<PAGE>
 


 
                       SECURITIES AND EXCHANGE COMMISSION

                             Washington, D.C. 20549

                                  -----------

                                  FORM 10-K/A

                                  ----------


                               Amendment No. 2 to
                 Annual Report Pursuant to Section 13 or 15(d)
                     of the Securities Exchange Act of 1934
                  For the Fiscal Year Ended December 31, 1996


                                  ----------


                          Commission File No. 0-18217


                            TRANSCEND SERVICES, INC.


                             A Delaware Corporation
                  (IRS Employer Identification No. 33-0378756)
                           3353 Peachtree Road, N.E.
                                   Suite 1000
                             Atlanta, Georgia 30326
                                 (404) 364-8000



     The undersigned registrant hereby amends the following items, financial
statements, exhibits or other portions of its Annual Report on Form 10-K for the
fiscal year ended December 31, 1996:

(List all such items, financial statements, exhibits or other portions amended)


Item 6.  Selected Financial Data.
Item 8.  Financial Statements and Supplementary Data.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
<PAGE>
 
                                    PART II

ITEM 6. SELECTED FINANCIAL DATA

  The following table sets forth selected consolidated financial data of the
Company for the periods indicated, which data has been derived from the
Company's consolidated financial statements.  The report of Arthur Andersen LLP,
independent public accountants, with respect to such consolidated financial
statements as of December 31, 1995 and 1996 and for the three years in the
period ended December 31, 1996 is included on page 23.   This selected
consolidated financial data should be read in conjunction with the consolidated
financial statements, related notes and other financial information included and
incorporated by reference herein.
<TABLE>
<CAPTION>
 
                                                    YEARS ENDED DECEMBER 31,
                                       ---------------------------------------------------
                                         1992     1993       1994         1995      1996
                                       -------  -------  -------------  --------  --------
                                              (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                    <C>      <C>          <C>         <C>       <C>
 
STATEMENTS OF OPERATIONS
   DATA(1)(2)(3):
Net revenues.........................  $1,702   $6,511      $12,886   $26,825   $37,970
   Direct costs......................     893    5,428       11,233    22,745    32,591
                                       ------   ------      -------   -------   -------
   Gross profit......................     809    1,083        1,653     4,080     5,379
Marketing and sales expense..........     209      378          929     2,186     2,480
General and administrative expense...     715    1,330        1,673     4,961     5,771
Write down of AmHealth...............      --       --           --        --     1,700
Amortization expense of
   intangible assets.................      --      310          357       633       535
                                       ------   ------      -------   -------   -------
Operating loss.......................    (115)    (935)      (1,306)   (3,700)   (5,107)
                                       ------   ------      -------   -------   -------
Interest, net........................     (16)    (132)         (65)      (21)     (262)
Other................................      (2)     101           25        --      (200)
                                       ------   ------      -------   -------   -------
Total other income (expenses)........     (18)     (31)         (40)      (21)     (462)
                                       ------   ------      -------   -------   -------
                                                         
Loss before income tax provision  
 and discontinued operations.......      (133)    (966)      (1,346)   (3,721)   (5,569)
Provision for income tax.............      --       --           13        --        --
                                       ------   ------        -------   -------   -------
Loss before discontinued operations..    (133)    (966)      (1,359)   (3,721)   (5,569)
Loss from discontinued operations....      --       --           --      (479)   (1,582)
                                       ------   ------      -------   -------   -------
Net Loss.............................  $ (133)  $ (966)     $(1,359)  $(4,200)  $(7,151)
                                       ======   ======      =======   =======   =======
Net loss per common share:
Loss before discontinued operations..   $(.02)   $(.11)       $(.14)    $(.20)    $(.30)
Loss from discontinued operations....      --       --           --      (.03)     (.08)
                                       ------   ------      -------   -------   -------
Net Loss.............................   $(.02)   $(.11)       $(.14)    $(.23)    $(.38)
                                       ======   ======      =======   =======   =======
Weighted average shares
   outstanding.......................   7,392    9,096        9,963    18,017    18,908
  
                                                         DECEMBER 31,
                                                         ------------
 
                                         1992     1993         1994      1995      1996
                                       ------   ------      -------   -------   -------
BALANCE SHEET DATA:
Working capital......................  $  202   $ (569)     $(2,983)  $   605   $(1,551)
Total assets.........................     790    1,200        2,751    16,592    16,144
Long-term debt and capital lease
   obligations.......................     300       --           --     2,431     2,284
Shareholders' equity.................     277      168       (1,180)    9,632     5,971
</TABLE>
--------
(1)  On January 10, 1995, the Company acquired a Georgia corporation then known
     as "Transcend Services, Inc." by the merger of Transcend into a subsidiary
     of the Company. The merger was treated for financial accounting purposes as
     the acquisition of the Company by the former Transcend and the historical
     financial statements of the former Transcend have become the financial
     statements of the Company and include the business of both companies after
     the effective date of the merger. See Note 1 of "Notes to Consolidated
     Financial Statements."

(2)  The Company has completed several acquisitions that could affect the
     comparability of the information reflected in the table. See Note 12 of
     "Notes to Consolidated Financial Statements."

(3)  The Company has restated the 1993, 1994 and 1995 period amounts to reflect 
     the 1996 acquisition of Express Medical Transcription, Inc. ("EMT") in a
     pooling transaction. See Note 12 of "Notes to Consolidated Financial
     Statements."

                                       1
<PAGE>
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

 The following financial statements are filed with this report:

 Report of Arthur Andersen LLP, Independent Public Accountants

 Consolidated Balance Sheets at December 31, 1995 and 1996

 Consolidated Statements of Operations for the years ended December 31, 1994,
 1995 and 1996

  Consolidated Statements of Shareholders' Equity for the years ended December
  31, 1994, 1995 and 1996

 Consolidated Statements of Cash Flows for the years ended December 31, 1994,
 1995 and 1996

 Notes to Consolidated Financial Statements
 
                                       2

<PAGE>
 
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

TO THE BOARD OF DIRECTORS AND SHAREHOLDERS OF
TRANSCEND SERVICES, INC.:

  We have audited the accompanying consolidated balance sheets of Transcend
Services, Inc. (a Delaware corporation) and subsidiaries as of December 31, 1995
and 1996 and the related consolidated statements of operations, shareholders'
equity, and cash flows for each of the three years in the period ended December
31, 1996. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

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

  In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Transcend Services, Inc. and
subsidiaries as of December 31, 1995 and 1996 and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1996 in conformity with generally accepted accounting principles.



                                                 ARTHUR ANDERSEN LLP



ATLANTA, GEORGIA
FEBRUARY 14, 1997

                                       3
<PAGE>
 
                            TRANSCEND SERVICES, INC.

                          CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
 
 
                                                                                    DECEMBER 31,
                                                                            ----------------------------
                                                                                1995           1996
                                                                            -------------  -------------
<S>                                                                         <C>            <C>
        ASSETS
       -------                                                              
 
CURRENT ASSETS:
                   Cash and cash equivalents..............................   $ 1,117,000   $  1,660,000
                   Accounts receivable, net of allowance for doubtful
                   accounts of $42,000 and $147,000 in 1995
                   and 1996, respectively.................................     3,165,000      3,594,000
                   Other..................................................       309,000        543,000
                                                                             -----------   ------------
                   Total current assets...................................     4,591,000      5,797,000
                                                                             -----------   ------------
 
NET ASSETS RELATED TO DISCONTINUED OPER-
 ATIONS...................................................................     2,414,000      2,577,000
SECURITIES OF AMHEALTH....................................................     2,050,000        350,000
EQUIPMENT and LEASEHOLD IMPROVEMENTS, at
                   cost, less accumulated depreciation and amortization
                   of $1,085,000 and $2,040,000 in 1995 and 1996,
                   respectively...........................................     1,766,000      2,434,000
DEPOSITS AND OTHER ASSETS.................................................       408,000        158,000
GOODWILL AND OTHER INTANGIBLE ASSETS,
                    less accumulated amortization of $1,301,000 and
                    $1,836,000 in 1995 and 1996, respectively.............     5,363,000      4,828,000
                                                                             -----------   ------------
                   Total assets...........................................   $16,592,000   $ 16,144,000
                                                                             ===========   ============
 
