AVALON COMMUNITY SERVICES INC, 10KSB, 1997-03-31

AVALON COMMUNITY SERVICES INC
10KSB, 1997-03-31
FACILITIES SUPPORT MANAGEMENT SERVICES

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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-KSB

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 1996

[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Commission File Number: 0-20307
AVALON COMMUNITY SERVICES, INC.
(Name of small business issuer in its charter)

Nevada 13-3592263
(State of Incorporation) (I.R.S. Employer I.D. Number)

13401 Railway Drive, Oklahoma City, Oklahoma 73114
(Address of Principal executive offices) (Zip Code)

Issuer's telephone number (405) 752-8802

Securities registered under Section 12 (b) of the Exchange Act: None

Securities registered under Section 12 (g) of the Exchange Act:

Shares of Class A Common Stock, par value $.001
(Title of class)

The issuer has (1) filed all reports required to be filed by Section 13 or
15 (d) of the Exchange Act during the past 12 months (or such shorter period as
the registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days: Yes X No ___

Disclosure of delinquent filers in response to Item 405 of Regulation S-B
is not contained in this form, and no disclosure will be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this form 10-KSB. [ X ]

Revenues for continuing operations for the year ended December 31, 1996
were $3,312,687 .

The aggregate market value of voting common stock held by non affiliates
was $8,780,320 on January 31, 1997, based on the average bid and asked prices of
such stock as reported by the National Association of Securities Dealers
Automated Quotations Systems ("NASDAQ") on that day. As of February 28, 1997,
2,927,135 shares of the issuer's common stock, par value $.001, were issued and
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the Proxy Statements for the 1997 Annual Meeting of
Shareholders are incorporated by reference in Part III.6

Transitional Small Business Disclosure Format: Yes No X .

TABLE OF CONTENTS
FORM 10-KSB ANNUAL REPORT
FOR THE YEAR ENDED DECEMBER 31, 1996

Item

PART I

1. Description of Business

2. Description of Property

3. Legal Proceedings

4. Submission of Matters to a Vote of Security Holders

PART II

5. Market for Common Equity and Related
Stockholders Matters

6. Management's Discussion and Analysis
Or Plan of Operation

7. Financial Statements

8. Changes in and Disagreements With Accountants
On Accounting and Financial Disclosure

PART III

9. Directors, Executive Officers, Promoters and Control
Persons of the Registrant

10. Executive Compensation

11. Security Ownership of Certain Beneficial Owners

12. Certain Relationships and Related Transactions

13. Exhibits and Reports on Form 8-K

Signatures

AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES

PART I
ITEM 1. DESCRIPTION OF BUSINESS.

The Company -

Avalon Community Services, Inc. ("Avalon" or the "Company"), is an Oklahoma
based corporation owning and operating private correctional facilities. Avalon
specializes in privatized community correctional facilities and intensive
correctional programming. Avalon currently operates in Oklahoma, Texas,
Missouri, and Nebraska with plans to significantly expand into additional states
throughout the Southwest. Avalon's business strategy is designed to escalate
Avalon into a dominant role as a provider of community correctional services on
a regional basis, by expanding its operations through new state contracts and
selective acquisitions, in order to capitalize on current rapid growth trends in
the privatized corrections industry.

The privatized community correctional services industry has experienced
significant growth in recent years. In 1994 there were 3.6 million individuals
on probation or parole; this population is expected to double by the year 2005
to 7.2 million. Community based alternatives to incarceration includes
individuals that have been granted parole or sentenced to probation. In the
period from 1980 to 1994, the parolee population increased by 213% and the
number of individuals on probation increased by 165%. These individuals are
typically placed in pre-release (community corrections) settings for the last
3-6 months on their sentence and prepared for re-entry into the community. Of
the 5.1 million individuals in the adult correctional system in 1994, over 3.6
million or 69% were either on probation (55%) or parole (14%). Avalon contracts
with various State agencies to provide community corrections services. Avalon
believes, with its management's background and abilities to own and operate
community correctional facilities and programing, it is fast becoming a dominant
player in the corrections industry.

Avalon currently owns and operates 649 private community corrections beds.
Avalon owns and manages two (2) minimum-security correctional facilities in
Oklahoma. Avalon believes it is the largest provider in Oklahoma of community
correctional services (505 beds). Avalon owns and manages one (1)
medium-security correctional facility in El Paso, Texas, used as an intermediate
sanction facility (144 beds). These facilities include many residential programs
for state offenders typically serving the last six months of their sentence. In
addition to providing governmental agencies the basic services relating to the
security, detention and care of inmates, Avalon has developed a broad range of
rehabilitative programs to reduce recidivism, including substance abuse
treatment and counseling, vocational training, work release programs, basic
educational programs, job and life skill training, and reintegration services.

Avalon provides nonresidential services for inmates in addition to owning
and operating residential correctional facilities. Avalon provides substance
abuse treatment services for incarcerated inmates in seven (7) correctional
facilities in Nebraska, and recently received contracts to provide substance
abuse treatment services in two (2) correctional facilities in Missouri.
Intensive programming is an essential part of community based corrections.
Avalon has provided substance abuse programs in facilities for over twelve (12)
years.

Avalon's management has been engaged in the business of providing private
correctional services since 1985. Avalon Enterprises, Inc. was incorporated in
Nevada in September 1990 and acquired Southern Correction Systems, Inc. in June
1992. Avalon Enterprises, Inc. subsequently changed its name to Avalon Community
Services, Inc. Avalon acquired two entities in December 1993 in the business of
providing residential care services.

Avalon has divested itself of its residential care facilities and
outpatient mental health management, and is currently planning on divesting its
assisted living centers interests to allow management to focus on the private
community based corrections industry. Avalon is aggressively pursuing privatized
correctional projects both at the request for proposal stage and at the
development stage.

Avalon's corporate office is located at 13401 Railway Drive in Oklahoma
City, Oklahoma. Avalon's common stock is traded on the NASDAQ SmallCap Market
with the symbol "CITY".

Facilities -

The following table summarizes certain information with respect to
facilities and programs managed by Avalon at March 21, 1997.
<TABLE>
<S> <C> <C> <C>
Facility Name
And Location Company Role Capacity Facility / Program Type
- ------------ ------------ -------- -----------------------

Carver Center, Complete Facility 250 Beds Minimum Security
Oklahoma City, OK Management Corrections

Avalon Correctional Center, Complete Facility 255 Beds Minimum Security
Tulsa, OK Management Corrections

El Paso Intermediate Complete Facility 144 Beds Intermediate Sanction
Sanction Facility, Management Correctional Facility
El Paso, TX
Nebraska State Penitentiary, Program Management 30 Clients Substance Abuse
Lincoln, NE Treatment Services

The Lincoln Correctional Program Management 50 Clients Substance Abuse
Center, Lincoln, NE Treatment Services

The Omaha Correctional Program Management 25 Clients Substance Abuse
Center, Omaha, NE Treatment Services

The Nebraska Diagnostic Program Management 30 Clients Substance Abuse
And Evaluation Center, Treatment Services
Lincoln, NE

The Nebraska Community Program Management 30 Clients Substance Abuse
Corrections Center, Treatment Services
Lincoln, NE

Community Correctional Program Management 45 Clients Substance Abuse
Center, Lincoln, NE Treatment Services

Community Correctional Program Management 30 Clients Substance Abuse
Center, Omaha, NE Treatment Services

Ozark Correctional Center, Program Management 650 Clients Substance Abuse
Jefferson City, MO Treatment Services

Tipton Correctional Center, Program Management 1,088 Clients Substance Abuse
Tipton, MO Treatment Services

Emerald Square, Complete Facility 60 Beds Assisted Living
Oklahoma City, OK Management For Elderly

Avalon Corporate Office, Corporate Headquarters N/A Administrative
Oklahoma City, OK
</TABLE>

Correctional Services -

Avalon owns and operates three correctional centers, Carver Center, Avalon
Correctional Center and El Paso Intermediate Sanction Facility. The correctional
centers provide complete correctional administration, correctional officer
staffing, room and board, vocational assistance, transportation, and
rehabilitation services.

Oklahoma. Avalon's contracts with the Oklahoma Department of Corrections
are one year in duration and extend through June 30, 1997, with the option to
renew for two (2) additional one year periods. Avalon has contracted with the
State of Oklahoma pursuant to similar contracts since 1985. The State of
Oklahoma's performance under the contracts is subject to annual appropriation by
the legislature.

