AMERICA SERVICE GROUP INC /DE - 10-K Annual Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

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FORM 10-K

[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [NO FEE REQUIRED]

For the fiscal year ended December 31, 1997

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

For the transition period from to
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Commission file number 0-23340

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AMERICA SERVICE GROUP INC.
(Exact name of registrant as specified in its charter)

DELAWARE 51-0332317
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification no.)

105 WESTPARK DRIVE, SUITE 300 37027
BRENTWOOD, TENNESSEE 37027 (Zip code)
(Address of principal executive offices)

Registrant's telephone number, including area code: (615) 373-3100

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: None

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: Common Stock, par
value $.01 per share

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-K 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. [ ]

The aggregate market value of the voting stock held by non-affiliates
of the registrant as of March 27, 1998 (based on the last reported closing price
per share of Common Stock as reported on The Nasdaq National Market on such
date) was approximately $37,305,844 As of March 27, 1998, the registrant had
3,528,645 shares of Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the Annual Meeting of Shareholders
to be held on May 19, 1998 are incorporated by reference in Part III.
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PART I

ITEM 1. BUSINESS.

This Form 10-K contains statements which may constitute "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended.
Those statements include statements regarding the intent, belief or current
expectations of America Service Group Inc. and members of its management team.
Prospective investors are cautioned that any such forward-looking statements are
not guarantees of future performance and involve risks and uncertainties, and
that actual results may differ materially from those contemplated by such
forward-looking statements. Important factors currently known to management that
could cause actual results to differ materially from those in forward-looking
statements are set forth below under the caption "Cautionary Statements."
America Service Group Inc. undertakes no obligation to update or revise
forward-looking statements to reflect changed assumptions, the occurrence of
unanticipated events or changes to future operating results over time.

GENERAL

America Service Group Inc. ("ASG" or the "Company"), through its
subsidiary Prison Health Services, Inc. ("PHS"), contracts to provide managed
healthcare services to correctional facilities throughout the United States. ASG
was incorporated in 1990 as a holding company for PHS. Unless the context
otherwise requires, the term "Company" refers to ASG and to its direct and
indirect subsidiaries. ASG's executive offices are located at 105 Westpark
Drive, Suite 300 Brentwood, Tennessee, 37027. Its telephone number is (615)
373-3100.

RECENT DEVELOPMENTS

On October 1, 1997, the Company entered into a Plan and Agreement of
Merger (the "Merger Agreement") with MedPartners, Inc., a Delaware corporation
("MedPartners"), and a wholly owned subsidiary of MedPartners, pursuant to which
the Company would have been acquired by MedPartners (the "Merger"). In
connection with the Merger, each issued and outstanding share of the Company's
Common Stock, $0.01 par value per share (the "Company's Common Stock"), would
have been converted into the right to receive 0.71 of a share of MedPartners'
Common Stock. On October 29, 1997, MedPartners entered into a Plan and Agreement
of Merger (the "PhyCor Merger Agreement") with PhyCor, Inc., a Delaware
corporation ("PhyCor"), pursuant to which MedPartners would have been acquired
by PhyCor (the "MedPartners/PhyCor Merger") and each issued and outstanding
share of MedPartners' Common Stock would have been converted into the right to
receive 1.18 shares of PhyCor Common Stock.

On November 20, 1997, the Company mailed a proxy statement to the
holders of its Common Stock relating to a special meeting of the Company's
stockholders scheduled to be held on December 29, 1997, for the purpose of
considering and voting upon the Merger. On December 29, the Company postponed
the special meeting at the request of MedPartners until January 20, 1998. On
January 7, 1998, MedPartners announced that the PhyCor Merger Agreement had been
terminated by the mutual agreement of MedPartners and PhyCor. In a related
announcement also on January 7, 1998, MedPartners stated that it expected to
record pre-tax charges to earnings in the fourth quarter of 1997 of
approximately $115 million related to the restructuring of certain of its
operating units and $30 million related to certain discontinued operations.
MedPartners further announced that it estimated that it could incur a loss in
the fourth quarter of 1997 from continuing operations in the range of $0.20 to
$0.25 per share and that its earnings per share in 1998 would be approximately
30% less than analysts' current consensus estimates. Following the announcements
by MedPartners, the price of a share of its Common Stock fell below $17.50.
Pursuant to the Merger Agreement, if the average price of MedPartners Common
Stock was less than $17.50 for a consecutive 30-day trading period prior to
consummation of the Merger, the Company had the right to terminate the Merger
Agreement.

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On January 20, 1998, the Company announced that it would not hold the
special meeting of its stockholders originally scheduled for December 29, 1997,
and that it was engaged in discussions with MedPartners regarding the Merger
Agreement. On February 26, 1998, the Company announced the termination of the
Merger Agreement and the execution of a Release and Settlement Agreement (the
"Settlement Agreement") with MedPartners relating to the Merger Agreement.
Pursuant to the Settlement Agreement, MedPartners agreed to pay the Company
approximately $3.5 million in cash and to reimburse or assume certain other
costs incurred by the Company in connection with the Merger in the amount of
approximately $2.0 million. The Company and MedPartners and certain of their
respective affiliates also entered into a Non-Compete, Non-Solicitation and
Standstill Agreement (the "Non-Competition Agreement") in connection with the
termination of the Merger Agreement.

CORRECTIONAL HEALTHCARE SERVICES

Generally. ASG, through PHS, contracts with state, county and local
governmental agencies to provide comprehensive healthcare services to inmates of
prisons and jails, with a focus on those facilities that maintain an average
daily population of over 300 inmates.

ASG generally enters into fixed fee contracts to provide comprehensive
healthcare to inmates from their admission to the facility through their
release. All of ASG's revenues from correctional healthcare services are
generated by payments from governmental agencies, none of which are dependent on
third party payment sources. Services provided by ASG include a wide range of
on-site healthcare programs, as well as off-site hospitalization and specialty
outpatient care. See "--Services Provided." Hospitalization and most outpatient
care is performed through subcontract arrangements with independent doctors and
local hospitals.

The following table sets forth information regarding ASG's correctional
contracts.

December 31
1997 1996 1995 1994 1993
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Number of correctional contracts (1) 31 34 35 35 41
Average number of inmates in all facilities
covered by correctional contracts (2) 54,364 83,288 82,310 51,939 46,509

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(1) Indicates the number of contracts in force at the end of the period
specified.

(2) Based on an average number of inmates during the last month of each
period specified, as used by ASG for billing purposes.

ASG's target correctional market consists of state prisons and county
and local jails. A prison is a facility in which an inmate is incarcerated for
an extended period of time (typically one year or longer). A jail is a facility
in which the inmate is held for a shorter period of time, often while awaiting
trial or sentencing. The higher inmate turnover in jails requires that
healthcare be provided to a much larger number of individual inmates over time.
Conversely, the costs of long-term healthcare requirements are greater with
respect to state prison contracts. State prison contracts often cover a larger
number of facilities and often have longer terms than jail contracts.

Services Provided. Generally, ASG's obligation to provide services to a
particular inmate begins upon the inmate's admission into the correctional
facility and ends upon the inmate's release. Emphasis is placed upon early
identification of serious injuries or illnesses so that prompt and
cost-effective treatment is commenced.

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Medical services provided on-site include physical and mental health
screening upon intake. Screening includes the compilation of the inmate's health
history and the identification of any current, chronic or acute healthcare
needs. After initial screening, services provided may include regular physical
and dental screening and care, psychiatric care, OB-GYN screening and care and
diagnostic testing. Sick call is held on a regular basis and infirmary bed care
is provided in some facilities. Nursing rounds are regularly conducted and
physicians, nurse practitioners, physicians' assistants and others are also
involved in the delivery of care on a regular basis. Appropriate medications are
administered by nursing staff, as needed.

Medical services provided off-site include specialty out-patient
diagnostic testing and care, emergency room care, surgery and hospitalization.
In addition, ASG provides administrative support services both on-site and at
ASG's headquarters and regional offices. Administrative programs include on-site
medical records and management and employee education and licensing. Central and
regional offices provide quality assurance, medical audits, credentialing,
continuing education and clinical program development activities. ASG maintains
a utilization review system to monitor the extent and duration of most
healthcare services required by inmates on an inpatient and outpatient basis.
See "--Administrative Systems."

ASG staffs most facilities it serves with nurses 24 hours a day. Doctors
at the facilities have regular hours and are generally available on call. In
addition, dentists, psychiatrists and other specialists are often available on a
routine basis. ASG enters into contractual arrangements with independent doctors
and local hospitals with respect to more significant off-site procedures and
hospitalization. ASG is responsible for all of the costs of such arrangements,
unless the relevant contract contains a limit on ASG's obligations in connection
with the treatment costs. See "--Contract Provisions."

The National Commission on Correctional Health Care (the "NCCHC") sets
standards for the correctional healthcare industry and offers accreditation to
facilities that meet its standards. These standards provide specific guidance
related to a service provider's operations including administration, personnel,
support services such as hospital care, regular services such as sick call,
records management and medical and legal issues. Although accreditation is
voluntary, many contracts require compliance with NCCHC standards.

Contract Provisions. ASG's correctional contracts generally provide for
a fixed annual fee, payable monthly, often in advance. In addition to the fixed
annual fee, some of ASG 's contracts provide for per diem price adjustments
based upon fluctuations in the size of inmate populations beyond a specified
range. Certain contracts also provide for annual increases in the fixed fee
based upon the regional medical care component of the Consumer Price Index. In
all other contracts that extend beyond one year, ASG utilizes a projection of
the future inflation rate when bidding and negotiating the fixed fee for future
years. ASG bears the risk of increased or unexpected costs, which could reduce
its profits or cause it to sustain losses, and benefits when costs are lower
than projected. Certain contracts also contain financial penalties when
performance criteria are not achieved.

Contracts accounting for approximately 46% of revenues for the year
ended December 31, 1997, including ASG's contracts with the Indiana Department
of Correction (the "Indiana Contract"), Delaware Department of Corrections,
Kansas Department of Corrections, and Alameda County, California, contain no
limits on ASG's exposure for treatment costs related to catastrophic illnesses
or injuries to inmates. Although the specific terms of the limits vary,
typically a dollar limit is placed on ASG's responsibility for costs related to
illness of or injury to an individual inmate, injuries to more than one inmate
resulting from an accident, or contagious illnesses, such as hepatitis,
affecting more than one inmate. When preparing bid proposals, ASG estimates the
extent of its exposure to cost increases, severe individual cases and
catastrophic events and attempts to compensate for its exposure in the pricing
of its bids. ASG's management has experience in evaluating these risks for
bidding purposes and maintains an extensive database of historical experience.
Nonetheless, increased or unexpected costs against which ASG is not protected
could render a contract unprofitable.

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In an effort to manage risk of catastrophic illness or injury of inmates
under contracts that do not limit ASG's exposure to such risk, ASG maintains
insurance from an unaffiliated insurer covering hospitalization for amounts in
excess of $125,000 per inmate. ASG believes this insurance mitigates its
exposure to unanticipated expenses of catastrophic hospitalization.

In general, contracts may be terminated by the governmental agency, and
often by ASG as well, without cause at any time upon proper notice (typically
between 30 and 180 days). Governmental agencies may be subject to political
influences that could lead to termination of a contract with no fault of the
contractor. As with other governmental contracts, ASG's contracts are subject to
adequate budgeting and appropriation of funds by the governing legislature or
administrative body.

The Indiana Contract provides for a fixed payment, per inmate, per day.
The remainder of ASG's largest existing contracts for the year ended December
31, 1997 -- contracts with the Kansas Department of Corrections, the Delaware
Department of Corrections, Alameda County, California, and the City of
Philadelphia, Pennsylvania -- provide for per diem price adjustments based upon
fluctuations in the size of inmate populations beyond a specified range. The
fixed fees under all five contracts take into account projected levels of
inflation. Of the aforementioned contracts, only the contracts with the City of
Philadelphia significantly limits ASG's obligations for treatment costs for
catastrophic illnesses and injuries. The restrictions imposed under that
contract are currently scheduled to expire in July 1998. See "-- Major
Contracts."

Administrative Systems. ASG has centralized its administrative systems
in order to enhance economies of scale and to provide management with accurate,
up-to-date field data for forecasting purposes. These systems also enable ASG to
bid more accurately and help ASG reduce the costs associated with the delivery
of consistent healthcare.

ASG maintains a utilization review system to monitor the extent and
duration of most healthcare services required by inmates on an inpatient and
outpatient basis. The current automated utilization review program is an
integral part of the services provided at each facility. The system is designed
to ensure that the medical care rendered is medically necessary and is provided
safely in the least costly setting while maintaining traditional standards of
quality of care. The program provides for determinations of medical necessity by
medical professionals through a process of pre-authorization and concurrent
review of the appropriateness of any hospital stay. The program seeks to
identify the maximum capability of on-site healthcare units so as to allow for a
more timely discharge from the hospital back to the correctional facility. The
utilization review staff consists of nurses who are supported by a medical
director at the corporate level and a panel of medical specialists who are
consultants to ASG.

