<PAGE>



 
                       SECURITIES AND EXCHANGE COMMISSION

                             Washington, D.C. 20549

                                  -----------

                                  FORM 10-K/A

                                  ----------


                               Amendment No. 1 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 3.  Legal Proceedings.
Item 7.  Management's Discussion and Analysis of Financial Condition and
         Results of Operations.
Item 11. Executive Compensation.

<PAGE>
 

ITEM 3. LEGAL PROCEEDINGS.

  The Company is subject to certain claims in the ordinary course of business
which are not material.

  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 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.   See Note 2 of "Notes to Consolidated Financial Statements."

  On March 21, 1997, The Los Angeles County Superior Court sustained the
defendants' demurrer to the Third Amended and Supplemental Complaint of the
plaintiffs (including the Company and certain of its

                                      2

<PAGE>
 
subsidiaries), without 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 WCAB 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 WCAB. A final order dismissing the Lawsuit will be
entered by the Court, and the Company will appeal the ruling to the California
Court of Appeals. By stipulation, the carriers' cross-complaints against the
plaintiffs were stayed pending resolution of the plaintiffs' appeal. If the
Superior Court's ruling is upheld on appeal, the cross complaints against the
plaintiffs also are likely to be dismissed.

  In 1996, the Company expensed approximately $1,582,000 of legal expenses
incurred in connection with the Lawsuit. Pursuant to an agreement with its legal
counsel retained in connection with the Lawsuit, with respect to any future
expenses related to the Lawsuit incurred at the trial court level, commencing in
December 1996, 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. With respect to the appeal of the Superior Court's March 21, 1997
ruling in the Lawsuit, the Company is only responsible for out-of-pocket
expenses and, pursuant to an agreement with its counsel, an immaterial amount of
legal fees to be incurred in connection with the appeal.

  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, the Company's subsidiary 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 plaintiff demands 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 the Company 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.

                                       3
<PAGE>
 
ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
          RESULTS OF OPERATIONS

 
  The following discussion should be read in conjunction with the consolidated
financial statements of the Company (including the notes thereto) contained
elsewhere in this Report.

OVERVIEW

  Transcend is a healthcare services company focused on the emerging field of
healthcare information management ("HIM") services to hospitals and other
associated healthcare providers. The Company provides a range of HIM services,
including: (i) contract management ("outsourcing") of the healthcare information
or medical records function, as well as the admissions function; (ii)
transcription of physicians' dictated medical notes; and (iii) consulting
services relating to medical records and reimbursement coding. As of December
31, 1996, the Company operated on a contract management basis, the medical
records and certain other HIM functions of 20 general acute care hospitals
located in 13 states and the District of Columbia. The Company also provides
through its 100% wholly owned subsidiary, Sullivan Health Management Services,
Inc., case management and disability management services to insurance carriers,
third party administrators and self-insured employers.

  The Company intends to expand the range of its contract management services to
include management of other functional areas of hospitals, such as management of
patient access (admissions), utilization review, quality assurance and the
business office. As of December 31, 1996, the Company provided full contract
management outsourcing services in the admissions departments for three of the
hospitals it manages. The Company is actively seeking to provide this expanded
range of services to its current and future hospital customers. The Company also
provides, through outsourcing as well as other contracts, medical records
transcription services through computer and telephone links from centralized
facilities to approximately 150 hospital customers.

  Approximately 3,000 hospitals in the United States have more than 100 beds and
constitute the Company's first tier of market opportunity. The Company had
contract management contracts covering the medical records departments of 15
hospitals as of December 31, 1995 and 20 hospitals as of December 31, 1996,
ranging in bed size from 56 beds to 541 beds, with the average contract size of
approximately $1.3 million. The initial contract terms of the Company's current
contracts range from two to five years and are generally terminable without
cause upon expiration of the initial term or for cause at any time during the
initial term thereof. The Company's existing contracts currently have remaining
terms ranging from approximately one to five years. Due to its limited operating
history in medical records management, the Company is unable at the present time
to assess or predict its contract renewal rate.

  The Company negotiates its contract management fees on a fixed installment
basis which represents, at contract inception, an immediate savings to the
contracting hospital as compared to its historical costs. In the early term of
such a contract, the Company's expenses in providing the contract services
remain relatively high, as a percentage of contract revenues received, as set-up
and training costs are incurred, new procedures are implemented and departmental
reorganizations are initiated. Completion of such steps should result in lower
operating expenses, which in turn should increase the profit margin of a
constant revenue stream over time. Due to the Company's limited operating
history in the contract management business, however, there can be no assurances
that operating expenses will sufficiently decrease over the life of such
contracts to achieve profitability.

