================================================================================
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                              ------------------




                                    FORM 8-K




                 CURRENT REPORT PURSUANT TO SECTION 13 OR 15(D)

                     OF THE SECURITIES EXCHANGE ACT OF 1934


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



                        DATE OF REPORT: AUGUST 26, 1997





                            HEALTHSOUTH CORPORATION
             (Exact Name of Registrant as Specified in its Charter)








<TABLE>
<CAPTION>
          DELAWARE                   1-10315           63-0860407
<S>                                <C>              <C>
     (State or Other               (Commission      (I.R.S. Employer
 Jurisdiction of Incorporation     File Number)     Identification No.)
     or Organization)
</TABLE>


                       ONE HEALTHSOUTH PARKWAY
                        BIRMINGHAM, ALABAMA         35243

            (Address of Principal Executive Offices)     (Zip Code)


                                 (205) 967-7116
              Registrant's Telephone Number, Including Area code:


================================================================================

<PAGE>



ITEM 5. OTHER EVENTS

     HEALTHSOUTH Corporation ("HEALTHSOUTH" or the "Company") files this Current
Report  on Form 8-K to  reflect  the  restatement  of its  audited  consolidated
financial  statements  at December 31, 1995,  and 1996,  and for the years ended
December 31, 1994,  1995 and 1996, and the resulting  revisions to  Management's
Discussion  and Analysis of Financial  Condition  and Results of  Operations  to
reflect the effects of HEALTHSOUTH'S acquisition of Health Images, Inc. ("Health
Images").  HEALTHSOUTH  acquired Health Images during the first quarter of 1997,
in a transaction that was accounted for as a pooling of interests.


                                       1


<PAGE>






                      SELECTED CONSOLIDATED FINANCIAL DATA
     The  data  set  forth  below  should  be  read  in  conjunction   with  the
consolidated financial statements,  related notes and other information included
herein.  The  financial  information  for all  periods  set forth below has been
restated to reflect the  acquisitions  of ReLife,  Inc.  ("ReLife")  in December
1994,  Surgical Health Corporation ("SHC") in June 1995, Sutter Surgery Centers,
Inc. ("SSCI") in October 1995, Surgical Care Affiliates, Inc. ("SCA") in January
1996, Advantage Health Corporation ("Advantage Health") in March 1996 and Health
Images,  Inc.  ("Health Images") in March 1997, each of which has been accounted
for as a pooling of interests.




<TABLE>
<CAPTION>
                                                                           YEAR ENDED DECEMBER 31,
                                                  -------------------------------------------------------------------------
                                                    1992          1993           1994           1995            1996
                                                  -----------   ------------   ------------   ------------   --------------
                                                                    (IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                                               <C>           <C>            <C>            <C>            <C>
INCOME STATEMENT DATA:
 Revenues  ....................................    $819,821     $1,055,295     $1,726,321     $2,118,681      $2,568,155
 Operating unit expenses  .....................     570,543       715,189      1,207,707      1,441,059        1,667,248
 Corporate general and administrative ex-
  penses                                             32,526        43,378         67,798         65,424           79,354
 Provision for doubtful accounts   ............      18,755        22,677         35,740         42,305           58,637
 Depreciation and amortization  ...............      42,107        75,425        126,148        160,901          207,132
 Merger and acquisition related expenses(1)              --           333          6,520         19,553           41,515
 Loss on impairment of assets(2)   ............          --            --         10,500         53,549           37,390
 Loss on abandonment of computer
  project(2)  .................................          --            --          4,500             --               --
 Loss on disposal of surgery centers(2)  ......          --            --         13,197             --               --
 NME Selected Hospitals Acquisition re-
  lated expense                                          --        49,742             --             --               --
 Terminated merger expense   ..................       3,665            --             --             --               --
 Loss on extinguishment of debt    ............         883            --             --             --               --
 Interest expense   ...........................      20,164        25,884         74,895        105,517           98,751
 Interest income ..............................      (9,757)       (6,179)        (6,658)        (8,009)          (6,034)
 Gain on sale of partnership interest    ......          --        (1,400)            --             --               --
 Gain on sale of MCA Stock(2)   ...............          --            --         (7,727)            --               --
                                                   --------     ----------     ----------     ----------      ----------
                                                    678,886       925,049      1,532,620      1,880,299        2,183,993
                                                   --------     ----------     ----------     ----------      ----------
 Income from continuing operations before
  income taxes, minority interests and ex-
  traordinary item                                  140,935       130,246        193,701        238,382          384,162
 Provision for income taxes  ..................      42,621        40,450         68,560         86,161          143,929
                                                   --------     ----------     ----------     ----------      ----------
                                                     98,314        89,796        125,141        152,221          240,233
 Minority interests ...........................      26,322        29,549         31,665         43,753           50,369
                                                   --------     ----------     ----------     ----------      ----------
 Income from continuing operations ............      71,992        60,247         93,476        108,468          189,864
 Income from discontinued operations  .........       3,283         3,986         (6,528)        (1,162)              --
 Extraordinary item(2) ........................          --            --             --         (9,056)              --
                                                   --------     ----------     ----------     ----------      ----------
  Net income  .................................    $ 75,275     $  64,233      $  86,948      $  98,250       $  189,864
                                                   ========     ==========     ==========     ==========      ==========
 Weighted average common and common
  equivalent shares outstanding(3) ............     265,267       275,316        291,314        307,792          336,807
                                                   ========     ==========     ==========     ==========      ==========
 Income per common and common equiv-
  alent share(3)
  Continuing operations   .....................    $   0.27     $    0.22      $    0.32      $    0.35       $     0.56
  Discontinued operations    ..................        0.01          0.01          (0.02)            --               --
  Extraordinary item   ........................          --            --             --          (0.03)              --
                                                   --------     ----------     ----------     ----------      ----------
  Net income  .................................    $   0.28     $    0.23      $    0.30      $    0.32       $     0.56
                                                   ========     ==========     ==========     ==========      ==========
 Income per common share -- assuming
  full dilution(3)(4)
  Continuing operations   .....................       N/A           N/A        $    0.32      $    0.35       $     0.55
  Discontinued operations .....................       N/A           N/A            (0.02)            --               --
  Extraordinary item   ........................       N/A           N/A               --          (0.03)              --
                                                   --------     ----------     ----------     ----------      ----------
  Net income  .................................       N/A           N/A        $    0.30      $    0.32       $     0.55
                                                   ========     ==========     ==========     ==========      ==========
</TABLE>




<TABLE>
<CAPTION>
                                                                        DECEMBER 31,
                                           -----------------------------------------------------------------------
                                             1992           1993           1994           1995           1996
                                           ------------   ------------   ------------   ------------   -----------
                                                                       (IN THOUSANDS)
<S>                                          <C>            <C>            <C>            <C>            <C>
BALANCE SHEET DATA:
 Cash and marketable securities   ......     $  190,153     $  153,011     $  134,040     $  159,793     $  153,831
 Working capital   .....................        285,645        300,876        308,770        406,601        554,589
 Total assets   ........................      1,264,334      2,000,566      2,355,920      3,107,808      3,529,706
 Long-term debt(5)    ..................        438,515      1,028,610      1,164,135      1,453,018      1,560,143
 Stockholders' equity    ...............        661,846        727,737        837,160      1,269,686      1,569,101
</TABLE>



----------

(1) Expenses  related to SHC's  Ballas  Merger in 1993,  the ReLife and Heritage
    Acquisitions  in 1994, the SHC, SSCI and NovaCare  Rehabilitation  Hospitals
    Acquisition  in 1995  and the SCA,  Advantage  Health,  PSCM  and  ReadiCare
    mergers in 1996.
(2) See "Notes to Consolidated Financial Statements".
(3) Adjusted to reflect a two-for-one stock split effected in the form of a 100%
    stock dividend paid on April 17, 1995 and a two-for-one stock split effected
    in the form of a 100% stock dividend paid on March 17, 1997.
(4) Fully-diluted  earnings  per  share in 1994,  1995 and 1996  reflect  shares
    reserved  for issuance  upon  conversion  of  HEALTHSOUTH's  5%  Convertible
    Subordinated Debentures due 2001, where applicable.
(5) Includes current portion of long-term debt.


                                       2

<PAGE>


                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS



GENERAL


     The following  discussion is intended to facilitate the  understanding  and
assessment  of  significant  changes  and  trends  related  to  the  results  of
operations and financial  condition of the Company,  including  certain  factors
related to recent  acquisitions  by the Company,  the timing and nature of which
have significantly affected the Company's results of operations. This discussion
and  analysis  should be read in  conjunction  with the  Company's  consolidated
financial statements and notes thereto included elsewhere in this Current Report
on Form 8-K.

     The Company completed the following  acquisitions over the last three years
(common share  amounts have been  adjusted to reflect a stock split  effected in
the form of a 100% stock dividend paid on March 17, 1997):


   o On December  29,  1994,  the Company  acquired  ReLife,  Inc.  (the "ReLife
     Acquisition").  A total of 22,050,580  shares of the Company's Common Stock
     were issued in the transaction, representing a value of $180,000,000 at the
     time of the  acquisition.  At  that  time,  ReLife  operated  31  inpatient
     facilities  with an  aggregate  of  1,102  licensed  beds,  including  nine
     free-standing  rehabilitation  hospitals,  nine acute rehabilitation units,
     five sub-acute  rehabilitation  units, seven transitional  living units and
     one  residential  facility,  and also  provided  outpatient  rehabilitation
     services at 12 centers.

   o On  April  1,  1995,   the  Company   purchased   the   operations  of  the
     rehabilitation   hospital   division  of  NovaCare,   Inc.  (the  "NovaCare
     Rehabilitation   Hospitals   Acquisition").    The   purchase   price   was
     approximately $235,000,000. The NovaCare Rehabilitation Hospitals consisted
     of 11 rehabilitation hospitals in seven states, 12 other facilities and two
     Certificates of Need.

   o On June 13, 1995, the Company  acquired  Surgical Health  Corporation  (the
     "SHC  Acquisition").  A total of 17,062,960  shares of the Company's Common
     Stock were issued in the transaction,  representing a value of $155,000,000
     at  the  time  of  the  acquisition.   The  Company  also  purchased  SHC's
     $75,000,000  aggregate  principal amount of 11.5% Senior Subordinated Notes
     due 2004 for an aggregate  consideration of approximately  $86,000,000.  At
     that time, SHC operated a network of 36 free-standing surgery centers in 11
     states, and five mobile lithotripsy units.

   o On October 26, 1995, the Company acquired Sutter Surgery Centers, Inc. (the
     "SSCI  Acquisition").  A total of 3,552,002  shares of the Company's Common
     Stock were issued in the  transaction,  representing a value of $44,444,000
     at the time of the acquisition. At that time, SSCI operated a network of 12
     freestanding surgery centers in three states.

   o On  December  1,  1995,  the  Company acquired Caremark Orthopedic Services
     Inc.  (the  "Caremark  Acquisition").  The purchase price was approximately
     $127,500,000.  At  that  time Caremark owned and operated approximately 120
     outpatient rehabilitation centers in 13 states.

   o On January 17, 1996, the Company acquired  Surgical Care  Affiliates,  Inc.
     (the "SCA  Acquisition").  A total of  91,856,678  shares of the  Company's
     Common  Stock  were  issued  in the  transaction,  representing  a value of
     approximately  $1,400,000,000 at the time of the acquisition. At that time,
     SCA operated a network of 67 freestanding surgery centers in 24 states.

   o On March 14, 1996, the Company acquired  Advantage Health  Corporation (the
     "Advantage  Health  Acquisition").  A total  of  18,203,978  shares  of the
     Company's Common Stock were issued in the transaction, representing a value
     of approximately $315,000,000 at the time of the acquisition. At that time,
     Advantage Health operated a network of 136 sites of service, including four
     freestanding rehabilitation hospitals, one freestanding multi-use hospital,
     one nursing  home, 68 outpatient  rehabilitation  facilities,  14 inpatient
     managed   rehabilitation  units,  24  rehabilitation   services  management
     contracts and six managed sub-acute rehabilitation units, primarily located
     in the northeastern United States.


                                       3

<PAGE>

   o On  August  20,  1996,  the  Company  acquired   Professional  Sports  Care
     Management,  Inc. (the "PSCM Acquisition").  A total of 3,622,888 shares of
     the Company's Common Stock were issued in the  transaction,  representing a
     value of approximately $59,000,000 at the time of the acquisition.  At that
     time,  PSCM operated a network of 36 outpatient  rehabilitation  centers in
     three states.



   o On December 2, 1996, the Company acquired  ReadiCare,  Inc. (the "ReadiCare
     Acquisition").  A total of 4,007,954  shares of the Company's  Common Stock
     were  issued  in the  transaction,  representing  a value of  approximately
     $76,000,000  at the  time  of the  acquisition.  At  that  time,  ReadiCare
     operated a network of 37 outpatient medical and  rehabilitation  centers in
     two states.


   o On  March  3,  1997,  the  Company  acquired  Health  Images, Inc. ("Health
     Images").  A  total of 10,343,470 shares of the Company's Common Stock were
     issued   in   the   transaction,  representing  a  value  of  approximately
     $208,162,000  at  the  time of the acquisition. At that time, Health Images
     operated  49  freestanding  diagnostic  centers in 13 states and six in the
     United Kingdom.


     The  NovaCare   Rehabilitation   Hospitals  Acquisition  and  the  Caremark
Acquisition each were accounted for under the purchase method of accounting and,
accordingly,  the acquired operations are included in the Company's consolidated
financial  information from their  respective dates of acquisition.  Each of the
ReLife  Acquisition,   the  SHC  Acquisition,  the  SSCI  Acquisition,  the  SCA
Acquisition,  the Advantage Health Acquisition and the Health Images Acquisition
was accounted for as a pooling of interests  and, with the exception of data set
forth relating to revenues derived from Medicare and Medicaid, all amounts shown
in the following  discussion  have been  restated to reflect such  acquisitions.
ReLife,  SHC, SSCI, SCA,  Advantage  Health and Health Images did not separately
track such revenues.  The PSCM  Acquisition and the ReadiCare  Acquisition  were
also accounted for as poolings of interests.  However,  due to the immateriality
of PSCM and ReadiCare,  the Company's  historical  financial  statements for all
periods  prior to the quarters in which the  respective  mergers took place have
not been restated. Instead,  stockholders' equity has been increased during 1996
to reflect the effects of the PSCM  Acquisition  and the ReadiCare  Acquisition.
The results of operations of PSCM and ReadiCare are included in the accompanying
financial  statements and the following  discussion from the date of acquisition
forward (see Note 2 of "Notes to Consolidated  Financial Statements" for further
discussion). 


     The Company determines the amortization period of the cost in excess of net
asset value of  purchased  facilities  based on an  evaluation  of the facts and
circumstances of each individual purchase  transaction.  The evaluation includes
an analysis of historic and projected  financial  performance,  an evaluation of
the  estimated  useful life of the  buildings  and fixed  assets  acquired,  the
indefinite  useful  life of  certificates  of need and  licenses  acquired,  the
competition  within local markets,  lease terms where applicable,  and the legal
terms  of  partnerships  where  applicable.  The  Company  utilizes  independent
appraisers and relies on its own management  expertise in evaluating each of the
factors  noted above.  With respect to the carrying  value of the excess of cost
over net asset value of purchased  facilities and other intangible  assets,  the
Company determines on a quarterly basis whether an impairment event has occurred
by  considering  factors  such as the market value of the asset,  a  significant
adverse  change in legal factors or in the business  climate,  adverse action by
regulators,  history of operating losses or cash flow losses, or a projection of
continuing  losses  associated with an operating  entity.  The carrying value of
excess cost over net asset value of purchased  facilities  and other  intangible
assets will be evaluated if the facts and circumstances suggest that it has been
impaired.  If this evaluation  indicates that the value of the asset will not be
recoverable,  as determined based on the  undiscounted  cash flows of the entity
acquired over the remaining amortization period, the Company's carrying value of
the asset will be reduced by the estimated shortfall of cash flows.


     Governmental,  commercial and private payors have  increasingly  recognized
the  need  to  contain  their  costs  for  healthcare  services.  These  payors,
accordingly,  are turning to closer monitoring of services,  prior authorization
requirements,   utilization  review  and  increased  utilization  of  outpatient
services.  During the periods  discussed  below,  the Company has experienced an
increased  effort by these payors to contain costs through  negotiated  discount
pricing. The Company views these efforts as an


                                        4

<PAGE>

opportunity to demonstrate the  effectiveness  of its clinical  programs and its
ability to provide  its  rehabilitative  healthcare  services  efficiently.  The
Company has entered into a number of contracts  with payors to provide  services
and has realized an increased volume of patients as a result.

     The  Company's  revenues  include net patient  service  revenues  and other
operating  revenues.  Net patient service revenues are reported at estimated net
realizable  amounts  from  patients,  insurance  companies,  third-party  payors
(primarily  Medicare and  Medicaid) and others for services  rendered.  Revenues
from third-party  payors also include  estimated  retroactive  adjustments under
reimbursement  agreements  which are subject to final review and  settlement  by
appropriate authorities.  Management determines allowances for doubtful accounts
and  contractual  adjustments  based on historical  experience  and the terms of
payor contracts. Net accounts receivable include only those amounts estimated by
management to be collectible.

     The Company, in many cases, operates more than one site within a market. In
such markets,  there is customarily an outpatient  center or inpatient  facility
with associated  satellite outpatient  locations.  For purposes of the following
discussion and analysis,  same store operations are measured on locations within
markets in which similar operations existed at the end of the period and include
the operations of additional  locations opened within the same market. New store
operations are measured on locations within new markets.


RESULTS OF OPERATIONS OF THE COMPANY


Twelve-Month Periods Ended December 31, 1994 and 1995


     The Company  operated 537 outpatient  rehabilitation  locations at December
31, 1995,  compared to 283 outpatient  rehabilitation  locations at December 31,
1994. In addition, the Company operated 95 inpatient rehabilitation  facilities,
122 surgery centers,  69 diagnostic centers and five medical centers at December
31,  1995,  compared  to 82  inpatient  rehabilitation  facilities,  112 surgery
centers, 51 diagnostic centers and five medical centers at December 31, 1994.

     The Company's  operations  generated revenues of $2,118,681,000 in 1995, an
increase of  $392,360,000,  or 22.7%,  as compared to 1994 revenues.  Same store
revenues for the twelve months ended December 31, 1995 were  $1,891,150,000,  an
increase of  $164,829,000,  or 9.5%, as compared to the same period in 1994. New
store revenues for 1995 were $227,531,000. New store revenues reflect (1) the 11
rehabilitation  hospitals and 12 other  facilities  associated with the NovaCare
Rehabilitation  Hospitals  Acquisition,  (2) the 120  outpatient  rehabilitation
centers  associated with the Caremark  Acquisition,  (3) the acquisition of five
surgery  centers and 16 outpatient  diagnostic  imaging  operation,  and (4) the
acquisition of outpatient  rehabilitation operations in 34 new markets. See Note
9 of "Notes to Consolidated Financial  Statements".  The increase in revenues is
primarily  attributable  to the addition of these  operations  and  increases in
patient volume. Revenues generated from patients under the Medicare and Medicaid
programs  respectively  accounted for 40.0% and 2.5% of total revenues for 1995,
compared to 41.0% and 3.2% of total  revenues for 1994.  Revenues from any other
single third-party payor were not significant in relation to the Company's total
revenues.  During 1995, same store outpatient visits, inpatient days and surgery
center  cases  increased  21.7%,  10.8%  and  4.8%,  respectively.  Revenue  per
outpatient  visit,  inpatient  day and  surgery  case for same store  operations
increased (decreased) by 0.8%, 2.5% and (0.9%), respectively.

     Operating expenses,  at the operating unit level, were  $1,441,059,000,  or
68.0% of revenues,  for 1995, compared to 70.0% of revenues for 1994. Same store
operating expenses for 1995 were  $1,291,546,000,  or 68.3% of related revenues.
New store operating  expenses were  $149,513,000,  or 65.7% of related revenues.
Corporate general and administrative expenses decreased from $67,798,000 in 1994
to  $65,424,000  in 1995.  As a percentage  of revenues,  corporate  general and
administrative  expenses  decreased  from  3.9% in 1994 to 3.1% in  1995.  Total
operating expenses were $1,506,483,000, or 71.1% of revenues, for 1995, compared
to  $1,275,505,000,  or 73.9% of revenues,  for 1994. The provision for doubtful
accounts  was  $42,305,000,   or  2.0%  of  revenues,   for  1995,  compared  to
$35,740,000, or 2.1% of revenues, for 1994. 


                                       5

<PAGE>






     Depreciation and amortization  expense was $160,901,000 for 1995,  compared
to $126,148,000  for 1994. The increase  represents the investment in additional
assets by the  Company.  Interest  expense  increased to  $105,517,000  in 1995,
compared to $74,895,000  for 1994,  primarily  because of the increased  average
borrowings during 1995 under the Company's  revolving line of credit.  For 1995,
interest income was $8,009,000, compared to $6,658,000 for 1994.


     Merger  expenses in 1994 of $6,520,000  represent costs incurred or accrued
in connection  with  completing the ReLife  Acquisition  ($2,949,000)  and SHC's
acquisition  of  Heritage  Surgical   Corporation   ($3,571,000).   For  further
discussion, see Note 2 of "Notes to Consolidated Financial Statements".

     During 1994,  the Company  recognized a  $10,500,000  loss on impairment of
assets.  This amount relates to the termination of a ReLife management  contract
and a permanently damaged ReLife facility. The Company determined not to attempt
to reopen such  damaged  facility  because,  under its existing  licensure,  the
facility was not  consistent  with the Company's  plans.  Also during 1994,  the
Company  recognized  a  $4,500,000  loss on  abandonment  of a  ReLife  computer
project. For further discussion, see Note 14 of "Notes to Consolidated Financial
Statements".

     During the fourth  quarter of 1994,  the  Company  adopted a formal plan to
dispose of three  surgery  centers and certain  other  properties  during fiscal
1995.  Accordingly,  a charge of  $13,197,000  was made to reflect the  expected
losses  resulting from the disposal of these centers.  The closings of the three
surgery centers were completed by December 31, 1995. For further discussion, see
Note 13 of "Notes to Consolidated Financial Statements".


     As a result of the NovaCare and SHC  Acquisitions,  the Company  recognized
$14,588,000 in merger and acquisition related expenses during the second quarter
of 1995.  Fees related to legal,  accounting  and  financial  advisory  services
accounted for $3,400,000 of the expense.  Accruals for employee separations were
approximately  $1,188,000.  In  addition,  the  Company  provided  approximately
$10,000,000 for the write-down of certain assets to net realizable  value as the
result of a facility  consolidation  in a market  where the  Company's  existing
services overlapped with those of an acquired facility. The employee separations
and facility consolidation were completed by the end of 1995. 

     In the fourth  quarter  of 1995,  the  Company  incurred  direct  costs and
expenses of $4,965,000 in connection with the SSCI  Acquisition.  These expenses
consist  primarily of fees related to legal,  accounting and financial  advisory
services and are included in merger and acquisition related acquisition expenses
for the year ended December 31, 1995.


     In connection with the SHC Acquisition the Company  recognized a $9,056,000
extraordinary  loss (net of  income  tax  benefit  of  $5,550,000)  on the early
extinguishment  of the SHC Notes  during  1995  (see  Notes 2 and 7 of "Notes to
Consolidated Financial Statements"). 

     Also during 1995, the Company  recognized a $53,549,000  loss on impairment
of  assets.  The  impaired  assets  relate to six SHC  facilities  and eight SCA
facilities  in which the projected  undiscounted  cash flows did not support the
book value of the long-lived assets of such facilities. See Note 14 of "Notes to
Consolidated Financial Statements".


     Income from continuing  operations before income taxes,  minority interests
and extraordinary  item for 1995 was $238,382,000,  compared to $193,701,000 for
1994.  Minority  interests  reduced  income before income taxes by  $43,753,000,
compared to $31,665,000  for 1994.  During the quarter ended March 31, 1995, the
Company discontinued the operations of Interactive Diagnostic Services,  Inc., a
wholly-owned  subsidiary  ("IDSI"),  and IDSI's financial results are treated as
discontinued  operations.  During  1995,  the  Company  recognized  a loss  from
discontinued  operations  and a loss on disposal of  discontinued  operations of
$1,162,000  in after tax losses  compared to  $6,528,000  in after tax losses in
1994. For further  discussion,  see Note 9 of "Notes to  Consolidated  Financial
Statements".  The provision for income taxes for 1995 was $86,161,000,  compared
to $68,560,000 for 1994,  resulting in effective tax rates of 44.3% for 1995 and
42.3% for 1994. Net income for 1995 was $98,250,000. 


Twelve-Month Periods Ended December 31, 1995 and 1996

     The Company  operated 739 outpatient  rehabilitation  locations at December
31, 1996,  compared to 537 outpatient  rehabilitation  locations at December 31,
1995. In addition, the Company operated 96


                                       6

<PAGE>






inpatient rehabilitation  facilities, 135 surgery centers, 72 diagnostic centers
and five  medical  centers  at  December  31,  1996,  compared  to 95  inpatient
rehabilitation  facilities,  122 surgery centers, 69 diagnostic centers and five
medical centers at December 31, 1995.

     The Company's  operations  generated revenues of $2,568,155,000 in 1996, an
increase of  $449,474,000,  or 21.2%,  as compared to 1995 revenues.  Same store
revenues for the twelve months ended December 31, 1996 were  $2,408,294,000,  an
increase of $289,613,000,  or 13.7%, as compared to the same period in 1995. New
store  revenues  for 1996 were  $159,861,000.  New store  revenues  reflect  the
acquisition of one inpatient  rehabilitation hospital, the addition of eight new
outpatient  surgery  centers,  and the acquisition of outpatient  rehabilitation
operations  in 57 new markets.  See Note 9 of "Notes to  Consolidated  Financial
Statements".  The increase in revenues is primarily attributable to the addition
of these  operations and increases in patient  volume.  Revenues  generated from
patients  under the Medicare and Medicaid  programs  respectively  accounted for
37.8% and 2.9% of total  revenues for 1996,  compared to 40.0% and 2.5% of total
revenues for 1995.  Revenues  from any other single  third-party  payor were not
significant in relation to the Company's total revenues. During 1996, same store
outpatient  visits,  inpatient  days and surgery center cases  increased  19.9%,
10.8% and 7.3%,  respectively.  Revenue per outpatient visit,  inpatient day and
surgery case for same store operations increased (decreased) by (0.8)%, 3.8% and
1.1%, respectively.

     Operating expenses,  at the operating unit level, were  $1,667,248,000,  or
64.9% of  revenues,  for 1996,  compared  to 68.0% of  revenues  for  1995.  The
decrease  in  operating  expenses  as a  percentage  of  revenues  is  primarily
attributable  to the 13.7% increase in same store revenues noted above.  In same
store operations,  the incremental costs associated with increased  revenues are
significantly  lower as a percentage  of those  increased  revenues.  Same store
operating expenses for 1996 were  $1,567,820,000,  or 65.1% of related revenues.
New store operating  expenses were  $99,428,000,  or 62.2% of related  revenues.
Corporate general and administrative expenses increased from $65,424,000 in 1995
to  $79,354,000  in 1996.  As a percentage  of revenues,  corporate  general and
administrative  expenses equaled 3.1% in 1995 and 1996. Total operating expenses
were $1,746,602,000, or 68.0% of revenues, for 1996, compared to $1,506,483,000,
or 71.1% of  revenues,  for  1995.  The  provision  for  doubtful  accounts  was
$58,637,000,  or 2.3% of revenues, for 1996, compared to $42,305,000, or 2.0% of
revenues, for 1995.

     Depreciation and amortization  expense was $207,132,000 for 1996,  compared
to  $160,901,000  for  1995.  The  increase  resulted  from  the  investment  in
additional  assets by the Company.  Interest expense decreased to $98,751,000 in
1996,  compared to  $105,517,000  for 1995,  primarily  because of the favorable
interest rates on the Company's  revolving  credit  facility (see "Liquidity and
Capital  Resources").  For 1996,  interest  income was  $6,034,000  compared  to
$8,009,000 for 1995. The decrease in interest income  resulted  primarily from a
decrease in the average amount outstanding in interest-bearing investments.


     Merger expenses in 1996 of $41,515,000  represent costs incurred or accrued
in connection with completing the SCA Acquisition  ($19,727,000),  the Advantage
Health  Acquisition  ($9,212,000),  the PSCM  Acquisition  ($5,513,000)  and the
ReadiCare Acquisition ($7,063,000). For further discussion, see Note 2 of "Notes
to Consolidated Financial Statements".


     Income   before   minority   interests   and  income  taxes  for  1996  was
$384,162,000,  compared to $238,382,000  for 1995.  Minority  interests  reduced
income before income taxes by $50,369,000, compared to $43,753,000 for 1995. The
provision for income taxes for 1996 was  $143,929,000,  compared to  $86,161,000
for 1995, resulting in effective tax rates of 43.1% for 1996 and 44.3% for 1995.
Net income for 1996 was $189,864,000. 


LIQUIDITY AND CAPITAL RESOURCES


     At December  31,  1996,  the Company had working  capital of  $554,589,000,
including cash and marketable  securities of  $153,831,000.  Working  capital at
December 31, 1995 was $406,601,000,  including cash and marketable securities of
$159,793,000.  For 1996, cash provided by operations was $388,345,000,  compared
to $350,059,000 for 1995. The Company used $485,193,000 for investing activities
during 1996, compared to $799,268,000 for 1995. Additions to property, plant and
equipment  and   acquisitions   accounted  for   $204,792,000  and  $91,391,000,
respectively, during 1996. Those same investing activities 


                                       7

<PAGE>


accounted for $183,867,000 and $517,773,000,  respectively,  in 1995.  Financing
activities   provided   $95,107,000  and  $484,042,000  during  1996  and  1995,
respectively.  Net borrowing proceeds (borrowings less principal reductions) for
1996 and 1995 were $101,366,000 and $205,215,000, respectively.

     Net accounts receivable were $540,389,000 at December 31, 1996, compared to
$433,688,000  at December  31, 1995.  The number of days of average  revenues in
average  receivables was 67.1 at December 31, 1996, compared to 63.4 at December
31,  1995.  The   concentration  of  net  accounts   receivable  from  patients,
third-party  payors,  insurance  companies  and others at December  31, 1996 was
consistent with the related concentration of revenues for the period then ended.


