PSYCHEMEDICS CORP - 10-K Annual Report

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U. S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

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

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

COMMISSION FILE NUMBER: 1-13738

PSYCHEMEDICS CORPORATION
(exact name of registrant as specified in its charter)

Delaware 58-1701987
- --------------------------------------- -------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

1280 Massachusetts Ave., Cambridge, MA 02138
- --------------------------------------- --------------------
(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code: 617-868-7455

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, $.005 Par Value American Stock Exchange
- ----------------------------- -------------------------------------------
(Title of class) (name of each exchange on which registered)

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

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.

YES [X] NO [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-B is not contained herein and will not 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-K or any amendment to this
Form 10-K. [X]

On March 15, 2002 the aggregate market value of the voting stock held by
non-affiliates of the registrant (assuming for these purposes, but without
conceding, that all executive officers, directors and 10% shareholders are
"affiliates" of the Registrant) was $41,725,711 and 21,036,895 shares of Common
Stock, $.005 par value, were outstanding at such date.

DOCUMENTS INCORPORATED BY REFERENCE

Part III - Portions of the Registrant's Proxy Statement relative to the 2002
Annual Meeting of Stockholders to be held on May 9, 2002.

PART I

The information provided by the Company in this Report may contain
"forward-looking" information which involves risks and uncertainties, such as
statements of the Company's plans, objectives, expectations and intentions. The
cautionary statements made in this report should be read as being applicable to
all forward-looking statements wherever they appear in this report. The
Company's actual results could differ materially from those discussed herein.
Factors that could cause or contribute to such differences include those
discussed in Item 7 below, as well as those discussed elsewhere herein.

ITEM 1. BUSINESS

GENERAL

Psychemedics Corporation ("the Company") is a Delaware corporation organized on
September 24, 1986 to provide testing services for the detection of abused
substances through the analysis of hair samples. The Company's testing methods
utilize a patented technology for performing immunoassays on enzymatically
dissolved hair samples with confirmation testing by mass spectrometry.

The Company's first application of its patented technology is a testing service
that screens for the presence of certain drugs of abuse in hair. The application
of radioimmunoassay procedures using hair differs from the more widely used
application of radioimmunoassay procedures using urine samples. The Company's
tests provide quantitative information which indicates the approximate amount of
drug ingested as well as historical data which can show a pattern of individual
drug use over a period of time. This information is useful to employers in both
applicant and employee testing, to physicians, treatment professionals, law
enforcement agencies, to the insurance industry; and to parents concerned about
drug use by their children and to other individuals and entities engaged in any
business where drug use is an issue. The Company provides commercial testing and
confirmation by mass spectrometry using industry-accepted practices for cocaine,
marijuana, PCP, methamphetamine, and opiates. As part of its methamphetamine
test, the Company also tests all hair samples it receives from both corporations
and individuals for the presence of Ecstasy,
(methylenedioxymethamphetamine/MDMA). The combination of sporadic use patterns
and rapid clearance from the body make Ecstasy difficult to detect through
available urine testing. In addition, the Company has developed a test for
methadone for use in the drug treatment industry.

Testing services are currently performed at the Company's laboratory at 5832
Uplander Way, Culver City, California. The Company's services are marketed under
the name RIAH (Radioimmunoassay of Hair), a registered service mark.

DEVELOPMENT OF RADIOIMMUNOASSAY OF HAIR

The application of special radioimmunoassay procedures to the analysis of hair
was initially developed in 1978 by the founders of the Company, Annette
Baumgartner and Werner A. Baumgartner, Ph.D. The Baumgartners demonstrated that
when certain chemical substances enter the bloodstream, the blood carries them
to the hair where they become "entrapped" in the protein matrix in amounts
roughly proportional to the

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amount ingested. The Company's drugs of abuse testing procedure involves washing
the hair sample to clean it of surface contaminants and then subjecting the
cleansed hair sample to the Company's unique proprietary process which involves
the direct analysis of liquefied hair samples by radioimmunoassay procedures
utilizing special reagents and antibodies. The antibodies detect the presence of
a specific drug or metabolite in the liquefied hair sample by reacting with the
drug present in the sample solution and an added radioactive analog of the drug.
The resulting antibody-drug complex is precipitated and analyzed. The amount of
drug present in the sample is inversely proportional to the amount of
radioactive analog in the precipitate. Depending upon both the length of head
hair and the hair growth rate (head hair grows approximately 1.3 centimeters per
month), the Company is able to provide historical information on drug use by the
person from whom the sample was obtained. Another testing option involves
sectional analysis of the hair sample. In this procedure, the hair is sectioned
lengthwise to approximately correspond to certain time periods. The sections are
then labeled by time period, which allows the Company to provide trend
information on drug use.

VALIDATION OF THE COMPANY'S PROPRIETARY TESTING METHOD

The process of analyzing human hair for the presence of drugs using the
Company's patented method has been the subject of numerous scientific field
studies. Results from the studies that have been published or accepted for
publication in scientific journals are generally favorable to the Company's
technology. These studies were performed with the following organizations:
Citizens for a Better Community Court, Columbia University, Koba Associates-DC
Initiative, Harvard Cocaine Recovery Project, Hutzel Hospital, ISA Associates
(Interscience America)-NIDA Workplace Study, University of California-Sleep
State Organization, Maternal/Child Substance Abuse Project, Matrix Center,
National Public Services Research Institute, Narcotic and Drug Research
Institute, San Diego State University-Chemical Dependency Center, Spectrum Inc.,
Stapleford Centre (London), Task Force on Violent Crime (Cleveland, Ohio);
University of Miami-Department of Psychiatry, University of Miami-Division of
Neonatology, University of South Florida-Operation Par Inc., University of
Washington, VA Medical Center-Georgia, U.S. Probation Parole-Santa Ana. The
above studies include research in the following areas: prenatal, treatment
evaluation, workplace drug use, the criminal justice system and epidemiology.
Many of the studies have been funded by the National Institute of Justice or the
National Institute on Drug Abuse ("NIDA"). Over 400 research articles written by
independent researchers have been published supporting the general validity and
usefulness of hair analysis.

Additional independent evaluation of the technology, favorable to the Company's
services, has been performed by submission of blind samples by Dr. Robert
DuPont, President of the Institute of Behavior and Health, Inc., the first
Director of the National Institute on Drug Abuse and presently a scientific
advisor to the Company. Some of the Company's customers have also completed
their own testing to validate the Company's proprietary hair testing method as a
prelude to utilizing the Company's services. These studies have consistently
confirmed the Company's superior detection rate compared to urinalysis testing.
When the results from utilizing the Company's patented hair testing method were
compared to urine results in side-by-side evaluations, 3 to 10 times as many
drug abusers were accurately identified with the Company's proprietary method.
In addition to these studies, the Company's proprietary method is validated
through the services it offers to over 2,200 clients for whom it has performed
testing.

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In 1998, the National Institute of Justice, utilizing Psychemedics hair testing,
completed a Pennsylvania Prison study where hair analysis revealed an average
prison use level in 1996 of approximately 7.9%. Comparatively, urinalysis
revealed virtually no positives. After measures to curtail drug use were
instituted, drug sniffing dogs, searches and scanners, the use level fell to
approximately 2% according to the results of hair analysis in 1998. Again, the
urine tests had virtually no positives. The study illustrated the usefulness of
hair analysis to monitor populations and the weakness of urinalysis.

In July of 1999, the scientific validity of the Company's hair analysis for
workplace testing was reported in an article published in the Journal of
Occupational and Environmental Medicine by Benjamin Hoffman, M.D. The study
reported hair analysis and urinalysis results on a group of 1,852 candidates for
employment at a large metropolitan police department. The results demonstrated
the superior capability of hair analysis over urinalysis in detecting drug users
by a three to one ratio and also showed no evidence of a bias of hair analysis
based on hair color or race.

The Company has received from the United States Food and Drug Administration
("FDA") 510k clearance on several of its assays used to test human hair for
drugs of abuse. Psychemedics is the only company to receive FDA clearance of any
assay for testing hair samples for drugs of abuse. See GOVERNMENT REGULATION.

ADVANTAGES OF USING THE COMPANY'S PATENTED METHOD

The Company asserts that hair testing using its patented method confers
substantive advantages relative to existing means of drug detection through
urinalysis. Although urinalysis testing can provide accurate drug use
information, the scope of the information is short-term and is generally limited
to the type of drug ingested within a few days of the test. Studies published in
many scientific publications have indicated that most drugs disappear from urine
within a few days.

In contrast to urinalysis testing, hair testing using the Company's patented
method can provide long-term historical drug use information resulting in a
significantly wider "window of detection." This "window" may be several months
or longer depending on the length of the hair sample. The Company's standard
test offering, however, uses a 3.9 centimeter length head hair sample cut close
to the scalp; therefore, it measures use for approximately the previous 90 days.

This wider window of detection enhances the detection efficiency of hair
analysis making it particularly useful in pre-employment testing. Hair testing
not only identifies more drug users, but can also uncover patterns and severity
of drug use, information most helpful in determining the scope of an
individual's involvement with drugs and serves as a deterrent against the use of
drugs. Hair testing using the Company's patented method greatly reduces the
incidence of "false negatives" associated with evasive measures typically
encountered with urinalysis testing. Urinalysis test results are impacted
adversely by excessive fluid intake prior to testing as well as adulteration of
the sample. Moreover, a drug user who abstains from use for a few days prior to
urinalysis testing can usually escape detection. Hair testing is effectively
free of these problems, as it cannot be thwarted by evasive measures typically
encountered with urinalysis testing. It is also attractive to customers since
sample collection is typically performed under close supervision yet is less
intrusive and less embarrassing for test subjects.

