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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

OR

Commission File Number 0-18217

TRANSCEND SERVICES, INC.

(Exact name of registrant as specified in its charter)

945 East Paces Ferry Rd, Suite 1475, Atlanta, Georgia 30326

(Address of principal executive offices and zip code)

Registrant’s telephone number, including area code: (404) 364-8000

N/A

(Former name, former address, and former fiscal year, if changed since last report)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x  No  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).   Yes  ¨  No  x

Indicate the number of shares outstanding of the Registrant’s common stock as of the latest practicable date.

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INDEX

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

TRANSCEND SERVICES, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)

The accompanying notes are an integral part of these consolidated balance sheets.

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TRANSCEND SERVICES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

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

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TRANSCEND SERVICES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

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

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TRANSCEND SERVICES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2003 and 2002

(Unaudited)

(1) The accompanying consolidated financial statements are unaudited and have been prepared by the management of Transcend Services, Inc. (the “Company” or “Transcend”) in accordance with the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments, consisting of normal recurring accruals necessary for the fair presentation of the consolidated financial position, results of operations and cash flows, have been included. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Form 10-K for the year ended December 31, 2002. Footnote disclosure that substantially duplicates the disclosure contained in that document has been omitted.

(2) On May 31, 2002, the Company sold certain assets and the operations of Cascade Health Information Software, Inc. (“Cascade”), a wholly owned subsidiary of the Company, to QuadraMed Corporation for $911,000 in cash, which resulted in a gain on the sale of assets of $954,000. All information presented in the accompanying consolidated financial statements has been restated to classify Cascade as discontinued operations. As a result of the sale of Cascade, the Company now operates in one, and only one, reportable business segment as a provider of medical transcription services. Cascade reported revenue of $345,000 and a net loss of $133,000 for the three months ended March 31, 2002.

(3) Effective April 1, 2002, the Company changed the estimated useful life of its proprietary T2K transcription system from four to six years to reflect the success of the Company’s on-going software maintenance and enhancement efforts, which are expensed as incurred, in extending the useful life of the system. This change reduced amortization expense by approximately $17,000 per month, or $51,000 (approximately $0.01 per share) for the three months ended March 31, 2003.

(4) The Company accounts for its income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109. Deferred tax assets and liabilities are recognized for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts and for operating loss and tax credit carry-forwards.

(5) The Company follows SFAS No. 128, “Earnings per Share.” That statement requires the disclosure of basic net income (loss) per share and diluted net income (loss) per share. Basic net income (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period and does not include any other potentially dilutive securities. Diluted net income per share gives effect to all potentially dilutive securities. Potentially dilutive securities were antidilutive and therefore are not included in diluted loss per share calculations in the accompanying statements of operations for the three months ended March 31, 2002.

(6) The Company accounts for comprehensive income (loss) under the provisions of SFAS No. 130, Reporting Comprehensive Income. The Company’s comprehensive income (loss) was equivalent to its net income (loss) attributable to common stockholders for the three months ended March 31, 2003 and 2002.

(7) On March 21, 2003, the Company extended the maturity date of its $1.5 million line of credit to March 31, 2004. Repayment of borrowings, if any, under this line of credit are personally guaranteed by the Company’s Chief Executive Officer and one of its Directors.

(8) On April 5, 2001, Our Lady of the Lakes Hospital, Inc. (“OLOL”) filed a lawsuit against the Company. The lawsuit, styled “Our Lady of the Lakes Hospital, Inc. v. Transcend Services, Inc.” was filed in the 19^th Judicial District Court, Parish of East, State of Louisiana, Civil Case Number 482775, Div. A. The lawsuit alleges, among other things, that the Company breached certain contracts entered into between OLOL and the Company, including a staffing and management servicing contract, a transcription platform agreement and a marketing agreement. OLOL is seeking an unspecified amount of monetary damages. On May 30, 2001, the Company filed a timely Answer that generally denied all liability, and the Company filed a counterclaim against OLOL primarily seeking fees owed by OLOL for services performed by the Company and interest on unpaid invoices. OLOL has subsequently added Transcend’s insurance carriers as defendants to the lawsuit.

The Company intends to vigorously defend all claims made by OLOL. The lawsuit is in an early procedural stage, however, and therefore it is not possible at this time to determine the outcome of the actions or the effect, if any, that their outcome may have on the Company’s results of operations and financial condition. There can be no assurances that this litigation will not have a material

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adverse effect on the Company’s results of operations and financial condition.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Certain information included in this Quarterly Report on Form 10-Q contains, and other reports or materials filed or to be filed by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company or its management) contain or will contain, “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, Section 27A of the Securities Act of 1933, as amended and pursuant to the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may relate to financial results and plans for future business activities, and are thus prospective. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Potential risks and uncertainties include, but are not limited to, general economic conditions, competition and other uncertainties detailed in this report and detailed from time to time in other filings by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company or its management). Any forward-looking statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and, as such speak only as of the date made.

