ms. Guarino was entitled to receive an annual salary of
$125,000. This annual salary could not be reduced without the approval of Ms.
Guarino and could be increased at the Board's discretion, with a minimum
increase of $5,000 per year. Ms. Guarino voluntarily waived her right to the
$5,000 increase in her salary that was due in September 1998 in consideration of
the financial circumstances of the Company. Ms. Guarino is entitled to all
benefits customary to full-time, exempt management employees of the Company. Ms.
Guarino was eligible to receive certain options on a quarterly basis if certain
corporate performance goals are achieved under the 1997 Stock Option Plan. In
1997, Ms. Guarino received no options and in 1998, Ms. Guarino received 15,000
options pursuant to this incentive stock option program under the 1997 Stock
Option Plan. Ms. Guarino resigned as Chief Financial Officer of the Company
effective June 4, 1999. Ms. Guarino continued her employment with the Company on
a part-time hourly basis through October 31, 1999. Subsequent to Ms. Guarino's
employment with the Company, she has provided consulting services on an hourly
basis. As part of her current consulting contract, if she provides consulting
assistance related to a specified and completed change of control of the
Company, she is to receive a payment of $50,000.

James R. Martin

         Effective November 1, 1999 James R. Martin, Executive Vice President
and Chief Financial Officer entered into an employment agreement for a term of
three years (3) which such term will automatically extend for an additional one
(1) year period unless terminated by the Company with ninety (90) days prior
written notice. Upon change of control of the Company (as defined in the
agreement), Mr. Martin will have the option of remaining with the Company or any
surviving company or being paid twelve (12) months pay as severance following
ninety (90) days of employment with the surviving company and written notice of
Mr. Martin's intent to resign. Mr. Martin was also appointed as a Director to
the Company's Board of Directors on October 27, 1999.

         Under the term of the agreement, Mr. Martin serves as the Executive
Vice president and Chief Financial Officer and reports directly to the Chief
Executive Officer. Mr. Martin is entitled to receive an annual salary of
$125,000. This annual salary cannot be reduced without the approval of Mr.
Martin and may be increased at the Board's discretion. Mr. Martin is entitled to
all benefits customary to full-time, exempt management employees of the Company.
Mr. Martin was granted 100,000 options, in accordance with his employment
agreement with 25,000 options vesting on November 1, 1999 and the remaining
options vesting upon the occurrence of specified events or upon change of
control of the Company. In addition, Mr. Martin is entitled to a Company car.



                                       30
<PAGE>   32




      COMPENSATION & NOMINATING COMMITTEE REPORT ON EXECUTIVE COMPENSATION

         Executive Compensation Policy. The Company's compensation policy for
all of its executive officers is formulated and administered by the Compensation
& Nominating Committee of the Board. The Compensation & Nominating Committee
also administers the Company's 1992 Stock Option Plan, the 1994 Non-Employee
Directors Stock Option Plan and the 1997 Stock Option Plan, and the granting of
any options made outside of the Company's stock option plans pursuant to which
the Compensation & Nominating Committee periodically grants options to
directors, executive officers and other employees of the Company.

         The primary goals of the Company's compensation policy are to attract,
retain and motivate skilled executive officers and to encourage them to act in
the best interests of the Company's stockholders. In determining the level of
executive compensation, certain quantitative and qualitative factors, including,
but not limited to, the Company's operating and financial performance, the
individual's level of responsibilities, experience, commitment, leadership and
accomplishments relative to stated objectives, and marketplace conditions are
taken into consideration.

         Chief Executive Officer's Compensation. For 1999, the compensation of
Mr. Zaucha, the Chief Executive Officer of the Company, was set by the terms of
his employment agreement. A summary of the key provisions of Mr. Zaucha's
employment agreement is included elsewhere in this Annual Report. See
"Employment Agreements." Mr. Zaucha also participates in benefit programs that
are generally available to employees of the Company, including medical benefits
and a 401(k) savings plan. Mr. Zaucha has not participated in the Company's
Stock Option Plans to date.

         Executive Officer Compensation. During 1999, the Company also had an
employment agreement with Ms. Guarino, the former Chief Financial Officer of the
Company who resigned from this position effective June 4, 1999. Effective
November 1, 1999, James R. Martin joined the Company as the Chief Financial
Officer under an employment agreement with the Company. A summary of the key
provisions of these employment agreements are included elsewhere in this Annual
Report. See "Employment Agreements." For the year ended December 31, 1999,
compensation paid to the executive officers of the Company was determined
primarily pursuant to the terms of the employment agreements negotiated by the
Company with the executives. For discretionary compensation paid to executive
officers that is not set by employment agreements, the Compensation & Nominating
Committee made subjective determinations on a case-by-case basis based on
recommendations of the Chief Executive Officer as to each executive's merit and
contribution to the success of the Company.

         Section 162(m) of the Code. Section 162(m) of the Internal Revenue Code
of 1986, as amended (the "Code"), generally limits to $1 million the
deductibility by the Company of compensation paid in any one year to any
executive officer named in the Summary Compensation Table. As none of the
executive officers of the Company are currently paid compensation in excess of
$1 million, the Company has not yet developed a policy with respect to Section
162(m) of the Code.
                                        As submitted by the
                                        Compensation & Nominating Committee,
                                              Mark G. Mykityshyn, Chairman
                                              Lawrence F. Jindra, M.D.
                                              Roger J. Reschini
                                              David B. White



                                       31
<PAGE>   33




PERFORMANCE GRAPH

         The following graph compares the cumulative return on the Common Stock
from December 31, 1994 to December 31, 1999 with such return for the NASDAQ
Stock Market Index (U.S.), and The Standard & Poor's Midcap 400 Health Care
Sector Index (an Industry Index consisting of a peer group of 28 companies (1)
("Peer Group Index"). The performance graph assumes an investment of $100 on
December 31, 1994, together with the reinvestment of dividends. Each measurement
point on the graph below represents the cumulative stockholder return as
measured by the closing price at the end of each period during the period from
December 31, 1993 through December 31, 1999.

                  COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*
         AMONG NORTHSTAR HEALTH SERVICES, INC., THE NASDAQ STOCK MARKET
                       (U.S.) INDEX AND A PEER GROUP (2)

<TABLE>
<CAPTION>
                                                 Cumulative Total Return
                               -------------------------------------------------------------
                                12/94     12/95      12/96      12/97       12/98      12/99
                                -----     -----      -----      -----       -----      -----
<S>                           <C>       <C>        <C>        <C>         <C>        <C>
NORTHSTAR HEALTH SERVICES      100.00     83.93      19.64      14.29      14.29       4.00
PEER GROUP                     100.00    137.23     132.57     148.06     191.78     216.02
NASDAQ STOCK MARKET (U.S.)     100.00    141.33     173.89     213.07     300.25     542.43
</TABLE>

(1) The Peer Group Index consists of the following 32 companies: Acuson Corp;
Apria Healthcare Group Inc.; Beckman Coulter, Inc.; Beverly Enterprises, Inc.;
Chiron Corp. NEW; Covance, Inc.; Dentsply Intl., Inc.; Express Scripts, Inc.
NEW; First Health Group Corp.; Forest Labs, Inc.; Foundation Health Sys., Inc.;
Genzyme Corp. NEW; Gilead Sciences, Inc. NEW; Health Mgmt. Assoc., Inc.; Icn
Pharmaceutical Inc.; Ivax Corp; Lincare Hldgs, Inc.; Medimmune, Inc. NEW;
Millennium Pharmaceuticals NEW; Minimed, Inc. NEW; Mylan Labs, Inc.; Omnicare,
Inc.; Oxford Health Plans, Inc.; Pacificare Hlth Sys., Inc., Quorum Health
Group, Inc.; Sepracor, Inc.; Steris Corp.; Stryker Corp.; Sybron Intl.; Total
Renal Care Hldgs, Inc.; Trigon Healthcare Inc.; and Visx, Inc. NEW.

(2) On May 31, 1996, NASDAQ suspended trading in the Company's Common Stock.



                                       32
<PAGE>   34



ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The following table sets forth information as of March 15, 2000 with
respect to the beneficial ownership of the Common Stock by (i) each person known
by the Company to be the beneficial owner of more than five percent (5%) of the
Common Stock; (ii) each person serving as a director of the Company; (iii) each
Named Executive Officer (persons who are named executive officers are identified
in the footnotes to the table below) and (iv) all current directors and
executive officers of the Company as a group. Unless otherwise indicated, all
shares are owned directly and the indicated owner has sole voting and
dispositive power with respect thereto.

<TABLE>
<CAPTION>
        Beneficial Owner                            COMMON STOCK BENEFICIALLY OWNED (1)
        ----------------                            -----------------------------------
                                                          Number (2)       Percent
                                                          ----------       -------
<S>                                                <C>                    <C>
5% HOLDERS (3)
Thomas W. Zaucha (4)                                       963,958          16.1%
Roger J. Reschini (6)                                      341,271           5.6%

DIRECTORS (3)
Lawrence F. Jindra, M.D. (5)                                75,000           1.2%
James R. Martin (7)                                        182,400           3.0%
James H. McElwain (5)                                       75,000           1.2%
Mark G. Mykityshyn (5)                                      75,000           1.2%
David B. White (5)                                          75,000           1.2%

(FORMER) NAMED EXECUTIVE OFFICER
Lisa S. Guarino (8)                                         17,000           0.3%

All Current Directors and Executive Officers as a
group (total 8 persons)                                  1,804,629          27.9%

</TABLE>

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

(1)  Pursuant to the regulations of the Securities and Exchange Commission (the
     "Commission"), shares are deemed to be "beneficially owned" by a person if
     such person directly or indirectly has or shares (i) the power to vote or
     dispose of such shares, whether or not such person has any pecuniary
     interest in such shares, or (ii) the right to acquire the power to vote or
     dispose of such shares within 60 days, including any right to acquire
     through the exercise of any option, warrant or right.

(2)  Represents total number of shares of Common Stock owned by each person,
     which each named person or group has the right to acquire, through the
     exercise of options within sixty (60) days, together with Common Stock
     currently owned, as a percentage of the total number of shares of Common
     Stock outstanding as of March 15, 2000. In accordance with the Commission's
     rules, the ownership percentage of each person or group is calculated
     treating all shares, including options to purchase shares, beneficially
     owned by such person or group as issued and outstanding shares.

(3)  Mr. Thomas W. Zaucha is also a Director, and as the President and the Chief
     Executive Officer of the Company; he is a Named Executive Officer.

(4)  Includes 681,201 shares of Common Stock owned directly by Mr. Zaucha and
     his wife, Alice L. Zaucha, as joint tenants, 207,757 shares of Common Stock
     are held by the Zaucha Family Limited Partnership whose sole partners are
     currently Mr. Zaucha, Mrs. Zaucha and their four children, and 75,000
     shares of Common Stock which are held by Mr. Zaucha as sole beneficial
     owner. If the Special Committee of the Board of Directors recommends the
     issuance of additional shares for payment of obligations due to the
     Zaucha's, Mr. Zaucha's beneficial ownership of Common Stock would increase
     significantly. Mr. Zaucha's business address is Northstar Health Services,
     Inc., 665 Philadelphia Street, Indiana, Pennsylvania 15701.




                                       33
<PAGE>   35


(5)  Comprised entirely of options to purchase shares of Common Stock.


(6)  Includes 108,271 shares of Common Stock indirectly owned by the Reschini
     Agency, Inc., of which Mr. Reschini is a majority owner, 10,000 shares of
     Common Stock which are held by Mr. Reschini as sole beneficial owner and
     options to purchase 75,000 shares of Common Stock. Mr. Reschini is also a
     Director.

(7)  Mr. James R. Martin is also a Director and, as Executive Vice President and
     Chief Financial Officer of the Company, he is a Named Executive Officer.
     The 182,400 shares noted above represent 100,000 options to purchase shares
     of common stock and 82,400 shares, which are held by family members where
     Mr. Martin is a beneficial owner.

(8)  Ms. Guarino was the former Executive Vice President and Chief Financial
     Officer of the Company and as such, is a former Named Executive Officer.
     The 17,000 shares noted above include 7,000 shares of Common Stock, which
     are held by Ms. Guarino as sole beneficial owner and options to purchase
     10,000 share of Common Stock.


ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         Current management does not adopt or affirm any related party
disclosures made in public filings prior to May 16, 1996, including financial
statements. The transactions discussed herein are based on current management's
knowledge at this point in time.

TRANSACTIONS RELATED TO THOMAS W. ZAUCHA

         CONSENT SOLICITATION EXPENSES

         In February 1997, Thomas W. Zaucha, the current Chairman of the Board
of Directors and Chief Executive Officer of Northstar, commenced a solicitation
of Northstar stockholder consents to remove and replace the other members of the
Northstar Board of Directors which at the time consisted of Messrs. Brody,
Jarrett, Pesci, Smallacombe and Watson (the "Brody Board") and effectuate
related changes in Northstar's bylaws (the "Consent Solicitation"). Shortly
thereafter, the Board of Directors terminated Mr. Zaucha's employment with the
Company, though he remained a member of the Board of Directors. On March 24,
1997, Mr. Zaucha delivered executed consents representing the votes of 61% of
the outstanding shares in favor of his proposals and, following confirmation of
the decision of the Delaware Chancery Court on May 8, 1997, Mr. Zaucha resumed
his duties as the Company's Chief Executive.

         Since the decision of the Delaware Chancery Court confirming the
results of the Consent Solicitation was affirmed by the Delaware Supreme Court
on August 1, 1997, the Company is reimbursing Mr. Zaucha for the expenses he
incurred in connection with the Consent Solicitation. To date, those expenses,
which primarily consist of investment advisory fees, legal fees, printing and
proxy solicitation costs and incidental expenses approximate $1,750,000, of
which $1,137,661 has been paid through December 31, 1999.

         KEYSTONE ACQUISITION

          Mr. Thomas Zaucha was the founder and principal owner of Keystone,
which merged with the Company in November 1995 and is now the Company's
principal operating subsidiary. In connection with the Keystone acquisition, Mr.
Thomas Zaucha sold his interest in the former Keystone and has gross debt and
other amounts due directly to him by the Company of $3,919,500 as of December
31, 1999, 1998 and 1997. In addition, Mr. Zaucha's Family Limited Partnership is
due $1,105,500 from the Company as of December 31, 1999, 1998 and 1997.