                   LIABILITIES AND SHAREHOLDERS' EQUITY
                   ------------------------------------                      
 
CURRENT LIABILITIES:
                   Current maturities of long term debt and note payable..   $   208,000   $  2,226,000
                   Accounts payable.......................................     1,268,000      1,989,000
                   Accrued compensation and employee benefits.............     1,570,000      1,702,000
                   Other accrued liabilities..............................       807,000      1,318,000
                   Deferred income taxes..................................       133,000        113,000
                                                                             -----------   ------------
                   Total current liabilities..............................     3,986,000      7,348,000
                                                                             -----------   ------------
 
CONVERTIBLE DEBENTURES....................................................     2,000,000      2,000,000
                                                                             -----------   ------------
 
LONG TERM DEBT, net of current maturities.................................       431,000        284,000
                                                                             -----------   ------------
 
DEFERRED INCOME TAXES.....................................................       543,000        541,000
                                                                             -----------   ------------
 
SHAREHOLDERS' EQUITY:
                   Preferred stock, $.01 par value; 21,000,000 shares
                   authorized; none outstanding...........................            --            ---
                   Common stock, $.01 par value, 30,000,000 shares
                   authorized, 18,343,000 and 19,469,000 shares issued
                   and outstanding as of December 31, 1995 and 1996,
                   respectively...........................................       183,000        194,000
                   Additional paid-in capital.............................    16,642,000     19,931,000
                   Retained deficit.......................................    (7,193,000)   (14,154,000)
                                                                             -----------   ------------
                      Total shareholders' equity..........................     9,632,000      5,971,000
                                                                             -----------   ------------
                      Total liabilities and shareholders' equity..........   $16,592,000   $ 16,144,000
                                                                             ===========   ============
 
--------------------
</TABLE>
 The accompanying notes are an integral part of these consolidated balance
sheets.  All prior period amounts have been restated to reflect the 1996 
acquisition of EMT in a pooling transaction. See Note 12 of "Notes to
Consolidated Financial Statements."

                                       4
<PAGE>
 
                            TRANSCEND SERVICES, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS



                                                   YEARS ENDED DECEMBER 31,
                                                   ------------------------
<TABLE> 
<CAPTION> 
                                                 1994          1995          1996
                                                 ----          ----          ----
 
<S>                                           <C>           <C>           <C>
NET REVENUE.................................  $12,886,000   $26,825,000   $37,970,000
DIRECT COSTS................................   11,233,000    22,745,000    32,591,000
                                              -----------   -----------   -----------
 Gross profit...............................    1,653,000     4,080,000     5,379,000
 
MARKETING AND SALES EXPENSES................      929,000     2,186,000     2,480,000
GENERAL AND ADMINISTRATIVE EXPENSES.........    1,673,000     4,961,000     5,771,000
WRITE DOWN OF AMHEALTH......................          -0-           -0-     1,700,000
AMORTIZATION EXPENSE........................      357,000       633,000       535,000
                                              -----------   -----------   -----------
 Loss from Operations.......................   (1,306,000)   (3,700,000)   (5,107,000)
 
OTHER INCOME (EXPENSE):
 Interest expense...........................      (66,000)      (96,000)     (320,000)
 Interest income............................        1,000        75,000        58,000
 Other......................................       25,000           -0-      (200,000)
                                              -----------   -----------   -----------
                                                  (40,000)      (21,000)     (462,000)
                                              -----------   -----------   -----------
 
LOSS BEFORE PROVISION FOR INCOME TAXES AND
  DISCONTINUED OPERATIONS...................   (1,346,000)   (3,721,000)   (5,569,000)
PROVISION FOR INCOME TAXES..................       13,000           -0-           -0-
                                              -----------   -----------   -----------
LOSS BEFORE DISCONTINUED OPERATIONS.........   (1,359,000)   (3,721,000)   (5,569,000)
LOSS FROM DISCONTINUED OPERATIONS...........          -0-      (479,000)   (1,582,000)
                                              -----------   -----------   -----------
NET LOSS....................................  $(1,359,000)  $(4,200,000)  $(7,151,000)
                                              ===========   ===========   ===========
 
NET LOSS PER COMMON SHARE:
BEFORE DISCONTINUED OPERATIONS..............       $(0.14)       $(0.20)  $     (0.30)
DISCONTINUED OPERATIONS.....................           --          (.03)        (0.08)
                                              -----------   -----------   -----------
NET LOSS....................................       $(0.14)       $(0.23)  $     (0.38)
                                              ===========   ===========   ===========
 
Weighted average common shares outstanding..    9,963,000    18,017,000    18,908,000
                                              ===========   ===========   ===========
 
-------------------
</TABLE>
 The accompanying notes are an integral part of these consolidated statements.
 All prior period amounts have been restated to reflect the 1996 acquisition of
 EMT in a pooling transaction. See Note 12 of "Notes to Consolidated Financial
 Statements."

                                       5
<PAGE>
 
                            TRANSCEND SERVICES, INC.

                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE> 
<CAPTION> 

                                                  ADDITIONAL                                TOTAL
                                         COMMON    PAID-IN    WARRANTS      RETAINED     SHAREHOLDERS'
                                         STOCK    CAPITAL    OUTSTANDING    DEFICIT        EQUITY
                                         -----    -------   -----------     -------        ------
<S>                                    <C>       <C>          <C>         <C>            <C>
BALANCE, December 31,1993............  $ 96,000  $ 1,564,000  $ 104,000   $ (1,596,000)  $   168,000
                                       --------  -----------  ---------   ------------   -----------
Issuance of 341,546
             shares of Common Stock
             from exercise of
             warrants................     3,000      101,000   (104,000)            --            --
 Other issuance of
             Common Stock............        --       11,000         --             --        11,000
 Net loss............................        --           --         --     (1,359,000)   (1,359,000)
                                       --------  -----------  ---------   ------------   -----------
BALANCE, December 31, 1994...........    99,000    1,676,000         --     (2,955,000)   (1,180,000)
                                       --------  -----------  ---------   ------------   -----------
Issuance of 7,792,446
             shares of Common Stock
             with Merger.............    78,000   14,533,000         --             --    14,611,000
Issuance of 60,000
             shares of Common Stock
             in Acquisition..........     1,000      171,000         --             --       172,000
Issuance of 527,130
             shares from exercise
             of options and other
             issuances...............     5,000      262,000         --             --       267,000
Net loss.............................        --           --         --     (4,200,000)   (4,200,000)
Distribution to Former Shareholder
    /Owner (1).......................        --           --         --        (38,000)      (38,000)
                                       --------  -----------  ---------   ------------   -----------
BALANCE, December 31, 1995...........   183,000   16,642,000         --     (7,193,000)    9,632,000
                                       --------  -----------  ---------   ------------   -----------
Issuance of 521,725
             shares of Common Stock
             in Private Placement....     5,000    2,441,000         --             --     2,446,000
 Issuance of 87,805
             shares of Common Stock
             in Acquisitions.........     1,000           --         --        311,000       312,000
Issuance of 476,054 shares of
    Common Stock from exercise
    of options and other issuances...     5,000      848,000         --             --       853,000
Net loss.............................        --           --         --     (7,151,000)   (7,151,000)
Distribution to Former Shareholder
   /Owner (1)........................        --           --         --       (121,000)     (121,000)
                                       --------  -----------  ---------   ------------   -----------
BALANCE, December 31, 1996...........  $194,000  $19,931,000  $     ---   $(14,154,000)  $ 5,971,000
                                       ========  ===========  =========   ============   ===========
</TABLE>
--------------------
(1) Distribution to former Shareholder/Owner of EMT prior to June, 1996
    acquisition made by Transcend.