ASG has developed a variety of customized databases to facilitate and
improve operational review including (i) a claims management tracking system
that monitors current incidents, claims and litigation against ASG and tracks
the types of claims historically brought against ASG, (ii) a comprehensive cost
review system that analyzes ASG's average costs per inmate at each facility and
(iii) a daily operating report to control staffing and off-site utilization.

Bid Process. Contracts with governmental agencies are obtained primarily
through the competitive bidding process, which is governed by applicable state
and local statutes and ordinances. Although practices vary, typically a formal
request for proposal ("RFP") is issued stating the scope of work to be
performed, length of contract, performance bonding requirements, minimum
qualifications of bidders, selection criteria and the format to be followed in
the bid or proposal. Usually, a committee appointed by the governmental agency
reviews bids and makes an award determination. The committee may award the
contract to a particular bidder or decide not to award the contract to the
private sector.

The award of a contract may be subject to formal or informal protest,
through a governmental appeals process, by unsuccessful bidders. There can be no
assurance that future protests will not have a material effect on the Company.

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Many RFPs for significant contracts require the bidder to post a bid
bond. Performance bonding requirements are for the length of the contract and at
December 31, 1997, generally ranged between 4% and 60% (and in one case, 100%)
of the 1997 contract fee. ASG is required to collateralize 10% to 15% of the
amount of its performance bonds.

A successful bidder must often agree to comply with numerous additional
requirements regarding record-keeping and accounting, non-discrimination in the
hiring of personnel, safety, safeguarding classified information, management
qualifications, professional licensing requirements and other matters. Upon a
violation of the terms of an applicable contractual or statutory provision, a
contractor may be debarred or suspended from obtaining future contracts for
specified periods of time in the applicable location. ASG has never been
debarred or suspended in any jurisdiction.

Marketing. ASG gathers and analyzes information on prisons and jails
around the country in order to identify the ones that best meet its marketing
criteria. Relevant factors include the quality and costs of healthcare in the
region, the management and operations of the correctional facility, the
financial stability of the governmental agency and the composition of the inmate
population. ASG then devotes a substantial portion of its marketing resources to
such potential customers. State prison systems, because of their more stable
inmate populations and, in many cases, larger number of facilities and longer
contract terms, are an important focal point of ASG's marketing plans. Also, ASG
will continue to identify those county and local jails that fit its market
profile and will pursue those contracts aggressively.

ASG maintains a small staff of sales and marketing representatives
assigned to specific geographic areas of the United States. In addition, ASG
uses consultants to help identify marketing opportunities, to determine the
needs of specific potential customers and to engage customers on ASG's behalf.
ASG uses paid advertising and promotion to reach prospective clients as well as
to reinforce its image with existing clients.

Risk Management. In March 1988, ASG formed Harbour Insurance, Inc.
("Harbour") as a wholly owned subsidiary of PHS. Harbour is a captive insurance
company organized and regulated under the laws of the State of Delaware. Harbour
has issued annual policies of insurance covering PHS' medical professional and
general liability arising out of its provision of healthcare services on a
claims-made basis with limits of $1,000,000 per medical incident for the periods
listed below, except for the period from January 1, 1997 to January 1, 1998,
when an annual policy was issued with limits of $500,000 per medical incident
and expanded coverage from a non-affiliated insurer was obtained. Harbour's
coverage has the following aggregate limits during the specified policy periods:

July 30, 1990 to July 30, 1991 not applicable
July 30, 1991 to July 30,1992 $2,000,000
July 30, 1992 to July 30, 1993 $2,000,000
July 30, 1993 to July 30, 1994 $2,250,000
July 30, 1994 to July 30, 1995 $2,450,000
July 30, 1995 to January 1, 1996 $1,100,000
January 1, 1996 to January 1, 1997 $3,250,000
January 1, 1997 to December 1, 1998 $3,500,000

For the policy year July 30, 1990 to July 30, 1991, PHS has third party
commercial excess insurance in the amount of $4 million, excess over a
self-insured retention of $2 million per medical incident and $2 million in the
aggregate. For each policy period commencing July 30, 1991 or thereafter, PHS
has third party commercial excess insurance, excess over a self-insured
retention in the amount of the respective Harbour limits. For two of those
policy periods (from July 30, 1993 to July 30, 1994 and from July 30, 1994 to
July 30, 1995), PHS quota-shared a portion of the commercial excess insurance,
effectively retaining 30% of the uppermost $3 million exposure within the $5
million commercial excess insurance. For the policy year January 1, 1997 to
January 1, 1998, PHS has third party commercial excess insurance of $15 million
per medical incident and $15 million in the aggregate, excess over a
self-insured retention of $500,000 per medical incident or per occurrence
(exclusive of loss adjustment expenses and attorneys' fees) and $3.5 million
annual aggregate (including loss adjustment expenses and attorneys' fees).

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With respect to the insurance provided by Harbour, only the premiums
paid and Harbour's initial capitalization (which was contributed by ASG) are
available to pay claims. The funding and premiums for Harbour are determined
annually by an independent actuary based upon PHS' prior experience, current
business, and industry data.

In July, 1997, ASG commenced operations under the Indiana Contract. The
Company has third party commercial insurance on an occurrence basis with respect
to the Indiana Contract.

For the period December 1, 1997 through December 31, 1998, ASG has third
party commercial insurance on a claims made basis with primary limits of $1
million each occurrence and $3 million in the aggregate. For the period January
1, 1998 through December 31, 1998, the Company has excess liability coverage on
a claims made basis of $15 million each claim and $15 million annual aggregate,
which excess coverage attaches at the limits of the underlying primary coverage.

Beginning in September 1996, for contracts where ASG's exposure to the
risk of inmates' catastrophic illness or injury is not limited, ASG procured
insurance from an unaffiliated insurer with respect to hospitalization for
amounts in excess of $125,000 per inmate. ASG believes this insurance mitigates
its exposure to unanticipated expenses of catastrophic hospitalization.

There can be no assurance that third-party commercial insurance will
continue to be available in the future or will be available at reasonable
prices. ASG believes its insurance coverage is maintained at reasonable levels,
but there can be no assurance that it will cover all claims that may be asserted
against ASG and its employees and agents.

EMPLOYEES AND INDEPENDENT CONTRACTORS

The services provided by ASG require an experienced staff of healthcare
professionals and facilities administrators. In particular, a nursing staff with
experience in correctional healthcare and specialized skills in all necessary
areas contributes significantly to ASG's ability to provide efficient service.
In addition, ASG maintains a small pool of employees, primarily nurses, who are
available to fill short-term staffing vacancies at any facility serviced by ASG.
In addition to nurses, ASG's staff of employees or independent contractors
includes physicians, dentists, psychologists and other healthcare professionals,
some of whom are independent contractors.

As of December 31, 1997, ASG had approximately 1,645 full-time
equivalent employees, including 1,375 medical personnel. ASG also had under
contract 230 independent contractors, most of whom are part-time, including
physicians, dentists, psychiatrists and psychologists. ASG's employees at its
Alameda County, California, City of Philadelphia and Delaware facilities, are
represented by labor unions. ASG believes that its employee relations are good.

COMPETITION

The business of providing correctional healthcare services to
governmental agencies is highly competitive, and ASG expects price competition
to become more intense. ASG is in direct competition with local, regional and
national correctional healthcare providers, some of which are public entities.
ASG believes that some of its competitors may have larger staffs and greater
resources than ASG. As the private market for providing correctional healthcare
matures, ASG's competitors may gain additional experience in bidding and
administering correctional healthcare contracts. In addition, new competitors,
some of whom may have extensive experience in related fields or greater
financial resources than ASG, may enter the market.

The Company and MedPartners and certain affiliates of MedPartners
entered into the Non-Competition Agreement in connection with the termination of
the Merger Agreement because significant amounts of confidential information
were shared by ASG and MedPartners in preparation for the consummation of the
Merger. Such agreement

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provides that for a period of three years no party may directly or indirectly or
by assisting others (i) compete with any other party to provide services
equivalent to the services provided by any other party to such other party's
existing clients, (ii) recruit or hire away each others employees or (iii)
acquire, conduct a tender offer for or solicit proxies for each others equity
securities or take any other action to effect the control of the management or
the Board of Directors of each other party, among other customary provisions.

MAJOR CONTRACTS

ASG's operating revenue is derived exclusively from contracts with
state, county and local governmental agencies. ASG's contracts with the State of
Kansas and the City of Philadelphia each accounted for approximately 14% of
revenues during the year ended December 31, 1997. The contract with the Georgia
Department of Corrections (the "Georgia Contract"), which expired on June 30,
1997, accounted for 24% of 1997 revenues. Generally, contracts may be
terminated by the governmental agency at will and without cause upon proper
notice (typically between 30 and 180 days). Governmental agencies may be subject
to political influences that could lead to termination of a contract through no
fault of the contractor. Although ASG generally attempts to renew or renegotiate
contracts at or prior to their termination, contracts that are put out for bid
are subject to intense competition. The loss of one or more of the major
contracts could have a material adverse effect on ASG's business.

CAUTIONARY STATEMENTS

All statements made by ASG that are not historical facts are based on
current expectations. These statements are forward looking in nature and involve
a number of risks and uncertainties. Actual results may differ materially. Among
the factors that could cause actual results to differ materially are the
following: dependence on major contracts; price competition in the prison
healthcare industry; ASG's ability to provide adequate staffing to meet its
contractual commitments; changes in performance bonding requirements;
substantial damage awards against ASG in connection with medical malpractice
claims; changes in laws or regulations or the application thereof, general
business and economic conditions, and the other risk factors described in ASG's
reports filed from time to time with the Commission.

Dependence on Major Contracts. ASG's operating revenue is derived
exclusively from contracts with state, county and local governmental agencies.
Generally, contracts may be terminated by the governmental agency at will and
without cause upon proper notice (typically between 30 and 180 days).
Governmental agencies may be subject to political influences that could lead to
termination of a contract through no fault of the contractor. Although ASG
generally attempts to renew or renegotiate contracts at or prior to their
termination, contracts that are put out for bid are subject to intense
competition. The loss of one or more of the major contracts could have a
material adverse effect on ASG's business.

Contracts with government agencies are generally complex in nature and
subject contractors to extensive regulation under state, county and local law.
Under certain circumstances, a government contractor may be debarred or
suspended from obtaining future contracts. While ASG considers the possibility
remote, such debarment or suspension could have a material adverse effect on
ASG.

Privatization of Government Services, Competition and Correctional
Population. ASG's future financial performance will depend in part on continued
privatization by state, county and local governmental agencies of healthcare
services for correctional facilities. There can be no assurance that this market
will continue to grow or that existing contracts will continue to be made
available to the private sector. The business of providing correctional
healthcare services to governmental agencies is highly competitive, and ASG
expects price competition to become more intense. ASG is in direct competition
with local, regional and national correctional healthcare providers, some of
which are public entities. ASG believes that some of its competitors may have
larger staffs and greater resources than ASG. As the private market for
providing correctional healthcare matures, ASG's competitors may gain additional
experience in bidding and administering correctional healthcare contracts. In
addition, new competitors, some of whom may have

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extensive experience in related fields or greater financial resources than ASG,
may enter the market. ASG's business could also be adversely affected by
material decreases in the inmate population of correctional facilities.

Acquisitions. ASG's expansion strategy involves both internal growth
and, as attractive opportunities become available, acquisitions. ASG has limited
experience acquiring businesses and successfully integrating them into its
operations. There can be no assurances that ASG will be able to integrate
successfully any acquired business into its operations. Furthermore, there can
be no assurance that ASG will be able to operate an acquired business in a
profitable manner.

Operating Results. ASG incurred an operating loss before extraordinary
items in the year ended December 31, 1996 due primarily to operating losses in
connection with the Georgia Contract, the pending expiration of the Georgia
Contract and non-recurring charges relating to executive compensation and
corporate reengineering and downsizing. There can be no assurances that ASG will
generate increased revenues or that additional revenues will generate operating
profits. ASG has in the past operated contracts at low profitability or a loss,
and there can be no assurances that ASG will be able to operate profitably under
future contracts with its customers.

Catastrophic Limits. Contracts accounting for 46% of revenues for the
year ended December 31, 1997, contain no limits on ASG's exposure for treatment
costs related to catastrophic illnesses or injuries to inmates. ASG maintains
insurance with respect to catastrophic illnesses or injuries for amounts in
excess of $125,000 per inmate for contracts that contain no catastrophic limits.
ASG attempts to compensate for the increased financial risk when pricing
contracts that do not contain catastrophic limits. Although, the occurrence of
severe individual cases without such limits could render the contract
unprofitable and could have a material adverse effect, ASG believes the
potential impact of any such occurrences is mitigated by such insurance.