         As required under the Keystone Merger Agreement, immediately prior to
the merger, Keystone sold, at fair market value determined by a third party
appraisal, all of the real estate previously owned by Keystone to the Zaucha
Family Limited Partnership, of which Mr. Zaucha is a general partner, and a
related entity, in





                                       34
<PAGE>   36

return for a payment of $5,215,568. The parcels of such real estate used in
Keystone's business were then leased to Keystone. At the request of Mr. Zaucha,
the Company formed a Special Committee of the Board to evaluate the fairness of
the lease agreements as well as certain other financial arrangements Mr. Zaucha
has with the Company. The Special Committee has evaluated, through an appraisal
by an independent real estate professional, the fair market lease rates for
these properties, and has determined that the leases are substantially within
the range of market rent in the aggregate, and therefore, a renegotiation of the
leases is not required. The leases are for a period of either five or ten years,
and commenced November 15, 1995. Lease payments were $489,087 for 1999 and
$470,360 for 1998 and 1997. Future minimum lease payments under these leases
aggregate in excess of $3.1 million.

         In conjunction with the acquisition of Keystone by Northstar, Mr.
Zaucha and the Zaucha Family Limited Partnership were granted certain contingent
payments (earn-out payments) based on the financial performance of Keystone
during the period from 1996 to 2000.

         IMPULSE DEVELOPMENT CORPORATION

         The Company also uses, on an as needed basis, the services of Impulse
Development Corporation, a Company controlled by Thomas Zaucha, for real estate
maintenance, housekeeping and leasehold improvement construction. Payments to
Impulse totaled $87,423 in 1999, $86,920 in 1998, and $80,404 in 1997.

         OTHER

         The Reschini Agency, Inc., of which Roger J. Reschini, a current
Director, is a majority owner, acts as the Company's broker for professional and
general liability insurance. During 1999, 1998 and 1997, the Company paid
premiums of approximately $149,000, $132,000 and $214,000, respectively, for
these insurance coverages. The agency received commissions of approximately
$16,000 in 1999, $14,000 in 1998 and $25,000 in 1997. During 1997, the Company
entered into a simultaneous transaction with the Reschini Agency, Inc. whereby
the Company paid $180,000 for insurance premiums and the Reschini Agency
purchased 108,271 shares of Common Stock.

         The Company retains the law firm of Burns, White & Hickton, of which
Mr. David B. White, a current director, is a named partner, for various
litigation matters.

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

(A)      1.   FINANCIAL STATEMENTS

         The financial statements, together with the report thereon of the
Company's independent accountants, are included in this report on the pages
listed below.

<TABLE>
<CAPTION>
                                                                               Page
                                                                               ----
<S>                                                                           <C>
         Report of Independent Public Accountants                               F-1

         Consolidated Balance Sheets
                  as of December 31, 1999 and 1998                              F-2

         Consolidated Statements of Operations
                  for the years ended December 31, 1999, 1998 and 1997          F-4

         Consolidated Statements of Stockholders' Equity
                  for the years ended December 31, 1999, 1998 and 1997          F-5

         Consolidated Statements of Cash Flows
                  for the years ended December 31, 1999, 1998 and 1997          F-7

         Notes to Consolidated Financial Statements                             F-8
</TABLE>



                                       35
<PAGE>   37


<TABLE>
<CAPTION>
<S>                                                                          <C>
(A)      2.   FINANCIAL STATEMENT SCHEDULES

         Report of Independent Public Accountants
                  On Financial Statement Schedule                               F-29

         Schedule II - Valuation and Qualifying Accounts
                  for  the years ended December 31, 1999, 1998 and 1997         F-30
</TABLE>

(A)      3.   LISTING OF EXHIBITS

         THE EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K ARE INCLUDED UNDER
ITEM 14(C) HERETO.

(B)      REPORTS ON FORM 8-K

         The registrant filed a Form 8-K Report dated November 15, 1999. The
         item listed was Item 5, other events; Item 7(c), Exhibits.

(C)      EXHIBITS REQUIRED BY ITEM 601 OF REGULATION S-K

         The following exhibits required by Item 601 of Regulation S-K are set
         forth in the following list and are filed either by incorporation or by
         reference from previous filings with the Securities and Exchange
         Commission or by attachment to this Form 10-K.

3.1.1    Articles of Incorporation of Northstar Health Services, Inc., as filed
         in the state of Delaware, filed as an exhibit to the Company's Annual
         Report on Form 10-K for fiscal year ended December 31, 1996, is
         incorporated by reference.

3.1.2    Amendment to Certificate of Incorporation, as filed in the state of
         Delaware, filed as an exhibit to the Company's Quarterly Report on Form
         10-Q dated August 7, 1998, is incorporated by reference.

3.2.1    Bylaws of Northstar Health Services, Inc., filed as an exhibit to the
         Company's Quarterly Report on Form 10-Q dated August 14, 1997, is
         incorporated by reference.

3.2.2    Amendment to the Bylaws of Northstar Health Services, Inc., filed as
         an exhibit in the Company's Form 8-K, dated September 1, 1998, is
         incorporated by reference.

4.1      1997 Stock Option Plan, filed as an exhibit to the Company's Annual
         Report on Form 10-K for fiscal year ended December 31, 1997, is
         incorporated by reference.

4.2      1992 Stock Option Plan, as amended, filed as an exhibit to the
         Company's Annual Report on Form 10-K for fiscal year ended December 31,
         1996, is incorporated by reference.

4.3      Form S-8 Registration Statement (No. 33-94584), 1992 Stock Option Plan
         filed July 14, 1995, is incorporated by reference.

4.4      Form S-8 Registration Statement (No. 333-57051), 1997 Stock Option
         Plan filed June 17, 1998, is incorporated by reference.

4.5      Post Effective Amendment No. 1 to Form S-8 Registration Statement
         (No. 33-94584), 1994 Stock Option Plan, filed June 17, 1998, is
         incorporated by reference.

10.1     Employment Agreement dated November 15, 1995, between Northstar Health
         Services, Inc. and Thomas W. Zaucha, filed as an exhibit to the
         Company's Form 8-K dated November 15, 1995, is incorporated by
         reference.





                                       36
<PAGE>   38


10.2     Employment Agreement dated October 18, 1999, between Northstar Health
         Services, Inc. and James R. Martin, filed as an exhibit to the
         Company's Form 8-K dated November 15, 1999, is incorporated by
         reference.

10.3     Amended and Restated Credit Agreement and related documents, filed as
         an Exhibit to the Company's Form 10-Q for the quarter ended
         September 30, 1999, is incorporated by reference.

21       Subsidiaries of the Registrant.

23       Consent of Counsel dated July 31, 2000.

27       Financial Data Schedule.

99       Opinion of Counsel dated March 23, 1998.



                                       37
<PAGE>   39


                                   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, on the 9th day of
August, 2000.

                                          NORTHSTAR HEALTH SERVICES, INC.

                                          By: /s/ Thomas W. Zaucha
                                              --------------------------------
                                              Thomas W. Zaucha, Chairman, CEO,
                                              President and Director
                                              (Principal Executive Officer)

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

<TABLE>
<CAPTION>
      Signature                                    Title                                Date
      ---------                                    -----                                ----
<S>                                <C>                                               <C>
/s/ James R. Martin                 Executive Vice President, Chief Financial
--------------------------          Officer, Treasurer and Director
                                    (Principal Accounting and Financial Officer)

/s/ Lawrence F. Jindra, MD          Director
--------------------------

/s/ James H. McElwain               Director
--------------------------

/s/ Mark G. Mykityshyn              Director
--------------------------

/s/ Roger J. Reschini               Director
--------------------------

/s/ David B. White                  Director
--------------------------
</TABLE>




                                       38
<PAGE>   40


   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


   To the Board of Directors and Shareholders of
   Northstar Health Services, Inc. and Subsidiaries:

   We have audited the accompanying consolidated balance sheets of Northstar
   Health Services, Inc. (a Delaware corporation and the Company) and
   Subsidiaries as of December 31, 1999 and 1998, and the related consolidated
   statements of operations, stockholders' equity and cash flows for each of the
   three years in the period ended December 31, 1999. These financial statements
   are the responsibility of the Company's management. Our responsibility is to
   express an opinion on these financial statements based on our audits.

   We conducted our audits in accordance with auditing standards generally
   accepted in the United States. 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.

   As explained in Note 1 to the financial statements, the Company has restated
   the consolidated balance sheets as of December 31, 1999 and 1998 and the
   related consolidated statements of operations, stockholders' equity and cash
   flows for each of the three years in the period ended December 31, 1999.

   In our opinion, the financial statements referred to above present fairly, in
   all material respects, the consolidated financial position of Northstar
   Health Services, Inc. and Subsidiaries as of December 31, 1999 and 1998, and
   the results of its operations and its cash flows for the three years then
   ended in conformity with accounting principles generally accepted in the
   United States.

   The accompanying financial statements have been prepared assuming that the
   Company will continue as a going concern. As discussed in Note 7 to the
   consolidated financial statements, the Company has suffered significant
   losses from operations, has a net capital deficiency, and has not paid all
   creditors on a timely basis. These matters raise substantial doubt about the
   Company's ability to continue as a going concern. Management's plans in
   regard to these matters are also described in Note 7. The financial
   statements do not include any adjustments relating to the recoverability and
   classification of asset carrying amounts or the amount and classification of
   liabilities that might result should the Company be unable to continue as a
   going concern.

                                                        /s/ Arthur Andersen LLP

   Pittsburgh, Pennsylvania,
   March 9, 2000 (Except with respect
   to the matter discussed in Note 21,
   as to which the date is March 15, 2000
   and the matter discussed in Note 1, as
   to which the date is August 2, 2000)



                                      F-1
<PAGE>   41



                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED BALANCE SHEETS (NOTE 1)
                             (Dollars in Thousands)


<TABLE>
<CAPTION>
                                A S S E T S                       Restated       Restated
                                -----------                     December 31,    December 31,
                                                                    1999           1998
                                                                ------------    -----------
<S>                                                            <C>             <C>
CURRENT ASSETS:
    Cash and cash equivalents                                      $   754        $   901
    Accounts receivable-
       Patients, net of allowances for doubtful
          accounts of $430 and $526, respectively                    3,850          4,366
       Management fees                                                  13            224
       Miscellaneous                                                   206            464
    Prepaid expenses and other current assets                          107            394
                                                                   -------        -------
    Total current assets                                             4,930          6,349
                                                                   -------        -------

PROPERTY AND EQUIPMENT, net (Notes  5 and 10)                        1,369          2,201

INTANGIBLE ASSETS, net (Note 4)                                     19,477         19,811
                                                                   -------        -------
INVESTMENT IN SUBSIDIARY                                               141            118

OTHER ASSETS                                                           110            123
                                                                   -------        -------

TOTAL ASSETS                                                       $26,027        $28,602
                                                                   =======        =======
</TABLE>


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


                                      F-2
<PAGE>   42



                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED BALANCE SHEETS (NOTE 1)
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
              LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)        Restated          Restated
                                                                  December 31,      December 31,
                                                                      1999              1998
                                                                  ------------      ------------
<S>                                                              <C>               <C>
CURRENT LIABILITIES:
    Current portion of long-term debt (Notes 6, 7, and 12)
       Senior Debt                                                  $ 13,802           $ 14,083
       Thomas Zaucha and Zaucha Family Limited Partnership             4,989              4,069
       Other debt                                                         87                509
    Accounts payable                                                     591                833
    Accrued expenses (Note 8)
       Thomas Zaucha and Zaucha Family Limited Partnership             9,827              8,907
       Other obligations                                               1,911              4,272
    Contractual obligations to employees (Note 16)                       709                915
                                                                    --------           --------
                  Total current liabilities                           31,916             33,588

LONG-TERM DEBT (Notes 6, 7, and 12)
    Thomas Zaucha and Zaucha Family Limited Partnership                   --                809
    Other debt                                                           306                242
                                                                    --------           --------
                  Total long-term debt                                   306              1,051

MINORITY INTEREST (Note 3)                                                71                 55
                                                                    --------           --------
                  Total liabilities                                   32,293             34,694
                                                                    --------           --------

STOCKHOLDERS' EQUITY (DEFICIT) (Notes 3, 12 and 13)
    Preferred stock, par value
    $.01 per share, 1,000,000 shares
       authorized, none issued                                            --                 --
                                                                                       --------
    Common stock, par value $.01 per share,
       20,000,000 shares authorized; 6,337,988 shares
       issued at December 31, 1999 and 1998
                                                                          63                 63
    Additional paid-in capital                                        22,642             22,599
    Warrants outstanding                                               1,487              1,487
    Retained deficit                                                 (30,005)           (29,788)
    Less: Treasury stock, 362,564 shares
      in 1999 and 1998, at cost                                         (453)              (453)
                                                                    --------           --------
                  Total stockholders' equity (deficit)                (6,266)            (6,092)
                                                                    --------           --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)                $ 26,027           $ 28,602
                                                                    ========           ========
</TABLE>


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



                                      F-3
<PAGE>   43



                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF OPERATIONS (NOTE 1)
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
                 (Dollars in Thousands, Except Per Share Data)

<TABLE>
<CAPTION>
                                                               Restated              Restated              Restated
                                                                 1999                  1998                  1997
                                                              -----------           -----------           -----------
<S>                                                          <C>                   <C>                   <C>
REVENUE:
   Net patient service revenue                                $    25,778           $    29,114           $    29,873
   Management fee revenue                                             844                 1,550                 1,782
                                                              -----------           -----------           -----------
            Total revenue                                          26,622                30,664                31,655

COSTS OF SERVICE                                                   12,477                15,142                17,324
                                                              -----------           -----------           -----------
       Gross profit                                                14,145                15,522                14,331

OPERATING EXPENSES:
    Selling, general and administrative expenses                    9,349                10,752                12,121
    Bad debt expense                                                  342                   365                 1,965
    Restructuring and other non-recurring items (Note 9)               41                   277                 1,871
    Amortization of intangibles (Note 4)                              880                   929                 1,117
    Depreciation and amortization                                     649                   598                   595
    Asset Impairment Charge (Notes  3, 4, 5)                          938                   837                   707
                                                              -----------           -----------           -----------
           Total operating expenses                                12,199                13,758                18,376
                                                              -----------           -----------           -----------

OPERATING INCOME/(LOSS)                                             1,946                 1,764                (4,045)

NON-OPERATING (INCOME)/EXPENSES:
    Interest expense, net                                           2,050                 1,934                 2,229
    Equity in Subsidiary income                                      (145)                 (190)                  (51)
    Other (income)/expense, net                                        29                  (263)                   50
                                                              -----------           -----------           -----------
             Total non-operating  expenses                          1,934                 1,481                 2,228
                                                              -----------           -----------           -----------

INCOME/(LOSS) BEFORE INCOME TAXES                                      12                   283                (6,273)

INCOME TAXES (CREDIT) (Note 14)                                       (14)                 (366)                 (770)
                                                              -----------           -----------           -----------

INCOME/(LOSS) BEFORE MINORITY INTEREST                                 26                   649                (5,503)

MINORITY INTEREST                                                     243                   248                   110
                                                              -----------           -----------           -----------