The accompanying notes are an integral part of these consolidated statements.
All prior period amounts have been restated to reflect the 1996 acquisition of 
EMT in a pooling transaction. See Note 12 of "Note to Consolidated Financial
Statements."
                                       6
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                     CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE> 
<CAPTION> 
                                                                                           YEARS ENDED DECEMBER 31,
                                                                                           ------------------------
                                                                                     1994            1995           1996
                                                                                     ----            ----           ----
CASH FLOWS FROM OPERATING ACTIVITIES:
<S>                                                                               <C>            <C>           <C>
Net Loss........................................................................   $(1,359,000)  $(4,200,000)  $(7,151,000)
                                                                                   -----------   -----------   -----------
   Adjustments to reconcile net loss to net cash used in operating activities:
   Depreciation and amortization................................................       540,000     1,141,000     1,423,000
   Write down of AmHealth Securities............................................            --            --     1,700,000
   Loss related to Discontinued Operations......................................            --       479,000     1,582,000
Changes in assets and liabilities, net of acquisitions:
   Accounts receivable..........................................................      (262,000)   (1,485,000)     (262,000)
   Prepaid expenses.............................................................       (51,000)     (187,000)     (230,000)
   Deposits and other assets....................................................      (101,000)     (351,000)      255,000
   Accounts payable.............................................................       554,000       (52,000)      706,000
   Accrued liabilities..........................................................       253,000       298,000       601,000
   Other........................................................................      (119,000)      123,000       (20,000)
                                                                                   -----------   -----------   -----------
Total adjustments...............................................................       814,000       (34,000)    5,755,000
                                                                                   -----------   -----------   -----------
Net Cash used in continuing operations..........................................      (545,000)   (4,234,000)   (1,396,000)
                                                                                   -----------   -----------   -----------
Net Cash provided by (used in) discontinued operations..........................            --       202,000    (1,745,000)
                                                                                   -----------   -----------   -----------
Net Cash used in operating activities...........................................      (545,000)   (4,032,000)   (3,141,000)
                                                                                   -----------   -----------   -----------
 
CASH FLOWS FROM INVESTING ACTIVITIES:
   Capital expenditures.........................................................      (464,000)   (1,279,000)   (1,338,000)
   Disposal and transfer of property............................................            --        60,000        11,000
   Cash acquired from acquisitions..............................................         2,000     7,560,000        37,000
   Acquisitions.................................................................    (1,000,000)   (1,527,000)           --
   Distribution to former shareholder/owner (1).................................            --       (38,000)     (121,000)
                                                                                   -----------   -----------   -----------
Net Cash (used in) provided by investing activities.............................    (1,462,000)    4,776,000    (1,411,000)
                                                                                   -----------   -----------   -----------
 
CASH FLOWS FROM FINANCING ACTIVITIES:
   Borrowings from short-term debt..............................................     1,000,000            --            --
   Repayments on short-term debt................................................            --            --      (100,000)
   Borrowings under line of credit agreement....................................     1,025,000        40,000     2,118,000
   Repayments on line of credit agreement.......................................            --    (2,025,000)           --
   Principal payments long-term debt............................................            --       (60,000)     (218,000)
   Proceeds - Convertible Debentures............................................            --     2,000,000            --
   Proceeds from private placement of  Common stock.............................            --            --     2,446,000
   Proceeds - Stock options and other issuances.................................        13,000       268,000       849,000
                                                                                   -----------   -----------   -----------
Net cash provided by financing activities.......................................     2,038,000       223,000     5,095,000
                                                                                   -----------   -----------   -----------
 
NET INCREASE IN CASH AND CASH EQUIVALENTS.......................................        31,000       967,000       543,000
CASH AND CASH EQUIVALENTS, at beginning of year.................................       119,000       150,000     1,117,000
                                                                                   -----------   -----------   -----------
CASH AND CASH EQUIVALENTS, at end of year.......................................   $   150,000   $ 1,117,000   $ 1,660,000
                                                                                   ===========   ===========   ===========
</TABLE>
---------------------------
(1) Distribution to former Shareholder/Owner of EMT prior to June, 1996
    acquisition made by Transcend.

The accompanying notes are an integral part of these consolidated statements.
All prior period amounts have been restated to reflect the 1996 acquisition of 
EMT in a pooling transaction. See Note 12 of "Notes to Consolidated Financial
Statements."
                                       7
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                       DECEMBER 31, 1994, 1995 AND 1996

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF BUSINESS

   Transcend Services, Inc. (the "Company") is engaged in the field of contract
outsourcing of the health information management/medical records and patient
access functions of hospitals. The Company offers operations evaluation,
consulting, reimbursement coding, transcription, and other services generally
resident in the medical records department of hospitals. Currently, it
emphasizes three- to five-year contractual relationships for management of the
entire hospital medical records and patient access departments. The Company's
three largest hospital contracts accounted for approximately 46%, 25% and 18% of
sales in 1994, 1995, and 1996, respectively.

   The Company was incorporated in 1976 and was reorganized as a Delaware
corporation in 1988. On January 10, 1995, the Company, formerly known as
TriCare, Inc., acquired Transcend Services, Inc., a Georgia corporation by the
merger of Transcend Services, Inc. into First Western Health Corporation
("Merger"), a subsidiary of the Company. On May 31, 1995, Transcend Services,
Inc., a California corporation following its January 10, 1995 merger into the
Company, and Veritas Healthcare Management, a California corporation owned by
the Company, merged into the Company, whose name was then changed to "Transcend
Services, Inc." The Merger was treated for financial accounting purposes as the
acquisition of TriCare by Transcend and the historical financial statements of
Transcend have become the financial statements of the Company and include the
businesses of both companies after the effective date of the Merger. The Company
has one wholly-owned operating subsidiary, Sullivan Health Management Services,
Inc. ("Sullivan") which provides case management and disability management
services.

BASIS OF PRESENTATION

   The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries. All significant intercompany accounts and
transactions have been eliminated in consolidation.

   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.

CASH AND CASH EQUIVALENTS

   The Company considers all highly-liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents.

ACCOUNTS RECEIVABLE

   An allowance for doubtful accounts has been established to provide for losses
on uncollectible accounts based on management's estimates and historical
collection. Bad debt expense amounted to $9,000, $0 and $101,000 in 1994, 1995
and 1996, respectively.

REVENUE AND COST RECOGNITION

   Revenue is recognized monthly as the work is performed.

   SERVICE LINE                            REVENUE RECOGNITION
   ------------                            -------------------

   Contract Management (Outsourcing):      Monthly; 1/12th of annual fixed fee.

                                       8
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                       DECEMBER 31, 1994, 1995 AND 1996


  Transcription:          Monthly; revenue recognized on a per line/per
                          character basis for actual dictation .
  Consulting & Coding:    Monthly; revenue recognized for
                          work incurred on time and material basis.
  Case Management:        Monthly; revenue recognized as work is
                          incurred; usually on fixed cost per hour per case.

  One-time nonrefundable contract implementation fees have been amortized over
the first three months of a contract to match when the costs are incurred for
implementation. Direct costs are expensed as incurred and include contract labor
costs related to medical records processing, transcription, coding costs and
case management costs, as well as purchased services, such as microfilming,
record storage, software licenses, etc.

DEPRECIATION

  Depreciation is computed using the straight-line method over the estimated
useful lives of the respective assets which range from three to seven years.

INCOME TAXES

  The Company accounts for its income taxes in accordance with Statement of
Financial Accounting Standards ("SFAS") No 109. Under the asset and liability
approach, deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
basis and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to
reverse.

DEPOSITS AND OTHER ASSETS

  Deposits and other assets includes $144,000 in restricted cash used as
collateral for a letter of credit related to a contract outsourcing agreement
which expires in September, 1997.

GOODWILL AND OTHER INTANGIBLE ASSETS

  Goodwill and other intangible assets are currently being amortized over
periods ranging from three to thirty years. The Company periodically evaluates
whether events and circumstances since acquisition have occurred that indicate
that the remaining estimated useful life of goodwill may warrant revision or
that the remaining balance of goodwill may not be recoverable. When factors
(such as a change in law or regulatory environment or forecasts showing changing
long-term profitability) indicate that goodwill should be evaluated for possible
impairment, the Company uses an estimate of the related business unit's
undiscounted net income over the remaining life of the goodwill to measure
whether the goodwill is recoverable.

FAIR VALUE OF DEBT

  In accordance with SFAS No. 107, "Disclosures About Fair Value of Financial
Investments", the fair value of short-term debt is estimated to approximate its
carrying value. The fair value of long-term debt is estimated based on
approximate market interest rates for similar issues. The estimated fair value
of long-term debt at December 31, 1995 and 1996 was equal to the carrying amount
included in the accompanying balance sheet.

                                       9
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                       DECEMBER 31, 1994, 1995 AND 1996

NET LOSS PER COMMON SHARE AND COMMON SHARE EQUIVALENT

   Net loss per common share has been computed based on the weighted average
number of the Company's common shares outstanding. Common equivalent shares from
stock options and warrants have not been included in the computation due to
their antidilutive effect.

NEW ACCOUNTING PRONOUNCEMENTS
  
   In March 1995, the Financial Accounting Standards Board issued SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of," which establishes accounting standards for the impairment of
long-lived assets, certain identifiable intangibles and goodwill related to
those assets to be held and used, as well as for long-lived assets and certain
identifiable intangibles to be disposed of. The Company adopted the new standard
on January 1, 1996. The impact of adopting this standard was not material.
Management periodically evaluates the carrying values of its long-lived assets,
based upon future cash flows and operating income generated by the underlying
assets in determining the carrying value.