  The Company is experimenting with an alternative volume-based pricing
structure, based upon a hospital's activity levels such as weighted average
number of annual patient discharges, or a "per member per month" ("PMPM")
capitated pricing option similar to current pricing mechanisms used by managed
healthcare groups. As of December 31, 1996, the Company had signed one contract
based on a volume oriented pricing structure tied to weighted annual patient
discharges. There is an opportunity to realize higher margins on an activity-
based pricing structure. The principal advantage of a volume-based pricing
mechanism is that as a hospital's volume of business increases, the Company's
revenues will increase at a faster rate than operating expenses. However, if a
customer's business volume decreases, the Company's revenues will also decrease
at a faster rate than its operating expenses.   The Company is also considering
pricing its contract management contracts, where possible, to provide for more
contingency sharing of either (i) the one-time cash flow savings that the
Company generates for its contract management customers through a reduction in
gross days receivables outstanding by processing bills being delayed

                                      4

<PAGE>
 
in the medical records department and/or (ii) increased revenues realized by
hospital customers as a result of the Company's favorable impact (through
enhanced coder and physician training) on the hospital's Case Mix Index (a
measurement of the hospital's severity/acuity level for DRG reimbursements under
Medicare).  Of its 20 contracts as of December 31, 1996, only one contract was
priced under a contingency sharing arrangement.

  The Company is typically paid for its transcription services on a production
basis at rates determined on a per-line-transcribed basis. Where transcription
services are included as part of the services provided in the Company's
outsourcing contracts, however, the services are provided by the Company as part
of a set contract fee. The Company is paid for its consulting and coding
services on a negotiated fee for services basis. In addition, the Company is
paid for its healthcare case management services primarily on an hourly basis.

RESULTS OF OPERATIONS

  The Company's losses from operations in 1994, 1995 and 1996 were $1,306,000,
$3,700,000 and $5,107,000, respectively. Management believes that the Company's
operating losses are primarily attributable to the significant expenses incurred
by the Company to build a larger sales and management organization to support an
increased number of outsourcing contracts and the expansion of the Company's
services to healthcare institutions. In fiscal 1994, 1995 and 1996, the
Company's marketing and sales expenses were $929,000, $2,186,000 and $2,480,000,
respectively. In addition, the Company's general and administrative expenses for
fiscal 1994, 1995 and 1996 were $1,673,000, $4,961,000 and $5,771,000,
respectively. The buildup of the Company's management infrastructure had been
put in place to match the anticipated rapid growth in its outsourcing business.
The Company's major reorganization, initiated in July/August of 1996, resulted
in significant cost reductions and helped the Company achieve a near break-even
result from continuing operations (operating loss prior to interest and
amortization expenses of approximately $100,000) in the fourth quarter of 1996.
The Company will be required to increase its revenues from contract management
and other services and effectively manage its costs to achieve profitability. In
addition, the Company's pricing mechanism on most of its outsourcing contracts
requires the Company to increase operating efficiencies over the life of the
contract in order to increase profit margins. The Company will also be required
to procure a critical mass of such contracts and be able to renew such contracts
on favorable terms. There can be no assurance that the Company will be able to
attain the required operating efficiencies or increase the number of outsourcing
contracts to the level needed to become profitable.

 Year Ended December 31, 1996 Compared to Year Ended December 31, 1995

  Net revenues for the Company increased from $26,825,000 in 1995 to $37,970,000
in 1996, an increase of 41.5%.  Contract management revenues were the largest
single service class revenue source for the Company representing 53.3% of total
revenues in 1995 and 57.3% in 1996.  Contract management revenues increased from
$14,300,000 in 1995 to $21,743,000 in 1996, an increase of 52.0%.  Medical
transcription revenues were the second largest source of revenues for the
Company for 1995 and 1996, representing 28.4% of total revenues in 1995 and
29.4% in the 1996. Medical transcription revenues grew from $7,605,000 in 1995
to $11,162,000 in 1996, an increase of 46.8%.  Consulting and coding revenues
represented 2.9% of the Company's total revenues for 1995 and 2.4% of the
Company's total revenues for 1996.  Consulting and coding revenues increased
20.6% from $768,000 in 1995 to $926,000 in 1996.  Case management revenues
represented 15.5% of the Company's total revenues in 1995 as compared to 9.1%
in 1996. Case management revenues decreased from $4,152,000 in 1995 to
$3,461,000 in 1996, a decrease of 16.6% due to a consolidation of certain sales
territories and the loss of several key accounts.

  The increase in total revenues for 1996 is primarily attributable to (i)
contract management outsourcing revenues of approximately $12,789,000 related to
16 contract management contracts signed in the second half of 1995 and for the
calendar year 1996 and (ii) increased medical transcription revenues, primarily
resulting from strong internal growth in existing locations and the acquisition
of two transcription businesses (Greiner Medical Transcription, "GMT", and
Express Medical Transcription, "EMT") in June of 1996.  GMT contributed
$782,000 and EMT contributed $1,277,000 in 1996 revenues, together representing
$2,059,000, or 58% of the total increase of $3,557,000 in medical transcription
revenues.  These increases were partially offset by the decrease in case
management revenues in the Company's wholly-owned subsidiary, Sullivan Health
Management, which has sustained the loss of several key accounts over the 1996
fiscal year.  In August, 1996, the Company hired an experienced sales and
operations manager to serve as President of Sullivan and lead a re-building
effort now underway to increase sales and improve the operations of Sullivan.
Sullivan experienced a net loss from continuing

                                      5

<PAGE>
 
operations of $726,000 for the year ended December 31, 1996 compared to a net
loss from continuing operations of $653,000 for the year ended December 31,
1995.