NET (LOSS)/INCOME                                             $      (217)          $       401           $    (5,613)
                                                              ===========           ===========           ===========

EARNINGS PER SHARE - BASIC                                           (.04)          $      0.07           $     (0.95)
                                                              ===========           ===========           ===========

EARNINGS PER SHARE - DILUTED                                         (.04)          $      0.07           $     (0.95)
                                                              ===========           ===========           ===========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES
  AND EQUIVALENTS - BASIC                                       5,975,424             5,975,424             5,880,501
                                                              ===========           ===========           ===========
WEIGHTED AVERAGE NUMBER OF COMMON SHARES
  AND EQUIVALENTS  - DILUTED                                    5,975,424             6,015,382             5,880,501
                                                              ===========           ===========           ===========
</TABLE>




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



                                      F-4
<PAGE>   44


                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
       CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (NOTE 1)
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
                                         Common Stock           Common Shares Issuable
                                         ------------           ----------------------        Additional         Warrants
                                    Shares Issue     Amount     Shares         Amount      Paid-in Capital     Outstanding
                                    ------------     ------     ------         ------      ---------------     -----------
<S>                                <C>              <C>        <C>            <C>         <C>                 <C>
BALANCE, December 31, 1996            6,229,718         62         --              --         $ 26,208             $ 1,951
  Issuance of common stock              108,270          1         --              --              180                  --
  Issuance of warrants for
  consulting services                        --         --         --              --               --                 441
  Net Loss                                   --         --         --              --               --                  --
                                      ---------        ---      -----           -----         --------             -------
BALANCE, December 31, 1997            6,337,988         63         --              --           26,388               2,392
  Expiration of warrants                     --         --         --              --              905                (905)
  Recognition of stock guarantee
    in connection with acquisition           --         --         --              --           (4,694)                 --
  Net Income                                 --         --         --              --               --                  --
                                      ---------        ---      -----           -----         --------             -------
BALANCE, December 31, 1998            6,337,988         63         --              --           22,599               1,487
  Reprice bank warrants                      --         --         --              --               43                  --
  Net Loss                                   --         --         --              --               --                  --
                                      ---------        ---      -----           -----         --------             -------

                                      =========        ===      =====           =====         ========             =======
BALANCE,  December 31, 1999           6,337,988        $63         --              --         $ 22,642             $ 1,487
                                      =========        ===      =====           =====         ========             =======
</TABLE>


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




                                      F-5
<PAGE>   45




                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
       CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) (NOTE 1)
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
                                                               Treasury Stock
                                          Retained         ----------------------      Notes
                                         (Deficit)          Shares         Amount    Receivable        Total
                                          --------         --------        ------    ----------        ------
<S>                                      <C>               <C>            <C>       <C>               <C>
BALANCE, December 31, 1996                (24,576)          362,564          (453)         --           3,192
  Issuance of common stock                     --                --            --          --             181
  Issuance of warrants for
  consulting services                          --                --            --          --             441

  Net Loss                                 (5,613)               --            --          --          (5,613)
                                          -------           -------          ----       -----          ------
BALANCE, December 31, 1997                (30,189)          362,564          (453)         --          (1,799)
  Expiration of warrants                       --                --            --          --              --
  Recognition of stock guarantee in
    connection with acquisition                --                --            --          --          (4,694)
  Net Income                                  401                --            --          --             401
                                          -------           -------          ----       -----          ------
BALANCE, December 31, 1998                (29,788)          362,564          (453)         --          (6,092)
  Reprice bank warrants                        --                --            --          --              43
  Net Loss                                   (217)               --            --          --            (217)
                                          -------           -------          ----       -----          ------

                                          =======           =======          ====       =====          ======
BALANCE, December 31, 1999                (30,005)          362,564          (453)         --          (6,266)
                                          =======           =======          ====       =====          ======
</TABLE>

     The accompanying notes are an integral part of these financial statements



                                      F-6
<PAGE>   46



                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
              CONSOLIDATED STATEMENTS OF CASH FLOWS (NOTES 1 AND 2)
              FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
                             (Dollars in Thousands)


<TABLE>
<CAPTION>

                                                                                  Restated          Restated          Restated
                                                                                    1999              1998              1997
                                                                                  --------          --------          --------
<S>                                                                              <C>               <C>               <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
    Net (loss)/income                                                              $  (217)          $   401           $(5,613)
    Adjustments to reconcile net (loss)/income to net cash provided by
       operating activities-
          Depreciation and amortization                                              2,156             3,154             3,229
          Legal settlements                                                           (263)               --            (2,001)
          Provision for doubtful accounts                                              342               365             1,965
          Provision for impairment of subsidiary assets                                930                --                --
          Loss on discounted obligation                                                 27                --                --
          Interest on discounted obligation                                            127               209               223
          Loss/(Gain) on sale of equipment                                               7               (13)               66
          Gain on sale of joint venture interests                                       --              (190)               --
          Provision for decrease/(increase) in contractual obligations to
              employees                                                                (75)               26                63
          Compensation expense related to options and warrants                          --                --               441
          Equity in Subsidiary Income                                                 (145)             (190)              (51)
          Minority interest                                                            243               248               110
          Change in current assets and liabilities -
              Decrease/(increase) in receivables                                       708             1,144            (1,350)
              Decrease/(increase) in other current assets                              287              (237)              564
              (Decrease)/increase in accounts payable                                 (242)           (1,568)              353
              (Decrease)/increase in accrued expenses                               (2,848)           (1,481)            2,846
                                                                                   -------           -------           -------
                  Net cash provided by operating activities                          1,037             1,868               845
                                                                                   -------           -------           -------

CASH FLOWS FROM INVESTING ACTIVITIES:

    Capital expenditures                                                              (418)             (540)             (428)
    Deposits, loans and investments                                                     13                57               100
    Proceeds from sale of equipment                                                     10                88
                                                                                                                            31
      Distribution from Subsidiary                                                     122               155                75
                                                                                   -------           -------           -------
                  Net cash used in investing activities                               (273)             (240)             (222)
                                                                                   -------           -------           -------
CASH FLOWS FROM FINANCING ACTIVITIES:
   Proceeds from issuance of common stock                                               --                --               181
   Payments on long-term debt                                                       (1,544)           (1,079)           (1,041)
   Payments of contractual obligations to employees                                   (131)             (143)             (665)
   Distributions to minority interests                                                (227)             (236)             (124)
   Borrowings on long-term debt                                                        991                75                76
                                                                                   -------           -------           -------
                  Net cash used in financing activities                               (911)           (1,383)           (1,573)
                                                                                   -------           -------           -------

NET INCREASE/(DECREASE) IN CASH AND CASH EQUIVALENTS                                  (147)              245              (950)

CASH AND CASH EQUIVALENTS, beginning balance                                           901               656             1,606
                                                                                   -------           -------           -------

CASH AND CASH EQUIVALENTS, end balance                                                 754           $   901           $   656
                                                                                   =======           =======           =======

SUPPLEMENTAL DISCLOSURE OF CASH FLOW DATA:
Interest paid                                                                      $ 2,458           $ 1,877           $ 1,520
Income taxes paid                                                                       --                11                41

NONCASH INVESTING ACTIVITIES:
Capital lease obligations                                                          $   281           $   194           $    43
Earn-out accrued on Keystone acquisition                                             1,407             2,502                --
Accrual for Keystone acquisition stock price guarantee                                  --             4,694                --
Issuance of Common Stock warrants for services                                          --                --               441
Reprice warrants to bank as debt discount                                               43                --                --
</TABLE>

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



                                      F-7
<PAGE>   47



                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.       DESCRIPTION OF BUSINESS ORGANIZATION AND SIGNIFICANT EVENTS:

Nature of Operations

         Northstar Health Services, Inc. and Subsidiaries ("Northstar" or the
"Company") is a regional provider of physical rehabilitation and other
healthcare services in Pennsylvania and Ohio providing services at outpatient
rehabilitation clinics and patient care facilities to patients suffering from
physical disabilities. The goals of rehabilitation therapy are to improve a
patient's physical strength and range of motion, reduce pain, prevent injury and
restore the ability to perform basic activities, including communication. The
Company provides these services primarily through outpatient rehabilitation
clinics and under contractual arrangements with other patient care facilities,
such as nursing homes and hospitals. The term "Company" means, unless otherwise
indicated, the Company and its subsidiaries and their respective predecessors.

Trading of Common Shares

         The Company's Common Stock was traded on the NASDAQ National Market
beginning June 3, 1993 under the symbol "NSTR". After some of the events
outlined below occurred, trading of the Company's Common Stock was halted by the
NASDAQ National Market on May 31, 1996.

Resignation of Auditors and Immediate Board Changes

         In March 1996, the Company's auditors, KPMG Peat Marwick ("KPMG"), who
had been appointed in late 1995, resigned prior to completing an audit of
Northstar. Soon after KPMG's resignation, the Company's former Chairman of the
Board, Mark A. DeSimone was asked to resign from the Company's Board of
Directors along with one independent director. Certain members of management
were also relieved from their duties. Concurrently, Thomas W. Zaucha was
appointed as Chairman of the Board and a non-employee member of the Board of
Directors was appointed to investigate certain allegations of improprieties.

Stockholders' Suits

         Following the resignation of KPMG, while the Company was conducting its
investigation and before the Company filed its suit as discussed below, the
Company was named in suits filed by groups of stockholders. See Note 20 for a
discussion of the settlement of this litigation.

Company's Suit

         Based upon the investigation completed by special independent legal
counsel, the Board of Directors voted to pursue legal actions against the
Company's former Chairman of the Board; certain former employees; the
predecessor auditors of the Company (for years prior to 1995), Richard A. Eisner
& Company; and certain other individuals and entities who were allegedly
involved in improper actions and diversion of funds to other entities. A
complaint was filed in the Western District of Pennsylvania United States
District Court on September 12, 1996. See Note 20 for a further discussion of
the settlement of this litigation.

Consent Solicitation

         In February 1997, Thomas W. Zaucha, the current and then Chairman of
the Board of Directors and Chief Executive Officer of the Company, commenced a
solicitation of Northstar shareholder consents to remove and replace the other
members of the Northstar Board of Directors and effectuate related changes in
Northstar's bylaws (the "Consent Solicitation"). Shortly thereafter, the Board
of Directors terminated Mr. Zaucha's employment with the Company, though he
remained a member of the Board of Directors. On March 24, 1997, Mr. Zaucha
delivered executed consents representing the votes of 61% of the outstanding
shares in favor of his proposals and, following confirmation of the decision by
the Delaware Chancery Court on May 8, 1997, Mr. Zaucha resumed his duties as the
Company's Chief Executive Officer.

         The ruling of the Delaware Chancery Court was appealed to the Delaware
Supreme Court by three of the Board members removed from office as a result of
the Chancery Courts' decision. On August 1, 1997, a unanimous panel of the
Delaware Supreme Court affirmed the decision of the Delaware Chancery Court
confirming the election of the current Board. See Note 9 regarding related legal
costs.




                                      F-8
<PAGE>   48


Restatement

         The financial statements for the years ended December 31, 1997, 1998
and 1999 have been restated to correct an error in recording the Company's 49%
ownership interest in an outpatient clinic partnership. The Company had
previously consolidated this partnership since the Company controlled the
operation of the Partnership. These statements have been corrected to reflect
the operations of the partnership using the Equity Method of Accounting. This
correction had no effect on Net Income or Shareholders' Equity of the Company.

         Management fee operating expenses have also been restated for better
presentation with no effect on operating or net income. Management fee expenses
had previously been reported on a separate line item in Operating Expenses.
These costs have now been more properly included in the appropriate expense
categories, primarily Cost of Service and Selling, general and administrative
expenses.

         The Company has recorded impairment charges during the three years
ended December 31, 1999. These charges have been restated and shown on a
separate line item in Operating Expenses. In 1997 and 1998, $707,000 and
$837,000, respectively, have been reclassified from Restructuring and other
non-recurring items to the restated Asset Impairment Charges line item. In 1999,
$938,000 was reclassified to this account with $9,000 from Restructuring and
other non-recurring items, $595,000 from Amortization of intangibles and
$335,000 from Other (income)/expense, net in Non-Operating Expenses. See Note 3
for a discussion of the nature of the items making up these charges. These
accounts were restated to more properly present the total impairment charges
incurred during the periods presented.

         The total of all restatements had no effect on net income/loss for any
of the years presented. However, total revenue decreased by $1,245,000,
$1,217,000 and $951,000 for the years 1999, 1998 and 1997, respectively. Total
operating expenses decreased by $535,000, $1,122,000 and $1,758,000 for the same
periods. Operating income and non-operating income for 1999 and 1998 decreased
by $631,000 and $386,000, respectively. The 1997 operating loss increased by
$104,000, as a result of the restatements non-operating expenses decreased by
$480,000, $189,000 and $51,000 in 1999, 1998 and 1997, respectively. Income
before income taxes in 1999 and 1998 decreased by $151,000 and $197,000,
respectively. Minority interest increased by the same amount for the respective
periods resulting in no effect on net income.

         The 1997 Loss before income taxes increased by $53,000 and minority
interest decreased by the same amount resulting in no effect on net income.


                   CONDENSED SUMMARY OF RESTATEMENTS FOR 1999
<TABLE>
<CAPTION>
                                                 1999                1999              1999
(In thousands)                                 AS FILED          RESTATEMENTS        RESTATED
                                               --------          ------------        --------
<S>                                           <C>               <C>                 <C>
TOTAL REVENUE                                   27,867               (1,245)           26,622

GROSS PROFIT                                    15,311               (1,166)           14,145

TOTAL OPERATING EXPENSES                        12,734                 (535)           12,199

OPERATING INCOME                                 2,577                 (631)            1,946

TOTAL NON-OPERATING EXPENSES                     2,414                 (480)            1,934

INCOME BEFORE MINORITY INTEREST                    177                 (151)               26

MINORITY INTEREST                                  394                 (151)              243

NET (LOSS)                                       (217)                   --              (217)
</TABLE>



                                      F-9
<PAGE>   49



<TABLE>
<CAPTION>
                   CONDENSED SUMMARY OF RESTATEMENTS FOR 1998

                                                 1998               1998               1998
(In thousands)                                 AS FILED          RESTATEMENTS        RESTATED
                                               --------          ------------        --------
<S>                                           <C>               <C>                 <C>
TOTAL REVENUE                                    31,881            (1,217)            30,664

GROSS PROFIT                                     17,030            (1,508)            15,522

TOTAL OPERATING EXPENSES                         14,880            (1,122)            13,758

OPERATING INCOME                                  2,150              (386)             1,764

TOTAL NON-OPERATING EXPENSES                      1,670              (189)             1,481

INCOME BEFORE  MINORITY INTEREST                    846              (197)               649

MINORITY INTEREST                                   445              (197)               248

NET INCOME                                          401                --                401
</TABLE>



<TABLE>
<CAPTION>
                   CONDENSED SUMMARY OF RESTATEMENTS FOR 1997

                                                 1997               1997               1997
(In thousands)                                 AS FILED          RESTATEMENTS        RESTATED
                                               --------          ------------        --------
<S>                                           <C>               <C>                 <C>
TOTAL REVENUE                                     32,606             (951)           31,655

GROSS PROFIT                                      16,193           (1,862)           14,331

TOTAL OPERATING EXPENSES                          20,134           (1,758)           18,376

OPERATING (LOSS)                                  (3,941)            (104)           (4,045)

TOTAL NON-OPERATING EXPENSES                       2,279              (51)            2,228

(LOSS) BEFORE MINORITY INTEREST                   (5,450)             (53)           (5,503)
MINORITY INTEREST                                    163              (53)              110

NET (LOSS)                                        (5,613)              --            (5,613)
</TABLE>


2.       SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

Principles of Consolidation

         The consolidated financial statements include the accounts of the
Company, its wholly owned subsidiaries, and its majority interest in
partnerships and joint venture arrangements only for the period subsequent to
their acquisition. All significant intercompany balances and transactions have
been eliminated. The Company uses the equity method of accounting for entities
that it does not have majority ownership in.

