10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

x Annual report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2005

or

¨ Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from              to             

Commission file number 0-18217

TRANSCEND SERVICES, INC.

(Exact name of registrant as specified in its charter)

Delaware	33-0378756
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)
945 East Paces Ferry Road, N.E., Suite 1475, Atlanta, Georgia	30326
(Address of principal executive offices)	(Zip Code)

(404) 364-8001

(Registrant’s telephone number, including area code)

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

Title of each class	Name of each exchange on which registered
None	Note Applicable

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

Common Stock, $0.05 par value

(Title of class)

Not Applicable

(Title of class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation SK is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  ¨                    Accelerated filer  ¨                    Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12-b2 of the Act).    Yes  ¨    No  x

State the aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s most recently completed second fiscal quarter: $16,586,320 as of June 30, 2005.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. 7,908,613 shares of Common Stock, $0.05 par value, as of February 28, 2006.

Documents incorporated by reference: Portions of the registrant’s proxy statement filed in connection with the 2005 Annual Meeting of Stockholders to be held on May 9, 2006, are incorporated by reference herein in response to Part III of this report.

TABLE OF CONTENTS

		Page
	Part I
Item 1.	Business	3
Item 1A.	Risk Factors	8
Item 2.	Properties	10
Item 3.	Legal Processings	10
Item 4.	Submission of Matters to a Vote of Security Holders	10
	Part II
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities	11
Item 6.	Selected Financial Data	11
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	15
Item 8.	Financial Statements and Supplementary Data	15
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	30
Item 9A.	Controls and Procedures	30
Item 9B.	Other Information	30
	Part III
Item 10.	Director and Executive Officers of the Registrant	30
Item 11.	Executive Compensation	30
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	30
Item 13.	Certain Relationships and Related Transactions	30
Item 14.	Principal Accounting Fees and Services	30
	Part IV
Item 15.	Exhibits, Financial Statement Schedules	31

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PART I

ITEM 1. BUSINESS

Transcend Services, Inc. (“Transcend”, “we”, “our”, “us” or the “Company”) provides medical transcription services to the healthcare industry. Transcription services encompass receiving, typing or editing, formatting and distributing electronic copies of physician-dictated medical documents.

Our mission is to provide accurate documentation of the patient / medical provider encounter on-time, the first time, at a fair price. Our state-of-the-art Web-based voice, speech recognition, typing, editing and formatting tools and data distribution technology provide an efficient and secure editing and typing platform for our home-based medical language specialists, who document patient care by converting physicians’ voice recordings into electronic medical record documents. We have invested significant time and financial and intellectual capital in designing and managing a production environment that ensures the timely, accurate and secure creation and distribution of electronic medical documents, which form the foundation for the patient medical record. We believe this tested and proven infrastructure helps us differentiate ourselves from the vast majority of transcription companies.

We provide two primary transcription options for our customers. If the customer does not have its own transcription technology or no longer has the desire or resources to maintain and upgrade whatever technology it has, Transcend can provide a turnkey solution using our technology and services. If the customer has invested in their own transcription technology and wishes to keep its system in place, we can access the system and perform all transcription services using the customer’s system. This second alternative is the core offering of our Medical Dictation, Inc. (“MDI”) subsidiary, acquired on January 31, 2005.

Using our turnkey solution, we create text files from voice files without regard to how the dictation was captured. Voice recordings can be captured on either our proprietary systems or on other third-party systems. Starting in late 2004, some voice files are processed through the speech recognition tool that is integrated into our BeyondTXT platform, translated into text, and then edited. The remaining voice files are typed, i.e. transcribed, in our traditional manner. We plan to gradually increase the percentage of voice files processed through the BeyondTXT speech recognition engine with the objective of processing the majority of the voice files through speech recognition by the end of 2006.

Portions of the BeyondTXT technology were provided to us by a third party vendor under a one-year, non-exclusive license that is renewable for up to six successive one-year periods. The proprietary third party technology consists of a natural language understanding processor, a conversational speech recognition engine and editing tools, all of which work in concert with each other to continually learn and translate voice records into editable, structured clinical documentation with improving levels of accuracy over time. BeyondTXT effectively addresses the short supply of qualified medical language specialists in the marketplace by enhancing the productivity of our employees, which we expect to positively impact our financial performance.

Our proven production technology helps us to ensure the timely, accurate and secure creation and distribution of electronic medical documents. Based upon comprehensive, written annual surveys from our customers, we believe that our services can be differentiated from that of our competitors by fast, predictable turnaround times; by quality and accuracy; by distribution methodology and flexibility; and perhaps most importantly, by the breadth and depth of our service offerings. We can create customized transcription services that fit a broad spectrum of customer needs, from the large in-house department that needs a new data center, to the department that desires a complete outsourcing solution, to project-based overflow work.

The market for our medical transcription services is sizable. According to a report on the transcription services industry prepared by the Medical Transcription Industry Alliance in January 2002, the total annual market potential for outsourced medical transcription services is estimated to be approximately $6 billion. While competition is significant with over 1,000 transcription services companies nationally, we believe that we are one of only a handful of companies that operates on a single, Internet-based technology.

Our customers include hospitals, hospital systems, multi-specialty clinics and physician group practices in the United States.

Government regulation, managed care and labor resource constraints are shaping new opportunities for us and other healthcare service providers. Breakthroughs in telecommunications technologies and the acceptance of the Internet are enabling home-based professionals to provide more and more services to meet the needs of healthcare. New applications, such as speech recognition, are also emerging, allowing for increased productivity, capacity and quality. In addition, legal requirements have increased the importance of the security and confidentiality of patient medical records at all levels of the healthcare industry. Demand for documentation of clinician decisions has increased, raising demand for the types of transcription services offered by us. Further, the security and confidentiality requirements of the Health Insurance Portability and Accountability Act (“HIPAA”) have provided us with an opportunity to differentiate Transcend from those unable to invest in the time and technologies necessary to ensure HIPAA compliance. As a result of these factors and trends, specialized healthcare service companies like Transcend are leveraging technology to increase their value to healthcare providers.

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INDUSTRY OVERVIEW

The healthcare industry continues to undergo rapid change. Government regulation and managed care have increased the focus on quality of care, quality of data, billing compliance and patient privacy. Healthcare providers continue to come under increased scrutiny from regulators and third-party payers. Reimbursement pressures from managed-care growth have fueled industry consolidation and the formation of various types of healthcare provider groups, from integrated delivery networks to managed service organizations. Documentation requirements have significantly increased, resulting in an increase in the need for dictation and transcription of medical encounters. As a result of breakthroughs in technology, telecommunications, the acceptance of the Internet, and new applications (such as speech recognition tools), healthcare providers are relying on new technologies and outsourcing to help them stay competitive. The ability to process transcription services off-site allows for faster turnaround times, increased availability of scarce skilled professionals, improved quality and lower costs.

HISTORY OF THE COMPANY

The Company was incorporated in California in 1976 and was reorganized as a Delaware corporation in 1988. On January 10, 1995, the Company, formerly known as TriCare, Inc., acquired Transcend Services, Inc., then a Georgia corporation, by the merger of Transcend Services, Inc. into First Western Health Corporation (“First Western”), a subsidiary of the Company (“the Merger”). On May 31, 1995, Transcend Services, Inc. and Veritas Healthcare Management (“Veritas”), another subsidiary of the Company, merged into the Company, whose name was then changed to Transcend Services, Inc. The Merger was treated for financial accounting purposes as the acquisition of TriCare, Inc. by Transcend Services, Inc. The historical financial statements of the former Transcend Services, Inc. became the financial statements of the Company and include the businesses of both companies as of the effective date of the Merger.

Prior to the Merger, Transcend Services, Inc., which was originally organized in 1984, provided consulting services for medical records management, quality and utilization management and records coding. In 1992, the former Transcend Services, Inc. developed, tested and marketed new lines of business intended to capitalize on the increasing need for the outsourcing of medical records, and by the end of 1992 had entered into its first long-term agreement for the management of a hospital’s medical records department.

In 1999, our Board of Directors approved management’s plan to restructure our business to focus on medical transcription using our Internet-based transcription technology. In 1999, we sold certain transcription operations and certain transcription contracts that operated using technologies other than our Internet-based transcription technology. In 2000, we sold our CodeRemote business, which provided remote coding services, and our Co-Sourcing business, which provided on-site management of hospital medical records operations, to Provider HealthNet Services, Inc.

In May 2002, we sold certain assets and the operations of our wholly owned subsidiary Cascade Health Information Software, Inc. (“Cascade”) to QuadraMed Corporation (“QuadraMed”) for $911,000 in cash and the assumption of certain liabilities by QuadraMed, which resulted in a gain on the sale of assets of $954,000. The strategic sale refocused us on our core recurring revenue transcription services business. As a result of the sale of Cascade, we now operate in one, and only one, reportable business segment as a provider of medical transcription services to the healthcare industry.

In December 2004, we introduced our BeyondTXT platform, a key component of which is a speech recognition engine which is provided to us by a third party vendor under a one-year, non-exclusive license that is renewable for up to six successive one-year periods. We plan to increase gradually the percentage of voice files processed through BeyondTXT speech recognition with the objective of processing the majority of the voice files through speech recognition by the end of 2006.

On January 31, 2005, the Company acquired Medical Dictation, Inc., (“MDI”), a Florida-based medical transcription services company. The Company paid $4.8 million in cash, stock and notes for all of the stock of MDI. MDI had 2005 revenue of $9.0 million for the eleven months since the acquisition.

Effective December 30, 2005, the Company purchased certain assets of the transcription business unit of PracticeXpert. Under the terms of the agreement, Transcend paid $40,000 at closing as an advance against future earn-outs, and may pay up to $460,000 more over three years on an earn-out basis.

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BUSINESS STRATEGY

Transcend’s sole focus is providing medical transcription services to the healthcare industry. Our strategy is to succeed in the marketplace by: (1) increasing our penetration in the market; (2) maintaining and enhancing customer satisfaction; (3) sustaining technological leadership; (4) attracting and retaining talented medical language specialists (transcriptionists and editors); (5) managing internal growth effectively; and (6) helping the market to understand how our offerings are different and superior.

Increase Market Penetration

We believe that our tested and proven infrastructure will allow us to serve substantially more customers without a significant increase in fixed costs. While continuing to focus on day-to-day customer satisfaction, we intend to add new accounts to our existing customer base to efficiently utilize the capacity of the Company’s infrastructure and established customer-oriented support organization.

We have a small but experienced sales team focused on the initial sale of medical transcription services to new accounts as well as additional sales to existing customers. Our established operations management organization will act as one of several lead generation sources for the Company’s sales team.

Maintain and Enhance Customer Satisfaction

We believe that satisfied customers, who provide sales leads and references, are a significant source of new business. Accordingly, we have an ongoing program to monitor and improve customer satisfaction. This program includes continuous monitoring of transcription production statistics relative to contracted standards, periodic transcription customer surveys and a dedicated regional operations support organization that maintains regular, often daily, contact with our customers.

We have an ongoing quality program in place that is focused on improving several processes with the goal of improving our level of service. This effort will continue with the implementation of recommended solutions stemming from customer and employee surveys and activities of several quality teams.

Sustain Technological Leadership

We intend to utilize the most effective technologies available to improve the medical transcription process because we believe that the application of advanced technologies will reshape the way patient information is managed across the healthcare delivery system in the future, as well as provide margin expansion through improved business efficiencies. We have converted all of our turnkey transcription operations to an Internet-based platform (BeyondTXT), which provides significant advantages in recruiting, workflow management and production control. We will continue to invest in improving our infrastructure to yield faster turnaround times, better workflow management and increased productivity by evaluating and implementing new technologies, such as speech recognition and natural language processing. We have also made a concerted effort to ensure that our data, and that of our clients, remain confidential and secure.