     The  Company  has  a   $1,250,000,000   revolving   credit   facility  with
NationsBank,  N.A.  ("NationsBank")  and other  participating  banks  (the "1996
Credit Agreement"). The 1996 Credit Agreement replaced a previous $1,000,000,000
revolving credit  agreement,  also with  NationsBank.  Interest is paid based on
LIBOR plus a predetermined  margin, a base rate or competitively  bid rates from
the  participating  banks. This credit facility has a maturity date of March 31,
2001. The Company  provided a negative  pledge on all assets for the 1996 Credit
Agreement.  The effective interest rate on the average outstanding balance under
the revolving credit facility was 5.98% for the twelve months ended December 31,
1996,  compared to the average  prime rate of 8.29% during the same  period.  At
December  31,  1996,  the Company had drawn  $995,000,000  under the 1996 Credit
Agreement.  For  further  discussion,  see  Note  7 of  "Notes  to  Consolidated
Financial Statements".


     In 1994, the Company issued $115,000,000 principal amount of 5% Convertible
Subordinated  Debentures  due 2001 (the  "Debentures").  The Company  called the
Debentures  for  redemption  on April 1, 1997.  The  holders of the  Convertible
Debentures  surrendered  substantially  all of the  Convertible  Debentures  for
conversion into  approximately  12,226,000 shares of the Company's Common Stock.


     On February 17, 1997,  the Company  entered into a definitive  agreement to
acquire Horizon/CMS Healthcare Corporation  ("Horizon/CMS") in a stock-for-stock
merger in which the  stockholders of Horizon/CMS will receive 0.84338 of a share
of the  Company's  common  stock per share of  Horizon/  CMS common  stock.  The
transaction is valued at approximately $1,600,000,000,  including the assumption
by the Company of approximately $700,000,000 in Horizon/CMS debt. It is expected
that the transaction will be accounted for as a purchase.  Horizon/CMS  operates
33 inpatient rehabilitation hospitals, 58 specialty hospitals and subacute units
and 282 outpatient  rehabilitation  centers.  Horizon/CMS  also owns,  leases or
manages  267  long-term  care  facilities,   a  contract  therapy  business,  an
institutional  pharmacy business and other healthcare services.  Consummation of
the transaction is subject to various regulatory approvals,  including clearance
under the Hart-Scott-Rodino  Antitrust Improvements Act, and to the satisfaction
of  certain  other  conditions.  The  Company  currently  anticipates  that  the
transaction will be consummated by October 1997.



     The Company  intends to pursue the acquisition or development of additional
healthcare  operations,   including  comprehensive   outpatient   rehabilitation
facilities,  inpatient  rehabilitation  facilities,  ambulatory surgery centers,
outpatient  diagnostic  centers  and  companies  engaged  in  the  provision  of
rehabilitation-related   services,   and  to  expand  certain  of  its  existing
facilities.  While it is not possible to estimate  precisely  the amounts  which
will actually be expended in the foregoing areas,  the Company  anticipates that
over  the  next  twelve  months,  it will  spend  approximately  $50,000,000  on
maintenance  and  expansion  of  its  existing   facilities  and   approximately
$300,000,000  on  development  of the  Integrated  Service  Model.  See  Item 1,
"Business -- Company Strategy",  in the Company's Annual Report on Form 10-K for
the year ended December 31, 1996, as amended. 

     Although the Company is continually considering and evaluating acquisitions
and  opportunities  for future  growth,  the Company  has not  entered  into any
agreements  with  respect  to  material  future   acquisitions  other  than  the
transactions  with Horizon/CMS and Health Images. In connection with the pending
acquisition  of  Horizon/CMS,  the  Company  has  obtained a  fully-underwritten
commitment  from  NationsBank,  N.A.  for a  $1,000,000,000  Senior  Bridge Loan
Facility  on  substantially  the same terms as the 1996  Credit  Agreement.  The
Company believes that existing cash, cash flow from  operations,  and borrowings
under  the  revolving  line of  credit  and the  bridge  loan  facility  will be
sufficient to satisfy the Company's  estimated  cash  requirements  for the next
twelve months, and for the reasonably foreseeable future.


                                       8

<PAGE>

     Inflation in recent years has not had a significant effect on the Company's
business,  and is not  expected  to  adversely  affect the Company in the future
unless it increases significantly.


     Statements  contained  in this  Current  Report  on Form 8-K  which are not
historical  facts are  forward-looking  statements.  In  addition,  the Company,
through its senior management,  from time to time makes  forward-looking  public
statements  concerning its expected future  operations and performance and other
developments.   Such  forward-  looking  statements  are  necessarily  estimates
reflecting  the  Company's  best  judgment  based upon current  information  and
involve a number of risks and uncertainties,  and there can be no assurance that
other factors will not affect the accuracy of such  forward-looking  statements.
While is  impossible  to identify all such  factors,  factors  which could cause
actual results to differ materially from those estimated by the Company include,
but are not limited to, changes in the regulation of the healthcare  industry at
either or both of the federal and state levels, changes in reimbursement for the
Company's services by governmental or private payors,  competitive  pressures in
the  healthcare  industry and the  Company's  response  thereto,  the  Company's
ability to obtain and retain favorable  arrangements  with  third-party  payors,
unanticipated  delays in the Company's  implementation of its Integrated Service
Model,  general conditions in the economy and capital markets, and other factors
which  may be  identified  from  time to time in the  Company's  Securities  and
Exchange Commission filings and other public announcements. 


                                       9

<PAGE>


                REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS



The Board of Directors
HEALTHSOUTH Corporation


     We have audited the accompanying consolidated balance sheets of HEALTHSOUTH
Corporation  and  Subsidiaries as of December 31, 1995 and 1996, and the related
consolidated statements of income,  stockholders' equity and cash flows for each
of the three  years in the period  ended  December  31,  1996.  Our audits  also
included the financial  statement  schedule  included  herein.  These  financial
statements and schedule are the responsibility of the Company's management.  Our
responsibility  is to  express  an opinion  on these  financial  statements  and
schedule 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 consolidated  financial  statements  referred to above
present fairly, in all material respects, the consolidated financial position of
HEALTHSOUTH  Corporation and Subsidiaries at December 31, 1995 and 1996, and the
consolidated  results of their  operations  and their cash flows for each of the
three years in the period ended December 31, 1996, 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



Birmingham, Alabama
August 20, 1997




                                       10

<PAGE>

                    HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS



<TABLE>
<CAPTION>
                                                                                                 DECEMBER 31,
                                                                                        -------------------------------
                                                                                           1995             1996
                                                                                        -------------   ---------------
                                                                                                (IN THOUSANDS)
<S>                                                                                     <C>              <C>
ASSETS
Current assets:
 Cash and cash equivalents (Note 3)  ................................................   $  155,449       $   150,071
 Other marketable securities (Note 3)   .............................................        4,344             3,760
 Accounts receivable, net of allowances for doubtful accounts of $60,100,000 in 1995
   and $75,360,000 in 1996  .........................................................      433,688           540,389
 Inventories    .....................................................................       39,556            47,408
 Prepaid expenses and other current assets    .......................................       80,339           128,174
 Deferred income taxes (Note 10)  ...................................................       24,804            15,238
                                                                                        -----------      -----------
Total current assets  ...............................................................      738,180           885,040
Other assets:
 Loans to officers    ...............................................................        1,625             1,396
 Other (Note 4)    ..................................................................       69,017            84,016
                                                                                        -----------      -----------
                                                                                            70,642            85,412
Property, plant and equipment, net (Note 5)   .......................................    1,378,016         1,464,833
Intangible assets, net (Note 6)   ...................................................      920,970         1,094,421
                                                                                        -----------      -----------
Total assets    .....................................................................   $ 3,107,808      $ 3,529,706
                                                                                        ===========      ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accounts payable  ..................................................................   $  116,387       $   116,451
 Salaries and wages payable    ......................................................       69,236            67,793
 Accrued interest payable and other liabilities  ....................................       94,428            99,118
 Current portion of long-term debt (Note 7)   .......................................       51,528            47,089
                                                                                        -----------      -----------
Total current liabilities   .........................................................      331,579           330,451
Long-term debt (Note 7)  ............................................................    1,401,490         1,513,054
Deferred income taxes (Note 10)   ...................................................       35,444            41,850
Other long-term liabilities (Note 14)   .............................................        8,705             3,558
Deferred revenue   ..................................................................        1,661               406
Minority interests - limited partnerships (Note 1)  .................................       59,243            71,286
Commitments and contingencies  (Note 11)  Stockholders'  equity (Notes 8, 12 and
15):
 Preferred stock, $.10 par value-1,500,000 shares authorized; issued and outstanding-
   none   ...........................................................................           --                --
 Common stock, $.01 par value-500,000,000 shares authorized; issued 164,129,000 in
   1995 and 326,493,000 in 1996   ...................................................        1,641             3,265
 Additional paid-in capital    ......................................................      965,905         1,060,012
 Retained earnings    ...............................................................      355,361           525,718
 Treasury stock, at cost (3,070,000 shares in 1995 and 91,000 shares in 1996)  ......      (30,864)             (323)
 Receivable from Employee Stock Ownership Plan   ....................................      (15,886)          (14,148)
 Notes receivable from stockholders  ................................................       (6,471)           (5,423)
                                                                                        -----------      -----------
Total stockholders' equity  .........................................................    1,269,686         1,569,101
                                                                                        -----------      -----------
Total liabilities and stockholders' equity    .......................................   $ 3,107,808      $ 3,529,706
                                                                                        ===========      ===========
</TABLE>


                             See accompanying notes.



                                       11

<PAGE>


                    HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                        CONSOLIDATED STATEMENTS OF INCOME




<TABLE>
<CAPTION>
                                                                          YEAR ENDED DECEMBER 31,
                                                                  ----------------------------------------
                                                                     1994          1995          1996
                                                                  ------------  ------------  ------------
                                                                  (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S>                                                               <C>           <C>           <C>
Revenues  ......................................................  $1,726,321    $2,118,681    $2,568,155

Operating unit expenses  .......................................  1,207,707     1,441,059     1,667,248
Corporate general and administrative expenses ..................     67,798        65,424        79,354
Provision for doubtful accounts   ..............................     35,740        42,305        58,637
Depreciation and amortization  .................................    126,148       160,901       207,132
Merger and acquisition related expenses (Notes 2 and 9)   ......      6,520        19,553        41,515
Loss on impairment of assets (Notes 9 and 14) ..................     10,500        53,549        37,390
Loss on abandonment of computer project (Note 14)   ............      4,500            --            --
Loss on disposal of surgery centers (Note 13) ..................     13,197            --            --
Interest expense   .............................................     74,895       105,517        98,751
Interest income ................................................     (6,658)       (8,009)       (6,034)
Gain on sale of equity securities (Note 1) .....................     (7,727)           --            --
                                                                  ----------    ----------    ----------
                                                                  1,532,620     1,880,299     2,183,993
                                                                  ----------    ----------    ----------
Income from continuing operations before income taxes, minor-
 ity interests and extraordinary item                               193,701       238,382       384,162
Provision for income taxes  ....................................     68,560        86,161       143,929
                                                                  ----------    ----------    ----------
                                                                    125,141       152,221       240,233
Minority interests .............................................     31,665        43,753        50,369
                                                                  ----------    ----------    ----------
Income from continuing operations before extraordinary item     .    93,476       108,468       189,864
Discontinued operations (Note 9):
   Loss from discontinued operations, net of income taxes ......      6,528           418            --
   Loss on disposal of discontinued operations, net of income
    taxes ......................................................         --           744            --
                                                                  ----------    ----------    ----------
Income before extraordinary item  ..............................     86,948       107,306       189,864
Extraordinary loss from early extinguishment of debt, net of
 income tax benefit of $5,550,000 (Notes 2 and 7)...............         --         9,056            --
                                                                  ----------    ----------    ----------
Net income   ...................................................  $  86,948     $  98,250     $ 189,864
                                                                  ==========    ==========    ==========
Weighted average common and common equivalent shares out-
 standing                                                           291,314       307,792       336,807
                                                                  ==========    ==========    ==========
Income per common and common equivalent share:
   Continuing operations .......................................  $    0.32     $    0.35     $    0.56
   Discontinued operations  ....................................      (0.02)           --            --
   Extraordinary loss ..........................................         --         (0.03)           --
                                                                  ----------    ----------    ----------
   Net income   ................................................  $    0.30     $    0.32     $    0.56
                                                                  ==========    ==========    ==========
Income per common share -- assuming full dilution:
   Continuing operations .......................................  $    0.32     $    0.35     $    0.55
   Discontinued operations  ....................................      (0.02)           --            --
   Extraordinary loss ..........................................         --         (0.03)           --
                                                                  ----------    ----------    ----------
   Net income   ................................................  $    0.30     $    0.32     $    0.55
                                                                  ==========    ==========    ==========
</TABLE>


                            See accompanying notes.


                                       12

<PAGE>



                    HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996

                                 (IN THOUSANDS)






<TABLE>
<CAPTION>
                                                                            COMMON STOCK      ADDITIONAL
                                                                        ---------------------   PAID-IN     RETAINED
                                                                          SHARES     AMOUNT     CAPITAL     EARNINGS
                                                                        ----------- --------- ------------ ------------
<S>                                                                      <C>        <C>       <C>          <C>
Balance at December 31, 1993 ..........................................  141,326    $ 1,414   $ 567,917    $ 195,168
Proceeds from excercise of options (Note 8) ...........................    2,317        23       16,482           --
Common shares exchanged in the exercise of options   ..................      (22)       --         (321)          --
Proceeds from issuance of common shares  ..............................    1,408        14       16,476           --
Income tax benefits related to incentive stock options (Note 8)  ......       --        --        6,470           --
Reduction in receivable from ESOP  ....................................       --        --           --           --
Payments received on stockholders' notes receivable  ..................       --        --           --           --
Purchase of limited partnership units .................................       --        --           --       (1,838)
Purchase of treasury stock   ..........................................       --        --           --           --
Net income ............................................................       --        --           --       86,948
Translation adjustment ................................................       --        --           --          536
Dividends paid   ......................................................       --        --           --       (7,046)
                                                                         -------    -------   ----------   ----------
Balance at December 31, 1994 ..........................................  145,029     1,451      607,024      273,768
Adjustment for Relife Merger (Note 2) .................................    2,732        27        7,114       (3,734)
Proceeds from excercise of options (Note 8) ...........................    1,136        11       10,218           --
Proceeds from issuance of common shares  ..............................   15,232       152      334,896           --
Income tax benefits related to incentive stock options (Note 8)  ......       --        --        6,653           --
Reduction in receivable from ESOP  ....................................       --        --           --           --
Loans made to stockholders   ..........................................       --        --           --           --
Purchase of limited partnership units .................................       --        --           --       (4,767)
Purchase of treasury stock   ..........................................       --        --           --           --
Net income ............................................................       --        --           --       98,250
Translation adjustment ................................................       --        --           --          247
Dividends paid   ......................................................       --        --           --       (8,403)
                                                                         -------    -------   ----------   ----------
Balance at December 31, 1995 ..........................................  164,129     1,641      965,905      355,361
Adjustment for Advantage Merger .......................................       --        --           --      (17,638)
Adjustment for 1996 Mergers (Note 2)  .................................    4,047        40       68,785       (1,256)
Proceeds from excercise of options (Note 8) ...........................    3,514        36       34,380           --
Income tax benefits related to incentive stock options (Note 8)  ......       --        --       23,767           --
Reduction in receivable from ESOP  ....................................       --        --           --           --
Payments received on stockholders' notes receivable  ..................       --        --           --           --
Purchase of limited partnership units .................................       --        --           --          (83)
Purchase of treasury stock   ..........................................       --        --           --           --
Retirement of treasury stock ..........................................   (1,835)      (18)     (31,259)          --
Net income ............................................................       --        --           --      189,864
Translation adjustment ................................................       --        --           --          692
Dividends paid   ......................................................       --        --           --       (1,222)
Stock split (Note 15)  ................................................  156,638     1,566       (1,566)          --
                                                                         -------    -------   ----------   ----------
Balance at December 31, 1996 ..........................................  326,493    $3,265    $1,060,012   $ 525,718
                                                                         =======    =======   ==========   ==========
<PAGE>


                    HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
                                  (Continued)

                                 (IN THOUSANDS)



<CAPTION>
                                                                                                                 NOTES
                                                                            TREASURY STOCK      RECEIVABLES    RECEIVABLE
                                                                        -----------------------     FROM          FROM
                                                                          SHARES      AMOUNT        ESOP      STOCKHOLDERS
                                                                        ----------- ----------- ------------- -------------
<S>                                                                        <C>      <C>          <C>            <C>
Balance at December 31, 1993 ..........................................    1,435    $(12,342)    $ (18,932)     $ (5,490)
Proceeds from excercise of options (Note 8) ...........................       --          --            --            --
Common shares exchanged in the exercise of options   ..................       --          --            --            --
Proceeds from issuance of common shares  ..............................       --          --            --            --
Income tax benefits related to incentive stock options (Note 8)  ......       --          --            --            --
Reduction in receivable from ESOP  ....................................       --          --         1,455            --
Payments received on stockholders' notes receivable  ..................       --          --            --           250
Purchase of limited partnership units .................................       --          --            --            --
Purchase of treasury stock   ..........................................    1,047     (10,025)           --            --
Net income ............................................................       --          --            --            --
Translation adjustment ................................................       --          --            --            --
Dividends paid   ......................................................       --          --            --            --
                                                                         -------    ---------    ---------      --------
Balance at December 31, 1994 ..........................................    2,482     (22,367)      (17,477)       (5,240)
Adjustment for Relife Merger (Note 2) .................................       --          --            --            --
Proceeds from excercise of options (Note 8) ...........................       --          --            --            --
Proceeds from issuance of common shares  ..............................       --          --            --            --
Income tax benefits related to incentive stock options (Note 8)  ......       --          --            --            --
Reduction in receivable from ESOP  ....................................       --          --         1,591            --
Loans made to stockholders   ..........................................       --          --            --        (1,231)
Purchase of limited partnership units .................................       --          --            --            --
Purchase of treasury stock   ..........................................      588      (8,497)           --            --
Net income ............................................................       --          --            --            --
Translation adjustment ................................................       --          --            --            --
Dividends paid   ......................................................       --          --            --            --
                                                                         -------    ---------    ---------      --------
Balance at December 31, 1995 ..........................................    3,070     (30,864)      (15,886)       (6,471)
Adjustment for Advantage Merger .......................................       --          --            --            --
Adjustment for 1996 Mergers (Note 2)  .................................       --          --            --            --
Proceeds from excercise of options (Note 8) ...........................       --          --            --            --
Income tax benefits related to incentive stock options (Note 8)  ......       --          --            --            --
Reduction in receivable from ESOP  ....................................       --          --         1,738            --
Payments received on stockholders' notes receivable  ..................       --          --            --         1,048
Purchase of limited partnership units .................................       --          --            --            --
Purchase of treasury stock   ..........................................       89        (736)           --            --
Retirement of treasury stock ..........................................   (3,068)     31,277            --            --
Net income ............................................................       --          --            --            --
Translation adjustment ................................................       --          --            --            --
Dividends paid   ......................................................       --          --            --            --
Stock split (Note 15)  ................................................       --          --            --            --
                                                                         -------    ---------    ---------      --------
Balance at December 31, 1996 ..........................................       91    $   (323)    $ (14,148)     $ (5,423)
                                                                         =======    =========    =========      ========

<PAGE>

                    HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
                                  (Continued)

                                 (IN THOUSANDS)

<CAPTION>
                                                                            TOTAL
                                                                        STOCKHOLDERS'
                                                                           EQUITY
                                                                        --------------
<S>                                                                      <C>
Balance at December 31, 1993 ..........................................  $  727,735
Proceeds from excercise of options (Note 8) ...........................      16,505
Common shares exchanged in the exercise of options   ..................        (321)
Proceeds from issuance of common shares  ..............................      16,490
Income tax benefits related to incentive stock options (Note 8)  ......       6,470
Reduction in receivable from ESOP  ....................................       1,455
Payments received on stockholders' notes receivable  ..................         250
Purchase of limited partnership units .................................      (1,838)
Purchase of treasury stock   ..........................................     (10,025)
Net income ............................................................      86,948
Translation adjustment ................................................         536
Dividends paid   ......................................................      (7,046)
                                                                         ----------
Balance at December 31, 1994 ..........................................     837,159
Adjustment for Relife Merger (Note 2) .................................       3,407
Proceeds from excercise of options (Note 8) ...........................      10,229
Proceeds from issuance of common shares  ..............................     335,048
Income tax benefits related to incentive stock options (Note 8)  ......       6,653
Reduction in receivable from ESOP  ....................................       1,591
Loans made to stockholders   ..........................................      (1,231)
Purchase of limited partnership units .................................      (4,767)
Purchase of treasury stock   ..........................................      (8,497)
Net income ............................................................      98,250
Translation adjustment ................................................         247
Dividends paid   ......................................................      (8,403)
                                                                         ----------
Balance at December 31, 1995 ..........................................   1,269,686
Adjustment for Advantage Merger .......................................     (17,638)
Adjustment for 1996 Mergers (Note 2)  .................................      67,569
Proceeds from excercise of options (Note 8) ...........................      34,416
Income tax benefits related to incentive stock options (Note 8)  ......      23,767
Reduction in receivable from ESOP  ....................................       1,738
Payments received on stockholders' notes receivable  ..................       1,048
Purchase of limited partnership units .................................         (83)
Purchase of treasury stock   ..........................................        (736)
Retirement of treasury stock ..........................................          --
Net income ............................................................     189,864
Translation adjustment ................................................         692
Dividends paid   ......................................................      (1,222)
Stock split (Note 15)  ................................................          --
                                                                         ----------
Balance at December 31, 1996 ..........................................  $1,569,101
                                                                         ==========
</TABLE>


                            See accompanying notes.
                                       13

<PAGE>


                    HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS




<TABLE>
<CAPTION>
                                                                          YEAR ENDED DECEMBER 31,
                                                               ---------------------------------------------
                                                                  1994            1995            1996
                                                               -------------   -------------   -------------
                                                                              (IN THOUSANDS)
<S>                                                             <C>             <C>             <C>
OPERATING ACTIVITIES
Net income  ................................................    $   86,948      $   98,250      $  189,864
Adjustments   to  reconcile  net  income  to  net  cash  
 provided by operating activities:
   Depreciation and amortization    ........................       126,148         160,901         207,132
   Provision for doubtful accounts  ........................        35,740          42,305          58,637
   Provision for losses on impairment of assets    .........        16,080          53,549          37,390
   Provision for losses on abandonment of computer
    project    .............................................         4,500              --              --
   Merger and acquisition related expenses   ...............         6,520          19,553          41,515
   Loss on disposal of surgery center  .....................        13,197              --              --
   Loss on extinguishment of debt   ........................            --          14,606              --
   Income applicable to minority interests of limited
    partnerships  ..........................................        31,665          43,753          50,928
   (Benefit) provision for deferred income taxes   .........       (14,658)            396          14,308
   Provision for deferred revenue   ........................          (164)         (1,990)         (1,255)
   Changes in operating assets and liabilities, net of 
    effects of acquisitions:
      Accounts receivable  .................................      (101,141)        (69,754)       (141,323)
      Inventories, prepaid expenses and other current
       assets  .............................................       (15,250)          1,370         (35,084)
      Accounts payable and accrued expenses  ...............        87,358         (12,880)        (33,767)
                                                                ----------      ----------      ----------
Net cash provided by operating activities    ...............       276,943         350,059         388,345
INVESTING ACTIVITIES
Purchases of property, plant and equipment   ...............      (202,520)       (183,867)       (204,792)
Proceeds from sale of property, plant and equipment   ......        68,330          16,026              --
Additions to intangible assets, net of effects of acquisi-
 tions                                                             (70,216)       (117,900)       (175,380)
Assets obtained through acquisitions, net of liabilities as-
 sumed                                                            (117,023)       (517,773)        (91,391)
Changes in other assets    .................................       (21,962)         (6,963)        (14,214)
Proceeds received on sale of other marketable securities .          19,857          22,513             584
Investments in other marketable securities   ...............       (21,393)        (11,304)             --
                                                                ----------      ----------      ----------
Net cash used in investing activities  .....................      (344,927)       (799,268)       (485,193)
</TABLE>


                                       14

<PAGE>

              HEALTHSOUTH Corporation and Subsidiaries
              CONSOLIDATED STATEMENTS OF CASH FLOWS - (CONTINUED )



<TABLE>
<CAPTION>
                                                                       YEAR ENDED DECEMBER 31,
                                                             -------------------------------------------
                                                               1994           1995            1996
                                                             ------------   ------------   -------------
                                                                           (IN THOUSANDS)
<S>                                                          <C>            <C>             <C>
FINANCING ACTIVITIES
Proceeds from borrowings    ..............................   $1,069,979     $ 721,973       $  205,873
Principal payments on long-term debt    ..................    (977,094)      (502,152)        (104,507)
Early retirement of debt .................................          --        (14,606)              --
Proceeds from exercise of options    .....................      14,868         10,083           34,415
Proceeds from issuance of common stock  ..................       1,136        330,954               --
Purchase of treasury stock  ..............................     (10,025)        (8,497)            (736)
Reduction in receivable from ESOP    .....................       1,455          1,591            1,738
Payments received on (loans made to) stockholders   ......         250         (1,231)           1,048
Dividends paid  ..........................................      (7,046)        (8,403)          (1,222)
Proceeds from investment by minority interests   .........       2,268          1,103              510
Purchase of limited partnership interests  ...............      (1,698)       (10,076)          (3,064)
Payment of cash distributions to limited partners   ......     (34,637)       (36,697)         (38,948)
                                                             ----------     ----------      ----------
Net cash provided by financing activities  ...............      59,456        484,042           95,107
                                                             ----------     ----------      ----------
(Decrease) increase in cash and cash equivalents    ......      (8,528)        34,833           (1,741)
Cash and cash equivalents at beginning of year (Note 2) .      124,649        116,121          155,449
Cash flows related to mergers (Note 2)  ..................          --          4,495           (3,637)
                                                             ----------     ----------      ----------
Cash and cash equivalents at end of year   ...............   $ 116,121      $ 155,449       $  150,071
                                                             ==========     ==========      ==========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year for:
 Interest    .............................................   $  61,519      $ 103,973       $   97,024
 Income taxes   ..........................................      61,022         85,714           67,975
</TABLE>


NON-CASH INVESTING ACTIVITIES:


     The Company assumed liabilities of $32,027,000, $84,820,000 and $19,197,000
during the years  ended  December  31,  1994,  1995 and 1996,  respectively,  in
conjunction with its acquisitions.

     During the year ended  December  31,  1994,  the Company  issued  1,747,000
common  shares  with  a  market  value  of  $12,862,000  as  consideration   for
acquisitions accounted for as purchases (see Note 9). 

     During the year ended  December  31,  1996,  the Company  issued  8,095,000
common shares as consideration for mergers (see Note 2).


NON-CASH FINANCING ACTIVITIES:

     During  1995 and 1997,  the Company  had a  two-for-one  stock split on its
common  stock,  which was  effected in the form of a one hundred  percent  stock
dividend.

     The Company  received a tax benefit from the  disqualifying  disposition of
incentive stock options of $6,470,000,  $6,653,000 and $23,767,000 for the years
ended December 31, 1994, 1995 and 1996, respectively.

     During  the year  ended  December  31,  1994,  22,000  common  shares  were
exchanged in the exercise of options. The shares exchanged had a market value on
the date of exchange of $321,000.

                             See accompanying notes.

                                       15

<PAGE>
                   HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                DECEMBER 31, 1996

1. SIGNIFICANT ACCOUNTING POLICIES

     The significant accounting policies followed by HEALTHSOUTH Corporation and
its  subsidiaries  ("the  Company")  are  presented  as an integral  part of the
consolidated financial statements.


PRINCIPLES OF CONSOLIDATION

     The consolidated  financial  statements include the accounts of HEALTHSOUTH
Corporation  ("HEALTHSOUTH") and its wholly-owned  subsidiaries,  as well as its
majority ownership or controlling  interest in limited  partnerships and limited
liability companies. All significant intercompany accounts and transactions have
been eliminated in consolidation.

     HEALTHSOUTH   Corporation   is  engaged  in  the   business  of   providing
comprehensive  rehabilitative,  clinical,  diagnostic  and  surgical  healthcare
services on an inpatient and outpatient basis.


USE OF ESTIMATES

     The  preparation  of financial  statements  in  conformity  with  generally
accepted  accounting  principles  requires  management  to  make  estimates  and
assumptions that affect the amounts  reported in the  accompanying  consolidated
financial   statements  and  notes.  Actual  results  could  differ  from  those
estimates.


MARKETABLE SECURITIES

     MARKETABLE   EQUITY  SECURITIES  AND  DEBT  SECURITIES  ARE  CLASSIFIED  AS
AVAILABLE-FOR-SALE.  AVAILABLE-FOR-SALE  securities  are  carried at fair value,
with the  unrealized  gains and  losses,  if  material,  reported  as a separate
component  of  stockholders'   equity,  net  of  tax.  During  1994,  marketable
securities consisting of $13,360,507 of common stock were sold and the resulting
gain was recognized in the consolidated  statement of income.  The adjusted cost
of the specific security sold method is used to compute gain or loss on the sale
of   securities.   Interest  and   dividends   on   securities   classified   as
available-for-sale   are  included  in  investment  income.   Marketable  equity
securities and debt  securities of the Company have  maturities of less than one
year.


Accounts Receivable and Third-Party Reimbursement Activities

     Receivables from patients,  insurance companies and third-party contractual
insured accounts  (Medicare and Medicaid) are based on payment  agreements which
generally  result  in the  Company  collecting  an  amount  different  from  the
established rates. Net third party settlement  receivables  included in accounts
receivable  were  $21,494,000  and  $21,138,000  at December  31, 1995 and 1996,
respectively.  Final  determination  of the  settlements is subject to review by
appropriate authorities.  The differences between original estimates made by the
Company and subsequent revisions (including final settlements) were not material
to the operations of the Company.  Adequate allowances are provided for doubtful
accounts and  contractual  adjustments.  Uncollectible  accounts are written off
against the allowance for doubtful  accounts after adequate  collection  efforts
are made.  Net  accounts  receivable  include  only those  amounts  estimated by
management to be collectible.

     The concentration of net accounts  receivable from third-party  contractual
payors and others,  as a  percentage  of total net accounts  receivable,  was as
follows:


<TABLE>
<CAPTION>
                                                           DECEMBER 31
                                                        -----------------
                                                         1995     1996
                                                         ----     ----
<S>                                                       <C>      <C>
       Medicare  ................................          24%      26%
       Medicaid  ................................           6        5
       Other  ...................................          70       69
                                                         ----     ----
                                                          100%     100%
                                                         ====     ====
</TABLE>

                                       16

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

1. Significant Accounting Policies - (CONTINUED)

INVENTORIES

     Inventories  are stated at the lower of cost or market  using the  specific
identification method.


PROPERTY, PLANT AND EQUIPMENT

     Property,  plant and equipment is recorded at cost. Upon sale or retirement
of property,  plant or equipment,  the cost and related accumulated depreciation
are  eliminated  from the  respective  account and the resulting gain or loss is
included in the results of operations.