Basis of Presentation

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




                                      F-10
<PAGE>   50


Reclassifications

         Certain reclassifications have been made to prior year financial
statements to conform with the current year presentation.

Industry Risks

         The healthcare industry in the United States continues to experience
significant change even without passage of comprehensive legislative reform at
the federal level. The primary force for change in today's competitive
marketplace continues to be the consolidation and increased efficiency in
healthcare delivery and financing.

         An increasing number of the Company's third-party payors are adopting
prospective payment systems. The Company has signed provider contracts with
managed care organizations, which emphasize utilization control and cost
containment, and the Company's business with these managed care organizations is
expected to increase significantly in the next few years. Managed care
organizations either directly transfer risk to healthcare providers through
capitation payment arrangements or pay for units of service on a steeply
discounted basis. These factors cause significant challenges to all providers,
including the Company.

Net Patient Service Revenue

         The Company recognizes all patient revenue at the time of service.
Contractual allowances are booked simultaneously for contractual arrangements
under fixed fee schedules that can be determined at the time of service. All
other contractual adjustments are reserved for by analyzing the amounts of
Accounts Receivable by payor class (i.e. Blue Cross, Blue Shield, etc.), by
aging, and by prior adjustments, if any, and a reserve balance is calculated
based on historical allowance percentages, by company, adjusted for current
changes is necessary. The Company has agreements with certain third-party payors
that provide for payments to the Company at amounts different from its
established fee schedules.

         For 1998 and prior, services rendered to Medicare program beneficiaries
are paid based on a cost reimbursement methodology subject to cost limitations.
The Company was reimbursed for services at a tentative interim rate with final
settlement determined after submission of annual cost reports by the Company and
audits thereof by the Medicare fiscal intermediary. The Company's Medicare cost
reports have been audited with final settlements determined by the Medicare
fiscal intermediary through December 31, 1997 for all providers. During 1999,
the Company recorded audit adjustments against net patient service revenues of
$995,000. This represents an audit settlement for 1996 - 1997 and a provision
for the expected settlement of the 1998 audit. These audit adjustments related
primarily to disallowed legal costs incurred with connection with the Consent
Solicitation referred to above and more fully discussed in Note 9. In accordance
with the Balanced Budget Act, effective January 1, 1999, the Company has been
reimbursed based upon the physician Medicare fixed fee schedule.

         The Company has also entered into payment agreements with certain
commercial insurance carriers, health maintenance organizations and preferred
provider organizations. The basis for payment to the Company under these
agreements includes prospectively determined rates and discounts from
established charges. Certain of these contracts provide capitation terms whereby
the Company receives a sum of money per covered member within the certain
insurance plan and in return the Company agrees to provide all of the
rehabilitation and certain diagnostic testing which is deemed medically
necessary for these plan members. In addition to the payments from the insurance
organizations, the Company may, depending on the coverage circumstances, collect
co-payment amounts directly from patients for each event of service.

         The Company grants credit without collateral to its patients, most of
who are local residents and are insured under third-party payor agreements. The
mix of gross receivables from patients and third-party payors at December 31,
1999 and 1998, was as follows:

                                                             1999        1998
                                                             ----        ----
Workers' compensation                                          22%         21%
Other third-party payors                                       40          35
Blue Cross, Blue Shield & related managed care products        26          22
Contracts with nursing homes and other such providers           5           9
Medicare                                                        6          11
Self-pay patients                                               -           1
Medicaid                                                        1           1
                                                              ---         ---
                                                              100%        100%
                                                              ---         ---




                                      F-11
<PAGE>   51

         The healthcare industry is subject to numerous laws and regulations of
federal, state and local governments. These laws and regulations include, but
are not necessarily limited to, matters such as licensure, accreditation,
requirements of government healthcare program participation, reimbursement for
patient services, and Medicare and Medicaid fraud and abuse. Recently,
government activity has increased with respect to investigations and allegations
concerning possible violations of fraud and abuse statutes and regulations by
healthcare providers. Violations of these laws and regulations could result in
expulsion from government healthcare programs together with imposition of
significant fines and penalties, as well as significant repayments for patient
services previously billed. Management believes that the Company is in
compliance with fraud and abuse as well as other government laws and
regulations.

While the Company is not aware of any current violations, compliance with such
laws and regulations can be subject to future government review and
interpretation as well as regulatory actions unknown or unasserted at this time.

Management Fees

         The Company previously managed, on a contract basis, a mobile
diagnostics business, which was discontinued in August 1999. Also, during a
portion of 1996 and 1997, the Company managed a physician practice, which was
discontinued in June 1997. In conjunction with these contracts, the Company
received compensation in the form of a monthly management fee. This fee was
equal to the net income or loss of the managed business after the payment of
certain agreed-upon salaries and benefits to certain parties. The management
fees are presented in the Revenue section of the Consolidated Statements of
Operations. Management fee income also includes fee income from the management
of a physical therapy partnership where the Company does not have majority
ownership.

Insurance

         The Company presently insures against malpractice with independent
third party insurers utilizing claims-made policies, and workers' compensation
risks with independent third-party insurers or state Workers' Compensation
insurance funds, where required.

Cash and Cash Equivalents

         All cash equivalents are stated at cost, which approximates market. The
Company considers all highly liquid investments with a maturity of three months
or less when purchased to be cash equivalents.

Property and Equipment

         The Company's property and equipment are stated at cost and are
depreciated using the straight-line method over the estimated useful lives of
the assets or the term of the lease, as appropriate. Most non-leased depreciable
assets have estimated useful lives in the range of five to seven years.

         Upon disposal of property items, the asset and related accumulated
depreciation accounts are relieved of the amounts recorded therein for such
items, and any resulting gain or loss is reflected in income.

Deferred Costs

         Debt issuance costs are generally amortized over the term of the debt.
Such costs are included in intangibles.

Intangible Assets

         Intangible assets consist of the excess of cost over net assets of
acquired organizations (goodwill), non- compete and employment agreements with
certain key employees of organizations which have been acquired, the Keystone
tradename and assembled workforce and other intangibles consisting primarily of
deferred financing costs.

         In March 1995, the Financial Accounting Standards Board (the "FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of." This accounting pronouncement requires that long-lived assets and
identifiable intangibles to be held and used by an entity are to be reviewed for
impairment whenever events or changes in circumstances indicate that the
carrying amount of the assets may not be recoverable.

         The Company chose early adoption of this accounting pronouncement as of
December 31, 1995. As factors indicate that intangible assets should be
evaluated for possible impairment, the Company has used an estimate of the
related operations' undiscounted cash flows over the remaining life of the
various intangible assets in measuring whether these intangible assets are
recoverable. The Company's evaluations have resulted in adjustments to





                                      F-12
<PAGE>   52

Property, Plant and Equipment, Goodwill and the Keystone assembled workforce as
of December 31, 1999, 1998 and 1997. (See Notes 3 and 4).

Treasury Stock

         The Company may periodically repurchase its own stock as a result of a
specific transaction or as part of an organized repurchase plan. The Company
accounts for such stock repurchases on the cost basis and records the stock
value as a contra-equity line item on its financial statements.

Earnings Per Common Share

         The Company has determined earnings per share in accordance with SFAS
No. 128, "Earnings Per Share", for all periods presented. Under SFAS No. 128,
earnings per share are classified as basic earnings per share and diluted
earnings per share. Basic earnings per share include only the weighted average
common shares outstanding. Diluted earnings per share include the weighted
average common shares outstanding and any dilutive common stock equivalent
shares in the calculation. All prior periods have been restated to reflect this
adoption. Treasury shares are treated as retired for earnings per share
purposes.

        The following table reflects the calculation of earnings per share under
SFAS No. 128 (dollars in thousands, except per share data):

<TABLE>
<CAPTION>
                                                          For the year ended December 31,
                                                  1999                  1998                1997
                                               -----------           ----------          -----------
<S>                                           <C>                   <C>                 <C>
Basic earnings per share:
   Net (loss)/income                            $     (217)          $      401           $   (5,613)
   Average shares outstanding                    5,975,424            5,975,424            5,880,501
   (Loss)/income per share                            (.04)                0.07                (0.95)
Diluted earnings per share:
   Net (loss)/income                                  (217)                 401               (5,613)
   Average shares outstanding                    5,975,424            5,975,424            5,880,501
   Stock options                                        --               39,958                   --
                                                ----------           ----------           ----------
   Diluted average shares outstanding            5,975,424            6,015,382            5,880,501
   (Loss) income per share                            (.04)                0.07                (0.95)
</TABLE>


         At December 31, 1999, 1998 and 1997, options to purchase 968,708,
723,333, 1,187,758, and warrants to purchase 565,000, 565,000, and 843,500
shares of common stock, respectively, were outstanding, but were not included in
the computation of diluted earnings per share because the options' and warrants'
exercise prices were greater than the average market price of the Company's
common shares for the periods and due to the loss position of the Company for
1999 and 1997. Also, not included in the calculation of diluted earnings per
share were the shares that may be issued to the Zauchas in connection with the
Keystone merger that is subject to the approval of the Special Committee and of
the Board of Directors. See Note 3. The Zaucha Stock Guarantee, which is
currently recorded as a liability in accrued expenses (see Note 8), could be
satisfied by all cash, all stock, or a combination of both cash and stock.

3.       MERGERS, ACQUISITIONS AND JOINT VENTURE AGREEMENTS:

Keystone Rehabilitation Systems, Inc. ("Keystone")

         On November 15, 1995, NSK Merger Corp., a newly-formed subsidiary of
the Company, was merged with and into Keystone (a Pennsylvania corporation).
Prior to this merger (the "Merger"), Keystone was the largest privately held
rehabilitation company in Pennsylvania, providing services in physical,
occupational and speech therapy, including sports rehabilitation and work
hardening in outpatient clinics, as well as in patient care facilities, located
throughout Pennsylvania and in New York, Ohio and West Virginia.

         The total purchase price for the Keystone Acquisition was $17,652,000,
which included $13,422,000 for intangible assets including goodwill
($8,922,000), Keystone Tradename ($2,500,000), Employment agreements
($1,000,000), and the Keystone Workforce ($1,000,000). As consideration for the
Merger, the shareholders of Keystone, Thomas W. Zaucha and Alice L. Zaucha and
the Zaucha Family Limited Partnership (collectively, the "Shareholders"),
received the following: (a) $2,500,000 in cash; (b) a Time Note due January 3,
1996, in the aggregate principal amount of $5,100,000; (c) a five-year, interest
free Term Note in the aggregate principal amount of $2,625,000; (d) the
agreement by the Company to issue, on January 3, 1996, a three-year, 6% Term
Note in the aggregate principal amount of $2,400,000 (the Three-Year Note); and
(e) the agreement by the Company to issue to the Shareholders, on January 3,
1996, an aggregate of 944,352 shares of Common Stock, par value $.01 per share
(the "Common Stock"), of the Company (the "Stock Consideration"). The debt
issued in this acquisition was discounted using current market rates. See
Note 6.




                                      F-13
<PAGE>   53

         In connection with the Merger, the Company (i) guaranteed the value of
the Stock Consideration to be at least $5,600,000 through certain periods ending
no later than December 31, 1997; (ii) agreed to seek necessary stockholder
approval to allow the Three-Year Note to be converted into Common Stock at the
conversion price of $5.93 per share and to pay any guaranteed amount in
additional shares of Northstar Common Stock based on the trading price of the
Common Stock at the time of issuance; and (iii) issued a five-year interest-free
note to David D. Watson, Keystone's former Chief Operating Officer and Executive
Vice President, in the aggregate principal amount of $375,000, in release of any
interest Mr. Watson might have had in Keystone. Similar to the debt in the
preceding paragraph, this obligation to Mr. Watson was discounted using the
Company's current borrowing rate. The remaining obligation was renegotiated in
1999. (See Note 18)

         As discussed above, a stock price of $5.93 per share was guaranteed to
the Shareholders for periods ending not later than December 31, 1997. Based on
the weighted average trading volume of the daily closing price per share for the
ten consecutive trading days immediately prior to the third business day prior
to the determination date of December 31, 1997, the Company's Common Stock was
valued at $0.96 per share. The Company has a contractual obligation to fund this
shortfall in stock value through a cash payment equal to the shortfall or, with
shareholder approval, through the issuance of additional shares to the
Shareholders in an amount equal to the shortfall. Based on above formula, the
Company was obligated to either make a cash payment of $4,693,423 or issue
approximately 4,888,982 additional shares of stock. The Company does not
currently have sufficient cash to pay this obligation. This amount is recorded
as a liability in accrued expenses at December 31, 1999 (Note 8), with the
offset recorded to Additional Paid-In Capital. The Special Committee of the
Board of Directors has been charged with the authority to negotiate the
satisfaction of this obligation with the Shareholders, which could be done
through the payment of cash, issuance of stock, issuance of notes, or a
combination of any or all of these items. At the Company's Annual Meeting held
on June 11, 1998, the Company's stockholders approved the issuance of up to
4,888,982 shares of Common Stock in order to enable the Company to fully satisfy
the obligations of the Company under the guarantee in stock if deemed
appropriate by the Special Committee. The stockholder has not requested any
payments in cash or stock to satisfy this obligation.