Attract and Retain Professional Staff

One of our critical success factors is the recruitment and retention of the industry’s best knowledge workers (medical language specialists, application developers and service professionals). We believe that there will be a shortage of qualified traditional medical language specialists in the future. The solution to this shortage will be to attract and retain workers by offering competitive pay and benefits, stable and responsive management, a predictable abundance of work, career development opportunities and the opportunity to work from home. We believe the shortage will be mitigated by the switch to speech recognition, since the ability to edit documents (as opposed to typing them) may open the labor market to a new pool of professionals. Our knowledge workers were all U.S.-based in 2005. We now have a small pilot program in place with an offshore partner. We will evaluate this pilot during the first quarter of 2006 to determine whether or not to expand our offshore capacity. If we do so, it will represent only a small portion of our total volume during 2006.

Manage Internal Growth Effectively

We intend to grow internally through a sales force focused on both new accounts and our existing customer base. This will involve adding sales and account management resources as necessary to concentrate on revenue growth. In addition, we will selectively consider acquisitions of medical transcription companies. We believe that we have the management team in place to manage this growth.

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Increase Target Market’s Understanding of Transcend Differentiators

We have designed a proven production technology that helps to ensure the timely, accurate and secure creation and distribution of electronic medical documents. Based upon comprehensive, written annual surveys from our customers, we believe that our services can be differentiated from those of competitors by a number of factors. These factors include: fast, predictable turnaround times; consistently high accuracy and document quality; flexible distribution methodology that delivers documents securely to a variety of end-user sources including hospital information systems, faxes, printers and Web-based consoles; and a breadth and depth of offerings which we believe few in the industry can match. We can create customized transcription services that fit customer’s needs, from the large in-house department that needs a new data center, to the department that desires a complete outsourcing solution, to project-based overflow work. Our offerings utilize a range of technologies, including our BeyondTXT speech recognition tool, an advanced typing platform, a secure and reliable data center and advanced integration and distribution technologies.

SERVICES

We provide two primary transcription options for our customers. If the customer does not have its own transcription technology or no longer has the desire or resources to maintain and upgrade whatever technology it has, Transcend can provide a turnkey solution using our technology and services. If the customer has invested in its own transcription technology and wishes to keep its system in place, we can access the system and perform all transcription services using the customer’s system. This second alternative is the core offering of our Medical Dictation, Inc. (“MDI”) subsidiary, acquired on January 31, 2005.

Using the turnkey approach, powered by our Web-enabled voice and data distribution technology, Transcend’s home-based medical language specialists convert physicians’ voice recordings into electronic medical record documents. Physicians may dictate from several dictation products on the market (including handheld devices) or any phone (including hospital-or clinic-based transcription stations, an office-or home-based land line, or even a cell phone). The information is securely captured in a digital format in our central voice hub in Atlanta, Georgia. The digital voice files are then compressed, encrypted and stored. Our home-based medical language specialists securely access these files over the Internet, play back the voice recordings using headsets and foot pedals, and either transcribe the recorded voice or edit the document created by our BeyondTXT speech recognition tool to create electronic documents. The completed electronic documents are then returned to the Atlanta hub over the Internet. The documents may then be accessed by remote quality assurance personnel, if necessary, and delivered electronically to the healthcare provider. Typically, documents are produced and delivered within 24 hours of the physicians’ dictation. Documents requiring faster turnaround times, many as quickly as four hours for STAT requests, are priced at a premium. The Company’s transcription operations run around the clock, every day of the year.

Our transcription services can become the complete, outsourced transcription solution for a customer. As an alternative, customers may choose to use their own in-house transcriptionists and outsource only some percentage of their transcription needs to us (via either overflow support or by allowing their staff to use our platform with our transcriptionists). Through our Web-based network share offering, a client’s medical transcriptionists have access to the same platform that we use in our business every day, so they get all the benefits of a sophisticated system especially designed to support transcription activities, but without the concerns of purchasing, updating and supporting the technology. Because our business depends on tight security and around-the-clock availability, we believe that we have implemented the finest Virtual Private Network and encryption technology, system redundancy and fault tolerance in the industry. But even though we provide and house the technology in our data center, the customer’s data remain with the customer and is always under its control, securely partitioned from other organizations’ documents.

CUSTOMERS

We currently deliver dictation and transcription services to over 130 hospitals and clinics with recurring revenue generally under long-term contracts or other arrangements. The average level of annual revenue generated by a transcription customer is approximately $200,000, but we had several customers that each contributed annual revenue exceeding $1 million in 2005.

Revenue attributable to one contract with Providence Health System-Washington for three hospitals totaled $2,924,000, $2,292,000 and $1,572,000 or 11.2%, 15.1% and 10.7% of total revenue for 2005, 2004 and 2003, respectively. In addition, in 2005 the Company had revenue under separate agreements with approximately 40 customers who are members of Health Management Associates, Inc., a single healthcare enterprise. Revenue attributable to members of this Health Management Associates, Inc. comprised $5,813,000 or 22.2% of the Company’s total revenue for 2005.

SALES AND MARKETING

Our sales team consists of three employees managed by the Executive Vice President of Operations. Historically, our sales leads were generated from personal contacts with senior hospital executives and from client referrals. Current initiatives recognize the importance of “same store” sales and referrals; therefore the sales team also has operational responsibilities. We believe, this customer- focused, operationally-oriented approach adds credibility to our offering. We have nine additional people with some sales and account development responsibilities, including six regional operations managers and three members of the senior management team.

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Tactics we will use to build visibility and attract leads include targeted public relations, advertising in industry trade publications, direct mailings, attending key industry meetings, exploiting our presence on the Internet, building upon existing software, hardware and service vendor relationships to generate leads and/or introductions to prospects for transcription services, and utilizing customer testimonials to generate new sales leads.

COMPETITION

We experience competition from many local, regional and national businesses. The medical transcription services market, which is estimated at over $6 billion in annual expenditures, is highly fragmented with more than 1,000 companies, ranging from sole practitioners to large public companies, in the United States alone. In addition, the medical transcription industry in the United States experiences overseas competition, primarily from India. With the increasing scrutiny of the security of medical records, overseas transcription raises certain concerns, but those concerns are being addressed successfully by overseas firms. Offshore quality and turnaround time, which in the past has been problematic, has improved as low quality firms have been weeded out and the market has matured. There is a schism in the market: some customers feel very strongly that their work should not go offshore; others embrace the idea if price and quality are acceptable.

Medical transcription is either done in-house by hospital or clinic personnel or outsourced to local, regional, national or offshore vendors. Hospitals and clinics may choose to outsource for many reasons: (1) the shortage of qualified medical transcriptionists; (2) the unique and burdensome management challenges of managing a 24/7 operation that must deliver critical patient care information quickly; and/or (3) the high cost of equipping in-house personnel with the hardware, software and support necessary for their jobs. Successful transcription companies make use of technological advances in Internet access, speech recognition, security, software and hardware that allow remotely located, highly trained personnel to function as well as (or even better than) in-house employees. We believe that the principal historical competitive factors of price and quality (turnaround time and accuracy) are expanding to include other factors such as speech recognition capability, electronic security, hardware redundancy (to protect against data loss) and data integration. In addition, we believe that the ability to recruit, train and, most importantly, manage personnel nationally and internationally, coupled with the use of Internet communications, will lead to further outsourcing, and that only those companies prepared to compete using resources outside the local market will prosper.

We believe that our top eight domestic competitors are MedQuist, Spheris, Heartland, CBay Systems, Transolutions, Webmedx, TSI and Cymed. Over the past several years, the medical transcription industry has been undergoing consolidation by Spheris and others. Competition for transcription software, which is used by in-house transcription personnel, comes largely from SoftMed Systems, Dictaphone Corporation, Vianeta Communications, Arrendale Associates and other application service providers. In the area of speech recognition, Transcend saw eScription as its main competitor prior to the acquisition of MDI. However, eScription is now an important partner and MDI is actively pursuing additional eScription business.

GOVERNMENT REGULATION

Virtually all aspects of the practice of medicine and the provision of healthcare services are regulated by federal or state statutes and regulations, by rules and regulations of state medical boards and state and local boards of health, and by codes established by various medical associations. We have attempted to structure our operations to comply with these regulations. We are not presently subject to direct regulation as an outsourcing services provider. Future government regulation of the practice of medicine and the provision of healthcare services and software may impact us and require us to restructure operations in order to comply with such regulations.

HIPAA contains provisions regarding standardization, privacy, security and administrative simplification in the healthcare industry. As a result of regulations that have been proposed and enacted under HIPAA, we have made and will continue to make investments to support customer operations in areas such as:

• Electronic transactions involving healthcare information;

• Privacy of individually identifiable health information; and

• Security of healthcare information and electronic signatures.

The regulations governing the electronic exchange of information established a standard format for the most common healthcare transactions, including claims, remittance, eligibility and claims status. The regulations also establish national privacy standards for the protection of individually identifiable health information. A substantial part of our activities involves the receipt or delivery of confidential health information concerning patients of our customers in connection with the provision of transcription services to participants in the healthcare industry. We intend to ensure our compliance with the regulations to the extent they are applicable to us. The regulations may restrict the manner in which we transmit and use certain information.

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Regulations regarding security and electronic HIPAA signature standards require certain healthcare organizations to implement administrative safeguards, physical safeguards, technical security services and technical security mechanisms with respect to information that is electronically maintained or transmitted in order to protect the confidentiality, integrity and availability of individually identifiable health information.

We have designated the President of MDI as our HIPAA compliance officer and have implemented physical, technical and administrative safeguards related to the access, use and/or disclosure of individually identifiable health information to help ensure the privacy and security of this information as required by HIPAA. We have made and continue to make investments in systems to support customer operations that are regulated by HIPAA.

EMPLOYEES

As of December 31, 2005, we had 597 full-time and 319 part-time employees. These include 508 full-time and 299 part-time medical language specialists. We are not currently a party to any collective bargaining agreement, nor are our employees. We have not experienced any strikes or work stoppages, and believe that our relations with our employees are good.

ITEM 1A. RISK FACTORS

Our business, financial condition and operating results can be affected by a number of factors, including those listed below, any one of which could cause our actual results to vary materially from recent results or from our anticipated future results. Any of these risks could also materially and adversely affect our business, financial condition or the price of our common stock.

We have a history of operating losses and an investment in our common stock is extremely speculative and involves a high degree of risk.

We reported net income attributable to common stockholders of $277,000 and $840,000 in 2004 and 2003, respectively. We reported a net loss attributable to common stockholders of $1,192,000 for the year ended December 31, 2005. We reported an accumulated deficit of $25,897,000 as of December 31, 2005. As a result, there can be no assurance that we will be able to achieve and maintain profitability during 2006 and beyond. Accordingly, an investment in our common stock is extremely speculative in nature and involves a high degree of risk.

Our ability to sustain and grow profitable operations is dependent upon our ability to maintain our financing arrangements.

On December 30, 2005, we entered into a four year, $5.6 million credit facility with Healthcare Finance Group. The new facility includes a $3.6 million revolving accounts receivable-based line of credit and up to $2.0 million of term loans to fund acquisitions. The credit facility requires that the Company maintain certain financial and other covenants. If we are unable to maintain the covenants we may lose the credit facility and not only not be able to make acquisitions that could be helpful to our business, but we also would not have enough resources to repay the current debt. In addition, our credit facility restricts our ability to complete large acquisitions without Healthcare Finance Group’s consent.

Our ability to sustain and grow profitable operations is dependent upon our ability to provide additional transcription services to existing and new customers at reasonable prices.

The market for transcription services is extremely cost competitive. Our future growth is dependent on our ability to attract new customers and our ability to sell additional transcription services to our existing customers. We cannot predict whether or not we will continue to provide transcription services to our existing customers at their current levels, if at all. If we are unable to attract new customers or sell additional services to our existing customers, our revenue will likely decline.