Carver Center is a 250-bed minimum security correctional facility located
in Oklahoma City, Oklahoma. Carver Center has been expanded from its initial
capacity of 25 beds in 1985, to its current capacity of 250 beds to accommodate
the increasing needs of the Oklahoma Department of Corrections. During December
1996, the average number of inmates residing at Carver Center was 143 and on
March 16, 1997 the census was 156. Avalon Correctional Center is a 255-bed
minimum security correctional facility located in Tulsa, Oklahoma. The Avalon
Correctional Center opened its 36,000 square foot facility in July, 1995. The
average number of inmates residing at Avalon Correctional Center during the
month of December, 1996 was 103, and on March 16, 1997 the census was 133.

Carver Center and Avalon Correctional Center are accredited by the American
Correctional Association ("ACA") as Adult Community Correctional Facilities. ACA
accreditation or candidacy is required to contract with the State of Oklahoma
for correctional services. The ACA, a private not-for-profit organization, was
established to develop uniformity and industry standards for inmate care.

Texas. Avalon purchased the El Paso Intermediate Sanction Facility in El
Paso, Texas in August 1996. The prison is being managed by Southern Corrections
Systems, Inc. a wholly owned subsidiary of Avalon. The prison is 36,000 square
foot with a capacity of 144 beds. Avalon signed a fifteen year contract to
provide services in the facility for the West Texas Community Supervision and
Corrections Department in July, 1996. Avalon also signed a three year contract
with the Texas Department of Criminal Justice in November, 1996, to provide
complete services for up to 50 male parole and mandatory supervision releases in
the facility. This new contract brought the prison to 100% of its capacity. The
average number of inmates at the El Paso Intermediate Sanction Facility during
December, 1996 was 113, and the census was 127 on March 16, 1997.

Nebraska. Avalon was awarded a contract in February, 1996, with the State
of Nebraska Department of Correctional Services to provide substance abuse
treatment services. The Nebraska contract has a fifteen-month term with two (2),
two year renewal options. The contract is to provide substance abuse treatment
services in seven prisons: the Nebraska State Penitentiary, the Lincoln
Correctional Center, The Omaha Correctional Center, the Nebraska Diagnostic and
Evaluation Center, the Nebraska Community Corrections Center at Lincoln, the
Community Correctional Center in Lincoln, and the Community Correctional Center
in Omaha. Avalon began providing the contract services in March, 1996.

Missouri. Avalon was awarded a four year contract in March, 1997 with the
Missouri Department of Corrections. The contract is to provide substance abuse
services in the Ozark Correctional Center, a 650 bed medium security prison in
Fordland, Missouri. Avalon is scheduled to begin providing services in the Ozark
Correctional Center on May 1, 1997.

Avalon was awarded a four year contract in March, 1997 with Missouri
Department of Corrections. The contract is to provide substance abuse
intervention services for the Tipton Correctional Center, a 1,088-bed medium
security prison in Tipton, Missouri. Avalon is scheduled to begin providing
services in the Tipton Correctional Center in June, 1997.

Avalon is evaluating additional correctional projects in Oklahoma,
Nebraska, Colorado, Texas, Missouri, Florida, and other states.

Assisted Living -

Assisted living centers are designed for ambulatory, elderly individuals
requiring assistance with daily living services, but not requiring the intensive
medical services provided by a nursing home. The Centers provide complete daily
living services including housing, food services, 24 hour per day staffing,
medication monitoring, housekeeping, laundry services, transportation, and
activities for the residents. Avalon is divesting itself of its assisted living
center interests to focus on the private corrections industry. A letter of
intent for the sale of one assisted living center was signed March 20, 1997.

Avalon entered into an agreement in 1996 to develop and operate an assisted
living center for the elderly in Oklahoma City, Oklahoma. The Center is owned by
Avalon Retirement Centers, LLC, an affiliate. Emerald Square Assisted Living
Center began operations in the fourth quarter of 1996.

Avalon entered into an agreement in 1996 with Avalon Retirement Centers of
Colorado, LLC, an affiliate, to develop and operate an assisted living center
for the elderly in Fort Collins, Colorado. Diamond Crest Assisted Living Center
began operations in the fourth quarter 1996. A letter of intent to sell Diamond
Crest was signed March 20, 1997.

Residential Care -

Avalon owned two residential care facilities in 1996 and provided contract
management services for a third residential care operation owned by an
affiliate. Residential care facilities provide a structured environment with
daily activities, room and board, monitoring of medications, transportation, and
daily living skills classes for residents requiring supportive assistance.
During the fourth quarter 1996, the management of Avalon decided to discontinue
the residential care segment of Avalon.

Avalon's wholly owned subsidiary, Elk City Properties, Inc., owned and
operated Connections Supportive Living Center ("Connections"), located in
Norman, Oklahoma, and Westcare Supportive Living Center ("Westcare"), located in
Elk City, Oklahoma. Connections was a 60-bed facility and Westcare was a 76-bed
facility with eight assisted living apartments. Connections and Westcare
operations were closed in the fourth quarter 1996, due to financial losses.

Avalon also provided contract management services during 1996 for Pathways
Supportive Living Center ("Pathways"), an 88-bed facility located in Oklahoma
City, Oklahoma. Pathways is owned by Southern Community Services, Inc. an
affiliated entity. The building, utilized by Pathways, is owned by Avalon and
was leased to Southern Community Services, Inc. The residential care operations
were discontinued in the fourth quarter of 1996. The building has proper zoning
for use as a correctional facility for female inmates. The building is being
renovated for use as a correctional facility for female inmates.

Competition -

Corrections. The trend in the United States toward privatization of
government services and functions has increased as governments have faced
continuing pressure to control costs and improve the quality of services.
Governmental agencies responsible for the operation of detention facilities are
privatizing facilities and contracting with private contractors for services in
an attempt to address these pressures. Fiscal pressures have forced some
government agencies to limit public services and to seek more cost-effective
means of providing the remaining services. Many do not have the
readily-available resources to make the changes to meet such mandates and must
seek private providers.

A combination of factors in many states (i.e., decreasing revenues,
increasing prison population, legal battles arising from substandard prison
conditions, and overcrowding) has led to a revamping of the corrections'
processes and a reallocation of limited prison resources. Private correctional
services provide a substantial economic savings to the state, allow the
contracting governmental agency to comply with legislative and judicial pressure
to improve prison conditions. Private operated correctional management companies
are able to provide high quality services at a lower cost. Private correctional
facilities operating as contractors for government agencies, pursuant to court
order or otherwise, exist in virtually every state. The private correctional
services industry has experienced rapid growth in recent years. According to the
Private Adult Correctional Facility Census, Ninth Edition, prepared by the
Private Corrections project, Center for Studies in Criminology & Law, University
of Florida, dated March 15, 1996, the rated capacity of international privatized
secure adult correctional facilities grew from 2,620 beds in 1986 to 63,595 beds
at year-end 1995 and, in a June 16, 1996 forecast prepared by the Project, is
projected to grow to 197,503 beds by year-end 2000.

The area of community corrections, like that of all other corrections
sectors, has experienced substantial growth over the past decade. Often referred
to as "community-based alternatives to incarceration", community corrections
includes individuals that have been granted parole or sentenced to probation.
Probation occurs when an individual is sentenced for an offense without
incarceration; however, the sentence is contingent upon good behavior. Parole
occurs when an inmate is released prior to the completion of his/her sentence.
These individuals are typically placed in pre-release (community corrections)
settings for the last 3-6 months of their sentence and are prepared for re-entry
into the community. Over the past decade, the number of individuals on probation
and parole has increased dramatically. In the period from 1980 to 1994, the
parolee population grew from 220,438 to 690,159, an increase of 213%. During the
same period, the number of individuals on probation increased from 1.1 million
to approximately 3.0 million, an increase of 165%. Historical annual growth
rates for parole and probation populations are 7.2% and 8.5%, respectively.
Based on historical annual growth rates, it is projected by industry analysts
that the parole population will increase to over 5.6 million by 2005.

Contracts for correctional services are awarded by government agencies and
are generally based upon competitive bidding and quality of services provided.
Management believes that Avalon has several competitive advantages in
contracting for correctional services including: a) a twelve-year history of
providing quality services to the Oklahoma Department of Corrections; b) a
geographic location allowing for lower administrative overhead charges when
bidding against competitors for regional contracts; c) accreditation maintained
by the American Correctional Association since 1990 and certification as a drug
and alcohol provider since 1985; and d) a high quality and cost-effective
corporate infrastructure for management, marketing, financial management,
financial reporting, quality assurance, and providing support services at
minimal costs. Utilizing the shared costs of these resources allows Avalon to
develop and maintain the necessary resources to provide quality services while
minimizing operating costs by allocating overhead costs among all operated
facilities. Access to these services allows Avalon to be more competitive in
bidding contracts.