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Hair testing using the Company's patented method (with mass spectrometry
confirmation) further reduces the prospects of error in conducting drug
detection tests. Urinalysis testing is more susceptible to problems such as
"evidentiary false positives" resulting from passive drug exposure (e.g. poppy
seeds). To combat this problem, in federally mandated testing, the opiate cutoff
levels for urine testing were raised 667% on December 1, 1998 and testing for
the presence of a heroin metabolite, 6-AM, was required. These new requirements,
however, effectively reduced the detection time frame for confirmed heroin in
urine down to several hours post-use. In contrast, the metabolite 6-AM is stable
in hair and can be detected for months.

In the event a positive urinalysis test result is challenged, a test on a newly
collected sample is not a viable remedy. Depending on the drug usage of the
forewarned individual prior to the date of the newly collected sample, a re-test
may yield a negative result when using urinalysis testing because of temporary
abstention. In contrast, when the Company's hair testing method is offered on a
repeat hair sample the individual suspected of drug use cannot as easily affect
the results because historical drug use data remain locked in the hair fiber.

DISADVANTAGES OF HAIR TESTING

There are some disadvantages of hair testing as compared to drug detection
through urinalysis. Because hair starts growing below the skin surface, drug
ingestion evidence does not appear in hair above the scalp until five to seven
days after use.

Thus, hair testing is not suitable for determining impairment in "for cause"
testing such as is done in connection with an accident investigation. It does,
however, provide a drug history which can complement urinalysis information in
"for cause" testing.

Currently, radioimmunoassay testing using hair samples under the Company's
patented method is only practiced by Psychemedics Corporation. The absence of
widespread familiarity and use of hair testing may adversely impact the
Company's revenue growth.

The Company's prices for its tests are generally somewhat higher than prices for
tests using urinalysis, but the Company believes that its superior detection
rates provide more value to the customer. This pricing policy could, however,
adversely impact the growth of the Company's sales volume.

PATENTS

In 1994, the Company was issued its first patent, U.S. Patent No. 5,324,642 (the
"642 Patent"). This patent pertains to the Company's universal drug extraction
procedure and immunoassay technology for the detection of drugs in hair
specimens. Some of the research on the inventions covered by the 642 Patent was
conducted at the Veteran's Administration Hospital ("VA"). Therefore, the U.S.
government has been granted a nonexclusive, irrevocable, royalty-free license to
use the basic invention covered by the 642 Patent, for all governmental
purposes. In 1995, the Company was granted an additional patent pertaining to
the immuno chemical screening assay for marijuana, which is the most difficult
drug to detect.

In 1996, the Company was issued its first European patent on the base hair
analysis method. The Company was also issued a European patent in 1996 on
another aspect

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of the Company's technology, related to the use of detergents to enhance the
hair digestion portion of the methodology.

In October 1998, the Japanese Patent Office informed the Company that it had
allowed the pending Japanese patent application containing broad claims to the
Company's proprietary hair test for drugs of abuse.

In August 1999, the Canadian Patent Office issued the Company a patent
containing broad claims to the Company's proprietary basic hair analysis method.

In December 1999, the Company was issued European patents related to the
analysis of marijuana analyte in hair. As a result of the issuance of this
patent, national patents are in effect in Germany, France, Italy, the United
Kingdom and Spain.

In February 2000, a third U.S. patent was issued which extends protection to yet
another aspect of the Company's methodology. This patent provides for the use of
metal salt to deactivate certain reagents used in the method, thus enhancing
efficiency.

In December 2001, a Japanese certificate of patent was issued related to the use
of detergents in the Psychemedics hair analysis process.

In January 2002, a second Canadian patent was issued, which relates to the use
of ion exchange resins in the marijuana assay.

In February 2002, a fourth U.S. Patent was issued which covers the base hair
analysis method, and broadens considerably the scope of the original U.S.
patent.

Certain aspects of the Company's hair analysis method are based on trade secrets
owned by the Company. The Company's ability to protect the confidentiality of
these trade secrets is dependent upon the Company's internal safeguards and upon
the laws protecting trade secrets and unfair competition. In the event that
patent protection or protection under the laws of trade secrets were not
sufficient and the Company's competitors succeeded in duplicating the Company's
products, the Company's business could be materially adversely affected.

TARGET MARKETS

1. Workplace

The Company focuses its primary marketing efforts on the private sector, with
particular emphasis on job applicant and employee testing.

The number of businesses using drug testing to screen job applicants and
employees has increased significantly in the last several years. The most recent
American Management Association (AMA) survey from 1996 indicated that 81% of
surveyed firms were engaged in some form of drug testing, a 277% increase since
the initial AMA survey in 1987. The prevalence of drug screening programs
reflects a growing concern that drug use contributes to employee health problems
and costs (increased absenteeism, reduced productivity, etc.) and in certain
industries, safety hazards. It has been estimated that the cost to industry in
terms of health care costs and lost productivity is at least $98.5 billion
annually.

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The principal criticism of employee drug screening programs centers on the
effectiveness of the testing program. Most private sector screening programs use
urinalysis. Such programs are susceptible to evasive maneuvers and the inability
to obtain identical repeat samples in the event of a challenged result.

Moreover, many employers, to accommodate concerns of their employees and to
avoid infringement of employee privacy rights, conduct their programs on a
pre-announced schedule, thereby providing an opportunity for many drug users to
simply abstain in order to escape detection.

The Company presents its patented hair analysis method to potential clients as a
better technology well suited to employer needs. Field studies and actual client
results support the accuracy and effectiveness of the Company's patented
technology and its ability to detect even casual drug use. This information
provides an employer with greater flexibility in assessing the scope of an
applicant's or an employee's drug problem.

The Company performs a confirmation test of all positive results through mass
spectrometry. The use of mass spectrometry is an industry accepted practice used
to confirm positive drug test results of an initial screen. In an employment
setting, mass spectrometry confirmation is typically used prior to the taking of
any disciplinary action against an employee. The Company offers its clients a
five-drug screen with mass spectrometry confirmation of cocaine, PCP, marijuana,
methamphetamine, including Ecstasy, and opiates.

2. Parents

The Company also offers a personal drug testing service, "PDT-90"(R), for
parents concerned about drug use by their children. It allows parents to collect
a small sample from their child in the privacy of the home, send it to the
Company's laboratory and have it tested for drugs of abuse by the Company. The
PDT-90 testing service uses the same patented method that is used with the
Company's workplace testing service.

3. Research

The list of research clients includes National Development and Research
Institute; The University of North Carolina Chapel Hill; The University of
Pennsylvania; The Jefferson Medical College, Rehab Follow Up; UCLA Drugs of
Abuse in Mentally Ill and Comorbid Parolees; The Boston University School of
Public Health; The Pacific Institute for Substance-Abusing Women and their
Children; The Research Institute of Addiction, Buffalo, NY; Mathematical Policy
Research, Effectiveness of Intervention on Drug Use; The Texas Christian
University, First Choice Women's Program; The Center for Substance Abuse
Research; Columbia University, Cocaine Exposure in Fetal Neural Development; and
The University of North Carolina, Antipsychotics in Schizophrenia.

SALES AND MARKETING

The Company markets its corporate drug testing services primarily through its
own sales force. Sales offices are located in major cities throughout the United
States in order to facilitate communications with corporate employers. The
Company markets its home drug testing service, PDT-90, through retail
distributors and the Internet.

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COMPETITION

The Company competes directly with numerous commercial laboratories that test
for drugs through urinalysis testing. Most of these laboratories, such as
Laboratory Corporation of America, have substantially greater financial
resources, market identity, marketing organizations, facilities, and numbers of
personnel than the Company. The Company has been steadily increasing its base of
corporate customers and believes that future success with new customers is
dependent on the Company's ability to communicate the advantages of implementing
a drug program utilizing the Company's patented hair analysis method.

The Company's ability to compete is also a function of pricing. The Company's
prices for its tests are generally somewhat higher than prices for tests using
urinalysis. However, the Company believes that its superior detection rates,
coupled with the customer's ability to test less frequently due to hair
testing's wider window of detection (approximately 90 days versus approximately
three days with urinalysis) provide more value to the customer. This pricing
policy could, however, lead to slower sales growth for the Company.

The Company is not aware of any other laboratories with a hair analysis
technology that is comparable in effectiveness to the Company's proprietary
procedures. The Company is aware of several laboratories that purport to test
hair samples using a method, which the Company presumes, includes the use of a
form of immunoassay procedures. The Company, however, does not believe that
immunoassay testing of hair samples is as effective on a commercial basis
without using the Company's unique patented method, which allows for the
efficient release of drugs from the hair through enzyme digestion without
destroying the drugs.

GOVERNMENT REGULATION

The Company is licensed as a clinical laboratory by the State of California as
well as certain other states. All tests are performed according to the
laboratory standards established by the Department of Health and Human Services,
through the Clinical Laboratories Improvement Amendments ("CLIA"), and various
state licensing statutes. Presently there are no other regulations required for
the operation of a clinical laboratory in the State of California.

A substantial number of states regulate drug testing. The scope and nature of
such regulations varies greatly from state to state and is subject to change
from time to time. The Company addresses state law issues on an ongoing basis.

With regard to federal regulatory activity, shortly after the introduction of
the Company's PDT-90 drug testing service in 1995, the FDA attempted to assert
jurisdiction over the Company's PDT-90 service by claiming that the collection
envelope distributed as part of the service was a "medical device" subject to
regulation under the Federal Food, Drug and Cosmetic Act, as amended (the "FDC
Act"). This ultimately led to the Company filing suit against the FDA contesting
the FDA's position. In March 1996, the FDA agreed to withdraw its claims against
the Company in exchange for the Company's agreement to discontinue its lawsuit.