We may not be able to recruit and hire a sufficient number of new or replacement medical language specialists to sustain or grow our current level of revenue.

We cannot provide transcription services to our customers within contracted delivery standards without an adequate number of qualified medical language specialists (“MLS’s”). MLS’s are in short supply. We rely upon in-house recruiters to hire a sufficient number of qualified MLS’s to meet our current and projected needs. We attempt to attract and retain MLS’s by offering competitive pay and benefits and the opportunity to work from home utilizing our state-of-the-art, Internet-based system. We are transitioning a

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large portion of our business from typing to editing, which we believe will allow us to attract a new supply of MLS’s. We also have the option of sourcing labor offshore. Nonetheless, there can be no assurance that we will be able to hire and retain a sufficient number of MLS’s to meet our needs. Failure to do so could have a material adverse effect on our ability to undertake additional business or to complete projects in a timely manner, which could adversely affect our operating results and financial condition.

Our inability to attract, hire or retain the necessary technical and managerial personnel could have a material adverse effect on our business, operating results and financial condition.

We are heavily dependent upon our ability to attract, retain and motivate skilled technical and managerial personnel, especially highly skilled technical, implementation and production management personnel who assist in the development, implementation and production management of the medical transcription service that we provide to our customers. The market for such individuals is intensely competitive. Due to the critical role of our system development, implementation and production management personnel, the inability to recruit successfully or the loss of a significant number of these personnel would have a material adverse effect on us. Our industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. There can be no assurance that we will be able to retain our current personnel, or that we will be able to attract, assimilate or retain other highly qualified technical and managerial personnel in the future. The inability to attract, hire or retain the necessary technical and managerial personnel could have a material adverse effect upon our business, operating results and financial condition.

The loss of our key personnel could have a material adverse effect on our business.

Our future success depends in part on the performance of our executive officers and key employees. We do not have employment agreements with any of our executive officers. The loss of the services of any of our executive officers or other key employees could have a material adverse effect on our business, operating results and financial condition.

Our success will depend on our ability to adapt to rapid technological change.

Our ability to remain competitive in the medical transcription industry is based on our ability to utilize state-of-the-art technology in the services that we provide to our customers. Accordingly, we have a substantial ongoing commitment to research and development. In this regard, we are currently investing in voice recognition and natural language processing technologies to yield faster turnaround times, better workflow management and increased productivity, all of which are essential for us to remain competitive. If we are unable to identify and implement technological changes in a timely manner, we may lose a portion of our market share, which would adversely affect our results of operations.

Reliance on key third party software.

Portions of our BeyondTXT speech recognition technology were provided to us by a third party under a one-year, non-exclusive license that is renewable for up to six successive one-year periods. Our inability to maintain the relationship with this third party or find a suitable replacement for the technology would adversely affect our results of operations.

Lack of a disaster recovery site.

In the case of a natural disaster or other disaster involving our main computer center in Atlanta, Georgia we would have no ability to transfer the processing of data to another site. Our inability to continue to transcribe for customers would adversely affect our results of operations.

We operate in a highly competitive market and can make no assurance that we will be able to compete successfully against our current or future competitors.

The market for medical transcription services is intensely competitive. We experience competition from many local, regional and national businesses. The medical transcription services market is highly fragmented with more than 1,000 companies competing in the United States alone. Our largest domestic competitors are MedQuist, Inc., Spheris, Heartland, CBay Systems, Transolutions, Webmedx, TSI and Cymed. In addition, the medical transcription industry in the United States has experienced price competition from overseas competitors located primarily in India and the Philippines. While we attempt to compete on the basis of fast, predictable turnaround times and consistently high accuracy and document quality, all offered at a reasonable price, there can be no assurance that we be able to compete effectively, if at all, against our low-priced competitors. These competitive forces could result in loss of market share, lower margins and/or increased technology investments. As a result, our business, operating results and financial condition could be materially and adversely affected.

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We are party to litigation that could have a significant adverse effect on our results of operations and financial condition.

Our Lady of the Lakes Hospital, Inc., a former customer of our former medical records contract management business, filed a lawsuit against us in 2001 alleging, among other things, that we breached certain contracts between us, including a staffing and management servicing contract, a transcription platform agreement and a marketing agreement. The former customer is seeking an unspecified amount of monetary damages from us. We denied the allegations and filed a counterclaim against the former customer seeking unpaid fees and interest thereon. While we believe that we have meritorious defenses against the allegations, an adverse judgment in the lawsuit against us could have a significant adverse effect on our results of operations and financial condition.

Our directors and executive officers own a significant amount of our common stock and will be able to exercise significant influence on matters requiring shareholder approval.

Our directors and executive officers collectively own approximately 28% of our outstanding common stock. Consequently, together they continue to be able to exert significant influence over the election of our directors, the outcome of most corporate actions requiring shareholder approval and our business, which may have the effect of delaying or precluding a third party from acquiring control of us. These transactions may include those that other shareholders deem to be in their best interest and in which these other shareholders might otherwise receive a premium for their shares over current market prices.

The market price for our common stock is extremely volatile which could cause you to lose a significant portion of your investment.

The market price of our common stock could be subject to significant fluctuations in response to certain factors, such as variations in our anticipated or actual results of operations, the operating results of other companies in the medical transcription industry, changes in conditions affecting the economy generally, general trends in the healthcare industry, sales of common stock by our insiders, as well as other factors unrelated to our operating results. Volatility in the market price of our common stock may prevent you from being able to sell your shares at or above the price you paid for your shares.

ITEM 2. PROPERTIES.

The Company leases the space for its principal office in Atlanta, Georgia under a lease that expires in October 2007. The Company leases space in Brooksville, FL for its wholly owned subsidiary Medical Dictation, Inc. under a lease that expires in November 2008. The Company leases space in Abilene, TX for a regional office that expires in May 2008. The Company also leases space in Beaverton, Oregon, which was utilized by Cascade, until select assets and the operations of Cascade were sold in May 2002. The Company sublet the Beaverton, Oregon space through April 30, 2005, at which time the Company reassumed responsibility for the lease through February 2007. See Note 5 to Consolidated Financial Statements for a summary of the Company’s lease commitments.

ITEM 3. LEGAL PROCEEDINGS.

On April 5, 2001, Our Lady of the Lakes Hospital, Inc. (“OLOL”) filed a lawsuit against the Company. The lawsuit, styled “Our Lady of the Lakes Hospital, Inc. v. Transcend Services, Inc.,” was filed in the 19th Judicial District Court, Parish of East, State of Louisiana, Civil Case Number 482775, Div. A. The lawsuit alleges, among other things, that the Company breached certain contracts entered into between OLOL and the Company, including a staffing and management servicing contract, a transcription platform agreement and a marketing agreement. OLOL is seeking an unspecified amount of monetary damages. On May 30, 2001, the Company filed a timely Answer that generally denied all liability, and the Company filed a counterclaim against OLOL primarily seeking fees owed by OLOL for services performed by the Company and interest on unpaid invoices. OLOL subsequently added Transcend’s insurance carriers as defendants to the lawsuit and later lost a court decision and related appeal in that regard. The Company intends to defend vigorously all claims made by OLOL. The lawsuit is in an early procedural stage, however, and therefore it is not possible at this time to determine the outcome of the actions or the effect, if any, that their outcome may have on the Company’s results of operations and financial condition. There can be no assurances that this litigation will not have a material adverse effect on the Company’s results of operations and financial condition.

The Company is involved in a dispute over fees payable to the Company by a third party under an earn-out provision of a prior year asset sale agreement. The dispute is being submitted to binding arbitration. The commencement date for the arbitration hearing has not been determined. At this time, it is not possible to predict the outcome of the binding arbitration process.

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

No matters were submitted to a vote of the security holders during the quarter ended December 31, 2005.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

The Company’s Common Stock is quoted on the Nasdaq SmallCap Market under the symbol “TRCR”. As of February 21, 2006 there were approximately 300 holders of record of the Company’s Common Stock. The table below sets forth for the periods indicated the high and low bid prices per share of the Company’s Common Stock as reported on the Nasdaq SmallCap Market for the periods indicated. These quotations also reflect inter-dealer prices without retail mark-ups, mark-downs or commissions, and may not necessarily represent actual transactions.

	Price Per Share of Common Stock
	High		Low
Year Ended December 31, 2005
First Quarter Ended March 31, 2005	$	3.25	$	2.75
Second Quarter Ended June 30, 2005	$	3.25	$	2.17
Third Quarter Ended September 30, 2005	$	3.18	$	2.19
Fourth Quarter Ended December 31, 2005	$	2.45	$	1.87
Year Ended December 31, 2004
First Quarter Ended March 31, 2004	$	5.25	$	3.68
Second Quarter Ended June 30, 2004	$	4.55	$	2.88
Third Quarter Ended September 30, 2004	$	3.33	$	2.70
Fourth Quarter Ended December 31, 2004	$	3.15	$	2.50

On December 30, 2005, Transcend Services, Inc. entered into a four year $5.6 million credit facility with Healthcare Finance Group. The credit facility with Healthcare Finance Group includes a Stock Purchase Warrant to purchase 100,000 shares of Transcend Services, Inc. $.05 par value common stock at a price of $2.25 per share. The election to purchase the stock is available between December 30, 2005 and the later of December 29, 2009 or 90 days following the date that the loans are paid in full. Neither this warrant, nor the shares of common stock for which it is exercisable, have been registered under the securities act of 1933 and no transfer or assignment of this warrant or the shares issuable upon its exercise may be made in the absence of an effective registration statement under such act or the availability of an exemption in fact from the registration provisions of such act in respect of such transfer or assignment. The issuance of these securities was made pursuant to a claim of exemption from registration under the Securities Act of 1933, as amended, by virtue of Section 4(2) and/or Regulation D promulgated thereafter.

The Company’s policy is to retain earnings for the expansion and development of the Company’s business. The Company does not anticipate paying cash dividends on its Common Stock in the foreseeable future.

See Note 9 of Notes to Consolidated Financial Statements for information with respect to the Company’s equity compensation plans.

ITEM 6. SELECTED FINANCIAL DATA

The following table sets forth selected consolidated financial data of the Company for the periods indicated, derived from the Company’s consolidated financial statements. The report of Miller Ray Houser & Stewart, independent public accountants, with respect to such consolidated financial statements as of December 31, 2005 and 2004 and for each of the three years in the period ended December 31, 2005 is included in Item 8. This selected financial data should be read in conjunction with the consolidated financial statements, related notes and other financial information included and incorporated by reference in this Form 10-K.

Selected Financial Data	2001			2002		2003		2004		2005
(in thousands, except per share data)
Results of Operations: (1)
Revenue	$	11,817		$	12,225	$	14,663	$	15,197	$	25,817
Income (loss) from operations	$	(214	)	$	42	$	1,030	$	299	$	(817	)
Income (loss) before discontinued operations	$	(139	)	$	999	$	1,020	$	277	$	(1,192	)
Income (loss) before discontinued operations per common share	$	(0.14	)	$	0.11	$	0.14	$	0.04	$	(0.16	)
Diluted weighted average shares of common stock		4,404			4,547		6,117		7,631		7,592
Financial Position at Year End:
Total assets	$	3,128		$	3,215	$	3,346	$	3,471	$	10,260
Total debt	$	0		$	0	$	200	$	0	$	5,062
Stockholders’ equity	$	2,009		$	2,421	$	2,440	$	2,729	$	2,616

(1) Certain prior year results related to the operations of Cascade have been reclassified to loss from discontinued operations for comparative purposes.