Dependence on Key Personnel. The success of ASG will depend in large
part on the ability and experience of its senior management. The loss of
services of one or more key employees could adversely affect ASG's operations.
ASG has employment contracts with Scott L. Mercy, President and Chief Executive
Officer, Michael Catalano, Executive Vice President of Development, General
Counsel and Secretary, Gerard F. Boyle, Executive Vice President and President
of PHS, and Bruce A. Teal, Senior Vice President and Chief Financial Officer.

Dependence on Healthcare Personnel. ASG's success will depend on its
ability to attract and retain highly skilled healthcare personnel. A shortage of
trained and competent employees and/or independent contractors may result in
overtime costs or the need to hire less efficient temporary staff. Attracting
qualified nurses at a reasonable cost has been and continues to be of concern to
ASG. There can be no assurance that ASG will be successful in attracting and
retaining a sufficient number of qualified healthcare personnel in the future.

Classification of Independent Contractors. Prior to July 1995, ASG
generally contracted with physicians, dentists and certain other healthcare
professionals as independent contractors to fulfill its contractual obligations
to state, county and local governmental agencies. Beginning in July 1995, ASG
treats any such person as an independent contractor only if (i) such person
provides eight hours or less of service to ASG per week or (ii) such person is
employed by or is part of a professional association or professional corporation
under state law. A determination by federal taxing authorities that ASG
misclassified a material number of persons as independent contractors could
adversely affect ASG and its operations.

Corporate Exposure to Professional Liability. ASG periodically becomes
involved in medical malpractice claims with the attendant risk of substantial
damage awards. The most significant source of potential liability in this regard
is the risk of suits brought by inmates alleging lack of timely or adequate
healthcare services. ASG may be liable, as employer, for the negligence of
nurses or other healthcare professionals who are employees of ASG. ASG may also

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10

have potential liability for the negligence of healthcare professionals engaged
by ASG as independent contractors. ASG's contracts generally provide for ASG to
indemnify the governmental agency for losses incurred related to healthcare
provided by ASG. ASG maintains professional liability insurance in amounts
deemed appropriate by management based upon ASG's claims history and the nature
and risks of its business. There can be no assurance that a future claim or
claims will not exceed the limits of available insurance coverage or that such
coverage will continue to be available at a reasonable cost.

Licensing of Healthcare Providers. No state in which ASG does business
has sought to apply its general insurance, health maintenance organization
("HMO") or similar statutes and regulations to ASG or, to the best of ASG's
knowledge, to its competitors. ASG does not believe that these statutes and
regulations were intended to apply to ASG or its activities since HMO's are
designed to provide voluntary enrollment or subscription, typically to employee
groups, in a plan providing healthcare as an alternative to other public or
private providers. However, if ASG is required to become licensed in and meet
the insurance or HMO reporting, financial, operating and other regulatory
requirements of any such state, failure to comply could result in fines or
proceedings ordering ASG to cease its activities in the state. ASG believes that
for it to satisfy the licensing and regulatory requirements of states in which
it operates would require the states to waive various statutory or regulatory
requirements which provide rights not available to inmates in correctional
institutions. These requirements vary from state to state but in some states
include providing participants the right to choose their physicians, the right
to be members of advisory panels and to participate in policy matters, the right
to convert coverage to individual coverage and the right to continuing benefits
after the contract terminates. Alternatively, ASG would be required to modify
its methods of doing business in any such state where such requirements are not
waived and could not be satisfied, principally by changing its pricing method
from a fixed fee to a fee for service arrangement. However, there is no
assurance that such waiver, licensing or modification could be accomplished.
Further, if ASG were to seek to become licensed or to modify its methods of
doing business, its profits could be adversely affected.

ITEM 2. PROPERTIES.

In February 1997, the Company completed the relocation of its
headquarters and principal administrative operations to Brentwood, Tennessee,
where it occupies approximately 12,500 square feet of leased office space. The
Company's lease on its current headquarters expires in October 2003. The Company
leases additional office facilities in Indianapolis, Indiana; Alameda,
California; and Topeka, Kansas. The Company owns land and the warehouse and
office building of approximately 30,000 square feet in Mobile, Alabama that
formerly housed the operations of UniSource, Inc., a subsidiary of the Company
that formerly sold pharmaceuticals and related products to institutions where
PHS delivered healthcare services as well as to other institutions. Such real
property is currently under contract for sale. In connection with the Merger,
the Company ceased operations at its regional offices in Atlanta, Georgia and
substantially reduced operations at its regional offices in Newark, Delaware.
Pursuant to the Settlement Agreement, MedPartners agreed to assume all of the
Company's obligations pursuant to the Company's leases of such offices,
effective as of February 1, 1998. The Company assigned to MedPartners all of its
right, title and interest in and to any and all amounts paid by any sublessee or
assignee of such leases and agreed to co-operate with MedPartners in its efforts
to sublease or assign the leases. While the Company may open additional offices
to meet the local needs of future contracts awarded in new areas, management
believes that its current facilities are adequate for its existing contracts for
the foreseeable future.

ITEM 3. LEGAL PROCEEDINGS.

The Company is subject to claims and suits in the ordinary course of
business. In management's opinion, such currently pending legal proceedings and
claims against the Company will not, in the aggregate, have a material adverse
effect on the Company.

The Company periodically becomes involved in medical malpractice claims
with the attendant risk of substantial damage awards. The most significant
source of potential liability in this regard is the risk of suits brought by
inmates alleging lack of timely or adequate healthcare services. The Company may
be liable, as employer, for the negligence

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of nurses or other healthcare professionals who are employees of the Company.
The Company may also have potential liability for the negligence of healthcare
professionals engaged by the Company as independent contractors. The Company's
contracts generally provide for the Company to indemnify the governmental agency
for losses incurred related to healthcare provided by the Company.

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

On December 29, 1997, a special meeting of the Company's stockholders
(the "Special Meeting") was held for the purpose of voting on the Merger. At the
Special Meeting, the stockholders voted, by a vote of 2,552,227 shares in favor,
none opposed, and none abstaining with no broker non-votes, to adopt a proposal
to temporarily adjourn the special meeting until January 20, 1998.

On January 20, 1998, the Special Meeting was reconvened, and the
stockholders adopted a proposal to permanently adjourn the Special Meeting by a
vote of 2,552,227 shares in favor, none opposed, and none abstaining with no
broker non-votes. See "General -- Recent Developments."

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PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS.

America Service Group Inc. common stock is traded on The Nasdaq Stock
Market's National Market System under the symbol ASGR. As of March 30, 1998,
there were approximately 1,320 holders of record of ASG common stock. The high
and low prices of the Company's common stock as reported on The Nasdaq Stock
Market during each quarter from January 1, 1996 through December 31, 1997 are
shown below:

Quarter Ended High Low
- ---------------------------------------------------

March 31, 1996 $9.00 $6.88
June 30, 1996 21.25 9.75
September 30, 1996 17.50 10.75
December 31, 1996 15.75 9.13
- ---------------------------------------------------
March 31, 1997 $13.63 $9.25
June 30, 1997 14.75 9.25
September 30, 1997 15.75 14.00
December 31, 1997 19.13 13.38
- ---------------------------------------------------

ITEM 6. SELECTED FINANCIAL DATA.

FOR THE YEAR ENDED DECEMBER 31,
-------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
(In thousands, except per share data)

STATEMENT OF OPERATIONS DATA:
Healthcare revenues ................................. $ 129,211 $ 152,282 $ 115,238 $ 109,983 $ 108,932
Income (loss) before income taxes (benefits) ........ 1,786 (9,933) 1,146 1,646 363
Net income (loss) ................................... 1,685 (8,686) 687 996 225
Net income (loss) attributable to common shares .... 1,742 (8,912) 687 996 225
Net income (loss) per common shares - basic ......... 0.50 (2.81)(a) 0.23 (a) 0.33(a) 0.08 (a)
Net income (loss) per common shares - diluted ....... 0.48 (2.81)(a) 0.21 (a) 0.32(a) 0.07 (a)
Weighted average common shares outstanding .......... 3,480 3,171 (a) 3,027 (a) 2,994(a) 2,989 (a)
Weighted average common shares outstanding and common
equivalent shares outstanding..................... 3,657 3,171 (a) 3,221 (a) 3,126(a) 3,148 (a)

AS OF DECEMBER 31,
---------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----

BALANCE SHEET DATA:
Working capital (deficit) ........................... $ 257 $ (2,434) $ 2,692 $ 2,302 $ (399)
Total assets ........................................ 27,754 42,709 42,501 32,108 34,634
Redeemable common stock, common stock,
additional paid-in-capital, retained
earnings (deficit) and treasury stock ............ 6,641 4,384 8,667 8,188 7,151

- ---------------

(a) The earnings per share amounts prior to 1997 have been restated as
required to comply with Statement of Financial Accounting Standards No.
128, Earnings Per Share ("Statement 128"). For further discussion of
earnings per share and the impact of Statement 128, see the notes to
the consolidated financial statements beginning on page F-8.

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13

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

RESULTS OF OPERATIONS

The following table sets forth, for the years indicated, the percentage
relationship to total revenue of certain items in the Consolidated Statements of
Operations.

YEAR ENDED DECEMBER 31,
PERCENTAGE OF TOTAL REVENUES 1997 1996 1995
- -------------------------------------------------------------------------

Healthcare revenue ........................... 99.5% 99.5% 99.8%
Interest income .............................. .5 .5 .2
------------------------
Total revenue ................................ 100.0 100.0 100.0
Healthcare expenses .......................... 91.3 95.2 89.3
------------------------
Gross margin ................................. 8.7 4.8 10.7
Selling, general and administrative expenses . 7.3 7.2 8.6
Nonrecurring charge .......................... -- 4.1 1.1
------------------------
Income (loss) from operations ................ 1.4 (6.5) 1.0
Provision for income taxes (benefits) ........ .1 (.8) .4
------------------------
Net income (loss) ............................ 1.3 (5.7) .6
Change in redeemable common stock ............ -- .1 --
------------------------
Net Income (loss) attributable to
common stock................................. 1.3% (5.8)% .6%
========================

1997 COMPARED TO 1996

Healthcare revenues decreased $23.1 million from $152.3 million in 1996
to $129.2 million in 1997, representing a 15% decrease. The decline in revenues
resulted primarily from the Georgia Contract, which took effect in October 1995,
and generated $30.9 million in the year ended December 31, 1997, compared to
$56.7 million in 1996. The Georgia Contract expired in June 1997. The Company
added five new contracts in 1997, which generated $9.9 million in new revenues,
and experienced $13.4 million of revenue growth from existing contracts through
contract renegotiations, automatic price adjustments and from being in effect a
full year. Revenues were negatively impacted by the loss of eight contracts
during 1997, which generated $40.2 million of revenues in 1997, compared to
$77.5 million of revenues in 1996. Contract revenues for 1996 include $9.1
million of revenues from contracts that were terminated in that year.

Interest income of $.7 million in 1997 declined from $.8 million in 1996
due to the cash usage involved with the expiration of the Georgia Contract.

The cost of healthcare decreased $27.0 million or 19% to $118.6 million
in 1997. Healthcare expenses as a percentage of revenues were 91% in 1997 versus
95% in 1996. Healthcare expenses exclusive of the Georgia Contract were 89% and
91% in 1997 and 1996, respectively. Personnel costs and fringe benefits related
to inmate care were 57% of revenues in 1997 versus 64% of revenues in 1996. The
significant decline is attributable to the existing contracts generally being
more full service versus staffing only. Costs related to outside services
(defined as hospitalization, emergency room and ambulance and outpatient
surgeries and visits) were 17% of revenues in 1997 and 1996.

At December 31, 1996, the Company had reserved $2.8 million in
anticipated losses relating to the Georgia Contract. During 1997, the Company
recorded an additional $1.4 million in healthcare expenses relating to the
further deterioration of the contract's operating performance. Due to continued
enhancements in the clinical and risk management areas, healthcare expenses were
positively impacted by $1.4 million in adjustments to Harbour's medical
malpractice claims.

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14

Selling general and administrative expenses were $9.5 million in 1997
compared to $11.1 million in 1996. The decrease was attributable to the
corporate reengineering and downsizing implemented throughout 1997.

The provision for income taxes was $.1 million of expense in 1997 compared
to $1.2 million of benefit in 1996. Income taxes for 1997 relate to various
state income taxes. The Company did not incur any federal income taxes due to
the utilization of net operating loss carryforwards. As of December 31, 1997,
the Company had approximately $7.5 million in unutilized net operating loss
carryforwards.