     Interest  cost  incurred   during  the   construction   of  a  facility  is
capitalized.  The Company  incurred  interest of $77,764,000,  $108,382,000  and
$102,694,000,  of which  $2,869,000,  $2,865,000 and $3,943,000 was  capitalized
during 1994, 1995 and 1996, respectively. 

     Depreciation  and amortization is computed using the  straight-line  method
over the  estimated  useful  lives of the  assets or the term of the  lease,  as
appropriate.  The  estimated  useful  life of  buildings  is 30-40 years and the
general range of useful lives for leasehold  improvements,  furniture,  fixtures
and equipment is 10-15 years.


INTANGIBLE ASSETS


     Cost in excess of net asset value of purchased facilities is amortized over
20 to 40 years using the  straight-line  method.  Organization  and  partnership
formation  costs are deferred  and  amortized  on a  straight-line  basis over a
period  of 36  months.  Costs  incurred  in  connection  with  implementing  the
Company's   clinical   and   administrative   programs   and   protocols   at  a
newly-developed  or acquired  facility are deferred and  amortized on a straight
line basis over a period of 36 months.  Organization,  partnership formation and
start-up costs and other  capitalized  costs for a project that is  subsequently
abandoned  are  charged to  operations  in that  period.  Debt  issue  costs are
amortized over the term of the debt.  Noncompete  agreements are amortized using
the straight-line method over the term of the agreements.



MINORITY INTERESTS

     The equity of  minority  investors  in  limited  partnerships  and  limited
liability  companies of the Company is reported on the balance sheet as minority
interests.  Minority  interests  reported in the  consolidated  income statement
reflect  the  respective  interests  in  the  income  or  loss  of  the  limited
partnerships  or  limited  liability  companies  attributable  to  the  minority
investors  (ranging from 1% to 50% at December 31, 1996), the effect of which is
removed from the results of operations of the Company.


REVENUES

     Revenues include net patient service revenues and other operating revenues.
Other operating  revenues include cafeteria revenue,  gift shop revenue,  rental
income,  trainer/contract  revenue,  management and  administrative  fee revenue
(related to non-consolidated  subsidiaries and affiliates) and  transcriptionist
fees which are insignificant to total revenues. Net patient service revenues are
reported at the  estimated net  realizable  amounts from  patients,  third-party
payors  and  others  for  services  rendered,  including  estimated  retroactive
adjustments under reimbursement agreements with third-party payors.


INCOME PER COMMON AND COMMON EQUIVALENT SHARE

     Income  per common and common  equivalent  share is  computed  based on the
weighted  average  number  of  common  shares  and  common   equivalent   shares
outstanding  during the  periods,  as adjusted for the  two-for-one  stock split
declared in April 1995 and the  two-for-one  stock split  declared in March 1997
(see Note 15).  Common  equivalent  shares  include  dilutive  employees'  stock
options, less the num-


                                       17

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

1. Significant Accounting Policies - (CONTINUED)


ber of treasury  shares  assumed to be  purchased  from the  proceeds  using the
average  market  price of the  Company's  shares in the  calculation  of primary
earnings per share and the  year-end  market  price of the  Company's  shares in
calculating fully diluted earnings per share if such market price is higher than
the average price used in computing  primary  earnings per share.  Fully diluted
earnings per share (based on 300,758,000,  320,018,000 and 349,033,000 shares in
1994,  1995 and 1996,  respectively)  assumes  conversion of the 5%  Convertible
Subordinated Debentures due 2001 (see Note 7).



IMPAIRMENT OF ASSETS

     In accordance with FASB Statement No. 121, Accounting for the Impairment of
Long-Lived  Assets and Long-Lived  Assets to Be Disposed Of, the Company records
impairment  losses on  long-lived  assets  used in  operations  when  events and
circumstances  indicate  that the assets might be impaired and the  undiscounted
cash flows  estimated to be generated by those assets are less than the carrying
amounts of those assets. Effective January 1, 1995, the Company adopted FASB 121
to account for long-lived assets.

     With  respect  to the  carrying  value of the excess of cost over net asset
value  of  purchased   facilities  and  other  intangible  assets,  the  Company
determines  on a quarterly  basis  whether an  impairment  event has occurred by
considering  factors  such as: the  market  value of the  asset;  a  significant
adverse change in legal factors or in the business climate;  adverse action by a
regulator;  a history  of  operating  or cash flow  losses  or a  projection  of
continuing  losses  associated with an operating  entity.  The carrying value of
excess cost over net asset value of purchased  facilities  and other  intangible
assets will be evaluated if the facts and circumstances suggest that it has been
impaired.  If this evaluation  indicates that the value of the asset will not be
recoverable,  as determined based on the  undiscounted  cash flows of the entity
acquired  over  the  remaining   amortization  period,  an  impairment  loss  is
calculated  based on the  excess of the  carrying  amount of the asset  over the
asset's fair value.


SELF-INSURANCE

     The Company is self-insured  for professional  liability and  comprehensive
general  liability.  Liabilities for asserted and unasserted  claims are accrued
based upon specific  claims and incidents and the claims history of the Company.
The reserves for estimated liabilities for asserted and unasserted claims, which
are not material in relation to the Company's consolidated financial position at
December  31,  1995 and 1996,  are  included  with  accrued  interest  and other
liabilities in the accompanying consolidated balance sheets.


RECLASSIFICATIONS


     Certain  amounts  in the 1994  and  1995  financial  statements  have  been
reclassified  to conform with the 1996  presentation.  Also in 1995, the Company
included the loss on extinguishment of debt with merger and acquisition  related
expenses.  Such amount has been  reclassified  as an  extraordinary  item in the
accompanying  1995 income  statement.  Such  reclassifications  had no effect on
previously reported consolidated financial position and consolidated net income.



2. MERGERS


     Effective  December  29,  1994, a  wholly-owned  subsidiary  of the Company
merged with ReLife,  Inc.  ("ReLife"),  and in connection  therewith the Company
issued  22,050,580  shares of its common  stock in exchange  for all of ReLife's
outstanding  common  stock.  Prior to the  merger,  ReLife  provided a system of
rehabilitation  services and operated 31 inpatient  facilities with an aggregate
of approximately 1,100 licensed beds, including nine freestanding rehabilitation
hospitals, nine acute rehabilitation units, five sub-acute rehabilitation units,
seven transitional living units and one residential facility, and provided 


                                       18

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)

outpatient  rehabilitation  services  at twelve  outpatient  centers.  Costs and
expenses of $2,949,000, primarily legal, accounting and financial advisory fees,
incurred by HEALTHSOUTH in connection  with the ReLife merger have been recorded
in  operations  in 1994 and  reported  as merger  expenses  in the  accompanying
consolidated statements of income.

     Effective  June 13, 1995, a  wholly-owned  subsidiary of the Company merged
with  Surgical  Health  Corporation  ("SHC"),  and in  connection  therewith the
Company  issued  17,062,960  shares of its common  stock in exchange  for all of
SHC's common and preferred stock. Prior to the merger, SHC operated a network of
36 freestanding  surgery centers and five mobile lithotripters in eleven states,
with an aggregate of 156 operating and  procedure  rooms.  Costs and expenses of
approximately  $4,588,000  incurred  by the Company in  connection  with the SHC
merger have been  recorded  in  operations  during  1995 and  reported as merger
expenses in the accompanying  consolidated statements of income. Fees related to
legal,  accounting and financial  advisory services  accounted for $3,400,000 of
the  expense.   Costs  related  to  employee   separations  were   approximately
$1,188,000.  Also in connection  with the SHC Merger,  the Company  recognized a
$14,606,000  extraordinary  loss as a result of the  retirement of the SHC Notes
(see Note 7). The extraordinary loss consisted  primarily of the associated debt
discount plus premiums and costs  associated with the retirement,  net of income
tax benefits of  $5,550,000.  SHC merged with Heritage  Surgical  Corporation on
January 18, 1994 in a transaction  accounted for as a pooling of interests.  SHC
recorded merger costs of $3,571,000 in connection with this transaction in 1994.

     Effective October 26, 1995, a wholly-owned subsidiary of the Company merged
with Sutter Surgery  Centers,  Inc.  ("SSCI"),  and in connection  therewith the
Company  issued  3,552,002  shares of its common  stock in  exchange  for all of
SSCI's outstanding common stock. Prior to the merger, SSCI operated a network of
12  freestanding  surgery  centers  in three  states,  with an  aggregate  of 54
operating and procedure rooms.  Costs and expenses of approximately  $4,965,000,
primarily legal, accounting and financial advisory fees, incurred by the Company
in connection with the SSCI merger have been recorded in operations  during 1995
and reported as merger expenses in the accompanying  consolidated  statements of
income.

     Effective January 17, 1996, a wholly-owned subsidiary of the Company merged
with Surgical Care Affiliates,  Inc.  ("SCA"),  and in connection  therewith the
Company  issued  91,856,678  shares of its common  stock in exchange  for all of
SCA's  outstanding  common stock.  Prior to the merger,  SCA operated 67 surgery
centers in 24 states. Costs and expenses of approximately $19,727,000, primarily
legal,  accounting  and  financial  advisory  fees,  incurred  by the Company in
connection with the SCA merger have been recorded in operations  during 1996 and
reported  as merger  expenses in the  accompanying  consolidated  statements  of
income.

     Effective  March 14, 1996, a wholly-owned  subsidiary of the Company merged
with  Advantage  Health  Corporation  ("Advantage  Health"),  and in  connection
therewith the Company issued  18,203,978  shares of its common stock in exchange
for all of Advantage  Health's  outstanding  common stock.  Prior to the merger,
Advantage  Health  operated a network of 136 sites of  service,  including  four
freestanding  rehabilitation hospitals, one freestanding multi-use hospital, one
nursing home,  68 outpatient  rehabilitation  facilities,  14 inpatient  managed
rehabilitation  units, 24 rehabilitation  services management  contracts and six
managed  sub-acute  rehabilitation  units.  Costs and expenses of  approximately
$9,212,000, primarily legal, accounting and financial advisory fees, incurred by
the Company in connection with the Advantage Health merger have been recorded in
operations  during  1996 and  reported as merger  expenses  in the  accompanying
consolidated statements of income.


     Effective  March 3, 1997, a  wholly-owned  subsidiary of the Company merged
with Health Images,  Inc.  ("Health  Images"),  and in connection  therewith the
Company  issued  10,343,470  shares of its common  stock in exchange  for all of
Health  Images'  outstanding  common stock.  Prior to the merger,  Health Images
operated 49 freestanding  diagnostic imaging centers in 13 states and six in the
United Kingdom. 


                                       19

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)


     The mergers of the Company with ReLife,  SHC, SSCI, SCA,  Advantage  Health
and Health Images were accounted for as poolings of interests and,  accordingly,
the Company's  consolidated  financial  statements have been restated to include
the results of the acquired companies for all periods presented.

     Combined and separate results of the Company and its material 1996 mergers,
SCA and Advantage Health,  and its 1997 merger with Health Images,  Inc., are as
follows (in thousands): 



<TABLE>
<CAPTION>
                                               ADVANTAGE     HEALTH
                      HEALTHSOUTH      SCA       HEALTH      IMAGES     COMBINED
                      ------------- ---------- ----------- ----------- -----------
<S>                     <C>           <C>        <C>       <C>           <C>
Year ended
 December 31, 1994
   Revenues .........   $1,274,365    $239,272   $135,562  $ 77,122      $1,726,321
   Net income  ......       50,493      29,280      8,310    (1,135)         86,948
Year ended
 December 31, 1995
   Revenues .........    1,556,687     263,866    182,593   115,535       2,118,681
   Net income  ......       78,949       3,322     10,250     5,729          98,250
Year ended
 December 31, 1996
   Revenues .........    2,380,587      11,028     44,922   131,618       2,568,155
   Net income  ......      216,654       1,746      2,418   (30,954)        189,864
</TABLE>



     There were no material  transactions among the Company,  ReLife, SHC, SSCI,
SCA,  Advantage  Health and Health  Images prior to the mergers.  The effects of
conforming the accounting policies of the combined companies are not material.

     Prior to its merger  with the  Company,  ReLife  reported  on a fiscal year
ending on September 30. The restated financial  statements for all periods prior
to and including  December 31, 1994, are based on a combination of the Company's
results for its December 31 fiscal year and ReLife's  results for its  September
30 fiscal year. Beginning January 1, 1995, all facilities acquired in the ReLife
merger  adopted a December 31 fiscal  year end;  accordingly,  all  consolidated
financial  statements  for  periods  after  December  31,  1994  are  based on a
consolidation of the Company and the former ReLife subsidiaries on a December 31
year-end.  ReLife's  historical results of operations for the three months ended
December 31, 1994 are not included in the Company's  consolidated  statements of
income or cash flows. An adjustment has been made to stockholders'  equity as of
January  1, 1995 to adjust  for the  effect of  excluding  ReLife's  results  of
operations  for the three months ended  December  31, 1994.  The  following is a
summary of ReLife's  results of  operations  and cash flows for the three months
ended December 31, 1994 (in thousands):



                                       20

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)


<TABLE>
<S>                                                 <C>
Statement of Income Data:
Revenues  .......................................   $ 38,174
Operating expenses:
 Operating units   ..............................     31,797
 Corporate general and administrative   .........      2,395
Provision for doubtful accounts   ...............        541
Depreciation and amortization  ..................      1,385
Interest expense   ..............................        858
Interest income .................................        (91)
HEALTHSOUTH merger expense  .....................      3,050
Loss on disposal of fixed assets  ...............      1,000
Loss on abandonment of computer project .........        973
                                                    ---------
                                                      41,908
                                                    ---------
Net loss  .......................................   $ (3,734)
                                                    =========
Statement of Cash Flow Data:
Net cash provided by operating activities  ......   $ 38,077
Net cash used in investing activities   .........     (9,632)
Net cash used in financing activities   .........    (23,950)
                                                    ---------
Net increase in cash  ...........................   $  4,495
                                                    =========
</TABLE>

     During the three months ended December 31, 1994, ReLife received $7,141,000
in proceeds from the exercise of stock options.


     Prior to its merger with the Company, Advantage Health reported on a fiscal
year ending on August 31. Accordingly,  the historical  financial  statements of
Advantage  Health  have been  recast to a November  30 fiscal  year-end  to more
closely  conform  to  the  Company's  calendar  fiscal  year-end.  The  restated
financial  statements  for all periods prior to and including  December 31, 1995
are based on a combination of the Company's results for their December 31 fiscal
year and  Advantage  Health's  results for its recast  November 30 fiscal  year.
Beginning  January 1, 1996,  all  facilities  acquired in the  Advantage  Health
merger  adopted a December 31 fiscal  year-end;  accordingly,  all  consolidated
financial  statements  for  periods  after  December  31,  1995  are  based on a
consolidation  of all of the Company's  subsidiaries  on a December 31 year-end.
Advantage  Health's  historical  results of  operations  for the one month ended
December 31, 1995 are not included in the Company's  consolidated  statements of
income or cash flows. An adjustment has been made to stockholders'  equity as of
January 1, 1996 to adjust for the effect of excluding Advantage Health's results
of  operations  for the one month ended  December 31, 1995.  The  following is a
summary of Advantage  Health's  results of operations and cash flows for the one
month ended December 31, 1995 (in thousands):



                                       21

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)


<TABLE>
<S>                                                       <C>
Statement of Income Data:
Revenues  .............................................   $ 16,111
Operating expenses:
 Operating units   ....................................     14,394
 Corporate general and administrative   ...............      1,499
Provision for doubtful accounts   .....................      1,013
Depreciation and amortization  ........................        283
Interest expense   ....................................        288
Interest income .......................................        (16)
Loss on impairment of assets   ........................     21,111
                                                          ---------
                                                            38,572
                                                          ---------
Loss before income taxes and minority interests  ......    (22,461)
Benefit for income taxes ..............................      4,959
Minority interest  ....................................       (136)
                                                          ---------
Net loss  .............................................   $(17,638)
                                                          =========
Statement of Cash Flow Data:
Net cash used in operating activities   ...............   $ (2,971)
Net cash provided by investing activities  ............        105
Net cash used in financing activities   ...............       (771)
                                                          ---------
Net decrease in cash  .................................   $ (3,637)
                                                          =========
</TABLE>

     In December 1995,  Advantage Health recorded an asset impairment  charge of
approximately  $21,111,000 relating to goodwill and tangible assets identifiable
with  one  inpatient  rehabilitation  hospital,  one  subacute  facility  and 32
outpatient  rehabilitation centers, all acquired by the Company in the Advantage
Health  merger.  The Company  intends to operate these  facilities on an ongoing
basis.

     The Company has historically assessed  recoverability of goodwill and other
long-lived  assets using  undiscounted  cash flows estimated to be received over
the useful  lives of the  related  assets.  In  December  1995,  certain  events
occurred  which  significantly  impacted the Company's  estimates of future cash
flows to be received from the facilities described above. Those events primarily
related to a decline in operating  results  combined with a deterioration in the
reimbursement  environment at these facilities. As a result of these events, the
Company revised its estimates of undiscounted cash flows to be received over the
remaining  estimated  useful  lives  of these  facilities  and  determined  that
goodwill and other long-lived assets (primarily property and equipment) had been
impaired.  The Company  developed its best  estimates of future  operating  cash
flows  at  these  locations   considering   future   requirements   for  capital
expenditures  as well as the impact of inflation.  The projections of cash flows
also took into account  estimates of  significant  one-time  expenses as well as
estimates of  additional  revenues and  resulting  income from future  marketing
efforts in the respective  locations.  The amount of the  impairment  charge was
determined by discounting the estimates of future cash flows, using an estimated
8.5% incremental  borrowing rate, which management believes is commensurate with
the risks  involved.  The  resulting  net present value of future cash flows was
then compared to the historical net book value of goodwill and other  long-lived
assets at each operating  location which resulted in an impairment loss relative
to these centers of $21,111,000.

     During   1996,   wholly-owned  subsidiaries  of  the  Company  merged  with
Professional  Sports Care Management, Inc. ("PSCM"), Fort Sutter Surgery Center,
Inc.  ("FSSCI")  and  ReadiCare,  Inc.  ("ReadiCare").  In connection with these
mergers  the  Company  issued  an  aggregate  of  8,094,598 shares of its common
stock.  Costs  and  expenses  of  approximately  $12,576,000,  primarily  legal,
accounting and financial advisory fees,


                                       22

<PAGE>
                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)

incurred by the Company in  connection  with the mergers  have been  recorded in
operations  during  1996 and  reported as merger  expenses  in the  accompanying
consolidated statements of income.

     The PSCM and ReadiCare mergers were accounted for as poolings of interests.
However,  due to the  immateriality of these mergers,  the Company's  historical
financial  statements  for all  periods  prior  to the  quarters  in  which  the
respective mergers were completed have not been restated. Instead, stockholders'
equity has been  increased  by  $43,230,000  to reflect  the effects of the PSCM
merger and  $15,431,000  to reflect the  effects of the  ReadiCare  merger.  The
results of operations  of PSCM and  ReadiCare  are included in the  accompanying
financial  statements  from the date of acquisition  forward.  In addition,  the
FSSCI merger was a stock-for-stock  acquisition.  Stockholders'  equity has been
increased by $8,908,000 to reflect the effects of the merger.


3. CASH, CASH EQUIVALENTS AND OTHER MARKETABLE SECURITIES

     Cash, cash  equivalents and other  marketable  securities  consisted of the
following:


<TABLE>
<CAPTION>
                                                                         DECEMBER 31
                                                                    ----------------------
                                                                     1995         1996
                                                                    ----------   ---------
                                                                        (IN THOUSANDS)
<S>                                                                 <C>          <C>
Cash ............................................................   $143,681     $140,278
Cash equivalents ................................................     11,768        9,793
                                                                    ---------    ---------
 Total cash and cash equivalents   ..............................    155,449      150,071
Certificates of deposit   .......................................      2,229        1,765
Municipal put bonds .............................................        615          495
Municipal put bond mutual funds .................................        500          500
Collateralized mortgage obligations   ...........................      1,000        1,000
                                                                    ---------    ---------
Total other marketable securities  ..............................      4,344        3,760
                                                                    ---------    ---------
Total cash, cash equivalents and other marketable securities (ap-
 proximates market value)                                           $159,793     $153,831
                                                                    =========    =========
</TABLE>


     For purposes of the  consolidated  balance  sheets and  statements  of cash
flows,  marketable securities purchased with an original maturity of ninety days
or less are considered cash equivalents.


4. OTHER ASSETS

     Other assets consisted of the following:


<TABLE>
<CAPTION>
                                                               DECEMBER 31
                                                           --------------------
                                                            1995       1996
                                                           ---------   --------
                                                              (IN THOUSANDS)
<S>                                                        <C>         <C>
Notes and accounts receivable   ........................   $24,628     $38,359
Investment in Caretenders Health Corp.   ...............     7,417       7,370
Prepaid long-term lease   ..............................     8,888       8,397
Investments in other unconsolidated subsidiaries  ......     6,754      15,362
Real estate investments   ..............................    14,324      10,020
Trusteed funds   .......................................     1,879       1,879
Other   ................................................     5,127       2,629
                                                           --------    --------
                                                           $69,017     $84,016
                                                           ========    ========
</TABLE>


                                       23

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

4. Other Assets - (CONTINUED)

     The  Company  has a 19%  ownership  interest in  Caretenders  Health  Corp.
("Caretenders");  accordingly,  the Company's  investment is being accounted for
using the equity method of accounting.  The  investment was initially  valued at
$7,250,000.  The Company's equity in earnings of Caretenders for the years ended
December 31, 1994,  1995 and 1996 was not material to the  Company's  results of
operations.

     It was not practicable to estimate the fair value of the Company's  various
investments in other unconsolidated subsidiaries (involved in operations similar
to those of the  Company)  because of the lack of a quoted  market price and the
inability to estimate fair value without incurring excessive costs. The carrying
amount at December 31, 1996  represents  the original  cost of the  investments,
which management believes is not impaired.




5. PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment consisted of the following:



<TABLE>
<CAPTION>
                                                                DECEMBER 31
                                                         --------------------------
                                                           1995           1996
                                                         ------------   -----------
                                                               (IN THOUSANDS)
<S>                                                      <C>            <C>
Land  ................................................   $   86,020     $   93,631
Buildings   ..........................................      799,286        844,775
Leasehold improvements  ..............................       87,216        112,149
Furniture, fixtures and equipment   ..................      700,757        801,443
Construction-in-progress   ...........................       50,157         73,815
                                                         -----------    -----------
                                                          1,723,436      1,925,813
Less accumulated depreciation and amortization  ......      345,420        460,980
                                                         -----------    -----------
                                                         $1,378,016     $1,464,833
                                                         ===========    ===========
</TABLE>


6. INTANGIBLE ASSETS

     Intangible assets consisted of the following:



<TABLE>
<CAPTION>
                                                                           DECEMBER 31
                                                                    --------------------------
                                                                      1995           1996
                                                                    ------------   -----------
                                                                          (IN THOUSANDS)
<S>                                                                 <C>            <C>
Organizational, partnership formation and start-up costs   ......   $  163,839     $  238,126
Debt issue costs ................................................       35,531         34,905
Noncompete agreements  ..........................................       70,636         86,566
Cost in excess of net asset value of purchased facilities  ......      787,397        947,104
                                                                    -----------    -----------
                                                                     1,057,403      1,306,701
Less accumulated amortization   .................................      136,433        212,280
                                                                    -----------    -----------
                                                                    $  920,970     $1,094,421
                                                                    ===========    ===========
</TABLE>


                                       24

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

7. LONG-TERM DEBT

     Long-term debt consisted of the following:



<TABLE>
<CAPTION>
                                                                             DECEMBER 31
                                                                      --------------------------
                                                                        1995           1996
                                                                      ------------   -----------
                                                                            (IN THOUSANDS)
<S>                                                                   <C>            <C>
Notes and bonds payable:
 Advances under a $1,000,000,000 credit agreement with banks       .  $  790,000     $       --
 Advances under a $1,250,000,000 credit agreement with banks       .          --        995,000
 9.5% Senior Subordinated Notes due 2001   ........................      250,000        250,000
 5.0% Convertible Subordinated Debentures due 2001  ...............      115,000        115,000
 Notes payable to banks and various other notes payable, at in-
   terest rates from 5.5% to 14.9%                                       241,520        151,384
 Hospital revenue bonds payable   .................................       32,337         22,503
Noncompete agreements payable with payments due at intervals
 ranging through December 2004 ....................................       24,161         26,256
                                                                      -----------    -----------
                                                                       1,453,018      1,560,143
Less amounts due within one year  .................................       51,528         47,089
                                                                      -----------    -----------
                                                                      $1,401,490     $1,513,054
                                                                      ===========    ===========
</TABLE>


     The fair value of total long-term debt  approximates book value at December
31, 1995 and 1996. The fair values of the Company's long-term debt are estimated
using discounted cash flow analysis,  based on the Company's current incremental
borrowing rates for similar types of borrowing arrangements.

     During 1995, the Company entered into a Credit Agreement with  NationsBank,
N.A. ("NationsBank") and other participating banks (the "1995 Credit Agreement")
which consisted of a  $1,000,000,000  revolving  credit  facility.  On April 18,
1996, the Company amended and restated the 1995 Credit Agreement to increase the
size of the  revolving  credit  facility  to  $1,250,000,000  (the "1996  Credit
Agreement"). Interest is paid based on LIBOR plus a predetermined margin, a base
rate, or competitively  bid rates from the  participating  banks. The Company is
required to pay a fee on the unused  portion of the  revolving  credit  facility
ranging from 0.08% to 0.25%,  depending on certain defined ratios. The principal
amount is payable in full on March 31,  2001.  The  Company  provided a negative
pledge on all assets under the 1996 Credit  Agreement,  and the lenders released
the first  priority  security  interest in all shares of stock of the  Company's
subsidiaries and rights and interests in the Company's  controlled  partnerships
which had been granted  under the 1995 Credit  Agreement.  At December 31, 1996,
the  effective  interest  rate  associated  with the 1996 Credit  Agreement  was
approximately 5.87%.

     On March 24, 1994, the Company issued $250,000,000 principal amount of 9.5%
Senior Subordinated Notes due 2001 (the "Notes"). Interest is payable on April 1
and October 1. The Notes are senior subordinated  obligations of the Company and
as such are  subordinated to all existing and future senior  indebtedness of the
Company,  and also are  effectively  subordinated  to all  existing  and  future
liabilities  of the  Company's  subsidiaries  and  partnerships.  The Notes rank
senior  to all  subordinated  indebtedness  of  the  Company,  including  the 5%
Convertible Subordinated Debentures due 2001 described below.
The Notes mature on April 1, 2001.

     Also on March 24, 1994, the Company issued $100,000,000 principal amount of
5% Convertible Subordinated Debentures due 2001 (the "Convertible  Debentures").
An additional  $15,000,000 of Convertible Debentures was issued in April 1994 to
cover underwriters'  overallotments.  Interest is payable on April 1 and October
1. The Convertible  Debentures are convertible  into common stock of the Company
at the option of the holder at a conversion  price of $9.406 per share,  subject
to adjustment upon the occurrence of certain events.


                                       25

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

7. Long-Term Debt - (CONTINUED)


     In June 1994, SHC (see Note 2) issued $75,000,000 principal amount of 11.5%
Senior  Subordinated Notes due July 15, 2004 (the "SHC Notes").  The proceeds of
the SHC  Notes  were  used to pay  down  indebtedness  outstanding  under  other
existing credit  facilities.  During 1995, the Company purchased  $67,500,000 of
the $75,000,000  outstanding principal amount of the SHC Notes in a tender offer
at 115% of the face value of the Notes, and the remaining $7,500,000 balance was
purchased on the open market,  using proceeds from the Company's other long-term
credit facilities. The loss on retirement of the SHC Notes totaled approximately
$14,606,000.  The loss consists of the premium,  write-off of  unamortized  bond
issue  costs and other fees and is reported  as an  extraordinary  loss on early
extinguishment of debt in the accompanying 1995 consolidated statement of income
(see Note 2). 

     Principal maturities of long-term debt are as follows:





<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31                                           (IN THOUSANDS)
-------------------------                                        ---------------
<S>                                                               <C>
1997   ......................................................      $    47,089
1998   ......................................................           36,703
1999   ......................................................           26,085
2000   ......................................................           24,034
2001   ......................................................        1,375,570
After 2001 ..................................................           50,662
                                                                   ------------
                                                                   $ 1,560,143
                                                                   ============
</TABLE>


8. STOCK OPTIONS

     THE COMPANY  HAS  VARIOUS  STOCKHOLDER-APPROVED  STOCK  OPTION  PLANS WHICH
PROVIDE FOR THE GRANT OF options to directors,  officers and other key employees
to  purchase  common  stock at 100% of the fair  market  value as of the date of
grant.  The  Audit  and  Compensation   Committee  of  the  Board  of  Directors
administers  the stock option plans.  Options may be granted as incentive  stock
options or as  non-qualified  stock  options.  Incentive  stock options vest 25%
annually, commencing upon completion of one year of employment subsequent to the
date of grant.  Non-qualified  stock  options  generally  are not subject to any
vesting  provisions.  The options expire at dates ranging from five to ten years
from the date of grant.

     In October, 1995, the Financial Accounting Standards Board issued Statement
of  Financial   Accounting   Standards  No.  123,  "Accounting  for  Stock-Based
Compensation  ("SFAS  123").  SFAS 123 is effective  for fiscal years  beginning
after  December 15, 1995 and allows for the option of  continuing to account for
stock-based  compensation  under  Accounting  Principles  Board  Opinion No. 25,
"Accounting   for  Stock   Issued  to   Employees"   ("APB  25"),   and  related
interpretations,  or selecting the fair value method of expense  recognition  as
described  in SFAS 123.  The Company has elected to follow APB 25 in  accounting
for its employee stock options.  The Company  follows SFAS 123 in accounting for
its non-employee stock options.  The total compensation  expense associated with
non-employee stock options granted in 1996 was not material.

     Pro forma  information  regarding  net  income  and  earnings  per share is
required  by  Statement  123,  and has been  determined  as if the  Company  had
accounted  for its employee  stock  options  under the fair value method of that
Statement.  The fair value for these  options was estimated at the date of grant
using a Black-Scholes  option pricing model with the following  weighted-average
assumptions for 1995 and 1996,  respectively:  risk-free interest rates of 5.87%
and 6.01%; dividend yield of 0%; volatility factors of the expected market price
of the Company's  common stock of .36 and .37; and a  weighted-average  expected
life of the options of 4.3 years.