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

Certain information included in this Annual Report on Form 10-K contains, and other reports or materials filed or to be filed by the Company with the Securities and Exchange Commission (as well as information included in oral statements or other written statements made or to be made by the Company or its management) contain or will contain, “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, Section 27A of the Securities Act of 1933, as amended and pursuant to the Private Securities Litigation Reform Act of 1995. Such forward-looking statements may relate to financial results and plans for future business activities, and are thus prospective. Such forward-looking statements are subject to risks, uncertainties and other factors that could cause actual results to differ materially from future results expressed or implied by such forward-looking statements. Among the important factors that could cause actual results to differ materially from those indicated by such forward-looking statements are competitive pricing pressures, loss of significant customers, the mix of revenue, changes in pricing policies, delays in revenue recognition, lower-than-expected demand for the Company’s products and services, business conditions in the integrated health care delivery network market, the effect of future acquisitions, if any, and the risk factors detailed from time to time in the Company’s periodic reports and registration statements filed with the Securities and Exchange Commission. Any forward-looking statements are made pursuant to the Private Securities Litigation Reform Act of 1995 and as such speak only as of the date made.

The Company’s consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America, which require management to make estimates and assumptions that affect the reported amounts and

11

disclosures in the Company’s financial statements and accompanying notes. Actual results could differ from those estimates. A summary of the Company’s significant accounting policies is contained in Note 1 of Notes to Consolidated Financial Statements. The Company believes that none of these accounting policies are extraordinarily complex or require an unusual degree of judgment as these policies relate to the Company’s operations and financial condition.

The following discussion should be read in conjunction with the consolidated financial statements of the Company, including the notes thereto, contained elsewhere in this report.

OVERVIEW

Transcend provides medical transcription services to the healthcare industry. Powered by our Web-based voice and data distribution technology, our home-based medical language specialists document patient care by converting physicians’ voice recordings into electronic medical record documents.

On January 31, 2005 we completed the acquisition of Medical Dictation, Inc. (“MDI”). On April 6, 2005, we fulfilled the prerequisites for receiving the proceeds under a Promissory Note dated March 1, 2005 payable to the Development Corporation of Abilene, Inc. (“DCOA”) in the principal amount of $1,000,000. On December 30, 2005, we entered into a four year $5.6 million credit facility with Healthcare Finance Group. These transactions have had a material effect on the Company’s financial statements for the year ended December 31, 2005 and are expected to have a material effect on future periods.

Critical Accounting Estimates which are Material to Registrant

A critical accounting estimate meets two criteria: (1) it requires assumptions about highly uncertain matters; and (2) there would be a material effect on the financial statements from either using a different, also reasonable, amount within the range of the estimate in the current period or from reasonably likely period-to-period changes in the estimate. Our critical accounting estimates are as follows:

Goodwill and Intangible Assets. As of December 31, 2005, we reported goodwill and intangible assets at carrying amounts of $3.7 million and $474,000, respectively. The total of $4.2 million represents approximately 41% of total assets as of December 31, 2005. Our intangible assets are amortized over their estimated useful lives. The Goodwill and intangible assets are associated with two acquisitions during 2005. The Company had no goodwill or intangibles as of December 31, 2004.

We will review goodwill and intangibles for impairment annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. In testing for impairment, we will calculate the fair value of the reporting units to which the goodwill and intangibles relate based on the present value of estimated future cash flows. The approach utilized will be dependent on a number of factors including estimate of future revenues and costs, appropriate discount rates and other variables. We will base our estimates on assumptions that we believe to be reasonable, but which are unpredictable and inherently uncertain. Therefore, future impairments could result if actual results differ from those estimates.

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

Revenue increased $10.6 million, or 70%, to $25.8 million in 2005, compared to revenue of $15.2 million in 2004. The increase in revenue is primarily attributable to the acquisition of MDI on January 31, 2005. MDI contributed revenue of $9.0 million for the year ended December 31, 2005. Excluding MDI, revenue increased $1.6 million, or 11%, during 2005. The net increase in revenue excluding MDI is primarily attributable to: (1) transcription revenue of $986,000 from new transcription customers; (2) a decrease of $74,000 in transcription revenue from customers that terminated contracts since December 31, 2004; (3) an increase in transcription revenue of $441,000 from existing customers; and (4) and increase of $29,000 in other revenue.

Direct costs increased $10.5 million, or 96%, to $21.4 million in 2005, compared to $10.9 million in 2004. The increase in direct costs is due primarily to the acquisition of MDI. MDI accounted for $7.4 million in direct costs during 2005. Direct costs include costs attributable to compensation for transcriptionists, recruiting of transcriptionists, production management, customer service, technical support for production operations, implementation of transcription services and depreciation and amortization related to production operations. Transcription compensation is a variable cost based on lines transcribed or edited multiplied by specified per-line pay rates that vary by individual as well as type of work. All direct costs referred to above other than compensation for transcriptionists are semi-variable production infrastructure costs that periodically change in anticipation of or in response to the overall level of production activity. Compensation for transcriptionists increased $8.9 million due to the overall increase in revenue of $10.6 million referred to above, most of which related to the acquisition of MDI. The remaining net increase in direct costs of $1.7 million was attributable to a net increase in production infrastructure costs to support a higher level of revenue that was not achieved and to train and transition transcriptionists to become speech recognition editors. The production infrastructure costs increased primarily due to additional recruiting and training costs, higher implementation expenses and higher compensation costs related to a reorganization that we anticipate will ultimately help us provide a higher level of customer service more efficiently.

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Gross profit increased $158,000, or 4%, to $4.4 million in 2005, compared to $4.3 million in 2004. Gross profit as a percentage of revenue decreased to 17.2% in 2005 compared to 28.2% in 2004. This decrease of 11 percentage points is primarily due to the increase in production infrastructure costs discussed above in anticipation of a projected revenue level that was not achieved in 2005 offset by the increase in gross profit due to the acquisition of MDI.

Sales and marketing expenses decreased $184,000, or 17%, to $893,000 in 2005, compared to $1.1 million in 2004. Sales and marketing expenses as a percentage of revenue in 2005 were 3% compared to 7% in 2004. The decrease in sales and marketing expense is primarily due to a reduction of the sales force during 2005. Much of the responsibility for sales has been shifted to operations management, the cost of which is reflected in direct costs.

Research and development expenses increased $60,000, or 17%, to $411,000 in 2005, compared to $351,000 in 2004. Research and development expenses as a percentage of revenue remained constant at 2% for both 2005 and 2004. The absolute dollar increase in research and development expenses as a percentage of revenue is primarily attributable to the addition of staff in order to integrate speech recognition technology into the Company’s platform. The Company believes that the current size of its research and development staff is sufficient to accomplish its planned research and development activities for the foreseeable future.

The Company capitalized internal software development costs of $200,000 and $199,000 for the years ended December 31, 2005 and 2004, respectively. Amortization expense for the years ended December 31, 2005 and 2004 was $52,000 and $6,000, respectively.

General and administrative expenses increased $1.4 million, or 55%, to $3.9 million in 2005, compared to $2.6 million in 2004. General and administrative expenses as a percentage of revenue were 15% in 2005 compared to 17% in 2004. This net dollar increase was primarily due to the addition of MDI, additional compensation, the cost of the Company’s performance improvement program introduced in December 2004, and increased group medical insurance and rent expense.

The Company reported expense of $372,000 in net other income (expense) in 2005, primarily due to $208,000 of interest on the note for the purchase of MDI and the borrowings on the line of credit and $100,000 in fees related to the closing of the new line of credit and acquisition loan. In 2004, the Company reported net other income (expense) of $21,000 primarily due to $5,000 of interest on sales tax returns, amortization expense of $8,000 for line of credit facility fees and interest of $1,000 on the promissory note payable related to the 2003 preferred stock redemption that was paid in full on April 1, 2004

The Company reported an income tax provision of $3,000 in 2005 and $1,000 in 2004 due to the expiration of certain state net operating loss carryforwards in 2004. The Company has net operating loss carryforwards of approximately $20 million as of December 31, 2005.

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

Revenue increased $534,000, or 4%, to $15.2 million in 2004, compared to revenue of $14.7 million in 2003. The net increase in revenue is primarily attributable to: (1) transcription revenue of $1,298,000 from new transcription customers; (2) a net decrease of $1,999,000 in transcription revenue from customers that terminated or announced their intention to terminate contracts since 2003; (3) a net increase in transcription revenue of $1,277,000 from existing customers; and (4) a decrease of $42,000 in other revenue.

Direct costs increased $875,000, or 9%, to $10.9 million in 2004, compared to $10.0 million in 2003. Direct costs include costs attributable to compensation for transcriptionists, recruiting of transcriptionists, production management, customer service, technical support for production operations, implementation of transcription services and depreciation and amortization related to production operations. Transcription compensation is a variable cost based on lines transcribed or edited multiplied by specified per-line pay rates that vary by individual as well as type of work. The per-line pay rates are higher for transcription work on the Company’s transcription platform than for transcription and editing work on a third-party’s voice recognition platform, used for approximately 10% and 4% of the Company’s revenue for 2004 and 2003, respectively. All direct costs referred to above other than compensation for transcriptionists are semi-variable production infrastructure costs that periodically change in anticipation of or in response to the overall level of production activity. Compensation for transcriptionists increased $365,000 due to the overall increase in revenue of $534,000 referred to above. The remaining net increase in direct costs of $510,000 was attributable to a net increase in production infrastructure costs to support a higher level of projected revenue, some of which was not achieved. Production management, the largest component of production infrastructure costs, increased $432,000, due primarily to the addition of quality control and documentation personnel to support a higher level of projected production activity and revenue, some of which was not achieved. The remaining production infrastructure costs increased $78,000 between 2004 and 2003.

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Gross profit decreased $341,000, or 7%, to $4.3 million in 2004, compared to $4.6 million in 2003. Gross profit as a percentage of revenue decreased to 28.2% in 2004 compared to 31.5% in 2003. This decrease of 3.3 percentage points is primarily due to: (i) an increase in production infrastructure costs, in particular in the production management area as discussed above, in anticipation of a projected revenue level that was not achieved in 2004, which accounted for 2.9 percentage points of the 3.3 percentage point unfavorable variance, and (ii) the incremental training costs associated with the introduction of the speech recognition platform. In addition, a higher mix of transcription work being performed on a third party’s voice recognition platform resulted in lower margins in 2004 compared to 2003.

Sales and marketing expenses increased $223,000, or 26%, to $1.1 million in 2004, compared to $854,000 in 2003. Sales and marketing expenses as a percentage of revenue in 2004 were 7% compared to 6% in 2003. The increase in sales and marketing expense is primarily due to an increase in the size of the sales force that resulted in higher levels of salaries, commissions on new sales and travel expenses. Additionally, in 2004 the Company participated in the AHIMA trade show for the first time. The higher trade show costs were offset by lower marketing collateral expenses in 2004.

Research and development expenses decreased $92,000, or 21%, to $351,000 in 2004, compared to $443,000 in 2003. Research and development expenses as a percentage of revenue in 2004 were 2% compared to 3% in 2003. During 2004, the Company capitalized internal software development costs of $155,000 related to the development of a speech recognition technology platform and enhancements to the Company’s billing system. In addition, the Company reduced its consulting fees related to the development and enhancements of the speech recognition and Web-based platforms in 2004. Partially offsetting these reductions of costs were the reassignment of technology resources from other areas to work on technology development projects.

During 2004, the Company capitalized $199,000 of salary expense (including the $155,000 referred to above) related to the development of a speech recognition technology platform, enhancements to the Company’s billing system and data distribution technology platform and development of interfaces for the Company’s enterprise transcription platform to various medical records systems.

General and administrative expenses increased $259,000, or 11%, to $2.6 million in 2004, compared to $2.3 million in 2003. General and administrative expenses as a percentage of revenue were 17% in 2004 compared to 16% in 2003. This net increase was primarily due to a state business and occupation tax assessment of $83,000 and increases in state franchise business taxes, as the Company’s operations have expanded to 48 states. In addition, regulatory reporting expenses and rent expenses increased in 2004.