On March 5, 1998, the FDA issued a proposed rule applicable to companies that
market "drugs of abuse test sample collection systems". Under the proposed rule,

8

companies engaged in the business of testing for drugs of abuse using a test
(screening assay) previously recognized by the FDA would be able to market their
test sample collection systems without pre-market approval or clearance by the
FDA so long as the test is conducted at a laboratory that is recognized by
laboratory certification agencies designated by the FDA and certain labeling and
product information procedures are followed. To date, the FDA has recognized
urine-screening assays that existed prior to the 1976 Medical Device Amendments
to the FDC Act, as well as subsequent assays, which have demonstrated
substantial equivalence to such previously existing assays. Under the FDA's
proposed rule, companies engaged in the business of testing for drugs of abuse
using assays not yet recognized by the FDA would be required to submit their
assay to the FDA for recognition prior to marketing. In addition, the laboratory
performing the tests would be required to be certified by a recognized agency.
The proposed rule included a transitional period of one year following the
publication of a final rule in order for companies not currently in compliance
with the proposed requirements to obtain the necessary data they need for
submission to the FDA.

The FDA rule became final on April 7, 2000, and the transition period expired in
May 2001. In response to the adoption of the final rule, the Company filed a
Petition for Review on May 5, 2000 in the United States Court of Appeals,
District of Columbia Circuit, challenging the validity of the final rule and
asserting that the FDA lacks jurisdiction over the Company's in-house
proprietary assays, which are not intended to be used for medical purposes.
While still contesting the legality of the final rule, and the FDA's
jurisdiction, the Company submitted 510k applications for its assays for
clearance by the FDA. The parties both agreed to hold the Petition for Review in
abeyance while they attempt to settle the matter. As of March 29, 2002, the
Company had received 510k clearance to market 4 of its 5 assays. The Company
believes that the final assay will be cleared for market by the FDA at the
conclusion of its review. If such clearance cannot be obtained, the FDA could
seek to enforce the remedies available to it under the new rule and the FDC Act
with respect to that assay. If the FDA were successful in such action, the
Company's business could be adversely affected. However, the Company believes
its Petition for Review presents a strong case against the enforceability of the
new FDA rule. Therefore, while the Company continues to undergo the application
process for clearance of its remaining assay, it has preserved its right to
proceed with its Petition for Review.

The Drug Testing Advisory Board ("DTAB") of the Substance Abuse and Mental
Health Services Administration ("SAMHSA") is promulgating new guidelines for
mandatory testing in federal workplace programs. SAMHSA has included a Hair
Testing Working Group to advise DTAB. This group is comprised of representatives
in the drug-testing arena, including representatives from the Company. In the
draft Mandatory Guidelines, hair is included as a specimen which may be
collected. Should the final version of the federal guidelines remain
substantially unchanged from the draft version, the federal workplace market,
previously limited to only urine testing, will be available to the Company.

RESEARCH AND DEVELOPMENT

The Company is continuously engaged in research and development activities.
During the years ended December 31, 2001, 2000 and 1999, $608,186, $475,700, and
$526,212, respectively, were expended for research and development. The Company
continues to perform research activities to develop new products and services
and to

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improve existing products and services utilizing the Company's proprietary
technology. Additional research using the Company's proprietary technology is
being conducted by outside research organizations through government-funded
studies.

Some of the research was directed to find alternative ways to more accurately
and reliably measure low concentrations of drugs present in hair, including the
use of Liquid Chromatography/Mass Spectrometry/Mass Spectrometry, (LC/MS/MS).
The Company has been the pioneer in this area and has developed three separate
assays for the determination of opiates, amphetamines and cocaine using this
technology. Some additional research has been conducted in the measurement of
concentrations of marijuana by Gas Chromatography/Mass Spectrometry/Mass
Spectrometry, (GC/MS/MS). This has been the most challenging, and requires the
most sensitive of equipment for its accurate measurement and qualitative
identification.

Additional research studies have been undertaken to facilitate medical
researchers in quantifying Ecstasy use at actual Rave parties at various
locations on the East Coast. The Company was asked to test saliva samples
submitted from these studies. Using our recently developed LC/MS/MS test for
Ecstasy, the Company was able to measure low concentrations of this drug in very
small saliva samples.

SOURCES AND AVAILABILITY OF RAW MATERIALS

Since its inception, the Company has purchased raw materials for its laboratory
services from outside suppliers. The most critical of these raw materials are
the radio-labeled drugs which the Company purchases from a single supplier,
although other suppliers of radio-labeled drugs exist. The Company has entered
into an agreement with its principal supplier to purchase certain proprietary
information regarding the manufacture of such radio-labeled drugs owned by the
supplier in the event that the supplier ceases to be able to supply such
radio-labeled drugs to the Company.

EMPLOYEES

As of December 31, 2001, the Company had 105 full-time equivalent employees, of
whom three full-time employees were in research and development. None of the
Company's employees is subject to a collective bargaining agreement.

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ITEM 2. PROPERTIES.

The Company maintains its corporate office and northeast sales office at 1280
Massachusetts Avenue, Cambridge, Massachusetts; the office is leased through
September 2003.

The Company leases 18,000 square feet of space in Culver City, California, for
laboratory purposes. This facility is leased through December 31, 2005 with an
option to renew for an additional two years. The Company also leases an
additional 5,400 square feet of space in Culver City, California for customer
service and information technology purposes. This office space is leased through
December 31, 2005.

ITEM 3. LEGAL PROCEEDINGS.

The Company is involved in various suits and claims in the ordinary course of
business. The Company does not believe that the disposition of any such suits or
claims will have a material adverse effect on the continuing operations or
financial condition of the Company.

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

Not applicable.

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PART II

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

The Company's common stock is traded on the American Stock Exchange under the
symbol "PMD". As of March 15, 2002, there were 350 record holders of the
Company's common stock. The following table sets forth for the periods indicated
the range of prices for the Company's common stock as reported by the American
Stock Exchange and dividends declared by the Company.

Calendar Period High Low Dividends
- --------------- ---- --- ---------

2001
Fourth Quarter $4.10 $3.20 $0.02
Third Quarter $4.46 $2.83 $0.02
Second Quarter $4.68 $3.94 $0.02
First Quarter $5.08 $3.65 $0.04

2000
Fourth Quarter $5.50 $4.25 $0.04
Third Quarter $5.25 $4.44 $0.04
Second Quarter $5.50 $4.50 $0.04
First Quarter $5.81 $4.25 $0.04

Future cash dividends may be declared at the discretion of the Board of
Directors.

ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data has been derived from the financial
statements of the Company and should be read in conjunction with, and is
qualified in its entirety by reference to, the financial statements and related
notes thereto.

As of and for the Years Ended
----------------------------------------------------------------
December 31,
----------------------------------------------------------------
2001 2000 1999 1998 1997
------- ------- ------- ------- -------
(In thousands, except for per share data)

Revenue $15,730 $19,220 $19,623 $17,670 $15,398
Gross profit 7,915 10,325 11,169 10,201 9,341
Income from operations 323 2,430 3,547 3,307 3,056
Net income 233 1,699 2,326 2,397 2,501
Basic net income per share 0.01 0.08 0.11 0.11 0.11
Diluted net income per share 0.01 0.08 0.11 0.11 0.11
Total assets 9,108 11,058 14,191 19,083 18,855
Working capital 4,075 5,523 8,184 11,609 13,090
Shareholders' equity 6,772 8,726 11,806 15,883 16,733
Cash dividends declared per
common share $ 0.10 $ 0.16 $ 0.16 $ 0.11 $ 0.08

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

FACTORS THAT MAY AFFECT FUTURE RESULTS

From time to time, information provided by the Company or statements made by its
employees may contain "forward-looking" information which involves risks and
uncertainties. In particular, statements contained in this report which are not
historical facts (including, but not limited to, the Company's expectations
regarding revenues, business strategy, anticipated operating results, strategies
with respect to governmental agencies and regulations, cash dividends and
anticipated cash requirements) may be "forward-looking" statements. The
Company's actual results may differ from those stated in any "forward-looking"
statements. Factors that may cause such differences include, but are not limited
to, employee hiring practices of the Company's principal customers, risks
associated with the continued expansion of the Company's sales and marketing
network, development of markets for new products and services offered by the
Company, the economic health of principal customers of the Company, financial
and operational risks associated with possible expansion of testing facilities
used by the Company, government regulation (including, but not limited to, Food
and Drug Administration regulations), competition and general economic
conditions.

CRITICAL ACCOUNTING POLICIES

The Company's significant accounting policies are described in Note 1 to the
financial statements included in Item 8 of this Form 10-K. Management believes
the most critical accounting policies include revenue recognition and income
taxes.

Revenue Recognition

Revenues from the Company's services are recognized upon reporting of drug test
results to the customer. Revenues related to sample collection kits not returned
for processing by customers are recognized when the likelihood of the Company
performing any service obligation is deemed remote.

Income Taxes

As part of the process of preparing the Company's financial statements, the
Company is required to estimate income taxes in each of the jurisdictions in
which it operates. This process involves the preparation of an estimate of the
Company's actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the balance sheet. The
Company must then assess the likelihood that the deferred tax assets will be
recovered from future taxable income and to the extent it believes that recovery
is not likely, it must establish a valuation allowance. To the extent the
Company establishes a valuation allowance or increase this allowance in a
period, it must include an expense within the tax provision in the statement of
operations.

Significant management judgment is required in determining the provision for
income taxes, deferred tax assets and liabilities and any valuation allowance
recorded against net deferred tax assets. In the event that actual results
differ from these estimates or the Company adjusts these estimates in future
periods, it may need to establish a

13

valuation allowance, which could materially impact the Company's financial
position and results of operations.

The above listing is not intended to be a comprehensive list of all of the
Company's accounting policies. In many cases, the accounting treatment of a
particular transaction is specifically dictated by accounting principles
generally accepted in the United States, with no need for management's judgment
in their application. There are also areas in which management's judgment in
selecting any available alternative would not produce a materially different
result.