Avalon has developed a broad range of programs intended to reduce
recidivism, including substance abuse treatment and counseling, vocational
training, work release programs, GED classes, job and life skills training, and
reintegration services in addition to providing fundamental residential services
for adult inmates. The management services offered by Avalon range from project
consulting to the design and development of new correctional facilities, and the
redesign, renovations and management of older facilities. Avalon believes its
success in owning and operating community correctional facilities and
programming, will be the basis for becoming a dominant operator in the community
corrections industry

Avalon contracts with the State of Oklahoma to provide services in Carver
Center and Avalon Correctional Center. Avalon contracts with West Texas
Community Supervision and Correctional Department and with the Texas Department
of Criminal Justice Parole Department to provide services in the El Paso
Intermediate Sanction Facility. Revenues generated from such contracts during
1996 comprised approximately 88% of total revenues, of which 66% are with the
Oklahoma Department of Corrections.

Assisted Living. Avalon management expects that as the assisted living
centers receives increased attention, competition will grow from new market
entrants focusing on assisted living centers. Although Avalon believes the
opportunities in the assisted living industry to be expanding, management has
decided to divest itself of its assisted living center interest and focus on
opportunities in the private corrections industry.

Insurance -

Avalon maintains insurance coverage for general liability, property and
contents, automobile physical damage and liability, workers' compensation, and
directors and officers. Avalon believes its existing insurance coverages are
adequate.

Regulations -

Avalon's correctional facilities in Oklahoma are accredited by the American
Correctional Association ("ACA"), an independent organization comprised of
professionals in the corrections industry, and uses compliance audit teams to
rigorously examine all aspects of the Company's facilities and operations. The
Company recognizes the importance of maintaining high quality management and
operations at its facilities. Accreditation is generally granted for a
three-year period. Carver Center has been accredited since 1990 and is currently
accredited through 1999. Avalon Correctional Center was accredited in 1996 and
is accredited through 1999.

The corrections industries is subject to federal, state and local
regulations administered by a variety of regulatory authorities. The
correctional services offered by Avalon in various states are subject to
regulations and oversight by the various state agencies. Management believes
that its operations are currently in compliance with all applicable laws and
regulations affecting Avalon's business.

Employees -

At March 18, 1997, Avalon had approximately 149 full-time employees,
including, directors, and officers. Avalon has not experienced a work stoppage,
and management considers its employee relations to be good.

ITEM 2. DESCRIPTION OF PROPERTIES.

Carver Center is a 250-bed minimum security correctional facility located
in Oklahoma City, Oklahoma. The facility is located on a five-acre tract of land
and includes five buildings. Avalon constructed a new 16,000 square foot
dormitory at Carver Center in the second quarter of 1995, for a total of
approximately 35,000 square feet.

Avalon Correctional Center is a 255-bed minimum security correctional
facility located in Tulsa, Oklahoma. The construction of the approximately
36,000 square foot facility was completed in July, 1995. The Avalon Correctional
Center opened in July, 1995.

El Paso Intermediate Sanction Facility is a 144-bed medium security
correctional facility located in El Paso, Texas utilized as an intermediate
sanction facility. The 36,000 square foot facility is a seven acre tract of
land, purchased in 1996.

Avalon owns a remodeled 60,000 square foot building located in Elk City,
Oklahoma. The building is zoned for the operation of a residential care facility
or an assisted living center. This building is currently held for sale.

Avalon owns a 32,000 square foot building in Oklahoma City, Oklahoma. The
building was leased through December, 1996. The building is zoned for the
operation of a residential care facility or a community based correctional
center for female inmates. The building is currently being renovated for a
correctional center for female inmates.

Avalon Corporate Office is located in Oklahoma City, Oklahoma, in a
commercial building at 13401 Railway Drive, Oklahoma City, Oklahoma 73114.

Substantially all property owned by Avalon is pledged as collateral on
Company debt. See Note 4 to the Consolidated Financial Statements.

ITEM 3. LEGAL PROCEEDINGS.

Avalon is a party to litigation arising in the normal course of business.
Management believes that the ultimate outcome of these matters will not have a
material effect on Avalon's financial condition or results of operations.

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

No matters were submitted to a vote of Avalon's stockholders during the
quarter ended December 31, 1996.

PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

Avalon's common stock trades on the NASDAQ SmallCap Market with the symbol
"CITY". The following table reflects the range of high and low bid prices, as
reported by the National Quotation Bureau for each quarterly period during 1995
and 1996. The prices represent inter-dealer prices, without retail mark up, mark
down, or commission and may not represent actual transactions. Trading in
Avalon's common stock is limited and may not be an indication of the value of
the common stock.

Quarterly Period Ended High Low
-----------------------------------------------------
March 31, 1995 $ 2 1/8 $ 1
June 30, 1995 2 11/16 1
September 30, 1995 3 1/8 1
December 31, 1995 3 3/8 2 1/4
March 31, 1996 2 1/2 2
June 30, 1996 7 5/8 2 1/2
September 30, 1996 5 7/8 4 1/8
December 31,1996 4 3/4 3 7/8

Avalon had approximately 790 holders of record of its common stock as of
March 15, 1997. No dividends were declared during 1995 and 1996. Avalon's Board
of Directors presently intends to retain any earnings in the foreseeable future
for use in Avalon's business. Payment of dividends on the Common Stock is
restricted by terms of Avalon's revolving credit facility.

The average of the bid and asked prices for the Common Stock, as reported
on the NASDAQ SmallCap Market System was $4.69 per share on February 28, 1997.

ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

Liquidity and Capital Resources -

The Company's business strategy is to focus on the private community
corrections industry, expanding its operations into additional states within the
Southwest region through new state contracts and selective acquisitions. The
strategy includes the necessity to divest itself of it's interest in residential
care management and assisted living centers, to allow management to concentrate
on the private corrections industry. The Company's strategy was implemented in
the fourth quarter 1996. All residential care facilities were discontinued. The
losses associated with the discontinuation of the residential care facilities in
the fourth quarter 1996 are reflected on the Consolidated Statements of
Operations. A letter of intent to sell Avalon's interest in an assisted living
center in Colorado was signed March 20, 1997. The remaining assisted living
center will be divested during 1997.

Working capital at December 31, 1996 was $179,000 for a current ratio of
1.18. Warrants were exercised in 1996, for a net funding of $1.183 million, used
primarily for the purchase of El Paso Intermediate Sanction Facility and
operating needs. Capital expenditures were $2.6 million in 1995, compared to
$171,300 in 1996. The significant expenditures during 1995 were the remaining
$381,000 for the expansion of Carver Center to a 250-bed facility, and $1.9
million to complete the construction of the Avalon Correctional Center, Proceeds
from asset dispositions, primarily the sale of vehicles, was $45,700 in 1996 and
were utilized to retire related debt.

The Company acquired the El Paso Intermediate Sanction Facility in El Paso,
Texas in August, 1996. The purchase price was approximately $3.681 million
including the assumption of $2.974 million related debt, $200,000 cash, and
approximately $307,000 assumption of certain liabilities. The Company also
issued 50,000 shares of common stock and 200,000 stock purchase warrants, having
a value of $200,000, relating to the acquisition.

Avalon's revolving bank line of credit provides for aggregate maximum
borrowing of $500,000. Long-term debt borrowed during 1996 totaled $3.63 million
primarily consisting of the assumption of the $2.974 million debt for the El
Paso Intermediate Sanction Facility, partially offset by repayments of long-term
debt.

Avalon believes it has sufficient cash reserves and ample cash flow from
operations to meet its current cash requirements. Based on current contracts,
Avalon expects to generate sufficient income to realize the deferred tax assets.
Additional sources of funding may be required for future expansion. Avalon will
explore other sources of funding such as additional bank borrowing's or the sale
of equity securities for future expansion. Additional funds may also be
available through the exercise of Avalon's outstanding stock purchase warrants.

Results of Operations -

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

Avalon had a net loss in 1995 of $84,800 or $.03 per share, as compared to
a net loss in 1996 of $1,033,700 or $.38 per share. The majority of the loss in
1996 was due to a loss of $976,000 on or $.36 per share loss from discontinued
residential care operations. The majority of loss in 1995, $81,400 or $.03 per
share, was due to discontinued park property management in 1995. The 1995
Consolidated Statement of Operations was restated to reflect the discontinuation
of residential care operations in 1996.