The Company reported net interest expense of $21,000 in 2004, primarily due to $5,000 of interest on sales tax returns, amortization expense of $8,000 for line of credit facility fees and interest of $1,000 on the promissory note payable related to the 2003 preferred stock redemption that was paid in full on April 1, 2004. In 2003, The Company reported net interest expense of $16,000 comprised primarily of $4,000 related to the amortization expense for the line of credit facility and $4,000 related to interest on the short-term promissory notes.

The Company reported an income tax provision of $1,000 in 2004 due to the expiration of certain state net operating loss carryforwards in 2004 and no income tax provision in 2003. The Company has net operating loss carryforwards of approximately $19 million as of December 31, 2004.

OFF-BALANCE SHEET ARRANGEMENTS

Other than operating lease obligations discussed below, the Company does not have any off-balance sheet arrangements.

CONTRACTUAL OBLIGATIONS

The Company has the following contractual obligations as of December 31, 2005:

	Payments due by period
Contractual Obligation	Total		Less than 1 year		1 - 3 years		3 - 5 years		More than 5 years
in (000’s)
Long-term debt obligations		5,829		767		2,333		1,879		850
Capital lease obligations
Operating lease obligations		1,968		887		1,055		26
Purchase obligations
Other long-term liabilities
Total	$	7,797	$	1,654	$	3,388	$	1,905	$	850

LIQUIDITY AND CAPITAL RESOURCES

The Company’s current financial condition has been significantly influenced by four factors: (1) the acquisition of MDI; (2) receipt of $1,000,000 related to the interest-free economic development loan to establish a training facility and hire medical language specialists in Abilene, Texas; (3) unprofitable and cash flow negative operations during 2005; and (4) a new credit facility described below.

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On December 30, 2005, the Company entered into a four year $5.6 million credit facility with Healthcare Finance Group. This new facility replaced the previous $2.0 credit facility with Bank of America, N.A. The new facility matures on December 30, 2009 and includes a $3.6 million revolving accounts receivable-based line of credit and up to $2.0 million of term loans to fund acquisitions. See Note 4 to the Notes to Financial Statements. As of December 31, 2005, the Company had $5.8 million of debt ($767,000 of which matured and was repaid on January 31, 2006). As of December 31, 2005, the Company had cash and cash equivalents of $762,000, working capital of $1.5 million, $324,000 available under the $3.6 million line of credit (this includes $1.0 million reserved for a note payable due January 31, 2006) and $2.0 million available for acquisitions.

Net cash used in operating activities totaled $875,000 in 2005, due primarily to the net loss from operations of ($817,000) partially offset by non-cash depreciation and amortization expenses.

Net cash used in investing activities totaled $2.1 million in 2005, and was comprised primarily of $1.3 million related to the acquisition of MDI on January 31, 2005 and net capital expenditures of $635,000.

Net cash used in financing activities during the 2005 totaled $3.3 million and consisted of $1.9 million of borrowings on the line of credit, $380,000 of proceeds from the issuance of stock (primarily related to the purchase of MDI) and $1,000,000 from the issuance of promissory notes.

Aside from cash available under its line of credit referred to above, during 2006 the Company has potential cash resources of an undetermined amount of earn-out payments, if any, payable by Provider HealthNet Services, Inc. (“PHNS”) based on a fixed percentage of certain defined future revenue recognized by PHNS from the Co-Sourcing and CodeRemote businesses sold to PHNS by Transcend in October 2000. However, the Company is involved in a dispute with PHNS over fees payable to the Company.

In addition, the Company is a defendant in a lawsuit. See Note 5 of the Notes to the Consolidated Financial Statements included with this report and “Legal Proceedings”.

Absent a material adverse outcome from the lawsuit, the Company anticipates that cash on hand, together with internally generated funds, cash available under its credit facility and potential cash from the PHNS earn-out agreement, if any, should be sufficient to finance operations and make capital investments in the normal and ordinary course of its business during 2006 and for the foreseeable future.

IMPACT OF INFLATION

Inflation has not had a material effect on the Company to date. However, the effects of inflation on future operating results will depend in part on the Company’s ability to increase prices or lower expenses, or both, in amounts that offset inflationary cost increases.

ITEM 7A. QUANTATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

The Company had no material exposure to market risk from derivatives or other financial instruments as of December 31, 2005.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The following financial statements are filed with this report:

Report of Independent Public Accountants

Consolidated Balance Sheets as of December 31, 2005 and 2004

Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2005, 2004 and 2003

Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003

Notes to Consolidated Financial Statements

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REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To the Board of Directors and Stockholders of Transcend Services, Inc.:

We have audited the accompanying consolidated balance sheets of Transcend Services, Inc. (a Delaware corporation) and subsidiary as of December 31, 2005 and 2004 and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Transcend Services, Inc. and subsidiary as of December 31, 2005 and 2004 and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America.

/s/ Miller Ray Houser & Stewart LLP

Atlanta, Georgia

February 1, 2006

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TRANSCEND SERVICES, INC.

CONSOLIDATED BALANCE SHEETS

	December 31,
	2005			2004
ASSETS
Current assets:
Cash and cash equivalents	$	762,000		$	458,000
Accounts receivable, net of allowances for doubtful accounts of $23,000 and $18,000 at December 31, 2005 and 2004, respectively		3,174,000			1,153,000
Prepaid expenses and other current assets		142,000			170,000
Total current assets		4,078,000			1,781,000
Property and equipment:
Computer equipment		3,215,000			2,423,000
Software		2,721,000			2,503,000
Furniture and fixtures		285,000			214,000
Total property and equipment		6,221,000			5,140,000
Accumulated depreciation and amortization		(4,555,000	)		(3,477,000	)
Property and equipment, net		1,666,000			1,663,000
Intangible assets:
Goodwill		3,694,000			—
Other intangible assets		575,000			—
Accumulated amortization		(101,000	)		—
Intangible assets, net		4,168,000			—
Other assets		348,000			27,000
Total assets	$	10,260,000		$	3,471,000
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Promissory notes payable		767,000		$	—
Accounts payable		243,000			79,000
Accrued compensation and benefits		787,000			417,000
Other accrued liabilities		749,000			246,000
Total current liabilities		2,546,000			742,000
Line of credit borrowings - long-term		1,879,000			—
Promissory notes payable - long-term		3,183,000			—
Other liabilities - long-term		36,000			—
Commitments and contingencies (Note 4)		—			—
Stockholders’ equity:
Preferred Stock, $.01 par value; 2,000,000 shares authorized and no shares outstanding at December 31, 2005 and December 31, 2004		—			—
Common Stock, $.05 par value; 15,000,000 shares authorized at December 31, 2005 and 2004; 7,876,000 and 7,332,000 shares issued and outstanding at December 31, 2005 and 2004, respectively		394,000			367,000
Additional paid-in capital		28,119,000			27,067,000
Accumulated deficit		(25,897,000	)		(24,705,000	)
Total stockholders’ equity		2,616,000			2,729,000
Total liabilities and stockholders’ equity	$	10,260,000		$	3,471,000

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

17

TRANSCEND SERVICES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

	Years Ended December 31,
	2005			2004			2003
Revenue	$	25,817,000		$	15,197,000		$	14,663,000
Direct costs		21,381,000			10,919,000			10,044,000
Gross profit		4,436,000			4,278,000			4,619,000
Operating expenses:
Marketing and sales		893,000			1,077,000			854,000
Research and development		411,000			351,000			443,000
General and administrative		3,949,000			2,551,000			2,292,000
Total operating expenses		5,253,000			3,979,000			3,589,000
Operating (loss) income		(817,000	)		299,000			1,030,000
Gains on sales of assets		—			—			6,000
Interest expense, net		(254,000	)		(21,000	)		(16,000	)
Other income (expense), net		(118,000	)		—			—
Income (loss) before taxes		(1,189,000	)		278,000			1,020,000
Income tax provision		(3,000	)		(1,000	)		—
Net income (loss)		(1,192,000	)		277,000			1,020,000
Dividends on preferred stock					0			(180,000	)
Net income (loss) attributable to common shareholders	$	(1,192,000	)	$	277,000		$	840,000
Basic earnings (loss) per share:
Net earnings (loss) per share attributable to common shareholders	$	(0.16	)	$	0.04		$	0.14
Weighted average shares outstanding		7,592,000			7,328,000			5,935,000
Diluted earnings (loss) per share:
Net earnings (loss) per share attributable to common shareholders	$	(0.16	)	$	0.04		$	0.14
Weighted average shares outstanding		7,592,000			7,631,000			6,117,000

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

18

TRANSCEND SERVICES, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

	Series A Preferred Stock			Series B Preferred Stock			Common Stock		Additional Paid-in Capital			Accumulated Deficit			Stockholders’ Equity
Balance, December 31, 2002	$	2,000		$	1,000		$	220,000	$	28,020,000		$	(25,822,000	)	$	2,421,000
Net income attributable to common stockholders		—			—			—		—			840,000			840,000
Conversion and Redemption of Preferred Stock		(2,000	)		(1,000	)		144,000		(962,000	)		—			(821,000	)
Balance, December 31, 2003		—			—			364,000		27,058,000			(24,982,000	)		2,440,000
Net income attributable to common stockholders		—			—			—		—			277,000			277,000
Issuance of Common Stock , net								3,000		9,000			—			12,000
Balance, December 31, 2004		—			—			367,000		27,067,000			(24,705,000	)		2,729,000
Net income attributable to common stockholders													(1,192,000	)		(1,192,000	)
Issuance of Common Stock from purchase of MDI								5,000		295,000						700,000
Issuance of restricted shares of Common Stock								12,000		544,000						156,000
Other Issuance of Common Stock, net								10,000		123,000						133,000
Amortization of restricted stock and stock warrant compensation expense										90,000						90,000
Balance, December 31, 2005	$	—		$	—		$	394,000	$	28,119,000		$	(25,897,000	)	$	2,616,000

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

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TRANSCEND SERVICES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Years Ended December 31,
	2005			2004			2003
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income attributable to common stockholders	$	(1,192,000	)	$	277,000		$	840,000
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		972,000			793,000			667,000
Non cash revenue-debt forgiven		(150,000	)		—			—
Gains on sales of assets		—			—			(6,000	)
Preferred Stock dividends		—			—			180,000
Changes in assets and liabilities:
Accounts receivable, net		(1,428,000	)		153,000			(359,000	)
Unbilled accounts receivable		590,000			—			—
Prepaid expenses and other current assets		36,000			46,000			(115,000	)
Other assets		(321,000	)		21,000			21,000
Accounts payable		124,000			(30,000	)		(45,000	)
Accrued liabilities		457,000			(13,000	)		(43,000	)
Deferred gain on sale and leaseback of assets		36,000			—			—
Total adjustments		316,000			970,000			300,000
Net cash provided by (used in) operating activities		(876,000	)		1,247,000			1,140,000
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures, net		(913,000	)		(1,159,000	)		(568,000	)
Proceeds from disposition of assets		278,000			—			—
Purchase of business, net of cash acquired		(1,305,000	)		—			—
Adjustment to purchase price for previous acquisition		(139,000	)		—			—
Net cash used in investing activities		(2,079,000	)		(1,159,000	)		(568,000	)
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings on lines of credit		1,879,000			—			—
Promissory notes		1,000,000			(200,000	)		—
Proceeds from issuances of common stock		380,000			12,000			—
Redemption of Preferred Stock		—			—			(600,000	)
Preferred Stock dividends		—			—			(110,000	)
Preferred Stock redemption/conversion expenses		—			—			(86,000	)
Net cash provided by (used in) financing activities		3,259,000			(188,000	)		(796,000	)
Net change in cash and cash equivalents		304,000			(100,000	)		(224,000	)
Cash and cash equivalents, at beginning of year		458,000			558,000			782,000
Cash and cash equivalents at end of year	$	762,000		$	458,000		$	558,000
Supplemental cash flow information:
Cash paid for interest expense	$	79,000		$	21,000		$	19,000
Cash paid for income taxes	$	3,000		$	4,400		$	—
Non cash investing and financing activities:
Issuance of promissory notes payable in conjunction with the redemption of Preferred Stock	$	—		$	—		$	200,000
Issuance of Common Stock in lieu of Preferred Stock cash dividends	$	—		$	—		$	70,000
Non cash capital expenditures	$	—		$	75,000		$	—
Promissory note in connection with the acquisition of MDI	$	3,100,000
Issuance of unregistered stock in connection with the acquisition of MDI	$	700,000		$	—		$	—
	$	3,800,000		$	—		$	—

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

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TRANSCEND SERVICES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

DECEMBER 31, 2005, 2004 AND 2003

1. NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

NATURE OF BUSINESS

Transcend Services, Inc. (the “Company”) provides medical transcription services to the healthcare industry. Powered by its Web-based voice and data distribution technology, the Company’s home-based medical language specialists document patient care by converting physicians’ voice recordings into electronic medical record documents.