  Gross profit increased 31.8% to $5,379,000 for 1996 from $4,080,000 in the
prior year. Gross profit as a percentage of total Company revenues decreased to
14.2% for 1996 from 15.2 % in the prior year. This decrease was primarily
attributable to the medical transcription division, which experienced a decrease
in gross margins from 18.9% in 1995 to 14.6% for 1996.  The margin decrease in
transcription was a result of increased operating costs in several of the
Company's transcription sites, including the costs associated with opening a new
branch location; the start-up costs incurred with implementing several new
outsourcing contracts in transcription and the costs associated with the
Company's recently acquired transcription companies in Salt Lake City (EMT) and
Los Angeles (GMT).  Gross profit as a percentage of revenues increased in the
contract management division from 14.3% in 1995 to 17.5% in 1996 as a result of
(i) decreased operating expenses incurred in several contract management
accounts during the fourth quarter of 1996; (ii) more effective implementation
of new sites and (iii) favorable re-pricing of two of its twenty contracts.
The Company's overall gross margin was further eroded in the 1995 to 1996
comparison by the decrease in case management's gross profit margin from 21.0%
for the year ended December 31, 1995 to 16.1% for the year ended December 31,
1996.  This decline in case management gross margin is the result of a higher
case management operating cost structure in place while revenues declined.
Sullivan's cost structure has been restructured to more closely match its
current revenue stream.

  Marketing and sales expenses increased 13.4% to $2,480,000 in 1996 from
$2,186,000 in the prior year and decreased as a percentage of revenues to 6.5%
for 1996 from 8.1% for 1995.  The decrease in sales and marketing expenditures
as a percentage of revenues is attributable to the Company's investment in a
national sales force  and marketing program in 1995 and early 1996 which has led
to a significant increase in sales in 1996 without a material increase in
marketing and sales expenditures in the 1996 fiscal year.  The Company believes
that as revenues increase, marketing and sales expense, as a percentage of
revenues, should decline.

  General and administrative expenses of $5,771,000 for the 1996 fiscal year
increased approximately 16.3% over the $4,961,000 expended in the same prior
year period; however, this represents a decrease as measured as a percentage of
revenues in comparing 1995 and 1996.  The decline in general and administrative
expenses as a percentage of revenues from 18.5% in 1995 to 15.2% in 1996 is a
result of the Company's leveraging its relatively fixed sales and administrative
cost structure over a higher revenue base.  The Company expensed approximately
$1.0 million in one-time charges incurred in connection with the Company's
internal reorganization and restructuring efforts.  The Company believes that
the reorganization of its sales, operating and administrative functions
undertaken in the third quarter of 1996 should result in a significant reduction
of selling, general and administrative ("S,G&A") expenses in 1997. Specifically,
S,G&A expenses (inclusive of its Sullivan subsidiary's S,G&A costs) included
one-time costs in 1996 of approximately $630,000, of which approximately 35%
were severance costs for employees whose job positions were eliminated.  Reduced
employee expenses were realized in the fourth quarter of 1996 and will continue
to be realized in 1997 as a result of these actions.  The remaining non-
recurring costs included: (i) moving expenses incurred in Sullivan's corporate
office relocation; (ii) costs incurred in connection with the EMT and GMT
acquisitions; (iii) consulting fees incurred in connection with the Company's
Information Service Center concept; and (iv) costs, including legal, incurred in
connection with the settlement of a lease/buy-out transaction. The impact of the
reorganization has been realized in the fourth quarter of 1996 and the Company
anticipates that it will continue thereafter in 1997 on a comparative basis as
the cost reductions inherent in this reorganization were more or less permanent.
The Company also recognized in the fiscal year ended December 31, 1996, through
its reorganization, approximately $400,000 of one-time non-recurring costs in
its direct operating costs that negatively impacted gross margins for the
contract management, transcription and Sullivan operations. These costs
primarily related to the loss and transition from one contract management
account and the setting up of a new large (outsourced) transcription customer.
These costs, on a comparative quarter-to-quarter basis, will not be repeated
going forward.

  In a quarter to quarter comparison, the Company's general and administrative
expenses declined as a percentage or revenue from 23.9% in the third quarter
ended September 30, 1996 to 12.6% of revenue in the fourth quarter ended
December 31, 1996.  This decrease was primarily the result of the Company's
reorganization and restructuring undertaken in July and August, 1996, and the
fact that there were significant one-time charges incurred in connection with
the reorganization efforts that were realized in the third quarter ended
September 30, 1996.

  Amortization expenses decreased to $535,000 in 1996 from $633,000 in 1995
reflecting the impact of the 1993 acquisition

                                      6

<PAGE>
 
of dataLogix, Inc. being fully amortized.