1996 COMPARED TO 1995

Healthcare revenues increased $37.1 million from $115.2 million in 1995
to $152.3 million in 1996, representing a 32% increase. The growth in revenues
resulted primarily from the Georgia Contract. The Georgia Contract generated
$56.7 million in the year ended December 31, 1996, compared to $13.5 million
recognized in 1995. The Company added five new contracts in 1996 which generated
$6.0 million in new revenues and experienced $6.9 million of revenue growth
under existing contracts through contract renegotiation, automatic price
adjustments and from being in effect a full year. Revenues were negatively
impacted by the loss of four contracts during 1996, which generated $9.2 million
of revenues in 1996 compared to $18.3 million of revenues in 1995. Contract
revenues for 1995 include $9.4 million of revenues from contracts that were
terminated in that year.

The cost of healthcare increased $42.5 million or 42% to $145.6 million in
1996. Healthcare expenses as a percentage of revenues were 95% in 1996 versus
89% in 1995. Healthcare expenses as a percentage of revenue, exclusive of the
Georgia Contract, were 91% and 89% in 1996 and 1995, respectively. Excluding
the Georgia Contract, contracts in effect at December 31, 1996 reflected
healthcare expenses of 91% of revenues. Personnel costs and fringe benefits
related to inmate care were 64% of revenues in 1996 and 1995. Costs related to
outside services (defined as hospitalization, emergency room and ambulance and
outpatient surgeries and visits) were 17% and 16% of revenues in 1996 and 1995,
respectively. Under the Georgia Contract, the Company incurred costs related to
outside services of 20% of revenues in 1996 and 1995.

Selling, general and administrative expenses were $11.1 million in 1996
compared to $9.9 million in 1995. The increase was attributable to additional
corporate personnel and services required by the Georgia Contract and the
relocation of the Company's headquarters to Brentwood, Tennessee from Newcastle,
Delaware.

During 1996, the Company recognized various, non-recurring charges
consisting of (i) a non-cash compensation charge of $2.4 million relating to the
appointment of the Company's new Chief Executive Officer and his receipt of
40,000 shares of redeemable common stock and options to purchase 175,000 shares
of common stock, (ii) $1.1 million resulting from reengineering and downsizing
of the Company's administrative processes and (iii) $2.8 million of estimated
reserves with respect to the Georgia Contract.

Interest income was $.8 million and $.2 million in 1996 and 1995. The
increase is mainly attributable to the investment of additional cash on hand
resulting from the prepayment of the Georgia premium.

The provision for income taxes was $1.2 million of benefit in 1996
compared to $.5 million of expense in 1995. Although the Company experienced a
$9.9 million pretax loss in 1996, the recognition of the associated tax benefit
is limited to income tax expense recorded in the last three fiscal years.

LIQUIDITY AND CAPITAL RESOURCES

The Company's cash and cash equivalents as of December 31, 1997 were $3.4
million compared to $12.6 million as of December 31, 1996. The reduction is
attributable to cash used in the Georgia Contract which approximated $14.6
million. During 1997, the Company received $.5 million in cash from the exercise
of stock options.

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15

Accrued expenses of the Company decreased $9.2 million from $25.7 million
at December 31, 1996 to $16.5 million at December 31, 1997. The reduction is
primarily attributable to the payout of medical claims, liability claims,
salaries and employee benefits and funding losses related to the Georgia
Contract.

Investments of Harbour, the Company's captive insurance company, are
restricted from general corporate uses. The settlement of professional and
medical liability claims has been satisfied through Harbour's general working
capital. Future settlement of cases in excess of available working capital will
be satisfied through planned maturities of the restricted investments.

The Company has a $20 million line of credit facility for general
corporate purposes, including working capital, the issuance of letters of credit
for performance bonds, and the funding of acquisitions. Under the line, which
matures in September 2000, the Company is limited to $5 million in working
capital needs through March 1998. The interest rate is based upon LIBOR or prime
rate, subject to the quarterly operating performance of the Company, as defined
in the agreement. The line of credit is subject to certain quarterly covenants.

Management believes that the current levels of cash, cash equivalents and
investments, when coupled with the internally generated funds and available
credit, are sufficient to meet the Company's immediate foreseeable future cash
needs and anticipated contract renewal activity.

INFLATION

The increase in the healthcare costs in December 1997 over December 1996
was 2.8% nationally compared to an overall increase in the Consumer Price Index
of 2.3% for all costs for the same period.

Some of the Company's contracts provide for annual increases in the fixed
base fee upon changes in the regional medical care component of the Consumer
Price Index. In all other contracts that extend beyond one year, the Company
utilizes a projection of the future inflation rate when bidding and negotiating
the fixed fee for future years. If the rate of inflation exceeds the levels
projected, such excess will be absorbed by the Company. Conversely, the Company
will benefit should the actual rate of inflation fall below the estimate used in
the bidding and negotiation process.

NEWLY ISSUED ACCOUNTING STANDARDS

In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement No. 130, Reporting Comprehensive Income ("Statement 130"). Statement
130 establishes standards for reporting and displaying comprehensive income and
its components in a full set of general purpose financial statements. Statement
130 is effective for interim and annual periods beginning in 1998. Comprehensive
income encompasses all changes in stockholders' equity (except those arising
from transactions from owners) and includes net income, net unrealized capital
gains or losses on available for sale securities and foreign currency
translation adjustments. Management of the Company does not expect the adoption
of Statement 130 to have a material impact on the Company's financial
statements.

In June 1997, the FASB issued Statement No. 131, Disclosures about
Segments of an Enterprise and Related Information ("Statement 131"). Statement
131 establishes standards for the way public business enterprises are to report
information about operating segments in annual financial statements and requires
these enterprises to report selected information about operating segments in
interim financial reports issued to shareholders. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. Statement 131 is effective for fiscal years beginning after December
15, 1997. Management of the Company is currently reviewing the impact of
Statement 131. The Company will adopt Statement 131 on December 31, 1998 and
will report interim information effective in the first quarter of 1999.

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IMPACT OF YEAR 2000

Some of the Company's older computer programs were written using two
digits rather than four to define the applicable year. As a result, those
computer programs recognize a date using "00" as the year 1900 rather than the
year 2000. This fact could cause a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions, send invoices or engage in similar normal business
activities (the "Year 2000 Issue").

The Company has completed an assessment and will have to modify or
replace portions of its software so that its computer systems will function
properly with respect to dates in the year 2000 and thereafter. The total Year
2000 Issue cost is estimated to be immaterial to the operating results of the
Company. Estimated costs consist primarily of the purchase of new software that
will be capitalized. To date, the Company has incurred minimal expenses relating
to the Year 2000 Issue.

The project is estimated to be completed not later than December 31,
1998, which is prior to any anticipated impact of the Year 2000 Issue on the
Company's operating systems. The Company believes that with modifications to
existing software and conversions to new software, the Year 2000 Issue will not
pose significant operational problems for its computer systems. However, if such
modifications and conversions are not made, or are not timely completed, the
Year 2000 Issue could have a material impact on the operations of the Company.

The costs of the project and the estimated date of completion are based
on management's best estimates, which were derived using numerous assumptions of
future events, including the continued availability of certain resources and
other factors. There can be no guarantee, however, that these estimates will be
achieved and actual results could differ materially from those anticipated.
Specific factors that might cause such material differences include, but are not
limited to, the availability and cost of personnel trained in this area, the
ability to locate and correct all relevant computer codes, and similar
uncertainties.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

The Company's Consolidated Financial Statements, together with the
reports thereon of Ernst & Young LLP, dated March 17, 1998 and Price Waterhouse
LLP, dated March 11, 1996 except as to Note 15, which is as of March 28, 1996,
begin on page F-1 of this Report.

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

There are no disagreements with accountants on accounting and financial
disclosure required to be reported in this annual report pursuant to Item 304 of
Regulation S-K.

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PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

The information contained under the heading "Information as to Directors
and Executive Officers" in the Company's definitive proxy statement for its
annual meeting of stockholders to be held on May 19, 1998 (the "1998 Proxy
Statement") is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION.

The information contained under the heading "Executive Compensation" in
the 1998 Proxy Statement is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

The information contained under the headings "Information as to Directors
and Executive Officers" and "Principal Stockholders" in the 1998 Proxy Statement
is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The information contained under the heading "Executive
Compensation--Certain Transactions" in the 1998 Proxy Statement is incorporated
herein by reference.

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PART IV

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

(a)(1) Financial Statements

Listed on the Index to the Consolidated Financial Statements and
Schedule on page F-1 of this Report.

(2) Financial Statement Schedule

Listed on the Index to the Consolidated Financial Statements and
Schedule on page F-1 of this Report.

(3) Exhibits

EXHIBIT DESCRIPTION
- ------- -----------

2.1 -- Plan and Agreement of Merger, as amended, dated October 1,
1997 by and among America Service Group, Inc., MedPartners,
Inc. and ASG Merger Corporation, a wholly-owned subsidiary of
MedPartners, Inc. (incorporated herein by reference to Exhibit
2.1 to ASG's Current Report on Form 8-K filed on October 2,
1997 (File No. 0-19673) and to Exhibit 2.1 to ASG's Current
Report on Form 8-K filed on December 30, 1997 (File No.
0-19673)).
2.2 -- Consent and Agreement, dated January 19, 1998 by and among
America Service Group, Inc., MedPartners, Inc. and ASG Merger
Corporation, a wholly-owned subsidiary of MedPartners, Inc.
(incorporated herein by reference to Exhibit 2.1 to ASG's
Current Report on Form 8-K filed on January 20, 1998 (File No.
0-19673)).
2.3 -- Release and Settlement Agreement, dated February 25, 1998 by
and among America Service Group, Inc., MedPartners, Inc. and
ASG Merger Corporation and EMSA Correctional Care, Inc.
3.1 -- Amended and Restated Certificate of Incorporation of America
Service Group Inc. (incorporated by reference to Exhibit 3.1 to
the Registrant's Registration Statement on Form S-1,
Registration No.
33-43306, as amended).
3.2 -- Amended and Restated By-Laws of America Service Group Inc.
(incorporated by reference to Exhibit 3.2 to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1996).
4.1 -- Specimen Common Stock Certificate (incorporated by reference
to Exhibit 4.1 to the Registrant's Registration Statement on
Form S-1, Registration No. 33-43306, as amended).
10.1 -- Prison Health Services, Inc. 1986 Employees' Stock Option
Plan (incorporated by reference to Exhibit 10.1 to the
Registrant's Registration Statement on Form S-1, Registration
No. 33-43306, as amended).
10.2 -- America Service Group Inc. Amended Incentive Stock Plan (as
adopted by the Board of Directors on March 19, 1996)
(incorporated by reference to Exhibit 10.1 to the Registrant's
Quarterly Report on Form 10-Q for the three month period ending
June 30, 1996), as subsequently amended by resolution of the
Board of Directors on September 16, 1996 to increase the number
of shares reserved for issuance thereunder from 1,075,000 to
1,182,500.
10.3 -- America Service Group Inc. 401(k) Profit Sharing Plan
(incorporated by reference to Exhibit 10.9 to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1992).
10.5 -- Settlement Agreement among Prison Health Services, Inc.,
Georgia Department of Corrections and The Georgia Department of
Administrative Services dated January 6, 1997 (incorporated by
reference to Exhibit 10.5 to the Registrant's Annual Report on
Form 10-K for the year ended December 31, 1997).
10.6 -- Prison Health Services, Inc. Medical Services Agreement for
Alameda County, California, dated July 1, 1992 (incorporated by
reference to Exhibit 10.6 to the Registrant's Annual Report on
Form 10-K for the year ended December 31, 1992).
10.7 -- Prison Health Services, Inc. Agreement for the Department of
Corrections of the State of Kansas, dated February 22, 1991,
and Amendment thereto, dated August 27, 1991 (incorporated by
reference to Exhibit 10.7 to the Registrant's Registration
Statement on Form S-1, Registration No. 33-43306, as amended).
10.8 -- Prison Health Services, Inc. Health Services Contract for
State of Maryland, Department of Public Safety and Correctional
Services dated November 30, 1992 (incorporated by reference to
Exhibit 10.14 to the Registrant's Annual Report on Form 10-K
for the year ended December 31, 1994).
10.9 -- Prison Health Services, Inc. Health Services Contract for
the City of Philadelphia Department of Public Health
(incorporated by reference to Exhibit 10.13 to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1993).