         The Company also agreed to make additional "earn-out" payments to the
Shareholders of $1,600,000 per year in the event that Keystone's "EBITDA"
exceeds $2,500,000 in any year from 1996 to 2000, inclusive. EBITDA is defined,
generally, to mean Keystone's earnings (including earnings from any internally
generated facility or contract but excluding earnings from any facility or
contract acquired from third parties) before taxes, interest, depreciation and
amortization. In the event an earn-out is not earned and therefore not paid in
any given year, the earn-out will be paid in the next year if EBITDA in such
next year exceeds the greater of $3,200,000 or $2,500,000 plus the amount of the
EBITDA shortfall in such prior year. The Shareholders are to receive an earn-out
of approximately $200,000 for 1995. The calculation for the earn-out amounts for
years 1996 through 2000 includes a reduction in the amount due in the event that
the current liabilities of Keystone at the date of the Merger (other than
permitted capital leases) exceeded $2,000,000. In addition, such earn-out
payments are to be reduced by 50% of such current liabilities up to $2,000,000.
Former management of the Company believed that, based on the results of
operations for 1996 as well as that management's interpretation of the
above-outlined adjustments, the 1996 earn-out computation resulted in no amounts
due to the Shareholders. The current Board of Directors appointed a Special
Committee to review these calculations and the issues in dispute. The Special
Committee and the Zaucha's have agreed that no earn-out will be paid for 1996,
the earn-out for the year 1997 will be reduced by $504,725 and the earn-out for
the years 1998 through 2000 will be reduced by a minimum of $192,800 per year.
The earn-out payments for all years will accelerate and become due within 90
days after any change in ownership or control of the Company or a sale of the
majority of the assets of the business. The Company has determined that, based
on the results of operations for 1997, there are no amounts due to the
Shareholders for the 1997 earn-out. However, the Company has determined that the
EBITDA for 1998 exceeds the greater of $3,200,000 or $2,500,000 plus the amount
of the EBITDA shortfall in 1997, and, therefore, in accordance with the
carryover provision above, there is an amount due to the Shareholders in the
amount of $1,095,275 for 1997. The Company has determined that, based on the
results of operations for 1998 and 1999, there is an amount due to the
Shareholders in the amount of $1,407,200 for each of 1998 and 1999. Accordingly,
at December 31, 1999 and 1998, the Company has accrued the cumulative earn-out
payments of $3,961,000 and $2,704,000, respectively, with an offsetting entry to
goodwill.

         The consideration for the Merger was determined by arms-length
negotiations among the various parties. In connection with this Merger, the
Company paid fees of approximately $145,000 to Commonwealth Associates and the
Company paid cash of $450,000 and issued 150,000 shares of Common Stock with a
market value of $937,500 to Commercial Financial Corporation. See Note 12.

         Immediately prior to the Merger and in accordance with the Merger
Agreement, Keystone transferred to the Zaucha Family Limited Partnership, of
which Thomas W. Zaucha is a general partner, all of the real estate owned by
Keystone for approximately $5,200,000, the independently appraised value of the
assets involved. These funds were used to pay off real estate and other debt
owed to a bank by Keystone. In connection with the Merger, the parcels of such
real estate used in Keystone's business were then leased to Keystone. See Note
12 for discussion of these rental payments.





                                      F-14
<PAGE>   54

         As part of the Merger, certain of the executive officers of Keystone
entered into employment agreements with and became executive officers of the
Company. See Note 15.

Penn Vascular Lab, P.C. ("PVL")

         On November 28, 1995, the Company acquired from PVL (a Pennsylvania
professional corporation) certain assets and 100% of the stock of Vascusonics,
Inc. (a Pennsylvania Corporation or Vascusonics). The agreement provided for a
management services contract whereby the Company would provide such services to
PVL for a period of two years in exchange for a fee equal to the excess of
collected revenue over the sum of $75,000 and PVL's business expenses. Although
the management services contract expired on November 28, 1997, it was renewable
annually at the mutual agreement of both parties. The purchase agreement also
provided the Company with the option to purchase the stock of PVL for one dollar
under certain circumstances, during the period one year after the management
services contract is terminated.

The Company also purchased certain assets of Penn Vascular Lab, PC. The total
purchase price of the Vascusonics/PVL acquisition was $2,300,000, which
consisted of the following:

         Cash                                                  $50,000
         Note                                                  100,000
         Common Stock, 362,564 shares                        2,150,000
                                                            ----------
         Total Consideration                                $2,300,000
                                                            ==========

         The purchase price was allocated as follows:

         Net Assets Acquired                                   467,000
         Non-Complete Agreements                                25,000
         Goodwill                                            1,808,000
                                                            ----------
         Total Consideration                                $2,300,000
                                                            ==========


In conjunction with the acquisition, the Company also agreed to lend the seller
$2,150,000 which was recorded on the books as a Note Receivable. The Northstar
stock issued to the seller as part of the purchase price was pledged as
collateral for the Note. Under the terms of the note, the seller agreed to pay
back the lesser of $2,150,000 or the proceeds from the sale of the stock. In
December 1996, the Company foreclosed on this stock and currently accounts for
these shares as treasury stock. The foreclosure resulted in a one-time, non-cash
expense of $1,607,000 equal to the decline in collateral value, which was booked
in 1996, and the write-off of the Note Receivable. In addition, the Company
promised to pay certain contingent payments to the Seller. The
non-interest-bearing note to the Seller was discounted using a market rate of
interest. (See Note 6)

         The contingent payments, as revised by mutual agreement in January
1997, to the Seller are based upon the Net Collected Revenues, as defined, for
the years ending December 31, 1997 and 1998. If during either of the two years
ending December 31, 1998, the Net Collected Revenues of the businesses acquired
exceeded $3,200,000, then a payment of $37,500 is to be made to the Seller. If
the Collected Revenues were in excess of $3,400,000 and $3,600,000, in each year
then the payment to the physician would be $137,500 and $237,500, respectively.
The Company has determined that under the terms of this calculation, there is no
contingent payment due for the years ending December 31, 1998 and 1997.

         In January 1997, the Company reached a settlement agreement with the
Seller of PVL regarding several disputes. In the terms of this agreement, the
Company reduced certain future payments due to the Seller from $100,000 to
$50,000, acquired ownership rights to disputed equipment, and reduced contingent
payment amounts.

         The Company borrowed $2,500,000 under the $6,500,000 acquisition
portion of its then existing $16,000,000 credit facility with IBJ Schroder Bank
and Trust Company. These borrowings financed the $2,150,000 promissory note to
the Seller and a $350,000 broker fee. Under the purchase agreement, Ultrasonics,
Inc. (Ultrasonics) took ownership of PVL's and Vascusonics' accounts receivable
on the date of purchase just prior to the consummation of the purchase
agreement. Also, Ultrasonics assumed certain leases for equipment used by the
Company and entered into new lease terms with the Company. Ultrasonics is a
related party that is owned and operated by Jeff Bergman.

         The Company believed that the lease arrangements with Ultrasonics were
for lease rates that were greatly in excess of market rates. At the date of the
merger, Ultrasonics paid off leases that represented a net liability to PVL of
$155,000. However, the lease arrangement with Ultrasonics obligated the Company
to principal payments totaling $1,333,000 over the term of the leases. The
Company originally treated the excessive lease payments of $1,177,000 as a
disproportionate dividend, because it was believed that his was a transaction
between related parties. However,





                                      F-15
<PAGE>   55

as both entities were not majority owned by the same party, the disproportionate
dividend has been corrected to be recorded as additional compensation expense in
1996 with no net effect on Equity. Northstar recorded the equipment at
Ultrasonics basis, and ceased making payments to Ultrasonics in March 1996. In
March 1997, Ultrasonics filed suit against the Company as a result of these
disputed lease agreements. In March 1998, the Company reached a settlement in
principle with Ultrasonics and Jeff Bergman that resulted in mutual releases and
no payments to either party.

         In connection with the PVL acquisition, the Company paid a brokerage
fee of $350,000 to Mr. James P. Shields. Mr. Shields is a cousin of Mr.
DeSimone, the former Chairman of the Board of Directors of the Company.
Additionally, in connection with the above mentioned management services
contract, the Company provided shares of Common Stock with a fair market value
of approximately $300,000 to Mr. Shields in consideration for him to renegotiate
his employment agreement with the Company so as to include duties with respect
to both PVL and Vascusonics. The term of this management contract was for a
period of seven years and compensation consisted of a management fee of 12% of
the gross collections. Prior to this revised contract, Mr. Shields received
compensation equal to 5% of gross collections. In March 1996, the Company
canceled Mr. Shield's contract and severed his relationship with the Company.
The Company received a management fee equal to the net collections of PVL less
certain expenses, primarily the salary and benefits of the radiologist employed
by PVL. This is included in the amount recorded in Management Fee Income on the
Statement of Operations.

         In August 1999, the Company terminated the remaining operations of
PVL's mobile diagnostics business and recorded a related charge of $929,000 in
the third quarter, for goodwill and fixed asset impairment, related to the
closing of this business. The amount of the charge was determined by calculating
the difference between the sale proceeds of PVL with the net book value of PVL's
goodwill and fixed assets. The business was sold in October 1999.

Joint Venture Activities

         Prior to 1995 the Company formed joint ventures with CDL Medical
Technologies, Inc. ("CDL") and C.F. Services, Inc. ("CFS") to provide mobile
diagnostic services, including cardiac services, in Western Pennsylvania. In
1998, the Company sold its 51% interest in each of these joint ventures to CDL
and CFS, recording a gain of approximately $167,000 and $23,000, respectively,
which is recorded as other income in the accompanying statement of consolidated
operations. The proceeds from the sale to CFS were received in 1998, and the
Company recorded the proceeds from the sale to CDL as a miscellaneous receivable
at December 31, 1998, with subsequent receipt in January 1999.

4.       INTANGIBLE ASSETS:

Intangible Assets and the related amortization periods consist of the following
(dollars in thousands):

<TABLE>
<CAPTION>
                                                                    December 31,
                                                            ---------------------------
                                                              1999               1998
                                                            --------           --------
<S>                                                        <C>                <C>
Excess of cost over net assets acquired (40 years)          $ 19,144           $ 18,708
Employment agreements (2 to 71/2 years)                          625                625
Keystone tradename (20 years)                                  2,500              2,500
Covenant not to compete (5 years)                                 53                 78
Assembled Keystone Workforce (5 years)                           400                450
Deferred financing and other costs (5 years)                     754                831
                                                            --------           --------
                                                            $ 23,476           $ 23,192
Less accumulated amortization                                 (3,999)            (3,381)
                                                            --------           --------
Intangible assets                                           $ 19,477           $ 19,811
                                                            ========           ========
</TABLE>


         As discussed in Note 2, the Company has chosen to adopt SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of" as of December 31, 1995. In accordance therewith, as of December
31, 1999, the Company has used an estimate of the related operations'
undiscounted cash flows over the remaining life of the various intangible assets
in measuring whether these assets are recoverable.

         As of December 31, 1997, 1998 and 1999, management's evaluation on the
remaining intangibles resulted in recording Assets Impairment Charges in each
year. In 1997, the Assembled Keystone Workforce evaluation resulted in a charge
of $230,000 (net of accumulated amortization) and $477,000 for those employment
contracts for individuals no longer employed by the Company. As of December 31,
1998, management evaluated the remaining intangibles that resulted in an Asset
Impairment Charge for the remaining goodwill balance related to terminated
nursing home contracts in the amount of $781,000 and an Assembled Keystone
Workforce charge in the amount of





                                      F-16
<PAGE>   56

$56,000, net of accumulated amortization to date. As of December 31, 1999,
management further evaluated the remaining intangibles that resulted in an
adjustment to decrease the Assembled Keystone Workforce in the amount of $9,000,
net of accumulated amortization to date. The Assembled Keystone Workforce
evaluation is based upon a detailed analysis of employees who were originally
associated with this asset and the account balance is decreased for any such
employees who have left the Company during the year. In addition, during 1999 as
a result of the termination and subsequent sale of the Company's mobile
diagnostics business (PVL) a charge for the Impairment of PVL's goodwill
($595,000) and fixed assets ($334,000) was recorded as discussed in Note 3. The
total PVL Impairment Charge of $929,000 is included in the Asset Impairment
Charge Operating Expense line item in the Consolidated Statement of Operations.
On a going-forward basis, the Company will continue to evaluate whether later
events and circumstances have occurred that indicate the remaining estimated
useful life of goodwill may warrant revision or that the remaining balance of
intangible assets may not be recoverable. When factors indicate that intangible
assets should be evaluated for possible impairment, the Company will use an
estimate of the related operation's undiscounted cash flow over the remaining
life of the goodwill in measuring whether the goodwill or other intangible asset
is recoverable. Any subsequent asset impairment will be accounted for as a
charge to the operating expenses of the Company.

5.       PROPERTY AND EQUIPMENT:

Property and equipment consists of the following (dollars in thousands):


<TABLE>
<CAPTION>
                                                 December 31,
                                           -------------------------
                                             1999             1998
                                           -------           -------
<S>                                       <C>               <C>
Vehicles                                   $    42           $   189
Clinical equipment                             838             1,678
Furniture and fixtures                         894               835
Leased medical equipment                       869             1,624
Leasehold improvements                       1,272               946
                                           -------           -------
                 Total cost basis          $ 3,915           $ 5,272
Less accumulated depreciation               (2,546)           (3,071)
                                           -------           -------
Property and equipment - net               $ 1,369           $ 2,201
                                           =======           =======
</TABLE>


During 1999, the Company recorded an Asset Impairment Charge of $334,000 for the
write-down and sale of its PVL fixed assets as more fully discussed in Note 4.

6.       DEBT:

Debt consists of the following (dollars in thousands):

<TABLE>
<CAPTION>
                                                                                                 December 31,
                                                                                           -----------------------
                                                                                             1999            1998
                                                                                           --------        -------
<S>                                                                                       <C>             <C>
Amended and Restated Credit Agreement with two senior lenders effective 9/30/99,
  due with graduated monthly payments through 12/31/00, including interest at a
  Base Rate plus 3%                                                                        $ 13,802        $    --

Term loan with senior lender due in 60 monthly graduated payments, plus interest
  at a Base Rate plus 1.5% in 1998
  (Note 7)                                                                                       --          6,083

Revolving line of credit with senior lender, due on demand and no later than
  10/20/00, interest payable monthly a Base
  Rate plus 1.5% in 1998 (Note 7)                                                                --          2,000

Acquisition facility with senior lender, due in equal monthly Installments
  beginning 4/30/97 at a Base Rate plus 2% in
  1998  (Note 7)                                                                                 --          6,000

Non-interest bearing term notes to Thomas Zaucha and the Zaucha Family Limited
  Partnership, approximately $85,000 due on 11/15/97 and then approximately
  $210,000 due quarterly until 11/15/00 (interest imputed at 9%)                              2,625          2,625

Term notes to Thomas Zaucha and the Zaucha Family Limited Partnership, due in
  equal quarterly installments beginning on 9/30/96 of $200,000, 6% stated
  interest rate (interest imputed at 9%)                                                      2,400          2,400

Capital lease obligations with interest rates ranging from
  9% to 15.6%                                                                                   192            579

Other debt                                                                                      380            441
                                                                                            -------        -------
Total debt                                                                                  $19,399        $20,128
                                                                                            =======        =======
</TABLE>



                                      F-17
<PAGE>   57




<TABLE>
<CAPTION>
                                             December 31,
                                       -----------------------
                                         1999          1998
                                       --------       --------
<S>                                   <C>            <C>
Less:
    Current portion                     (18,878)       (18,661)
    Debt discount                          (215)          (416)
                                       --------       --------
Long-term debt                             $306       $  1,051
                                       ========       ========
</TABLE>


The Company's weighted average interest rate was 9.5% and 9.0% for 1999 and
1998, respectively.