     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


                                       26

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

8. Stock Options - (CONTINUED)

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 options' vesting period.  The Company's
pro forma information follows (in thousands, except for per share amounts):



<TABLE>
<CAPTION>
                                                        1995        1996
                                                        ----        ----
<S>                                                    <C>         <C>
Pro forma net income   ............................    $80,059     $162,463
Pro forma earnings per share:
 Primary   ........................................    $  0.26     $   0.48
 Fully diluted   ..................................    $  0.26     $   0.48
</TABLE>

     The effect of compensation expense from stock options on 1995 pro forma net
income  reflects  only the vesting of 1995 awards.  However,  1996 pro forma net
income reflects the second year of vesting of the 1995 awards and the first year
of vesting of 1996  awards.  Not until  1998 is the full  effect of  recognizing
compensation expense for stock options representative of the possible effects on
pro forma net income for future years.


     A summary of the Company's  stock option  activity and related  information
for the years ended December 31 follows:


<TABLE>
<CAPTION>
                                                        1994                 1995                  1996
                                                 ------------------- --------------------- --------------------
                                                                                WEIGHTED              WEIGHTED
                                                                                 AVERAGE              AVERAGE
                                                 OPTIONS    PRICE     OPTIONS   EXERCISE    OPTIONS   EXERCISE
                                                  (000)     RANGE      (000)      PRICE      (000)     PRICE
                                                 --------- --------- ---------- ---------- ---------- ---------
<S>                                              <C>       <C>       <C>        <C>        <C>        <C>
Options outstanding January 1:   ............... 31,547               30,150        $4      35,068       $ 5
 Granted .......................................  3,356    $5 - $9     7,639         9       4,769        17
 Exercised  .................................... (3,877)   $1 - $4    (2,237)        4      (6,709)        5
 Canceled   ....................................   (876)                (484)        5        (322)        6
                                                 -------             --------              --------
Options outstanding at December 31  ............ 30,150               35,068        $5      32,806       $ 7
Options exercisable at December 31  ............ 22,533               26,293        $5      27,678       $ 6
Weighted average fair value of options granted
 during the year  ..............................    N/A              $  3.81               $  7.13
</TABLE>


     The following table summarizes  information about stock options outstanding
at December 31, 1996:


<TABLE>
<CAPTION>
                                       OPTIONS OUTSTANDING                    OPTIONS EXERCISABLE
                          ---------------------------------------------   ---------------------------
                                              WEIGHTED
                                              AVERAGE        WEIGHTED                       WEIGHTED
      EXERCISE               OPTIONS         REMAINING       AVERAGE        OPTIONS         AVERAGE
       PRICE               OUTSTANDING       CONTRACTUAL     EXERCISE     EXERCISABLE       EXERCISE
       RANGE               AT 12/31/96          LIFE          PRICE       AT 12/31/96       PRICE
-----------------------   ----------------   -------------   ----------   ---------------   ---------
                          (IN THOUSANDS)      (YEARS)                     (IN THOUSANDS)
<S>                       <C>                <C>             <C>          <C>               <C>
Under $8.40............       21,380            5.50           $ 4.12         20,014          $ 4.08
$8.40 - $16.40.........        9,305            8.55            10.94          7,172           11.59
$16.41 and above ......        2,121            9.14            18.20            492           19.02
</TABLE>


                                       27

<PAGE>


                    HEALTHSOUTH Corporation and Subsidiaries
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED )

9. ACQUISITIONS

1994 Acquisitions

     At various dates during 1994, the Company  acquired 53 separate  outpatient
operations and a majority  equity  interest in five  outpatient  surgery centers
located  throughout  the United  States.  The combined  purchase  price of these
acquired outpatient operations was approximately  $80,456,000.  The Company also
acquired  a  specialty  medical  center in  Dallas,  Texas,  a therapy  staffing
service, a diagnostic  imaging company,  four physical therapy practices and two
home health  agencies.  The  combined  purchase  price of these  operations  was
approximately  $32,044,000.  The form of  consideration  constituting  the total
purchase  prices  of  $112,500,000  was   approximately   $88,455,000  in  cash,
$14,122,000  in notes payable and  approximately  624,000 shares of common stock
valued at $9,923,000.

     In connection with these transactions,  the Company entered into noncompete
agreements with former owners totaling $10,814,000. In general, these noncompete
agreements are payable in monthly or quarterly installments over periods ranging
from five to ten years.

     The fair value of the total net assets  relating  to the 1994  acquisitions
described  above  was  approximately  $17,958,000.   The  total  cost  for  1994
acquisitions exceeded the fair value of the net assets acquired by approximately
$94,542,000.  The Company evaluated each acquisition  independently to determine
the appropriate amortization period for the cost in excess of net asset value of
purchased  facilities.  Each  evaluation  included an  analysis of historic  and
projected  financial  performance,  evaluation of the estimated  useful lives of
buildings and fixed assets  acquired,  the indefinite  lives of  certificates of
need and licenses acquired,  the competition  within local markets,  lease terms
where applicable, and the legal term of partnerships where applicable.  Based on
these  evaluations,  the Company determined that the cost in excess of net asset
value of  purchased  facilities  relating  to the 1994  acquisitions  should  be
amortized over periods ranging from 25 to 40 years on a straight-line  basis. No
other identifiable intangible assets were recorded in the acquisitions described
above.


     Also during August 1994,  Health Images (see Note 2) acquired the remaining
interest in its equity affiliate,  National Diagnostic Systems, Inc. ("NDS") and
merged NDS into a  wholly-owned  subsidiary  of the  Company,  which was renamed
Interactive Diagnostic Services,  Inc. ("IDSI"). The total consideration for NDS
included $2,939,000 in common stock, forgiveness debt by NDS to Health Images of
$1,010,000,  and other consideration totalling $981,000.  Goodwill of $4,272,000
was recorded and acquisition costs of $1,087,000 were expensed.  On December 31,
1994,  the  Company  wrote off the  $4,272,000  in  goodwill  related to the NDS
investment in addition to the previous  write-off of  $1,087,000 in  acquisition
costs.  In addition,  Health Images  expensed  $219,000 for  estimated  contract
losses and $539,000 in organization  and start-up  costs.  Health Images filed a
lawsuit on February 21, 1995 against the selling  shareholders of NDS asking for
rescission of the  acquisition  described above and  restitution.  The complaint
alleges   breach   of   contract,   intentional   misrepresentation,   negligent
misrepresentation  and  suppession  of  fact.  Health  Images  discontinued  the
operations  fo IDSI  during the  quarter  ended  March 31,  1995.  The loss from
discontinued  operations  recorded in the accompanying 1994 consolidated  income
statement  includes an impairment charge of $5,580,000  related to the write-off
of the assets described above. Revenues attributable to discontinued  operations
were  $402,000  for 1995.  The loss  from  discontinued  operations  and loss on
disposal of discontinued  operations in 1995 totaled $1,874,000,  less an income
tax benefit of $712,000. 

     All  of  the  1994  acquisitions  described  above  were  accounted  for as
purchases and, accordingly, the results of operations of the acquired businesses
(not material individually or in the aggregate) are included in the accompanying
consolidated financial statements from their respective dates of acquisition.

1995 Acquisitions

     Effective April 1, 1995, the Company acquired the rehabilitation  hospitals
division  of  NovaCare,  Inc.  ("NovaCare"),  consisting  of  11  rehabilitation
hospitals,  12 other  facilities,  and  certificates  of need to build two other
facilities.   The  total  purchase   price  for  the  NovaCare   facilities  was
approximately


                                       28

<PAGE>

                   HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

9. ACQUISITIONS - (CONTINUED)

$235,000,000  in cash.  The cost in excess of net asset value was  approximately
$173,000,000.  Of this  excess,  approximately  $129,000,000  was  allocated  to
leasehold  value and the  remaining  $44,000,000  to cost in excess of net asset
value of purchased facilities. As part of the acquisition,  the Company acquired
approximately  $4,790,000  in deferred  tax assets.  The Company  also  provided
approximately $10,000,000 for the write-down of certain assets to net realizable
value as the result of a planned  facility  consolidation  in a market where the
Company's existing services  overlapped with those of an acquired facility.  The
planned employee  separations and facility  consolidation  were completed by the
end of 1995.

     Effective  December  1,  1995,  the  Company  acquired  Caremark Orthopedic
Services  Inc.  ("Caremark"). At the time of the acquisition, Caremark owned and
operated  approximately  120 outpatient rehabilitation centers in 13 states. The
total purchase price was approximately $127,500,000 in cash.


     Also at various  dates  during  1995,  the  Company  acquired  70  separate
outpatient rehabilitation operations located throughout the United States, three
physical  therapy  practices,  one home  health  agency,  one nursing  home,  75
licensed  subacute  beds,  five  outpatient  surgery  centers and 16  outpatient
diagnostic   imaging   operations.   The  combined   purchase  prices  of  these
acquisitions  was   approximately   $178,393,000.   The  form  of  consideration
constituting the combined purchase prices was approximately $152,833,000 in cash
and $25,560,000 in notes payable. 

     In connection with these transactions,  the Company entered into noncompete
agreements with former owners totaling $16,222,000. In general, these noncompete
agreements are payable in monthly or quarterly installments over periods ranging
from five to ten years.


     The fair value of the total net assets  relating  to the 1995  acquisitions
described  above,   excluding  the  NovaCare   acquisition,   was  approximately
$81,455,000. The total cost of these acquisitions exceeded the fair value of the
net assets acquired by  approximately  $224,438,000.  Based on the evaluation of
each acquisition  utilizing the criteria described above, the Company determined
that the cost in excess of net asset value of purchased  facilities  relating to
the 1995  acquisitions  should be amortized  over periods  ranging from 25 to 40
years on a straight-line  basis. No other  identifiable  intangible  assets were
recorded in the acquisitions described above.


     All  of  the  1995  acquisitions  described  above  were  accounted  for as
purchases and, accordingly, the results of operations of the acquired businesses
are included in the accompanying  consolidated  financial  statements from their
respective  dates of  acquisition.  With the exception of NovaCare,  none of the
above acquisitions were material individually or in the aggregate.


1996 Acquisitions


     At  various  dates  during  1996,   the  Company   acquired  80  outpatient
rehabilitation  facilities,  three  outpatient  surgery  centers,  one inpatient
rehabilitation  hospital,  and  one  diagnostic  imaging  center.  The  acquired
operations are located throughout the United States. The total purchase price of
the  acquired   operations   was   approximately   $104,321,000.   The  form  of
consideration   constituting   the  total  purchase  prices  was   approximately
$92,319,000 in cash and $12,002,000 in notes payable.

     In connection with these transactions,  the Company entered into noncompete
agreements with former owners totaling $11,900,000. In general, these noncompete
agreements are payable in monthly or quarterly installments over periods ranging
from five to ten years.

     The fair value of the total net assets  relating  to the 1996  acquisitions
described  above  was  approximately  $40,259,000.  The  total  cost of the 1996
acquisitions exceeded the fair value of the net assets acquired by approximately
$64,062,000.  Based on the evaluation of each acquisition utilizing the criteria
described above,


                                       29

<PAGE>

                   HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

9. ACQUISITIONS - (CONTINUED)

the Company  determined  that the cost in excess of net asset value of purchased
facilities  relating to the 1996  acquisitions  should be amortized over periods
ranging  from 25 to 40 years on a  straight-line  basis.  No other  identifiable
intangible assets were recorded in the acquisitions described above.

     All  of  the  1996  acquisitions  described  above  were  accounted  for as
purchases and, accordingly, the results of operations of the acquired businesses
(not material individually or in the aggregate) are included in the accompanying
consolidated financial statements from their respective dates of acquisition.


10. INCOME TAXES

     HEALTHSOUTH  and its  subsidiaries  file a consolidated  federal income tax
return. The limited  partnerships and limited liability  companies file separate
income tax returns. HEALTHSOUTH's allocable portion of each partnership's income
or loss is included in the taxable income of the Company.  The remaining  income
or loss of each partnership is allocated to the limited partners.


     The  Company  utilizes the liability method of accounting for income taxes,
as  required  by  Financial Accounting Standards Board (FASB) Statement No. 109,
"Accounting for Income Taxes".


     Significant components of the Company's deferred tax assets and liabilities
as of December 31, 1995 are as follows:


<TABLE>
<CAPTION>
                                                CURRENT      NONCURRENT       TOTAL
                                                ----------   ------------   -------------
                                                             (IN THOUSANDS)
<S>                                             <C>          <C>            <C>
Deferred tax assets:
 Accruals   .................................     $  8,016    $      --      $   8,016
 Disposal of surgery centers  ...............        2,675           --          2,675
 Impairment of assets   .....................        1,309        5,434          6,743
 Development costs   ........................           --          849            849
 Acquired net operating loss  ...............           --       16,277         16,277
 Allowance for bad debts   ..................       31,650           --         31,650
 Other   ....................................        2,084        5,469          7,553
                                                 ---------    ---------      ---------
Total deferred tax assets  ..................       45,734       28,029         73,763
Deferred tax liabilities:
Depreciation and amortization ...............           --       42,591         42,591
 Non-accrual experience method   ............       14,559           --         14,559
 Purchase price accounting ..................           --        4,802          4,802
 Contracts  .................................        3,849           --          3,849
 Capitalized costs   ........................           --       12,916         12,916
 Other   ....................................        2,522        3,164          5,686
                                                 ---------    ---------      ---------
Total deferred tax liabilities   ............       20,930       63,473         84,403
                                                 ---------    ---------      ---------
Net deferred tax assets (liabilities)  ......     $ 24,804    $ (35,444)     $ (10,640)
                                                 =========    =========      =========
</TABLE>



     At December 31, 1996, the Company has net operating loss  carryforwards  of
approximately  $14,747,000  for income tax  purposes  expiring  through the year
2009. Those carryforwards resulted from the Company's acquisitions of Diagnostic
Health Corporation,  Renaissance  Rehabilitation Center, Inc., Rebound, Inc. and
Health Images, Inc.



                                       30

<PAGE>


                   HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

10. INCOME TAXES - (CONTINUED)

     Deferred  income  taxes  reflect the net effects of  temporary  differences
between the carrying  amounts of assets and liabilities for financial  reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities as of December 31, 1996 are as
follows:


<TABLE>
<CAPTION>
                                                CURRENT     NONCURRENT       TOTAL
                                                ---------   ------------   -------------
                                                             (IN THOUSANDS)
<S>                                             <C>         <C>            <C>
Deferred tax assets:
 Acquired net operating loss  ...............   $    --      $   5,283      $   5,283
 Development costs   ........................        --            849            849
 Accruals   .................................     6,634             --          6,634
 Allowance for bad debts   ..................    34,700             --         34,700
 Other   ....................................     2,433          2,597          5,030
                                                --------     ---------      ---------
Total deferred tax assets  ..................    43,767          8,729         52,496
Deferred tax liabilities:
 Depreciation and amortization   ............        --         20,501         20,501
 Purchase price accounting ..................        --          4,802          4,802
 Non-accrual experience method   ............    17,694             --         17,694
 Contracts  .................................     3,849             --          3,849
 Capitalized costs   ........................     5,013         22,672         27,685
 Other   ....................................     1,973          2,604          4,577
                                                --------     ---------      ---------
Total deferred tax liabilities   ............    28,529         50,579         79,108
                                                --------     ---------      ---------
Net deferred tax assets (liabilities)  ......   $15,238      $ (41,850)     $ (26,612)
                                                ========     =========      =========
</TABLE>


     The provision for income taxes was as follows:


<TABLE>
<CAPTION>
                                    YEAR ENDED DECEMBER 31,
                              ------------------------------------
                                1994          1995        1996
                              ------------   ---------   ---------
                                         (IN THOUSANDS)
<S>                           <C>            <C>         <C>
Currently payable:
 Federal ..................    $  72,416     $70,629     $116,023
 State   ..................       10,802       9,586       13,598
                               ---------     --------    ---------
                                  83,218      80,215      129,621
Deferred (benefit) expense:
 Federal ..................      (12,920)        367       13,281
 State   ..................       (1,738)         29        1,027
                               ---------     --------    ---------
                                 (14,658)        396       14,308
                               ---------     --------    ---------
Total provision   .........    $  68,560     $80,611     $143,929
                               =========     ========    =========
</TABLE>



     As part of the  acquisitions  of PSCM,  Readicare  and FSSCI,  the  Company
acquired approximately $1,664,000 in deferred tax liabilities.



                                       31

<PAGE>


                   HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

10. INCOME TAXES - (CONTINUED)

     The  difference  between  the  provision  for  income  taxes and the amount
computed by applying  the  statutory  federal  income tax rate to income  before
taxes was as follows:



<TABLE>
<CAPTION>
                                                                      YEAR ENDED DECEMBER 31
                                                            ------------------------------------------
                                                              1994           1995           1996
                                                            ------------   ------------   ------------
                                                                          (IN THOUSANDS)
<S>                                                         <C>            <C>            <C>
Federal taxes at statutory rates ........................    $  67,795      $  78,322      $ 134,457
Add (deduct):
   State income taxes, net of federal tax benefit  ......        5,254          6,250          9,506
   Minority interests   .................................      (11,014)       (15,102)       (17,303)
   Disposal/impairment/merger charges  ..................          668          9,955          6,563
   Other ................................................        5,857          1,186         10,706
                                                             ---------      ---------      ---------
                                                             $  68,560      $  80,611      $ 143,929
                                                             =========      =========      =========
</TABLE>


11. COMMITMENTS AND CONTINGENCIES

     The Company is a party to legal proceedings  incidental to its business. In
the opinion of management,  any ultimate liability with respect to these actions
will not materially  affect the  consolidated  financial  position or results of
operations of the Company.

     At December 31, 1996,  anticipated capital expenditures for the next twelve
months are $350,000,000.  This amount includes  expenditures for maintenance and
expansion  of the  Company's  existing  facilities  as well as  development  and
integration of the Company's services in selected metropolitan markets.

     Beginning   December  1,  1993,   the  Company  became   self-insured   for
professional   liability  and  comprehensive  general  liability.   The  Company
purchased  coverage  for all claims  incurred  prior to  December  1,  1993.  In
addition,  the  Company  purchased  underlying  insurance  which would cover all
claims  once  established  limits  have  been  exceeded.  It is the  opinion  of
management that at December 31, 1996, the Company has adequate reserves to cover
losses on asserted and unasserted claims.

     Prior to consummation of the SCA and Advantage Health mergers (see Note 2),
these  companies   carried   professional   malpractice  and  general  liability
insurance.  The policies were carried on a claims made basis.  The companies had
policies in place to track and monitor incidents of significance.  Management is
unaware of any claims that may result in a loss in excess of amounts  covered by
existing insurance.


     Operating  leases  generally  consist of short-term  lease  agreements  for
buildings  where  facilities  are located.  These leases  generally  have 5-year
terms, with one or more renewal options, with terms to be negotiated at the time
of renewal.  Total  rental  expense for all  operating  leases was  $77,228,000,
$103,308,000  and  $131,994,000  for the years ended December 31, 1994, 1995 and
1996, respectively. 

     The  following is a schedule of future  minimum  lease  payments  under all
operating  leases  having  initial or  remaining  non-cancelable  lease terms in
excess of one year:



          YEAR ENDING DECEMBER 31               (IN THOUSANDS)
          -------------------------             ---------------
          1997   ..................                $111,140
          1998   ..................                 101,651
          1999   ..................                  88,490
          2000   ..................                  73,625
          2001   ..................                  57,165
          After 2001   ............                 251,915
                                                   ---------
                                                   $683,986
                                                   =========
                                              
                                

                                       32

<PAGE>


                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED )

12. EMPLOYEE BENEFIT PLANS


     The Company has a 401(k)  savings plan which matches 15% of the first 4% of
earnings  that an employee  contributes.  All  contributions  are in the form of
cash.  All  employees  who have  completed one year of service with a minimum of
1,000  hours  worked  are  eligible  to   participate   in  the  plan.   Company
contributions   are  gradually   vested  over  a  seven-year   service   period.
Contributions  to  the  plan  by  the  Company  were  approximately  $1,293,000,
$1,408,000 and $2,420,000 in 1994, 1995 and 1996, respectively.


     In 1991, the Company  established an Employee Stock Ownership Plan ("ESOP")
for the purpose of  providing  substantially  all  employees  of the Company the
opportunity to save for their  retirement and acquire a proprietary  interest in
the Company.  The ESOP  currently  owns  approximately  3,320,000  shares of the
Company's  common  stock,  which were  purchased  with funds  borrowed  from the
Company, $10,000,000 in 1991 (the "1991 ESOP Loan") and $10,000,000 in 1992 (the
"1992 ESOP Loan").  At December 31, 1996,  the combined ESOP Loans had a balance
of  $14,148,000.  The 1991 ESOP Loan,  which bears an  interest  rate of 10%, is
payable in annual  installments  covering interest and principal over a ten-year
period  beginning in 1992.  The 1992 ESOP Loan,  which bears an interest rate of
8.5%, is payable in annual  installments  covering interest and principal over a
ten-year period  beginning in 1993.  Company  contributions to the ESOP began in
1992  and  shall  at least  equal  the  amount  required  to make all ESOP  loan
amortization  payments for each plan year. The Company  recognizes  compensation
expense based on the shares allocated  method.  Compensation  expense related to
the ESOP recognized by the Company was $3,673,000,  $3,524,000 and $3,198,000 in
1994,  1995 and 1996,  respectively.  Interest  incurred  on the ESOP  Loans was
approximately  $1,608,000,  $1,460,000  and  $1,298,000 in 1994,  1995 and 1996,
respectively.  Approximately  1,212,000  shares  owned  by the  ESOP  have  been
allocated to participants at December 31, 1996.

     During 1993, the American  Institute of Certified Public Accountants issued
Statement of Position 93-6,  "Employers  Accounting for Employee Stock Ownership
Plans" ("SOP 93-6"). Among other provisions, SOP 93-6 requires that compensation
expense relating to employee stock ownership plans be measured based on the fair
market value of the shares when  allocated to the  employees.  The provisions of
SOP 93-6 apply only to leveraged ESOPs formed after December 31, 1992, or shares
newly acquired by an existing  leveraged  ESOP after December 31, 1992.  Because
all shares owned by the Company's ESOP were acquired prior to December 31, 1992,
the Company's accounting policies for the shares currently owned by the ESOP are
not affected by SOP 93-6.

13. LOSS ON DISPOSAL OF SURGERY CENTERS


     During the fourth  quarter of 1994,  the  Company  adopted a formal plan to
dispose of three  surgery  centers and certain  other  properties  during  1995.
Accordingly,  a loss of  $13,197,000  was made to reflect  the  expected  losses
resulting from the disposal of these centers. The loss is comprised primarily of
losses on the sale of owned  facilities and  equipment,  write-off of intangible
and  other  assets,  and  accrual  of future  operating  lease  obligations  and
estimated operating losses through the anticipated date of disposal.

     The following are the major components of the loss (in thousands):


<TABLE>
<S>                                                                                     <C>
Write-down of land, buildings and equipment   .......................................   $ 4,806
Write-off of excess of cost over fair value of net assets acquired and other assets       2,762
Estimated operating losses through anticipated date of disposal .....................     1,750
Accrual of future lease commitments and other obligations resulting from disposal ...     3,879
                                                                                        --------
                                                                                        $13,197
                                                                                        ========
</TABLE>

     The closings of the three  surgery  centers were  completed by December 31,
1995.  An  accrual  of  $929,000  is  included  in  accrued  liabilities  on the
accompanying  December 31, 1995  consolidated  balance  sheet for the  remaining
costs to be incurred  relative to the disposal of these surgery  centers and the
other properties. The remaining accrual was used in 1996.


                                       33

<PAGE>

                    HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

14. IMPAIRMENT OF LONG-TERM ASSETS

     During 1994,  certain events  occurred which impaired the value of specific
long-term  assets of ReLife (see Note 2). A hospital in Missouri with a distinct
part unit  which  ReLife was  managing  was  purchased  in 1994 by an acute care
provider  which  terminated  the  contract  with ReLife.  Remaining  goodwill of
$1,700,000  and costs  allocated to the management  contract of $1,300,000  were
written off as there is no value remaining for the terminated contract.

     A ReLife  facility in central Florida  incurred  tornado damage and has not
operated since September 1993. During 1994, management of ReLife determined that
it was  probable  that  this  facility  would  not  reopen.  Start-up  costs  of
$1,600,000 were written off. This facility is leased under an operating lease as
described  in Note 11 through  the year 2001.  An  impairment  accrual  has been
established  based on the projected  undiscounted net cash flows related to this
non-operating  facility for the remainder of the lease term. The accrual totaled
$5,900,000  and consists of $4,700,000 in lease payments and $1,200,000 in fixed
costs and operating expenses,  including property taxes,  maintenance,  security
and other related costs.

     During 1994,  ReLife entered into a contract for a new information  system.
Payments under the contract and related costs were capitalized  during the year.
After the agreement to merge with  HEALTHSOUTH  was entered  into,  the computer
project  was  abandoned,  resulting  in  a  write-off  of  capitalized  cost  of
$4,500,000.

     In 1995, the Company recorded an asset  impairment  charge of approximately
$53,549,000  relating to goodwill and tangible assets identifiable with fourteen
surgery centers. Approximately $47,984,000 of this charge related to ten surgery
centers  which the  Company  intends to operate on an ongoing  basis,  while the
remaining loss of $5,565,000 is identifiable with four surgery centers which the
Company decided during the fourth quarter of 1995 to close.

     With  respect to the ten surgery  centers  the Company  intends to continue
operating,  certain  events  occurred  in  the  fourth  quarter  of  1995  which
significantly  impacted  the  Company's  estimates  of future  cash  flows to be
received  from these  centers.  Those events  primarily  related to a decline in
operating  results  combined  with a  deterioration  in  relationships  with key
physicians  at  certain of those  locations.  As a result of these  events,  the
Company revised its estimates of undiscounted cash flows to be received over the
remaining  estimated  useful lives of these centers and determined that goodwill
and  other  long-lived  assets  (primarily  property  and  equipment)  had  been
impaired.  The Company  developed its best  estimates of future  operating  cash
flows  at  these  locations   considering   future   requirements   for  capital
expenditures  as well as the impact of inflation.  The projections of cash flows
also took into account  estimates of  significant  one-time  expenses as well as
estimates of  additional  revenues and  resulting  income from future  marketing
efforts in the respective  locations.  The amount of the  impairment  charge was
determined by discounting the estimates of future cash flows, using an estimated
8.5% incremental  borrowing rate which management  believes is commensurate with
the risks  involved.  The  resulting  net present value of future cash flows was
then compared to the historical net book value of goodwill and other  long-lived
assets at each operating  location which resulted in an impairment loss relative
to these centers of $47,984,000.

     The remaining impairment charge of $5,565,000 relating to the centers to be
closed was based on the fair value of the related assets less estimated costs to
sell. One of these  facilities is expected to be sold by the middle of 1997. The
Company  continues to operate the remaining  three  facilities and is evaluating
its alternatives for their disposition.  Assets held for sale having a remaining
net book value of  $2,839,000  and  $2,309,000  are  included  in  property  and
equipment  on the  accompanying  December  31,  1995  and 1996  balance  sheets,
respectively.


     The above amounts are included in operations  for 1995 in the  accompanying
consolidated statement of income.



                                       34

<PAGE>


                   HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

14. IMPAIRMENT OF LONG-TERM ASSETS - (CONTINUED)


     In 1996, the Company recorded an asset  impairment  charge of approximately
$37,390,000  relating to tangible assets  identifiable  with the development and
manufacture  of the HI  Standard  and  HI  STAR  MRI  systems.  Improvements  in
technology,  and the related  reduction  in purchase  price,  of high field (1.5
Tesla) MRI systems significantly affected the viability of continued development
and  manufacture of mid field (0.6 Tesla) MRI systems.  Both the HI Standard and
HI STAR MRI systems were mid field systems.  The impairment  charge was based on
the fair value of the related assets. 


15. SUBSEQUENT EVENTS


     On  January  18,  1997,  the  Company's  Board of  Directors  authorized  a
two-for-one  stock split to be  effected  in the form of a 100% stock  dividend,
subject to the  approval by the  Company's  stockholders  of an amendment to its
Certificate  of  Incorporation  increasing  the number of  authorized  shares of
common  stock  from  250,000,000  to  500,000,000.  The  Company's  stockholders
approved the amendment on March 12, 1997. The stock dividend is payable on March
17, 1997 to holders of record on March 13, 1997. Accordingly,  all share and per
share  amounts  included  in the  accompanying  financial  statements  have been
restated to give effect to the stock split.  The stock  dividend is reflected in
the accompanying statement of stockholders' equity as a 1996 transaction.

     On February 17, 1997,  the Company  entered into a definitive  agreement to
acquire Horizon/CMS Healthcare Corporation  ("Horizon/CMS") in a stock-for-stock
merger in which the  stockholders  of  Horizon/CMS  will receive  .84338  (after
adjustment for the two-for-one  stock split) of a share of the Company's  common
stock  per share of  Horizon/CMS  common  stock.  The  transaction  is valued at
approximately  $1,600,000,000,  including  the  assumption  by  the  Company  of
approximately  $700,000,000  in  Horizon/CMS  debt.  It  is  expected  that  the
acquisition  will  be  accounted  for as a  purchase.  Horizon/CMS  operates  32
inpatient  rehabilitation  hospitals,  37 specialty hospitals and subacute units
and 278 outpatient  rehabilitation  centers.  Horizon/CMS  also owns,  leases or
manages  134  long-term  care  facilities,   a  contract  therapy  business,  an
institutional  pharmacy business and other healthcare services.  Consummation of
the transaction is subject to various regulatory approvals,  including clearance
under the Hart-Scott-Rodino  Antitrust Improvements Act, and to the satisfaction
of  certain  other  conditions.  The  Company  currently  anticipates  that  the
transaction will be consummated by October 1997. 


                                       35

<PAGE>


ITEM 7: FINANCIAL STATEMENTS AND EXHIBITS.


 (a)     Financial Statements of businesses acquired: Not applicable.
 (b)     Pro forma financial information: Not applicable.
 (c)     The following are filed as Exhibits to this Report:
         Exhibit (11) -- Statement Re: Computation of Per Share Earnings.
         Exhibit (23) -- Consent of Ernst & Young LLP.
         Exhibit (27) -- Financial Data Schedule.
 (d)     Financial Statement Schedules.
         Schedule II: Valuation and Qualifying Accounts


                                       36

<PAGE>

               SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS



<TABLE>
<CAPTION>
          COLUMN A                 COLUMN B                   COLUMN C                COLUMN D         COLUMN E
-------------------------------   --------------   -------------------------------   -------------   ---------------
                                                                    ADDITIONS
                                                   ADDITIONS       CHARGED TO
                                  BALANCE AT       CHARGED TO         OTHER
                                  BEGINNING OF     COSTS AND        ACCOUNTS         DEDUCTIONS      BALANCE AT END
        DESCRIPTION                 PERIOD         EXPENSES         DESCRIBE          DESCRIBE        OF PERIOD
-------------------------------   --------------   ------------   ----------------   -------------   ---------------
<S>                               <C>              <C>            <C>                <C>             <C>
Year ended December 31, 1994:
   Allowance for doubtful
    accounts ..................    $ 34,871        $ 35,740        $     6,850(1)    $ 32,799(2)       $44,662
Year ended December 31, 1995:
   Allowance for doubtful
    accounts ..................    $ 44,662        $ 42,305        $    21,078(1)    $ 47,945(2)       $ 60,100
Year ended December 31, 1996:
   Allowance for doubtful
    accounts ..................    $ 60,100        $ 58,637        $    13,643(1)    $ 57,020(2)       $ 75,360
</TABLE>


----------


(1) Allowances of acquisitions in years 1994, 1995 and 1996, respectively.