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19

10.10 -- Healthcare Services Contract with the State of Delaware,
dated June 3, 1996 (incorporated by reference to Exhibit 10.5
to the Registrant's Quarterly Report on Form 10-Q for the three
month period ending June 30, 1996).
10.11 -- Contractual Agreement between the Indiana Department of
Correction and Prison Health Services, Inc. dated April 18,
1997 (incorporated by reference to Exhibit 10.26 to the
Registrant's Quarterly Report on Form 10-Q for the three month
period ending June 30, 1997).
10.12 -- Credit Agreement dated May 30, 1997 for $20,000,000 with
NationsBank of Tennessee, N.A. (incorporated by reference to
Exhibit 10.25 to the Registrant's Quarterly Report on Form 10-Q
for the three month period ending June 30, 1997).
10.13 -- Employment Agreement dated April 1, 1996 between Scott L.
Mercy and America Service Group Inc., as amended (incorporated
by reference to Exhibit 10.2 to the Registrant's Quarterly
Report on Form 10-Q for the three month period ending June 30,
1996 and to Exhibit 10.28 to Registrant's Quarterly Report on
Form 10-Q for the three month period ending June 30, 1997).
10.14 -- Employment Agreement dated November 1, 1996 between Jeffrey
J. Bairstow and America Service Group Inc. (incorporated by
reference to Exhibit 10.17 to the Registrant's Annual Report on
Form 10-K for the year ended December 31, 1997).
10.15 -- Non-qualified Stock Option by America Service Group Inc. and
Jeffrey J. Bairstow dated December 18, 1996 (incorporated by
reference to Exhibit 10.18 to the Registrant's Annual Report on
Form 10-K for the year ended December 31, 1997).
10.16 -- Employment Agreement dated July 12, 1996 between Michael
Catalano and America Service Group Inc. (incorporated by
reference to Exhibit 10.1 to the Registrant's Quarterly Report
on Form 10-Q for the three month period ending September 31,
1996).
10.17 -- Non-Qualified Stock Option between America Service Group
Inc. and Michael Catalano dated July 12, 1996 (incorporated by
reference to Exhibit 10.20 to the Registrant's Annual Report on
Form 10-K for the year ended December 31, 1997).
10.18 -- Employment Agreement dated February 20, 1998 between Bruce
A. Teal and America Service Group, Inc.
10.19 -- Non-Qualified Stock Option between America Service Group
Inc. and Bruce A. Teal dated December 18, 1996 (incorporated
by reference to Exhibit 10.21 to the Registrant's Annual
Report on Form 10-K for the year ended December 31, 1997).
10.20 -- Employment Agreement dated February 12, 1998 between Gerard
F. Boyle and America Service Group Inc.
10.21 -- Non-Qualified Stock Option between America Service Group
Inc. and Gerard F. Boyle dated February 12, 1998.
10.22 -- Lease Agreement for office located at Two Penns Way, Suite
200, New Castle, Delaware 19720, and amendments thereto
(incorporated by reference to Exhibit 10.8 to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1995).
10.23 -- Lease by and between Principal Mutual Life Insurance Company
and America Service Group Inc. dated September 6, 1996
(incorporated by reference to Exhibit 10.23 to the Registrant's
Annual Report on Form 10-K for the year ended December 31,
1997).
10.24 -- Sublease Agreement, dated April 22, 1997, between the
Registrant and Citibank Delaware for office space located at
Two Penns Way, Suite 200, New Castle, Delaware (incorporated by
reference to Exhibit 10.24 to the Registrant's Quarterly Report
on Form 10-Q for the three months ending March 31, 1997).
10.25 -- Amended and Restated Incentive Stock Plan of the Registrant
(incorporated by reference to Exhibit 10.27 to the Registrant's
Quarterly Report on Form 10-Q for the three months ending June
30, 1997).
21.1 -- Subsidiaries of the Registrant.
23.1 -- Consent of Ernst & Young LLP.
23.2 -- Consent of Price Waterhouse LLP.
27.1 -- Financial Data Schedule for the year ended December 31, 1997
27.2 -- Restated Financial Data Schedule for the year ended December
31, 1996
27.3 -- Restated Financial Data Schedule for the year ended December
31, 1995

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20
(b) Reports on Form 8-K.

The following reports on Form 8-K were filed during the fourth quarter of
1997.

(a) Current Report on Form 8-K dated October 1, 1997
reporting the execution of the Merger Agreement between the Company and
MedPartners.

(b) Current Report on Form 8-K dated December 9, 1997
reporting the issuance of a press release regarding the decision of Scott L.
Mercy, the President and Chief Executive Officer of the Company, to leave the
Company and take a position with Columbia/HCA Healthcare Corporation upon
consummation of the proposed merger between the Company and MedPartners.

(c) Current Report on Form 8-K dated December 29, 1997
reporting the amendment of the Merger Agreement between the Company and
MedPartners and the adjournment until January 20, 1998 of the special meeting of
stockholders scheduled to consider the proposed merger between the Company and
MedPartners.

-20-
21

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registration has duly caused this report to be signed
on behalf of the undersigned, thereunto duly authorized, on March 30, 1998.

AMERICA SERVICE GROUP INC.

By: /s/ SCOTT L. MERCY
----------------------------
Scott L. Mercy
President and Chief Executive Officer

Pursuant to the Requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons in the capacities
indicated on March 30, 1998.

Signatures

/s/ SCOTT L. MERCY Title: President and Chief Executive Officer
- ------------------------ and Director
SCOTT L. MERCY

/s/ MICHAEL CATALANO Title: Executive Vice President of Development,
- ------------------------ General Counsel and Secretary
MICHAEL CATALANO

/s/ BRUCE A. TEAL Title: Senior Vice President and
- ------------------------ Chief Financial Officer
BRUCE A. TEAL

/s/ WILLIAM EBERLE Title: Director, Chairman of the Board
- ------------------------
WILLIAM EBERLE

/s/ THOMAS BOGAN Title: Director
- ------------------------
THOMAS BOGAN

/s/ JACK O. BOVENDER, JR. Title: Director
- ------------------------
JACK O. BOVENDER, JR.

/s/ JOHN GILDEA Title: Director
- ------------------------
JOHN GILDEA

/s/ CAROL R. GOLDBERG Title: Director
- ------------------------
CAROL R. GOLDBERG

/s/ DOUGLAS L. JACKSON Title: Director
- ------------------------
DOUGLAS L. JACKSON

-21-
22
AMERICA SERVICE GROUP INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE

Page
Financial Statements Number
- -------------------- ------

Report of Ernst & Young LLP, Independent Auditors........................ F-2

Report of Independent Accountants........................................ F-3

Consolidated Balance Sheets at December 31, 1997 and 1996................ F-4

Consolidated Statements of Operations for the years
ended December 31, 1997, 1996 and 1995.............................. F-5

Consolidated Statements of Changes in Common
Stock, Additional Paid-in Capital, Retained Earnings
(Deficit) and Treasury Stock for the years
ended December 31, 1997, 1996 and 1995.............................. F-6

Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995.................................... F-7

Notes to Consolidated Financial Statements............................... F-8

Financial Statement Schedule

Report of Ernst & Young LLP, Independent Auditors........................ F-2

Report of Independent Accountants on Financial Statement Schedule........ F-25

Valuation and Qualifying Accounts and Reserves
(Schedule II) for the years ended
December 31, 1997, 1996 and 1995 ................................... F-26

All other schedules are omitted as the required information is inapplicable or
is presented in the Company's Consolidated Financial Statements or the Notes
thereto.

F-1
23

REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

Board of Directors and Stockholders
America Service Group Inc.

We have audited the accompanying consolidated balance sheets of America Service
Group Inc. and subsidiaries as of December 31, 1997 and 1996, and the related
consolidated statements of operations, changes in common stock, additional
paid-in capital, retained earnings (deficit) and treasury stock, and cash flows
for each of the two years in the period ended December 31, 1997. Our audits also
included the financial statement schedule for 1997 and 1996 listed in the Index
at Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of America Service
Group Inc. and subsidiaries at December 31, 1997 and 1996, and the consolidated
results of their operations and their cash flows for each of the two years in
the period ended December 31, 1997, in conformity with generally accepted
accounting principles. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken as
a whole, presents fairly, in all material respects the information set forth
therein.

ERNST & YOUNG LLP

Nashville, Tennessee
March 17, 1998

F-2
24

REPORT OF INDEPENDENT ACCOUNTANTS

To the Board of Directors and Stockholders of
America Service Group Inc.

In our opinion, the consolidated statements of operations, of cash flows and of
changes in stockholders' equity for the year ended December 31, 1995 (appearing
on pages F-4 through F-26 of the America Service Group Inc.'s 1997 Annual Report
to Shareholders which has been incorporated by reference in this Form 10-K
Annual Report) present fairly, in all material respects, the results of
operations and cash flows of America Service Group Inc. and its subsidiaries for
the year ended December 31, 1995, in conformity with generally accepted
accounting principles. These financial statements are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements based on our audit. We conducted our audit of these
statements in accordance with generally accepted auditing standards which
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, assessing the accounting principles
used and significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for the opinion expressed above. We have not audited the
consolidated financial statements of America Service Group Inc. for any period
subsequent to December 31, 1995.

PRICE WATERHOUSE LLP
Linthicum, Maryland
March 11, 1996,
Except as to Note 15, which is as of
March 28, 1996.

F-3
25

AMERICA SERVICE GROUP INC.

CONSOLIDATED BALANCE SHEETS

DECEMBER 31
ASSETS 1997 1996
------------ -----------

Current assets:
Cash and cash equivalents $ 3,445,000 $12,550,000
Short-term investments 1,559,000 2,105,000
Accounts receivable: Healthcare and other
Less allowance for doubtful accounts
of $384,000 and $2,016,000, respectively 8,242,000 9,146,000
Assets held for sale - 2,900,000
Prepaid expenses and other current assets 2,384,000 3,688,000
Current deferred taxes 2,116,000 2,152,000
------------ -----------
Total currents assets 17,746,000 32,541,000

Restricted investments 5,639,000 5,458,000
Property and equipment, net 2,468,000 3,036,000
Deferred taxes 1,193,000 1,056,000
Cost in excess of net assets acquired, net 411,000 453,000
Other assets 297,000 165,000
============ ===========
Total assets $ 27,754,000 $42,709,000
============ ===========

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities:
Accounts payable $ 3,243,000 $ 7,656,000
Accrued expenses 12,836,000 22,319,000
Deferred revenue 1,410,000 5,000,000
------------ -----------
Total current liabilities 17,489,000 34,975,000

Noncurrent portion of accrued expenses 3,624,000 3,350,000
Commitments and contingencies

Redeemable common stock, $.01 par value, 186,000 shares
issued and outstanding at December 31, 1997 and 1996 1,842,000 1,916,000
Preferred stock, $.01 par value, 2,000,000 shares authorized;
none outstanding - -
Common stock, $.01 par value, 10,000,000 shares authorized;
3,529,000 and 3,404,000 shares issued and outstanding at
December 31, 1997 and 1996 35,000 34,000
Additional paid-in-capital 7,926,000 7,546,000
Accumulated deficit (3,162,000) (4,904,000)
Less: Treasury stock, at cost, 31,000 shares at
December 31, 1996 - (208,000)
=========== ===========
Total liabilities and stockholders' equity $27,754,000 $42,709,000
=========== ===========

See accompanying notes.

F-4
26

AMERICA SERVICE GROUP INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

YEAR ENDED DECEMBER 31
1997 1996 1995
------------- ------------- -------------

Healthcare revenue $ 129,211,000 $ 152,282,000 $ 115,238,000
Investment and interest income 679,000 751,000 223,000
------------- ------------- -------------
Total revenue 129,890,000 153,033,000 115,461,000
Healthcare expenses 118,631,000 145,618,000 103,150,000
------------- ------------- -------------
Gross margin 11,259,000 7,415,000 12,311,000
Selling, general, and administrative expenses 9,461,000 11,065,000 9,921,000
Nonrecurring charges -- 6,241,000 1,225,000
------------- ------------- -------------
Income (loss) from operations 1,798,000 (9,891,000) 1,165,000
Interest expense 12,000 42,000 19,000
------------- ------------- -------------
Income (loss) before income taxes (benefits) 1,786,000 (9,933,000) 1,146,000
Provision for income taxes (benefits) 101,000 (1,247,000) 459,000
------------- ------------- -------------
Net income (loss) 1,685,000 (8,686,000) 687,000
Decrease (increase) in redeemable common stock 57,000 (226,000) --
============= ============= =============
Net income (loss) attributable to common shares $ 1,742,000 $ (8,912,000) $ 687,000
============= ============= =============

Net income (loss) per common share:
Basic $ .50 $ (2.81) $ .23
============= ============= =============
Diluted $ .48 $ (2.81) $ .21
============= ============= =============

Weighted average common shares outstanding:
Basic 3,480,000 3,171,000 3,027,000
============= ============= =============
Diluted 3,657,000 3,171,000 3,221,000
============= ============= =============

See accompanying notes.

F-5
27

AMERICA SERVICE GROUP INC.