Total revenues for continuing operations increased by 56% from $2.119
million in 1995 to $3.313 million in 1996, primarily due to an increase in
revenue from the addition of a correctional facility in El Paso, Texas and to
increased census at the Avalon Correction Center in Tulsa, Oklahoma.

Corrections. Operating income, before interest, depreciation and income
taxes, was $705,500 for 1996 as compared to $452,600 for 1995, an increase of
approximately 56%. Revenues increased from $2.119 million in 1995 to $3.313
million in 1996 directly as a result of the increase in census at Avalon
Correctional Center and the acquisition of El Paso Intermediate Sanction
Facility. The average daily inmate census increased from 198 in 1995 to 332 in
1996.

Direct operating expenses increased by 84% from 1995 to 1996, primarily as
a result of the increase in expenses at Avalon Correctional Center due to
additional census and the acquisition of El Paso Intermediate Sanction Facility.
The profit margin at Avalon Correctional Center and the El Paso Intermediate
Sanction Facility was low due to low census, thereby reducing the overall profit
margin from 50% in 1995 to 41% in 1996. The census was increased in 1997 at both
facilities, improving the profit margin in 1997. El Paso Intermediate Sanction
Facility was awarded a second contract in November, 1996 bringing the facility
to its full capacity, and Avalon Correctional Center received an increase of 30
additional inmates during the first quarter 1997, and is expected to increase
census again during 1997. The profit margin for Nebraska Substance Abuse
Programs was a contributing factor to lower profit margins in 1996. Substance
abuse programs profit margin is typically lower than residential correctional
facilities, primarily due to lower overhead costs.

Residential Care. The operations were discontinued in the fourth quarter,
1996, primarily due to financial losses, and to the Company's strategy to focus
on the corrections industry. Net discontinued operating loss for 1995 and 1996
was $28,500 and $649,247, respectively, net of income tax allocations. Revenues
in 1995 and 1996 were $936,900 and $409,300, respectively. The decrease in
revenues of 56% in 1996 was primarily a result of a decrease in census and the
closing of the facilities in the fourth quarter 1996. The loss on the disposal
of assets related to the discontinuation is estimated to be $325,000, primarily
due to a write down of $318,000 on assets. The Company also paid $87,000 in a
litigation settlement associated with the residential care operations.

Park Management . Avalon ceased operations and canceled its park management
contract in June 1995. The loss on the disposal of operations, net of income tax
benefit of $27,400, was $34,100. Loss from operations in 1995 was $18,800.

Corporate. General and administrative expenses increased in 1996 by 7% from
$603,300 to $645,700. The increase was a result of additional staffing,
increased legal expenses, and an increase in advertising, marketing, and
promotional costs. The increase in 1996 of $200,700 in interest expense was
primarily due to interest on the funds borrowed for the acquisition of the El
Paso Intermediate Sanction Facility, $129,300, and the construction of Avalon
Correctional Center, $96,000. Depreciation and amortization expense increased by
$69,000 primarily as a result of the acquisition of the El Paso facility and one
full year of depreciation of the Avalon Correctional Center in 1996.

MANAGEMENT -

Name Age Position(s) with the Company
---- --- ----------------------------
Donald E. Smith ............44 Chief Executive Officer, Director
Jerry M. Sunderland ........60 President, Director
Kathryn A. Avery ...........44 Chief Financial Officer, Vice President
Walter L. DeBoe ............49 Vice President of Operations
Robert O. McDonald .........58 Director

Directors and Officers of the Company -

The following is a brief description of the business experience during the
past five years of each of the above-name persons:

Donald E. Smith has served as Chief Executive Officer of Avalon since June,
1992 , and has held the same position with Avalon's subsidiaries since their
inception. Mr. Smith has owned, managed and developed a number of private
corporations since 1985 to provide private corrections, residential care, mental
health care, and other related services. Mr. Smith received a Bachelor of
Science degree in 1974 from Northwestern State College.

Jerry M. Sunderland has served as President of Avalon since June, 1995. Mr.
Sunderland served as Correctional Services Administrator for one of Avalon's
subsidiaries from 1990 to 1993 and for an affiliate of Avalon since 1988. Mr.
Sunderland also serves as a Director of Avalon's subsidiaries and for certain
affiliated private corporations. Mr. Sunderland was employed by the Oklahoma
Department or Corrections for sixteen years and twelve years as an agent for the
Oklahoma State Department of Investigation.

Kathryn A. Avery was appointed Chief Financial Officer and Vice President
in June, 1995. Ms. Avery was employed by Red Eagle Corporation for five years,
serving for three years as acting Controller and Chief Financial Officer. Ms.
Avery received a degree in Business Administration from the University of
Oklahoma in 1982, is a certified public accountant and a member of the Oklahoma
Society of CPAs.

Walter L. DeBoe serves as the Vice President and Regional Administrator for
Avalon since 1996. Mr. DeBoe served as the Administrator of Carver Center, since
January, 1992. Mr. DeBoe is responsible for Avalon's correctional operations,
including recruitment and training of personnel, maintaining accreditation by
the American Correctional Association, and compliance with contractual
requirements. Mr. DeBoe's experience includes over eighteen years experience in
the correctional field.

Robert O. McDonald was appointed as Director of Avalon in October, 1994.
Mr. McDonald is Chairman of the Board of Directors of Capital West Securities
and its parent holding company, Affinity Holding Corp. Mr. McDonald started his
investment career in 1961 with Allen and Company and left in 1967 to form
McDonald Bennahum and Co., which later joined with Langenburg Thalmann and Co.
where Mr. McDonald was a Senior Partner. Mr. McDonald joined Planet Oil Mineral
Corporation in 1971 and became president in 1973. From 1975 until 1993, Mr.
McDonald was affiliated with Stifel Nicolaus & Company and headed its municipal
syndicated effort. Mr. McDonald received a Bachelor's Degree in Finance from the
University of Oklahoma in 1960. He also served as an Officer in the United
States Army and Army Reserve.

Item 7. Financial Statements.

Index to Financial Statements:

Reports of Independent Accountants

Consolidated Balance Sheets

Consolidated Statements of Operations

Consolidated Statements of Stockholders' Equity

Consolidated Statements of Cash Flows

Notes to Consolidated Financial Statements

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors of
Avalon Community Services, Inc.

We have audited the accompanying consolidated balance sheet of Avalon Community
Services, Inc. and subsidiaries (the "Company") as of December 31, 1995, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for the year then ended. These consolidated financial statements are the
responsibility of Avalon's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audit.

We conducted our audit 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 audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of the
Company as of December 31, 1995, and the consolidated results of their
operations and their cash flows for the year then ended in conformity with
generally accepted accounting principles.

COOPERS & LYBRAND L.L.P.

Oklahoma City, Oklahoma
March 21, 1996

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS

Board of Directors
Avalon Community Services, Inc.

We have audited the accompanying consolidated balance sheet of Avalon Community
Services, Inc. and subsidiaries as of December 31, 1996, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
the year then ended. 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 audit.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of Avalon
Community Services, Inc. and subsidiaries as of December 31, 1996, and the
consolidated results of their operations and their consolidated cash flows for
the year then ended in conformity with generally accepted accounting principles.

Grant Thornton LLP

Oklahoma City, Oklahoma
March 14 , 1997

AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

December 31,
1995 1996
----------------------------
ASSETS
Current assets:
Cash and cash equivalents ................. $ 121,176 $ 313,558
Accounts receivable,
net of allowance for
doubtful accounts of
$5,079 and $0, respectively ............ 283,116 400,643
Due from affiliates ....................... 52,966 119,588
Prepaid expenses and other ................ 236,382 311,351
- -------------------------------------------------------------------------------
Total current assets ................. 693,640 1,145,140
- -------------------------------------------------------------------------------
Property and equipment, net .................. 5,525,311 8,312,385
Due from affiliates .......................... 231,248 --
Other assets ................................. -- 66,000
- -------------------------------------------------------------------------------
Total assets ........................ $ 6,450,199 $ 9,523,525
===============================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable, accrued
liabilities and other .................. $ 183,233 $ 447,668
Due to affiliates ......................... 175,028 --
Current maturities of
long-term debt ......................... 278,837 518,866
- -------------------------------------------------------------------------------
Total current liabilities ........... 637,098 966,534
- -------------------------------------------------------------------------------
Long-term debt, less current maturities ...... 3,449,275 5,861,514
Deferred income taxes ........................ 23,000 --

Commitments and contingencies ................ -- --
Stockholders' equity:
Common stock:
Class A - par value $.001;
20,000,000 shares authorized;
2,496,905 and 2,927,135 shares
issued and outstanding in 1995
and 1996, respectively ............. 2,497 2,927
Class B - no par 4,000,000 shares
authorized; 1,210,000 and
3,410,000 shares issued and
outstanding in 1995 and 1996,
respectively ....................... -- --
Preferred stock; par value $.001;
1,000,000 shares authorized;
none issued ............................ -- --
Paid-In capital ........................... 2,678,214 4,066,128
Accumulated deficit ....................... (339,885) (1,373,578)
-------------------------------------------------------------------------------
Total stockholders' equity .......... 2,340,826 2,695,477
- -------------------------------------------------------------------------------
Total liabilities and
stockholders' equity ............. $ 6,450,199 $ 9,523,525
===============================================================================

These accompanying notes are an integral part of these consolidated financial
statements.

AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS

Year Ended December 31,
1995 1996
---------------------------

Revenues ....................................... $ 2,119,123 $ 3,312,687
Costs and expenses
Direct operating ............................ 1,063,286 1,961,567
General and administrative .................. 603,264 645,660
Depreciation and
amortization expense ................... 237,702 306,865
Interest expense .......................... 218,331 419,012
- -------------------------------------------------------------------------------
Loss from continuing operations
before income tax expense ................. (3,460) (20,417)
Income tax expense .......................... -- 39,370
- -------------------------------------------------------------------------------
Loss from continuing operations ................ (3,460) (59,787)
- -------------------------------------------------------------------------------
Discontinued operations:
Loss on operations, net of
income tax benefit of
$36,400 in 1995 and $0 in 1996 ........... (47,299) (649,247)
Loss on disposal, net of income
tax benefit of $27,400 in 1995
and $120,000 in 1996 ..................... (34,081) (324,659)
- -------------------------------------------------------------------------------
Loss from discontinued operations ..... (81,380) (973,906)
- -------------------------------------------------------------------------------

Net loss ....................................... $ (84,840) $(1,033,693)
===============================================================================

Net loss per share:
Continuing operations ....................... $ (0.00) $ (0.02)
Discontinued operations ..................... (0.03) (0.36)
- -------------------------------------------------------------------------------
Net loss per share: ................... $ (0.03) $ (0.38)
===============================================================================

Weighted average number of common

and common equivalent shares outstanding .... 2,496,905 2,745,879
===============================================================================

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

AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Common Stock Total
---------------------------------------
Class A Class A Class B Paid-In Accumulated Stockholders'
Shares Amount Shares Capital Deficit Equity
----------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1995 ..................... 2,496,905 $ 2,497 1,210,000 $ 2,678,214 (255,045) $ 2,425,666
Net Loss ..................................... -- -- -- -- (84,840) (84,840)
----------------------------------------------------------------------------------
Balance, December 31, 1995 ................... 2,496,905 $ 2,497 1,210,000 $ 2,678,214 (339,885) $ 2,340,826
Net loss ..................................... -- -- -- -- (1,033,693) (1,033,693)
Stock options exercised ...................... 3,230 3 -- 5,235 -- 5,238
Class B shares issued ........................ -- -- 2,200,000 -- -- --
Stock issued for purchase of
El Paso Facility ........................ 50,000 50 -- 199,950 -- 200,000
Warrants exercised, net of
issuance costs ........................... 377,000 377 -- 1,182,729 -- 1,183,106
----------------------------------------------------------------------------------
Balance, December 31, 1996 ................... 2,927,135 $ 2,927 3,410,000 $ 4,066,128 $(1,373,578) $ 2,695,477
==================================================================================

The accompanying notes are an integral part of these consolidated financial statements.
</TABLE>
AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW

Year ended December 31,

1995 1996
--------------------------

OPERATING ACTIVITIES:
Net loss ...................................... $ (84,840) $(1,033,693)

Adjustments to reconcile net loss to
net cash provided by (used for)
operating activities
Depreciation and amortization ............ 310,602 381,913
Deferred income taxes .................... (31,800) (89,000)
Loss on sale of property ................ 36,740 14,266
Write down of property ................... -- 317,689
Changes in operating assets
and liabilities:
Decrease (increase) in -
Accounts receivable .................... 54,370 (117,527)
Due to / from affiliates .............. -- (10,402)
Prepaid expenses and other assets ...... (133,119) (129,320)
Accounts payable, accrued
liabilities and other ............... (96,370) (27,372)
- -------------------------------------------------------------------------------
Net cash provided by
(used in) operations ................... 55,583 (693,446)
- -------------------------------------------------------------------------------

INVESTING ACTIVITIES:
Capital expenditures .......................... (2,600,022) (171,347)
Payment for purchase of business .............. -- (200,000)
Proceeds from disposition of property ......... 24,655 45,688
Proceeds from disposition of
discontinued operations .................... 46,509 --
- -------------------------------------------------------------------------------
Net cash used in investing activities .... (2,528,858) (325,659)
- -------------------------------------------------------------------------------

FINANCING ACTIVITIES:
Net cash advances from affiliates ............. 183,126 --
Proceeds from borrowing ....................... 4,447,444 3,444,704
Repayment of borrowing ........................ (2,684,878) (3,451,496)
Proceeds from warrant and option exercise ..... -- 1,324,361
Payments of warrant issue costs ............... -- (106,082)
- -------------------------------------------------------------------------------
Net cash provided by financing activities .. 1,945,692 1,211,487
- -------------------------------------------------------------------------------

Net Increase (Decrease) in Cash
And Cash Equivalents ........................ $ (527,583) $ 192,382
- -------------------------------------------------------------------------------
Cash and Cash Equivalents,
Beginning of Period ......................... $ 648,759 $ 121,176
- -------------------------------------------------------------------------------
Cash and Cash Equivalents,
End of Period .............................. $ 121,176 $ 313,558
===============================================================================

SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid during the year for:
Interest ................................ $ 312,179 $ 482,034
Income Taxes ............................ 19,500 4,253

In conjunction with the acquisition of a business in August, 1996, the
Company acquired property and equipment of $3,681,407, assumed debt of
$2,974,403 and liabilities of $307,004, and issued common stock and stock
purchase warrants with a fair value of $200,000.

During 1996, the Company applied $29,485 of deferred warrant costs against
the proceeds received upon the exercise of certain stock purchase warrants.

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

AVALON COMMUNITY SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED 1995 AND 1996

NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Nature of Business -

Avalon Community Services, Inc. ("the Company" or "Avalon") is an Oklahoma
based corporation owning and operating private correctional facilities . The
Company specializes in privatized community correctional facilities and
intensive correctional programming. The Company currently operates in Oklahoma,
Texas, Missouri, and Nebraska with plans to significantly expand into additional
states throughout the Southwest. The Company owns and operates three (3)
community correctional facilities and provides substance abuse services in nine
(9) correctional facilities for the various states.

Principles of Consolidation -

The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries after elimination of all material intercompany
balances and transactions.

Use of Estimates -

The preparation of the consolidated financial statements requires the use
of management's estimates and assumptions in determining the carrying values of
certain assets and liabilities and disclosures of contingent assets and
liabilities at the date of the consolidated financial statements and the
reported amounts for certain revenues and expenses during the reporting period.
Actual results could differ from those estimated.

Cash and Cash Equivalents -

The Company considers all highly liquid investments with original
maturities of three months or less when purchased to be cash equivalents.

Concentrations of Credit Risk -

Financial instruments potentially subjecting the Company to concentrations
of credit risk consist principally of temporary cash investments and accounts
receivable. The Company places its temporary cash investments with high credit
quality financial institutions and limits the amount of credit exposure to any
one institution. Concentrations of credit risk with respect to accounts
receivable are limited due to the fact that a significant portion of the
Company's receivables are from state governments. The Company maintains an
allowance for doubtful accounts for potential credit losses. Actual bad debt
expenses have not been material.

Property and Equipment -

Property and equipment are recorded at cost. Expenditures for major
additions and improvements are capitalized, while minor replacements,
maintenance and repairs are charged to expense as incurred. When property and
equipment is retired or otherwise disposed of, the cost and related accumulated
depreciation are removed from the accounts and any resulting gain or loss is
reflected in current operations. Depreciation is provided using the
straight-line method over the following estimated useful lives:

Buildings and Improvements 40 Years
Furniture and Equipment 5 to 7 Years
Transportation Equipment 3 to 6 Years

Impairment losses are recorded on long-lived assets when indicators of
impairment are present and the undiscounted cash flows estimated to be generated
by those assets are less than the assets' carrying amounts. When required,
impairment losses are recognized based upon the estimated fair value of the
asset

The Company's policy is to capitalize interest on debt incurred during the
construction of major projects. During the year ended 1995, the total interest
capitalized was $60,200. Total interest costs, including interest for
discontinued operations and capitalized interest, was $318,400, and $ 482,034
for 1995 and 1996, respectively.