   The Company accounts for its stock-based compensation plans under Accounting
Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to
Employees." Effective in 1996, the Company adopted the disclosure option of SFAS
No. 123, "Accounting for Stock-Based Compensation." SFAS No. 123 requires that
companies which do not choose to account for stock-based compensation as
prescribed by this statement shall disclose the pro forma effects on net income
and per share data as if SFAS No. 123 had been adopted. Additionally, certain
other disclosures are required with respect to stock compensation and the
assumptions used to determine the pro forma effects of SFAS No. 123 (Note 10).

RESTATEMENT OF PRIOR YEAR BALANCES

   Certain prior year balances have been restated to conform with current year
presentation.

2. DISCONTINUED OPERATIONS

   LEGAL PROCEEDINGS

   On September 17, 1993, the Company and its healthcare subsidiaries, First
Western Health Corporation and Veritas Healthcare Management, and the physician-
owned medical groups, FWHC Medical Group, Inc. and Veritas Medical Group, Inc.,
which had contracts with the healthcare subsidiaries, initiated a lawsuit in the
Superior Court of the State of California, County of Los Angeles, against 22 of
the largest California workers' compensation insurance carriers, which was
subsequently amended to name 16 defendants (including State Compensation
Insurance Fund, Continental Casualty Company, California Compensation Insurance
Company, Zenith National Insurance Corporation and Pacific Rim Assurance
Company). The action seeks $115 million in compensatory damages plus punitive
damages. The plaintiffs claim abuse of process, intentional interference with
contractual and prospective business relations, negligent interference and
unlawful or unfair business practices which led to the discontinuation in April
1993 of the former business of the Company's healthcare subsidiaries and their
contracting associated medical groups (the "Lawsuit"). The claims arise out of
the Company's former business, which prior to the merger with Transcend
Services, Inc., included providing medical/legal evaluations and medical
treatment services (in association with managed medical groups) in the workers'
compensation industry in California. Seven defendants in the Lawsuit have filed
cross complaints against the plaintiffs seeking restitution, accounting from the
plaintiffs for monies previously paid by the defendants, disgorgement of
profits, injunctive relief, attorneys' fees and punitive damages, based upon
allegations of illegal corporate practice of medicine, illegal referral
arrangements, specific statutory violations and related improper conduct. The
Company and its counsel do not believe that it is likely that the Company will
be held liable on any of the cross complaints; however, there can be no
assurance that the Company will be successful in the defense of the cross
complaints. In addition, there can be no assurance as to the recovery by the
Company of the damages sought in its complaint against the defendants. The costs
associated with the conduct of the Lawsuit cannot be ascertained with certainty
but are

                                      10
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                       DECEMBER 31, 1994, 1995 AND 1996
                                        
expected to be substantial. Based upon facts and circumstances known to date, in
the opinion of management, final resolution of the Lawsuit will not have a
material adverse effect on the Company's financial condition or results of
operations.
 
  Following a hearing in November, 1996, the Los Angeles County Superior Court,
on December 20, 1996, sustained the defendants' demurrer to the Second Amended
Complaint of the plaintiffs (including the Company and certain of its
subsidiaries), with leave to further amend the complaint. The Court determined
in such ruling that exclusive jurisdiction with respect to the claims contained
in the Lawsuit resides with the California Workers' Compensation Appeals Board
and that the Superior Court of the State of California is an improper forum. The
Company has been advised by counsel that there is no remedy for the damages
claimed in the Lawsuit from the California Workers' Compensation Appeals Board.
However, the plaintiffs will file a Third Amended Complaint with the Superior
Court and a hearing is expected to be held respecting the Third Amended
Complaint by the end of the first quarter of 1997. If the Court sustains the
defendants' demurrer at such hearing, a final order dismissing the Lawsuit will
be entered and the Company expects to appeal any such ruling. If the Superior
Court's ruling is upheld on appeal, the cross complaints against the plaintiffs
also are likely to be dismissed.

  With respect to any future expenses related to the Lawsuit, commencing in
December 1996 and for the remainder of the case, the Company is only responsible
for out-of-pocket expenses and the payment to its legal counsel of a percentage
of any recovery awarded in the Lawsuit. In 1995 and 1996, the Company expensed
approximately $479,000 and $1,582,000, respectively, of legal expenses connected
with the Lawsuit. All future out-of-pocket legal expenses, in excess of the
capped legal fees, will continue to be expensed on a current basis going
forward.
  
  First Western/Veritas

  At December 31, 1996, the net assets related to the discontinued operations of
the Company's healthcare subsidiaries, First Western Health Corporation ("First
Western") and Veritas Healthcare Management ("Veritas") were $2,577,000,
consisting of $5,992,000 of gross accounts receivable offset by $3,415,000 in
collection liabilities. In October, 1995, the Company sold approximately 38% of
the gross accounts receivable to a third party with which the Company has also
contracted with to service and manage the remaining accounts receivable balance
for a set fee. The net accounts receivable from the discontinued operations
represent reimbursements that are owed the Company by certain insurance
companies from applicant/legal evaluation services provided by FWHC Medical
Group, Inc. and Veritas Medical Group, Inc., two managed medical groups
associated with the Company's former subsidiaries, First Western and Veritas.
The applicant/legal evaluation services were provided to injured California
workers who, under Section 4620 of the California Labor Code (the "California
Code"), are entitled to "medical-legal" testimony from a physician of his or her
choosing in order to provide medical evidence that he or she is entitled to
benefits under California's workers' compensation system. Under section 4621 of
the California Code, employers are responsible for paying the employees' costs
of such medical-legal expenses that are reasonably, actually and necessarily
incurred and payment for such costs must be made or objected to within 60 days
of receipt of the billing from the provider. Notwithstanding the requirement for
prompt payment and objection, many insurance companies fail to pay promptly.

  In the event of non-payment, a lien is filed with the California Workers'
Compensation Appeals Board ("WCAB"), after which the medical-legal provider is
known as a "lien claimant." In connection with the accounts receivable owed the
Company, liens have been filed with the WCAB for all $5,992,000 of the gross
accounts receivable outstanding as of December 31, 1996. While lien claimants
are supposed to be paid immediately, they are not entitled to a determination as
to the collectibility on the lien by an administrative court hearing until there
has been a hearing on the employee's underlying case. Accordingly, if an insurer
fails to pay a medical-legal provider's bill as required and continues to
dispute payment after the filing of a lien, the provider may have to wait years
until the injured worker's health status reaches the point that entitlement to
benefits may be determined. In addition, after the WCAB has made a determination
as to collectability, backlogs in the system often create delays of several
years before an order for payment can be obtained. The situation is analogous to
the several years or longer that it often takes in the civil court system to
obtain judgement after filing an action.

                                      11
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                       DECEMBER 31, 1994, 1995 AND 1996
                                        
Although it may take a number of years, the Company does not believe that there
is any dispute as to the Company's ability to attempt collection on the liens
and expects to collect the accounts receivable from discontinued operations over
the next several years under the provisions of the sale and service agreement
that the Company has entered into with the third party for servicing and
managing the remaining accounts receivable balance. During the year  ended
December 31, 1996, the Company collected approximately $456,000 on the
receivables and wrote off approximately $295,000.  As a further delay to the
Company obtaining an order of payment, four insurers that are defendants in the
Lawsuit have obtained stays of the proceedings before the WCAB, pending
resolution of the Lawsuit.  Such stays relate to the collection of $5,528,000 of
the total gross receivables. Although over 92% of the accounts receivable are
subject to the stays of proceeds, the Company believes that it will be able to
collect such accounts as the stays of proceedings only impact the timing of the
Company's collection, not the insurance companies' legal obligation to pay for
the services rendered.  The sale of approximately 38% of the gross receivables
to a third party did not result in any gain or loss to the Company.  In
estimating net accounts receivable, the Company believes that it has made
adequate provisions as to the estimated amount of gross receivables that the
Company can expect to collect upon resolution by the California WCAB of the
collectibility of the disputed receivables. The Company will continue to re-
evaluate the net realizability of the net assets related to discontinued
operations on an ongoing basis. Any such re-evaluation could result in an
adjustment that may potentially be material to the carrying value of the asset.