  Other expenses increased to $462,000 for  1996 as compared to $21,000 for
1995, primarily due to the impact of interest expense incurred in connection
with (i) the August 15, 1995 private placement of 8% Subordinated Convertible
Debentures and (ii) the Company's borrowings against its working capital line of
credit totaling $2,118,000 as of December 31, 1996. Also, the Company expensed
$200,000 in the third quarter of 1996 to cover all of its legal, accounting and
printing costs incurred in connection with its filing of a registration
statement in May 1996 to raise additional capital through a public offering of
its Common Stock.  Due to adverse market conditions, the Company withdrew its
offering in July, 1996.

  The Company's loss before discontinued operations increased to $5,569,000 for
1996 from $3,721,000 in the prior year, inclusive of several one-time, non-
recurring charges; namely (i) the $1.7 million write down of the AmHealth
receivable; (ii) approximately $200,000 incurred in connection with the
Company's attempt to raise additional capital through a public offering of its
Common Stock in May of 1996; and (iii) approximately $1.0 million incurred in
connection with the Company's internal reorganization and restructuring.  The
Company's reorganization has resulted in a more streamlined management, sales
and implementation effort and has lowered the Company's overall selling,
general, administrative and operating costs. This was first evident in the three
month period ending December 31, 1996 where results from continuing operations,
before interest and amortization, were at a near break-even level (approximately
$100,000 loss) and this represented the Company's single best operating quarter
since September, 1994.

  The loss from discontinued operations increased to $1,582,000 for 1996 from
$479,000 in 1995 as a result of the charge for legal fees incurred in connection
with the Company's civil lawsuit against certain insurance companies in the
state of California. With respect to any future expenses related to the Lawsuit
incurred at the trial court level, commencing in December 1996, 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. With respect to the
appeal of the Superior Court's March 21, 1997 ruling, the Company is only
responsible for out-of-pocket expenses and, pursuant to an agreement with its
counsel, an immaterial amount of legal fees to be incurred in connection with
the appeal. See "Item 3. Legal Proceedings."

 Year Ended December 31, 1995 Compared with Year Ended December 31, 1994

  Net revenues increased 108.2% to $26,825,000 in 1995 from $12,886,000 in 1994.
The increase in net revenues is primarily attributable to operations in the
Company's contract management outsourcing division, contributing $5,058,000 of
the overall increase due to the addition of six new outsourcing contracts.
Contract management revenues grew 54.7% from 1994 to 1995 and represented 71.7%
of the Company's total revenues in 1994 as compared to 53.3% of total revenues
in 1995. Medical transcription revenues grew from $2,920,000 in 1994 to
$7,605,000 for 1995, where $1,676,000 of this increase was due to the
acquisition of International Dictating Services, Inc. ("IDS") and where
$1,584,000 of this increase was due to the Medical Transcription of Atlanta,
Inc. ("MTA") acquisition.  Medical transcription revenues represented 22.7% of
the Company's total revenues in 1994 as compared to 28.4% of total revenues in
1995. Sullivan's 1994 revenues are not included as they were prior to the
Merger; therefore, $4,152,000 of the $13,939,000 total revenue increase in the
Company's revenues between 1994 and 1995 is due to the inclusion of Sullivan in
1995.

  Gross profit increased 146.8% to $4,080,000 in 1995 from $1,653,000 in 1994.
Gross profit as a percentage of revenues increased to 15.2% in 1995 from 12.8%
in 1994. This increase was primarily attributable to the addition of Sullivan's
case management revenues reflecting an overall 21% gross margin. Gross margins
in contract management outsourcing increased to 14.3% from 11.5% in 1994.
Average transcription margins increased from 17.3% to 18.9%.

  Marketing and sales expenses increased 135% to $2,186,000 in 1995 from
$929,000 in 1994 and increased as a percentage of revenues to 8.1% from 7.2% in
1994. The increase is attributable to expenses of approximately $80,000
associated with the efforts to heighten market awareness of the Company and
contract outsourcing, the expansion of the Company's sales force by the addition
of one person, an increase in commission compensation of approximately $156,000
relating to the six new contract management contracts signed in the third
quarter and the additional sales costs of approximately $765,000 related to the
case management division.

  General and administrative expenses increased 196.5% to $4,961,000 in 1995
from $1,673,000 in 1994 and increased as a percentage of revenues to 18.5% from
13%. The increase reflects additional expense of approximately $874,000 for
expanded management and support staff incurred to position the Company for
future growth, as well as the additional

                                      7

<PAGE>
 
overhead of approximately $761,000 attributable to the Merger.

  Amortization expenses increased to $633,000 in 1995 from $357,000 in 1994
reflecting the additional amortization expense of $276,000 related to the full
impact of the intangible assets associated with the Company's acquisition of
three medical transcription businesses and the additional amortization expense
of $162,000 related to the Merger.

  Other expense decreased to $21,000 in 1995 from $50,000 in 1994, primarily as
the result of the Company's recognition of higher interest income as applied
against interest expense.

  The Company's loss before discontinued operations increased to $3,721,000 in
1995 from $1,359,000 in 1994; however, beginning in the second quarter of 1995,
the Company realized an improving trend with regard to minimizing its loss from
operations. The Company's loss from continuing operations was $1,387,000 in the
second quarter ending June 30, 1995. The loss from continuing operations for the
third quarter ended September 30, 1995 was $792,000, while the fourth quarter
ended December 31, 1995 loss from operations decreased to $439,000.