(2) Write-offs of uncollectible patient accounts receivable.

<PAGE>

                                   SIGNATURES

     Pursuant to the  requirements  of the Securities  Exchange Act of 1934, the
Registrant  has duly  caused  this  Report  to be  signed  on its  behalf by the
undersigned hereunto duly authorized.


                                         HEALTHSOUTH CORPORATION


                                         By     /s/ WILLIAM W. HORTON
                                         --------------------------------------
                                         William W. Horton
                                         Senior Vice President


Date: August 26, 1997
[{"type": "8-K", "sequence": "1", "description": "FORM 8-K", "secsgml_size_bytes": 171234}]
{"company-data": {"conformed-name": "HEALTHSOUTH CORP", "cik": "0000785161", "assigned-sic": "8093", "irs-number": "630860407", "state-of-incorporation": "DE", "fiscal-year-end": "1231"}, "filing-values": {"form-type": "8-K", "act": "34", "file-number": "333-24429", "film-number": "97670028"}, "business-address": {"street1": "TWO PERIMETER PARK S", "street2": "STE 224W", "city": "BIRMINGHAM", "state": "AL", "zip": "35243", "phone": "2059677116"}, "mail-address": {"street1": "TWO PERIMETER PARK SOUTH", "city": "BIRMINGHAM", "state": "AL", "zip": "35243"}, "former-company": {"former-conformed-name": "HEALTHSOUTH REHABILITATION CORP", "date-changed": "19920703"}}
================================================================================
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                              ------------------

                                    FORM 8-K

                 CURRENT REPORT PURSUANT TO SECTION 13 OR 15(D)

                     OF THE SECURITIES EXCHANGE ACT OF 1934

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

                        DATE OF REPORT: AUGUST 26, 1997

                            HEALTHSOUTH CORPORATION
             (Exact Name of Registrant as Specified in its Charter)
DELAWARE                   1-10315           63-0860407
(State or Other               (Commission      (I.R.S. Employer
 Jurisdiction of Incorporation     File Number)     Identification No.)
     or Organization)
ONE HEALTHSOUTH PARKWAY
                        BIRMINGHAM, ALABAMA         35243

            (Address of Principal Executive Offices)     (Zip Code)

                                 (205) 967-7116
              Registrant's Telephone Number, Including Area code:

================================================================================
ITEM 5. OTHER EVENTS

     HEALTHSOUTH Corporation ("HEALTHSOUTH" or the "Company") files this Current
Report  on Form 8-K to  reflect  the  restatement  of its  audited  consolidated
financial  statements  at December 31, 1995,  and 1996,  and for the years ended
December 31, 1994,  1995 and 1996, and the resulting  revisions to  Management's
Discussion  and Analysis of Financial  Condition  and Results of  Operations  to
reflect the effects of HEALTHSOUTH'S acquisition of Health Images, Inc. ("Health
Images").  HEALTHSOUTH  acquired Health Images during the first quarter of 1997,
in a transaction that was accounted for as a pooling of interests.

                                       1
SELECTED CONSOLIDATED FINANCIAL DATA
     The  data  set  forth  below  should  be  read  in  conjunction   with  the
consolidated financial statements,  related notes and other information included
herein.  The  financial  information  for all  periods  set forth below has been
restated to reflect the  acquisitions  of ReLife,  Inc.  ("ReLife")  in December
1994,  Surgical Health Corporation ("SHC") in June 1995, Sutter Surgery Centers,
Inc. ("SSCI") in October 1995, Surgical Care Affiliates, Inc. ("SCA") in January
1996, Advantage Health Corporation ("Advantage Health") in March 1996 and Health
Images,  Inc.  ("Health Images") in March 1997, each of which has been accounted
for as a pooling of interests.
YEAR ENDED DECEMBER 31,
                                                  -------------------------------------------------------------------------
                                                    1992          1993           1994           1995            1996
                                                  -----------   ------------   ------------   ------------   --------------
                                                                    (IN THOUSANDS, EXCEPT PER SHARE DATA)
INCOME STATEMENT DATA:
 Revenues  ....................................    $819,821     $1,055,295     $1,726,321     $2,118,681      $2,568,155
 Operating unit expenses  .....................     570,543       715,189      1,207,707      1,441,059        1,667,248
 Corporate general and administrative ex-
  penses                                             32,526        43,378         67,798         65,424           79,354
 Provision for doubtful accounts   ............      18,755        22,677         35,740         42,305           58,637
 Depreciation and amortization  ...............      42,107        75,425        126,148        160,901          207,132
 Merger and acquisition related expenses(1)              --           333          6,520         19,553           41,515
 Loss on impairment of assets(2)   ............          --            --         10,500         53,549           37,390
 Loss on abandonment of computer
  project(2)  .................................          --            --          4,500             --               --
 Loss on disposal of surgery centers(2)  ......          --            --         13,197             --               --
 NME Selected Hospitals Acquisition re-
  lated expense                                          --        49,742             --             --               --
 Terminated merger expense   ..................       3,665            --             --             --               --
 Loss on extinguishment of debt    ............         883            --             --             --               --
 Interest expense   ...........................      20,164        25,884         74,895        105,517           98,751
 Interest income ..............................      (9,757)       (6,179)        (6,658)        (8,009)          (6,034)
 Gain on sale of partnership interest    ......          --        (1,400)            --             --               --
 Gain on sale of MCA Stock(2)   ...............          --            --         (7,727)            --               --
                                                   --------     ----------     ----------     ----------      ----------
                                                    678,886       925,049      1,532,620      1,880,299        2,183,993
                                                   --------     ----------     ----------     ----------      ----------
 Income from continuing operations before
  income taxes, minority interests and ex-
  traordinary item                                  140,935       130,246        193,701        238,382          384,162
 Provision for income taxes  ..................      42,621        40,450         68,560         86,161          143,929
                                                   --------     ----------     ----------     ----------      ----------
                                                     98,314        89,796        125,141        152,221          240,233
 Minority interests ...........................      26,322        29,549         31,665         43,753           50,369
                                                   --------     ----------     ----------     ----------      ----------
 Income from continuing operations ............      71,992        60,247         93,476        108,468          189,864
 Income from discontinued operations  .........       3,283         3,986         (6,528)        (1,162)              --
 Extraordinary item(2) ........................          --            --             --         (9,056)              --
                                                   --------     ----------     ----------     ----------      ----------
  Net income  .................................    $ 75,275     $  64,233      $  86,948      $  98,250       $  189,864
                                                   ========     ==========     ==========     ==========      ==========
 Weighted average common and common
  equivalent shares outstanding(3) ............     265,267       275,316        291,314        307,792          336,807
                                                   ========     ==========     ==========     ==========      ==========
 Income per common and common equiv-
  alent share(3)
  Continuing operations   .....................    $   0.27     $    0.22      $    0.32      $    0.35       $     0.56
  Discontinued operations    ..................        0.01          0.01          (0.02)            --               --
  Extraordinary item   ........................          --            --             --          (0.03)              --
                                                   --------     ----------     ----------     ----------      ----------
  Net income  .................................    $   0.28     $    0.23      $    0.30      $    0.32       $     0.56
                                                   ========     ==========     ==========     ==========      ==========
 Income per common share -- assuming
  full dilution(3)(4)
  Continuing operations   .....................       N/A           N/A        $    0.32      $    0.35       $     0.55
  Discontinued operations .....................       N/A           N/A            (0.02)            --               --
  Extraordinary item   ........................       N/A           N/A               --          (0.03)              --
                                                   --------     ----------     ----------     ----------      ----------
  Net income  .................................       N/A           N/A        $    0.30      $    0.32       $     0.55
                                                   ========     ==========     ==========     ==========      ==========
DECEMBER 31,
                                           -----------------------------------------------------------------------
                                             1992           1993           1994           1995           1996
                                           ------------   ------------   ------------   ------------   -----------
                                                                       (IN THOUSANDS)
BALANCE SHEET DATA:
 Cash and marketable securities   ......     $  190,153     $  153,011     $  134,040     $  159,793     $  153,831
 Working capital   .....................        285,645        300,876        308,770        406,601        554,589
 Total assets   ........................      1,264,334      2,000,566      2,355,920      3,107,808      3,529,706
 Long-term debt(5)    ..................        438,515      1,028,610      1,164,135      1,453,018      1,560,143
 Stockholders' equity    ...............        661,846        727,737        837,160      1,269,686      1,569,101
----------

(1) Expenses  related to SHC's  Ballas  Merger in 1993,  the ReLife and Heritage
    Acquisitions  in 1994, the SHC, SSCI and NovaCare  Rehabilitation  Hospitals
    Acquisition  in 1995  and the SCA,  Advantage  Health,  PSCM  and  ReadiCare
    mergers in 1996.
(2) See "Notes to Consolidated Financial Statements".
(3) Adjusted to reflect a two-for-one stock split effected in the form of a 100%
    stock dividend paid on April 17, 1995 and a two-for-one stock split effected
    in the form of a 100% stock dividend paid on March 17, 1997.
(4) Fully-diluted  earnings  per  share in 1994,  1995 and 1996  reflect  shares
    reserved  for issuance  upon  conversion  of  HEALTHSOUTH's  5%  Convertible
    Subordinated Debentures due 2001, where applicable.
(5) Includes current portion of long-term debt.

                                       2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

     The following  discussion is intended to facilitate the  understanding  and
assessment  of  significant  changes  and  trends  related  to  the  results  of
operations and financial  condition of the Company,  including  certain  factors
related to recent  acquisitions  by the Company,  the timing and nature of which
have significantly affected the Company's results of operations. This discussion
and  analysis  should be read in  conjunction  with the  Company's  consolidated
financial statements and notes thereto included elsewhere in this Current Report
on Form 8-K.

     The Company completed the following  acquisitions over the last three years
(common share  amounts have been  adjusted to reflect a stock split  effected in
the form of a 100% stock dividend paid on March 17, 1997):

   o On December  29,  1994,  the Company  acquired  ReLife,  Inc.  (the "ReLife
     Acquisition").  A total of 22,050,580  shares of the Company's Common Stock
     were issued in the transaction, representing a value of $180,000,000 at the
     time of the  acquisition.  At  that  time,  ReLife  operated  31  inpatient
     facilities  with an  aggregate  of  1,102  licensed  beds,  including  nine
     free-standing  rehabilitation  hospitals,  nine acute rehabilitation units,
     five sub-acute  rehabilitation  units, seven transitional  living units and
     one  residential  facility,  and also  provided  outpatient  rehabilitation
     services at 12 centers.

   o On  April  1,  1995,   the  Company   purchased   the   operations  of  the
     rehabilitation   hospital   division  of  NovaCare,   Inc.  (the  "NovaCare
     Rehabilitation   Hospitals   Acquisition").    The   purchase   price   was
     approximately $235,000,000. The NovaCare Rehabilitation Hospitals consisted
     of 11 rehabilitation hospitals in seven states, 12 other facilities and two
     Certificates of Need.

   o On June 13, 1995, the Company  acquired  Surgical Health  Corporation  (the
     "SHC  Acquisition").  A total of 17,062,960  shares of the Company's Common
     Stock were issued in the transaction,  representing a value of $155,000,000
     at  the  time  of  the  acquisition.   The  Company  also  purchased  SHC's
     $75,000,000  aggregate  principal amount of 11.5% Senior Subordinated Notes
     due 2004 for an aggregate  consideration of approximately  $86,000,000.  At
     that time, SHC operated a network of 36 free-standing surgery centers in 11
     states, and five mobile lithotripsy units.

   o On October 26, 1995, the Company acquired Sutter Surgery Centers, Inc. (the
     "SSCI  Acquisition").  A total of 3,552,002  shares of the Company's Common
     Stock were issued in the  transaction,  representing a value of $44,444,000
     at the time of the acquisition. At that time, SSCI operated a network of 12
     freestanding surgery centers in three states.

   o On  December  1,  1995,  the  Company acquired Caremark Orthopedic Services
     Inc.  (the  "Caremark  Acquisition").  The purchase price was approximately
     $127,500,000.  At  that  time Caremark owned and operated approximately 120
     outpatient rehabilitation centers in 13 states.

   o On January 17, 1996, the Company acquired  Surgical Care  Affiliates,  Inc.
     (the "SCA  Acquisition").  A total of  91,856,678  shares of the  Company's
     Common  Stock  were  issued  in the  transaction,  representing  a value of
     approximately  $1,400,000,000 at the time of the acquisition. At that time,
     SCA operated a network of 67 freestanding surgery centers in 24 states.

   o On March 14, 1996, the Company acquired  Advantage Health  Corporation (the
     "Advantage  Health  Acquisition").  A total  of  18,203,978  shares  of the
     Company's Common Stock were issued in the transaction, representing a value
     of approximately $315,000,000 at the time of the acquisition. At that time,
     Advantage Health operated a network of 136 sites of service, including four
     freestanding rehabilitation hospitals, one freestanding multi-use hospital,
     one nursing  home, 68 outpatient  rehabilitation  facilities,  14 inpatient
     managed   rehabilitation  units,  24  rehabilitation   services  management
     contracts and six managed sub-acute rehabilitation units, primarily located
     in the northeastern United States.

                                       3
o On  August  20,  1996,  the  Company  acquired   Professional  Sports  Care
     Management,  Inc. (the "PSCM Acquisition").  A total of 3,622,888 shares of
     the Company's Common Stock were issued in the  transaction,  representing a
     value of approximately $59,000,000 at the time of the acquisition.  At that
     time,  PSCM operated a network of 36 outpatient  rehabilitation  centers in
     three states.

   o On December 2, 1996, the Company acquired  ReadiCare,  Inc. (the "ReadiCare
     Acquisition").  A total of 4,007,954  shares of the Company's  Common Stock
     were  issued  in the  transaction,  representing  a value of  approximately
     $76,000,000  at the  time  of the  acquisition.  At  that  time,  ReadiCare
     operated a network of 37 outpatient medical and  rehabilitation  centers in
     two states.

   o On  March  3,  1997,  the  Company  acquired  Health  Images, Inc. ("Health
     Images").  A  total of 10,343,470 shares of the Company's Common Stock were
     issued   in   the   transaction,  representing  a  value  of  approximately
     $208,162,000  at  the  time of the acquisition. At that time, Health Images
     operated  49  freestanding  diagnostic  centers in 13 states and six in the
     United Kingdom.

     The  NovaCare   Rehabilitation   Hospitals  Acquisition  and  the  Caremark
Acquisition each were accounted for under the purchase method of accounting and,
accordingly,  the acquired operations are included in the Company's consolidated
financial  information from their  respective dates of acquisition.  Each of the
ReLife  Acquisition,   the  SHC  Acquisition,  the  SSCI  Acquisition,  the  SCA
Acquisition,  the Advantage Health Acquisition and the Health Images Acquisition
was accounted for as a pooling of interests  and, with the exception of data set
forth relating to revenues derived from Medicare and Medicaid, all amounts shown
in the following  discussion  have been  restated to reflect such  acquisitions.
ReLife,  SHC, SSCI, SCA,  Advantage  Health and Health Images did not separately
track such revenues.  The PSCM  Acquisition and the ReadiCare  Acquisition  were
also accounted for as poolings of interests.  However,  due to the immateriality
of PSCM and ReadiCare,  the Company's  historical  financial  statements for all
periods  prior to the quarters in which the  respective  mergers took place have
not been restated. Instead,  stockholders' equity has been increased during 1996
to reflect the effects of the PSCM  Acquisition  and the ReadiCare  Acquisition.
The results of operations of PSCM and ReadiCare are included in the accompanying
financial  statements and the following  discussion from the date of acquisition
forward (see Note 2 of "Notes to Consolidated  Financial Statements" for further
discussion). 

     The Company determines the amortization period of the cost in excess of net
asset value of  purchased  facilities  based on an  evaluation  of the facts and
circumstances of each individual purchase  transaction.  The evaluation includes
an analysis of historic and projected  financial  performance,  an evaluation of
the  estimated  useful life of the  buildings  and fixed  assets  acquired,  the
indefinite  useful  life of  certificates  of need and  licenses  acquired,  the
competition  within local markets,  lease terms where applicable,  and the legal
terms  of  partnerships  where  applicable.  The  Company  utilizes  independent
appraisers and relies on its own management  expertise in evaluating each of the
factors  noted above.  With respect to the carrying  value of the excess of cost
over net asset value of purchased  facilities and other intangible  assets,  the
Company determines on a quarterly basis whether an impairment event has occurred
by  considering  factors  such as the market value of the asset,  a  significant
adverse  change in legal factors or in the business  climate,  adverse action by
regulators,  history of operating losses or cash flow losses, or a projection of
continuing  losses  associated with an operating  entity.  The carrying value of
excess cost over net asset value of purchased  facilities  and other  intangible
assets will be evaluated if the facts and circumstances suggest that it has been
impaired.  If this evaluation  indicates that the value of the asset will not be
recoverable,  as determined based on the  undiscounted  cash flows of the entity
acquired over the remaining amortization period, the Company's carrying value of
the asset will be reduced by the estimated shortfall of cash flows.

     Governmental,  commercial and private payors have  increasingly  recognized
the  need  to  contain  their  costs  for  healthcare  services.  These  payors,
accordingly,  are turning to closer monitoring of services,  prior authorization
requirements,   utilization  review  and  increased  utilization  of  outpatient
services.  During the periods  discussed  below,  the Company has experienced an
increased  effort by these payors to contain costs through  negotiated  discount
pricing. The Company views these efforts as an

                                        4
opportunity to demonstrate the  effectiveness  of its clinical  programs and its
ability to provide  its  rehabilitative  healthcare  services  efficiently.  The
Company has entered into a number of contracts  with payors to provide  services
and has realized an increased volume of patients as a result.

     The  Company's  revenues  include net patient  service  revenues  and other
operating  revenues.  Net patient service revenues are reported at estimated net
realizable  amounts  from  patients,  insurance  companies,  third-party  payors
(primarily  Medicare and  Medicaid) and others for services  rendered.  Revenues
from third-party  payors also include  estimated  retroactive  adjustments under
reimbursement  agreements  which are subject to final review and  settlement  by
appropriate authorities.  Management determines allowances for doubtful accounts
and  contractual  adjustments  based on historical  experience  and the terms of
payor contracts. Net accounts receivable include only those amounts estimated by
management to be collectible.

     The Company, in many cases, operates more than one site within a market. In
such markets,  there is customarily an outpatient  center or inpatient  facility
with associated  satellite outpatient  locations.  For purposes of the following
discussion and analysis,  same store operations are measured on locations within
markets in which similar operations existed at the end of the period and include
the operations of additional  locations opened within the same market. New store
operations are measured on locations within new markets.

RESULTS OF OPERATIONS OF THE COMPANY

Twelve-Month Periods Ended December 31, 1994 and 1995

     The Company  operated 537 outpatient  rehabilitation  locations at December
31, 1995,  compared to 283 outpatient  rehabilitation  locations at December 31,
1994. In addition, the Company operated 95 inpatient rehabilitation  facilities,
122 surgery centers,  69 diagnostic centers and five medical centers at December
31,  1995,  compared  to 82  inpatient  rehabilitation  facilities,  112 surgery
centers, 51 diagnostic centers and five medical centers at December 31, 1994.

     The Company's  operations  generated revenues of $2,118,681,000 in 1995, an
increase of  $392,360,000,  or 22.7%,  as compared to 1994 revenues.  Same store
revenues for the twelve months ended December 31, 1995 were  $1,891,150,000,  an
increase of  $164,829,000,  or 9.5%, as compared to the same period in 1994. New
store revenues for 1995 were $227,531,000. New store revenues reflect (1) the 11
rehabilitation  hospitals and 12 other  facilities  associated with the NovaCare
Rehabilitation  Hospitals  Acquisition,  (2) the 120  outpatient  rehabilitation
centers  associated with the Caremark  Acquisition,  (3) the acquisition of five
surgery  centers and 16 outpatient  diagnostic  imaging  operation,  and (4) the
acquisition of outpatient  rehabilitation operations in 34 new markets. See Note
9 of "Notes to Consolidated Financial  Statements".  The increase in revenues is
primarily  attributable  to the addition of these  operations  and  increases in
patient volume. Revenues generated from patients under the Medicare and Medicaid
programs  respectively  accounted for 40.0% and 2.5% of total revenues for 1995,
compared to 41.0% and 3.2% of total  revenues for 1994.  Revenues from any other
single third-party payor were not significant in relation to the Company's total
revenues.  During 1995, same store outpatient visits, inpatient days and surgery
center  cases  increased  21.7%,  10.8%  and  4.8%,  respectively.  Revenue  per
outpatient  visit,  inpatient  day and  surgery  case for same store  operations
increased (decreased) by 0.8%, 2.5% and (0.9%), respectively.

     Operating expenses,  at the operating unit level, were  $1,441,059,000,  or
68.0% of revenues,  for 1995, compared to 70.0% of revenues for 1994. Same store
operating expenses for 1995 were  $1,291,546,000,  or 68.3% of related revenues.
New store operating  expenses were  $149,513,000,  or 65.7% of related revenues.
Corporate general and administrative expenses decreased from $67,798,000 in 1994
to  $65,424,000  in 1995.  As a percentage  of revenues,  corporate  general and
administrative  expenses  decreased  from  3.9% in 1994 to 3.1% in  1995.  Total
operating expenses were $1,506,483,000, or 71.1% of revenues, for 1995, compared
to  $1,275,505,000,  or 73.9% of revenues,  for 1994. The provision for doubtful
accounts  was  $42,305,000,   or  2.0%  of  revenues,   for  1995,  compared  to
$35,740,000, or 2.1% of revenues, for 1994. 

                                       5
Depreciation and amortization  expense was $160,901,000 for 1995,  compared
to $126,148,000  for 1994. The increase  represents the investment in additional
assets by the  Company.  Interest  expense  increased to  $105,517,000  in 1995,
compared to $74,895,000  for 1994,  primarily  because of the increased  average
borrowings during 1995 under the Company's  revolving line of credit.  For 1995,
interest income was $8,009,000, compared to $6,658,000 for 1994.

     Merger  expenses in 1994 of $6,520,000  represent costs incurred or accrued
in connection  with  completing the ReLife  Acquisition  ($2,949,000)  and SHC's
acquisition  of  Heritage  Surgical   Corporation   ($3,571,000).   For  further
discussion, see Note 2 of "Notes to Consolidated Financial Statements".

     During 1994,  the Company  recognized a  $10,500,000  loss on impairment of
assets.  This amount relates to the termination of a ReLife management  contract
and a permanently damaged ReLife facility. The Company determined not to attempt
to reopen such  damaged  facility  because,  under its existing  licensure,  the
facility was not  consistent  with the Company's  plans.  Also during 1994,  the
Company  recognized  a  $4,500,000  loss on  abandonment  of a  ReLife  computer
project. For further discussion, see Note 14 of "Notes to Consolidated Financial
Statements".

     During the fourth  quarter of 1994,  the  Company  adopted a formal plan to
dispose of three  surgery  centers and certain  other  properties  during fiscal
1995.  Accordingly,  a charge of  $13,197,000  was made to reflect the  expected
losses  resulting from the disposal of these centers.  The closings of the three
surgery centers were completed by December 31, 1995. For further discussion, see
Note 13 of "Notes to Consolidated Financial Statements".

     As a result of the NovaCare and SHC  Acquisitions,  the Company  recognized
$14,588,000 in merger and acquisition related expenses during the second quarter
of 1995.  Fees related to legal,  accounting  and  financial  advisory  services
accounted for $3,400,000 of the expense.  Accruals for employee separations were
approximately  $1,188,000.  In  addition,  the  Company  provided  approximately
$10,000,000 for the write-down of certain assets to net realizable  value as the
result of a facility  consolidation  in a market  where the  Company's  existing
services overlapped with those of an acquired facility. The employee separations
and facility consolidation were completed by the end of 1995. 

     In the fourth  quarter  of 1995,  the  Company  incurred  direct  costs and
expenses of $4,965,000 in connection with the SSCI  Acquisition.  These expenses
consist  primarily of fees related to legal,  accounting and financial  advisory
services and are included in merger and acquisition related acquisition expenses
for the year ended December 31, 1995.

     In connection with the SHC Acquisition the Company  recognized a $9,056,000
extraordinary  loss (net of  income  tax  benefit  of  $5,550,000)  on the early
extinguishment  of the SHC Notes  during  1995  (see  Notes 2 and 7 of "Notes to
Consolidated Financial Statements"). 

     Also during 1995, the Company  recognized a $53,549,000  loss on impairment
of  assets.  The  impaired  assets  relate to six SHC  facilities  and eight SCA
facilities  in which the projected  undiscounted  cash flows did not support the
book value of the long-lived assets of such facilities. See Note 14 of "Notes to
Consolidated Financial Statements".

     Income from continuing  operations before income taxes,  minority interests
and extraordinary  item for 1995 was $238,382,000,  compared to $193,701,000 for
1994.  Minority  interests  reduced  income before income taxes by  $43,753,000,
compared to $31,665,000  for 1994.  During the quarter ended March 31, 1995, the
Company discontinued the operations of Interactive Diagnostic Services,  Inc., a
wholly-owned  subsidiary  ("IDSI"),  and IDSI's financial results are treated as
discontinued  operations.  During  1995,  the  Company  recognized  a loss  from
discontinued  operations  and a loss on disposal of  discontinued  operations of
$1,162,000  in after tax losses  compared to  $6,528,000  in after tax losses in
1994. For further  discussion,  see Note 9 of "Notes to  Consolidated  Financial
Statements".  The provision for income taxes for 1995 was $86,161,000,  compared
to $68,560,000 for 1994,  resulting in effective tax rates of 44.3% for 1995 and
42.3% for 1994. Net income for 1995 was $98,250,000. 

Twelve-Month Periods Ended December 31, 1995 and 1996

     The Company  operated 739 outpatient  rehabilitation  locations at December
31, 1996,  compared to 537 outpatient  rehabilitation  locations at December 31,
1995. In addition, the Company operated 96

                                       6
inpatient rehabilitation  facilities, 135 surgery centers, 72 diagnostic centers
and five  medical  centers  at  December  31,  1996,  compared  to 95  inpatient
rehabilitation  facilities,  122 surgery centers, 69 diagnostic centers and five
medical centers at December 31, 1995.

     The Company's  operations  generated revenues of $2,568,155,000 in 1996, an
increase of  $449,474,000,  or 21.2%,  as compared to 1995 revenues.  Same store
revenues for the twelve months ended December 31, 1996 were  $2,408,294,000,  an
increase of $289,613,000,  or 13.7%, as compared to the same period in 1995. New
store  revenues  for 1996 were  $159,861,000.  New store  revenues  reflect  the
acquisition of one inpatient  rehabilitation hospital, the addition of eight new
outpatient  surgery  centers,  and the acquisition of outpatient  rehabilitation
operations  in 57 new markets.  See Note 9 of "Notes to  Consolidated  Financial
Statements".  The increase in revenues is primarily attributable to the addition
of these  operations and increases in patient  volume.  Revenues  generated from
patients  under the Medicare and Medicaid  programs  respectively  accounted for
37.8% and 2.9% of total  revenues for 1996,  compared to 40.0% and 2.5% of total
revenues for 1995.  Revenues  from any other single  third-party  payor were not
significant in relation to the Company's total revenues. During 1996, same store
outpatient  visits,  inpatient  days and surgery center cases  increased  19.9%,
10.8% and 7.3%,  respectively.  Revenue per outpatient visit,  inpatient day and
surgery case for same store operations increased (decreased) by (0.8)%, 3.8% and
1.1%, respectively.

     Operating expenses,  at the operating unit level, were  $1,667,248,000,  or
64.9% of  revenues,  for 1996,  compared  to 68.0% of  revenues  for  1995.  The
decrease  in  operating  expenses  as a  percentage  of  revenues  is  primarily
attributable  to the 13.7% increase in same store revenues noted above.  In same
store operations,  the incremental costs associated with increased  revenues are
significantly  lower as a percentage  of those  increased  revenues.  Same store
operating expenses for 1996 were  $1,567,820,000,  or 65.1% of related revenues.
New store operating  expenses were  $99,428,000,  or 62.2% of related  revenues.
Corporate general and administrative expenses increased from $65,424,000 in 1995
to  $79,354,000  in 1996.  As a percentage  of revenues,  corporate  general and
administrative  expenses equaled 3.1% in 1995 and 1996. Total operating expenses
were $1,746,602,000, or 68.0% of revenues, for 1996, compared to $1,506,483,000,
or 71.1% of  revenues,  for  1995.  The  provision  for  doubtful  accounts  was
$58,637,000,  or 2.3% of revenues, for 1996, compared to $42,305,000, or 2.0% of
revenues, for 1995.

     Depreciation and amortization  expense was $207,132,000 for 1996,  compared
to  $160,901,000  for  1995.  The  increase  resulted  from  the  investment  in
additional  assets by the Company.  Interest expense decreased to $98,751,000 in
1996,  compared to  $105,517,000  for 1995,  primarily  because of the favorable
interest rates on the Company's  revolving  credit  facility (see "Liquidity and
Capital  Resources").  For 1996,  interest  income was  $6,034,000  compared  to
$8,009,000 for 1995. The decrease in interest income  resulted  primarily from a
decrease in the average amount outstanding in interest-bearing investments.

     Merger expenses in 1996 of $41,515,000  represent costs incurred or accrued
in connection with completing the SCA Acquisition  ($19,727,000),  the Advantage
Health  Acquisition  ($9,212,000),  the PSCM  Acquisition  ($5,513,000)  and the
ReadiCare Acquisition ($7,063,000). For further discussion, see Note 2 of "Notes
to Consolidated Financial Statements".

     Income   before   minority   interests   and  income  taxes  for  1996  was
$384,162,000,  compared to $238,382,000  for 1995.  Minority  interests  reduced
income before income taxes by $50,369,000, compared to $43,753,000 for 1995. The
provision for income taxes for 1996 was  $143,929,000,  compared to  $86,161,000
for 1995, resulting in effective tax rates of 43.1% for 1996 and 44.3% for 1995.
Net income for 1996 was $189,864,000. 