3.   ASSET WRITEDOWN

   In September 1994, the Company sold substantially all the assets and
liabilities of its wholly-owned subsidiary, Occu-Care, Inc., which operated
industrial medical clinics, to AmHealth, Inc. ("AmHealth") for a price of
$4,000,000. The purchase price included $1,500,000 in cash paid at closing and
the issuance of two promissory notes bearing interest at 8% per annum.
AmHealth defaulted on the first interest payments on the two notes. In
conjunction with the Merger on January 10, 1995, the Company recorded these
notes as one note due for $2,050,000, which was the Company's estimate of fair
market value (using a discounted cash flow method). AmHealth defaulted on a
December 1, 1995 mandatory redemption of a portion this obligation.

   On May 10, 1996, AmHealth executed a definitive agreement with CORE, Inc., a
public company, pursuant to which CORE would purchase for cash substantially all
the assets of AmHealth in a transaction expected to close by July, 1996. In
anticipation of the consummation of the foregoing transaction, in June, 1996,
the Company executed a definitive settlement agreement pursuant to which
AmHealth had agreed to pay the Company the sum of $2,050,000 (the carrying value
of the asset) and $5,287 in attorney's fees in full satisfaction of AmHealth's
obligation to the Company arising out of the sale of all of the assets and
liabilities of Occu-Care, Inc. Under the terms of the settlement agreement, the
Company agreed to extend the maturity of the note through July 31, 1996 and to
accept payment under the note simultaneously with the closing of the acquisition
of AmHealth by CORE. The Company dismissed its lawsuit against AmHealth, filed
on June 6, 1996 for breach of AmHealth's mandatory redemptive obligation on the
$2.5 million owed to the Company, without prejudice on June 26, 1996.

   In July, 1996, CORE announced that it had terminated its agreement to
purchase, for cash, substantially all of the assets of AmHealth, citing market
conditions related to a public offering of stock by CORE. Since CORE's decision
to terminate the AmHealth Agreement, the Company investigated several different
means by which to ultimately collect its monies due, as an unsecured creditor,
from AmHealth. AmHealth officials reported that AmHealth was running cash flow
positive, prior to debt service, and that it was currently negotiating with some
of its secured creditors, as well as other third parties who may have had an
interest in acquiring certain of AmHealth's assets, to determine future actions.
While the Company will vigorously pursue all of the assets to which it has a
right (approximately $2.9 million inclusive of accrued interest), in August,
1996, the Company took a $1.7 million write down of the receivable from AmHealth
to its estimated fair value.

   In November, 1996, AmHealth had its four Northern California operating
entities (three clinics and its Employee Services Division) foreclosed on by the
senior creditors. The operations were turned over to the senior creditors and
the outstanding

                                      12
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                       DECEMBER 31, 1994, 1995 AND 1996

receivables for those four entities are now being collected by the creditor who
had the first lien position on all of the outstanding accounts receivable.
There are five remaining clinics under AmHealth ownership in Southern
California, all of which are generating operating profits according to AmHealth
officials.   AmHealth is in the process of trying to sell the remaining clinics
and use the proceeds from the sale to negotiate a final payout - albeit
substantially lower than the current principal amount of debt outstanding to all
of AmHealth's creditors.   With all of the information the Company has received
from AmHealth regarding the likelihood of a final payment and the potential
amount of that payment, the Company believes the carrying value of the AmHealth
receivable is properly valued on the Company's December 31, 1996 balance sheet.

4. EQUIPMENT AND LEASEHOLD IMPROVEMENTS

   The summary of office furniture and equipment at December 31, 1995 and 1996
is as follows: 
<TABLE>
<CAPTION>
 
                                                                                     1995            1996
                                                                                ---------------  ------------
<S>                                                                           <C>                <C>
 Office equipment and furniture.............................................       $ 2,851,000   $ 4,474,000
 Less accumulated depreciation..............................................        (1,085,000)   (2,040,000)
                                                                                   -----------   -----------
                                                                                   $ 1,766,000   $ 2,434,000
                                                                                   ===========   ===========
 
5. INDEBTEDNESS
 
    Long-term debt is summarized as follows at December 31, 1995 and 1996:
 
                                                                                       1995          1996
                                                                                   -----------   ----------- 
 Note payable, interest at 8.5%; paid in full  on
   January 1, 1996..........................................................           100,000            --
  Note payable, interest at 8.5% monthly payments
   of principal and interest of 11,284 maturing
   on May 19, 2000..........................................................           490,000       392,000
  $5,000,000 revolving line of credit, interest computed
   at prime plus 0.5 percent (8.75% at December 31, 1996),
   matures April 5, 1997....................................................                --     1,870,000
  $750,000 equipment line, interest computed at prime
   plus 1 percent (9.25% at December 31, 1996),
   matures June 5, 1999.....................................................                --       248,000
  Other.....................................................................            49,000            --
                                                                                   -----------   -----------
  Total Debt................................................................           639,000     2,510,000
  Less: Current Maturities of Long-Term Debt................................          (208,000)   (2,226.000)
                                                                                   -----------   -----------
                                                                                   $   431,000   $   284,000
                                                                                   ===========   ===========
</TABLE>

    The Company expended $1,232,000 in cash to acquire the medical transcription
businesses of IDS and MTA in 1995 and, as a result, the Company issued $2.0
million in Subordinated Convertible Debt, which took place on August 15, 1995.
Key terms of the debt are:

      Interest Rate:        8%
      Interest Paid:        Semi-annually
      Term:                 Five (5) Years, due in full at maturity if not
                            converted Secured Status: Unsecured and subordinated
                            to all other indebtedness Convertible Features:
      .  Convertible for five (5) years at $3.50 per share of Transcend's common
         stock as recorded on August 15, 1995, the "Closing Price".
      .  Convertible by the Company if Transcend's common stock trades at three
         (3) times the Closing Price for 30 consecutive trading days.

Subsequent to year end, the Company entered into a new working capital facility
with Coast Business Credit which provides for maximum borrowings of $5.0 million
and is based on 1.5 times monthly contractual contract management revenues, plus
80% of all medical transcription receivables under 90 days (aging).  The
facility will have a term of two years and will be priced at prime plus 2.25%
declining to prime plus 1.75% upon two consecutive quarters of achievement and
ongoing maintenance of debt service coverage of not less than 1.5 times measured
on an EBITA basis including all principal and interest (excluding depreciation).
The facility will be secured by a first security interest on all Company assets.
The Company will use the proceeds from this facility to pay off the balance on
the $5,000,000 revolver due and equipment line.


                                      13
<PAGE>
 

                            TRANSCEND SERVICES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1994, 1995 AND 1996


      SUPPLEMENTAL CASH FLOW INFORMATION

      Cash paid for interest was approximately $36,000, $56,000 and $311,000 for
the three years ended December 31, 1994, 1995 and 1996, respectively.

6. COMMITMENTS AND CONTINGENCIES

LEASE COMMITMENTS

   The Company leases certain office facilities under noncancellable operating
leases. Future minimum annual rental obligations under noncancelable operating
leases as of December 31, 1996 are as follows:
<TABLE>
<CAPTION>
 
<S>           <C>
1997.......................................................  $535,000
1998.......................................................   508,000
1999.......................................................   434,000
2000.......................................................   270,000
2001.......................................................    74,000
Thereafter.................................................     4,000
                                                             --------
                                                           $1,825,000
                                                           ==========
</TABLE>

   Rent expense was approximately $150,000, $443,000 and $665,000 for the
three years ended December 31 1994, 1995 and 1996, respectively.

LITIGATION

   On September 17, 1993, the Company and its healthcare subsidiaries, First
Western Health Corporation and Veritas Healthcare Management, and the physician-
owned medical groups, FWHC Medical Group, Inc. and Veritas Medical Group, Inc.,
which had contracts with the healthcare subsidiaries, initiated a lawsuit in the
Superior Court of the State of California, County of Los Angeles, against 22 of
the largest California workers' compensation insurance carriers, which lawsuit
was subsequently amended to name 16 defendants (including State Compensation
Insurance Fund, Continental Casualty Company, California Compensation Insurance
Company, Zenith National Insurance Corporation and Pacific Rim Assurance
Company). (See Note 2 where discussed.)

   On June 22, 1995, an action was filed by Timothy S. Priest in his capacity
as administrator of the estate of Robert V. Taylor against Carol Brown, Debbie
Ostwald, Sullivan Health & Rehabilitation Management, Inc. ("Sullivan") and
Fireman's Fund Insurance Company, in the circuit Court of Franklin County,
Tennessee, alleging breach of the duty to provide reasonably competent nursing
care to an injured individual.  The Company's subsidiary, Sullivan, and a former
employee of Sullivan are defendants in the case.  The Plaintiff seeks
compensatory damages in the amount of $1 million and punitive damages in the
amount of $2 million, plus costs.  Management of the Company believes that
Sullivan has meritorious defenses to the allegations and intends to vigorously
contest liability in this matter.  At the present time, management of the
Company cannot predict the outcome of this litigation, but does not believe that
the resolution of the litigation will have a material adverse effect on the
Company's financial condition or results of operations.