  The Company's loss from discontinued operations of $479,000 in 1995 represents
legal expenses incurred in connection with the Lawsuit.  "See Item 3.  Legal
Proceedings."

  Total current assets increased 384.3% to $4,591,000 in 1995 from $948,000 in
1994 and trade accounts receivable increased 330.0% to $3,165,000 in 1995 from
$736,000 in 1994. This increase in current assets and accounts receivable is
attributable to a number of factors including (i) the Merger, which accounted
for $955,000 and $782,000 of the increase in total current assets and trade
accounts receivable, respectively, (ii) the acquisition of Sullivan, which
accounted for $842,000 and $702,000 of the increase in total current assets and
trade accounts receivable, respectively, (iii) the addition of new outsourcing
contracts, which accounted for $810,000 and $630,000 of the increase in total
current assets and trade accounts receivable, respectively, and (iv) the growth
of the Company's transcription business following the acquisitions of MTA and
IDS, which accounted for $1,017,000 of the increase in total current assets and
trade accounts receivable.  In addition, in connection with the growth of the
Company's transcription and its consulting and coding businesses, accounts
receivable increased for fiscal 1995 because it took transcription and
consulting and coding accounts receivable approximately 30 days to turn in 1995
as compared to approximately 20 days in 1994.

LIQUIDITY AND CAPITAL RESOURCES

  The Company's cash flows from continuing operations required the use of cash
of $545,000 and $4,234,000 and $1,396,000 in 1994, 1995 and 1996, respectively.
Cash has been used to continue funding the Company's operating losses and, in
1995, to finance the growth of certain of the Company's acquisitions' working
capital needs. See "Consolidated Statements of Cash Flows."

  Discontinued operations used cash of $1,745,000 in 1996.   This is a net cash
total that includes cash contributed from discontinued operations (through the
collection of accounts receivable) of $456,000 and cash expenditures of
$2,201,000 for collection costs and legal fees and expenses incurred in
connection with the Company's civil lawsuit filed against certain insurance
carriers in the Superior Court in California.   "See Item 3.  Legal
Proceedings."   The accounts receivable from the discontinued operations
represent reimbursements that are owed the Company by certain insurance
companies for applicant medical/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 gross receivables, however, are subject to liens before the WCAB, an
administrative body charged with determining an insurance company's liability
for the payment of medical-legal evaluation services.   The Company 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 a third party for servicing and managing the
remaining accounts receivable balance.   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 portion
of the 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 assets.  "See Item 1.  Business-
Discontinued Operations."

                                      8

<PAGE>
 
  The Company's working capital position decreased during the twelve months
ended December 31, 1996, from $605,000 at December 31, 1995 to a negative
$1,551,000 at December 31, 1996. This decline in the Company's working capital
position is primarily the result of the Company having to increase its short
term debt (i.e., working capital credit facility provided by Silicon Valley
Bank) by $2.1 million to help finance the Company's large losses from continuing
and discontinued (i.e., lawsuit fees and expenses) operations.  Although the
Company has a negative cash flow, the Company's accounts receivables turn faster
than related payables, allowing the Company to operate and grow its business.
Under the terms of its contract management fixed-fee pricing schedules, the
Company receives the annual fee in monthly payments in advance (due on the first
day of the month), prior to actually incurring any of the month's fixed and/or
variable operating expenses.  This results in accounts receivables for contract
management turning in approximately seven days.  The Company also receives an
up-front implementation fee prior to incurring any costs associated with the
actual start-up of a contract management site.

  The Company's cash flows from investing activities used cash of $1,462,000 and
$1,411,000 in 1994 and 1996, respectively, and provided cash of $4,776,000 in
1995. The Company's principal uses of cash for investing purposes are for
capital expenditures and acquisitions.  In 1996, the Company incurred $1,338,000
in capital expenditures, primarily in its medical transcription division for
digital dictation equipment and related technology investments.  In early 1997,
the Company has made a commitment to fund its first Data Delivery Center.  The
total expenditure of approximately $400,000 is expected to be financed through
either the working capital facility with Coast Business Credit described below
or another third party financing relationship.  In 1995, in connection with the
Company's acquisition of TriCare, it acquired approximately $7.5 million of
cash.

  In 1995 the Company expended $1,232,000 in cash to acquire the medical
transcription businesses of IDS and MTA. In connection with these acquisitions,
on August 15, 1995, the Company raised $2 million in cash through the private
placement of 8% Subordinated Convertible Debentures. The Debentures are
unsecured and subordinated to all other debt of the Company. The interest rate
on the Debentures is 8%, payable semi-annually, and the principal amount is due
in full on August 15, 2000. The Debentures are convertible into Common Stock by
the holder at any time prior to August 15, 2000 at a rate of 286 shares of
Common Stock for each $1,000 in principal amount and are convertible by the
Company at any time when the Common Stock trades at $10.50 per share for 30
consecutive trading days. The Company may redeem the Debentures at any time upon
30 to 60 days notice to the holder of a Debenture.