LIQUIDITY AND CAPITAL RESOURCES

     At December  31,  1996,  the Company had working  capital of  $554,589,000,
including cash and marketable  securities of  $153,831,000.  Working  capital at
December 31, 1995 was $406,601,000,  including cash and marketable securities of
$159,793,000.  For 1996, cash provided by operations was $388,345,000,  compared
to $350,059,000 for 1995. The Company used $485,193,000 for investing activities
during 1996, compared to $799,268,000 for 1995. Additions to property, plant and
equipment  and   acquisitions   accounted  for   $204,792,000  and  $91,391,000,
respectively, during 1996. Those same investing activities 

                                       7
accounted for $183,867,000 and $517,773,000,  respectively,  in 1995.  Financing
activities   provided   $95,107,000  and  $484,042,000  during  1996  and  1995,
respectively.  Net borrowing proceeds (borrowings less principal reductions) for
1996 and 1995 were $101,366,000 and $205,215,000, respectively.

     Net accounts receivable were $540,389,000 at December 31, 1996, compared to
$433,688,000  at December  31, 1995.  The number of days of average  revenues in
average  receivables was 67.1 at December 31, 1996, compared to 63.4 at December
31,  1995.  The   concentration  of  net  accounts   receivable  from  patients,
third-party  payors,  insurance  companies  and others at December  31, 1996 was
consistent with the related concentration of revenues for the period then ended.

     The  Company  has  a   $1,250,000,000   revolving   credit   facility  with
NationsBank,  N.A.  ("NationsBank")  and other  participating  banks  (the "1996
Credit Agreement"). The 1996 Credit Agreement replaced a previous $1,000,000,000
revolving credit  agreement,  also with  NationsBank.  Interest is paid based on
LIBOR plus a predetermined  margin, a base rate or competitively  bid rates from
the  participating  banks. This credit facility has a maturity date of March 31,
2001. The Company  provided a negative  pledge on all assets for the 1996 Credit
Agreement.  The effective interest rate on the average outstanding balance under
the revolving credit facility was 5.98% for the twelve months ended December 31,
1996,  compared to the average  prime rate of 8.29% during the same  period.  At
December  31,  1996,  the Company had drawn  $995,000,000  under the 1996 Credit
Agreement.  For  further  discussion,  see  Note  7 of  "Notes  to  Consolidated
Financial Statements".

     In 1994, the Company issued $115,000,000 principal amount of 5% Convertible
Subordinated  Debentures  due 2001 (the  "Debentures").  The Company  called the
Debentures  for  redemption  on April 1, 1997.  The  holders of the  Convertible
Debentures  surrendered  substantially  all of the  Convertible  Debentures  for
conversion into  approximately  12,226,000 shares of the Company's Common Stock.

     On February 17, 1997,  the Company  entered into a definitive  agreement to
acquire Horizon/CMS Healthcare Corporation  ("Horizon/CMS") in a stock-for-stock
merger in which the  stockholders of Horizon/CMS will receive 0.84338 of a share
of the  Company's  common  stock per share of  Horizon/  CMS common  stock.  The
transaction is valued at approximately $1,600,000,000,  including the assumption
by the Company of approximately $700,000,000 in Horizon/CMS debt. It is expected
that the transaction will be accounted for as a purchase.  Horizon/CMS  operates
33 inpatient rehabilitation hospitals, 58 specialty hospitals and subacute units
and 282 outpatient  rehabilitation  centers.  Horizon/CMS  also owns,  leases or
manages  267  long-term  care  facilities,   a  contract  therapy  business,  an
institutional  pharmacy business and other healthcare services.  Consummation of
the transaction is subject to various regulatory approvals,  including clearance
under the Hart-Scott-Rodino  Antitrust Improvements Act, and to the satisfaction
of  certain  other  conditions.  The  Company  currently  anticipates  that  the
transaction will be consummated by October 1997.

     The Company  intends to pursue the acquisition or development of additional
healthcare  operations,   including  comprehensive   outpatient   rehabilitation
facilities,  inpatient  rehabilitation  facilities,  ambulatory surgery centers,
outpatient  diagnostic  centers  and  companies  engaged  in  the  provision  of
rehabilitation-related   services,   and  to  expand  certain  of  its  existing
facilities.  While it is not possible to estimate  precisely  the amounts  which
will actually be expended in the foregoing areas,  the Company  anticipates that
over  the  next  twelve  months,  it will  spend  approximately  $50,000,000  on
maintenance  and  expansion  of  its  existing   facilities  and   approximately
$300,000,000  on  development  of the  Integrated  Service  Model.  See  Item 1,
"Business -- Company Strategy",  in the Company's Annual Report on Form 10-K for
the year ended December 31, 1996, as amended. 

     Although the Company is continually considering and evaluating acquisitions
and  opportunities  for future  growth,  the Company  has not  entered  into any
agreements  with  respect  to  material  future   acquisitions  other  than  the
transactions  with Horizon/CMS and Health Images. In connection with the pending
acquisition  of  Horizon/CMS,  the  Company  has  obtained a  fully-underwritten
commitment  from  NationsBank,  N.A.  for a  $1,000,000,000  Senior  Bridge Loan
Facility  on  substantially  the same terms as the 1996  Credit  Agreement.  The
Company believes that existing cash, cash flow from  operations,  and borrowings
under  the  revolving  line of  credit  and the  bridge  loan  facility  will be
sufficient to satisfy the Company's  estimated  cash  requirements  for the next
twelve months, and for the reasonably foreseeable future.

                                       8
Inflation in recent years has not had a significant effect on the Company's
business,  and is not  expected  to  adversely  affect the Company in the future
unless it increases significantly.

     Statements  contained  in this  Current  Report  on Form 8-K  which are not
historical  facts are  forward-looking  statements.  In  addition,  the Company,
through its senior management,  from time to time makes  forward-looking  public
statements  concerning its expected future  operations and performance and other
developments.   Such  forward-  looking  statements  are  necessarily  estimates
reflecting  the  Company's  best  judgment  based upon current  information  and
involve a number of risks and uncertainties,  and there can be no assurance that
other factors will not affect the accuracy of such  forward-looking  statements.
While is  impossible  to identify all such  factors,  factors  which could cause
actual results to differ materially from those estimated by the Company include,
but are not limited to, changes in the regulation of the healthcare  industry at
either or both of the federal and state levels, changes in reimbursement for the
Company's services by governmental or private payors,  competitive  pressures in
the  healthcare  industry and the  Company's  response  thereto,  the  Company's
ability to obtain and retain favorable  arrangements  with  third-party  payors,
unanticipated  delays in the Company's  implementation of its Integrated Service
Model,  general conditions in the economy and capital markets, and other factors
which  may be  identified  from  time to time in the  Company's  Securities  and
Exchange Commission filings and other public announcements. 

                                       9
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

The Board of Directors
HEALTHSOUTH Corporation

     We have audited the accompanying consolidated balance sheets of HEALTHSOUTH
Corporation  and  Subsidiaries as of December 31, 1995 and 1996, and the related
consolidated statements of income,  stockholders' equity and cash flows for each
of the three  years in the period  ended  December  31,  1996.  Our audits  also
included the financial  statement  schedule  included  herein.  These  financial
statements and schedule are the responsibility of the Company's management.  Our
responsibility  is to  express  an opinion  on these  financial  statements  and
schedule 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 consolidated  financial  statements  referred to above
present fairly, in all material respects, the consolidated financial position of
HEALTHSOUTH  Corporation and Subsidiaries at December 31, 1995 and 1996, and the
consolidated  results of their  operations  and their cash flows for each of the
three years in the period ended December 31, 1996, 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

Birmingham, Alabama
August 20, 1997

                                       10
HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
DECEMBER 31,
                                                                                        -------------------------------
                                                                                           1995             1996
                                                                                        -------------   ---------------
                                                                                                (IN THOUSANDS)
ASSETS
Current assets:
 Cash and cash equivalents (Note 3)  ................................................   $  155,449       $   150,071
 Other marketable securities (Note 3)   .............................................        4,344             3,760
 Accounts receivable, net of allowances for doubtful accounts of $60,100,000 in 1995
   and $75,360,000 in 1996  .........................................................      433,688           540,389
 Inventories    .....................................................................       39,556            47,408
 Prepaid expenses and other current assets    .......................................       80,339           128,174
 Deferred income taxes (Note 10)  ...................................................       24,804            15,238
                                                                                        -----------      -----------
Total current assets  ...............................................................      738,180           885,040
Other assets:
 Loans to officers    ...............................................................        1,625             1,396
 Other (Note 4)    ..................................................................       69,017            84,016
                                                                                        -----------      -----------
                                                                                            70,642            85,412
Property, plant and equipment, net (Note 5)   .......................................    1,378,016         1,464,833
Intangible assets, net (Note 6)   ...................................................      920,970         1,094,421
                                                                                        -----------      -----------
Total assets    .....................................................................   $ 3,107,808      $ 3,529,706
                                                                                        ===========      ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
 Accounts payable  ..................................................................   $  116,387       $   116,451
 Salaries and wages payable    ......................................................       69,236            67,793
 Accrued interest payable and other liabilities  ....................................       94,428            99,118
 Current portion of long-term debt (Note 7)   .......................................       51,528            47,089
                                                                                        -----------      -----------
Total current liabilities   .........................................................      331,579           330,451
Long-term debt (Note 7)  ............................................................    1,401,490         1,513,054
Deferred income taxes (Note 10)   ...................................................       35,444            41,850
Other long-term liabilities (Note 14)   .............................................        8,705             3,558
Deferred revenue   ..................................................................        1,661               406
Minority interests - limited partnerships (Note 1)  .................................       59,243            71,286
Commitments and contingencies  (Note 11)  Stockholders'  equity (Notes 8, 12 and
15):
 Preferred stock, $.10 par value-1,500,000 shares authorized; issued and outstanding-
   none   ...........................................................................           --                --
 Common stock, $.01 par value-500,000,000 shares authorized; issued 164,129,000 in
   1995 and 326,493,000 in 1996   ...................................................        1,641             3,265
 Additional paid-in capital    ......................................................      965,905         1,060,012
 Retained earnings    ...............................................................      355,361           525,718
 Treasury stock, at cost (3,070,000 shares in 1995 and 91,000 shares in 1996)  ......      (30,864)             (323)
 Receivable from Employee Stock Ownership Plan   ....................................      (15,886)          (14,148)
 Notes receivable from stockholders  ................................................       (6,471)           (5,423)
                                                                                        -----------      -----------
Total stockholders' equity  .........................................................    1,269,686         1,569,101
                                                                                        -----------      -----------
Total liabilities and stockholders' equity    .......................................   $ 3,107,808      $ 3,529,706
                                                                                        ===========      ===========
See accompanying notes.

                                       11
HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                        CONSOLIDATED STATEMENTS OF INCOME
YEAR ENDED DECEMBER 31,
                                                                  ----------------------------------------
                                                                     1994          1995          1996
                                                                  ------------  ------------  ------------
                                                                  (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Revenues  ......................................................  $1,726,321    $2,118,681    $2,568,155

Operating unit expenses  .......................................  1,207,707     1,441,059     1,667,248
Corporate general and administrative expenses ..................     67,798        65,424        79,354
Provision for doubtful accounts   ..............................     35,740        42,305        58,637
Depreciation and amortization  .................................    126,148       160,901       207,132
Merger and acquisition related expenses (Notes 2 and 9)   ......      6,520        19,553        41,515
Loss on impairment of assets (Notes 9 and 14) ..................     10,500        53,549        37,390
Loss on abandonment of computer project (Note 14)   ............      4,500            --            --
Loss on disposal of surgery centers (Note 13) ..................     13,197            --            --
Interest expense   .............................................     74,895       105,517        98,751
Interest income ................................................     (6,658)       (8,009)       (6,034)
Gain on sale of equity securities (Note 1) .....................     (7,727)           --            --
                                                                  ----------    ----------    ----------
                                                                  1,532,620     1,880,299     2,183,993
                                                                  ----------    ----------    ----------
Income from continuing operations before income taxes, minor-
 ity interests and extraordinary item                               193,701       238,382       384,162
Provision for income taxes  ....................................     68,560        86,161       143,929
                                                                  ----------    ----------    ----------
                                                                    125,141       152,221       240,233
Minority interests .............................................     31,665        43,753        50,369
                                                                  ----------    ----------    ----------
Income from continuing operations before extraordinary item     .    93,476       108,468       189,864
Discontinued operations (Note 9):
   Loss from discontinued operations, net of income taxes ......      6,528           418            --
   Loss on disposal of discontinued operations, net of income
    taxes ......................................................         --           744            --
                                                                  ----------    ----------    ----------
Income before extraordinary item  ..............................     86,948       107,306       189,864
Extraordinary loss from early extinguishment of debt, net of
 income tax benefit of $5,550,000 (Notes 2 and 7)...............         --         9,056            --
                                                                  ----------    ----------    ----------
Net income   ...................................................  $  86,948     $  98,250     $ 189,864
                                                                  ==========    ==========    ==========
Weighted average common and common equivalent shares out-
 standing                                                           291,314       307,792       336,807
                                                                  ==========    ==========    ==========
Income per common and common equivalent share:
   Continuing operations .......................................  $    0.32     $    0.35     $    0.56
   Discontinued operations  ....................................      (0.02)           --            --
   Extraordinary loss ..........................................         --         (0.03)           --
                                                                  ----------    ----------    ----------
   Net income   ................................................  $    0.30     $    0.32     $    0.56
                                                                  ==========    ==========    ==========
Income per common share -- assuming full dilution:
   Continuing operations .......................................  $    0.32     $    0.35     $    0.55
   Discontinued operations  ....................................      (0.02)           --            --
   Extraordinary loss ..........................................         --         (0.03)           --
                                                                  ----------    ----------    ----------
   Net income   ................................................  $    0.30     $    0.32     $    0.55
                                                                  ==========    ==========    ==========
See accompanying notes.

                                       12
HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996

                                 (IN THOUSANDS)
COMMON STOCK      ADDITIONAL
                                                                        ---------------------   PAID-IN     RETAINED
                                                                          SHARES     AMOUNT     CAPITAL     EARNINGS
                                                                        ----------- --------- ------------ ------------
Balance at December 31, 1993 ..........................................  141,326    $ 1,414   $ 567,917    $ 195,168
Proceeds from excercise of options (Note 8) ...........................    2,317        23       16,482           --
Common shares exchanged in the exercise of options   ..................      (22)       --         (321)          --
Proceeds from issuance of common shares  ..............................    1,408        14       16,476           --
Income tax benefits related to incentive stock options (Note 8)  ......       --        --        6,470           --
Reduction in receivable from ESOP  ....................................       --        --           --           --
Payments received on stockholders' notes receivable  ..................       --        --           --           --
Purchase of limited partnership units .................................       --        --           --       (1,838)
Purchase of treasury stock   ..........................................       --        --           --           --
Net income ............................................................       --        --           --       86,948
Translation adjustment ................................................       --        --           --          536
Dividends paid   ......................................................       --        --           --       (7,046)
                                                                         -------    -------   ----------   ----------
Balance at December 31, 1994 ..........................................  145,029     1,451      607,024      273,768
Adjustment for Relife Merger (Note 2) .................................    2,732        27        7,114       (3,734)
Proceeds from excercise of options (Note 8) ...........................    1,136        11       10,218           --
Proceeds from issuance of common shares  ..............................   15,232       152      334,896           --
Income tax benefits related to incentive stock options (Note 8)  ......       --        --        6,653           --
Reduction in receivable from ESOP  ....................................       --        --           --           --
Loans made to stockholders   ..........................................       --        --           --           --
Purchase of limited partnership units .................................       --        --           --       (4,767)
Purchase of treasury stock   ..........................................       --        --           --           --
Net income ............................................................       --        --           --       98,250
Translation adjustment ................................................       --        --           --          247
Dividends paid   ......................................................       --        --           --       (8,403)
                                                                         -------    -------   ----------   ----------
Balance at December 31, 1995 ..........................................  164,129     1,641      965,905      355,361
Adjustment for Advantage Merger .......................................       --        --           --      (17,638)
Adjustment for 1996 Mergers (Note 2)  .................................    4,047        40       68,785       (1,256)
Proceeds from excercise of options (Note 8) ...........................    3,514        36       34,380           --
Income tax benefits related to incentive stock options (Note 8)  ......       --        --       23,767           --
Reduction in receivable from ESOP  ....................................       --        --           --           --
Payments received on stockholders' notes receivable  ..................       --        --           --           --
Purchase of limited partnership units .................................       --        --           --          (83)
Purchase of treasury stock   ..........................................       --        --           --           --
Retirement of treasury stock ..........................................   (1,835)      (18)     (31,259)          --
Net income ............................................................       --        --           --      189,864
Translation adjustment ................................................       --        --           --          692
Dividends paid   ......................................................       --        --           --       (1,222)
Stock split (Note 15)  ................................................  156,638     1,566       (1,566)          --
                                                                         -------    -------   ----------   ----------
Balance at December 31, 1996 ..........................................  326,493    $3,265    $1,060,012   $ 525,718
                                                                         =======    =======   ==========   ==========
HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
                                  (Continued)

                                 (IN THOUSANDS)
NOTES
                                                                            TREASURY STOCK      RECEIVABLES    RECEIVABLE
                                                                        -----------------------     FROM          FROM
                                                                          SHARES      AMOUNT        ESOP      STOCKHOLDERS
                                                                        ----------- ----------- ------------- -------------
Balance at December 31, 1993 ..........................................    1,435    $(12,342)    $ (18,932)     $ (5,490)
Proceeds from excercise of options (Note 8) ...........................       --          --            --            --
Common shares exchanged in the exercise of options   ..................       --          --            --            --
Proceeds from issuance of common shares  ..............................       --          --            --            --
Income tax benefits related to incentive stock options (Note 8)  ......       --          --            --            --
Reduction in receivable from ESOP  ....................................       --          --         1,455            --
Payments received on stockholders' notes receivable  ..................       --          --            --           250
Purchase of limited partnership units .................................       --          --            --            --
Purchase of treasury stock   ..........................................    1,047     (10,025)           --            --
Net income ............................................................       --          --            --            --
Translation adjustment ................................................       --          --            --            --
Dividends paid   ......................................................       --          --            --            --
                                                                         -------    ---------    ---------      --------
Balance at December 31, 1994 ..........................................    2,482     (22,367)      (17,477)       (5,240)
Adjustment for Relife Merger (Note 2) .................................       --          --            --            --
Proceeds from excercise of options (Note 8) ...........................       --          --            --            --
Proceeds from issuance of common shares  ..............................       --          --            --            --
Income tax benefits related to incentive stock options (Note 8)  ......       --          --            --            --
Reduction in receivable from ESOP  ....................................       --          --         1,591            --
Loans made to stockholders   ..........................................       --          --            --        (1,231)
Purchase of limited partnership units .................................       --          --            --            --
Purchase of treasury stock   ..........................................      588      (8,497)           --            --
Net income ............................................................       --          --            --            --
Translation adjustment ................................................       --          --            --            --
Dividends paid   ......................................................       --          --            --            --
                                                                         -------    ---------    ---------      --------
Balance at December 31, 1995 ..........................................    3,070     (30,864)      (15,886)       (6,471)
Adjustment for Advantage Merger .......................................       --          --            --            --
Adjustment for 1996 Mergers (Note 2)  .................................       --          --            --            --
Proceeds from excercise of options (Note 8) ...........................       --          --            --            --
Income tax benefits related to incentive stock options (Note 8)  ......       --          --            --            --
Reduction in receivable from ESOP  ....................................       --          --         1,738            --
Payments received on stockholders' notes receivable  ..................       --          --            --         1,048
Purchase of limited partnership units .................................       --          --            --            --
Purchase of treasury stock   ..........................................       89        (736)           --            --
Retirement of treasury stock ..........................................   (3,068)     31,277            --            --
Net income ............................................................       --          --            --            --
Translation adjustment ................................................       --          --            --            --
Dividends paid   ......................................................       --          --            --            --
Stock split (Note 15)  ................................................       --          --            --            --
                                                                         -------    ---------    ---------      --------
Balance at December 31, 1996 ..........................................       91    $   (323)    $ (14,148)     $ (5,423)
                                                                         =======    =========    =========      ========
HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                  YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
                                  (Continued)

                                 (IN THOUSANDS)
TOTAL
                                                                        STOCKHOLDERS'
                                                                           EQUITY
                                                                        --------------
Balance at December 31, 1993 ..........................................  $  727,735
Proceeds from excercise of options (Note 8) ...........................      16,505
Common shares exchanged in the exercise of options   ..................        (321)
Proceeds from issuance of common shares  ..............................      16,490
Income tax benefits related to incentive stock options (Note 8)  ......       6,470
Reduction in receivable from ESOP  ....................................       1,455
Payments received on stockholders' notes receivable  ..................         250
Purchase of limited partnership units .................................      (1,838)
Purchase of treasury stock   ..........................................     (10,025)
Net income ............................................................      86,948
Translation adjustment ................................................         536
Dividends paid   ......................................................      (7,046)
                                                                         ----------
Balance at December 31, 1994 ..........................................     837,159
Adjustment for Relife Merger (Note 2) .................................       3,407
Proceeds from excercise of options (Note 8) ...........................      10,229
Proceeds from issuance of common shares  ..............................     335,048
Income tax benefits related to incentive stock options (Note 8)  ......       6,653
Reduction in receivable from ESOP  ....................................       1,591
Loans made to stockholders   ..........................................      (1,231)
Purchase of limited partnership units .................................      (4,767)
Purchase of treasury stock   ..........................................      (8,497)
Net income ............................................................      98,250
Translation adjustment ................................................         247
Dividends paid   ......................................................      (8,403)
                                                                         ----------
Balance at December 31, 1995 ..........................................   1,269,686
Adjustment for Advantage Merger .......................................     (17,638)
Adjustment for 1996 Mergers (Note 2)  .................................      67,569
Proceeds from excercise of options (Note 8) ...........................      34,416
Income tax benefits related to incentive stock options (Note 8)  ......      23,767
Reduction in receivable from ESOP  ....................................       1,738
Payments received on stockholders' notes receivable  ..................       1,048
Purchase of limited partnership units .................................         (83)
Purchase of treasury stock   ..........................................        (736)
Retirement of treasury stock ..........................................          --
Net income ............................................................     189,864
Translation adjustment ................................................         692
Dividends paid   ......................................................      (1,222)
Stock split (Note 15)  ................................................          --
                                                                         ----------
Balance at December 31, 1996 ..........................................  $1,569,101
                                                                         ==========
See accompanying notes.
                                       13
HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31,
                                                               ---------------------------------------------
                                                                  1994            1995            1996
                                                               -------------   -------------   -------------
                                                                              (IN THOUSANDS)
OPERATING ACTIVITIES
Net income  ................................................    $   86,948      $   98,250      $  189,864
Adjustments   to  reconcile  net  income  to  net  cash  
 provided by operating activities:
   Depreciation and amortization    ........................       126,148         160,901         207,132
   Provision for doubtful accounts  ........................        35,740          42,305          58,637
   Provision for losses on impairment of assets    .........        16,080          53,549          37,390
   Provision for losses on abandonment of computer
    project    .............................................         4,500              --              --
   Merger and acquisition related expenses   ...............         6,520          19,553          41,515
   Loss on disposal of surgery center  .....................        13,197              --              --
   Loss on extinguishment of debt   ........................            --          14,606              --
   Income applicable to minority interests of limited
    partnerships  ..........................................        31,665          43,753          50,928
   (Benefit) provision for deferred income taxes   .........       (14,658)            396          14,308
   Provision for deferred revenue   ........................          (164)         (1,990)         (1,255)
   Changes in operating assets and liabilities, net of 
    effects of acquisitions:
      Accounts receivable  .................................      (101,141)        (69,754)       (141,323)
      Inventories, prepaid expenses and other current
       assets  .............................................       (15,250)          1,370         (35,084)
      Accounts payable and accrued expenses  ...............        87,358         (12,880)        (33,767)
                                                                ----------      ----------      ----------
Net cash provided by operating activities    ...............       276,943         350,059         388,345
INVESTING ACTIVITIES
Purchases of property, plant and equipment   ...............      (202,520)       (183,867)       (204,792)
Proceeds from sale of property, plant and equipment   ......        68,330          16,026              --
Additions to intangible assets, net of effects of acquisi-
 tions                                                             (70,216)       (117,900)       (175,380)
Assets obtained through acquisitions, net of liabilities as-
 sumed                                                            (117,023)       (517,773)        (91,391)
Changes in other assets    .................................       (21,962)         (6,963)        (14,214)
Proceeds received on sale of other marketable securities .          19,857          22,513             584
Investments in other marketable securities   ...............       (21,393)        (11,304)             --
                                                                ----------      ----------      ----------
Net cash used in investing activities  .....................      (344,927)       (799,268)       (485,193)
14
HEALTHSOUTH Corporation and Subsidiaries
              CONSOLIDATED STATEMENTS OF CASH FLOWS - (CONTINUED )
YEAR ENDED DECEMBER 31,
                                                             -------------------------------------------
                                                               1994           1995            1996
                                                             ------------   ------------   -------------
                                                                           (IN THOUSANDS)
FINANCING ACTIVITIES
Proceeds from borrowings    ..............................   $1,069,979     $ 721,973       $  205,873
Principal payments on long-term debt    ..................    (977,094)      (502,152)        (104,507)
Early retirement of debt .................................          --        (14,606)              --
Proceeds from exercise of options    .....................      14,868         10,083           34,415
Proceeds from issuance of common stock  ..................       1,136        330,954               --
Purchase of treasury stock  ..............................     (10,025)        (8,497)            (736)
Reduction in receivable from ESOP    .....................       1,455          1,591            1,738
Payments received on (loans made to) stockholders   ......         250         (1,231)           1,048
Dividends paid  ..........................................      (7,046)        (8,403)          (1,222)
Proceeds from investment by minority interests   .........       2,268          1,103              510
Purchase of limited partnership interests  ...............      (1,698)       (10,076)          (3,064)
Payment of cash distributions to limited partners   ......     (34,637)       (36,697)         (38,948)
                                                             ----------     ----------      ----------
Net cash provided by financing activities  ...............      59,456        484,042           95,107
                                                             ----------     ----------      ----------
(Decrease) increase in cash and cash equivalents    ......      (8,528)        34,833           (1,741)
Cash and cash equivalents at beginning of year (Note 2) .      124,649        116,121          155,449
Cash flows related to mergers (Note 2)  ..................          --          4,495           (3,637)
                                                             ----------     ----------      ----------
Cash and cash equivalents at end of year   ...............   $ 116,121      $ 155,449       $  150,071
                                                             ==========     ==========      ==========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year for:
 Interest    .............................................   $  61,519      $ 103,973       $   97,024
 Income taxes   ..........................................      61,022         85,714           67,975
NON-CASH INVESTING ACTIVITIES:

     The Company assumed liabilities of $32,027,000, $84,820,000 and $19,197,000
during the years  ended  December  31,  1994,  1995 and 1996,  respectively,  in
conjunction with its acquisitions.

     During the year ended  December  31,  1994,  the Company  issued  1,747,000
common  shares  with  a  market  value  of  $12,862,000  as  consideration   for
acquisitions accounted for as purchases (see Note 9). 

     During the year ended  December  31,  1996,  the Company  issued  8,095,000
common shares as consideration for mergers (see Note 2).

NON-CASH FINANCING ACTIVITIES:

     During  1995 and 1997,  the Company  had a  two-for-one  stock split on its
common  stock,  which was  effected in the form of a one hundred  percent  stock
dividend.

     The Company  received a tax benefit from the  disqualifying  disposition of
incentive stock options of $6,470,000,  $6,653,000 and $23,767,000 for the years
ended December 31, 1994, 1995 and 1996, respectively.

     During  the year  ended  December  31,  1994,  22,000  common  shares  were
exchanged in the exercise of options. The shares exchanged had a market value on
the date of exchange of $321,000.

                             See accompanying notes.

                                       15
HEALTHSOUTH CORPORATION AND SUBSIDIARIES
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                DECEMBER 31, 1996

1. SIGNIFICANT ACCOUNTING POLICIES

     The significant accounting policies followed by HEALTHSOUTH Corporation and
its  subsidiaries  ("the  Company")  are  presented  as an integral  part of the
consolidated financial statements.

PRINCIPLES OF CONSOLIDATION

     The consolidated  financial  statements include the accounts of HEALTHSOUTH
Corporation  ("HEALTHSOUTH") and its wholly-owned  subsidiaries,  as well as its
majority ownership or controlling  interest in limited  partnerships and limited
liability companies. All significant intercompany accounts and transactions have
been eliminated in consolidation.

     HEALTHSOUTH   Corporation   is  engaged  in  the   business  of   providing
comprehensive  rehabilitative,  clinical,  diagnostic  and  surgical  healthcare
services on an inpatient and outpatient basis.

USE OF ESTIMATES

     The  preparation  of financial  statements  in  conformity  with  generally
accepted  accounting  principles  requires  management  to  make  estimates  and
assumptions that affect the amounts  reported in the  accompanying  consolidated
financial   statements  and  notes.  Actual  results  could  differ  from  those
estimates.

MARKETABLE SECURITIES

     MARKETABLE   EQUITY  SECURITIES  AND  DEBT  SECURITIES  ARE  CLASSIFIED  AS
AVAILABLE-FOR-SALE.  AVAILABLE-FOR-SALE  securities  are  carried at fair value,
with the  unrealized  gains and  losses,  if  material,  reported  as a separate
component  of  stockholders'   equity,  net  of  tax.  During  1994,  marketable
securities consisting of $13,360,507 of common stock were sold and the resulting
gain was recognized in the consolidated  statement of income.  The adjusted cost
of the specific security sold method is used to compute gain or loss on the sale
of   securities.   Interest  and   dividends   on   securities   classified   as
available-for-sale   are  included  in  investment  income.   Marketable  equity
securities and debt  securities of the Company have  maturities of less than one
year.

Accounts Receivable and Third-Party Reimbursement Activities

     Receivables from patients,  insurance companies and third-party contractual
insured accounts  (Medicare and Medicaid) are based on payment  agreements which
generally  result  in the  Company  collecting  an  amount  different  from  the
established rates. Net third party settlement  receivables  included in accounts
receivable  were  $21,494,000  and  $21,138,000  at December  31, 1995 and 1996,
respectively.  Final  determination  of the  settlements is subject to review by
appropriate authorities.  The differences between original estimates made by the
Company and subsequent revisions (including final settlements) were not material
to the operations of the Company.  Adequate allowances are provided for doubtful
accounts and  contractual  adjustments.  Uncollectible  accounts are written off
against the allowance for doubtful  accounts after adequate  collection  efforts
are made.  Net  accounts  receivable  include  only those  amounts  estimated by
management to be collectible.