IBJ Schroder and Cerberus Partners Facility

         In 1995, the Company closed on a credit facility with IBJ Schroder Bank
and Trust Company ("IBJ"). The facility had a final maturity of five years from
the date of closing. The term loan was funded in full at closing and was used to
repay an existing bank credit facility. The IBJ facility was secured by a first
priority lien on substantially all of the assets of the Company. In addition,
the credit agreement had various financial compliance covenants including
certain ratios and free cash flow requirements. (See Note 7)

         In addition, the Company issued to IBJ certain warrants (the "IBJ
Warrants"). The IBJ Warrants may be exercised to purchase up to 240,000 shares
of the Company's Common Stock at an exercise price of $6.76 until October 20,
2000. The Company accounted for the IBJ Warrants as a debt discount and is
amortizing the fair market value of these warrants on a straight-line basis over
the 60 months.

         In September 1997, Cerberus Partners, LP, ("Cerberus") a diversified
financial securities firm that invests in publicly traded and private debt
issues of both large and middle market companies, purchased from IBJ all of the
Company's senior debt amounting to $15.3 million, including principal and
accrued interest. The debt was purchased subject to the existing Credit
Agreement and forbearance agreement and extensions thereof. The Company executed
an Assignment and Acceptance Agreement and consented to the transfer of the IBJ
Warrants to Cerberus in connection with this matter. Effective September 30,
1999 the Company successfully renegotiated its senior debt with an Amended and
Restated Credit Agreement with Cerberus Capital Management, LLC, and the Chase
Manhattan Bank. The 240,000 warrants have been repriced at $0.25 per share. The
agreement provides for scheduled monthly repayments through December 31, 2000,
at which time the balance is due. The senior debt currently provides for
interest at a base rate plus 3% and contains numerous covenants. The Company is
currently in technical default of certain covenants, for which no waiver has
been obtained.

         At December 31, 1999, the scheduled aggregate annual maturities of
long-term debt are as follows (dollars in thousands):


                          2000               $19,066
                          2001                   131
                          2002                    79
                          2003                    33
                          2004                    12
                          Thereafter              78
                                             -------
                          Total              $19,399
                                             =======


7.       COVENANTS UNDER CREDIT AGREEMENT:

         The Amended and Restated Credit Agreement (Senior Debt) effective
September 30, 1999 contains numerous financial and other covenants including,
among other restrictions; (a) limiting capital expenditures; (b) requiring a
portion of defined excess cash flow to be paid toward the senior debt; (c)
requiring the implementation of a cash management system; (d) requiring
compliance with various financial ratios and related representations and
periodic financial reports and other notices; (d) requiring certain specific
insurance coverage's and lease restrictions; (f) requiring minimum monthly
billing levels and weekly cash collections; (j) and other positive and negative
covenants. The Company is not currently in compliance with the cash management
system transfer requirement and certain other covenants. However, the senior
lenders have not issued a notice of default and are working with the Company to
correct the technical defaults.

         The Company experienced a modest profit of $401,000 for the year ended
December 31, 1998 and a small loss of $217,000 for the year ended December 31,
1999. As of December 31, 1999 the Company has a net





                                      F-18
<PAGE>   58

shareholders equity deficiency of $6,266,000. Additionally, the Company has not
paid all creditors on a timely basis and has not met certain financial and other
covenants which the lender has not waived. These matters and the need to
refinance the remaining loan balance at December 31, 2000 raise significant
doubt about the Company's ability to continue as a going concern. These
financial statements do not include any adjustments relating to the
recoverability and classification of asset carrying amounts or the amount and
classification of liabilities that might result should the Company be unable to
continue as a going concern. All indebtedness to the senior lenders is
classified as current in the accompanying Consolidated Balance Sheet.

         Management has focused its efforts in two main areas: improving
operating performance and refinancing the senior debt balance before December
31, 2000. During the years ended December 31, 1999, operational improvements
were made that resulted in operating profit before changes related to the sale
of Penn Vascusonics (See Note 3) and Medicare adjustments related to 1996 - 1998
(See Note 2)

         If the Company is unable to effectuate a business combination with a
financially stronger entity or to raise additional capital and/or effect a
permanent restructuring of its debt, the Company could be required to file a
petition for relief under the provisions of the Bankruptcy Code, or could have
an involuntary petition thereunder filed against it.

8.       ACCRUED EXPENSES:

Accrued expenses consist of the following (dollars in thousands):
<TABLE>
<CAPTION>
                                                                                 December 31,
                                                                            -----------------------
                                                                             1999             1998
                                                                            -------          ------
<S>                                                                        <C>            <C>
Earn-out payments due to the Zaucha's                                        $3,961         $ 2,704
Stock guarantee due to the Zaucha's                                           4,694           4,694
Accrued interest due to the Zaucha's                                            560             415
Reimbursement of consent solicitation costs to Thomas Zaucha                    612           1,094
Payroll, including payroll taxes and deductions                                 973             921
Accrued interest - other                                                        137             953
Other                                                                           801           2,398
                                                                            -------          ------
Total accrued expenses                                                      $11,738         $13,179
                                                                            =======         =======
</TABLE>

9.       RESTRUCTURING AND NON-RECURRING ITEMS:

         During 1997 and 1996, following the resignation of KPMG as its
independent public accountants, the Company incurred professional fees in
connection with the ensuing independent investigation, shareholder litigation
and suit against the parties allegedly responsible for the wrong doings against
the Company and its shareholders. The majority of the most significant expenses
related to these matters were incurred prior to 1998. However, no significant
additional professional fees in connection with these actions are anticipated in
the future, as only a few remaining legal matters are yet to be resolved.

         Because of the actions of the DeSimone management group, the Company
has been faced with recording certain transactions that are unusual in nature
and are not expected to be recurring in future years. These transactions
include, but are not limited to, the recognition of losses on notes receivable
collateralized with Common Stock and other unusual compensation arrangements
offered to certain former employees.

         In addition, significant expenses were incurred as a result of the
Consent Solicitation described in Note 1. All expenses related to this action
were expensed in 1997. The Company has agreed to reimburse Mr. Zaucha for the
costs incurred which total $1,750,000. This included $1,418,000 for legal fees,
$175,060 for investment Banking Services, $101,293 for the Proxy Solicitation
Firm services and $55,420 for printing and other. As of December 31, 1999,
unpaid professional fees in this matter are approximately $612,000 See Note 8.

         A summary of these unusual and non-recurring items is as follows
(dollars in thousands):

<TABLE>
<CAPTION>
                                                               Restated        Restated        Restated
                                                                 1999            1998            1997
                                                               --------        --------        --------
<S>                                                           <C>             <C>             <C>
Company costs for legal services related to consent
    solicitation incurred by Brody management (Note 12)          $ --           $   --          $   527
Consent solicitation costs incurred by Mr. Zaucha                  --               --            1,750
Legal and accounting fees                                          --               --              693
Litigation costs                                                   43               75              558
Corporate restructuring costs                                      (2)             202              344
Ultrasonics and management services legal settlements              --               --           (2,001)
                                                                 ----           ------          -------
Total                                                            $ 41           $  277          $ 1,871
                                                                 ====           ======          =======
</TABLE>



                                      F-19
<PAGE>   59

         Corporate Restructuring costs incurred in 1997 and 1998 legal fees
related to the restructuring of the Company's debt agreement with its primary
lender; legal and other costs incurred related to the duties of the Special
Committee of the Board of Directors; and legal fees incurred for other projects
related to corporate restructuring.

         In 1997, the Company realized a benefit of $1,418,751 for the write-off
of lease obligations as the result of the settlement of the Ultrasonics/Jeff
Bergman suit. In 1997 the Company recorded a benefit of $501,779 related to
accruals for a management services agreement with James Shields. The action was
based upon an investigation and the opinion of counsel that the possibility that
Mr. Shields might recover on any claim he may have against the Company under the
management agreement in question is remote. This matter was concluded in 1999 by
a settlement to the Company of $75,000, net of related legal fees.

10.      LEASES:

         The Company has entered into various non-cancelable operating leases
expiring at various dates through December 31, 2004 for office and medical
equipment, vehicles and office space at its headquarters and certain
rehabilitation centers. During the years ended December 31, 1999, 1998 and 1997,
rental expense included in the statement of operations was $3,251,000,
$3,278,000, $2,888,000 respectively. As discussed in Note 12, the Company leases
certain properties from a related party.

         Future minimum lease commitments for all non-cancelable leases as of
December 31, 1999 are as follows (dollars in thousands):

                                                      Operating
           Year Ending December 31,                     Leases
           ------------------------                     ------
           2000                                         $2,795
           2001                                          2,186
           2002                                          1,605
           2003                                          1,218
           2004                                            816
           Thereafter                                      690
                                                        ------
           Total Payments                               $9,310
                                                        ======


11.      EMPLOYEE BENEFIT PLANS:

         The Company has a deferred compensation plan for its employees pursuant
to Section 401(k) of the Internal Revenue Code of 1986, as amended (the
"Keystone Plan"). The Plan provides for certain matching of employee
contributions equal to 50% of participants' contributions up to three hundred
dollars per year. The Keystone plan also provides that the Company may make
discretionary contributions; however, no such contributions were made during
1999, 1998 or 1997.

         During 1999, 1998, and 1997 the Company made contributions to the Plans
of approximately $56,000, $64,000, and $63,000, respectively.

12.      RELATED-PARTY TRANSACTIONS:

         The current management of the Company does not adopt or affirm any
related party disclosures made in prior management's financial statements or
public filings. The transactions disclosed below are based on management's
knowledge at this point in time.

Keystone Acquisition

         As part of the acquisition of Keystone, the Company paid cash of
$450,000 and issued 150,000 shares of Common Stock with a market value of
$937,500 to Commercial Financial Corporation ("CFC") for services rendered. CFC
is wholly owned by Nicholas P. Horoszko who is a personal friend and business
associate of Mr. Mark DeSimone. CFC is believed by the Company to be a related
party. Additionally, the Company had made certain guarantees to CFC that the
aforementioned shares would be able to be sold with net proceeds of at least
$937,500. These costs were expensed during 1995.

         The Company believes that these shares of Common Stock were sold on
February 12, 1996 for approximately $840,000. In the opinion of management, as
Mr. Horoszko did not perform any services of value, he was not entitled to the
common shares discussed above or any additional compensation thereon. Mr.
Horoszko is a defendant in the Company's suit as discussed in Notes 1 and 20.




                                      F-20
<PAGE>   60


         In connection with the Keystone acquisition, Mr. Thomas Zaucha and Mr.
David Watson, who both sold interests in the former Keystone, and are now or
were officers with Northstar, have gross debt due directly to them of $3,919,500
and $163,549, respectively, as of December 31, 1999, and Mr. Zaucha's Family
Limited Partnership is due $1,105,500 as of December 31, 1999. In addition, Mr.
Zaucha and Mr. Zaucha's Family Limited Partnership have other amounts due
directly to them of $7,187,108 and $2,027,134, respectively, as of December 31,
1999, for accrued interest, stock guarantee expense, and earn-out payments due
as a result of the Keystone acquisition. See Note 6.

         As required under the Merger Agreement, immediately prior to the
merger, Keystone sold, at fair market value determined by a third party
appraisal, all of the real estate previously owned by Keystone to the Zaucha
Family Limited Partnership, of which Mr. Zaucha, is a general partner, and a
related entity, in return for a payment of $5,215,568. The parcels of such real
estate used in Keystone's business were then leased to Keystone. The Board of
Directors, when led by Steven Brody, one of the directors removed from office as
a result of the Consent Solicitation (see Note 1), alleged that these leasing
arrangements, which were negotiated when Mr. Brody was acting as a consultant to
Mr. Zaucha in the merger of Keystone with Northstar, were in excess of fair
market value. A Special Committee of the current Board of Directors of the
Company has evaluated, through an appraisal by an independent real estate
professional, the fair market lease rates for these properties, and has
determined that the leases are substantially within the range of market rent in
the aggregate, and therefore, a renegotiation of the leases is not required.

         The leases are for a period of either five or ten years, with most
commencing in 1995. Lease payments were $484,986 for 1999, and $470,360 for 1998
and 1997. Future minimum lease payments under these leases as of December 31,
1999, which are also disclosed within Note 10, are as follows:

                           2000                 $ 498,361
                           2001                   549,640
                           2002                   548,292
                           2003                   548,292
                           2004                   533,667
                           Thereafter             462,693
                                               ----------
                           Total               $3,140,945
                                               ==========


         The Company also uses, on an as needed basis, the services of Impulse
Development Corporation, a company controlled by Thomas Zaucha, primarily for
leasehold improvement construction. Subsequent to the Consent Solicitation and
the reinstatement of Thomas Zaucha as Chairman and CEO, the current Board of
Directors solicited bids for these construction services from other companies,
and Impulse submitted the lowest bid. Payments to Impulse totaled $87,423,
$86,920, and $80,404, in 1999, 1998, and 1997, respectively.

Transactions with Board Members

         In 1996, Brody Associates, a consulting firm wholly-owned by Steven
Brody, one of the Directors removed from office as a result of the Consent
Solicitation (see Note 1), was retained to perform a variety of consulting
services for the Company related to its investigation of former management and
related to the corporate restructuring of the Company. The Company paid $148,103
in 1997 to Brody Associates for these services and related business expenses.
The agreement was terminated as a result of the Consent Solicitation described
in Note 1. The Company entered into a settlement and release agreement with
Steven Brody and Brody Associates in November 1997 that provided for, among
other things, a payment of approximately $26,000 in outstanding consulting bills
with Brody Associates, which has been paid in full as of December 31, 1998. See
Note 13 for stock option activity.