  Cash flows from financing activities provided $2,038,000, $223,000 and
$5,095,000 in 1994, 1995, and 1996, respectively. The Company's primary sources
of cash over the past several years have been (i) proceeds from borrowings under
a line of credit facility (1994 and April, 1996); (ii) proceeds from the
issuance of convertible debentures (August, 1995); (iii) proceeds from the
issuance of common stock and warrants through a private placement in September,
1996 and (iv) proceeds from the exercise of incentive stock options.  In 1995,
the Company retired its line of credit and issued $2 million of convertible
debentures as discussed above.  During 1996, financing activities provided
$5,095,000, primarily from (i) the proceeds received on the exercise of
incentive stock options in the amount of $849,000; (ii) the utilization of
credit facilities (as described below) in the amount of $2,118,000; and (iii)
proceeds of $2,446,000 received in connection with the sale of common stock and
warrants (as described below).

  On April 30, 1996, the Company established two separate credit-facilities with
Silicon Valley East (Wellesley, Massachusetts) a division of Silicon Valley
Bank, a California-chartered bank (Santa Clara, California). The aggregate
credit available (under both facilities) is $5.75 million. The banking
facilities are secured by all of the Company's assets. One of the facilities is
a $5.0 million working capital credit line under which the Company may borrow a
certain percentage of its accounts receivable balance, subject to an initial cap
of $3.0 million that was to be removed if the Company realized net income of at
least $50,000 in the quarter ended September 30, 1996. Because the Company
recognized a loss in the third quarter as well as the fourth quarter, this
facility remains capped at $3.0 million. The second facility is a $750,000 term
facility set up to help the Company meet any of its capital investment
requirements in the near term which include the purchase of computers and
transcription related equipment. This term note is subject to an initial cap of
$250,000, with the cap being removed during such periods that the Company
maintains a minimum debt service ratio of 1.5 to 1.0, where debt service is
defined as earnings before interest and taxes plus depreciation and
amortization, divided by total interest plus current portion of long-term debt.
As of December 31, 1996 the Company was not maintaining the required debt
service ratio, therefore, the cap of $250,000 remains in place on this term
facility. As of December 31, 1996 total borrowings under both facilities totaled
$2,118,000. The stated interest rate on the working capital facility is prime
plus 0.5% and the stated interest rate on the term loan is prime plus 1.0%. Both
of these facilities will mature on April 30, 1997. Due to the Company's
financial losses, the

                                      9

<PAGE>
 
Company's borrowing capacity is currently capped at the $2,118,000 level of
debt.  The Company has been in negotiations with Silicon Valley to re-define all
of its major financial covenants and establish new borrowing capabilities with
Silicon Valley East as a result of its third and fourth quarter losses
(inclusive of all one-time, non-recurring balance sheet adjustments).

  On February 28, 1997, the Company received full loan committee approval from
Coast Business Credit, a California-based asset-based lender (and a division of
Southern Pacific Thrift and Loan Association) to provide the Company a $5.0
million working capital facility to be effective (funding capability) by early
April, 1997.  The facility will be used to pay off Silicon Valley in full upon
initial funding.  This new Coast facility does not contain any financial
covenants and is based on a funding formula (for determining funding limits) as
follows:  1.5 times monthly contractual contract management revenues, plus 80%
of all medical transcription receivables under 90 days (aging).  Based on
current monthly contractual contract management revenues and 80% of all medical
transcription receivables under 90 days as of February 28, 1997, this would
provide the Company with a current funding capacity of approximately $3.8
million.  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.

  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.
 
  The Company anticipates that cash on hand, together with internally generated
funds,  cash collected from discontinued operations and cash available under its
new working capital facility with Coast Business Credit, should be sufficient to
finance continuing operations, make capital investments in the normal and
ordinary course of its business, fund the legal fees incurred in connection with
the appeal of the Superior Court's March 21, 1997 ruling in the Lawsuit and fund
the out-of-pocket expenses incurred in connection with the Lawsuit. See "Item 3.
Legal Proceedings." The Company will continue to pursue various alternatives to
allow for the effective use of cash (i.e., leasing for capital asset funding).
This should help the Company to (i) continue its rapid growth, (ii) achieve
operating profitability and positive cash flow from operations during 1997, and
(iii) continue to fund the out-of-pocket expenses and certain legal fees to be
incurred in connection with the Lawsuit.

IMPACT OF INFLATION

  Inflation has not had a material effect on the Company to date. However, the
effects of inflation on future operating results will depend in part, on the
Company's ability to increase prices and/or lower expenses in amounts offsetting
inflationary cost increases.

                                      10

<PAGE>

ITEM 11. EXECUTIVE COMPENSATION

          The following table provides certain summary information for the
fiscal years ended December 31, 1994, 1995 and 1996 concerning compensation paid
or accrued by the Company to or on behalf of the Company's Chief Executive
Officer and the other executive officers of the Company whose total annual
salary and bonus exceeded $100,000 during the year ended December 31, 1996 (the
"Named Executive Officers").