CONSOLIDATED STATEMENTS OF CHANGES IN COMMON STOCK,
ADDITIONAL PAID-IN CAPITAL, RETAINED EARNINGS (DEFICIT) AND TREASURY STOCK

COMMON STOCK ADDITIONAL RETAINED
----------------------------- PAID-IN EARNINGS TREASURY
SHARES AMOUNT CAPITAL (DEFICIT) STOCK
----------------------------------------------------------------------------------

Balance at January 1, 1995 3,404,000 $ 34,000 $ 7,096,000 $ 3,321,000 $(2,263,000)
Purchase of treasury stock
(100,000 shares) -- -- -- -- (525,000)
Exercise of options -- -- (209,000) -- 526,000
Net income -- -- -- 687,000 --
----------- ----------- ----------- ----------- -----------
Balance at December 31, 1995 3,404,000 34,000 6,887,000 4,008,000 (2,262,000)
Purchase of treasury stock
(130,000 shares) -- -- -- -- (875,000)
Issuance of redeemable
common stock -- -- -- -- 1,004,000
Issuance of common stock
under employee stock plan -- -- 67,000 -- 50,000
Exercise of options -- -- (1,442,000) -- 1,875,000
Compensation for stock options -- -- 2,034,000 -- --
Increase in redemption of value
of common stock -- -- -- (226,000) --
Net loss -- -- -- (8,686,000) --
----------- ----------- ----------- ----------- -----------
Balance at December 31, 1996 3,404,000 34,000 7,546,000 (4,904,000) (208,000)
Issuance of common stock
under employee stock plan 8,000 -- 68,000 -- --
Exercise of options 117,000 1,000 312,000 -- 208,000
Decrease in redemption value of
common stock -- -- -- 57,000 --
Net income -- -- -- 1,685,000 --
=========== =========== =========== =========== ===========
Balance at December 31, 1997 3,529,000 $ 35,000 $ 7,926,000 $(3,162,000) $ --
=========== =========== =========== =========== ===========

See accompanying notes.

F-6
28

AMERICA SERVICE GROUP INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

YEAR ENDED DECEMBER 31
1997 1996 1995
------------ ------------ ------------

OPERATING ACTIVITIES
Net income (loss) $ 1,685,000 $ (8,686,000) $ 687,000
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 1,114,000 1,533,000 738,000
Noncash compensation charge -- 2,384,000 --
Noncash change in redeemable common stock (17,000) 62,000 --
Provision for contract cancellation -- 3,802,000 --
Provision for doubtful accounts 841,000 1,822,000 421,000
Deferred income tax provision (101,000) -- (588,000)
Loss on disposal of assets held for sale 457,000 -- --
Changes in operating assets and liabilities:
Accounts receivable 63,000 5,621,000 (1,904,000)
Assets held for sale 2,900,000 -- --
Prepaid expenses and other current assets 1,304,000 (2,136,000) 153,000
Other assets (132,000) (72,000) 186,000
Accounts payable (4,413,000) 243,000 1,970,000
Accrued expenses (9,209,000) 4,839,000 3,021,000
Deferred revenue (3,590,000) (4,109,000) 4,766,000
Income taxes payable -- (284,000) 156,000
------------ ------------ ------------
Net cash provided by (used in) operating activities (9,098,000) 5,019,000 9,606,000

INVESTING ACTIVITIES
Proceeds (purchases) of short-term investments 546,000 (1,405,000) 63,000
Proceeds from sale of restricted investments 625,000 1,392,000 1,520,000
Purchases of restricted investments (806,000) (2,276,000) (1,356,000)
Capital expenditures (961,000) (4,268,000) (1,405,000)
Proceeds from sale of property and equipment -- 81,000 --
------------ ------------ ------------
Net cash used in investing activities (596,000) (6,476,000) (1,178,000)

FINANCING ACTIVITIES
Purchase of treasury stock -- (875,000) (525,000)
Issuance of redeemable common stock -- 1,278,000 --
Issuance of common stock 68,000 67,000 --
Exercise of stock options 521,000 1,487,000 317,000
------------ ------------ ------------
Net cash provided by (used in) financing activities 589,000 1,957,000 (208,000)

Net increase (decrease) in cash and cash equivalents (9,105,000) 500,000 8,220,000
Cash and cash equivalents at beginning of year 12,550,000 12,050,000 3,830,000
============ ============ ============
Cash and cash equivalents at end of year $ 3,445,000 $ 12,550,000 $ 12,050,000
============ ============ ============

SUPPLEMENTAL CASH FLOW INFORMATION
Cash paid for interest $ 12,000 $ 42,000 $ 19,000
============ ============ ============
Cash paid for income taxes $ -- $ 326,000 $ 835,000
============ ============ ============

See accompanying notes.

F-7
29

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 1997

1. DESCRIPTION OF BUSINESS

America Service Group Inc. (the "Company") and its consolidated subsidiaries
provide managed healthcare services to correctional facilities under capitated
contracts (with certain adjustments) with state and local governments. The
Company also provides medical supplies to certain of its contract sites as well
as private sector customers. The health status of inmates may impact results of
operations under such contractual arrangements.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries, Prison Health Services, Inc. (PHS) and its
wholly-owned captive insurance subsidiary Harbour Insurance, Inc. (Harbour),
Southern Health Partners, Inc. (SHP) and UniSource, Inc. (UniSource). The
Company disposed of 90% of its interest in SHP in July 1996 and the remaining
10% in July 1997. All significant intercompany transactions and account balances
have been eliminated.

Use of Estimates

The preparation of the consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the consolidated financial
statements and accompanying notes. Actual results could differ from those
estimates. Estimates are used primarily in the recording of the accruals of
unbilled medical services and professional and general liability claims.
Additional estimates in 1996 were used in the recording of estimated losses on
the Georgia Department of Corrections contract, sublease receipts and employee
severance.

Fair Value of Financial Instruments

The carrying amounts of the Company's financial instruments, which consist of
cash and cash equivalents, short-term investments, accounts receivable,
restricted investments and accounts payable, approximate their fair values.

F-8
30

AMERICA SERVICE GROUP INC.

NOTES CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Revenue and Cost Recognition

The Company engages principally in fixed price contracts with correctional
institutions adjusted for census fluctuations. Revenues earned under contracts
with correctional institutions are recognized in the period that services are
rendered. Cash received in advance for future services is recorded as deferred
revenue and recognized as income when the service is performed. Revenues on
pharmaceutical and related products are recorded when shipped.

Healthcare expenses include the compensation of physicians, nurses and other
healthcare professionals including any related benefits and all other direct
costs of providing the managed care. The cost of healthcare services provided or
contracted for are recognized in the period in which they are provided based in
part on estimates, including an accrual for unbilled medical services rendered
through the balance sheet dates. Additionally, reserves have been recorded for
certain reported and unreported professional and general liability claims
associated with the delivery of medical services.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand, demand deposits, money market
funds and investments with original maturities of three months or less.

Short-Term Investments

Short-term investments consist of temporary investments in certificates of
deposit and money market funds with brokers. Investments are available for sale
and by their nature are stated at fair value.

Depreciation

Depreciation is provided using straight-line and accelerated methods over the
estimated useful lives of the assets.

F-9
31

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Assets Held for Sale

Assets held for sale at December 31, 1996, consisted primarily of computer
hardware and software acquired or developed by the Company under the terms of
the Georgia Department of Corrections contract. The assets were purchased by the
State of Georgia for $2,900,000 subsequent to the expiration of the contract on
June 30, 1997.

Cost in Excess of Net Assets Acquired

Cost in excess of net assets acquired represents the unamortized excess of the
acquisition cost over the fair value of the net assets received at the date of
acquisition. Amortization expense of $42,000, $43,000 and $42,000 for 1997, 1996
and 1995, respectively, was computed using the straight-line method over 15
years, the estimated useful life of the intangible assets acquired. Accumulated
amortization as of December 31, 1997 and 1996 was $323,000 and $281,000,
respectively.

Long-Lived Assets

Statement of Financial Accounting Standards (SFAS) No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,
requires that companies consider whether indicators of impairment of long-lived
assets held for use are present. If such indicators are present, companies
determine whether the sum of the estimated undiscounted future cash flows
attributable to such assets is less than their carrying amount, and if so,
companies recognize an impairment loss based on the excess of the carrying
amount of the assets over their fair value. Accordingly, management periodically
evaluates the ongoing value of property and equipment and cost in excess of net
assets acquired and has determined there were no indications of impairment as of
December 31, 1997 and 1996.

Treasury Stock

Prior to December 1996, the Board of Directors had authorized the Company to
purchase treasury stock to be available for issuance under stock options and
other benefits under the Company's Incentive Stock Plan. Upon exercise of the
stock options, the difference between the cost of the treasury shares, on a
first-in, first-out basis, and the price of options exercised was reflected in
additional paid-in capital. Treasury stock includes 31,000 and 420,000 common
shares at December 31, 1996 and 1995, respectively. The 31,000 common shares
held in treasury as of December 31, 1996, were issued during 1997.

F-10
32

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Preferred Stock

Preferred stock may be issued in one or more series with distinctive serial
designations. The Board of Directors has the power and authority to establish
preferences related to dividends, redemptions, payment on liquidation,
conversion privileges and voting rights. As of December 31, 1997 and 1996, the
Company had no shares of preferred stock issued.

Income Taxes

The Company uses the liability method of accounting for federal and state income
taxes. Under the liability method, deferred tax assets and liabilities are
determined based on the difference between the financial statement carrying
amounts and tax bases of assets and liabilities using enacted tax rates in
effect in the years in which the differences are expected to reverse.
Differences between taxable income and income for financial statement purposes
result from the recognition of certain income and expense items for tax purposes
in periods which differ from those used for financial statement purposes.

Income (Loss) Per Share

In 1997, the Financial Accounting Standards Board ("FASB") issued Statement No.
128, Earnings Per Share ("Statement 128"). Statement 128 replaced the
calculation of primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options, warrants and convertible
securities. Diluted earnings per share is very similar to the previously
reported fully diluted earnings per share, and uses the treasury stock method in
calculating dilution. All earnings per share amounts for all periods have been
presented and restated to conform to Statement 128 requirements.

Stock Options

The Company has elected to follow Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB 25), and related Interpretations
in accounting for its employee stock options because the alternative fair value
accounting provided for under SFAS No. 123, Accounting for Stock-Based
Compensation, requires use of option valuation models that were not developed
for use in valuing employee stock options. Under APB 25, compensation expense is
recognized as the difference between the exercise price of the Company's
employee stock options and the market price of the underlying stock on the date
of grant.

F-11
33

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Newly Issued Accounting Standards

In June 1997, the FASB issued Statement No. 130, Reporting Comprehensive Income
("Statement 130"). Statement 130 establishes standards for reporting and
displaying comprehensive income and its components in a full set of general
purpose financial statements. Statement 130 is effective for interim and annual
periods beginning in 1998. Comprehensive income encompasses all changes in
stockholders' equity (except those arising from transactions from owners) and
includes net income, net unrealized capital gains or losses on available for
sale securities and foreign currency translation adjustments. Management of the
Company does not expect the adoption of Statement 130 to have a material impact
on the Company's financial statements.

In June 1997, the FASB issued Statement No. 131, Disclosures about Segments of
an Enterprise and Related Information ("Statement 131"). Statement 131
establishes standards for the way public business enterprises are to report
information about operating segments in annual financial statements and requires
these enterprises to report selected information about operating segments in
interim financial reports issued to shareholders. It also establishes standards
for related disclosures about products and services, geographic areas, and major
customers. Statement 131 is effective for fiscal years beginning after December
15, 1997. Management of the Company is currently reviewing the impact of
Statement 131. The Company will adopt Statement 131 on December 31, 1998 and
will report interim information effective in the first quarter of 1999.

Reclassifications

Certain amounts in the 1996 and 1995 consolidated financial statements have been
reclassified to conform with the 1997 presentation.

3. RELEASE AND SETTLEMENT AGREEMENT

On October 1, 1997, the Company entered into a Plan and Agreement of Merger (the
"Merger Agreement") with MedPartners, Inc., a Delaware corporation
("MedPartners"), and a wholly owned subsidiary of MedPartners, pursuant to which
the Company would have been acquired by MedPartners (the "Merger"). In
connection with the proposed Merger, each issued and outstanding share of the
Company's common stock, $0.01 par value per share (the "Common Stock") would
have been converted into the right to receive 0.71 of a share of MedPartners'
Common Stock. On October 29, 1997, MedPartners entered into a Plan and Agreement
of Merger (the "PhyCor Merger Agreement") with PhyCor, Inc., a Delaware
corporation ("PhyCor"), pursuant to which MedPartners would have been acquired
by PhyCor (the "MedPartners/PhyCor Merger") and each issued and outstanding
share

F-12
34

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

3. RELEASE AND SETTLEMENT AGREEMENT (CONTINUED)

of MedPartners' Common Stock would have been converted into the right to receive
1.18 shares of PhyCor Common Stock.