BASIS OF PRESENTATION

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary, Medical Dictation, Inc. acquired on January 31, 2005. All intercompany accounts and transactions have been eliminated in consolidation.

ACCOUNTING ESTIMATES

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

CASH AND CASH EQUIVALENTS

All highly liquid investments purchased with an original maturity of three months or less are classified as cash equivalents.

ACCOUNTS RECEIVABLE

Accounts receivable are recorded net of an allowance for doubtful accounts established to provide for losses on uncollectible accounts based on management’s estimates and historical collection experience. Charges for bad debts were $5,000, $0 and $14,000 in 2005, 2004 and 2003, respectively.

REVENUE AND COST RECOGNITION

Transcription service fee revenue is recognized as the related transcription work is performed on the basis of the number of lines transcribed times the contracted billing rate per line transcribed. Implementation fees related to transcription services are recognized on the basis of hours worked by each implementation person times the contracted hourly billing rate applicable to each such implementation person. WebConsole user fees and interface maintenance fees are billed annually in advance, but revenue is recognized monthly on a straight-line basis over the applicable service period.

PROPERTY AND EQUIPMENT

Property, equipment and software are stated at cost, less accumulated depreciation or amortization. Charges for depreciation and amortization of capital assets are computed generally using the straight-line method over their estimated useful lives, which range from three to seven years, and are included in direct costs and general and administrative expenses in the accompanying consolidated statements of operations. Depreciation and amortization expense totaled $1.1 million, $793,000, and $667,000 in 2005, 2004 and 2003, respectively.

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Effective April 1, 2002, the Company changed the estimated useful life of its proprietary transcription system from four to six years to reflect the success of the Company’s ongoing software maintenance efforts, which are expensed as incurred, in extending the useful life of the system. This change increased amortization expense by approximately $178,000 ($.02 per share) in 2005 and $178,000 ($0.02 per share) in 2004, and reduced amortization expense by $204,000 ($0.03 per share) in 2003. The transcription system was fully amortized by December 31, 2005.

All costs in the internal software development process that are classified as research and development are expensed as incurred until technological feasibility has been established. Once technological feasibility has been established, such costs are considered for capitalization. The Company’s policy is to amortize these costs either using the straight-line method or using the percent utilization method over the remaining estimated economic life of the product, not to exceed seven years. Software development costs were capitalized totaling $200,000 in 2005, $499,000 in 2004 and $17,000 in 2003, which related to internally developed software.

OTHER ASSETS

Other assets consist primarily of deferred costs of financing and deposits for rented facilities.

GOODWILL AND OTHER INTANGIBLE ASSETS

The Company accounts for goodwill and other intangible assets in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets. Under the provisions of this Statement, goodwill and intangible assets that have indefinite useful lives are tested at least annually for impairment rather than being amortized like intangible assets with finite useful lives, which are amortized over their useful lives. The Company has net intangibles of $474,000 and goodwill of $3.7 million at December 31, 2005 related to the acquisitions of MDI and PracticeXpert during 2005. There was no goodwill or intangible assets as of December 31, 2004 and 2003.

In connection with certain of Transcend’s acquisitions, Transcend allocated a portion of the purchase price to acquired customer relationships and covenants-not-to-compete based on appraisals and discounted cash flow analysis. The estimated fair values attributed to the relationships and covenants are being amortized over a period of five years, which represented the estimated average remaining lives of the contracts and relationships.

The Company accounts for long-lived assets such as property and equipment and purchased intangible assets with finite lives under the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. This Statement requires that such long-lived assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future undiscounted net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the estimated fair value of the assets based on a discounted cash flow approach or, when available and appropriate, to comparable market values. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost to sell. In management’s opinion, the long-lived assets are appropriately valued in the accompanying balance sheets.

FAIR VALUE OF FINANCIAL INSTRUMENTS

In accordance with SFAS No. 107, Disclosures About Fair Value of Financial Instruments, the fair value of short-term debt, which totaled $767,000 as of December 31, 2005, was estimated to approximate its carrying value. There was no short-term debt as of December 31, 2004. The fair value of long-term debt is estimated based on approximate market interest rates for similar issues. The Company had long-term debt at December 31, 2005 of $5.1 million and no long-term debt as of December 31, 2004. The Company’s other financial instruments approximate fair value due to the short-term nature of those assets and liabilities.

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STOCK-BASED COMPENSATION

In accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, the Company measures stock-based compensation expense as the excess of the market price on date of grant over the amount of the grant. The Company grants stock-based compensation at the market price on the date of grant as well as below the market price, therefore compensation expense is recognized when stock is granted at below the market price on the date of grant.

In December 2004, the Financial Accounting Standards Board (“FASB”) published Statement of Financial Standards No. 123 (revised 2004) “Share-Based Payment” (“SFAS 123R”). The provisions of SFAS 123R become generally accepted accounting principles beginning January 1, 2006. Such provisions will affect the way that the Company accounts for stock-based compensation plans and will result in increased compensation expense of a presently indeterminable amount being included in the Company’s results of operations after the effective date of such provisions. As permitted, prior to the effectiveness of SFAS 123R, the Company has elected to adopt only the disclosure provisions of SFAS No. 123, Accounting for Stock-based Compensation (see Note 9 and “Recent Accounting Pronouncements” below).

If the Company had accounted for these plans in accordance with SFAS No. 123, the Company’s reported and pro forma net income for the years ended December 31, 2005, 2004 and 2003 would have been as follows:

	2005			2004		2003
Net income attributable to common stockholders:
As reported	$	(1,192,000	)	$	277,000	$	840,000
Pro forma		(1,349,000	)	$	46,000	$	744,000
Basic and diluted net income per share attributable to common stockholders:
As reported	$	(0.16	)	$	0.04	$	0.14
Pro forma		(0.18	)	$	0.01	$	0.12

INCOME TAXES

The Company accounts for its income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109. Deferred tax assets and liabilities, if any, are recognized for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their reported amounts and for operating loss and tax credit carryforwards. The Company records a valuation allowance to reduce the deferred tax assets to the amount that is more likely than not to be realized.

NET EARNINGS PER SHARE

The Company follows SFAS No. 128, Earnings per Share. That statement requires the disclosure of basic net earnings (loss) per share and diluted net earnings (loss) per share. Basic net earnings (loss) per share is computed by dividing net income (loss) available to common shareholders by the weighted average number of common shares outstanding during the period and does not include any other potentially dilutive securities. Diluted net income (loss) per share gives effect to all potentially dilutive securities. The Company’s stock options and warrants to purchase common stock are potentially dilutive securities.

The reconciliation of the numerators and denominators of the basic and diluted EPS calculations is shown below:

	Year Ended December 31,
	2005			2004		2003
Numerator:
Net income from continuing operations	$	(1,192,000	)	$	277,000	$	840,000
Denominator:
Weighted average shares outstanding		7,592,000			7,328,000		5,935,000
Denominator for basic calculation		7,592,000			7,328,000		5,935,000
Effect of dilutive securities:
Common stock options		—			275,000		182,000
Common stock warrant		—			28,000		—
Denominator for diluted calculation		7,592,000			7,631,000		6,117,000
Basic earning per share	$	(0.16	)	$	0.04	$	0.14
Diluted earnings per share	$	(0.16	)	$	0.04	$	0.14

CREDIT RISK

The Company’s accounts receivable potentially subject the Company to credit risk, as collateral is generally not required. The Company’s risk of loss is limited due to the ability to terminate access on most delinquent accounts. The carrying amount of the Company’s receivables approximates their fair values. The Company monitors the financial condition of the institutions in which it has depository accounts and believes the risk of loss is minimal.

2. ACQUISITIONS

Transcend acquired Medical Dictation, Inc. (“MDI”) on January 31, 2005 in a stock purchase transaction accounted for as a purchase. MDI is a Florida-based medical transcription service company. Transcend paid $4.8 million, consisting of a $3.5 million promissory note, $1.0 million in cash and $300,000 of Transcend common stock, and incurred acquisition-related costs of approximately $400,000. The consideration exchanged exceeded the value of the net tangible assets acquired by approximately $4.2 million, which was allocated as follows:

$50,000 to covenants-not-to-compete to be amortized over a period of five years;

$500,000 to customer relationships to be amortized over a period of five years; and

$3.7 million to goodwill.

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All goodwill and other intangible asset amortization related to the acquisition of MDI are expected to be deductible for income tax purposes. Transcend has included the results of operations of the acquired company in its financial statements from the date of acquisition.

The following unaudited proforma consolidated financial information for the twelve months ended December 31, 2005 and 2004 assumes the acquisition of MDI had occurred at the beginning of each period presented:

	2005			2004
Revenue	$	26,438,000		$	21,624,000
Net (loss) income		(1,152,000	)		246,000
Net (loss) income per share (diluted)	$	(0.15	)	$	0.03

Effective December 30, 2005, the Company purchased certain assets of the transcription business unit of PracticeXpert. Under the terms of the agreement, the Transcend will pay up to $500,000 over three years, on an earn-out basis. The consideration exchanged exceeded the value of the net tangible assets acquired by approximately $139,000, which was allocated as follows: $25,000 to customer relationships to be amortized over a period of five years and $114,000 to goodwill.

3. INTANGIBLE ASSETS

Intangibles assets at December 31, 2005 and 2004 are summarized as follows (in thousands):

		December 31, 2005						December 31, 2004
	Useful Life in Years	Gross Assets		Accumulated Amortization		Net Assets		Gross Assets		Accumulated Amortization		Net Assets
Amortized intangible assets:
Covenants-not-to-compete	5	$	50,000	$	9,167	$	40,833		—		—		—
Customer relationships	5		525,000		91,667		433,333		—		—		—
Total intangible assets		$	575,000	$	100,834	$	474,166	$	—	$	—	$	—

Total amortization expense for the year ended December 31, 2005 was $101,000 and there was no amortization expense for the years ended December 31, 2004 or 2003. Estimated amortization expense for the next five fiscal years is as follows:

2006	$	115,000
2007	$	115,000
2008	$	115,000
2009	$	115,000
2010	$	14,166

4. BORROWING ARRANGEMENTS

On March 25, 2002, the Company signed a one-year promissory note due March 31, 2003 that established a $1.5 million line of credit (the “LOC”) with Bank of America, N.A. (“B of A”). Borrowings under this LOC bore interest at B of A’s prime rate less one-half percent. On March 21, 2003, the Company extended the maturity date of the LOC to March 31, 2004. Repayment of borrowings, if any, under the LOC were personally guaranteed by the Company’s Chief Executive Officer and one of its Directors (the “Guarantors”). On July 23, 2003 the independent members of the board of directors authorized the payment of an annual facility fee to the Guarantors in an amount equal to 1% of the LOC facility (or $15,000 in aggregate). In addition, quarterly usage fees were payable to the Guarantors at the rate of 2% per annum on average daily borrowings under the LOC during the quarter. No such usage fees were payable to the Guarantors during 2003. On March 8, 2004, the Company replaced its existing $1.5 million LOC with a $1 million LOC that had a maturity date of April 30, 2005 and no personal guarantees. On January 31, 2005 the Company expanded its line of credit from $1.0 million to $1.5 million and extended the maturity date to April 30, 2006. On March 1, 2005, the Company expanded its line of credit from $1.5 million to $2.0 million. On December 30, 2005, the B of A line of credit was paid off and terminated.