                           SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
                                                                                LONG-TERM
                                                                              COMPENSATION
                                                                               SECURITIES
                                                                               UNDERLYING
NAME AND PRINCIPAL POSITION              YEAR(1)       SALARY($)  $BONUS($)  OPTIONS/SAR'S(#)
--------------------------------------  ---------      --------  --------   -----------------
<S>                                     <C>           <C>        <C>        <C>      
Larry G. Gerdes.......................   12/31/96     $ 210,115  $     --           --
President and Chief Executive.........   12/31/95       205,376        --           --
 Officer..............................   12/31/94       116,700        --           --
 
Julian L. Cohen (2)...................   12/31/96     $ 205,000        --           --
Chief Operating Officer...............   12/31/95       193,756        --         45,000
                                         12/31/94     $  39,600        --        100,000
 
G. Scott Dillon (3)...................   12/31/96     $ 191,932        --           --
Executive Vice President Outsourcing..   12/31/95        59,599        --         60,000
 Services.............................   12/31/94            --        --           --
David W. Murphy.......................   12/31/96     $ 120,000  $     --           --
Executive Vice President Finance,.....   12/31/95       100,130    22,675         40,000
 Chief Financial Officer,.............   12/31/94        28,385        --         20,000
 Treasurer and Secretary
</TABLE>
--------
(1)  The fiscal year ended December 31, 1994 was for a seven month period.
(2)  Mr. Cohen's employment with the Company was terminated in November 1996.
(3)  The 1996 compensation listed above includes $32,182 in commissions paid
     based on achieving certain 1996 sales objectives.

COMPENSATION OF DIRECTORS

         Directors of the Company who are compensated as officers of the Company
serve without compensation for their services as directors. Each director of the
Company who is not a compensated officer of the Company is paid a fee of $8,000
per annum. Each person who first becomes a non-employee director is granted, as
of the date such person becomes a director of the Company, an option to purchase
10,000 shares of Common Stock. Each non-employee director will be granted an
option to purchase 6,000 shares of the Common Stock, except the Chairman who
will be granted an option to purchase 9,000 shares, upon election or re-election
at the annual meeting of shareholders provided they have served on the board a
minimum of six months.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

         The following persons served as members of the Stock Option and
Compensation Committee of the Board of Directors during the year ended December
31, 1996: Walter J. Huff, Jr. and Charles E. Thoele. None of the members of the
Stock Option and Compensation Committee has been an officer or employee of the
Company.

         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. Participating in this private placement were Walter S. Huff, Jr., a
director of the Company, who purchased 225,225 shares at $4.44 per share and
warrants to purchase an additional 225,225 shares at $.25 per warrant and
Charles E. Thoele, a director of the Company, who purchased 11,261 shares at
$4.44 per share and warrants to purchase an additional 11,261 shares at $.25 per
warrant. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources."

                                      11



<PAGE>
 
STOCK OPTION PLAN

         The Company has adopted a 1992 Stock Option Plan, as amended (the
"Plan") for selected employees and directors who are not employed by the Company
("Non-Employee Directors"). The Plan is administered by the Stock Option and
Compensation Committee of the Board of Directors. The Plan was amended at a
special meeting of shareholders held on June 5, 1996, increasing the number of
shares reserved for issuance under the Plan by 400,000 shares such that the Plan
currently provides for the grant of incentive and non-qualified stock options to
purchase up to 2,000,000 shares of Common Stock.

         Under the terms of the Plan, the Stock Option and Compensation
Committee may determine the employees to whom options will be granted, the time
or times of exercise, the number of shares subject to an option and the terms
and conditions of each stock option agreement. The Stock Option and Compensation
Committee also determines whether an option is an incentive stock option or a
non-qualified stock option. The price per share of stock subject to an incentive
stock option must equal 100% of the fair market value thereof on the date of
grant. The price per share of stock subject to a non-qualified stock option is
to be determined by the Stock Option and Compensation Committee and may be less
than fair market value. The exercise period for an incentive stock option cannot
exceed ten years, while there is no limitation with respect to non-qualified
stock options. In addition, the Stock Option and Compensation Committee cannot
grant an incentive stock option to any person who owns at least 10% of the
outstanding Common Stock unless the price is 110% of fair market value and the
option exercise period does not exceed five years.

         The Plan also provides for non-discretionary or automatic grants of
options to Non-Employee Directors. See "Executive Compensation--Compensation of
Directors." The price of Common Stock subject to a Non-Employee Director option
is the fair market value on the date of grant, except that the price of Common
Stock subject to options granted on March 16, 1992 was the fair market value on
October 14, 1992, the date the Plan was approved by the shareholders of the
Company. Each Non-Employee Director option must conform to the provisions of the
Plan. Non-Employee Director options become exercisable six months from the date
of grant and expire ten years from the date of grant. Moreover, in the event a
Non-Employee Director terminates membership on the Board for any reason, an
option held by him may be exercised until the earlier of the expiration of the
option or 12 months from the date of termination.