The Company mailed a Proxy Statement to the holders of its Common Stock on
November 20, 1997. The Proxy Statement related to a special meeting of the
Company's stockholders scheduled to be held on December 29, 1997, for the
purpose of considering and voting upon the Merger. On December 29, the Company
postponed the special meeting at the request of MedPartners until January 20,
1998.

On January 20, 1998, the Company announced that it would not hold the special
meeting of its stockholders originally scheduled for December 29, 1997, and that
it was engaged in discussions with MedPartners regarding the Merger Agreement.
On February 26, 1998, the Company announced the termination of the Merger
Agreement and the execution of a Release and Settlement Agreement (the
"Settlement Agreement") with MedPartners relating to the Merger Agreement.
Pursuant to the Settlement Agreement, MedPartners agreed to pay the Company
approximately $3.5 million in cash and to reimburse or assume certain other
costs incurred by the Company in connection with the Merger in the amount of
approximately $2.0 million. The Company and MedPartners and certain of their
respective affiliates also entered into a Non-Compete, Non-solicitation and
Standstill Agreement (the "Non-Competition Agreement") in connection with the
termination of the Merger Agreement.

The Company has capitalized Merger related costs totaling $965,000, included in
prepaid expenses and other current assets in the Consolidated Balance Sheet, and
accrued related expenses of $247,000 at December 31, 1997.

Results of operations of the Company as of December 31, 1997 do not include any
direct costs relating to the Merger Agreement as all such amounts are to be
reimbursed as part of the Settlement Agreement.

4. NONRECURRING CHARGES

During the fourth quarter of 1996, the Company commenced the move of its
corporate headquarters from New Castle, Delaware to Brentwood, Tennessee.
Related costs accrued were $1,055,000 for reengineering and downsizing of the
Company's administrative processes.

The Company increased its 1996 second quarter $1,000,000 loss estimate relating
to the State of Georgia Department of Corrections contract by $2,802,000 in the
fourth quarter, upon notification from the state in October 1996 of its
intention not to renew the contract expiring June 30, 1997. The estimate
includes an approximate $500,000 write-down of equipment, which the state of
Georgia agreed to purchase for $2,900,000. The Company feels it has satisfied
substantially all obligations relating to the contract with the State of Georgia
as of December 31, 1997.

F-13
35

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

4. NONRECURRING CHARGES (CONTINUED)

In April 1996, the Company entered into an agreement to grant the Chief
Executive Officer 175,000 stock options at the fair market value of the shares
on March 28, 1996. The options were granted in May 1996 upon approval by the
Shareholders, pursuant to an amendment to the Incentive Stock Plan in May 1996.
The options contained accelerated vesting provisions, based upon the Company's
stock achieving certain targeted price levels. During the year, these price
levels were obtained and a $2,034,000 noncash compensation charge was
recognized, based upon the difference between the exercise price agreed upon in
March 1996 and the fair market value on the date of grant. The Chief Executive
Officer was also awarded 40,000 redeemable common shares which resulted in a
$350,000 compensation charge based upon the fair market value of the shares on
the date of award.

In 1995, a severance charge of $1,225,000 was recorded relating to the
resignation of the former President and Chief Executive Officer, and the Vice
President and General Counsel of the Company.

5. RESTRICTED INVESTMENTS

Restricted investments represent required funding for Harbour, the captive
insurance subsidiary, and accordingly, are intended to be held to maturity. All
restricted investments are stated at cost, adjusted for amortization of premiums
and accretion of discounts, which are recognized as adjustments to interest
income.

The amortized cost and approximate market value of restricted investments are as
follows:

DECEMBER 31
------------------------------------------------------------
AMORTIZED COST MARKET VALUE
------------------------------- ----------------------------
1997 1996 1997 1996
---------- ---------- ---------- ----------

U.S.Treasury and governmental
agency obligations $1,723,000 $1,722,000 $1,738,000 $1,721,000
Corporate bonds 3,262,000 2,921,000 3,194,000 2,929,000
Mortgage backed securities 654,000 815,000 654,000 808,000
========== ========== ========== ==========
$5,639,000 $5,458,000 $5,586,000 $5,458,000
========== ========== ========== ==========

The amortized cost of restricted investments at December 31, 1997 mature as
follows: due less than one year $1,373,000; due after one year through five
years - $3,257,000; due after five years - $1,009,000.

F-14
36

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

6. PROPERTY AND EQUIPMENT

Property and equipment is stated at cost and comprised of the following:

DECEMBER 31 ESTIMATED
1997 1996 USEFUL LIVES
--------------------------------------------------

Building and improvements $ 604,000 $ 617,000 10 - 31.5 years
Equipment and furniture 3,988,000 5,004,000 5 - 10 years
Medical equipment 344,000 341,000 5 - 7 years
Automobile 14,000 14,000 3 - 5 years
---------- ---------- ---------------
4,950,000 5,976,000
Less: Accumulated depreciation (2,482,000) (2,940,000)
========== ==========
$2,468,000 $3,036,000
========== ==========

Depreciation expense for the years ended December 31, 1997, 1996 and 1995 was
$1,072,000, $1,490,000 and $696,000, respectively.

7. ACCRUED EXPENSES

Accrued expenses consist of the following:

DECEMBER 31
1997 1996
---------------------------------

Medical claims $ 6,047,000 $ 5,471,000
Liability claims 4,494,000 5,992,000
Salaries and employee benefits 4,345,000 7,868,000
Merger costs 247,000 265,000
Legal 429,000 1,270,000
Severance 290,000 1,055,000
Accrued loss on Georgia contract 200,000 2,883,000
Other 408,000 865,000
------------ ------------
16,460,000 25,669,000
Less: Noncurrent portion of liability claims (3,624,000) (3,350,000)
============ ============
$ 12,836,000 $ 22,319,000
============ ============

F-15
37

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

8. BANKING ARRANGEMENTS

On March 28, 1997, the Company entered into a $20,000,000 line of credit
facility for general corporate purposes including working capital, the issuance
of letters of credit for performance bonds and the funding of acquisitions.
Under the line, which matures September 2000, the Company is limited to
$5,000,000 for working capital needs through March 1998. The interest rate is
based on LIBOR or prime rates subject to the quarterly operating performance of
the Company, as defined in the Agreement. The line of credit is collateralized
by all assets of the Company and its operating subsidiaries. The line of credit
is also subject to certain quarterly financial covenants of which the Company
was in compliance with throughout 1997. The Company had a $26,500,000 line of
credit facility at December 31, 1996, which expired in July 1997. No borrowings
were outstanding under the lines of credit at December 31, 1997 and 1996.

PHS had open letters of credit of $3,641,000 and $10,865,000 at December 31,
1997 and 1996, respectively, supporting performance guarantees on specific
contracts. At December 31, 1996, $6,000,000 related to the Georgia Department of
Corrections' contract. In addition, Harbour had unused letters of credit of $0
and $700,000 at December 31, 1997 and 1996.

9. INCOME TAXES

The Company's provision (benefit) for income taxes consists of the following:

YEAR ENDED DECEMBER 31
1997 1996 1995
----------------------------------------------------

Current income taxes:
Federal $ -- $(1,110,000) $ 838,000
State -- (137,000) 209,000
----------- ----------- -----------
-- (1,247,000) 1,047,000
Deferred taxes:
Federal -- -- (438,000)
State 101,000 -- (150,000)
----------- ----------- -----------
101,000 -- (588,000)
=========== =========== ===========
Income taxes (benefits) $ 101,000 $(1,247,000) $ 459,000
=========== =========== ===========

F-16
38

Deferred tax assets (liabilities) are comprised of the following at December 31:

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

9. INCOME TAXES (CONTINUED)

YEAR ENDED DECEMBER 31
1997 1996
-------------------------------

Net operating loss carryforwards $ 2,835,000 $ 347,000
Self-insurance reserves 1,714,000 2,351,000
Executive stock options 773,000 773,000
Accrued vacation 299,000 804,000
Accrued merger costs 247,000 --
Bad debt allowance 146,000 769,000
Accrued legal 140,000 410,000
Accrued severance 109,000 348,000
Accrued loss on Georgia contract 76,000 675,000
Depreciation (461,000) (266,000)
Other 96,000 6,000
----------- -----------
5,974,000 6,217,000
Valuation allowance (2,665,000) (3,009,000)
=========== ===========
$ 3,309,000 $ 3,208,000
=========== ===========

As of December 31, 1997, the Company had federal and state net operating loss
carryforwards of $7,459,000 expiring in 2005 through 2006.

A valuation allowance has been established for deferred tax assets, where
utilization is uncertain. The Company believes it is more likely than not that
the remaining deferred tax assets will be realized through the future reversal
of existing taxable temporary differences and the generation of future taxable
income.

A reconciliation of the federal statutory rate to the effective tax rate is as
follows:

YEAR ENDED DECEMBER 31
1997 1996 1995
----------------------------------

Federal tax 34.0% (34.0)% 34.0%
State income taxes 5.7 (1.4) 5.2
Other 1.0 -- 0.8
Increase (decrease) in valuation allowance (35.0) 22.8 --
==== ==== ====
5.7% (12.6)% 40.0%
==== ==== ====

F-17
39

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

10. REDEEMABLE COMMON STOCK

During 1996, the Company sold 146,000 shares of common stock (purchased shares)
and issued a stock award of 40,000 shares (awarded shares) of common stock to
its newly appointed Chief Executive Officer. The 146,000 shares were sold at the
then current fair market value of $8.75 per share. The vesting of the awarded
shares was accelerated under the terms of the award and a compensation charge of
$8.75 per share was recorded representing the fair market value of the shares on
the date of issuance. Both the purchased and awarded shares are redeemable under
the terms of the officer's employment agreement upon termination of employment.
The redemption value of the shares was calculated at the average closing market
value of the Company's common stock for the 30 trading days immediately
preceding notification of intent to redeem the shares. As of March 31, 1997, the
redemption price was fixed at $9.90 per share, through an amendment to the Chief
Executive Officer's employment agreement. Changes in the redemption value of the
purchased and awarded shares were recorded as adjustments to retained earnings
and compensation expense, respectively. During 1997, the Company adjusted the
redemption value of the purchased and awarded shares, respectively, by $57,000
and $17,000, and during 1996 by $226,000 and $62,000.

11. NET INCOME (LOSS) PER SHARE

The table below sets forth the computation of basic and diluted earnings per
share as required by FASB Statement No. 128 for the three years in the period
ended December 31, 1997.

YEAR ENDED DECEMBER 31,
1997 1996 1995
--------------------------------------------------

NUMERATOR:

Net income (loss) $ 1,685,000 $(8,686,000) $ 687,000
Decrease (increase) in redeemable common stock 57,000 (226,000) --
=========== =========== ===========
Numerator for basic and diluted
earnings per share - income (loss)
available to common stockholders $ 1,742,000 $(8,912,000) $ 687,000
=========== =========== ===========

DENOMINATOR:

Denominator for basic earnings
per share - weighted average
shares 3,480,000 3,171,000 3,027,000
Effect of dilutive securities:
Employee stock options 177,000 -- 194,000
----------- ----------- -----------
Denominator for diluted earnings
per share - adjusted weighted
average shares and assumed
conversions 3,657,000 3,171,000 3,221,000
=========== =========== ===========
Basic earnings (loss) per share $ .50 $ (2.81) $ .23
=========== =========== ===========
Diluted earnings (loss) per share $ .48 $ (2.81) $ .21
=========== =========== ===========

F-18
40

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

11. NET INCOME (LOSS) PER SHARE (CONTINUED)

During any given quarter for the years ended December 31, 1997, 1996 and 1995
there were no more than 175,000, 762,000, and 180,000 options, respectively, to
purchase common stock with weighted average exercise prices of $12.84, $8.60,
and $9.52, respectively, not included in the computation of diluted earnings per
share because the option's exercise price was greater than the average market
price of the common shares for the period or there was a loss for the year and,
therefore, the effect would be antidilutive.

In addition, during any given quarter for the years ended December 31, 1997 and
1996 there were no more than 186,000 shares of common stock which the Company is
required to repurchase upon termination of the Chief Executive Officer, as part
of the written put option included in the employment agreement (see Note 10),
which were not included in the computation of diluted earnings per share because
the exercise (redemption) price was less than the average market price of the
common shares for the period or there was a loss for the year and, therefore,
the effect would be antidilutive.

12. STOCK OPTION PLANS

The Company has an Incentive Stock Plan, which provides for the granting of
options, stock awards and stock appreciation rights to officers, key employees
and non-employee directors for up to 1,182,500 shares of the Company's common
stock. Awards and vesting periods under the plan are discretionary and are
administered by a committee of the Board of Directors. The exercise price of the
options shall not be less than the fair market value at the date of grant.
Options and other benefits expire at such times as the committee shall determine
at the time of grant, but no later than ten years from the grant date.