Results of Operations

Transcend Services, Inc. (the “Company”) provides medical transcription services to the healthcare industry. Powered by its web-based voice and data distribution technology, the Company’s home-based medical language specialists document patient care by converting physicians’ voice recordings into electronic medical record documents. During 2002, Transcend began offering a separate transcription product line (“ECHO”) to small and medium-sized clinics and physician groups of all sizes. On May 31, 2002, the Company sold certain assets and the operations of its wholly owned subsidiary, Cascade Health Information Software, Inc. (“Cascade”). Cascade previously provided software for the coding and abstracting of patient medical records and is presented as discontinued operations in 2002.

Three Months Ended March 31, 2003 Compared to Three Months Ended March 31, 2002

Revenue increased $568,000, or 19%, to $3.5 million for the three months ended March 31, 2003 when compared to revenue of $2.9 million for the three months ended March 31, 2002. The net addition of 20 customers since the first quarter of 2002 contributed revenue of $510,000 and resulted in additional monthly base revenue of approximately $200,000 as of March 31, 2003 when compared to March 31, 2002. This increase in revenue between periods is also due to revenue of $58,000 from Transcend’s new product line (“ECHO”).

Gross profit increased $327,000, or 42%, to $1.1 million for the three months ended March 31, 2003 when compared to the gross profit amount in the comparable prior year period. Gross profit as a percentage of revenue increased to 32% in the first quarter of 2003 compared to 27% in the first quarter of 2002. The increase in gross profit margin is primarily due to relatively higher margins on revenue from ECHO and other new customers when compared to the margins on revenue from customers during the three months ended March 31, 2002.

Sales and marketing expenses increased $118,000, or 140%, to $202,000 in the first quarter of 2003 compared to the same period in 2002. As a result, sales and marketing expenses as a percentage of revenue increased to 6% in the first quarter of 2003 compared to 3% in the first quarter of 2002. The increase in sales and marketing expense is primarily due to increased commissions of $73,000 on new sales, outsourced marketing services of $18,000 and an increase in the size of the sales force and related recruiting, salary and travel expenses of $21,000.

Research and development expenses increased $27,000, or 32%, to $111,000 in the first quarter of 2003 when compared to the amount in the prior year period and were 3% of revenue in both periods. The increase is primarily due to a reassignment of technology resources from other areas to work on transcription technology development projects. The Company believes that the size of its current research and development staff is sufficient to accomplish its planned development activities for the remainder of the year.

General and administrative expenses increased $9,000, or 2%, to $599,000, primarily due to an increase in the bad debt reserve of $33,000 partially offset by decreased depreciation expense of $27,000 in the first quarter of 2003 when compared to the amount in the prior year period.

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The Company reported net interest income of $1,000 that was earned primarily on the investment of cash in overnight money market funds for the three months ended March 31, 2003 compared to net interest expense of $1,000 due to infrequent periodic insignificant borrowings under the Company’s line of credit during the three months ended March 31, 2002.

The Company reported a loss from discontinued operations of $133,000 in the first quarter of 2002 attributable to Cascade’s operations that were sold during the second quarter of 2002. The loss is primarily due to relatively low software revenue from new customers in the first quarter of 2002.

Liquidity and Capital Resources

The proceeds of $911,000 from the Company’s sale of certain assets and the operations of Cascade during the second quarter of 2002 and the Company’s profitable and positive cash flow operations during the fourth quarter of 2002 and the first quarter of 2003 contributed significantly to the Company’s current financial condition. As of March 31, 2003, the Company had cash and cash equivalents of $905,000, working capital of $1,203,000, no debt and full availability of its $1.5 million line of credit, which expires on March 31, 2004.

Net cash provided by operating activities totaled $325,000 for the three months ended March 31, 2003 due primarily to profitable operations and non-cash depreciation and amortization expenses.

Net cash used in investing activities of the Company were capital expenditures of $129,000, primarily for computer hardware and software upgrades and enhancements.

Net cash used in financing activities of the Company during the three months of 2003 were the payments of the quarterly preferred stock dividends of $119,000 partially offset by the issuance of common stock to certain preferred shareholders who elected to receive common stock in lieu of cash dividends at the February 15, 2003 preferred stock dividend date.

To simplify its capital structure and to eliminate the adverse cash and net income effects of the preferred stock dividends, the Company is currently soliciting its stockholders’ approval to redeem a portion of its preferred stock and convert the remaining preferred stock to common stock at its annual meeting of stockholders scheduled for May 6, 2003 (the “Preferred Stock Strategy”). If the stockholders approve the Preferred Stock Strategy, the Company is required to expend $800,000 cash to redeem a portion of the preferred stock. The Company projects that $600,000 of this total cash expenditure would occur in the second quarter of 2003, $100,000 in the fourth quarter of 2003 and the remaining $100,000 in the first quarter of 2004.

Aside from cash available under its $1.5 million line of credit referred to above, during the fourth quarter of each year between 2003 and 2005 inclusive, the Company has potential cash resources of an undetermined amount of earn-out payments, if any, payable by Provider HealthNet Services, Inc. (“PHNS”) based on a fixed percentage of certain defined future revenue recognized by PHNS from the Co-Sourcing and CodeRemote businesses sold to PHNS by Transcend in October 2000.