RESULTS OF OPERATIONS

Revenue was $15.7 million in 2001, as compared to $19.2 million in 2000 and
$19.6 million in 1999, representing decreases of 18% in 2001 and 2% in 2000
versus prior year levels. The decrease in revenue for 2001 was due primarily to
a decrease in volume of hair samples processed from existing customers, while
the average price per sample remained relatively constant. The Company believes
that this lower volume in 2001 is due largely to the continued current economic
downturn, as many clients experienced deep reductions in their new hires and the
number of their drug tests. The decrease in revenue in 2000 was due to reduced
revenue related to PDT-90 consumer test kits, offset in part by an increase of
1% in revenue derived from the processing of hair samples for all other
customers. Gross margin was 50% of sales in 2001 as compared to 54% of sales in
2000 and 57% of sales in 1999. The decrease in gross margin in 2001 was caused
by fixed and semi-variable direct costs being spread over a lower number of
tests performed. Despite the 18% decrease in revenue, the Company's gross margin
only decreased from 54% to 50% for the year ended December 31, 2001 as compared
to December 31, 2000, as a result of the implementation of cost reduction
measures at its laboratory during 2001. The decrease in gross margin in 2000 was
due primarily to moderate increases in labor and material costs, while the
Company's prices remained consistent with the prior year.

General and administrative expenses decreased by $161,000 to $3.1 million from
2000 to 2001 and increased by $222,000 to $3.3 million from 1999 to 2000. The
decrease in general and administrative expenses for 2001 as compared to 2000 was
due to reduced professional fees related to legal services and investor
relations along with a decrease in bad debt expense, partially offset by an
increase in professional fees related to strategic corporate development, while
all other general and administrative expenses remained relatively constant.
Professional fees related to legal services, investor relations, consulting
services related to computer services and strategic corporate development
accounted for most of the increase in 2000 as compared to 1999, while all other
general and administrative expenses remained relatively constant. General and
administrative expenses represented 20% of revenue in 2001 as compared to 17% of
revenue in 2000 and 16% of revenue in 1999. The increase in general and
administrative expenses as a percentage of sales is primarily due to the factors
previously discussed and a lower revenue base.

Marketing and selling expenses decreased by $275,000 to $3.9 million from 2000
to 2001 and increased by $101,000 to $4.1 million from 1999 to 2000. The
decrease in marketing and selling expenses for 2001 as compared to 2000 was due
to reduced expenses related to public relations, advertising and recruitment
costs, which were offset to some extent by a slight increase in customer service
costs. The increase in marketing and selling expenses for 2000 as compared to
1999 was due to expenses

14

pertaining to additions to the sales force and expanded marketing activities
related to the corporate market which were partially offset by decreased
customer service costs. The Company expects to continue to aggressively promote
its drug testing services in future years in order to expand its client base.
Marketing and selling expenses for the year ended December 31, 2001 increased to
25% of revenue versus 22% in 2000 and 21% in 1999. The increase in marketing and
selling expenses as a percentage of sales is primarily due to the factors
previously discussed and a lower revenue base.

Research and development expenses increased $132,000 to $608,000 from 2000 to
2001 and decreased by $51,000 to $476,000 from 1999 to 2000. This increase was
primarily due to expenses related to applying for FDA 510k clearance for the
Company's assays. Research and development expenses represented 4% of revenue in
2001 but remained constant as a percentage of revenue at 3% in 2000 and 1999.
The increase in research and development expenses as a percentage of sales from
2000 to 2001 is primarily due to the factors previously discussed and a lower
revenue base.

Other income decreased $336,000 to $125,000 from 2000 to 2001 and increased
$74,000 to $462,000 from 1999 to 2000, largely as a result of a $200,000 legal
settlement received by the Company from a breach of contract dispute with a
third party administrator in 2000. The remainder of other income represented
interest earned on cash equivalents and short-term investments. Net interest
income decreased by $136,000 in 2001 as compared to 2000, due to lower average
investment balances along with decreased yields on these investments. Although
the yields on investment balances increased during 2000 as compared to 1999,
interest income decreased by $126,000 due to lower average investment balances.
For 1999, other income consisted solely of net interest income.

During 2001, the Company recorded a tax provision of $216,000, reflecting an
effective tax rate of 48.2%, as compared to tax provisions of $1,192,750 and
$1,609,000 and effective tax rates of 41.3% and 40.9% for the years ended
December 31, 2000 and December 31, 1999, respectively. The increase in the
effective tax rate in 2001 was due primarily to non-deductible expenses for tax
purposes. The increase in the effective tax rate in 2000 resulted largely from
the reduction in the utilization of tax credits that were primarily generated in
1998.

LIQUIDITY AND CAPITAL RESOURCES

At December 31, 2001, the Company had $3.1 million of cash and cash equivalents,
compared to $3.4 million at December 31, 2000. The Company's operating
activities generated net cash of $2,466,000 in 2001, $3,205,000 in 2000 and
$2,926,000 in 1999. Investing activities used $591,000 in 2001, and generated
$4,139,000 in 2000 and $3,654,000 in 1999. Financing activities used $2,199,000
in 2001, $4,809,000 in 2000 and $6,406,000 in 1999.

Operating cash flows decreased by $739,000 in 2001 as compared to 2000, due
primarily to a decrease in net income in 2001 of $1,466,000 as compared to 2000,
and an increase in net deferred tax assets. Offsetting these amounts was a
decrease in accounts receivable in 2001 of $963,000 as compared to 2000, and an
increase in deferred revenue. The non-cash effect of depreciation and
amortization in 2001, 2000 and 1999 was $1,268,000, $1,277,000, and $1,323,000,
respectively.

15

Capital expenditures in 2001 were $580,000, a decrease of $196,000 from 2000
expenditures of $776,000. The expenditures related principally to new equipment,
including laboratory and computer equipment. The Company currently plans to make
capital expenditures of approximately $700,000 in 2002, primarily in connection
with the purchase of additional laboratory and computer equipment. The Company
believes that within the next two to four years it may be required to expand its
existing laboratory or develop a second laboratory, the cost of which is
currently believed to range from $2 million to $4 million.

During 2001, the Company repurchased a total of 129,356 shares for treasury at
an aggregate cost of $505,000. During 2000, the Company repurchased a total of
286,600 shares for treasury at an aggregate cost of $1,418,000. During 1999, the
Company repurchased a total of 638,800 shares for treasury at an aggregate cost
of $2,935,000.

The Company distributed $2,115,000, $3,394,000 and $3,486,000 of cash dividends
to its shareholders in 2001, 2000 and 1999, respectively.

At December 31, 2001, the Company's principal sources of liquidity included $3.1
million of cash and cash equivalents. Management currently believes that such
funds, together with future operating profits, should be adequate to fund
anticipated working capital requirements and capital expenditures in the near
term. Depending upon the Company's results of operations, its future capital
needs and available marketing opportunities, the Company may use various
financing sources to raise additional funds. Such sources could include joint
ventures, issuance of common stock or debt financing. At December 31, 2001, the
Company had no debt.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion about the Company's market risk disclosures involves
forward-looking statements. Actual results could differ materially from those
projected in the forward-looking statements. The Company is exposed to market
risk related to changes in interest rates. The Company does not use derivative
financial instruments for speculative or trading purposes.

Interest Rate Sensitivity. The Company maintains a short-term investment
portfolio consisting principally of money market securities that are not
sensitive to sudden interest rate changes.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements are included in this report on pages F-1 through F-16.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE

None.

16

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

Following is a list that sets forth as of March 29, 2002 the names, ages and
positions within the Company of all of the Executive Officers of the Company and
the Directors of the Company. Each such director has been nominated for
reelection at the Company's 2002 Annual Meeting, to be held on May 9, 2002 at
2:30 P.M. at the Charles Hotel, 1 Bennett Street, Cambridge, Massachusetts.

NAME AGE POSITION
- ---- --- --------

Raymond C. Kubacki, Jr. 57 Chief Executive Officer, President,
Director

A. Clinton Allen 58 Interim Chairman of the Board,
Director

Peter C. Monson 46 Chief Financial Officer, Vice
President and Treasurer

William Thistle, Esq. 52 Senior Vice President,
General Counsel

Michael I. Schaffer, Ph.D 57 Vice President,
Laboratory Operations

William Dausey 51 Vice President, Sales

Donald F. Flynn 62 Director,
Audit Committee member,
Options Committee member

Walter S. Tomenson, Jr. 55 Director,
Audit Committee member,
Options Committee member

Fred J. Weinert 54 Director,
Audit Committee member,
Options Committee member

All Directors hold office until the next annual meeting of stockholders or until
their successors are elected. Officers serve at the discretion of the Board of
Directors.

Mr. Kubacki has served as President and Chief Executive Officer and as a
Director of the Company since 1991. Prior to joining the Company, he served as
Vice President-National Accounts and Director of Sales and Marketing for
Reliance COMM/TEC Corporation, a subsidiary of Reliance Electric Co.

Mr. Allen was elected interim Chairman of the Board on March 28, 2002 following
the retirement of Werner A. Baumgartner on such date. Previously he served as
Vice Chairman. Mr. Allen has been a Director of the Company since 1989. He is
also Chairman and Chief Executive Officer of A.C. Allen & Company, Inc., an
investment banking

17

consulting firm located in Cambridge, Massachusetts. He is a director of Swiss
Army Brands, Inc., Steinway Musical Instruments, Inc., Collectors Universe,
Inc., and The DeWolfe Companies, Inc., where he serves as Vice Chairman.

Mr. Monson has been the Company's Chief Financial Officer since March 2000. He
has served as a Vice President, Treasurer of the Company since 1998. From
November 1996 until joining the Company, Mr. Monson was a financial consultant
to several different companies, most recently with GTE Internetworking. From
1994 to 1996, Mr. Monson was Chief Financial Officer of Bet Systems, Inc. From
1991 to 1994, Mr. Monson was the Corporate Controller and Treasurer of Gamma
International, Ltd., a publicly traded gaming company.

Mr. Thistle joined the Company in 1995 as Vice President and General Counsel and
was made a Senior Vice President in September of 2001. Prior to joining the
Company, he served as Associate General Counsel for MGM Grand in Las Vegas from
1993 to 1995. From 1989 to 1993, Mr. Thistle was Associate General Counsel for
Harrah's Casino Resorts. Mr. Thistle is on the Legal Advisory Board of the
Institute for a Drug Free Workplace and is a board member of the Drug and
Alcohol Testing Industry Association ("DATIA").