The following is a summary of stock option activity under the plan:

WEIGHTED
AVERAGE
OPTIONS PRICE RANGE EXERCISE PRICE
----------------------------------------------

Outstanding, January 1, 1995 776,400 $ 2.33 - 11.19 $ 4.60
Granted 140,800 4.50 - 6.31 3.91
Exercised (80,500) 2.33 - 6.50 3.60
Canceled (168,500) 2.66 - 6.50 3.59
-------- -------------- -------
Outstanding, December 31, 1995 668,200 2.33 - 11.19 5.00
Granted 402,350 6.93 - 13.13 10.53
Exercised (324,950) 2.33 - 6.50 3.39
Stock award vested (40,000) 8.75 - 8.75 8.75
Canceled (18,800) 4.50 - 13.12 12.16
-------- -------------- -------
Outstanding, December 31, 1996 686,800 2.67 - 13.12 8.66
Granted 97,500 10.19 - 14.44 12.98
Exercised (147,500) 2.67 - 13.13 3.45
Canceled (42,500) 4.50 - 13.88 11.91
======== ============== =======
Outstanding, December 31, 1997 594,300 $ 4.50 - 14.44 $ 10.41
======== ============== =======

F-19
41

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

12. STOCK OPTION PLANS (CONTINUED)

Total options available for future grants at December 31, 1997 and 1996, were
76,000 and 131,000, respectively. Under a separate plan and as part of the
recruitment of the Chief Operating Officer, the Company granted 75,000 options
at fair market value during 1996.

In April 1996, the Company granted the Chief Executive Officer 175,000 stock
options pursuant to an amendment to the Incentive Stock Plan in May 1996 which
resulted in a $2,034,000 noncash compensation charge.

As of December 31, 1997, 449,000 options were exercisable under all plans. The
Company has reserved 818,000 shares of common stock for options outstanding and
for options which may be granted in the future.

OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ------------------------------------------------------------------------ ------------------------------------
WEIGHTED AVG. WEIGHTED
RANGE OF OUTSTANDING REMAINING AVERAGE NUMBER EXERCISABLE WEIGHTED AVERAGE
EXERCISE PRICES AT 12/31/97 CONTRACTUAL LIVE EXERCISE PRICE AT 12/31/97 EXERCISE PRICE
- ------------------------------------------------------------------------ ------------------------------------

$ 4.50 - 6.50 67,700 6.95 $ 5.74 61,900 $ 5.78
8.75 - 11.19 429,000 8.53 9.68 351,300 9.71
13.13 - 14.44 172,600 9.55 13.59 35,800 13.13
-------------- ------- -------
$ 4.50 - 14.44 669,300 449,000
============== ======= =======

Options exercisable at December 31, 1996 had a weighted average exercise price
of $6.72.

Pro forma information regarding net income (loss) and earnings per share is
required by SFAS No. 123 which also requires that the information be determined
as if the Company has accounted for its employee stock options granted
subsequent to December 31, 1994 under the fair method of that Statement. The
fair value of these options was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted-average
assumptions:

YEAR ENDED DECEMBER 31,
-----------------------
1997 1996
----------------------

Volatility..................... 0.7 1.0
Interest rate.................. 5.8% 8.5%
Expected life (years).......... 3 3
Dividend yields................ 0.0% 0.0%

F-20
42

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

12. STOCK OPTION PLANS (CONTINUED)

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

For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the option's vesting period. The Company's pro
forma information for the years ended December 31, 1997 and 1996 is as follows:

YEAR ENDED DECEMBER 31,
-------------------------------------------------
1997 1996
-------------------------------------------------
AS PRO AS PRO
REPORTED FORMA REPORTED FORMA
-------------------------------------------------
(in thousands, except per share data)

Net income (loss).................................. $1,685 $1,029 $(8,686) $(7,190)
Income (Loss) per common share:
Basic........................................... $ .50 $ .30 $ (2.81) $ (2.04)
Diluted......................................... $ .48 $ .28 $ (2.81) $ (2.04)

The resulting pro forma disclosures may not be representative of that to be
expected in future years.

13. EMPLOYEE BENEFIT PLAN

The Company has a 401(k) Retirement Savings Plan (the "Plan") covering
substantially all employees who have completed one year and 1,000 hours of
service. The Plan permits eligible employees to defer and contribute to the Plan
a portion of their compensation. The Company matches such employee contributions
to the Plan ranging from 1% to 3% depending on their years of participation. The
Company recorded an expense of $266,000, $299,000 and $338,000 for the years
ended December 31, 1997, 1996 and 1995, respectively, related to the matching
contributions of the Plan.

The Company instituted an Employee Stock Purchase Plan during 1996. Employees
who have completed one year of service are eligible to contribute up to 10% of
their annual salaries whereby common shares will be purchased at 85% of the
Company's fair market value as defined within the agreement. At December 31,
1997, the Company has recorded $136,000, included in accrued expenses, related
to a one-time opportunity for employees to rescind the purchase of common stock
under the plan and to receive a refund of their payroll deductions for the July
1, 1997 through December 31, 1997 period.

F-21
43

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

14. PROFESSIONAL AND GENERAL LIABILITY INSURANCE

Harbour Insurance, Inc., a PHS wholly-owned captive insurance company
incorporated under the laws of the state of Delaware, currently provides
professional and general liability coverage to PHS with limits of $1,000,000 per
claim and various aggregate limits per policy year. The aggregate limit for
policy years ended December 31, 1997, 1996 and 1995 was $3,500,000, $3,250,000
and $2,450,000, respectively.

Possible claims in excess of the individual and aggregate claims per policy year
up to a maximum of $15,000,000 for 1997 and $5,000,000 for 1996 and 1995, are
covered by third-party insurance policies on a claims-made basis. During the
1994-95 and 1993-94 policy years, the Company retained 30% of this excess
coverage on a risk-sharing basis.

Any liabilities in excess of the third-party insurance limits are assumed by the
Company. The Harbour policy relative to the contract with the Georgia Department
of Corrections, which terminated on June 30, 1997, is an occurrence-based policy
with similar levels of self-insured retention.

In July 1997, the Company commenced operations under the Indiana contract. The
Company has third party commercial insurance on an occurrence basis with respect
to the Indiana contract.

In prior years, PHS has contributed approximately $1,100,000 for capitalization
of Harbour. Amounts contributed are adequate to meet legal capitalization
requirements and are restricted from general use by PHS.

The Company records a liability for reported and unreported professional and
general liability claims based upon the cost of settling losses and loss
adjustment expenses discounted at 6% in 1997 and 1996, and 7% in 1995. Amounts
accrued were $4,494,000 and $5,992,000 at December 31, 1997 and 1996,
respectively, and are included in accrued expenses and non-current portion of
accrued expenses. Changes in estimates of losses resulting from the continuous
review process and differences between estimates and loss payments are
recognized in the period in which the estimates are changed or payments are
made. Reserves for medical malpractice exposures are subject to fluctuations in
frequency and severity. Given the inherent degree of variability in any such
estimates, the reserves reported at December 31, 1997, represent management's
best estimate of the amounts necessary to discharge the Company's obligations.

15. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company leases office space and equipment through October 2003 under certain
noncancelable operating leases.

F-22
44

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

15. COMMITMENTS AND CONTINGENCIES (CONTINUED)

The Company has a sublease agreement with a third party for its former corporate
office space in New Castle, Delaware. The sublease is for the period May 1, 1997
through April 30, 1999, with two six- month renewal options through April 30,
2000. The original lease term expires July 31, 2000. Based upon the anticipated
option renewal through April 30, 2000, no lease termination expense has been
recorded by the Company. In connection with the MedPartners Settlement Agreement
(see Note 3), the Company closed its regional offices in Atlanta, Georgia, and
Newark, Delaware and assigned future lease payments totaling $230,000 to
MedPartners.

Future minimum annual lease payments at December 31, 1997 are as follows:

Year ending December 31:

1998 $ 581,000
1999 602,000
2000 460,000
2001 230,000
2002 211,000
Thereafter 176,000
----------
2,260,000
Sublease receipts (407,000)
==========
$1,853,000
==========

Rental expense under operating leases was $516,000, $564,000 and $457,000 for
the years ended December 1997, 1996 and 1995, respectively.

Catastrophic Limits

Many of the Company's contracts require reimbursement to the Company for all
treatment costs or, in some cases, only out-of-pocket treatment costs related to
certain catastrophic events, and/or for AIDS or AIDS-related illnesses. Certain
contracts do not contain such limits. The Company attempts to compensate for the
increased financial risk when pricing contracts that do not contain individual,
catastrophic or AIDS-related limits. However, the occurrence of severe
individual cases, AIDS-related illnesses or a catastrophic event in a facility
governed by a contract without such limitations could render the contract
unprofitable and could have a material adverse effect on the Company's
operations. The Company maintains insurance from an unaffiliated insurer for
contracts, which do not contain catastrophic protection for hospitalization
amounts in excess of $125,000 per inmate. The Company believes this insurance
significantly mitigates its exposure to unanticipated expenses of catastrophic
hospitalization.

F-23
45

AMERICA SERVICE GROUP INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

15. COMMITMENTS AND CONTINGENCIES (CONTINUED)

Litigation and Claims

The Company is a party to various legal proceedings incidental to its business.
Certain claims, suits and complaints arising in the ordinary course of business
have been filed or are pending against the Company. An estimate of the amounts
payable on existing claims for which the liability of the Company is probable is
included in accrued expenses at December 31, 1997 and 1996. The Company is not
aware of any material unasserted claims and, based on its past experience, would
not anticipate that potential future claims would have a material adverse effect
on its consolidated financial position or results of operations.

16. MAJOR CUSTOMERS AND GEOGRAPHICAL CONCENTRATIONS

The following is a summary of revenues from major customers:

YEAR ENDED DECEMBER 31
1997 1996 1995
---------------------------------------------------------------------------------
REVENUE PERCENT REVENUE PERCENT REVENUE PERCENT
---------------------------------------------------------------------------------
(In thousands)

State of Georgia $30,854 23.9% $56,662 37.2% $13,530 11.8%
State of Kansas 18,095 14.0 17,096 11.2 15,476 13.5
City of Philadelphia 17,865 13.8 16,034 10.5 14,713 12.8
State of Maryland - - 15,479 10.2 18,747 16.3

Estimated credit losses associated with the receivables are provided for in the
consolidated financial statements. The contract with the state of Georgia
expired June 30, 1997 (see Note 4).

17. FOURTH QUARTER ADJUSTMENTS (UNAUDITED)

The Company made a year end adjustment in 1997 resulting from a change in
estimate relating to medical malpractice reserves. The adjustment of $1,400,000
increased basic and diluted earnings per share by $.40 and $.39, respectively.

F-24
46

REPORT OF INDEPENDENT ACCOUNTANTS
FINANCIAL STATEMENT SCHEDULE

To the Board of Directors of
America Service Group Inc.

Our audits of the consolidated financial statements referred to in our report
dated March 11, 1996 except as to Note 15, which is as of March 28, 1996,
appearing on page F-3 of the 1997 Annual Report to Shareholders of America
Service Group Inc. (which report and consolidated financial statements are
incorporated by reference in this Annual Report on Form 10-K) also included an
audit of the Financial Statement Schedule listed in Item 14(a) of this Form
10-K. In our opinion, this Financial Statement Schedule presents fairly, in all
material respects, the information set forth therein when read in conjunction
with the related consolidated financial statements.

PRICE WATERHOUSE LLP
Linthicum, Maryland
March 11, 1996
Except as to Note 15, which is as of
March 28, 1996

F-25
47

Schedule II

AMERICA SERVICE GROUP INC.

VALUATION AND QUALIFYING ACCOUNTS AND RESERVES

ADDITIONS
BALANCE AT CHARGED TO BALANCE AT
BEGINNING OF COSTS AND END OF
PERIOD EXPENSES DEDUCTIONS PERIOD
----------------------------------------------------------------

DECEMBER 31, 1997
Allowance for doubtful accounts $2,016,000 $ 841,000 $2,473,000 $ 384,000
Valuation allowance for deferred
tax asset 3,009,000 -- 344,000 2,665,000
========== ========== ========== ==========
$5,025,000 $ 841,000 $2,817,000 $3,049,000
========== ========== ========== ==========

DECEMBER 31, 1996
Allowance for doubtful accounts $ 840,000 $1,822,000 $ 646,000 $2,016,000
Valuation allowance for deferred
tax asset -- 3,009,000 -- 3,009,000
========== ========== ========== ==========
$ 840,000 $4,831,000 $ 646,000 $5,025,000
========== ========== ========== ==========

DECEMBER 31, 1995
Allowance for doubtful accounts $ 419,000 $ 421,000 -- $ 840,000
========== ========== ========== ==========

F-26