The Company is a defendant in the OLOL lawsuit. See Note 8 to the Consolidated Financial Statements included with this report and “Legal Proceedings”. It is unlikely that the outcome of the OLOL matter will be known in 2003. However, if the outcome of the OLOL lawsuit is unfavorable to Transcend, the Company would most likely appeal the verdict or decision. Nonetheless, the OLOL lawsuit could have a material adverse effect on the Company’s results of operations and financial condition in the future.

Absent a material adverse outcome from the lawsuit discussed above, the Company anticipates that cash on hand, together with internally generated funds, cash available under its line of credit and potential cash from the PHNS earn-out agreement, if any, should be sufficient to finance continuing operations, make capital investments in the normal and ordinary course of its business, meet its Series A Convertible Preferred Stock dividend payment requirements and fund the Preferred Stock Strategy during the remainder of 2003 and for the foreseeable future.

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 or lower expenses, or both, in amounts that offset inflationary cost

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increases.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company has no material exposure to market risk from derivatives or other financial instruments as of March 31, 2003.

Item 4. Controls and Procedures

Management has developed and implemented a policy and procedures for reviewing disclosure controls and procedures and internal controls on a quarterly basis. On April 16, 2003 (the evaluation date related to this quarterly report on Form 10-Q for the quarterly period ended March 31, 2003) management, including the Company’s principal executive and financial officer, evaluated the effectiveness of the design and operation of disclosure controls and procedures, and, based on its evaluation, our principal executive and financial officer has concluded that these controls and procedures are operating effectively. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of management’s evaluation. Management noted no significant deficiencies in the design or operation of the Company’s internal controls and the Company’s auditors were so advised.

Disclosure controls and procedures are the Company’s controls and other procedures that are designed to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files under the Exchange Act is accumulated and communicated to management, including the principal executive and financial officer, as appropriate to allow timely decisions regarding required disclosure.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

On April 5, 2001, Our Lady of the Lakes Hospital, Inc. (“OLOL”) filed a lawsuit against the Company. The lawsuit, styled “Our Lady of the Lakes Hospital, Inc. v. Transcend Services, Inc.” was filed in the 19^th Judicial District Court, Parish of East, State of Louisiana, Civil Case Number 482775, Div. A. The lawsuit alleges, among other things, that the Company breached certain contracts entered into between OLOL and the Company, including a staffing and management servicing contract, a transcription platform agreement and a marketing agreement. OLOL is seeking an unspecified amount of monetary damages. On May 30, 2001, the Company filed a timely Answer that generally denied all liability, and the Company filed a counterclaim against OLOL primarily seeking fees owed by OLOL for services performed by the Company and interest on unpaid invoices. OLOL has subsequently added Transcend’s insurance carriers as defendants to the lawsuit.

The Company intends to vigorously defend all claims made by OLOL. The lawsuit is in an early procedural stage, however, and therefore it is not possible at this time to determine the outcome of the actions or the effect, if any, that their outcome may have on the Company’s results of operations and financial condition. There can be no assurances that this litigation will not have a material adverse effect on the Company’s results of operations and financial condition.

Item 2. Changes in Securities and Use of Proceeds

On February 15, 2003, certain holders of the Company’s Series A Convertible Preferred Stock elected to receive their quarterly cash dividends in the aggregate amount of $45,450 in the form of 30,300 shares of unregistered common stock of the Company. The closing stock price per share as reported on the Nasdaq SmallCap Market was $1.50 on February 14, 2003, the last trading day before the transaction. The issuance of securities described above was made in reliance on the exemption from registration provided by Section 4(2) of the Securities Act of 1933 as a transaction by an issuer not involving a public offering. The securities were acquired by the recipients thereof for investment and with no view toward the resale or distribution thereof. The offers and sales of the above securities were made without any public solicitation and the stock certificates bear restrictive legends. No underwriter was involved in the transaction and no commissions were paid.

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Item 6. Exhibits and Reports on Form 8-K

The following report on Form 8-K was filed during the three months ended March 31, 2003:

(1) Form 8-K, dated and filed January 22, 2003, a press release announcing the Company’s unaudited operating results for the three months and year ended December 31, 2002 and its unaudited financial condition as of December 31, 2002.

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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.

CERTIFICATION

I, Larry G. Gerdes, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Transcend Services, Inc;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which they were made, not misleading with respect to the period covered by the quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. I am responsible for establishing and maintaining disclosure controls and procedures for the registrant and I have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant (including its consolidated subsidiary) is made known to me by others within these entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report my conclusions about the effectiveness of the disclosure controls and procedures based on my evaluation as of the Evaluation Date;

5. I have disclosed, based on my most recent evaluation, to the registrant’s auditors and audit committee of the registrant’s board of directors:

a) All significant deficiencies in the design or operation of the registrant’s internal controls which could adversely affect the company’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in the internal controls; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of my most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

Date: April 30, 2003

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