Dr. Schaffer joined the Company in April 1999 as Vice President of Laboratory
Operations. Prior to joining the Company, he served as Director of Toxicology,
Technical Manager and Responsible Person for the Leesburg, Florida laboratory of
SmithKline Beecham Clinical Laboratories, from 1990 to 1999. Dr. Schaffer has
been an inspector for the Substance Abuse and Mental Health Services
Administration's National Laboratory Certification Program since 1989. Dr.
Schaffer was also a member of the Board of Directors of the American Board of
Forensic Toxicologists from 1990 to 1999.

Mr. Dausey joined the Company in April, 2000 as Vice President of Sales. From
1996 until joining the Company, Mr. Dausey was Vice President of Sales for
NorthWestern Corporation. Previous positions include Vice President of Sales for
PTC Aerospace and various positions at BF Goodrich Company.

Mr. Flynn has been the sole stockholder of Flynn Enterprises, Inc., a venture
capital, hedging and consulting firm based in Chicago, Illinois since its
inception in 1988. He also served as Chairman of the Board of LKQ Corporation, a
company engaged in the automobile recycling business, since 1999, and served as
its sole director from 1998 to 1999. He was the Vice Chairman of the Blue Chip
Casino, Inc., an owner and operator of a riverboat gaming vessel in Michigan
City, Indiana from 1997 until 1999 when Blue Chip was sold to Boyd Gaming
Corporation. Mr. Flynn also was Chairman of the Board from 1992 until 1996 and
Chief Executive Officer from 1992 until 1995 of Discovery Zone, Inc., an
operator of indoor entertainment and fitness facilities for children. From 1972
to 1990, Mr. Flynn served in various positions with Waste Management, Inc.
including Senior Vice President and Chief Financial Officer. Mr. Flynn serves as
a Director of Extended Stay America, Inc., an owner and operator of
extended-stay lodging facilities. Mr. Flynn has been a director of the Company
since 1989.

Mr. Tomenson has been Managing Director and Chairman of Client Development of
Marsh, Inc. since 1998. From 1993 to 1998, he was chairman of FINPRO, the
financial services division of Marsh, Inc. In addition, he is a member of the
Board of Directors of Marsh, Inc. Mr. Tomenson is a Director of Ronald McDonald
House and a Trustee of

18

the Children's Oncology Society of New York, Inc. He is a Director of the
Trinity College School Fund, Inc. He also serves on the Executive Council of the
Inner-City Scholarship Fund. Mr. Tomenson has been a director of the Company
since 1999.

Mr. Weinert is the majority shareholder and serves as CEO of San Telmo, Inc.,
Barrington Services Group, Inc. and H20 Plus, S.R.L. From 1989 to 1995, he was
President of H20 Plus L.P., MW Partners, and Century Entertainment Ltd. Previous
to that, he had a 16 year career with Waste Management, Inc. during which he
served as a Vice President and also as President of Waste Management
International, Inc. from 1983 to 1989. For the last 17 years he has served on
the Business Advisory Council for the University of Dayton. He is a trustee of
the Center for Excellence in Education based in Washington, DC. Mr. Weinert has
been a director of the Company since 1991.

SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE

Based solely on its reviews of copies of reports filed pursuant to Section 16(a)
of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), or
written representations from persons required to file such reports ("Reporting
Persons"), the Company believes that all such filings required to be made by
such Reporting Persons were timely made in accordance with the requirements of
the Exchange Act.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item will be set forth in the Proxy Statement
of the Company relating to the 2002 Annual Meeting of Stockholders to be held on
May 9, 2002 and is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this item will be set forth in the Proxy Statement
of the Company relating to the 2002 Annual Meeting of Stockholders to be held on
May 9, 2002 and is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item will be set forth in the Proxy Statement
of the Company relating to the 2002 Annual Meeting of Stockholders to be held on
May 9, 2002 and is incorporated herein by reference.

19

PART IV

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

PAGE
----
(a) (1) Financial Statements:

Report of Independent Public Accountants F-1

Balance Sheets as of December 31, 2001 and 2000 F-2

Statements of Income for the Years Ended December
31, 2001, 2000 and 1999 F-3

Statements of Shareholders' Equity for the Years
Ended December 31, 2001, 2000 and 1999 F-4

Statements of Cash Flows for the Years Ended
December 31, 2001, 2000 and 1999 F-5

Notes to Financial Statements F-6

(2) Schedules

None

(3) Exhibits (see the Index to Exhibits included elsewhere in this Report)

(b) REPORTS ON FORM 8-K

None

20

SIGNATURES

Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange
Act of 1934, the registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized.

PSYCHEMEDICS CORPORATION

By: /s/ Raymond C. Kubacki, Jr.
-------------------------------------
Raymond C. Kubacki, Jr.
President and Chief Executive Officer

Date: March 29, 2002

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

/s/ Raymond C. Kubacki, Jr. March 29, 2002
- ----------------------------------------
Raymond C. Kubacki, Jr.
President and Chief Executive Officer,
Director (Principal Executive Officer)

/s/ Peter C. Monson March 29, 2002
- ----------------------------------------
Peter C. Monson
Vice President, Chief Financial
Officer & Treasurer (Principal Financial
and Accounting Officer)

/s/ A. Clinton Allen March 29, 2002
- ----------------------------------------
A. Clinton Allen
Director

/s/ Donald F. Flynn March 29, 2002
- ----------------------------------------
Donald F. Flynn
Director

/s/ Walter S. Tomenson, Jr. March 29, 2002
- ----------------------------------------
Walter S. Tomenson, Jr.
Director

/s/ Fred J. Weinert March 29, 2002
- ----------------------------------------
Fred J. Weinert
Director

21

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Psychemedics Corporation:

We have audited the accompanying balance sheets of Psychemedics Corporation (a
Delaware corporation) as of December 31, 2001 and 2000 and the related
statements of income, shareholders' equity and cash flows for each of the three
years in the period ended December 31, 2001. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Psychemedics Corporation as of
December 31, 2001 and 2000, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 2001, in conformity
with accounting principles generally accepted in the United States.

ARTHUR ANDERSEN LLP

Boston, Massachusetts
February 4, 2002

F-1

PSYCHEMEDICS CORPORATION
BALANCE SHEETS

DECEMBER 31,
------------------------------
2001 2000
------------ ------------

ASSETS

CURRENT ASSETS:
Cash and cash equivalents $ 3,110,700 $ 3,434,593
Accounts receivable, net of allowance for
doubtful accounts of $544,244 and $486,066
in 2001 and 2000, respectively 2,025,423 2,988,185
Laboratory supplies 364,985 396,497
Deferred tax asset 471,028 471,339
Prepaid expenses and other current assets 439,200 454,632
------------ ------------
Total current assets 6,411,336 7,745,246
------------ ------------
PROPERTY AND EQUIPMENT, AT COST:
Computer software 1,205,840 1,205,840
Office furniture and equipment 1,603,016 1,476,163
Laboratory equipment 5,406,950 5,007,103
Leasehold improvements 900,336 846,552
------------ ------------
9,116,142 8,535,658
Less - Accumulated depreciation and amortization (6,753,733) (5,552,558)
------------ ------------
2,362,409 2,983,100
------------ ------------
DEFERRED TAX ASSET 61,120 --
------------ ------------
OTHER ASSETS - NET 273,518 329,551
------------ ------------
$ 9,108,383 $ 11,057,897
============ ============

LIABILITIES AND SHAREHOLDERS' EQUITY

CURRENT LIABILITIES:
Accounts payable $ 376,089 $ 431,846
Accrued expenses 708,724 678,541
Accrued income taxes 498,308 475,604
Deferred revenue 753,283 636,304
------------ ------------
Total current liabilities 2,336,404 2,222,295
------------ ------------
DEFERRED TAX LIABILITY -- 109,432
------------ ------------
COMMITMENTS (Note 7)
SHAREHOLDERS' EQUITY:
Preferred stock, $0.005 par value; authorized
1,000,000 shares; none outstanding -- --
Common stock, $0.005 par value; authorized
50,000,000 shares; issued 22,625,315 shares
in 2001 and 22,612,440 shares in 2000 113,127 113,062
Paid-in capital 24,486,747 24,445,386
Accumulated deficit (10,324,621) (8,441,892)
Less - Treasury stock, at cost;
1,588,420 common shares in 2001 and
1,459,064 common shares in 2000 (7,503,274) (6,998,767)
Less - Receivable from officer -- (391,619)
------------ ------------
Total shareholders' equity 6,771,979 8,726,170
------------ ------------
$ 9,108,383 $ 11,057,897
============ ============

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

F-2

PSYCHEMEDICS CORPORATION
STATEMENTS OF INCOME

YEARS ENDED DECEMBER 31,
-------------------------------------------
2001 2000 1999
----------- ----------- -----------

REVENUE $15,730,106 $19,219,700 $19,622,625
COST OF REVENUE 7,815,019 8,895,148 8,453,261
----------- ----------- -----------
Gross profit 7,915,087 10,324,552 11,169,364
----------- ----------- -----------
OPERATING EXPENSES:
General and administrative 3,128,280 3,288,951 3,067,062
Marketing and selling 3,855,429 4,130,197 4,029,219
Research and development 608,186 475,700 526,212
----------- ----------- -----------
7,591,895 7,894,848 7,622,493
----------- ----------- -----------
Income from operations 323,192 2,429,704 3,546,871
----------- ----------- -----------
OTHER INCOME
Interest income 125,333 261,644 387,693
Other income -- 200,000 --
----------- ----------- -----------
Other income 125,333 461,644 387,693
----------- ----------- -----------
INCOME BEFORE PROVISION FOR INCOME TAXES 448,525 2,891,348 3,934,564
PROVISION FOR INCOME TAXES 216,000 1,192,750 1,609,000
----------- ----------- -----------
NET INCOME $ 232,525 $ 1,698,598 $ 2,325,564
=========== =========== ===========
BASIC NET INCOME PER SHARE $ 0.01 $ 0.08 $ 0.11
=========== =========== ===========
DILUTED NET INCOME PER SHARE $ 0.01 $ 0.08 $ 0.11
=========== =========== ===========
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING, BASIC 21,140,829 21,224,277 21,823,650
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING, ASSUMING DILUTION 21,346,286 21,496,870 22,055,990