                                      14
<PAGE>
 
                           TRANSCEND SERVICES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1994, 1995 AND 1996

7. RETIREMENT PLAN

      The Company maintains a 401(k) retirement plan that covers substantially
all eligible employees. Employees are eligible to contribute amounts to the plan
subject to certain minimum and maximum limitations. The Company matches employee
contributions on a discretionary basis as determined by the Company's board of
directors.  For 1994, 1995 and 1996, the Company contributions totaled
approximately $17,000, $0 and $0, respectively.

8. TRANSACTIONS WITH RELATED PARTIES

      Approximately 23% of the subordinated debt (Note 4) is held by parties
related to certain members of the board of directors.
 
      Approximately 69% of $2.4 million in a private placement of common stock
and warrants to purchase common stock was purchased by certain members of the
Board of Directors (See Note 9).

9. SHAREHOLDERS' EQUITY

      In 1995, the Company increased the authorized common stock to 30,000,000
shares. The Company has authorized 21,000,000 shares of preferred stock, $.01
par value.

      On September 5, 1996, the Company raised $2.4 million in a private
placement of common stock and warrants to purchase common stock. A total of
522,000 shares of common stock were sold at a price of $4.44 per share and a
total of 522,000 warrants were sold at a price of $0.25 per warrant to 20
investors. The $4.44 price represents the ten day average of the closing price
of the Company's common stock prior to the board meeting approving the private
placement. The securities issued in the private placement were issued in
reliance on certain exemptions from registration under federal and state
securities laws. The warrants have a five-year term and are exercisable at a
price of $4.44 per share, are redeemable by the Company at any time with thirty
days notice (during which time the holder may exercise the warrants) at an
exercise price of $4.44 and are non-transferrable. The shares of common stock
underlying the warrants and the common stock issued in the private placement
carry piggy-back registration rights, subject to certain limitations, in the
event the Company proposes to register the sale of any of its securities for its
own account or for the account of its shareholders.

10. STOCK OPTIONS AND WARRANTS

      The Company has established a stock option plan for the employees of the
Company. The plan provides for the issuance of incentive stock options and
nonstatutory options.  Under this plan, options are granted for the Company's
common stock at the approximate fair value, as defined in the option agreement.
The following is a summary of transactions:
<TABLE>
<CAPTION>
 
                                            AVERAGE PRICE                                                OPTIONS       PER SHARE
------------------------------------------------------------------------------------------------------  ----------  ---------------
<S>                                                                                                     <C>         <C>
                      OPTIONS OUTSTANDING, December 31, 1993..........................................    724,000   $ .07 to $ .30
                      Forfeited.......................................................................    (31,000)            $.07
                      Exercised.......................................................................    (10,000)            $.07
                                                                                                        ---------
                      OPTIONS OUTSTANDING, December 31, 1994..........................................    683,000   $ .07 to $ .30
                      Options issued in Merger (Note 1)...............................................  1,158,000   $1.87 to $3.75
                      Granted.........................................................................    331,000   $1.87 to $5.62
                      Forfeited.......................................................................   (161,000)  $ .07 to $3.13
                      Exercised.......................................................................   (511,000)  $ .07 to $3.13
                                                                                                        ---------
                      OPTIONS OUTSTANDING DECEMBER 31, 1995...........................................  1,500,000
                      Granted.........................................................................    152,000   $4.00 to $11.38
                      Forfeited.......................................................................   (202,000)  $ .30 to $7.13
                      Exercised.......................................................................   (436,000)  $ .07 to $3.50
                                                                                                        ---------
                      OPTIONS OUTSTANDING, DECEMBER 31, 1996..........................................  1,014,000
                                                                                                        =========
                      Options eligible for exercise at December 31, 1996                                  792,000   $ .07 to $11.25
</TABLE>

      At December 31, 1996 there were a total of 631,375 shares of common stock
available for grant.

                                      15

<PAGE>
 
                            TRANSCEND SERVICES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1994, 1995 AND 1996

      On April 30, 1996, the Company granted a warrant to purchase shares of its
Common Stock to Silicon Valley Bank, a California-chartered bank (the "Silicon
Valley Warrant"), in connection with two credit facilities the Company
established with Silicon Valley East, a Division of Silicon Valley Bank.  The
Silicon Valley Warrant entitles the holder to purchase an aggregate of 25,000
shares of the Company's Common Stock, subject to certain adjustments, at an
exercise price of $11.25 per share.  The Silicon Valley Warrant expires April
30, 2001.

STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 123

      During 1995, the Financial Accounting Standards Board issued SFAS No. 123,
"Accounting for Stock-Based Compensation," which defined a fair value-based
method of accounting for an employee stock option or similar equity instrument
and encourages all entities to adopt that method of accounting for all of their
employee stock compensation plans. However, it also allows an entity to continue
to measure compensation cost for those plans using the method of accounting
prescribed by APB Opinion No. 25, "Accounting for Stock Issued to Employees."
Entities electing to remain with the accounting methodology required by APB
Opinion No. 25 must make pro forma disclosures of net income as if the fair
value-based method of accounting defined in SFAS No. 123 was used.

      The Company has elected to account for its stock-based compensation plans
under APB Opinion No. 25, under which no compensation cost has been recognized
by the Company.  However, the Company has computed, for pro forma disclosure
purposes, the value of all options for shares of the Company's common stock
granted during 1996 and 1995 to employees and non-employee directors of the
Company using the Black-Scholes option-pricing model prescribed by SFAS No. 123
and the following weighted average assumptions:

        Risk-free interest rate              5.08% - 7.89%
        Expected dividend yield              0%
        Expected lives                       Four years
        Expected volatility                  0.70

      The total fair value of the options granted during the years ended
December 31, 1996 and 1995 was computed as approximately $517,000 and $364,000,
respectively, which would be amortized over the vesting period of the options.
If the Company had accounted for these plans in accordance with SFAS No. 123,
the Company's reported pro forma net loss for the years ended December 31, 1996
and 1995 would have been as follows:
<TABLE>
<CAPTION>
 
                                  1996          1995
                              ------------  ------------
<S>                           <C>           <C>          
Net Loss:
  As reported                  $(7,151,000)  $(4,200,000)  
  Pro forma                     (7,443,000)  (4,314,000)
Net Loss per Common Share:
  As reported                        (0.38)        (0.23)
  Pro forma                          (0.39)        (0.24)
 
</TABLE>

   Because SFAS No. 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the resulting pro forma compensation cost may
not be representative of that to be expected in future years.


                                      16
<PAGE>
 
                            TRANSCEND SERVICES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1994, 1995 AND 1996
                                        
   The following table summarized the Company's portion of stock option
transactions under the Parent Company's stock option plan.
<TABLE>
<CAPTION>
                                                  Weighted
                                                   Number     Average
                                                     of        Price
                                                   Shares    Per Share
                                                 ----------  ---------
<S>                                              <C>         <C>
      Outstanding at December 31, 1994             683,000       $0.15
       Options transferred in Merger (Note 1)    1,158,000        2.22
       Granted                                     336,000        3.55
       Forfeited                                  (161,000)       1.38
       Exercised                                  (511,000)       0.52
                                                 ---------       -----
      Outstanding at December 31, 1995           1,505,000        2.43
       Granted                                     147,000        6.79
       Forfeited                                  (202,000)       5.01
       Exercised                                  (436,000)       1.75
                                                 ---------       -----
      Outstanding at December 31, 1996           1,014,000        2.83
                                                 =========       =====
 
</TABLE>

   The following table sets forth the exercise price range, number of shares,
weighted average exercise price, and remaining contractual lives by groups of
similar price and grant date:
<TABLE>
<CAPTION>
 
 
                                 Number      Weighted                 Number
                              Outstanding     Average    Weighted  Exercisable   Weighted
                 Actual            at        Remaining   Average        at       Average
                Range of      December 31,  Contractual  Exercise  December 31,  Exercise
              Exercise Price      1996         Life       Price        1996       Price
----------------------------  ------------  -----------  --------  ------------  --------
<S>                           <C>           <C>          <C>       <C>           <C>
 