         As of March 1, 1997, options to purchase a total of 1,095,500 shares of
Common Stock were outstanding at a weighted average exercise price of $2.95 per
share. In addition, as of March 1, 1997, options to purchase a total of  4,680
shares of Common Stock were outstanding under the former Transcend Services,
Inc. stock option plan at a weighted average exercise price of $.30 per share.
During fiscal 1996, no options were granted under the Plan to the Named
Executive Officers.

         During fiscal 1996, no options were granted under the Plan to the Named
Executive Officers.  The following table sets forth certain information
concerning the unexercised stock options held by the Named Executive Officers.

  AGGREGATED OPTION EXERCISES IN FISCAL 1996 AND FISCAL YEAR END OPTION VALUES

                                 VALUE OF UNEXERCISED OPTIONS AT FISCAL YEAR END
                                 -----------------------------------------------
<TABLE>
<CAPTION>
                                                                   NUMBER                     VALUE OF
                                                                OF SECURITIES               UNEXERCISED(1)
                                                                  UNDERLYING             IN-THE-MONEY OPTIONS
                                 SHARES                          EXERCISED                   AT FY-END($)
                                ACQUIRED      VALUE          OPTIONS AT FY-END               IN-THE-MONEY
NAME                           ON EXERCISE   REALIZED     EXERCISABLE/UNEXERCISABLE     EXERCISABLE/UNEXERCISABLE
----                           -----------   --------     -------------------------     -------------------------
<S>                            <C>           <C>          <C>                           <C>               
Larry G. Gerdes............       100,000    $256,200          616,000 /   --            $    2,011,200 /   --
Julian L. Cohen (2)........        63,500     341,800            --  /     --                    --     /   --
G. Scott Dillon............         7,500      15,000          7,500 / 45,000            $   13,125 / $ 78,750
David W. Murphy............            --          --         20,000 / 40,000            $   56,875 / $103,125
</TABLE> 
--------
(1) Dollar values calculated by determining the difference between the fair
    market value of the underlying securities at December 31, 1996 ($5.25 per
    share) and the aggregate exercise price of the options.

(2)  All unexercised options held by Mr. Cohen were canceled upon Mr. Cohen's
     departure from the Company in November, 1996.

EMPLOYEE RETIREMENT SAVINGS PLAN

  The Company has established a savings and retirement plan that qualifies as a
tax-deferred savings plan under Section 401(k) of the Internal Revenue Code (the
"401(k) Plan") for its salaried, clerical and hourly employees. Under the 401(k)
Plan, eligible employees may contribute up to $9,500 of their gross salary to
the 401(k) Plan in 1996. Each participating employee is fully vested in
contributions made by such employee. The Company currently does not match 
employee contributions,

                                      12



<PAGE>
 
but the Company's policy regarding matching contributions may be changed
annually in the discretion of the Board of Directors. All amounts contributed
under the 401(k) Plan are invested in one or more investment accounts
administered by an independent plan administrator.

EMPLOYEE STOCK PURCHASE PLAN

  The Company has adopted a 1990 Employee Stock Purchase Plan, as amended (the
"Stock Purchase Plan"). The purpose of the Stock Purchase Plan is to provide an
incentive for employees of the Company and its subsidiaries to acquire or
increase their proprietary interests in the Company through the purchase of
shares of Common Stock of the Company. The Stock Purchase Plan is administered
by the Board of Directors of the Company, which has the authority to interpret
the Stock Purchase Plan, to prescribe, amend and rescind rules and regulations
relating to it and to establish the terms of each offering of Common Stock under
the Stock Purchase Plan. All employees of the Company are eligible to
participate in the Stock Purchase Plan with certain limited exceptions.

  Participants may direct the deduction of a specified percentage, as set by the
Board of Directors, from their eligible compensation to be used to purchase
Common Stock under the Stock Purchase Plan. The terms of the Stock Purchase Plan
provide for two six month offering periods each calendar year in which eligible
employees may elect to participate. At the end of each offering period, the
Company uses the accumulated payroll deductions to purchase Common Stock for the
participant. The price of Common Stock purchased with such payroll deductions
during each offering period shall be the lesser of: (i) 85% of the mean between
the bid and asked prices of the Common Stock at the beginning of each offering;
or (ii) 85% of the mean between the bid and asked prices of the Common Stock on
the last day of such offering period.

  The Company will not grant to any participant any right to purchase Common
Stock under the Stock Purchase Plan if the exercise of such right would cause
such participant to own 5% or more of the combined voting power or value of all
classes of the Company's capital stock. In addition, an employee may not
participate if such participation would permit the employee to purchase stock
under all employee stock purchase plans of the Company and its subsidiaries to
accrue at a rate which exceeds $25,000 of the fair market value of the stock for
each calendar year in which an option to purchase stock under the plan is
outstanding at any time.

  An aggregate of 225,000 shares of Common Stock have been reserved for issuance
under the Stock Purchase Plan.

                                      13


<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: April 21, 1997                    By:  /s/ David W. Murphy
                                            ---------------------------------
                                            David W. Murphy   
                                            Executive Vice President, Finance 
                                            and Chief Financial Officer
                                            (principal financial and 
                                            accounting officer)