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

F-3

PSYCHEMEDICS CORPORATION
STATEMENTS OF SHAREHOLDERS' EQUITY

COMMON STOCK TREASURY STOCK
-------------------- ----------------------
$0.005 PAID-IN ACCUMULATED RECEIVABLE
SHARES PAR VALUE CAPITAL DEFICIT SHARES COST FROM OFFICER TOTAL
---------- --------- ----------- ------------ ---------- ----------- ------------ -----------

BALANCE, December 31, 1998 22,607,290 $113,036 $24,403,949 $ (5,585,453) 533,664 $(2,645,232) $(403,791) $15,882,509

Exercise of stock options 5,150 26 7,575 -- -- -- -- 7,601
Tax benefits from the
exercise of stock options -- -- 3,461 -- -- -- -- 3,461
Payments on receivable from
officer -- -- -- -- -- -- 8,121 8,121
Cash dividends declared
($0.16 per share) -- -- -- (3,486,268) -- -- -- (3,486,268)
Acquisition of treasury stock -- -- -- -- 638,800 (2,935,061) -- (2,935,061)
Net income -- -- -- 2,325,564 -- -- -- 2,325,564
---------- -------- ----------- ------------ ---------- ----------- --------- -----------
BALANCE, December 31, 1999 22,612,440 113,062 24,414,985 (6,746,157) 1,172,464 (5,580,293) (395,670) 11,805,927

Compensation expense from
issuance of options -- -- 30,401 -- -- -- -- 30,401
Payments on receivable from
officer -- -- -- -- -- -- 4,051 4,051
Cash dividends declared
($0.16 per share) -- -- -- (3,394,333) -- -- -- (3,394,333)
Acquisition of treasury stock -- -- -- -- 286,600 (1,418,474) -- (1,418,474)
Net income -- -- -- 1,698,598 -- -- -- 1,698,598
---------- -------- ----------- ------------ ---------- ----------- --------- -----------
BALANCE, December 31, 2000 22,612,440 113,062 24,445,386 (8,441,892) 1,459,064 (6,998,767) (391,619) 8,726,170

Exercise of stock options 12,875 65 28,750 -- -- -- -- 28,815
Tax benefits from the
exercise of stock options -- -- 10,101 -- -- -- -- 10,101
Compensation expense from
issuance of options -- -- 2,510 -- -- -- -- 2,510
Reduction of receivable from
officer -- -- -- -- -- -- 391,619 391,619
Cash dividends declared
($0.10 per share) -- -- -- (2,115,254) -- -- -- (2,115,254)
Acquisition of treasury stock -- -- -- -- 129,356 (504,507) -- (504,507)
Net income -- -- -- 232,525 -- -- -- 232,525
---------- -------- ----------- ------------ ---------- ----------- --------- -----------
BALANCE, December 31, 2001 22,625,315 $113,127 $24,486,747 $(10,324,621) $1,588,420 $(7,503,274) $ -- $ 6,771,979
========== ======== =========== ============ ========== =========== ========= ===========

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

F-4

PSYCHEMEDICS CORPORATION
STATEMENTS OF CASH FLOWS

YEARS ENDED DECEMBER 31,
---------------------------------------------
2001 2000 1999
----------- ----------- -----------

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 232,525 $ 1,698,598 $ 2,325,564
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 1,267,507 1,276,631 1,323,411
Compensation expense from issuance of options 2,510 30,401 --
Deferred income taxes (170,241) (191,675) 70,768
Changes in current assets and liabilities:
Accounts receivable 962,762 231,325 (143,892)
Laboratory supplies 31,512 52,606 60,913
Prepaid expenses and other current assets 15,432 102,644 (74,888)
Accounts payable (55,757) (80,734) (162,492)
Accrued expenses 30,183 204,816 (109,029)
Accrued income taxes 22,704 106,539 206,708
Deferred revenue 116,979 (225,784) (574,579)
Tax benefit associated with exercise of options 10,101 -- 3,461
----------- ----------- -----------
Net cash provided by operating activities 2,466,217 3,205,367 2,925,945
----------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net sales of short-term investments -- 4,938,463 4,149,973
Purchases of property and equipment (580,484) (776,345) (495,662)
Increase in other assets (10,299) (23,523) --
----------- ----------- -----------
Net cash provided by (used in) investing activities (590,783) 4,138,595 3,654,311
----------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the exercise of stock options 28,815 -- 7,601
Proceeds from the receivable from officer -- 4,051 8,121
Dividends paid (2,115,254) (3,394,333) (3,486,268)
Acquisition of treasury stock (112,888) (1,418,474) (2,935,061)
----------- ----------- -----------
Net cash used in financing activities (2,199,327) (4,808,756) (6,405,607)
----------- ----------- -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS (323,893) 2,535,206 174,649
CASH AND CASH EQUIVALENTS, beginning of year 3,434,593 899,387 724,738
----------- ----------- -----------
CASH AND CASH EQUIVALENTS, end of year $ 3,110,700 $ 3,434,593 $ 899,387
=========== =========== ===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:

Cash paid for income taxes $ 371,332 $ 1,277,886 $ 1,334,985
=========== =========== ===========
SUPPLEMENTAL DISCLOSURE OF NON-CASH TRANSACTIONS:
Retirement of fully depreciated fixed assets $ -- $ 813,173 $-
=========== =========== ===========
Treasury stock acquired as settlement of
receivable from officer $ 391,619 $ -- $ --
=========== =========== ===========

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

F-5

PSYCHEMEDICS CORPORATION

NOTES TO FINANCIAL STATEMENTS

DECEMBER 31, 2001

1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The Company

Psychemedics Corporation (the Company) was incorporated in 1986. The Company
utilizes a patented hair analysis method involving radioimmunoassay technology
to analyze human hair to detect abused substances. The founder of the Company
has granted to the Company an exclusive license to all his rights in this hair
analysis technology, including his rights to the drug extraction method (see
Note 3).

The Company is subject to a number of risks and uncertainties similar to those
of other companies, such as those associated with the continued expansion of the
Company's sales and marketing network, development of markets for new products
and services offered by the Company, the economic health of principal customers
of the Company, financial and operational risks associated with possible
expansion of testing facilities used by the Company, government regulation
(including, but not limited to, Food and Drug Administration regulations),
competition and general economic conditions.

Management Estimates

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

Cash Equivalents

The Company considers all highly liquid investments with original maturities of
90 days or less from the date of purchase to be cash equivalents. Cash
equivalents consist principally of money market accounts at December 31, 2001,
and money market accounts and commercial paper at December 31, 2000.

F-6

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

Property and Equipment

Property and equipment are stated at cost. Depreciation and amortization are
provided over the estimated useful lives of the assets, using the straight-line
method. The estimated useful lives of the assets are as follows:

Computer software 5 years
Office furniture and equipment 5 to 7 years
Laboratory equipment 5 to 7 years
Leasehold improvements Lesser of 5 years or life of lease

Other Assets

Other assets primarily consist of capitalized legal costs relating to patent
applications on the Company's drug extraction method. The Company is amortizing
the cost of these patents over 10 years from the date of grant. The Company
recorded amortization of $66,332, $64,937 and $63,960 in 2001, 2000 and 1999,
respectively. In accordance with SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, the Company
evaluates the realizability of its patents based on estimated cash flows to be
generated from such assets as compared to the original estimates. To the extent
an impairment is identified, the Company will recognize a write-down of the
related assets. To date, no impairment has been identified.

Revenue Recognition

Except as described herein, revenues from the Company's services are recognized
upon reporting of drug test results to the customer. Revenues related to sample
collection kits not returned for processing by customers are recognized when the
likelihood of the Company performing any service obligation is deemed remote.
During 2000 and 1999, the Company recorded $109,000 and $625,000, respectively,
of revenue related to test kits that were sold for which the Company's
obligations to provide service was deemed remote. The Company did not record any
such revenue during 2001. At December 31, 2001 and 2000, the Company had
deferred revenue balances of approximately $753,000 and $636,000, respectively,
reflecting payments for its personal drug testing service received prior to the
performance of the related test.

Income Taxes

The Company accounts for income taxes in accordance with the provisions of SFAS
No. 109, Accounting for Income Taxes. This statement requires the Company to
recognize a current tax liability or asset for current taxes payable or
refundable and a deferred tax liability or asset for the estimated future tax
effects of temporary differences between the financial statement and tax
reporting bases of assets and liabilities to the extent that they are
realizable. Deferred tax expense (benefit) results from the net change in
deferred tax assets and liabilities during the year. A deferred tax valuation
allowance is required if it is more likely than not that all or a portion of the
recorded deferred tax assets will not be realized.

F-7

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

Research and Development Expenses

The Company charges all research and development expenses to operations as
incurred.

Concentration of Credit Risk

The Company has no significant off-balance-sheet or concentration of credit
risk. Financial instruments that potentially subject the Company to
concentrations of credit risk are principally cash equivalents and accounts
receivable. The Company places its investments in highly rated institutions.
Concentration of credit risk with respect to accounts receivable is limited to
certain customers to whom the Company makes substantial sales. To reduce risk,
the Company routinely assesses the financial strength of its customers and, as a
consequence, believes that its accounts receivable credit risk exposure is
limited. The Company maintains an allowance for potential credit losses but
historically has not experienced any significant losses related to individual
customers or groups of customers in any particular industry or geographic area.

Significant Customers

No single customer accounted for greater than 10% of revenues in 2001, 2000 or
1999. As of December 31, 2001 and 2000, no single customer accounted for greater
than 10% of total accounts receivable.