            $  0.07 - $0.30         15,339          0.3    $ 0.14        11,504     $0.14
            $    1.88-$2.94        754,500          0.7      2.02       508,125      1.99
            $    3.50-$5.75        194,500          2.4      4.12        48,625      5.05
            $  10.63-$11.38         49,500          3.4     11.00             0      0.00
               -------------     ---------          ---    ------       -------     -----
            $  0.07-$11.38       1,013,839          1.2    $ 2.83       568,254     $2.22
               =============     =========          ===    ======       =======     =====
 
</TABLE>

11. INCOME TAXES

   The tax effects of temporary differences between the carrying amounts of
assets and liabilities in the financial statements and their respective tax
bases, which give rise to deferred tax assets and liabilities as of December 31,
1995 and 1996 were as follows:
<TABLE>
<CAPTION>
 
                                        1995          1996
                                    ------------  ------------
<S>                                 <C>           <C>
Deferred tax liabilities:
Equipment and leasehold...........  $   (44,000)  $   (71,000)
Intangibles Assets................     (290,000)     (234,000)
Discontinued Operations...........     (942,000)   (1,005,000)
Equity............................           --      (263,000)
                                    -----------   -----------
                                     (1,276,000)   (1,573,000)
                                    -----------   -----------
 
Deferred tax assets:
Net operating loss carryforwards..    3,122,000     6,525,000
Cash-basis deferral...............      330,000       220,000
Accrued Liabilities...............      331,000       226,000
Other.............................      186,000            --
Valuation allowance...............   (3,369,000)   (6,052,000)
                                    -----------   -----------
Net deferred tax (liabilities)....  $  (676,000)  $  (654,000)
                                    ===========   ===========
</TABLE>

          At December 31, 1996, the Company had net operating loss carryforwards
of approximately $16,731,000 which can be used to reduce future income taxes. If
not utilized these carryforwards will begin to expire in 2007.  The Company has


                                      17
<PAGE>
 
 
                            TRANSCEND SERVICES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1994, 1995 AND 1996
                                        
established a valuation allowance of $3,369,000 and $6,052,000 at December 31,
1995 and 1996, respectively due to the uncertainty regarding the realizability
of certain deferred tax assets, including its net operating loss carryforward.

12. ACQUISITIONS

          On September 30, 1994, the Company acquired substantially all of the
assets of Script-Ease, Inc., a Pittsburgh-based medical transcription business
under the terms of an asset purchase agreement for approximately $1,000,000.
The acquisition was accounted for as a purchase in accordance with APB No. 16
and accordingly the purchase price has been allocated to the net assets acquired
based on the estimated fair values as of the acquisition  date.   The majority
of the excess purchase price over net tangible assets related to customer lists,
which is being amortized over seven years and a non-compete agreement that is
being amortized over a three year period. The balance of the additional
intangibles is goodwill which is being amortized over thirty years.

          On January 10, 1995, Transcend acquired TriCare, Inc. in a merger
accounted for as a reverse merger (Note 1). The acquisition was treated as a
purchase in accordance with APB No. 16. There were approximately 7.7 million
shares issued in the transaction resulting in goodwill of approximately $3.2
million. This goodwill is being amortized over twenty years. On June 15, 1994,
TriCare had completed the acquisition of Sullivan for an adjusted purchase price
of $3,285,000. Subsequent to the Merger, the Company issued a final payment of
$285,000 in lieu of the $1,260,000 obligation which was payable in stock in
January 1995 and July 1995, to the former owners of Sullivan Health and
Rehabilitation in full satisfaction of its long-term obligation related to the
acquisition of Sullivan and gave the former owners a release from any and all
further liabilities in connection therewith.

          On January 31, 1995, the Company acquired the assets of International
Dictating Services ("IDS"), a Boston based medical transcription business for
approximately $832,000, which consisted of approximately $682,000 paid in cash
at closing with the balance payable to the sellers over the next two years. The
Company accounted for the acquisition under the purchase method of accounting.
The results of operations for IDS are included in the statement of loss of the
Company beginning on the date of acquisition. The fair value of tangible assets
acquired and liabilities assumed was $245,000 and $86,000, respectively. The
intangible related to customer lists is being amortized over seven years and a
non-compete agreement is being amortized over a two year period. The balance of
the additional intangible asset is goodwill which is being amortized over twenty
years.

          On April 19, 1995, the Company acquired the assets of Medical
Transcription of Atlanta, Inc. ("MTA") for $1,372,000, consisting of $550,000
paid in cash at closing, promissory notes of $650,000, and 60,000 shares of
Transcend common stock valued at $172,000 at the time of the acquisition. The
Company accounted for the acquisition under the purchase method of accounting.
The results of operations for MTA are included in the statement of loss of the
Company beginning on the date of acquisition. The fair value of tangible assets
acquired and liabilities assumed was $363,000 and $27,000, respectively. The
intangible related to customer lists is being amortized over seven years and a
non-compete agreement is being amortized over a three-year period. The balance
of the additional intangible is goodwill which is being amortized over twenty
years.

          The following pro-forma amounts presented below represent the results
of operations (excluding discontinued operations) of the Company adjusted to
include TriCare, Script-Ease, Inc. and MTA as if these transactions had been
consummated at the beginning of each period presented.
<TABLE> 
<CAPTION> 
                                                    YEAR ENDED DECEMBER 31
                                                   --------------------------
                                                      1995           1996
                                                   -----------    -----------
<S>                                     <C>                      <C>        
           
 (UNAUDITED)
 Sales.................................             $28,554,000   $38,531,000
 Net Loss from  Continuing Operations..             $(3,586,000)  $(5,460,000)
 Net Loss per Common Share.............                  ($0.20)       ($0.29)
 Weighted Average Shares Outstanding                 18,154,000    18,908,000
 
</TABLE>

          On June 19, 1996, the Company acquired the stock of Greiner's Medical
Transcription, Inc. ("GMT"), a California corporation, under the pooling of
interests method of accounting. Historical financial statements have not been
restated to reflect the combined operations of Transcend and GMT as the impact
of the results was not material.  The Company issued 87,805 shares of Transcend
Common stock at the time of acquisition.  The results of operations for GMT are
included in the statement of operations beginning on the date of acquisition.

          On June 28, 1996, the Company acquired the stock of Express Medical
Transcription, Inc. ("EMT"), a Utah corporation, under the pooling of interests
method of accounting.  Financial statements have been restated to reflect the
combined

                                      18
<PAGE>
 
                            TRANSCEND SERVICES, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                        DECEMBER 31, 1994, 1995 AND 1996

operations of Transcend and EMT.  The Company issued 230,000 shares of Transcend
common stock at the time of acquisition.

          A reconciliation between revenue and net loss from continuing
operations as previously reported and as restated follows:
<TABLE> 
<CAPTION>                                                      YEARS ENDED DECEMBER 31
                                                             -------------------------
                                                                1994          1995
                                                             -----------   -----------
<S>                                                         <C>            <C> 
(UNAUDITED)
Net Revenues:   
     As Previously Reported                                  $12,393,000   $25,882,000
     EMT                                                         493,000       943,000
                                                             -----------   -----------
     As Restated                                             $12,886,000   $26,825,000
                                                             -----------   -----------
 
Net Income (Loss) from Continuing Operations:
     As Previously Reported                                  $(1,393,000)  $(3,896,000)
     EMT                                                          47,000       175,000
                                                             -----------   -----------
     As Restated                                             $(1,346,000)  $(3,721,000)
                                                             -----------   -----------
</TABLE>

      
13.  SIGNIFICANT CUSTOMERS

          During 1994, Tulane University Hospital and Clinic, Memorial Medical
Center of Jacksonville, Greater Southeast Community Hospital, and Good Samaritan
Hospital made up 16%, 15%, 15%, and 14%, respectively of the Company's net
revenue. No individual customer made up greater than 10% of net revenue during
1995 and 1996.

                                      19
<PAGE>
 
                                   PART IV

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

  (a) The following documents are filed as a part of this Annual Report for
      Transcend Services, Inc.:

  (1) Financial Statements

     The Consolidated Financial Statements, the Notes to Consolidated Financial
     Statements and the Report of Independent Public Accountants listed below
     appear as Item 8.

     Report of Independent Public Accountants.

     Consolidated Balance Sheets as of December 31, 1995 and 1996

     Consolidated Statements of Operations for the years ended December 31,
     1994,1995 and 1996

     Consolidated Statements of Shareholder's Equity for the years ended
     December 31, 1994, 1995 and 1996

     Consolidated Statements of Cash Flows for the years ended December 31,
     1994, 1995 and 1996

     Notes to Consolidated Financial statements

     No financial statement schedules are required

  (b) Reports on Form 8-K.   No reports on Form 8-K have been filed by the
      Company during the fourth quarter of fiscal 1996.