Income Taxes -

Deferred income taxes are recognized for the tax consequences in future
years of differences between the tax bases of assets and liabilities and their
financial reporting amounts at each year-end based on enacted tax laws and
statutory tax rates applicable to the period in which the differences are
expected to affect taxable income. Valuation allowances are established when
necessary to reduce deferred tax assets to the amount expected to be realized.
Income tax expense is the tax payable for the period and the change during the
period in deferred tax assets and liabilities.

Revenue Recognition -

The Company recognizes revenues as the related services are provided.

Deferred Development Costs -

Deferred development costs consist of costs that can be directly associated
with an anticipated contract and, if the recoverability from that contract is
probable, they are deferred until the anticipated contract has been awarded. At
the commencement of operations of the facility or contract period, the deferred
development costs are amortized over the life of the contract (including option
periods). Costs of unsuccessful or abandoned contracts are charged to expense
when their recovery is not considered probable. Facility costs are incurred
(after a contract is awarded) in connection with the opening of new facilities
under the contract. These costs, which are required under the contract, to the
extent recoverable, are capitalized from the date of award until commencement of
operations, at which time they are amortized on a straight-line basis over the
term (including option periods) ranging from one to five year periods of the
government contracts.

Net Loss Per Common Share -

Net loss per common share is calculated based on the weighted average
number of common, and when dilutive, common equivalent shares outstanding using
the treasury stock method, excluding Class B common shares which have no
dividend or liquidation rights. There were no differences between primary and
fully diluted earnings per share for the periods presented.

Reclassifications -

Certain 1995 amounts have been reclassified to conform to the 1996
presentation, specifically discontinued operations.

NOTE 2. PROPERTY AND EQUIPMENT

The elements of property and equipment and related accumulated depreciation
as of December 31, 1995 and 1996 are as follows:

Accumulated

Cost Depreciation
---------------------------
December 31, 1995:
Land .................................... $ 545,552 $ --
Buildings and Improvements .............. 4,590,350 327,208
Furniture and Equipment ................. 875,921 314,345
Transportation Equipment ................ 243,678 88,637
---------- ----------
$6,255,501 $ 730,190
========== ==========

December 31, 1996:
Land .................................... $ 618,552 $ --
Buildings and Improvements .............. 7,591,268 384,115
Furniture and Equipment ................. 717,547 320,107
Transportation Equipment ................ 155,813 66,573
---------- ----------
$9,083,180 $ 770,795
========== ==========

The Company changed its' estimate of the useful lives of buildings and
improvements from 25 to 40 years during 1996. The change resulted in a decrease
in net loss, net of income tax expense of $28,000, at December 31, 1996 of
approximately $55,000 or $.02 per share.

NOTE 3. STATE CONTRACTS

The Company contracts with various states to provide services. The
contracts generally provide for compensation on a per person, per day basis.
Revenues generated from such contracts during 1995 and 1996 comprised 71% and
88%, respectively, of total Company revenues, of which 68% and 66% are with the
Oklahoma Department of Corrections, in 1995 and 1996, respectively.

The Company has a fifteen (15) year contract with West Texas Community
Supervision and Corrections Department and a four year contract with the Texas
Department of Criminal Justice Parole Department to provide correctional
services in El Paso, Texas. The Company's current contracts with the Oklahoma
Department of Corrections extend through June 30, 1997 with an option by the
state to renew for two additional one year periods with the same terms and
conditions. The Company has a fifteen month contract with the state of Nebraska
Department of Correctional Services for which the state has two (2) two year
renewal options.

NOTE 4. NOTES PAYABLE AND LONG-TERM DEBT

Notes payable and long-term debt consists of the following:
December 31,
1995 1996
------------------------
Revolving bank line of credit subsequently
refinanced .................................... $ 263,434 $ 37,504

Notes payable to banks, collateralized by
equipment due in installments through
May 1998 with interest from 7.99% to 11% ...... 173,992 137,059

Notes payable to banks, collateralized
by transportation equipment, due in
installments through November 1997
with interest ranging from 6.25% to 9.99% .... 141,586 71,483

Notes payable to banks, collateralized
by land, buildings and improvements
due in installments through August 2004
with interest ranging from 8.5% to 12% ........ 3,149,100 5,584,334

Note payable to corporation collateralized by
buildings, with interest at 8.5%
with principal due in full January 1998 ....... -- 550,000
---------- ----------
3,728,112 6,380,380
Less - current maturities .......................... 278,837 518,866
---------- ----------
$3,449,275 $5,861,514
========== ==========

The aggregate maturities of long-term debt for each of the next five years
are as follows: 1997: $519,000; 1998: $1,451,000; 1999: $835,000; 2000:
$1,951,000; 2001: $ 391,000; thereafter: $1,233,000. Substantially all notes
payable and long-term debt has been personally guaranteed by the Company's CEO.

The revolving bank line of credit provides for aggregate maximum borrowings
of $500,000 and bears interest at 1% over national prime, (effective rates of
9.5% and 9.2%, at December 31, 1995 and 1996, respectively) The line of credit
is collateralized by the Company's state contract revenues. Payment of dividends
is restricted by terms of the Company's revolving credit facility. Subsequent to
year end, the Company extended the due date of the line of credit from February
1997 to April 1998, and accordingly, the outstanding draws under this agreement
have been classified as long-term debt at December 31, 1996.

NOTE 5. STOCKHOLDERS' EQUITY

Stock purchase warrants were issued in connection with a public offering of
Avalon common stock in 1991. The Class A warrants which provided for the
purchase of the Company's Class A common stock expired in March 1996, and the
Class B warrants will expire in March 26, 1999. The Company has outstanding
275,100 Class B stock purchase warrants providing for the purchase of the
Company's Class A common stock at a price of $6.00 per share. The warrants may
be exercised at any time. The warrants may be redeemed by the Company at any
time for $.01 per share, with the exception of certain warrants relating to
1,600 shares of common stock.

The Company completed a private placement of 1,000,000 shares of its common
stock and 1,000,000 stock purchase warrants in August 1994. The Class C stock
purchase warrants provide for the purchase of the Company's Class A common stock
at a price of $3.50 per share through December 20,1999. The warrants may be
redeemed by the Company upon certain events, for $.01 per share. In the private
placement there are 100,000 shares of common stock and 100,000 Class C stock
purchase warrants reserved for underwriters.

The Company issued Class D Warrants in August, 1996, to purchase 200,000
shares of Common Stock in connection with the acquisition of the El Paso
Intermediate Sanction Facility. The Class D stock purchase warrants provide for
the purchase of the Company's Class A common stock at a price of $5.125 per
share through August 2, 2001. The warrants may be redeemed by the Company upon
certain events for $.01 per share.

The Company issued 2,200,000 shares of Class B common stock to the
Company's CEO during 1996 in connection with his personal guarantee of debt
associated with the construction cost of Carver Center and Avalon Correctional
Center. Class B shares are voting rights only, are non-transferable and have no
liquidation or dividend rights.

NOTE 6. STOCK OPTION PLAN

The Company adopted a stock option plan (the "Plan") providing for the
issuance of 250,000 shares of Class A common stock pursuant to both incentive
stock options, intended to qualify under Section 422 of the Internal Revenue
Code, and options that do not qualify as incentive stock options
("non-statutory"). The Option Plan was registered with the Securities and
Exchange Commission in November 1995. The purpose of the Plan is to provide
continuing incentives to the Company's officers, key employees, members of the
Board of Directors and consultants. The options generally vest over a four or
five-year period with a ten year expiration period. On December 1, 1996, the
Company amended its stock option plan, increasing the number of shares available
under the Plan to 600,000. Non-statutory options have been granted providing for
the issuance of 469,770 shares of Class A common stock at exercise prices
ranging from $1.50 to $4.00 per share. Options providing for the issuance of
57,005 shares were exercisable at December 31, 1996.

The Company uses the intrinsic value method to account for its stock option
plan in which compensation is recognized only when the fair value of each option
exceeds its exercise price at the date of grant. Accordingly, no compensation
cost has been recognized for the options issued. Had compensation cost been
determined based on the fair value of the options at the grant dates, the
Company's net loss and loss per share would have been increased to the pro forma
amounts indicated below.