         In 1996, the Company retained Executive Advisory Group, Ltd., whose
sole owner is Robert Smallacombe, one of the Directors removed from office as a
result of the Consent Solicitation (see Note 1), to serve as a management
consultant and to aid in the corporate restructuring. For these services and
related business expenses, the Company paid $ 53,179 in 1997 and $189,503 in
1996 to Executive Advisory Group, Ltd. In addition, in February 1997, after the
Brody Board removed Thomas Zaucha from office as Chairman and CEO, Smallacombe
was appointed the new CEO and his existing consulting agreement was converted
into an employment contract. The Company paid $65,708 in salary and expenses in
1997 under this employment agreement. This contract was terminated for cause as
a result of the Consent Solicitation (see Note 1). As of December 31, 1999, the
Company continues to dispute any obligation to Smallacombe under the terminated
employment agreement. See Note 13 for option activity. (See Note 20.)

         The Company obtains it's professional and general liability insurance
through The Reschini Agency, Inc., a company owned by Roger Reschini, a member
of the current Board of Directors. Policy premiums through this





                                      F-21
<PAGE>   61

company totaled approximately $149,000, $132,000, and $214,000 in 1999, 1998 and
1997, respectively, with the agency earning a commission on these premiums of
approximately $16,000, $14,000, and $25,000 in 1999, 1998 and 1997,
respectively. During 1997, the Company entered into a simultaneous transaction
with the Reschini Agency whereby the Company paid approximately $180,000 for
insurance premiums and the Reschini Agency purchased 108,270 shares of the newly
issued Company Common Stock at a per share price of $1.66 per share, which
represents the average of the previous five days closing stock prices.

         The Company also retains the law firm of Burns, White and Hickton, of
which Mr. David B. White, a current director, is a named partner, for various
litigation matters.

         The Company had transactions involving Thomas Zaucha and related
parties as discussed in Notes 3 and earlier in Note 12.

13.      STOCK OPTIONS AND WARRANTS:

Stock Options

         The Company adopted a stock option plan in 1992 (the "1992 Plan"), a
1994 stock option plan for non-employee directors (the "1994 Plan") and a 1997
stock option plan (the "1997 Plan"), collectively (the "Plans"). As permitted,
the Company accounts for these plans under APB Opinion No. 25, which does not
normally require recognition of compensation expense. Had compensation cost been
determined consistent with FASB Statement No. 123, the Company's pro forma net
loss and loss per share would have been (dollars in thousands, except per share
data):

<TABLE>
<CAPTION>
                                                                     1999           1998          1997
                                                                     ----           ----          ----
<S>                                      <C>                      <C>              <C>         <C>
       Net Profit/(Loss)                  As Reported              $ (217)          $ 401       $(5,613)
                                          Pro Forma                $ (309)          $ 203       $(7,003)

       Basic income/(loss) per share      As Reported              $ (.04)          $0.07       $ (0.95)
                                          Pro Forma                $ (.05)          $0.03       $ (1.19)
</TABLE>

  The activity regarding the 1992, 1994, 1997 and Independent Plans is as
follows:

<TABLE>
<CAPTION>
                                          1999                          1998                         1997
                                          ----                          ----                         ----
                                                Wt. Avg.                     Wt. Avg.                      Wt. Avg.
                                  Shares        Ex Price        Shares       Ex Price        Shares        Ex Price
                                  ------        --------        ------       --------        ------        --------
<S>                              <C>           <C>            <C>           <C>            <C>            <C>
Outstanding at beginning of
    year                          1,072,499         1.59       1,187,758         $2.54        681,200         $ 4.12
Granted                             172,500          .45         402,966          0.68        921,933           2.06
Exercised                                --           --              --            --             --             --
Expired/canceled                   (242,833)        1.86        (518,225)         3.07       (415,375)          4.09
Outstanding at end of year        1,002,166         1.33       1,072,499          1.59      1,187,758           2.53
Exercisable at end of year          927,166         1.42       1,072,499          1.59      1,187,758           2.53
Wt. Avg. fair value of
    options granted                   $ .20                       $ 0.61                       $ 1.90
</TABLE>

         The fair value of the option grants as outlined above for the 1992,
1994, 1997 and Independent Plans is estimated using the Black-Scholes option
pricing model with the following assumptions: life of the options ranging from 3
to 5 years; an assumed risk free rate of interest ranging from 4.86% to 6.00%;
an expected dividend yield of 0%, consistent with the Company's policy; expected
volatility of 224% for the grants during 1999, 164% for the grants during 1998,
and 168% volatility for grants during 1997.

         A total of 1,800,000 shares is authorized and has been reserved for
issuance under the Plans: 650,000 for the 1992 Plan, 150,000 for the 1994 Plan,
and 1,000,000 for the 1997 Plan. Options may be either "incentive stock options"
within the meaning of Section 422 of the United States Internal Revenue Code of
1986, or non-qualified options. The Plans are administered by the Compensation
and Nominating Committee of the Board of Directors who determine among other
things, those individuals who shall receive options, the time period during
which the options may be partially or fully exercised, the number of shares of
Common Stock that may be purchased under each option, and the option exercise
price.



                                      F-22
<PAGE>   62





    The following summarizes the activity under the 1992 Plan:

<TABLE>
<CAPTION>
                                                 December 31, 1999         December 31, 1998        December 31, 1997
                                                 -----------------         -----------------        -----------------
<S>                                             <C>                       <C>                      <C>
   Options
   Outstanding at beginning of year                   335,950                   564,175                  418,700
   Granted                                               --                      2,000                   393,350
   Exercised                                             --                        --                       --
   Expired/Canceled                                   (82,000)                 (230,225)                (247,875)
   Outstanding at end of year                         253,950                   335,950                  564,175
</TABLE>

<TABLE>
<CAPTION>
                                                 December 31, 1999         December 31, 1998        December 31, 1997
                                                 -----------------         -----------------        -----------------
<S>                                             <C>                       <C>                      <C>
   Options price share ranges
   Outstanding at beginning of year                $.625 - 7.875             $1.50 - 7.875            $1.50 - 7.875
   Granted                                               --                     $ 0.625              $1.625 - 2.3125
   Options exercisable at end of year                 253,950                   335,950                  564,175
   Exercisable option price ranges                 $1.625 - 2.312            $0.625 - 7.875           $1.50 - 7.875
   Options available for grant at end of year         372,050                   290,050                   61,825
</TABLE>

         Under the 1992 plan, on October 6, 1997, the Compensation and
Nominating Committee awarded stock option grants to 533 Company employees to
purchase 365,850 shares of Common Stock at $2.31 per share (the fair market
value on the date of grant). Eligible employees included those who were employed
on or before October 1, 1997 and who were still with the Company on January 1,
1998. These options collectively expire on October 6, 2002. In addition, the
Company's former Chief Financial Officer received an option to purchase 15,000
shares of Common Stock at an exercise price of $2.00 per share pursuant to an
employment contract dated September 1, 1997. The plan also has participants who
received stock options that were awarded prior to the Northstar/Keystone merger,
those of whom are still employed with the Company.

         The stock option information presented herein represents current
management's belief of the transactions that have occurred. Certain
reclassifications of prior year information have been made to reflect current
management's belief and available information. Due to the net losses in such
years, this change has no impact on earnings per share. To date, 24,000 options
have been exercised under the 1992 Stock Option Plan.

    The following summarizes the activity under the 1994 Plan:

<TABLE>
<CAPTION>
                                                 December 31, 1999         December 31, 1998        December 31, 1997
                                                 -----------------         -----------------        -----------------
<S>                                             <C>                       <C>                      <C>
   Options
   Outstanding at beginning of year                    37,500                    37,500                   17,500
   Granted                                               --                        --                     37,500
   Exercised                                             --                        --                       -
   Expired/Canceled                                      --                        --                    (17,500)
   Outstanding at end of year                          37,500                    37,500                   37,500
</TABLE>

<TABLE>
<CAPTION>
                                                 December 31, 1999         December 31, 1998        December 31, 1997
                                                 -----------------         -----------------        -----------------
<S>                                             <C>                       <C>                      <C>
   Options price share ranges
   Outstanding at beginning of year                    $2.375                    $2.375              $6.125 - 7.3125
   Granted                                               --                        --                     $2.375
   Options exercisable at end of year                  37,500                    37,500                   37,500
   Exercisable option price ranges                     $2.375                    $2.375                   $2.375
   Options available for grant at end of year         112,500                   112,500                  112,500
</TABLE>

         Under the 1994 Plan, on March 24, 1997, the five non-employee members
of the Board of Directors each received an option to purchase 7,500 shares of
Common Stock at an exercise price of $2.375 per share with an expiration date of
March 24, 2007. The option prices represented fair market value at the dates of
grant. During 1997, options for 7,500 shares were cancelled pursuant to a
settlement agreement with a former director. Options totaling 10,000 shares
belonging to a former director expired in March 1997.





                                      F-23
<PAGE>   63



    The following summarizes the activity under the 1997 Plan:

<TABLE>
<CAPTION>
                                                 December 31, 1999         December 31, 1998     December 31, 1997
                                                 -----------------         -----------------     -----------------
<S>                                             <C>                       <C>                      <C>
   Options-
   Outstanding at beginning of year                   654,049                   253,583                  --
   Granted                                            172,500                   400,966               253,583
   Exercised                                             --                        --                    --
   Expired/Canceled                                  (160,833)                   (500)                   --
   Outstanding at end of year                         665,716                   654,049               253,583
</TABLE>

<TABLE>
<CAPTION>
                                                 December 31, 1999         December 31, 1998     December 31, 1997
                                                 -----------------         -----------------     -----------------
<S>                                             <C>                       <C>                      <C>
   Option price share ranges
   Outstanding at beginning of year                $.610 - 1.875            $1.5625 - 1.875              --
   Granted                                         $.156 - 1.200              $0.61 - 1.02         $1.5625 -1.875
   Options exercisable at end of year                 590,716                   654,049               253,583
   Exercisable option price ranges                 $.156 - 1.875             $0.61 - 1.875        $1.5625 - 1.875
   Options available for grant at end of year         334,284                   345,951               746,417
</TABLE>

         The 1997 stock option plan received shareholder approval at the annual
meeting of stockholders in September 1997. The plan authorizes 1,000,000 shares
to be reserved for issuance under the plan. The 1997 plan is intended as an
incentive and to encourage stock ownership by officers, certain key employees,
consultants and directors of the Company. Several members of management
personnel were subsequently awarded stock options by the Compensation and
Nominating Committee pursuant to employment agreements entered into in the
fourth quarter of 1997. In addition, upon re-election to the Board in September
1997, the five non-employee directors and the Corporate Secretary each received
an option to purchase 25,000 shares of Common Stock at an exercise price of
$1.687, which was the fair market value of the grant date of September 11, 1997.

         Beginning in 1994, the Company entered into contracts or agreements
with Directors or officers which bound the Company to provide stock option
grants outside of the existing plans, which have been categorized into an
Independent Plan (the "Independent Plan"). Options granted under this category
typically involve terms which differ from the existing stock option plans of the
Company, namely in the amount of the options granted, the length of the options
and the individuals or groups of individuals to which they are granted.

    The following summarizes the activity under the Independent Plan:


<TABLE>
<CAPTION>
                                                 December 31, 1999         December 31, 1998        December 31, 1997
                                                 -----------------         -----------------        -----------------
<S>                                             <C>                       <C>                      <C>
   Options
   Outstanding at beginning of year                    45,000                   332,500                  245,000
   Granted                                               --                        --                    237,500
   Exercised                                             --                        --                       --
   Expired/Canceled                                      --                    (287,500)                (150,000)
   Outstanding at end of year                          45,000                    45,000                  332,500
</TABLE>


<TABLE>
<CAPTION>

                                                 December 31, 1999         December 31, 1998        December 31, 1997
                                                 -----------------         -----------------        -----------------
<S>                                             <C>                       <C>                      <C>
   Options price share ranges
   Outstanding at beginning of year                 $1.25 - 5.25             $ 1.25 - 5.25            $ 0.75 - 5.25
   Granted                                               --                        --                 $1.25 - 2.375
   Options exercisable at end of year                  45,000                    45,000                  332,500
   Exercisable option price ranges                  $1.25 - 5.25             $1.25 - $5.25             $0.75 - 5.25
</TABLE>

         The terms of these grants include: (a) As part of a mutual release and
settlement agreement with a former director, Steven N. Brody, the Company set
forth an option to purchase 40,000 shares of Common Stock in exchange for other
compensation and consideration which resulted in the cancellation of 25,000
previously issued options; (b) substantially all of the remaining options have
been cancelled or expired.

Stock Warrants

         Since the Company's initial public offering of Common Stock in 1993,
the Company had numerous occasions to issue warrants to underwriters, their
lenders and other organizations.

         On June 9, 1997, the Company issued 100,000 warrants to Commonwealth
Associates for the purchase of its Common Stock at $2.55 per share as
compensation for advisory services. The Company also reset the exercise price of
the 70,000 warrants issued on May 18, 1995 to Commonwealth Associates and 17,500
warrants to Andres V.





                                      F-24
<PAGE>   64

Bello to $2.55 per share. The fair value of these warrants on the grant date
based upon a Black-Scholes model calculation was approximately $185,000 and
$161,875, respectively. In addition, on July 23, 1997, the Company issued 25,000
warrants to Stephen Booke and Gerald Amato, both of Booke & Company, for
investor relations consulting services. The fair value for each of these
warrants on the grant date based upon a Black-Scholes model calculation was
approximately $47,000. In connection with the refinancing of the Company's
senior debt, effective September 30, 1999, the Company re-priced 240,000
warrants to Cerberus Capital Management, LLC, at $0.25 per share. The expiration
date of these warrants is January 1, 2003. The fair market value of these
warrants on the grant date, based on a Black-Scholes model calculation, was
approximately $64,970.