On December 30, 2005, the Company entered into a four year $5.6 million credit facility with Healthcare Finance Group. This new facility replaced the previous $2.0 million credit facility with B of A. The new facility matures on December 30, 2009 and is comprised of a $3.6 million revolving accounts receivable-based line of credit and up to $2.0 million of term loans to fund acquisitions. As a part of the agreement with Healthcare Finance Group, the Company issued a warrant to Healthcare Finance Group to purchase 100,000 shares of Transcend Common Stock at an exercise price of $2.25 per share, which warrant expires at the later of December 29, 2009 or 90 days following the payoff of the loans. Borrowings bear interest at LIBOR plus 4% (8.22% as of December 31, 2005), are secured by Company assets and require that the Company maintain certain financial and other covenants. The balance outstanding under the new line of credit was $1.9 million as of December 31, 2005. There was no balance outstanding on the term loans as of December 31, 2005. There was no balance outstanding under the LOC with B of A as of December 31, 2004 and December 31, 2003.

During 2005, the weighted average borrowings under the B of A line of credit were $1.0 million at a weighted average interest rate of 6.2%. At December 31, 2005, $2.0 million was available for borrowing under the new Healthcare Finance Group acquisition loan and $324,000 was available under the Healthcare Finance Group line of credit excluding a $1.0 million reserve for a January 31, 2006 note payment.

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On April 6, 2005, the Company fulfilled the prerequisites for receiving the proceeds under a Promissory Note dated March 1, 2005 payable to the Development Corporation of Abilene, Inc. (“DCOA”) in the principal amount of $1.0 million (the “Promissory Note”). Transcend received $850,000 under the Promissory Note on April 7, 2005 and was pre-funded $150,000 under the Promissory Note on March 31, 2005.

The Promissory Note relates to the Agreement for Financial Assistance by and between DCOA and Transcend effective as of March 1, 2005 (the “Agreement”) that was approved by DCOA on March 4, 2005. Under the terms of the Agreement, DCOA shall provide up to $2 million of interest-free, secured loans to Transcend (the “Loans”). In return, Transcend shall establish and operate a medical transcription training center and regional office in Abilene, Texas (the “Facility”). In addition, Transcend shall recruit, hire and train in the Facility up to 208 medical transcription professionals, the majority of whom shall be recruited from Abilene or the area surrounding Abilene, as defined in the Agreement. DCOA shall offer the Loans to Transcend in two increments of $1 million each in return for Transcend recruiting, hiring and training up to 104 medical transcription professionals for each Loan. The Promissory Note is the first such Loan.

Transcend and DCOA intend for the Promissory Note to be paid by Transcend using job creation/retention incentive payments provided to Transcend by DCOA based upon job creation incentives, as defined in the Agreement, that are earned by Transcend as provided in the Agreement. The Promissory Note was initially secured by a $150,000 letter of credit from a bank and certain furniture and equipment (the “Collateral”). The letter of credit was released December 7, 2005 and the remaining collateral shall be released as the principal balance of the Promissory Note is reduced by job creation incentives that are earned by Transcend. Principal reductions of the Promissory Note shall be effected through earned job creation incentives, not cash, as follows: (1) $25,000 per month for the first six months of the Agreement provided that 15 employees are hired by Transcend during that period; and (2) the straight-line amortization of job creation incentives earned by Transcend on or before March 31, 2010 over 20 quarters through March 31, 2012. As of December 31, 2005, Transcend had earned principal reduction credits of $150,000. The principal balance of the Promissory Note, if any, remaining on March 31, 2012 is payable in cash by Transcend unless said balance is forgiven by DCOA.

On August 15, 2005, the holder of the promissory note originating in the MDI transaction reduced the principal amount of the promissory note by $100,000 in consideration for 35,971 unregistered shares of Transcend’s common stock issued at a fair market value per share of $2.78. On December 26, 2005, the holder of the promissory note originating in the MDI transaction reduced the principal amount of the promissory note by an additional $300,000 in consideration for 140,815 unregistered shares of Transcend’s common stock issued at a fair market value per share of $2.13.

5. COMMITMENTS AND CONTINGENCIES

Lease Commitments

Future minimum annual rental obligations under non-cancelable operating leases as of December 31, 2005 are as follows:

2006	887
2007	780
2008	275
2009	15
Thereafter	11
Total rental obligation	1,968

Rental expense was $546,000, $301,000 and $226,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

Litigation

On April 5, 2001, Our Lady of the Lakes Hospital, Inc. (“OLOL”) filed a lawsuit against the Company. The lawsuit, styled “Our Lady of the Lakes Hospital, Inc. v. Transcend Services, Inc.,” was filed in the 19th Judicial District Court, Parish of East, State of Louisiana, Civil Case Number 482775, Div. A. The lawsuit alleges, among other things, that the Company breached certain contracts entered into between OLOL and the Company, including a staffing and management servicing contract, a transcription platform agreement and a marketing agreement. OLOL is seeking an unspecified amount of monetary damages. On May 30, 2001, the Company filed a timely Answer that generally denied all liability, and the Company filed a counterclaim against OLOL primarily seeking fees owed by OLOL for services performed by the Company and interest on unpaid invoices. OLOL subsequently added Transcend’s insurance carriers as defendants to the lawsuit and later lost a court decision and related appeal in that regard. The Company intends to defend vigorously all claims made by OLOL. The lawsuit is in an early procedural stage, however, and therefore it is not possible at this time to determine the outcome of the actions or the effect, if any, that their outcome may have on the Company’s results of operations and financial condition. There can be no assurances that this litigation will not have a material adverse effect on the Company’s results of operations and financial condition.

The Company is involved in a dispute over fees payable to the Company by a third party under an earn-out provision of a prior year asset sale agreement. The dispute is being submitted to binding arbitration. The commencement date for the arbitration hearing has not been determined. At this time, it is not possible to predict the outcome of the binding arbitration process.

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6. RETIREMENT PLAN

The Company maintains a 401(k) retirement plan that covers substantially all eligible employees. Employees are eligible to contribute amounts to the plan subject to certain minimum and maximum limitations. The Company matches employee contributions on a discretionary basis as determined by the Company’s Board of Directors. There have been no Company matching contributions for 2005, 2004 or 2003.

7. TRANSACTIONS WITH RELATED PARTIES

In 2003, the Company’s Chairman and Chief Executive Officer and one of its independent Directors received $15,000 in the aggregate for personally guaranteeing the repayment of borrowings, if any, under the Company’s then existing line of credit. See Note 4.

The Company’s Chairman and Chief Executive Officer and two of its independent Directors received an aggregate of 836,687 shares of the 2,903,422 shares of common stock issued in the stockholder-approved conversion of the Company’s preferred stock and in lieu of cash at the preferred stock dividend payment dates of February 15 and May 15, 2003. See Note 8.

There were no transactions with related parties during 2004.

Susan McGrogan is the President of the Company’s wholly owned subsidiary, Medical Dictation, Inc. Ms. McGrogan is also the co-founder of Medical Dictation, Inc. which was purchased by Transcend January 31, 2005. On August 15, 2005 and December 26, 2005, Ms. McGrogan converted $100,000 and $300,000, respectively, of a note payable to her by Transcend into Transcend Common Stock. See Note 8.

During December 2005, the Chairman and Chief Executive Officer loaned the Company $100,000. The Company repaid the loan plus $550 in interest on December 30, 2005.

8. STOCKHOLDERS’ EQUITY

On June 25, 2003, the stockholders of the Company approved an amendment to the Company’s Certificate of Incorporation that authorized the Company to increase the number of authorized shares of common stock, par value $0.05, from 6,000,000 shares to 15,000,000 shares, and to decrease the number of authorized shares of preferred stock, par value $0.01, from 21,000,000 shares to 2,000,000 shares.

The Company issued 2,860,000 shares of its unregistered common stock to the holders of its Series A and B Convertible Preferred Stock in a stockholder-approved transaction to convert most of its outstanding preferred stock to common stock at $2.00 per share on June 25, 2003. The Company redeemed the remaining outstanding shares of its preferred stock on July 1, 2003 in a stockholder-approved transaction for $600,000 in cash and two short-term promissory notes of $100,000 each. In addition, the Company issued 31,050 and 12,372 shares of its unregistered common stock at $1.50 and $2.00 per share, respectively, to certain holders of its Series A Convertible Preferred Stock who elected to receive their quarterly preferred stock dividends in common stock in lieu of cash at the preferred stock dividend payment dates of February 15 and May 15, 2003. The 2,903,422 shares of common stock that were issued in the preferred stock conversion and in lieu of preferred stock dividends were registered for potential resale by certain shareholders of the Company in a registration statement that was declared effective by the Securities and Exchange Commission on October 1, 2003. The Company did not and will not receive any proceeds from the sale of the registered shares by the selling shareholders.

On October 27, 2004, the Company issued a warrant to purchase 100,000 shares of its unregistered common stock to a strategic business partner, who is an unrelated third party. The issuance of this warrant was made in reliance on the exemption from registration provided in section 4(2) of the Securities Act of 1933 as a transaction by an issuer not involving a public offering. The warrant is exercisable at any time before October 27, 2007 at $2.55 per share, which was the closing price of the Company’s common stock on the Nasdaq SmallCap Market on the date of issuance. The difference between the exercise price of the warrant and its fair value determined using the Black-Scholes pricing model will be recorded as compensation over the shorter of the period that the warrant is outstanding or the three-year exercise period of the warrant. Neither this warrant, nor the shares of common stock for which it is exercisable, have been registered under the securities act of 1933 and no transfer or assignment of this warrant or the shares issuable upon its exercise may be made in the absence of an effective registration statement under such act or the availability of an exemption in fact from the registration provisions of such act in respect of such transfer or assignment. The issuance of these securities was made pursuant to a claim of exemption from registration under the Securities Act of 1933, as amended, by virtue of Section 4(2) and/or Regulation D promulgated thereafter.

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An Option Agreement to Purchase Stock was entered into by and between Susan McGrogan and Transcend Services, Inc. (“Transcend”) effective as of August 15, 2005, (the “Agreement”). This Agreement was amended on December 21, 2005 as is explained below. Susan McGrogan is a Florida resident and current employee of Transcend. Ms. McGrogan is also the co-founder of Medical Dictation, Inc. which was purchased by Transcend January 31, 2005.

Under the terms of the original Agreement, Transcend granted to Ms. McGrogan four options to purchase shares of common stock each at a total exercise price of $200,000 on August 15, 2005, February 15, 2006, August 15, 2006 and February 15, 2007. No separate consideration was received by Transcend for the option grants. The exercise price for each option shall be comprised of $100,000 in cash and a $100,000 reduction in the amount of the outstanding principal balance of the $3,500,000 Transcend Promissory Note dated January 31, 2005 in favor of Ms. McGrogan. The total number of shares purchased will be equal to the total exercise price divided by 110% of the average closing price per share of the Transcend common stock on the Nasdaq Small Cap Market for the ten trading days immediately prior to the effective date of exercise. Should Ms. McGrogan choose not to exercise an option, the debt would not be reduced. Ms. McGrogan purchased 71,942 shares of Transcend common stock on August 15, 2005 pursuant to this agreement. The issuance of these securities was made pursuant to a claim of exemption from registration under the Securities Act of 1933, as amended, by virtue of Section 4(2) and/or Regulation D promulgated thereafter. Ms. McGrogan acquired the securities for investment purposes only and not with a view to distribution thereof, and received or had access to adequate information about Transcend.