1995 1996
-----------------------------------------
Net loss
As reported .................. $ (84,840) $ (1,033,693)

Pro forma .................... (188,596) (1,375,159)
Loss per share
As reported ................... $ (0.03) $ (0.38)
Pro forma ..................... (0.08) (0.50)

These pro forma amounts may not be representative of future disclosures
because they do not take into effect pro forma compensation expense related to
grants made before 1995. The fair value of each grant is estimated on the date
of grant using the Black-Scholes options-pricing model with the following
weighted-average assumptions used for grants in 1995 and 1996, respectively: no
expected dividends; expected volatility of 105% and 96%; risk-free interest rate
of 6.1% and 5.7%; and expected lives of ten years.

The Black-Scholes options valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.

A summary of the status of the Company's stock option plan as of December
31, 1995 and 1996, and changes during the years ending on those dates is
presented below.
<TABLE>
<CAPTION>
1995 1996
--------------------- --------------------
Weighted Weighted
average average
exercise exercise
Shares price Shares price
--------------------- --------------------
<S> <C> <C> <C> <C>
Outstanding at beginning of year ..................... 175,800 $ 1.50 229,900 $ 1.71
Granted ........................................... 157,200 1.80 259,600 3.93
Exercised ......................................... -- -- (3,230) 1.62
Forfeited ......................................... (103,100) 1.50 (16,500) 1.78
-------------------- --------------------
Outstanding at end of year ........................... 229,900 1.71 469,770 2.93
Options exercisable at year end ...................... 14,740 1.50 57,005 1.63
Weighted average fair value of
options granted during the year .................. $ 2.52 $ 3.70
======== ========
</TABLE>
The following table summarizes information about fixed-price stock options
outstanding at December 31, 1996:
<TABLE>
<CAPTION>
Options outstanding Options exercisable
--------------------------------------------- ------------------------------
Weighted Weighted Weighted
Number average average Number average
outstanding at remaining exercise exercisable exercise
12/31/196 contractual life price at 12/31/96 price
--------------------------------------------- -----------------------------
<S> <C> <C> <C> <C> <C>
Range of exercise prices
$1.50 to $2.25 210,170 8.21 $ 1.70 57,005 $ 1.63
$3.26 to $4.00 259,600 9.87 3.93 --- ---
--------------------------------------------- -----------------------------
$1.50 to $4.00 469,770 57,005
========== ===========
</TABLE>

NOTE 7. ACQUISITION

The Company acquired the El Paso Intermediate Sanction Facility in El Paso,
Texas from Secure Corrections, Inc. in August, 1996. The facility is a four year
old, 144-bed, 36,000 square foot medium security correctional facility on
approximately seven acres of real estate. The purchase price was approximately
$3,681,400 including $2,974,400 for the outstanding debt on the building,
$200,000 of cash, and approximately $300,000 for the assumption of certain
operating liabilities. The Company also issued 50,000 shares of common stock and
200,000 stock purchase warrants at a value of $200,000. Pro forma financial
information for the acquisition is not presented because financial information
of Secure Correction Systems, Inc. is not available. A subsidiary of the
Company, Southern Corrections Systems, Inc., entered into a fifteen (15) year
contract to provide services in the facility for the West Texas Community
Supervision and Corrections Department to begin August 1, 1996. Southern
Corrections Systems, Inc. also entered into a contract effective November, 1996,
to provide services in the facility for the Texas Department of Criminal Justice
and Parole Division. The facility is now at full capacity.

NOTE 8. DISCONTINUED OPERATIONS

The Company terminated the contract to manage the recreational activities
at Lake Stanley Draper Park in June 1995. This contract comprised all of the
operations of the Company's park management segment. The Company ceased
operations and vacated the park premises in June 1995. The Company has been
released from all contract provisions. Net assets of the park management segment
totaled approximately $107,900, consisting primarily of recreational equipment.
All assets were disposed of by June 30, 1995. Revenues for the year ended
December 31, 1995, were $10,900. The loss from operations, net of income tax
benefit, was $18,800 for the year ended 1995. The loss on the disposal, net of
income tax benefit of $27,400, was $34,100. Proceeds from the disposal were
$46,500.

The Company discontinued the residential care and management of outpatient
mental health operations in the fourth quarter 1996. Revenues for the years
ended 1995 and 1996 were $936,909 and $492,835, with a net discontinued loss
from operations, net of income tax benefit, of $28,500 and $649,247. The net
discontinued loss from operations at December 31, 1996 includes a loss of
approximately $405,000 resulting from the write off of affiliate receivables
related to this segment. Loss from the disposition of assets was approximately
$325,000, including a $318,000 write down of assets.

The net assets and liabilities of the discontinued operations included as
accounts payable, accrued liabilities and other in the accompanying consolidated
balance sheet, as of December 31, 1996 are as follows:

Assets
Property and equipment, net $ 328,475
Liabilities
Accounts payable and accrued liabilities (25,039)
Note payable (315,346)
-----------------
Net liabilities of discontinued operations $ (11,910)
=================

As a result of the sale and discontinuation of the park management and
residential care segments, the Company operates in only one segment,
correctional services.

NOTE 9. FAIR VALUE OF FINANCIAL INSTRUMENTS

The carrying values of cash, cash equivalents, and financial instruments
included in other assets approximate their fair values principally because of
the short-term maturities of these instruments. The fair values of the Company's
debt maturing within one year, the revolving credit facility and other long-term
debt approximate the carrying values due to the nature of the instruments
involved.

In the normal course of business, the Company has letters of credit,
performance bonds, and other guarantees that are not reflected in the
accompanying consolidated balance sheets. In the past, no significant claims
have been made against these financial instruments. Management believes that the
likelihood of performance under these financial instruments is minimal and
expects no material losses to occur in connection with these financial
instruments.

NOTE 10. INCOME TAX

The components of the provision for (benefit from) income taxes for the
years ended December 31, 1995 and 1996 from continuing operations were as
follows:

Federal State Total
------- ------- -------
1995 -
Current ..................... $ -- $ -- $ --

-------
Deferred .................... -- -- --
------- ------- -------
$ -- $ -- $ --
======= ======= =======
1996 -
Current ..................... $ 7,100 $ 1,270 $ 8,370
Deferred .................... 26,300 4,700 31,000
------- ------- -------
$33,400 $ 5,970 $39,370
======= ======= =======

The difference between the tax basis of assets and liabilities and their
financial reporting amounts that give rise to significant portions of deferred
income tax assets and liabilities are: assets - excess tax basis in certain
contributed property; liabilities - accelerated tax depreciation. At December
31, 1996, the Company had approximately $786,000 of net operating loss carry
forwards which expire in 2011.

The following is a reconciliation of the provision for (benefit from)
income taxes from continuing operations computed by applying the Federal
statutory rate of 34% and the effective income tax rate for the years ended
December 31, 1995 and 1996:
December 31,
1995 1996
--------- ---------
Provision for (benefit from)
income taxes
at statutory rate ........................... $ -- $ (6,900)

Nondeductible expenses ......................... -- 2,900

State income taxes ............................. -- 5,970

Change in valuation allowance .................. -- 13,400

Tax-exempt income .............................. -- --

Additional prior year taxes paid................ -- 24,000

Other, net ..................................... -- --
--------- ---------
Total provision for (benefit from)
income taxes ............................ $ -- $ 39,370
========= =========

Deferred tax assets and
liabilities are as follows:

Deferred tax assets:

Net operating loss carry forward ............ $ 31,800 $ 314,300

Property & equipment ........................ -- 120,000

Shareholder contributed property ............ 46,000 46,000

Vacation Accrual ............................ 8,900 9,400

Other ....................................... 2,100 300
--------- ---------
88,800 490,000
Less: Valuation allowance ................... (40,800) (353,000)
--------- ---------
Deferred tax assets .................... 48,000 137,000
--------- ---------
Deferred tax liabilities:
Property and equipment ...................... (71,000) (71,000)

--------- ---------
Deferred tax liabilities ............... (71,000) (71,000)
--------- ---------
Net deferred tax
(liability) asset ................... $ (23,000) $ 66,000
========= =========

The valuation allowance on tax assets increased $2,900 in 1995 and $312,200
in 1996, of which $13,400 relates to continuing operations.