The following summarizes the Company's warrant activity:

<TABLE>
<CAPTION>
                                           December 31, 1999          December 31, 1998           December 31, 1997
                                           -----------------          -----------------           -----------------
<S>                                       <C>                        <C>                         <C>
Warrants-
Outstanding at beginning of year                565,000                    843,500                     693,500
Granted                                            --                         --                       237,500
Exercised                                          --                         --                          --
Expired/Canceled                                   --                     (278,500)                   (87,500)
Outstanding at end of year                      565,000                    565,000                     843,500
</TABLE>


<TABLE>
<CAPTION>
                                           December 31, 1999          December 31, 1998           December 31, 1997
                                           -----------------          -----------------           -----------------
<S>                                        <C>                       <C>                         <C>
Warrant price per share ranges
Outstanding at beginning of year             $2.55 - 8.29                $2.55 - 8.29               $5.50 - 6.29
Granted during the year                          $ .25                        --                        $2.55
Warrants exercisable at end of year             565,000                    565,000                     843,500
Exercisable warrant price ranges              $.25 - 8.29                $2.55 - 8.29               $2.55 - 8.29
</TABLE>

14.   INCOME TAXES:

         The provision (benefit) for income taxes consisted of the following (in
thousands):

<TABLE>
<CAPTION>
                                         Year Ended December 31,
                                  1999            1998             1997
                                  ----            ----             ----
<S>                              <C>             <C>             <C>
Current:
     Federal                      $  --           $(272)          $  (770)
     State                           --              --                --
Deferred:
     Federal                        102             734            (1,461)
     State                           19            (316)             (150)
     Valuation allowance           (135)           (512)            1,611
                                  -----           -----           -------
                                  $ (14)          $(366)          $  (770)
                                  =====           =====           =======
</TABLE>

The reconciliation between income taxes computed by applying the statutory U.S.
federal income tax rate to the loss before income taxes and the actual
expense/(benefit) for income taxes is as follows (in thousands):

<TABLE>
<CAPTION>
                                                                      Year Ended December 31,
                                                               1999            1998              1997
                                                               ----            ----              ----
<S>                                                            <C>             <C>             <C>
Income tax at U.S. federal statutory rate                      $ (74)          $ 163           $(2,115)
State income taxes, net of federal income tax benefit              8            (208)             (150)
Permanent differences                                            187             191              (117)
Valuation allowance                                             (135)           (512)            1,612
                                                               -----           -----           -------
                                                               $ (14)          $(366)          $  (770)
                                                               =====           =====           =======
</TABLE>

         The Company had $9,630,000 in deferred tax assets at December 31, 1999,
due primarily to timing differences resulting from provisions for doubtful
accounts receivable, net book value of fixed and intangible assets, certain
reserves and net operating loss carryforwards. The Company had approximately
$13,600,000 of federal net operating losses and approximately $23,900,000 of
state net operating losses at December 31, 1999, which expire in varying amounts
between 2005 and 2018. The Company also has an AMT credit of $13,000 that does
not expire.

         A valuation allowance has been recorded to reduce net deferred tax
assets to zero because the Company believes, based on the weight of available
evidence, it is more likely than not that the deferred tax assets will not be
realized.






                                      F-25
<PAGE>   65

15.      EMPLOYMENT AGREEMENTS:

         On April 30, 1996, one of the former owners of an acquired business
terminated her employment agreement with the Company due to a change in control
clause in the employee's contract. A new contract was negotiated with the same
salary; however, the new agreement ended approximately six months prior to the
initial contract. The Company and this employee later agreed to terminate this
employee's contract as a result of operational difficulties. This matter was
settled in 1999 and as of December 31, 1999, the Company has recorded a
liability of $35,000 to be paid in scheduled periodic payments in the year 2000.

     In July 1997, the Company's former President, who was also one of the Board
members removed by the Consent Solicitation, was terminated. The Company was
involved in a dispute with this former employee which was settled in 1999. (See
Note 19)

         The Company has entered into employment agreements, expiring from 2000
through 2004, with certain of its officers and other key employees. The minimum
annual payments required under these agreements are as follows (dollars in
thousands):
                              2000            $1,040
                              2001               623
                              2002               561
                              2003               471
                              2004               485
                                              ------
                              Total           $3,180
                                              ======

         Included in the above figures are employment agreement obligations to
facility directors who have also provided working capital funds to the Company
as discussed in Note 16. The employment agreements for these employees do not
have a fixed termination date. As such, the payments to those individuals of
approximately $500,000 annually will continue indefinitely beyond 2004.

         Between October 29 and November 1, 1997, pursuant to employment
contracts entered into with certain key management personnel, the Company
granted options to purchase a total of 97,500 shares of Common Stock for amounts
of shares ranging from 2,500 to 25,000, at an exercise price of $1.875. The
options were granted at the fair market value on the date of grant. In addition,
certain employees also were entitled to additional options based on performance
as outlined in the agreements. Subsequently, the Company granted approximately
6,000 options to purchase Common Stock during the fourth quarter at exercise
prices based upon an average of the closing price of the Company's stock for the
five days preceding the date of grant. These contracts provide for quarterly
option grants based upon the financial performance of certain operating units of
the business. Such grants are made on the filing date of the Company's financial
data with the Securities and Exchange Commission.

         The employment contracts of various members of management include
change in control provisions whereby said employees would receive a maximum of
six months base salary. Change in control provisions include, acquisition by
third parties, mergers, consolidation, sale of more than 50% of assets, any
person or group becoming the beneficial owner of more than 30% of the stock of
the Company, or if Thomas W. Zaucha no longer serves as the CEO or Chairman.

16.      CONTRACTUAL OBLIGATIONS TO EMPLOYEES:

         Prior to the acquisition of Keystone, certain former partners of
Keystone and clinicians executed employment agreements with Keystone. These
contracts required the employees to provide funds to Keystone as part of their
incentive compensation arrangements. In return these employees received
incentive compensation equivalent to 25% of the net income for their facilities
for each month. As of December 31, 1999 and 1998, the balance of the funds
provided to Keystone was $346,315 and $349,190, respectively.

         As provided for within these agreements, the change in controlling
interest in Keystone enables these employees to terminate the contracts and be
entitled to either the funds they provided to Keystone or two times the most
recent twelve months of pre-commission net income of the facility that they
operate. During 1997, six of these employees exercised their buyout option
resulting in an obligation of $904,312. Four of these employees were paid in
full in 1997, with a remaining unpaid liability of $237,000 as of December 31,
1997, which was paid pursuant to payment schedules arranged with the remaining
two employees. As of December 31, 1999 and 1998, the calculated maximum amounts
due to the remaining employees under these agreements, including the $237,000
discussed above, is $709,227 and $914,979, respectively. (See Note 12)




                                      F-26
<PAGE>   66


17.      FAIR VALUE OF FINANCIAL INSTRUMENTS:

         The carrying amounts and estimated fair values of the Company's
financial instruments as of December 31, 1999, 1998 and 1997, are as follows
(dollars in thousands):

<TABLE>
<CAPTION>
                                        1999                       1998                         1997
                                        ----                       ----                         ----
                               Carrying      Fair          Carrying        Fair         Carrying         Fair
                                Amount       Value          Amount         Value         Amount          Value
                               --------      -----         --------        -----        --------         -----
<S>                           <C>          <C>            <C>            <C>           <C>           <C>
Cash and cash
    equivalents                 $   754     $   754         $   901       $   901       $   656       $   656
Long-term debt, including
    Current portion
                                $19,257     $19,257         $19,549       $19,549       $19,786       $19,786
</TABLE>

         The following methods and assumptions were used by the Company in
estimating the fair value of each class of financial instruments for which it is
practicable to estimate that value. Fair value is defined as the amount at which
the instrument could be exchanged in a transaction between willing parties.

CASH AND CASH EQUIVALENTS

         The carrying amount reported in the balance for cash and cash
equivalents approximates their fair value.

LONG-TERM DEBT

         The fair value of long-term debt is estimated based on the quoted
market prices for the same or similar issues or on the current rates offered to
the Company for debt of the same remaining maturities.

18.      SIGNIFICANT CUSTOMERS:

         Although net patient service revenue is generated by performing
procedures or services for the ultimate patients, who are referred for care
through their physician, the Company receives most of its revenues through
payments made by certain governmental programs, private insurers such as Blue
Cross and Blue Shield of Western Pennsylvania and others. Additionally, the
Company receives management fees for certain entities for which it performs
certain management services.

19.      COMMITMENTS AND CONTINGENCIES:

         David D. Watson, former President of the Company, has made claims
against the Company in excess of $500,000 in relation to an Employment Agreement
and Note. See Notes 3 and 15. During 1999 a settlement of these claims has been
reached. As of December 31, 1999, the Company has recorded a settlement
obligation to Mr. Watson of $163,548 which is to be paid through scheduled
periodic payments subject to certain restrictions on the senior debt agreement.

20.      LITIGATION:

         In the ordinary course of business, the Company may be subject to
claims and legal actions, from time to time, by patients and others. The Company
does not believe that any such pending actions, if adversely decided, would have
a material adverse effect on its financial condition.

         In November, 1997, a comprehensive settlement of a number of
shareholder lawsuits filed in 1996 and consolidated into one action in federal
court in the Western District of Pennsylvania (Butler v. Northstar, No. 96-701
W.D. Pa) was given approval by the court. The lawsuit alleged violations of
federal securities laws by the Company and certain of its former officers and
directors, and an alleged scheme to disseminate false and misleading information
regarding the Company. In December 1997, with no party having appealed the order
approving the settlement, the decision became final. The settlement agreement
which was approved by the court, created a settlement fund of $6.45 million, of
which $5.75 million, less expenses and legal counsel fees was paid in 1999 to
those Northstar shareholders who submitted proofs of claim and which the court
approves as valid claims. The Company contributed $100,000 to the $6.45 million
settlement fund; the insurer on the Company's directors and officers' liability
policy contributed the $1.0 million limits of coverage of that policy; and the
$5.35 million balance in the fund was contributed by other defendants.

         In September 1996, the Company filed an action in federal court in
Pittsburgh, seeking to recover damages from Northstar's former Chief Executive
Officer and various Northstar related-parties and others. (Northstar v.



                                      F-27
<PAGE>   67


DeSimone, C.A. No. 96-1695, W.D. Pa.). Since then, in connection with the
settlement of the Butler class action, Northstar has settled its claims against
its former Chief Executive Officer for the sum of $600,000 which was then
contributed to the settlement fund created in the Butler action. Subsequently,
Northstar has also agreed to settle its claims against another related-party and
his affiliated companies (the Bergman defendants). Northstar's claims against
the two remaining sets of defendants (the Shields and Horoszko defendants) were
settled in 1999.

         In February 1997, Thomas W. Zaucha, the current Chairman of the Board
of Directors and Chief Executive Officer of Northstar, commenced a solicitation
of Northstar stockholder consents to remove and replace the other members of the
Northstar Board of Directors which at the time consisted of Messrs. Brody,
Jarrett, Pesci, Smallacombe and Watson (the "Brody Board") and effectuate
related changes in Northstar's bylaws (the "Consent Solicitation"). Shortly
thereafter, the Board of Directors terminated Mr. Zaucha's employment with the
Company, though he remained a member of the Board of Directors. On March 24,
1997, Mr. Zaucha delivered executed consents representing the votes of 61% of
the outstanding shares in favor of his proposals and, following confirmation of
the decision of the Delaware Chancery Court on May 8, 1997, Mr. Zaucha resumed
his duties as the Company's Chief Executive Officer. The ruling of the Delaware
Chancery Court was appealed to the Delaware Supreme Court by three of the Board
members removed from office as a result of the Chancery Courts' decision. On
August 1, 1997, a unanimous panel of the Delaware Supreme Court affirmed the
decision of the Delaware Chancery Court confirming the election of the current
Board.

         In January 1997, the Justice Department initiated an action against
Samuel Armfield, III, M.D. for claims amounting to $300,000 in connection with
Dr. Armfield's Medicare billings. Although such claims could be trebled if Dr.
Armfield is convicted, the Company believes that its exposure, through its
dealings with Vascusonics, would aggregate $50,000 to $100,000. In addition, the
Company has recourse against Dr. Armfield for any amounts assessed against the
Company, which the Company plans to aggressively pursue, if necessary. A payment
of $30,000 was made to Dr. Armfield in March of 2000 in settlement of all other
claims and counter claims.

         In 1998, Robert J. Smallacombe, a former director, consultant and
employee of the Company filed a Writ of Summons against the Company and other
related parties. Mr. Smallacombe in May 1997. (See Note 15.) Mr. Smallacombe
believes he is entitled to the balance of his employment contract and certain
stock options that may or may not have been granted. The Company believes that
it has counterclaims against Mr. Smallacombe, and intends to vigorously defend
itself against these claims. No action was taken against the Company in 1999
related to this matter.

         In 1998, Nicholas P. Horoszko, a named defendant in the lawsuit filed
by the Company in September 1996 described above, filed a demand for arbitration
against the Company for alleged breach of contract. This matter was settled in
1999.

21.      SUBSEQUENT EVENT:

         On March 15, 2000, the Company signed a definitive agreement to become
a wholly owned subsidiary of Benchmark Medical, Inc. of Malvern, PA. Benchmark
is a newly formed, privately held company funded by Wind Point Partners, a
private equity investment firm based in Chicago, IL.

         The agreement calls for Benchmark to acquire all of the outstanding
shares and certain options and warrants of Northstar stock at $1.50 per share.
The options and warrants are triggered upon the occurrence of specified events
set forth in the option and warrant agreements.

         The total consideration is approximately $36 million, which includes
payments to stockholders and repayment or assumption of certain obligations of
the company. The transaction is subject to certain closing conditions including
expiration of the Hart-Scott Rodino waiting period. The transaction is expected
to close during the third calendar quarter of this current year.





                                      F-28
<PAGE>   68



                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
                         ON FINANCIAL STATEMENT SCHEDULE


         To Northstar Health Services, Inc.:

                  We have audited in accordance with auditing standards
         generally accepted in the United States, the financial statements
         included in Northstar Health Services, Inc.'s Form 10-K, and have
         issued our report thereon dated March 9, 2000. Our audit was made for
         the purpose of forming an opinion on those statements taken as a whole.
         The schedule listed in the index in Item 14(a) of this Form 10-K is the
         responsibility of the Company's management and is presented for
         purposes of complying with the Securities and Exchange Commission's
         rules and is not part of the basic financial statements. This schedule
         has been subjected to the auditing procedures applied in the audit of
         the basic financial statements and, in our opinion, fairly states in
         all material respects the financial data required to be set forth
         therein in relation to the basic financial statements taken as a whole.

                                                    Arthur Andersen LLP

         Pittsburgh, Pennsylvania
             March 9, 2000




                                      F-29
<PAGE>   69




                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                        VALUATION AND QUALIFYING ACCOUNTS
                FOR YEARS ENDING DECEMBER 31, 1999, 1998 AND 1997
                             (Dollars in Thousands)

<TABLE>
<CAPTION>
                                 Restated           Restated        Restated           Restated          Restate       Restated
                                Balance at         Charged to                                                         Balance at
                               Beginning of        Costs and                       Deductions from                      End of
                                  Period            Expenses       Recoveries        Reserve (1)          Other         Period
                               ------------        ----------      ----------      ----------------      -------      ----------
<S>                           <C>                 <C>             <C>             <C>                   <C>          <C>
Year ended December 31,
  1997 - Allowance for
  doubtful accounts               $2,015             1,965            --               (2,680)               --          $1,300

Year ended December 31,
  1998 - Allowance for
  doubtful accounts               $1,300               365            --               (1,139)               --          $  526

Year ended December 31,
  1999 - Allowance for
  doubtful accounts               $  526               342            --                 (438)               --          $  430
</TABLE>

(1)      Represents uncollected accounts charged against the allowance account.


                                      F-30