     The concentration of net accounts  receivable from third-party  contractual
payors and others,  as a  percentage  of total net accounts  receivable,  was as
follows:
DECEMBER 31
                                                        -----------------
                                                         1995     1996
                                                         ----     ----
Medicare  ................................          24%      26%
       Medicaid  ................................           6        5
       Other  ...................................          70       69
                                                         ----     ----
                                                          100%     100%
                                                         ====     ====
16
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

1. Significant Accounting Policies - (CONTINUED)

INVENTORIES

     Inventories  are stated at the lower of cost or market  using the  specific
identification method.

PROPERTY, PLANT AND EQUIPMENT

     Property,  plant and equipment is recorded at cost. Upon sale or retirement
of property,  plant or equipment,  the cost and related accumulated depreciation
are  eliminated  from the  respective  account and the resulting gain or loss is
included in the results of operations.

     Interest  cost  incurred   during  the   construction   of  a  facility  is
capitalized.  The Company  incurred  interest of $77,764,000,  $108,382,000  and
$102,694,000,  of which  $2,869,000,  $2,865,000 and $3,943,000 was  capitalized
during 1994, 1995 and 1996, respectively. 

     Depreciation  and amortization is computed using the  straight-line  method
over the  estimated  useful  lives of the  assets or the term of the  lease,  as
appropriate.  The  estimated  useful  life of  buildings  is 30-40 years and the
general range of useful lives for leasehold  improvements,  furniture,  fixtures
and equipment is 10-15 years.

INTANGIBLE ASSETS

     Cost in excess of net asset value of purchased facilities is amortized over
20 to 40 years using the  straight-line  method.  Organization  and  partnership
formation  costs are deferred  and  amortized  on a  straight-line  basis over a
period  of 36  months.  Costs  incurred  in  connection  with  implementing  the
Company's   clinical   and   administrative   programs   and   protocols   at  a
newly-developed  or acquired  facility are deferred and  amortized on a straight
line basis over a period of 36 months.  Organization,  partnership formation and
start-up costs and other  capitalized  costs for a project that is  subsequently
abandoned  are  charged to  operations  in that  period.  Debt  issue  costs are
amortized over the term of the debt.  Noncompete  agreements are amortized using
the straight-line method over the term of the agreements.

MINORITY INTERESTS

     The equity of  minority  investors  in  limited  partnerships  and  limited
liability  companies of the Company is reported on the balance sheet as minority
interests.  Minority  interests  reported in the  consolidated  income statement
reflect  the  respective  interests  in  the  income  or  loss  of  the  limited
partnerships  or  limited  liability  companies  attributable  to  the  minority
investors  (ranging from 1% to 50% at December 31, 1996), the effect of which is
removed from the results of operations of the Company.

REVENUES

     Revenues include net patient service revenues and other operating revenues.
Other operating  revenues include cafeteria revenue,  gift shop revenue,  rental
income,  trainer/contract  revenue,  management and  administrative  fee revenue
(related to non-consolidated  subsidiaries and affiliates) and  transcriptionist
fees which are insignificant to total revenues. Net patient service revenues are
reported at the  estimated net  realizable  amounts from  patients,  third-party
payors  and  others  for  services  rendered,  including  estimated  retroactive
adjustments under reimbursement agreements with third-party payors.

INCOME PER COMMON AND COMMON EQUIVALENT SHARE

     Income  per common and common  equivalent  share is  computed  based on the
weighted  average  number  of  common  shares  and  common   equivalent   shares
outstanding  during the  periods,  as adjusted for the  two-for-one  stock split
declared in April 1995 and the  two-for-one  stock split  declared in March 1997
(see Note 15).  Common  equivalent  shares  include  dilutive  employees'  stock
options, less the num-

                                       17
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

1. Significant Accounting Policies - (CONTINUED)

ber of treasury  shares  assumed to be  purchased  from the  proceeds  using the
average  market  price of the  Company's  shares in the  calculation  of primary
earnings per share and the  year-end  market  price of the  Company's  shares in
calculating fully diluted earnings per share if such market price is higher than
the average price used in computing  primary  earnings per share.  Fully diluted
earnings per share (based on 300,758,000,  320,018,000 and 349,033,000 shares in
1994,  1995 and 1996,  respectively)  assumes  conversion of the 5%  Convertible
Subordinated Debentures due 2001 (see Note 7).

IMPAIRMENT OF ASSETS

     In accordance with FASB Statement No. 121, Accounting for the Impairment of
Long-Lived  Assets and Long-Lived  Assets to Be Disposed Of, the Company records
impairment  losses on  long-lived  assets  used in  operations  when  events and
circumstances  indicate  that the assets might be impaired and the  undiscounted
cash flows  estimated to be generated by those assets are less than the carrying
amounts of those assets. Effective January 1, 1995, the Company adopted FASB 121
to account for long-lived assets.

     With  respect  to the  carrying  value of the excess of cost over net asset
value  of  purchased   facilities  and  other  intangible  assets,  the  Company
determines  on a quarterly  basis  whether an  impairment  event has occurred by
considering  factors  such as: the  market  value of the  asset;  a  significant
adverse change in legal factors or in the business climate;  adverse action by a
regulator;  a history  of  operating  or cash flow  losses  or a  projection  of
continuing  losses  associated with an operating  entity.  The carrying value of
excess cost over net asset value of purchased  facilities  and other  intangible
assets will be evaluated if the facts and circumstances suggest that it has been
impaired.  If this evaluation  indicates that the value of the asset will not be
recoverable,  as determined based on the  undiscounted  cash flows of the entity
acquired  over  the  remaining   amortization  period,  an  impairment  loss  is
calculated  based on the  excess of the  carrying  amount of the asset  over the
asset's fair value.

SELF-INSURANCE

     The Company is self-insured  for professional  liability and  comprehensive
general  liability.  Liabilities for asserted and unasserted  claims are accrued
based upon specific  claims and incidents and the claims history of the Company.
The reserves for estimated liabilities for asserted and unasserted claims, which
are not material in relation to the Company's consolidated financial position at
December  31,  1995 and 1996,  are  included  with  accrued  interest  and other
liabilities in the accompanying consolidated balance sheets.

RECLASSIFICATIONS

     Certain  amounts  in the 1994  and  1995  financial  statements  have  been
reclassified  to conform with the 1996  presentation.  Also in 1995, the Company
included the loss on extinguishment of debt with merger and acquisition  related
expenses.  Such amount has been  reclassified  as an  extraordinary  item in the
accompanying  1995 income  statement.  Such  reclassifications  had no effect on
previously reported consolidated financial position and consolidated net income.

2. MERGERS

     Effective  December  29,  1994, a  wholly-owned  subsidiary  of the Company
merged with ReLife,  Inc.  ("ReLife"),  and in connection  therewith the Company
issued  22,050,580  shares of its common  stock in exchange  for all of ReLife's
outstanding  common  stock.  Prior to the  merger,  ReLife  provided a system of
rehabilitation  services and operated 31 inpatient  facilities with an aggregate
of approximately 1,100 licensed beds, including nine freestanding rehabilitation
hospitals, nine acute rehabilitation units, five sub-acute rehabilitation units,
seven transitional living units and one residential facility, and provided 

                                       18
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)

outpatient  rehabilitation  services  at twelve  outpatient  centers.  Costs and
expenses of $2,949,000, primarily legal, accounting and financial advisory fees,
incurred by HEALTHSOUTH in connection  with the ReLife merger have been recorded
in  operations  in 1994 and  reported  as merger  expenses  in the  accompanying
consolidated statements of income.

     Effective  June 13, 1995, a  wholly-owned  subsidiary of the Company merged
with  Surgical  Health  Corporation  ("SHC"),  and in  connection  therewith the
Company  issued  17,062,960  shares of its common  stock in exchange  for all of
SHC's common and preferred stock. Prior to the merger, SHC operated a network of
36 freestanding  surgery centers and five mobile lithotripters in eleven states,
with an aggregate of 156 operating and  procedure  rooms.  Costs and expenses of
approximately  $4,588,000  incurred  by the Company in  connection  with the SHC
merger have been  recorded  in  operations  during  1995 and  reported as merger
expenses in the accompanying  consolidated statements of income. Fees related to
legal,  accounting and financial  advisory services  accounted for $3,400,000 of
the  expense.   Costs  related  to  employee   separations  were   approximately
$1,188,000.  Also in connection  with the SHC Merger,  the Company  recognized a
$14,606,000  extraordinary  loss as a result of the  retirement of the SHC Notes
(see Note 7). The extraordinary loss consisted  primarily of the associated debt
discount plus premiums and costs  associated with the retirement,  net of income
tax benefits of  $5,550,000.  SHC merged with Heritage  Surgical  Corporation on
January 18, 1994 in a transaction  accounted for as a pooling of interests.  SHC
recorded merger costs of $3,571,000 in connection with this transaction in 1994.

     Effective October 26, 1995, a wholly-owned subsidiary of the Company merged
with Sutter Surgery  Centers,  Inc.  ("SSCI"),  and in connection  therewith the
Company  issued  3,552,002  shares of its common  stock in  exchange  for all of
SSCI's outstanding common stock. Prior to the merger, SSCI operated a network of
12  freestanding  surgery  centers  in three  states,  with an  aggregate  of 54
operating and procedure rooms.  Costs and expenses of approximately  $4,965,000,
primarily legal, accounting and financial advisory fees, incurred by the Company
in connection with the SSCI merger have been recorded in operations  during 1995
and reported as merger expenses in the accompanying  consolidated  statements of
income.

     Effective January 17, 1996, a wholly-owned subsidiary of the Company merged
with Surgical Care Affiliates,  Inc.  ("SCA"),  and in connection  therewith the
Company  issued  91,856,678  shares of its common  stock in exchange  for all of
SCA's  outstanding  common stock.  Prior to the merger,  SCA operated 67 surgery
centers in 24 states. Costs and expenses of approximately $19,727,000, primarily
legal,  accounting  and  financial  advisory  fees,  incurred  by the Company in
connection with the SCA merger have been recorded in operations  during 1996 and
reported  as merger  expenses in the  accompanying  consolidated  statements  of
income.

     Effective  March 14, 1996, a wholly-owned  subsidiary of the Company merged
with  Advantage  Health  Corporation  ("Advantage  Health"),  and in  connection
therewith the Company issued  18,203,978  shares of its common stock in exchange
for all of Advantage  Health's  outstanding  common stock.  Prior to the merger,
Advantage  Health  operated a network of 136 sites of  service,  including  four
freestanding  rehabilitation hospitals, one freestanding multi-use hospital, one
nursing home,  68 outpatient  rehabilitation  facilities,  14 inpatient  managed
rehabilitation  units, 24 rehabilitation  services management  contracts and six
managed  sub-acute  rehabilitation  units.  Costs and expenses of  approximately
$9,212,000, primarily legal, accounting and financial advisory fees, incurred by
the Company in connection with the Advantage Health merger have been recorded in
operations  during  1996 and  reported as merger  expenses  in the  accompanying
consolidated statements of income.

     Effective  March 3, 1997, a  wholly-owned  subsidiary of the Company merged
with Health Images,  Inc.  ("Health  Images"),  and in connection  therewith the
Company  issued  10,343,470  shares of its common  stock in exchange  for all of
Health  Images'  outstanding  common stock.  Prior to the merger,  Health Images
operated 49 freestanding  diagnostic imaging centers in 13 states and six in the
United Kingdom. 

                                       19
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)

     The mergers of the Company with ReLife,  SHC, SSCI, SCA,  Advantage  Health
and Health Images were accounted for as poolings of interests and,  accordingly,
the Company's  consolidated  financial  statements have been restated to include
the results of the acquired companies for all periods presented.

     Combined and separate results of the Company and its material 1996 mergers,
SCA and Advantage Health,  and its 1997 merger with Health Images,  Inc., are as
follows (in thousands):
ADVANTAGE     HEALTH
                      HEALTHSOUTH      SCA       HEALTH      IMAGES     COMBINED
                      ------------- ---------- ----------- ----------- -----------
Year ended
 December 31, 1994
   Revenues .........   $1,274,365    $239,272   $135,562  $ 77,122      $1,726,321
   Net income  ......       50,493      29,280      8,310    (1,135)         86,948
Year ended
 December 31, 1995
   Revenues .........    1,556,687     263,866    182,593   115,535       2,118,681
   Net income  ......       78,949       3,322     10,250     5,729          98,250
Year ended
 December 31, 1996
   Revenues .........    2,380,587      11,028     44,922   131,618       2,568,155
   Net income  ......      216,654       1,746      2,418   (30,954)        189,864
There were no material  transactions among the Company,  ReLife, SHC, SSCI,
SCA,  Advantage  Health and Health  Images prior to the mergers.  The effects of
conforming the accounting policies of the combined companies are not material.

     Prior to its merger  with the  Company,  ReLife  reported  on a fiscal year
ending on September 30. The restated financial  statements for all periods prior
to and including  December 31, 1994, are based on a combination of the Company's
results for its December 31 fiscal year and ReLife's  results for its  September
30 fiscal year. Beginning January 1, 1995, all facilities acquired in the ReLife
merger  adopted a December 31 fiscal  year end;  accordingly,  all  consolidated
financial  statements  for  periods  after  December  31,  1994  are  based on a
consolidation of the Company and the former ReLife subsidiaries on a December 31
year-end.  ReLife's  historical results of operations for the three months ended
December 31, 1994 are not included in the Company's  consolidated  statements of
income or cash flows. An adjustment has been made to stockholders'  equity as of
January  1, 1995 to adjust  for the  effect of  excluding  ReLife's  results  of
operations  for the three months ended  December  31, 1994.  The  following is a
summary of ReLife's  results of  operations  and cash flows for the three months
ended December 31, 1994 (in thousands):

                                       20
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)
Statement of Income Data:
Revenues  .......................................   $ 38,174
Operating expenses:
 Operating units   ..............................     31,797
 Corporate general and administrative   .........      2,395
Provision for doubtful accounts   ...............        541
Depreciation and amortization  ..................      1,385
Interest expense   ..............................        858
Interest income .................................        (91)
HEALTHSOUTH merger expense  .....................      3,050
Loss on disposal of fixed assets  ...............      1,000
Loss on abandonment of computer project .........        973
                                                    ---------
                                                      41,908
                                                    ---------
Net loss  .......................................   $ (3,734)
                                                    =========
Statement of Cash Flow Data:
Net cash provided by operating activities  ......   $ 38,077
Net cash used in investing activities   .........     (9,632)
Net cash used in financing activities   .........    (23,950)
                                                    ---------
Net increase in cash  ...........................   $  4,495
                                                    =========
During the three months ended December 31, 1994, ReLife received $7,141,000
in proceeds from the exercise of stock options.

     Prior to its merger with the Company, Advantage Health reported on a fiscal
year ending on August 31. Accordingly,  the historical  financial  statements of
Advantage  Health  have been  recast to a November  30 fiscal  year-end  to more
closely  conform  to  the  Company's  calendar  fiscal  year-end.  The  restated
financial  statements  for all periods prior to and including  December 31, 1995
are based on a combination of the Company's results for their December 31 fiscal
year and  Advantage  Health's  results for its recast  November 30 fiscal  year.
Beginning  January 1, 1996,  all  facilities  acquired in the  Advantage  Health
merger  adopted a December 31 fiscal  year-end;  accordingly,  all  consolidated
financial  statements  for  periods  after  December  31,  1995  are  based on a
consolidation  of all of the Company's  subsidiaries  on a December 31 year-end.
Advantage  Health's  historical  results of  operations  for the one month ended
December 31, 1995 are not included in the Company's  consolidated  statements of
income or cash flows. An adjustment has been made to stockholders'  equity as of
January 1, 1996 to adjust for the effect of excluding Advantage Health's results
of  operations  for the one month ended  December 31, 1995.  The  following is a
summary of Advantage  Health's  results of operations and cash flows for the one
month ended December 31, 1995 (in thousands):

                                       21
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)
Statement of Income Data:
Revenues  .............................................   $ 16,111
Operating expenses:
 Operating units   ....................................     14,394
 Corporate general and administrative   ...............      1,499
Provision for doubtful accounts   .....................      1,013
Depreciation and amortization  ........................        283
Interest expense   ....................................        288
Interest income .......................................        (16)
Loss on impairment of assets   ........................     21,111
                                                          ---------
                                                            38,572
                                                          ---------
Loss before income taxes and minority interests  ......    (22,461)
Benefit for income taxes ..............................      4,959
Minority interest  ....................................       (136)
                                                          ---------
Net loss  .............................................   $(17,638)
                                                          =========
Statement of Cash Flow Data:
Net cash used in operating activities   ...............   $ (2,971)
Net cash provided by investing activities  ............        105
Net cash used in financing activities   ...............       (771)
                                                          ---------
Net decrease in cash  .................................   $ (3,637)
                                                          =========
In December 1995,  Advantage Health recorded an asset impairment  charge of
approximately  $21,111,000 relating to goodwill and tangible assets identifiable
with  one  inpatient  rehabilitation  hospital,  one  subacute  facility  and 32
outpatient  rehabilitation centers, all acquired by the Company in the Advantage
Health  merger.  The Company  intends to operate these  facilities on an ongoing
basis.

     The Company has historically assessed  recoverability of goodwill and other
long-lived  assets using  undiscounted  cash flows estimated to be received over
the useful  lives of the  related  assets.  In  December  1995,  certain  events
occurred  which  significantly  impacted the Company's  estimates of future cash
flows to be received from the facilities described above. Those events primarily
related to a decline in operating  results  combined with a deterioration in the
reimbursement  environment at these facilities. As a result of these events, the
Company revised its estimates of undiscounted cash flows to be received over the
remaining  estimated  useful  lives  of these  facilities  and  determined  that
goodwill and other long-lived assets (primarily property and equipment) had been
impaired.  The Company  developed its best  estimates of future  operating  cash
flows  at  these  locations   considering   future   requirements   for  capital
expenditures  as well as the impact of inflation.  The projections of cash flows
also took into account  estimates of  significant  one-time  expenses as well as
estimates of  additional  revenues and  resulting  income from future  marketing
efforts in the respective  locations.  The amount of the  impairment  charge was
determined by discounting the estimates of future cash flows, using an estimated
8.5% incremental  borrowing rate, which management believes is commensurate with
the risks  involved.  The  resulting  net present value of future cash flows was
then compared to the historical net book value of goodwill and other  long-lived
assets at each operating  location which resulted in an impairment loss relative
to these centers of $21,111,000.

     During   1996,   wholly-owned  subsidiaries  of  the  Company  merged  with
Professional  Sports Care Management, Inc. ("PSCM"), Fort Sutter Surgery Center,
Inc.  ("FSSCI")  and  ReadiCare,  Inc.  ("ReadiCare").  In connection with these
mergers  the  Company  issued  an  aggregate  of  8,094,598 shares of its common
stock.  Costs  and  expenses  of  approximately  $12,576,000,  primarily  legal,
accounting and financial advisory fees,

                                       22
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

2. Mergers - (CONTINUED)

incurred by the Company in  connection  with the mergers  have been  recorded in
operations  during  1996 and  reported as merger  expenses  in the  accompanying
consolidated statements of income.

     The PSCM and ReadiCare mergers were accounted for as poolings of interests.
However,  due to the  immateriality of these mergers,  the Company's  historical
financial  statements  for all  periods  prior  to the  quarters  in  which  the
respective mergers were completed have not been restated. Instead, stockholders'
equity has been  increased  by  $43,230,000  to reflect  the effects of the PSCM
merger and  $15,431,000  to reflect the  effects of the  ReadiCare  merger.  The
results of operations  of PSCM and  ReadiCare  are included in the  accompanying
financial  statements  from the date of acquisition  forward.  In addition,  the
FSSCI merger was a stock-for-stock  acquisition.  Stockholders'  equity has been
increased by $8,908,000 to reflect the effects of the merger.

3. CASH, CASH EQUIVALENTS AND OTHER MARKETABLE SECURITIES

     Cash, cash  equivalents and other  marketable  securities  consisted of the
following:
DECEMBER 31
                                                                    ----------------------
                                                                     1995         1996
                                                                    ----------   ---------
                                                                        (IN THOUSANDS)
Cash ............................................................   $143,681     $140,278
Cash equivalents ................................................     11,768        9,793
                                                                    ---------    ---------
 Total cash and cash equivalents   ..............................    155,449      150,071
Certificates of deposit   .......................................      2,229        1,765
Municipal put bonds .............................................        615          495
Municipal put bond mutual funds .................................        500          500
Collateralized mortgage obligations   ...........................      1,000        1,000
                                                                    ---------    ---------
Total other marketable securities  ..............................      4,344        3,760
                                                                    ---------    ---------
Total cash, cash equivalents and other marketable securities (ap-
 proximates market value)                                           $159,793     $153,831
                                                                    =========    =========
For purposes of the  consolidated  balance  sheets and  statements  of cash
flows,  marketable securities purchased with an original maturity of ninety days
or less are considered cash equivalents.

4. OTHER ASSETS

     Other assets consisted of the following:
DECEMBER 31
                                                           --------------------
                                                            1995       1996
                                                           ---------   --------
                                                              (IN THOUSANDS)
Notes and accounts receivable   ........................   $24,628     $38,359
Investment in Caretenders Health Corp.   ...............     7,417       7,370
Prepaid long-term lease   ..............................     8,888       8,397
Investments in other unconsolidated subsidiaries  ......     6,754      15,362
Real estate investments   ..............................    14,324      10,020
Trusteed funds   .......................................     1,879       1,879
Other   ................................................     5,127       2,629
                                                           --------    --------
                                                           $69,017     $84,016
                                                           ========    ========
23
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

4. Other Assets - (CONTINUED)

     The  Company  has a 19%  ownership  interest in  Caretenders  Health  Corp.
("Caretenders");  accordingly,  the Company's  investment is being accounted for
using the equity method of accounting.  The  investment was initially  valued at
$7,250,000.  The Company's equity in earnings of Caretenders for the years ended
December 31, 1994,  1995 and 1996 was not material to the  Company's  results of
operations.

     It was not practicable to estimate the fair value of the Company's  various
investments in other unconsolidated subsidiaries (involved in operations similar
to those of the  Company)  because of the lack of a quoted  market price and the
inability to estimate fair value without incurring excessive costs. The carrying
amount at December 31, 1996  represents  the original  cost of the  investments,
which management believes is not impaired.

5. PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment consisted of the following:
DECEMBER 31
                                                         --------------------------
                                                           1995           1996
                                                         ------------   -----------
                                                               (IN THOUSANDS)
Land  ................................................   $   86,020     $   93,631
Buildings   ..........................................      799,286        844,775
Leasehold improvements  ..............................       87,216        112,149
Furniture, fixtures and equipment   ..................      700,757        801,443
Construction-in-progress   ...........................       50,157         73,815
                                                         -----------    -----------
                                                          1,723,436      1,925,813
Less accumulated depreciation and amortization  ......      345,420        460,980
                                                         -----------    -----------
                                                         $1,378,016     $1,464,833
                                                         ===========    ===========
6. INTANGIBLE ASSETS

     Intangible assets consisted of the following:
DECEMBER 31
                                                                    --------------------------
                                                                      1995           1996
                                                                    ------------   -----------
                                                                          (IN THOUSANDS)
Organizational, partnership formation and start-up costs   ......   $  163,839     $  238,126
Debt issue costs ................................................       35,531         34,905
Noncompete agreements  ..........................................       70,636         86,566
Cost in excess of net asset value of purchased facilities  ......      787,397        947,104
                                                                    -----------    -----------
                                                                     1,057,403      1,306,701
Less accumulated amortization   .................................      136,433        212,280
                                                                    -----------    -----------
                                                                    $  920,970     $1,094,421
                                                                    ===========    ===========
24
HEALTHSOUTH Corporation and Subsidiaries
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

7. LONG-TERM DEBT

     Long-term debt consisted of the following:
DECEMBER 31
                                                                      --------------------------
                                                                        1995           1996
                                                                      ------------   -----------
                                                                            (IN THOUSANDS)
Notes and bonds payable:
 Advances under a $1,000,000,000 credit agreement with banks       .  $  790,000     $       --
 Advances under a $1,250,000,000 credit agreement with banks       .          --        995,000
 9.5% Senior Subordinated Notes due 2001   ........................      250,000        250,000
 5.0% Convertible Subordinated Debentures due 2001  ...............      115,000        115,000
 Notes payable to banks and various other notes payable, at in-
   terest rates from 5.5% to 14.9%                                       241,520        151,384
 Hospital revenue bonds payable   .................................       32,337         22,503
Noncompete agreements payable with payments due at intervals
 ranging through December 2004 ....................................       24,161         26,256
                                                                      -----------    -----------
                                                                       1,453,018      1,560,143
Less amounts due within one year  .................................       51,528         47,089
                                                                      -----------    -----------
                                                                      $1,401,490     $1,513,054
                                                                      ===========    ===========
The fair value of total long-term debt  approximates book value at December
31, 1995 and 1996. The fair values of the Company's long-term debt are estimated
using discounted cash flow analysis,  based on the Company's current incremental
borrowing rates for similar types of borrowing arrangements.

     During 1995, the Company entered into a Credit Agreement with  NationsBank,
N.A. ("NationsBank") and other participating banks (the "1995 Credit Agreement")
which consisted of a  $1,000,000,000  revolving  credit  facility.  On April 18,
1996, the Company amended and restated the 1995 Credit Agreement to increase the
size of the  revolving  credit  facility  to  $1,250,000,000  (the "1996  Credit
Agreement"). Interest is paid based on LIBOR plus a predetermined margin, a base
rate, or competitively  bid rates from the  participating  banks. The Company is
required to pay a fee on the unused  portion of the  revolving  credit  facility
ranging from 0.08% to 0.25%,  depending on certain defined ratios. The principal
amount is payable in full on March 31,  2001.  The  Company  provided a negative
pledge on all assets under the 1996 Credit  Agreement,  and the lenders released
the first  priority  security  interest in all shares of stock of the  Company's
subsidiaries and rights and interests in the Company's  controlled  partnerships
which had been granted  under the 1995 Credit  Agreement.  At December 31, 1996,
the  effective  interest  rate  associated  with the 1996 Credit  Agreement  was
approximately 5.87%.

     On March 24, 1994, the Company issued $250,000,000 principal amount of 9.5%
Senior Subordinated Notes due 2001 (the "Notes"). Interest is payable on April 1
and October 1. The Notes are senior subordinated  obligations of the Company and
as such are  subordinated to all existing and future senior  indebtedness of the
Company,  and also are  effectively  subordinated  to all  existing  and  future
liabilities  of the  Company's  subsidiaries  and  partnerships.  The Notes rank
senior  to all  subordinated  indebtedness  of  the  Company,  including  the 5%
Convertible Subordinated Debentures due 2001 described below.
The Notes mature on April 1, 2001.

     Also on March 24, 1994, the Company issued $100,000,000 principal amount of
5% Convertible Subordinated Debentures due 2001 (the "Convertible  Debentures").
An additional  $15,000,000 of Convertible Debentures was issued in April 1994 to
cover underwriters'  overallotments.  Interest is payable on April 1 and October
1. The Convertible  Debentures are convertible  into common stock of the Company
at the option of the holder at a conversion  price of $9.406 per share,  subject
to adjustment upon the occurrence of certain events.

                                       25
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

7. Long-Term Debt - (CONTINUED)

     In June 1994, SHC (see Note 2) issued $75,000,000 principal amount of 11.5%
Senior  Subordinated Notes due July 15, 2004 (the "SHC Notes").  The proceeds of
the SHC  Notes  were  used to pay  down  indebtedness  outstanding  under  other
existing credit  facilities.  During 1995, the Company purchased  $67,500,000 of
the $75,000,000  outstanding principal amount of the SHC Notes in a tender offer
at 115% of the face value of the Notes, and the remaining $7,500,000 balance was
purchased on the open market,  using proceeds from the Company's other long-term
credit facilities. The loss on retirement of the SHC Notes totaled approximately
$14,606,000.  The loss consists of the premium,  write-off of  unamortized  bond
issue  costs and other fees and is reported  as an  extraordinary  loss on early
extinguishment of debt in the accompanying 1995 consolidated statement of income
(see Note 2). 

     Principal maturities of long-term debt are as follows:
YEAR ENDING DECEMBER 31                                           (IN THOUSANDS)
-------------------------                                        ---------------
1997   ......................................................      $    47,089
1998   ......................................................           36,703
1999   ......................................................           26,085
2000   ......................................................           24,034
2001   ......................................................        1,375,570
After 2001 ..................................................           50,662
                                                                   ------------
                                                                   $ 1,560,143
                                                                   ============
8. STOCK OPTIONS

     THE COMPANY  HAS  VARIOUS  STOCKHOLDER-APPROVED  STOCK  OPTION  PLANS WHICH
PROVIDE FOR THE GRANT OF options to directors,  officers and other key employees
to  purchase  common  stock at 100% of the fair  market  value as of the date of
grant.  The  Audit  and  Compensation   Committee  of  the  Board  of  Directors
administers  the stock option plans.  Options may be granted as incentive  stock
options or as  non-qualified  stock  options.  Incentive  stock options vest 25%
annually, commencing upon completion of one year of employment subsequent to the
date of grant.  Non-qualified  stock  options  generally  are not subject to any
vesting  provisions.  The options expire at dates ranging from five to ten years
from the date of grant.

     In October, 1995, the Financial Accounting Standards Board issued Statement
of  Financial   Accounting   Standards  No.  123,  "Accounting  for  Stock-Based
Compensation  ("SFAS  123").  SFAS 123 is effective  for fiscal years  beginning
after  December 15, 1995 and allows for the option of  continuing to account for
stock-based  compensation  under  Accounting  Principles  Board  Opinion No. 25,
"Accounting   for  Stock   Issued  to   Employees"   ("APB  25"),   and  related
interpretations,  or selecting the fair value method of expense  recognition  as
described  in SFAS 123.  The Company has elected to follow APB 25 in  accounting
for its employee stock options.  The Company  follows SFAS 123 in accounting for
its non-employee stock options.  The total compensation  expense associated with
non-employee stock options granted in 1996 was not material.

     Pro forma  information  regarding  net  income  and  earnings  per share is
required  by  Statement  123,  and has been  determined  as if the  Company  had
accounted  for its employee  stock  options  under the fair value method of that
Statement.  The fair value for these  options was estimated at the date of grant
using a Black-Scholes  option pricing model with the following  weighted-average
assumptions for 1995 and 1996,  respectively:  risk-free interest rates of 5.87%
and 6.01%; dividend yield of 0%; volatility factors of the expected market price
of the Company's  common stock of .36 and .37; and a  weighted-average  expected
life of the options of 4.3 years.