  (c) Exhibits.
  --------

  The following exhibits are filed with or incorporated by reference into this
report. The exhibits which are denoted by an asterisk (*) were previously filed
as a part of, and are hereby incorporated by reference from, either (i) a
Registration Statement on Form S-1 under the Securities Act of 1933 for the
Company, Registration No. 33-32587, filed on December 14, 1989 (referred to as
"1989 S-1"); (ii) a Registration Statement on Form S-1 under the Securities Act
of 1933 for the Company, Registration No. 33-41361, filed on June 26, 1991
(referred to as "1991 S-1"); (iii) a Registration Statement on Form S-4 under
the Securities Act of 1933 for the Company, Registration No. 33-83344, filed on
December 2, 1993 (referred to as "S-4"); (iv) a Registration Statement on Form
S-3 under the Securities Act of 1933 for the Company, Registration No. 333-
19177, filed on January 2, 1997 (referred to as "S-3"); (v) a Registration
Statement on Form S-8 under the Securities Act of 1933 for the Company,
Registration No. 33-37685, filed on November 8, 1990 (referred to as "1990 S-
8"); (vi) a Registration Statement on Form S-8 under the Securities Act of 1933
for the Company, Registration No. 33-57072, filed on January 15, 1993 (referred
to as "1993 S-8"); (vii) a Registration Statement on Form S-8 under the
Securities Act of 1933 for the Company, Registration No. 333-16213, filed on
November 15, 1996 (referred to as "1996 S-8"); (viii) the Company's Current
Report on Form 8-K relating to an event which occurred on March 1, 1992
(referred to as "3/1/92 8-K"); (ix) the Company's Current Report on Form 8-K
relating to an event which occurred June 15, 1994 (referred to as "6/15/94 8-
K"); (x) the Company's Current Report on Form 8-K relating to an event which
occurred September 16, 1994 (referred to as "9/16/94 8-K"); (xi) the Company's
Annual Report on Form 10-K for the year ended May 31, 1990 (referred to as "1990
10-K"); (xii) the Company's Annual Report on Form 10-K for the year ended May
31, 1992 (referred to as "1992 10-K"); (xiii) the Company's Annual Report on
form 10-K for the year ended May 31, 1993 (referred to as "1993 10-K"); (xiv)
the Company's Quarterly Report on Form 10-Q for the quarter ended November 30,
1995 (referred to as "11/30/95 10-Q"); and (xv) the Company's Quarterly Report
on Form 10-Q for the quarter ended June 30, 1995 (referred to as "6/30/95 10-
Q"); and (xvi) Amendment No. 1 to the Company's Quarterly Report on Form 10-Q
for the quarter ended September 30, 1996 (referred to as "9/30/96 10-Q/A No. 1".

                                      20
<PAGE>
 
EXHIBIT
NO.      DESCRIPTION
---      -----------

*2.1  -  Acquisition of Industrial Plus Health Network, Inc. by Occu-Care, Inc.
      (3/31/92 8-K, Exhibit 2(a))

*2.2  - Stock Purchase Agreement between TriCare, Inc., and Dorothy C. Sullivan
      and Timothy Sullivan for the purchase and sale of all issued and
      outstanding capital stock of Sullivan Health & Rehabilitation Management,
      Inc. (6/15/94 8-K, Exhibit 2(a))

*2.3  - Asset Acquisition Agreement, executed on September 16, 1994 by and among
      Occu-Care, Inc. ("OCI"), a wholly owned subsidiary of TriCare, Inc.,
      Industrial PlusHealth Network, a wholly-owned subsidiary of OCI, together
      with AmHealth, Inc. (9/16/94 8-K, Exhibit 2(a))

*2.4  - Agreement and Plan of Merger dated as of May 13, 1994 by and among
      TriCare, Inc., First Western Health Corporation and Transcend Services,
      Inc., as amended (included as Appendix A to the Prospectus contained in
      Part I of the S-4)

*2.5  - Letter Agreement, dated December 30, 1994, between AmHealth, Inc. and
      Occu-Care, Inc. to exchange AmHealth Inc. convertible redeemable preferred
      stock for the existing junior promissory notes held by Occu-Care and
      issued by AmHealth (11/30/95 10-Q, Exhibit 2(a))

*3.1.1 - Certificate of Incorporation, as amended (1989 S-1, Exhibit 3(a))

*3.1.2 - Certificate of Incorporation (6/30/95 10-Q, Exhibit 3)

*3.2  -  Bylaws (as restated) (1993 10-K, Exhibit 3(a))

*4.1  -  1990 Employee Stock Purchase Plan (1990 S-8, Exhibit 4)

*4.2  -  1992 Stock Option Plan, as amended (1993 S-8, Exhibit 4(a))

*4.3   - 1992 Stock Option Plan, as Amended and Restated (1996 S-8, Exhibit 4.1)
 
*4.4  -  Subordinated Convertible Debenture Purchase Agreement (9/30/95 10-Q,
         Exhibit 4)

*4.5  -  1986 Incentive Stock Option Plan, as amended (1989 S-1, Exhibit 10(i))

*4.6   - Loan and Security Agreement, $5,000,000 Working Capital Line and
         $750,000 Equipment Line, provided by Silicon Valley Bank to Transcend
         Services, Inc. (9/30/96 10-Q/A No. 1, Exhibit 4.1)

*4.7   - Working Capital Note (9/30/96 10-Q/A No. 1, Exhibit 4.2)

*4.8   - Equipment Term Note (9/30/96 10-Q/A No. 1, Exhibit 4.3)

*4.9   - Warrant to Purchase Common Stock (9/30/96 10-Q/A No. 1, Exhibit 4.4)

*4.10 -  Silicon Valley Bank Antidilution Agreement (9/30/96 10-Q/A No. 1,
         Exhibit 4.5)

*4.11 -  Silicon Valley Registration Rights Agreement (9/30/96 10-Q/ No. 1,
         Exhibit 4.6)

*10.1  - Form of Non-qualified Stock Option Agreement (1989 S-1, Exhibit
         10(g))

*10.2  - Form of Incentive Stock Option Agreement (1989 S-1, Exhibit 10(j))

                                      21
<PAGE>
 
*10.3  - Form of Incentive Stock Option Agreement under 1992 Stock Option
         Plan, as Amended and Restated (1996 S-8, Exhibit 4.2)

*10.4  - Restated Rental and Management Agreement between First Western Health
         Corporation and FWHC Medical Group, Inc. dated January 17, 1990 (1989
         S-1, Exhibit 10(l))

*10.5  - Form of Covenants Not to Compete between Occu-Care and each of the
         other parties to the Acquisition Agreement (1990 10-K, Exhibit
         10(c))

*10.6  - Management Agreement between Veritas Healthcare Management and
         Veritas Medical Group, Inc. dated as of January 1, 1991 (1991 S-1,
         Exhibit (10(b))

*10.7  - Rental and Management Agreement between Occu-Care, Inc. and Occu-
         Care Medical Group, Inc. dated as of May 31, 1990, as amended (1991
         S-1, Exhibit 10(a))

*10.8  - Rental and Management Agreement between Occu-Care, Inc. and Del Amo
         Industrial Medical Clinic dated as of March 1, 1992 (1992 10-K, Exhibit
         10(a))

*10.9  - Form of indemnification agreement (1993 10-K, Exhibit 10(a))

*10.10 - Letter Agreement dated December 5, 1996 by and between the Company and
         VHA, Inc. (S-3, Exhibit 10.1)

*10.11-  Services Agreement dated December 5, 1996 by and between the Company
         and VHA, Inc. (S-3, Exhibit 10.2)

 11   -  Statement re: Computation of earnings per share


 21.1 -  Subsidiaries of the Registrant

 23   -  Consent of Arthur Andersen LLP

 27   -  Financial Data Schedule (for SEC use only)

                                      22
<PAGE>
 
 
                                   SIGNATURES


     Pursuant to the requirements of the Securities  Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.


                                         TRANSCEND SERVICES, INC.


Dated: June 2, 1997                      By:  /s/ David W. Murphy
                                            ---------------------------------
                                            David W. Murphy   
                                            Executive Vice President, Finance 
                                            and Chief Financial Officer
                                            (principal financial and 
                                            accounting officer)