NOTE 11. RELATED PARTY TRANSACTIONS

The Company's initial operations were formed by acquiring existing
operations from the Company's CEO in 1992 and 1993. In connection with those
acquisitions, certain agreements related to providing management, administrative
and accounting services and leases of buildings were continued, resulting in
related party transactions.

During 1995 and 1996, $187,000 and $397,500 were charged to affiliated
entities by the Company for management, administrative, and accounting services.
Such amounts have been reflected as a reduction of general and administrative
expenses in the Consolidated Statement of Operations.

The balance due from affiliates resulted from charges for administrative
and accounting services, as well as net cash advances made. The outstanding
balance related to residential care operations was included in discontinued
operations in 1995 and 1996.

The Company managed the operations of a residential care operation and
leased a building to an affiliated entity in 1995 and 1996. The Company also
leased a building and equipment from an affiliated entity in 1995 and 1996. The
leases resulted in net lease expense of $2,000 and $4,400 in 1995 and 1996,
respecctively.

The Company entered into an agreement effective in May 1994 with the
Company's CEO to issue certain securities in exchange for his guarantee of
certain Company indebtedness. The agreement provides for the issuance of one
share of Class B common stock (voting only) for each dollar of Company debt
guaranteed. The Company issued 1,210,000 shares of Class B common stock in 1994
and 2,200,000 shares of Class B common stock in 1996 pursuant to this agreement.
The agreement also provides for the issuance of 750,000 common stock purchase
warrants providing for the purchase of Class A common stock at a price of $1.50
per share for each dollar of Company debt guaranteed. The warrants will have a
five year term from the date of issuance. Pursuant to the terms of this
agreement the warrants were issuable in 1995. Management believes these warrants
have no economic value and accordingly, no amount has been assigned to such
warrants in the financial statements.

The Company entered into agreements with affiliated entities in 1995 and
1996 to develop and manage assisted living centers in Oklahoma Citiy, Oklahoma
and Fort Collins, Colorado. The Company received a 15% equity interest in each
assisted living center and funded start up costs of approximately $357,000 for
these centers in 1996. The Company plans to divest these operations in 1997.

NOTE 12. COMMITMENTS AND CONTINGENCIES

Total lease expense was $101,000 and $118,000 for 1995 and 1996 under all
operating leases. The future minimum lease payments are as follows: 1997 -
$46,000, 1998 - $33,000, 1999 - $7,000 , 2000 - $2,000, and 2001 - $1,000.

The Company executed a five-year employment agreement with the Company's
CEO in 1992. The agreement provides for compensation to be determined on an
annual basis by the Board of Directors. The agreement also contains provisions
for severance pay and disability payments, as well as a non-compete agreement
preventing him from engaging in a business deemed similar to that of the
Company.

During 1996, the Company guaranteed the debt of affiliates for an amount of
$3,110,000.

NOTE 13. LITIGATION

The Company is a party to litigation arising in the normal course of
business. Management believes that the ultimate outcome of these matters will
not have a material effect on the Company's financial condition or results of
operations.

NOTE 14. SUBSEQUENT EVENTS

The Company was awarded a four year service contract in March, 1997 with
the Missouri Department of Corrections. The contract is to provide substance
abuse treatment services in the Ozark Correctional Center, a 650 bed medium
security prison located in Fordland, Missouri. The contract is expect to
generate annual revenues of approximately $800,000 for the Company. Avalon is
scheduled to begin providing services in the Ozark Correctional Center on May 1,
1997.

The Company was awarded a four year contract in March, 1997 with the
Missouri Department of Corrections. The contract is to provide substance abuse
services in the Tipton Correctional Center, a 1,088 bed medium security prison
in Tipton, Missouri. The contract is expected to generate annual revenues of
approximately $300,000 for the Company. Avalon is schedule to begin providing
services in the Tipton Correctional Center in June, 1997.

Item 8. Change In and Disagreements with Accountants on Accounting and Financial
Disclosure.

On February 25, 1997, the Company dismissed Coopers & Lybrand L.L.P., the
Registrant's independent auditors, and appointed the accounting firm of Grant
Thornton, LLP as independents accountants for fiscal year ended 1996.Such
dismissal and appointment was approved by the Board of Directors of the Company.
During the two most recent fiscal years and the three interim periods subsequent
to December 31, 1995, and through the date of dismissal, there have been no
disagreements with Coopers & Lybrand L.L.P. on any matter of accounting
principles or practices, financial statement disclosure or auditing scope or
procedure or any reportable event. In addition, no report on the financial
statements of the Company rendered by Coopers & Lybrand L.L.P. contained an
adverse opinion or disclaimer of opinion or was qualified or modified as to
uncertainty, the scope of audit performed, or accounting principles. The Company
had not consulted with Grant Thornton, LLP prior to their appointment with
respect to any matters of accounting principles or practices, financial
statement disclosure, auditing scope or procedure or any disagreement with the
Company.

PART III

Items 9, 10, 11 and 12.

The information required by these Items has been incorporated by Reference
from the Company's definitive proxy statement which will be filed with the
Commission not later than 120 days after December 31, 1996.

Item 13. Exhibit and Reports on Form 8-K.

(a) Exhibits:

3. i Articles of Incorporation (1)
ii Bylaws (1)
iii Articles of Amendment to Registrant's Articles of Incorporation (2)
iv Amendment to Registrant's Articles of Incorporation dated December
31, 1995
v Unanimous Consent of Board of Directors authorizing extension of
expiration dates of Class "B" Redeemable Warrants (3)
vi Certificate of Corporate Resolutions, dated December 13, 1993,
regarding authorization of Class B Common Stock and Amendment
to Articles (5)

4. i Form of Stock Certificate (1)
ii Form of Class "B" Redeemable Warrant (1)
iii Form of Class "B" Warrant Agreement (1)
iv Form of Class "C" Redeemable Warrant (6)
v Form of Class "C" Warrant Agreement (6)
vi Form of Class "D" Redeemable Warrant (7)
vii Form of Class "D" Warrant Agreement (7)

10. i Contract between Southern Correction Systems, Inc. and the Oklahoma
Department of Corrections for halfway house services for the
year ended June 30, 1997 (6)
ii Contract between Southern Correction Systems, Inc. and the Oklahoma
Department of Corrections for public works inmates for the
year ended June 30, 1997 (6)
iii Employment Agreement with Donald E. Smith (2)
vi Stock Option Plan adopted by Board of Directors on August 16,
1994 (6)
vii Debt Guaranty Agreement dated May 16, 1994, between Registrant
and Donald E. Smith (6)
ix Placement Agent Agreement dated May 15, 1994, between Registrant
and Westminster Securities Corporation (6)
x Acquisition Agreement dated August 2, 1996 between Registrant,
Kensington Capital Plc, and RECOR, Inc. (7)

16. i Letter re: Change in Certified Accountant (8)

21. i Subsidiaries of Registrant (5)

(b) Reports on Form 8-K. No reports were filed on Form 8-K during the
quarter ended December 31, 1996.

Footnotes:
1) Incorporated herein by reference to the Registrant's Registration
Statement on Form S-18 dated March 26, 1991.
2) Incorporated herein by reference to the Registrant's Post-Effective
Amendment No. 1 to Registration Statement on Form S-18 dated
August 3, 1992.
3) Incorporated herein by reference to the Registrant's Post-Effective
Amendment No. 2 to Registration Statement on Form S-18 dated
October 26, 1992.
4) Incorporated herein by reference to the Registrant's Form 8-K dated
January 13, 1994.
5) Incorporated herein by reference to the Registrant's Form 10-KSB for
the fiscal year ended December 31, 1993 and dated March 24,
1994.
6) Incorporated herein by reference to the Registrant's Registration
Statement on Form SB-2 dated December 30, 1994.
7) Incorporated herein by reference to the Registrant's Registration
Statement on Form S-2 Amendment No. 1, dated September 30,
1996.
8) Incorporated herein by reference to the Registrant's Form 8-K dated
March 4, 1997.

SIGNATURES

In accordance with Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.

AVALON COMMUNITY SERVICES, INC.

By: Donald E. Smith
Donald E. Smith
Chief Executive Officer and Director

Dated: March 29, 1997

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

By: Donald E. Smith
Donald E. Smith
Chief Executive Officer and Director Dated: March 29, 1997

By: Jerry M. Sunderland
Jerry M. Sunderland
President and Director Dated: March 29, 1997

By: Robert O. McDonald
Robert O. McDonald
Director Dated: March 29,1997

By: Kathryn A. Avery
Kathryn A. Avery
Chief Financial Officer Dated: March 29, 1997

<ARTICLE> 5

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