Basic and Diluted Net Income per Share

In accordance with SFAS No. 128, Earnings per Share, basic net income per share
is computed by dividing net income available to common shareholders by the
weighted average number of common shares outstanding during the period. Diluted
net income per share is computed by dividing net income by the weighted average
number of common and dilutive common equivalent shares outstanding during the
period. The number of dilutive common equivalent shares outstanding during the
period has been determined in accordance with the treasury-stock method. Common
equivalent shares consist of common stock issuable upon the exercise of
outstanding options.

Basic and diluted weighted average common shares outstanding are as follows:

2001 2000 1999
---------- ---------- ----------

Weighted average common shares
outstanding 21,140,829 21,224,277 21,823,650
Dilutive common equivalent shares 205,457 272,593 232,340
---------- ---------- ----------
Weighted average common shares
outstanding, assuming dilution 21,346,286 21,496,870 22,055,990
========== ========== ==========

For the years ending December 31, 2001, 2000, and 1999, options to purchase
1,414,370, 1,086,070 and 752,570 common shares, respectively, were outstanding
but

F-8

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

not included in the dilutive common equivalent share calculation as their effect
would have been antidilutive.

Financial Instruments

SFAS No. 107, Disclosures about Fair Value of Financial Instruments, requires
disclosure about the fair value of financial instruments. Financial instruments
principally consist of cash equivalents, accounts receivable and accounts
payable. The estimated fair values of these financial instruments approximates
their carrying values due to short-term nature of these financial instruments
and, except for accounts receivable and accounts payable, is based primarily on
market quotes. The Company's cash equivalents are generally money market
accounts and commercial paper.

Comprehensive Income

SFAS No. 130, Reporting Comprehensive Income, requires disclosure of all
components of comprehensive income on an annual and interim basis. Comprehensive
income is defined as the change in equity of a business enterprise during a
period from transactions and other events and circumstances from nonowner
sources. The Company's comprehensive income was the same as reported net income
for all periods presented.

Segment Reporting

SFAS No. 131, Disclosures About Segments of an Enterprise and Related
Information, establishes standards for reporting information regarding operating
segments in annual financial statements and requires selected information for
those segments to be presented in interim financial reports issued to
shareholders. SFAS No. 131 also establishes standards for related disclosures
about products and services and geographic areas. To date, the Company has
managed its operations as one segment, drug testing services. As a result, the
financial information disclosed herein materially represents all of the
financial information related to the Company's principal operating segment.
Substantially all of the Company's revenues are generated in the United States.
All of the Company's assets are located in the United States.

Software Development Costs

Computer software costs associated with internal use software are charged to
operations as incurred until certain capitalization criteria have been met. As
of December 31, 2001 and 2000, $1,205,840 of software development costs have
been capitalized. During the years ended December 31, 2001, 2000 and 1999,
$241,176, $241,176 and $240,848 of related amortization was charged to
operations, respectively.

F-9

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

Derivative Instruments and Hedging Activities

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as
amended by SFAS No. 137 and SFAS No. 138, establishes accounting and reporting
standards for derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. It requires entities to
recognize all derivatives as either assets or liabilities in the statement of
financial position and to measure those instruments at fair value. The adoption
of these statements did not have a material impact on the Company's financial
position or results of operations. As of December 31, 2001, the Company did not
have any derivatives or other financial instruments.

Critical Accounting Policies

Management believes the most critical accounting policies include revenue
recognition and income taxes.

Revenue Recognition

Revenues from the Company's services are recognized upon reporting of drug test
results to the customer. Revenues related to sample collection kits not returned
for processing by customers are recognized when the likelihood of the Company
performing any service obligation is deemed remote.

Income Taxes

As part of the process of preparing the Company's financial statements, the
Company is required to estimate income taxes in each of the jurisdictions in
which it operates. This process involves the preparation of an estimate of the
Company's actual current tax exposure together with assessing temporary
differences resulting from differing treatment of items, such as deferred
revenue, for tax and accounting purposes. These differences result in deferred
tax assets and liabilities, which are included within the balance sheet. The
Company must then assess the likelihood that the deferred tax assets will be
recovered from future taxable income and to the extent it believes that recovery
is not likely, it must establish a valuation allowance. To the extent the
Company establishes a valuation allowance or increase this allowance in a
period, it must include an expense within the tax provision in the statement of
operations.

Significant management judgment is required in determining the provision for
income taxes, deferred tax assets and liabilities and any valuation allowance
recorded against net deferred tax assets. In the event that actual results
differ from these estimates or the Company adjusts these estimates in future
periods, it may need to establish a valuation allowance, which could materially
impact the Company's financial position and results of operations.

The above listing is not intended to be a comprehensive list of all of the
Company's accounting policies. In many cases, the accounting treatment of a
particular transaction is specifically dictated by accounting principles
generally accepted in the United States, with no need for management's judgment
in their application. There are also areas in

F-10

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

which management's judgment in selecting any available alternative would not
produce a materially different result.

New Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No.
142, Goodwill and Other Intangible Assets. SFAS No. 142 eliminates the
amortization of goodwill and certain other intangibles and instead subjects
these assets to periodic impairment assessments. SFAS No. 142 is effective
immediately for all goodwill and certain other intangible assets acquired after
June 30, 2001 and shall commence on January 1, 2002 for all goodwill and certain
other intangibles existing on June 30, 2001. The adoption of this statement is
not expected to have a material impact on the Company's financial position or
results of operations.

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, which supercedes SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of.
SFAS No. 144 further refines the requirements of SFAS No. 121 that companies (1)
recognize an impairment loss only if the carrying amount of a long-lived asset
is not recoverable based on its undiscounted future cash flows and (2) measure
an impairment loss as the difference between the carrying amount and fair value
of the asset. In addition, SFAS No. 144 provides guidance on accounting and
disclosure issues surrounding long-lived assets to be disposed of by sale. The
Company will be required to adopt SFAS No. 144 on January 1, 2002. Management
does not expect the adoption of this statement will have a material impact on
the Company's financial position or results of operations.

2. RECEIVABLE FROM OFFICER

The amounts receivable from officer represent loans made by the Company for the
purchase of common stock by an officer. The notes were repaid during the fourth
quarter of 2001 in a cashless transaction whereby the Company received 99,356
shares held by the officer at the then fair market value of the Company's stock.

3. ROYALTY AGREEMENTS

The Company has a royalty-free license from the founder for the proprietary
rights to the patented hair analysis technology used by the Company in its drug
testing services. The Company has two agreements to sublicense its technology,
which have not generated significant royalties to date.

F-11

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

4. INCOME TAXES

The income tax provisions for the years ended December 31, 2001, 2000 and 1999,
consist approximately of the following:

2001 2000 1999
--------- ---------- ----------

Current -
Federal $ 300,000 $1,071,000 $1,181,000
State 86,000 314,000 357,000
--------- ---------- ----------
386,000 1,385,000 1,538,000
--------- ---------- ----------
Deferred -
Federal (132,000) (149,000) 56,000
State (38,000) (43,000) 15,000
--------- ---------- ----------
(170,000) (192,000) 71,000
--------- ---------- ----------
$ 216,000 $1,193,000 $1,609,000
========= ========== ==========

The provisions for income taxes differ from the amount computed by applying the
statutory federal income tax rate as follows:

2001 2000 1999
---- ---- ----

Federal statutory rate 34.0% 34.0% 34.0%
Increase (decrease) resulting from -
State tax provision, net of federal benefit 6.0 6.0 6.0
Utilization of tax credits -- (1.5) (1.3)
Non-deductible expenses 8.2 2.8 2.2
---- ---- ----
Effective tax rate 48.2% 41.3% 40.9%
==== ==== ====

The components of the net deferred tax assets included in the accompanying
balance sheets are as follows:

2001 2000
-------- ---------

Deferred revenue $301,314 $ 297,674
Nondeductible reserves and accruals 169,714 173,665
Property basis differences 61,120 (109,432)
-------- ---------
Net asset $532,148 $ 361,907
======== =========

The long-term deferred tax asset and long-term deferred tax liability on the
Company's balance sheet as of December, 31, 2001 and 2000, respectively,
principally represents property basis differences.

5. PREFERRED STOCK

The Company's bylaws provide for, and the Board of Directors and stockholders
authorized, 1,000,000 shares of $0.005 par value preferred stock. The Board of
Directors has the authority to issue such shares in one or more series and to
fix the relative rights and preferences without vote or action by the
stockholders. The Board of Directors has no present plans to issue any shares of
preferred stock.

F-12

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

6. STOCK OPTIONS

The Company has various stock option plans under which options to acquire shares
of the Company's common stock may be granted to directors, officers and certain
employees of the Company. Options granted under the plans are non-qualified or
incentive stock options and are granted at a price that is not less than the
fair market value of the common stock at the date of grant. These options have
lives of five or ten years and vest over periods from zero to four years.

A summary of all stock option transactions for the years ended December 31,
2001, 2000 and 1999, is as follows (in thousands, except per share amounts):

Weighted Average
Number of Exercise Price
Shares Per Share
--------- ----------------

Outstanding, December 31, 1998 1,466 $4.43
Granted 391 4.45
Exercised (5) 2.82
Terminated (110) 5.66
----- -----
Outstanding, December 31, 1999 1,742 4.37
Granted 343 4.98
Terminated (20) 4.72
----- -----
Outstanding, December 31, 2000 2,065 4.46
----- -----
Granted 75 4.81
Exercised (13) 2.24
Terminated (82) 6.60
----- -----
Outstanding, December 31, 2001 2,045 $4.40
===== =====
Exercisable, December 31, 2001 1,590 $4.29
===== =====
Exercisable, December 31, 2000 1,382 $4.26
===== =====
Exercisable, December 31, 1999 1,122 $4.07
===== =====

The following table summarizes information about stock options outstanding at
December 31, 2001 (in thousands, except per share amounts):

Options Outstanding Options Exercisable
--------------------------------------------- ------------------------
Weighted Average Weighted Weighted
Number Remaining Average Number Average
Exercise Price of Contractual Life Exercise Price of Exercise Price
Range Shares (in years) Per Share Shares Per Share
- --------------- ------ ---------------- -------------- ------ --------------

$1.85 213 1.93 $1.85 213 $1.85
2.82 - 3.58 392 3.09 2.98 392 2.98
4.28 - 6.22 1,399 6.60 5.11 944 5.26
7.06 41 5.20 7.06 41 7.06
------ ----- ----- -----
2,045 $4.40 1,590 $4.29

F-13

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

SFAS No. 123, Accounting for Stock-Based Compensation, requires the measurement
of the fair value of stock options or warrants to be included in the statement
of income or disclosed in the notes to financial statements. The Company
accounts for stock-based compensation for options granted to employees under
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, electing the disclosure-only alternative under SFAS No. 123. The
Company has computed the value of options using the Black-Scholes option pricing
model prescribed by SFAS No. 123.