     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

                                       26
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

8. Stock Options - (CONTINUED)

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 options' vesting period.  The Company's
pro forma information follows (in thousands, except for per share amounts):
1995        1996
                                                        ----        ----
Pro forma net income   ............................    $80,059     $162,463
Pro forma earnings per share:
 Primary   ........................................    $  0.26     $   0.48
 Fully diluted   ..................................    $  0.26     $   0.48
The effect of compensation expense from stock options on 1995 pro forma net
income  reflects  only the vesting of 1995 awards.  However,  1996 pro forma net
income reflects the second year of vesting of the 1995 awards and the first year
of vesting of 1996  awards.  Not until  1998 is the full  effect of  recognizing
compensation expense for stock options representative of the possible effects on
pro forma net income for future years.

     A summary of the Company's  stock option  activity and related  information
for the years ended December 31 follows:
1994                 1995                  1996
                                                 ------------------- --------------------- --------------------
                                                                                WEIGHTED              WEIGHTED
                                                                                 AVERAGE              AVERAGE
                                                 OPTIONS    PRICE     OPTIONS   EXERCISE    OPTIONS   EXERCISE
                                                  (000)     RANGE      (000)      PRICE      (000)     PRICE
                                                 --------- --------- ---------- ---------- ---------- ---------
Options outstanding January 1:   ............... 31,547               30,150        $4      35,068       $ 5
 Granted .......................................  3,356    $5 - $9     7,639         9       4,769        17
 Exercised  .................................... (3,877)   $1 - $4    (2,237)        4      (6,709)        5
 Canceled   ....................................   (876)                (484)        5        (322)        6
                                                 -------             --------              --------
Options outstanding at December 31  ............ 30,150               35,068        $5      32,806       $ 7
Options exercisable at December 31  ............ 22,533               26,293        $5      27,678       $ 6
Weighted average fair value of options granted
 during the year  ..............................    N/A              $  3.81               $  7.13
The following table summarizes  information about stock options outstanding
at December 31, 1996:
OPTIONS OUTSTANDING                    OPTIONS EXERCISABLE
                          ---------------------------------------------   ---------------------------
                                              WEIGHTED
                                              AVERAGE        WEIGHTED                       WEIGHTED
      EXERCISE               OPTIONS         REMAINING       AVERAGE        OPTIONS         AVERAGE
       PRICE               OUTSTANDING       CONTRACTUAL     EXERCISE     EXERCISABLE       EXERCISE
       RANGE               AT 12/31/96          LIFE          PRICE       AT 12/31/96       PRICE
-----------------------   ----------------   -------------   ----------   ---------------   ---------
                          (IN THOUSANDS)      (YEARS)                     (IN THOUSANDS)
Under $8.40............       21,380            5.50           $ 4.12         20,014          $ 4.08
$8.40 - $16.40.........        9,305            8.55            10.94          7,172           11.59
$16.41 and above ......        2,121            9.14            18.20            492           19.02
27
HEALTHSOUTH Corporation and Subsidiaries
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED )

9. ACQUISITIONS

1994 Acquisitions

     At various dates during 1994, the Company  acquired 53 separate  outpatient
operations and a majority  equity  interest in five  outpatient  surgery centers
located  throughout  the United  States.  The combined  purchase  price of these
acquired outpatient operations was approximately  $80,456,000.  The Company also
acquired  a  specialty  medical  center in  Dallas,  Texas,  a therapy  staffing
service, a diagnostic  imaging company,  four physical therapy practices and two
home health  agencies.  The  combined  purchase  price of these  operations  was
approximately  $32,044,000.  The form of  consideration  constituting  the total
purchase  prices  of  $112,500,000  was   approximately   $88,455,000  in  cash,
$14,122,000  in notes payable and  approximately  624,000 shares of common stock
valued at $9,923,000.

     In connection with these transactions,  the Company entered into noncompete
agreements with former owners totaling $10,814,000. In general, these noncompete
agreements are payable in monthly or quarterly installments over periods ranging
from five to ten years.

     The fair value of the total net assets  relating  to the 1994  acquisitions
described  above  was  approximately  $17,958,000.   The  total  cost  for  1994
acquisitions exceeded the fair value of the net assets acquired by approximately
$94,542,000.  The Company evaluated each acquisition  independently to determine
the appropriate amortization period for the cost in excess of net asset value of
purchased  facilities.  Each  evaluation  included an  analysis of historic  and
projected  financial  performance,  evaluation of the estimated  useful lives of
buildings and fixed assets  acquired,  the indefinite  lives of  certificates of
need and licenses acquired,  the competition  within local markets,  lease terms
where applicable, and the legal term of partnerships where applicable.  Based on
these  evaluations,  the Company determined that the cost in excess of net asset
value of  purchased  facilities  relating  to the 1994  acquisitions  should  be
amortized over periods ranging from 25 to 40 years on a straight-line  basis. No
other identifiable intangible assets were recorded in the acquisitions described
above.

     Also during August 1994,  Health Images (see Note 2) acquired the remaining
interest in its equity affiliate,  National Diagnostic Systems, Inc. ("NDS") and
merged NDS into a  wholly-owned  subsidiary  of the  Company,  which was renamed
Interactive Diagnostic Services,  Inc. ("IDSI"). The total consideration for NDS
included $2,939,000 in common stock, forgiveness debt by NDS to Health Images of
$1,010,000,  and other consideration totalling $981,000.  Goodwill of $4,272,000
was recorded and acquisition costs of $1,087,000 were expensed.  On December 31,
1994,  the  Company  wrote off the  $4,272,000  in  goodwill  related to the NDS
investment in addition to the previous  write-off of  $1,087,000 in  acquisition
costs.  In addition,  Health Images  expensed  $219,000 for  estimated  contract
losses and $539,000 in organization  and start-up  costs.  Health Images filed a
lawsuit on February 21, 1995 against the selling  shareholders of NDS asking for
rescission of the  acquisition  described above and  restitution.  The complaint
alleges   breach   of   contract,   intentional   misrepresentation,   negligent
misrepresentation  and  suppession  of  fact.  Health  Images  discontinued  the
operations  fo IDSI  during the  quarter  ended  March 31,  1995.  The loss from
discontinued  operations  recorded in the accompanying 1994 consolidated  income
statement  includes an impairment charge of $5,580,000  related to the write-off
of the assets described above. Revenues attributable to discontinued  operations
were  $402,000  for 1995.  The loss  from  discontinued  operations  and loss on
disposal of discontinued  operations in 1995 totaled $1,874,000,  less an income
tax benefit of $712,000. 

     All  of  the  1994  acquisitions  described  above  were  accounted  for as
purchases and, accordingly, the results of operations of the acquired businesses
(not material individually or in the aggregate) are included in the accompanying
consolidated financial statements from their respective dates of acquisition.

1995 Acquisitions

     Effective April 1, 1995, the Company acquired the rehabilitation  hospitals
division  of  NovaCare,  Inc.  ("NovaCare"),  consisting  of  11  rehabilitation
hospitals,  12 other  facilities,  and  certificates  of need to build two other
facilities.   The  total  purchase   price  for  the  NovaCare   facilities  was
approximately

                                       28
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

9. ACQUISITIONS - (CONTINUED)

$235,000,000  in cash.  The cost in excess of net asset value was  approximately
$173,000,000.  Of this  excess,  approximately  $129,000,000  was  allocated  to
leasehold  value and the  remaining  $44,000,000  to cost in excess of net asset
value of purchased facilities. As part of the acquisition,  the Company acquired
approximately  $4,790,000  in deferred  tax assets.  The Company  also  provided
approximately $10,000,000 for the write-down of certain assets to net realizable
value as the result of a planned  facility  consolidation  in a market where the
Company's existing services  overlapped with those of an acquired facility.  The
planned employee  separations and facility  consolidation  were completed by the
end of 1995.

     Effective  December  1,  1995,  the  Company  acquired  Caremark Orthopedic
Services  Inc.  ("Caremark"). At the time of the acquisition, Caremark owned and
operated  approximately  120 outpatient rehabilitation centers in 13 states. The
total purchase price was approximately $127,500,000 in cash.

     Also at various  dates  during  1995,  the  Company  acquired  70  separate
outpatient rehabilitation operations located throughout the United States, three
physical  therapy  practices,  one home  health  agency,  one nursing  home,  75
licensed  subacute  beds,  five  outpatient  surgery  centers and 16  outpatient
diagnostic   imaging   operations.   The  combined   purchase  prices  of  these
acquisitions  was   approximately   $178,393,000.   The  form  of  consideration
constituting the combined purchase prices was approximately $152,833,000 in cash
and $25,560,000 in notes payable. 

     In connection with these transactions,  the Company entered into noncompete
agreements with former owners totaling $16,222,000. In general, these noncompete
agreements are payable in monthly or quarterly installments over periods ranging
from five to ten years.

     The fair value of the total net assets  relating  to the 1995  acquisitions
described  above,   excluding  the  NovaCare   acquisition,   was  approximately
$81,455,000. The total cost of these acquisitions exceeded the fair value of the
net assets acquired by  approximately  $224,438,000.  Based on the evaluation of
each acquisition  utilizing the criteria described above, the Company determined
that the cost in excess of net asset value of purchased  facilities  relating to
the 1995  acquisitions  should be amortized  over periods  ranging from 25 to 40
years on a straight-line  basis. No other  identifiable  intangible  assets were
recorded in the acquisitions described above.

     All  of  the  1995  acquisitions  described  above  were  accounted  for as
purchases and, accordingly, the results of operations of the acquired businesses
are included in the accompanying  consolidated  financial  statements from their
respective  dates of  acquisition.  With the exception of NovaCare,  none of the
above acquisitions were material individually or in the aggregate.

1996 Acquisitions

     At  various  dates  during  1996,   the  Company   acquired  80  outpatient
rehabilitation  facilities,  three  outpatient  surgery  centers,  one inpatient
rehabilitation  hospital,  and  one  diagnostic  imaging  center.  The  acquired
operations are located throughout the United States. The total purchase price of
the  acquired   operations   was   approximately   $104,321,000.   The  form  of
consideration   constituting   the  total  purchase  prices  was   approximately
$92,319,000 in cash and $12,002,000 in notes payable.

     In connection with these transactions,  the Company entered into noncompete
agreements with former owners totaling $11,900,000. In general, these noncompete
agreements are payable in monthly or quarterly installments over periods ranging
from five to ten years.

     The fair value of the total net assets  relating  to the 1996  acquisitions
described  above  was  approximately  $40,259,000.  The  total  cost of the 1996
acquisitions exceeded the fair value of the net assets acquired by approximately
$64,062,000.  Based on the evaluation of each acquisition utilizing the criteria
described above,

                                       29
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

9. ACQUISITIONS - (CONTINUED)

the Company  determined  that the cost in excess of net asset value of purchased
facilities  relating to the 1996  acquisitions  should be amortized over periods
ranging  from 25 to 40 years on a  straight-line  basis.  No other  identifiable
intangible assets were recorded in the acquisitions described above.

     All  of  the  1996  acquisitions  described  above  were  accounted  for as
purchases and, accordingly, the results of operations of the acquired businesses
(not material individually or in the aggregate) are included in the accompanying
consolidated financial statements from their respective dates of acquisition.

10. INCOME TAXES

     HEALTHSOUTH  and its  subsidiaries  file a consolidated  federal income tax
return. The limited  partnerships and limited liability  companies file separate
income tax returns. HEALTHSOUTH's allocable portion of each partnership's income
or loss is included in the taxable income of the Company.  The remaining  income
or loss of each partnership is allocated to the limited partners.

     The  Company  utilizes the liability method of accounting for income taxes,
as  required  by  Financial Accounting Standards Board (FASB) Statement No. 109,
"Accounting for Income Taxes".

     Significant components of the Company's deferred tax assets and liabilities
as of December 31, 1995 are as follows:
CURRENT      NONCURRENT       TOTAL
                                                ----------   ------------   -------------
                                                             (IN THOUSANDS)
Deferred tax assets:
 Accruals   .................................     $  8,016    $      --      $   8,016
 Disposal of surgery centers  ...............        2,675           --          2,675
 Impairment of assets   .....................        1,309        5,434          6,743
 Development costs   ........................           --          849            849
 Acquired net operating loss  ...............           --       16,277         16,277
 Allowance for bad debts   ..................       31,650           --         31,650
 Other   ....................................        2,084        5,469          7,553
                                                 ---------    ---------      ---------
Total deferred tax assets  ..................       45,734       28,029         73,763
Deferred tax liabilities:
Depreciation and amortization ...............           --       42,591         42,591
 Non-accrual experience method   ............       14,559           --         14,559
 Purchase price accounting ..................           --        4,802          4,802
 Contracts  .................................        3,849           --          3,849
 Capitalized costs   ........................           --       12,916         12,916
 Other   ....................................        2,522        3,164          5,686
                                                 ---------    ---------      ---------
Total deferred tax liabilities   ............       20,930       63,473         84,403
                                                 ---------    ---------      ---------
Net deferred tax assets (liabilities)  ......     $ 24,804    $ (35,444)     $ (10,640)
                                                 =========    =========      =========
At December 31, 1996, the Company has net operating loss  carryforwards  of
approximately  $14,747,000  for income tax  purposes  expiring  through the year
2009. Those carryforwards resulted from the Company's acquisitions of Diagnostic
Health Corporation,  Renaissance  Rehabilitation Center, Inc., Rebound, Inc. and
Health Images, Inc.

                                       30
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

10. INCOME TAXES - (CONTINUED)

     Deferred  income  taxes  reflect the net effects of  temporary  differences
between the carrying  amounts of assets and liabilities for financial  reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities as of December 31, 1996 are as
follows:
CURRENT     NONCURRENT       TOTAL
                                                ---------   ------------   -------------
                                                             (IN THOUSANDS)
Deferred tax assets:
 Acquired net operating loss  ...............   $    --      $   5,283      $   5,283
 Development costs   ........................        --            849            849
 Accruals   .................................     6,634             --          6,634
 Allowance for bad debts   ..................    34,700             --         34,700
 Other   ....................................     2,433          2,597          5,030
                                                --------     ---------      ---------
Total deferred tax assets  ..................    43,767          8,729         52,496
Deferred tax liabilities:
 Depreciation and amortization   ............        --         20,501         20,501
 Purchase price accounting ..................        --          4,802          4,802
 Non-accrual experience method   ............    17,694             --         17,694
 Contracts  .................................     3,849             --          3,849
 Capitalized costs   ........................     5,013         22,672         27,685
 Other   ....................................     1,973          2,604          4,577
                                                --------     ---------      ---------
Total deferred tax liabilities   ............    28,529         50,579         79,108
                                                --------     ---------      ---------
Net deferred tax assets (liabilities)  ......   $15,238      $ (41,850)     $ (26,612)
                                                ========     =========      =========
The provision for income taxes was as follows:
YEAR ENDED DECEMBER 31,
                              ------------------------------------
                                1994          1995        1996
                              ------------   ---------   ---------
                                         (IN THOUSANDS)
Currently payable:
 Federal ..................    $  72,416     $70,629     $116,023
 State   ..................       10,802       9,586       13,598
                               ---------     --------    ---------
                                  83,218      80,215      129,621
Deferred (benefit) expense:
 Federal ..................      (12,920)        367       13,281
 State   ..................       (1,738)         29        1,027
                               ---------     --------    ---------
                                 (14,658)        396       14,308
                               ---------     --------    ---------
Total provision   .........    $  68,560     $80,611     $143,929
                               =========     ========    =========
As part of the  acquisitions  of PSCM,  Readicare  and FSSCI,  the  Company
acquired approximately $1,664,000 in deferred tax liabilities.

                                       31
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

10. INCOME TAXES - (CONTINUED)

     The  difference  between  the  provision  for  income  taxes and the amount
computed by applying  the  statutory  federal  income tax rate to income  before
taxes was as follows:
YEAR ENDED DECEMBER 31
                                                            ------------------------------------------
                                                              1994           1995           1996
                                                            ------------   ------------   ------------
                                                                          (IN THOUSANDS)
Federal taxes at statutory rates ........................    $  67,795      $  78,322      $ 134,457
Add (deduct):
   State income taxes, net of federal tax benefit  ......        5,254          6,250          9,506
   Minority interests   .................................      (11,014)       (15,102)       (17,303)
   Disposal/impairment/merger charges  ..................          668          9,955          6,563
   Other ................................................        5,857          1,186         10,706
                                                             ---------      ---------      ---------
                                                             $  68,560      $  80,611      $ 143,929
                                                             =========      =========      =========
11. COMMITMENTS AND CONTINGENCIES

     The Company is a party to legal proceedings  incidental to its business. In
the opinion of management,  any ultimate liability with respect to these actions
will not materially  affect the  consolidated  financial  position or results of
operations of the Company.

     At December 31, 1996,  anticipated capital expenditures for the next twelve
months are $350,000,000.  This amount includes  expenditures for maintenance and
expansion  of the  Company's  existing  facilities  as well as  development  and
integration of the Company's services in selected metropolitan markets.

     Beginning   December  1,  1993,   the  Company  became   self-insured   for
professional   liability  and  comprehensive  general  liability.   The  Company
purchased  coverage  for all claims  incurred  prior to  December  1,  1993.  In
addition,  the  Company  purchased  underlying  insurance  which would cover all
claims  once  established  limits  have  been  exceeded.  It is the  opinion  of
management that at December 31, 1996, the Company has adequate reserves to cover
losses on asserted and unasserted claims.

     Prior to consummation of the SCA and Advantage Health mergers (see Note 2),
these  companies   carried   professional   malpractice  and  general  liability
insurance.  The policies were carried on a claims made basis.  The companies had
policies in place to track and monitor incidents of significance.  Management is
unaware of any claims that may result in a loss in excess of amounts  covered by
existing insurance.

     Operating  leases  generally  consist of short-term  lease  agreements  for
buildings  where  facilities  are located.  These leases  generally  have 5-year
terms, with one or more renewal options, with terms to be negotiated at the time
of renewal.  Total  rental  expense for all  operating  leases was  $77,228,000,
$103,308,000  and  $131,994,000  for the years ended December 31, 1994, 1995 and
1996, respectively. 

     The  following is a schedule of future  minimum  lease  payments  under all
operating  leases  having  initial or  remaining  non-cancelable  lease terms in
excess of one year:

          YEAR ENDING DECEMBER 31               (IN THOUSANDS)
          -------------------------             ---------------
          1997   ..................                $111,140
          1998   ..................                 101,651
          1999   ..................                  88,490
          2000   ..................                  73,625
          2001   ..................                  57,165
          After 2001   ............                 251,915
                                                   ---------
                                                   $683,986
                                                   =========
                                              
                                

                                       32
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED )

12. EMPLOYEE BENEFIT PLANS

     The Company has a 401(k)  savings plan which matches 15% of the first 4% of
earnings  that an employee  contributes.  All  contributions  are in the form of
cash.  All  employees  who have  completed one year of service with a minimum of
1,000  hours  worked  are  eligible  to   participate   in  the  plan.   Company
contributions   are  gradually   vested  over  a  seven-year   service   period.
Contributions  to  the  plan  by  the  Company  were  approximately  $1,293,000,
$1,408,000 and $2,420,000 in 1994, 1995 and 1996, respectively.

     In 1991, the Company  established an Employee Stock Ownership Plan ("ESOP")
for the purpose of  providing  substantially  all  employees  of the Company the
opportunity to save for their  retirement and acquire a proprietary  interest in
the Company.  The ESOP  currently  owns  approximately  3,320,000  shares of the
Company's  common  stock,  which were  purchased  with funds  borrowed  from the
Company, $10,000,000 in 1991 (the "1991 ESOP Loan") and $10,000,000 in 1992 (the
"1992 ESOP Loan").  At December 31, 1996,  the combined ESOP Loans had a balance
of  $14,148,000.  The 1991 ESOP Loan,  which bears an  interest  rate of 10%, is
payable in annual  installments  covering interest and principal over a ten-year
period  beginning in 1992.  The 1992 ESOP Loan,  which bears an interest rate of
8.5%, is payable in annual  installments  covering interest and principal over a
ten-year period  beginning in 1993.  Company  contributions to the ESOP began in
1992  and  shall  at least  equal  the  amount  required  to make all ESOP  loan
amortization  payments for each plan year. The Company  recognizes  compensation
expense based on the shares allocated  method.  Compensation  expense related to
the ESOP recognized by the Company was $3,673,000,  $3,524,000 and $3,198,000 in
1994,  1995 and 1996,  respectively.  Interest  incurred  on the ESOP  Loans was
approximately  $1,608,000,  $1,460,000  and  $1,298,000 in 1994,  1995 and 1996,
respectively.  Approximately  1,212,000  shares  owned  by the  ESOP  have  been
allocated to participants at December 31, 1996.

     During 1993, the American  Institute of Certified Public Accountants issued
Statement of Position 93-6,  "Employers  Accounting for Employee Stock Ownership
Plans" ("SOP 93-6"). Among other provisions, SOP 93-6 requires that compensation
expense relating to employee stock ownership plans be measured based on the fair
market value of the shares when  allocated to the  employees.  The provisions of
SOP 93-6 apply only to leveraged ESOPs formed after December 31, 1992, or shares
newly acquired by an existing  leveraged  ESOP after December 31, 1992.  Because
all shares owned by the Company's ESOP were acquired prior to December 31, 1992,
the Company's accounting policies for the shares currently owned by the ESOP are
not affected by SOP 93-6.

13. LOSS ON DISPOSAL OF SURGERY CENTERS

     During the fourth  quarter of 1994,  the  Company  adopted a formal plan to
dispose of three  surgery  centers and certain  other  properties  during  1995.
Accordingly,  a loss of  $13,197,000  was made to reflect  the  expected  losses
resulting from the disposal of these centers. The loss is comprised primarily of
losses on the sale of owned  facilities and  equipment,  write-off of intangible
and  other  assets,  and  accrual  of future  operating  lease  obligations  and
estimated operating losses through the anticipated date of disposal.

     The following are the major components of the loss (in thousands):
Write-down of land, buildings and equipment   .......................................   $ 4,806
Write-off of excess of cost over fair value of net assets acquired and other assets       2,762
Estimated operating losses through anticipated date of disposal .....................     1,750
Accrual of future lease commitments and other obligations resulting from disposal ...     3,879
                                                                                        --------
                                                                                        $13,197
                                                                                        ========
The closings of the three  surgery  centers were  completed by December 31,
1995.  An  accrual  of  $929,000  is  included  in  accrued  liabilities  on the
accompanying  December 31, 1995  consolidated  balance  sheet for the  remaining
costs to be incurred  relative to the disposal of these surgery  centers and the
other properties. The remaining accrual was used in 1996.

                                       33
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

14. IMPAIRMENT OF LONG-TERM ASSETS

     During 1994,  certain events  occurred which impaired the value of specific
long-term  assets of ReLife (see Note 2). A hospital in Missouri with a distinct
part unit  which  ReLife was  managing  was  purchased  in 1994 by an acute care
provider  which  terminated  the  contract  with ReLife.  Remaining  goodwill of
$1,700,000  and costs  allocated to the management  contract of $1,300,000  were
written off as there is no value remaining for the terminated contract.

     A ReLife  facility in central Florida  incurred  tornado damage and has not
operated since September 1993. During 1994, management of ReLife determined that
it was  probable  that  this  facility  would  not  reopen.  Start-up  costs  of
$1,600,000 were written off. This facility is leased under an operating lease as
described  in Note 11 through  the year 2001.  An  impairment  accrual  has been
established  based on the projected  undiscounted net cash flows related to this
non-operating  facility for the remainder of the lease term. The accrual totaled
$5,900,000  and consists of $4,700,000 in lease payments and $1,200,000 in fixed
costs and operating expenses,  including property taxes,  maintenance,  security
and other related costs.

     During 1994,  ReLife entered into a contract for a new information  system.
Payments under the contract and related costs were capitalized  during the year.
After the agreement to merge with  HEALTHSOUTH  was entered  into,  the computer
project  was  abandoned,  resulting  in  a  write-off  of  capitalized  cost  of
$4,500,000.

     In 1995, the Company recorded an asset  impairment  charge of approximately
$53,549,000  relating to goodwill and tangible assets identifiable with fourteen
surgery centers. Approximately $47,984,000 of this charge related to ten surgery
centers  which the  Company  intends to operate on an ongoing  basis,  while the
remaining loss of $5,565,000 is identifiable with four surgery centers which the
Company decided during the fourth quarter of 1995 to close.

     With  respect to the ten surgery  centers  the Company  intends to continue
operating,  certain  events  occurred  in  the  fourth  quarter  of  1995  which
significantly  impacted  the  Company's  estimates  of future  cash  flows to be
received  from these  centers.  Those events  primarily  related to a decline in
operating  results  combined  with a  deterioration  in  relationships  with key
physicians  at  certain of those  locations.  As a result of these  events,  the
Company revised its estimates of undiscounted cash flows to be received over the
remaining  estimated  useful lives of these centers and determined that goodwill
and  other  long-lived  assets  (primarily  property  and  equipment)  had  been
impaired.  The Company  developed its best  estimates of future  operating  cash
flows  at  these  locations   considering   future   requirements   for  capital
expenditures  as well as the impact of inflation.  The projections of cash flows
also took into account  estimates of  significant  one-time  expenses as well as
estimates of  additional  revenues and  resulting  income from future  marketing
efforts in the respective  locations.  The amount of the  impairment  charge was
determined by discounting the estimates of future cash flows, using an estimated
8.5% incremental  borrowing rate which management  believes is commensurate with
the risks  involved.  The  resulting  net present value of future cash flows was
then compared to the historical net book value of goodwill and other  long-lived
assets at each operating  location which resulted in an impairment loss relative
to these centers of $47,984,000.

     The remaining impairment charge of $5,565,000 relating to the centers to be
closed was based on the fair value of the related assets less estimated costs to
sell. One of these  facilities is expected to be sold by the middle of 1997. The
Company  continues to operate the remaining  three  facilities and is evaluating
its alternatives for their disposition.  Assets held for sale having a remaining
net book value of  $2,839,000  and  $2,309,000  are  included  in  property  and
equipment  on the  accompanying  December  31,  1995  and 1996  balance  sheets,
respectively.

     The above amounts are included in operations  for 1995 in the  accompanying
consolidated statement of income.

                                       34
HEALTHSOUTH Corporation and Subsidiaries
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

14. IMPAIRMENT OF LONG-TERM ASSETS - (CONTINUED)

     In 1996, the Company recorded an asset  impairment  charge of approximately
$37,390,000  relating to tangible assets  identifiable  with the development and
manufacture  of the HI  Standard  and  HI  STAR  MRI  systems.  Improvements  in
technology,  and the related  reduction  in purchase  price,  of high field (1.5
Tesla) MRI systems significantly affected the viability of continued development
and  manufacture of mid field (0.6 Tesla) MRI systems.  Both the HI Standard and
HI STAR MRI systems were mid field systems.  The impairment  charge was based on
the fair value of the related assets. 

15. SUBSEQUENT EVENTS

     On  January  18,  1997,  the  Company's  Board of  Directors  authorized  a
two-for-one  stock split to be  effected  in the form of a 100% stock  dividend,
subject to the  approval by the  Company's  stockholders  of an amendment to its
Certificate  of  Incorporation  increasing  the number of  authorized  shares of
common  stock  from  250,000,000  to  500,000,000.  The  Company's  stockholders
approved the amendment on March 12, 1997. The stock dividend is payable on March
17, 1997 to holders of record on March 13, 1997. Accordingly,  all share and per
share  amounts  included  in the  accompanying  financial  statements  have been
restated to give effect to the stock split.  The stock  dividend is reflected in
the accompanying statement of stockholders' equity as a 1996 transaction.

     On February 17, 1997,  the Company  entered into a definitive  agreement to
acquire Horizon/CMS Healthcare Corporation  ("Horizon/CMS") in a stock-for-stock
merger in which the  stockholders  of  Horizon/CMS  will receive  .84338  (after
adjustment for the two-for-one  stock split) of a share of the Company's  common
stock  per share of  Horizon/CMS  common  stock.  The  transaction  is valued at
approximately  $1,600,000,000,  including  the  assumption  by  the  Company  of
approximately  $700,000,000  in  Horizon/CMS  debt.  It  is  expected  that  the
acquisition  will  be  accounted  for as a  purchase.  Horizon/CMS  operates  32
inpatient  rehabilitation  hospitals,  37 specialty hospitals and subacute units
and 278 outpatient  rehabilitation  centers.  Horizon/CMS  also owns,  leases or
manages  134  long-term  care  facilities,   a  contract  therapy  business,  an
institutional  pharmacy business and other healthcare services.  Consummation of
the transaction is subject to various regulatory approvals,  including clearance
under the Hart-Scott-Rodino  Antitrust Improvements Act, and to the satisfaction
of  certain  other  conditions.  The  Company  currently  anticipates  that  the
transaction will be consummated by October 1997. 

                                       35
ITEM 7: FINANCIAL STATEMENTS AND EXHIBITS.

 (a)     Financial Statements of businesses acquired: Not applicable.
 (b)     Pro forma financial information: Not applicable.
 (c)     The following are filed as Exhibits to this Report:
         Exhibit (11) -- Statement Re: Computation of Per Share Earnings.
         Exhibit (23) -- Consent of Ernst & Young LLP.
         Exhibit (27) -- Financial Data Schedule.
 (d)     Financial Statement Schedules.
         Schedule II: Valuation and Qualifying Accounts

                                       36
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
COLUMN A                 COLUMN B                   COLUMN C                COLUMN D         COLUMN E
-------------------------------   --------------   -------------------------------   -------------   ---------------
                                                                    ADDITIONS
                                                   ADDITIONS       CHARGED TO
                                  BALANCE AT       CHARGED TO         OTHER
                                  BEGINNING OF     COSTS AND        ACCOUNTS         DEDUCTIONS      BALANCE AT END
        DESCRIPTION                 PERIOD         EXPENSES         DESCRIBE          DESCRIBE        OF PERIOD
-------------------------------   --------------   ------------   ----------------   -------------   ---------------
Year ended December 31, 1994:
   Allowance for doubtful
    accounts ..................    $ 34,871        $ 35,740        $     6,850(1)    $ 32,799(2)       $44,662
Year ended December 31, 1995:
   Allowance for doubtful
    accounts ..................    $ 44,662        $ 42,305        $    21,078(1)    $ 47,945(2)       $ 60,100
Year ended December 31, 1996:
   Allowance for doubtful
    accounts ..................    $ 60,100        $ 58,637        $    13,643(1)    $ 57,020(2)       $ 75,360
----------

(1) Allowances of acquisitions in years 1994, 1995 and 1996, respectively.

(2) Write-offs of uncollectible patient accounts receivable.
SIGNATURES

     Pursuant to the  requirements  of the Securities  Exchange Act of 1934, the
Registrant  has duly  caused  this  Report  to be  signed  on its  behalf by the
undersigned hereunto duly authorized.

                                         HEALTHSOUTH CORPORATION

                                         By     /s/ WILLIAM W. HORTON
                                         --------------------------------------
                                         William W. Horton
                                         Senior Vice President

Date: August 26, 1997