The assumptions used and the weighted average information for the years ended
December 31, 2001, 2000 and 1999, are as follows:

2001 2000 1999
------- ------- --------

Risk-free interest rates 4.56% 6.15% 5.54%
Expected dividend yield 2.3% 3.3% 3.5%
Expected lives 5 years 5 years 5 years
Expected volatility 42.22% 44.40% 42.23%
Weighted average grant-date fair value of
options granted during the period $1.74 $1.88 $1.62

Had compensation cost for the Company's stock option plans been determined
consistent with SFAS No. 123, net (loss) income and basic and diluted net (loss)
income per share would have been as follows:

2001 2000 1999
--------- ---------- ----------

As reported -
Net income $ 232,525 $1,698,598 $2,325,564
Basic net income per share $ 0.01 $ 0.08 $ 0.11
Diluted net income per share $ 0.01 $ 0.08 $ 0.11
Pro forma -
Net (loss) income $(175,116) $ 958,048 $1,719,967
Basic net (loss) income per share $ (0.01) $ 0.05 $ 0.08
Diluted net (loss) income per share $ (0.01) $ 0.04 $ 0.08

In 2000, the Company granted options to purchase 20,000 common shares to a
nonemployee that vested ratably over a year. The Company accounts for
stock-based awards granted to nonemployees under Emerging Issues Task Force
(EITF) 96-18, Accounting for Equity Instruments that are Issued to Other than
Employees for Acquiring, or in Connection with Selling, Goods, or Services.
Under EITF 96-18, the fair value of the stock options is charged to operations
over the performance period (vesting period). The Company recognized $2,510 and
$30,401 of stock-based compensation expense during the years ended December 31,
2001 and 2000, respectively, which was included in general and administrative
expenses in the respective statements of income. The Company did not grant any
stock options to nonemployees during 2001 or 1999.

F-14

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

7. COMMITMENTS

The Company leases certain of its facilities and equipment under operating lease
agreements expiring on various dates through December 2005. Total minimum lease
payments, including scheduled increases, are charged to operations on the
straight-line basis over the life of the respective lease. Rent expense for the
years ended December 31, 2001, 2000 and 1999 was approximately $533,000,
$529,000 and $473,000, respectively.

At December 31, 2001, minimum commitments remaining under lease agreements were
approximately as follows:

Amount
----------
Years Ending December 31:
2002 $555,000
2003 509,000
2004 376,000
2005 377,000
----------
$1,817,000
==========

8. EMPLOYEE BENEFIT PLAN

On November 1, 1997, the Company adopted the Psychemedics Corporation 401(k)
Savings and Retirement Plan (the 401(k) Plan). The 401(k) Plan is a qualified
defined contribution plan in accordance with Section 401(k) of the Internal
Revenue Code. All employees over the age of 21 who have completed one year of
service are eligible to make pre-tax contributions up to a specified percentage
of their compensation. Under the 401(k) Plan, the Company may, but is not
obligated to, match a portion of the employees' contributions up to a defined
maximum. A matching contribution of $115,355, $112,339 and $99,683 was made in
2001, 2000 and 1999, respectively.

9. ACCRUED EXPENSES

Accrued expenses consist of the following:

December 31,
--------------------
2001 2000
------- --------
Accrued payroll and employee benefits $397,662 $453,364
Other accrued expenses 311,062 225,177
-------- --------
$708,724 $678,541
======== ========

F-15

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

10. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

The following are selected quarterly financial data for the years ended December
31, 2001 and 2000:

Quarter Ended
--------------------------------------------------------
March 31, June 30, September 30, December 31,
2001 2001 2001 2001
---------- ---------- ------------ -----------

Revenues $4,064,323 $4,518,430 $3,955,117 $3,192,236
Gross profit 2,011,260 2,514,349 1,981,025 1,408,453
(Loss) income from operations (17,802) 532,195 184,411 (375,612)
Net income (loss) 9,241 328,235 116,271 (221,222)
Basic net income (loss) per share -- 0.02 0.01 (0.01)
Diluted net income (loss) per share -- 0.02 0.01 (0.01)

Quarter Ended
--------------------------------------------------------
March 31, June 30, September 30, December 31,
2000 2000 2000 2000
---------- ---------- ------------ -----------

Revenues $4,682,027 $5,472,701 $5,021,437 $4,043,535
Gross profit 2,531,841 3,119,607 2,757,522 1,915,582
Income (loss) from operations 660,399 1,094,763 708,800 (34,528)
Net income 554,744 677,915 450,478 15,461
Basic net income per share 0.03 0.03 0.02 --
Diluted net income per share 0.03 0.03 0.02 --

11. VALUATION AND QUALIFYING ACCOUNTS

A summary of the allowance for doubtful accounts is as follows:

2001 2000 1999
--------- --------- ---------

Balance, beginning of period $ 486,066 $ 312,169 $ 377,000
Provision for doubtful accounts 113,500 176,500 178,377
Write-offs (55,322) (2,603) (243,208)
--------- --------- ---------
Balance, end of period $ 544,244 $ 486,066 $ 312,169
--------- --------- ---------

F-16

PSYCHEMEDICS CORPORATION

10-K

INDEX TO EXHIBITS

EXHIBIT
NUMBER DESCRIPTION
- ------ -----------

3 ARTICLES OF INCORPORATION AND BY-LAWS

3.1 Certificate of Incorporation filed September 24, 1986 - (Incorporated
by reference from the Registrant's Registration Statement on Form
S-18, File No. 33-10186 LA).

3.2 Amendment to Certificate of Incorporation filed October 29, 1986 -
(Incorporated by reference from the Registrant's Registration
Statement on Form S-18, File No. 33-10186 LA).

3.3 Amendment to Certificate of Incorporation filed July 12, 1989 -
(Incorporated by reference from the Registrant's Annual Report on Form
10-K for the fiscal year ended June 30, 1989.)

3.4 Amendment to Certificate of Incorporation filed August 7, 1990 -
(Incorporated by reference from the Registrant's Quarterly Report on
Form 10-Q for the Quarter ended September 30, 1990 as amended by a
First Amendment on Form 8 filed December 15, 1990.)

3.5 Amendment to Certificate of Incorporation filed May 9, 1991 -
(Incorporated by reference from the Registrant's Quarterly Report on
Form 10-Q for the quarter ended June 30, 1991.)

3.6 By-Laws of the Company Filed herewith

4 INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS

4.1 Specimen Stock Certificate - (Incorporated by reference from the
Registrant's Registration Statement on Form S-18, File No. 33-10186
LA).

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

EXHIBIT
NUMBER DESCRIPTION
- ------ -----------

10 MATERIAL CONTRACTS

10.1 License Agreement with Werner Baumgartner, Ph.D. and Annette
Baumgartner dated January 17, 1987 - (Incorporated by reference from
the Registrant's Registration Statement on Form S-18, File No.
33-10186 LA).

10.2* 1989 Employee Stock Option Plan, as amended - (Incorporated by
reference from the Registrant's 1997 Annual Proxy Statement.)

10.3* 1989 Non-Qualified Stock Option Plan, as amended (Incorporated by
reference from the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1996. 10.4* 1991 Non-Qualified Stock
Option Plan - (Incorporated by reference from the Registrant's Annual
Report on Form 10-K for the fiscal year ended December 31, 1991.)

10.5 Lease dated October 6, 1992 with Mitchell H. Hersch, et. al with
respect to premises in Culver City, California - (Incorporated by
reference from the Registrant's Annual Report on Form 10-KSB for for
the fiscal year ended December 31, 1992.)

10.5.1 Security Agreement dated October 6, 1992 with Mitchell H. Hersch et.
al - (Incorporated by reference from the Registrant's Annual Report on
Form 10-KSB for the fiscal year ended December 31, 1992.)

10.5.2 First Amendment to Lease dated with Mitchell H. Hersch, et.al
California - (Incorporated by reference from the Registrant's Annual
Report on Form 10-K for for the fiscal year ended December 31, 1997.)

10.5.3 Second Amendment to Lease dated with Mitchell H. Hersch, et.al.
California - (Incorporated by reference from the Registrant's Annual
Report on Form 10-K for for the fiscal year ended December 31, 1997.)

PSYCHEMEDICS CORPORATION
NOTES TO FINANCIAL STATEMENTS - (CONTINUED)

EXHIBIT
NUMBER DESCRIPTION
- ------ -----------
10.5.4 Third Amendment to Lease dated December 31, 1997 with Mitchell H.
Hersch, et.al. California - (Incorporated by reference from the
Registrant's Annual Report on Form 10-K for for the fiscal year ended
December 31, 1997.)

10.6* 2000 Employee Stock Option Plan, - (Incorporated by reference from the
Registrant's 2000 Annual Proxy Statement.)

23 Consents of Experts and Counsel

23.1 Consent of Arthur Andersen LLP Filed herewith

99 Additional Exhibits

99.1 Letter to Commission Pursuant to Temporary Note 3T Filed herewith

* Represents a management contract or compensatory plan in which a
director or named executive officer of the Registrant participates.