The amendment to the Agreement allows Ms. McGrogan to accelerate the portion of each of the remaining grants of February 15, 2006, August 15, 2006 and February 15, 2007 that relates to the reduction of debt. The amendment also changes the price, for the reduction of debt portion of the grant only, to 105% of the average closing price per share of the Transcend common stock on the National Association of Stock Dealers Automatic Quotation System for the ten trading days immediately prior to the Effective Date of Exercise. Effective December 26, 2005, Ms. McGrogan exercised this right and received 140,815 unregistered shares in exchange for a reduction of $300,000 to the $3,500,000 Transcend Promissory Note dated January 31, 2005 in favor of Ms. McGrogan.

On December 30, 2005, Transcend Services, Inc. entered into a four year $5.6 million credit facility with Healthcare Finance Group. The credit facility with Healthcare Finance Group includes a Stock Purchase Warrant to purchase 100,000 shares of Transcend Services, Inc. $.05 par value common stock at a price of $2.25 per share. The election to purchase the stock is available between December 30, 2005 and the later of December 29, 2009 or 90 days following the date that the loans are paid in full. The difference between the exercise price of the warrant and its fair value determined using the Black-Scholes pricing model will be recorded as compensation over the shorter of the period that the warrant is outstanding or the period of the warrant. Neither this warrant, nor the shares of common stock for which it is exercisable, have been registered under the securities act of 1933 and no transfer or assignment of this warrant or the shares issuable upon its exercise may be made in the absence of an effective registration statement under such act or the availability of an exemption in fact from the registration provisions of such act in respect of such transfer or assignment. The issuance of these securities was made pursuant to a claim of exemption from registration under the Securities Act of 1933, as amended, by virtue of Section 4(2) and/or Regulation D promulgated thereafter.

The Company had 7,875,858 shares of Common Stock and no shares of Preferred Stock outstanding as of December 31, 2005.

9. STOCK OPTION AND STOCK PURCHASE PLANS

The Company has four stockholder-approved stock option plans for its key employees, directors and key consultants (the “Plans”). The Plans provide for the grant of incentive stock options, nonstatutory stock options and restricted stock awards. The options to purchase shares of the Company’s common stock are granted at fair market value, as defined in the option agreement, on the date of grant. Also, 100,000 shares of restricted stock awards were granted and outstanding under the Plans as of December 31, 2005.

The following is a summary of stock option transactions:

	NUMBER OF SHARES SUBJECT TO STOCK OPTIONS		AVERAGE PRICE PER SHARE		WEIGHTED AVERAGE PRICE PER SHARE
Outstanding at 12/31/02	434,200		$	0.74 to $18.13	$	2.13
Granted	362,200		$	1.45 to $4.15	$	3.22
Forfeited	(29,200	)	$	0.74 to $18.13	$	8.02
Exercised	—			—	$	0.00
Outstanding at 12/31/03	767,200		$	0.74 to $6.88	$	2.46
Granted	178,500		$	2.75 to $4.98	$	3.10
Forfeited	(10,500	)	$	0.74 to $1.78	$	1.08
Exercised	(14,000	)	$	0.79 to $2.13	$	1.25
Outstanding at 12/31/04	921,200		$	0.74 to $6.88	$	2.62
Granted	315,031		$	1.91 to $3.05	$	2.50
Forfeited	(305,125	)	$	0.74 to $6.88	$	2.78
Exercised	(126,531	)	$	0.74 to $2.65	$	1.51
Outstanding at 12/31/05	804,575		$	0.74 to $6.56	$	2.69
Exercisable at 12/31/05	483,806		$	0.74 to $6.56	$	2.64

The following table provides additional stock option information. See Note 8.

	Number of securities to be issued upon exercise of outstanding options, warrants and rights (a)	Weighted-average exercise price of outstanding options, warrants and rights (b)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
Equity compensation plans approved by security holders	804,575	$	2.69	196,425
Equity compensation plans not approved by security holders	0		N/A	0
Total	804,575	$	2.69	196,425

The Company has elected to account for its stock-based compensation plans under Accounting Principles Board Opinion No. 25, under which no compensation cost has been recognized by the Company. However, the Company has computed, for pro forma disclosure purposes, the value of all options for shares of the Company’s common stock granted during 2005, 2004 and 2003 to

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employees, directors and a key consultant of the Company using the Black-Scholes option-pricing model and the following weighted average assumptions:

	2005		2004		2003
Risk-free interest rate	4.54	%	3.25	%	2.55	%
Expected dividend yield	—		—		—
Expected life	Four years		Four years		Four years
Expected volatility	42	%	47	%	55	%

The total fair value of the options granted during the years ended December 31, 2005, 2004 and 2003 was computed to be approximately $232,000, $222,000 and $537,000, respectively, which would be amortized over the vesting period of the options. If the Company had accounted for these plans in accordance with SFAS No. 123R, the Company’s reported and pro forma net income for the years ended December 31, 2005, 2004 and 2003 would have been as follows:

	2005			2004		2003
Net income attributable to common stockholders:
As reported	$	(1,192,000	)	$	277,000	$	840,000
Pro forma		(1,349,000	)	$	46,000	$	744,000
Basic and diluted net income per share attributable to common stockholders:
As reported	$	(0.16	)	$	0.04	$	0.14
Pro forma		(0.18	)	$	0.01	$	0.12

The following table sets forth the exercise price range, number of shares, weighted average exercise price, and remaining contractual lives by groups of similar prices and grant dates:

	Outstanding Options				Options Exercisable
Actual Range of Exercise Price	Outstanding at December 31, 2005	Average Remaining Contractual Life	Weighted Average Exercise Price		Exercisable at December 31, 2005	Weighted Average Exercise Price
$0.74 - $1.09	23,625	6.9 years	$	0.80	21,125	$	0.80
$1.10 -$1.50	73,250	5.5 years	$	1.29	70,000	$	1.28
$1.51 - $2.00	82,750	6.5 years	$	1.84	50,750	$	1.74
$2.01 - $3.00	393,200	8.6 years	$	2.58	197,181	$	2.60
$3.01 - $5.00	228,250	8.2 years	$	3.77	141,250	$	3.86
$5.01 - $6.88	3,500	3.4 years	$	6.12	3,500	$	6.12
$0.00 - $6.88	804,575	7.9 years.	$	2.69	483,806	$	2.64

On May 6, 2004, the stockholders of the Company approved an employee stock purchase plan (the “ESPP”) that commenced on July 1, 2004. The ESPP permitted eligible employees to purchase up to 250 shares of the Company’s common stock at 85% of the lower of the fair market value of the common stock per share at either the beginning or end of the offering period during a calendar quarter through payroll deductions of up to 10% of a participant’s compensation each pay period during the quarter. A total of 500,000 shares of the Company’s common stock was initially reserved for issuance under the ESPP. During 2005, the Company issued 9,381 shares of its common stock under the ESPP. On December 1, 2005, the Company announced the termination of the ESPP plan effective December 31, 2005. During the first quarter of 2006 the Company issued 2,437 shares of its common stock under the ESPP related to the fourth quarter of 2005.

10. INCOME TAXES

Since substantially all of the Company’s taxable income for the years ended December 31, 2005, 2004 and 2003 was offset by available net operating loss (“NOL”) carryforwards, no income tax provision was recorded in 2003, but a provision for income taxes totaling $3,000 was required in 2005 and $1,000 in 2004 for state taxable income, for which no NOL carryforwards were available.

At December 31, 2005 and 2004, the Company had net operating loss carryforwards of approximately $20,190,000 and $18,890,000, respectively, that may be used to reduce future income taxes. If not utilized, these carryforwards will begin to expire in 2009. The Company has established a valuation allowance of $7,870,000 and $7,367,000 at December 31, 2005 and 2004, respectively, due to the uncertainty regarding the realizability of its net operating loss carryforwards.

	2005		2004		2003
Reconciliation of Tax Rates:
Federal	34	%	34	%	34	%
State	5	%	5	%	5	%
Net operating loss carryforwards	0	%	0	%	0	%
Valuation allowance	-39	%	-39	%	-39	%
Effective tax rate	0	%	0	%	0	%

11. DIVESTITURES

On October 13, 2000, the Company sold its Co-Sourcing and CodeRemote business units (the “Businesses”) to Provider HealthNet Services, Inc. (“PHNS”) pursuant to an Asset Purchase Agreement (the “Agreement”) with PHNS under which the Company received $4.7 million in cash during 2000, with the potential to receive additional consideration payable over the subsequent five years. The amount of future consideration, if any, is based on a fixed percentage of certain defined future revenue recognized by PHNS from the Businesses. The Company received no earn-out payment in 2005 or 2004 and $6,000 in 2003. The Company and PHNS are currently in a dispute regarding the earn-out calculation. See Note 5 regarding litigation.

12. MAJOR CUSTOMERS

Revenue attributable to one contract with Providence Health System-Washington for three hospitals totaled $2,924,000, $2,292,000 and $1,572,000 or 11.2%, 15.1% and 10.7% of total revenue for 2005, 2004 and 2003, respectively. In addition, in 2005 the Company had revenue under separate agreements with approximately 40 customers who are members of Health Management Associates, Inc., a single healthcare enterprise. Revenue attributable to members of this Health Management Associates, Inc. comprised $5,813,000 or 22.2% of the Company’s total revenue for 2005.

13. SEGMENT INFORMATION

The continuing operations of the Company, as presented in the accompanying consolidated financial statements, were devoted exclusively to one reportable segment (medical transcription) in 2005, 2004 and 2003.

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14. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)

	First Quarter		Second Quarter			Third Quarter			Fourth Quarter
2005
Revenue	$	5,319,000	$	6,540,000		$	6,654,000		$	7,304,000
Gross Profit	$	1,257,000	$	1,208,000		$	912,000		$	1,059,000
Net income (loss) attributable to common shareholders	$	12,000	$	(242,000	)	$	(518,000	)	$	(444,000	)
Diluted net earnings per share attributable to common shareholders	$	—	$	(0.03	)	$	(0.07	)	$	(0.06	)
2004
Revenue	$	3,867,000	$	3,761,000		$	3,668,000		$	3,901,000
Gross Profit	$	1,028,000	$	1,107,000		$	1,030,000		$	1,113,000
Net income attributable to common shareholders	$	63,000	$	93,000		$	39,000		$	82,000
Diluted net earnings per share attributable to common shareholders	$	0	$	0		$	0		$	0

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

There has been no occurrence requiring a response to this item.

ITEM 9A. CONTROLS AND PROCEDURES

The SEC defines the term “disclosure controls and procedures” to mean a company’s controls and other procedures that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. The Company’s principal executive officer and principal financial officer, based on their evaluation of the effectiveness of the Company’s disclosure controls and procedures as of the end of the quarterly period covered by this report (the three months ended December 31, 2005), concluded that the Company’s disclosure controls and procedures were effective for this purpose.

Internal control over financial reporting consists of control processes designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external reporting purposes in accordance with GAAP. To the extent that components of the Company’s internal control over financial reporting are included in the Company’s disclosure controls, they are included in the scope of the evaluation by the Company’s principal executive officer and principal financial officer referenced above. There were no changes in the Company’s internal control over financial reporting during the Company’s fourth fiscal quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

ITEM 9B. OTHER INFORMATION

Not applicable.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The disclosures required by this item are incorporated by reference from the Company’s proxy statement to be filed in connection with the 2006 Annual Meeting of Stockholders to be held May 9, 2006.

ITEM 11. EXECUTIVE COMPENSATION

The disclosures required by this item are incorporated by reference from the Company’s proxy statement to be filed in connection with the 2006 Annual Meeting of Stockholders to be held May 9, 2006.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The disclosures required by this item are incorporated by reference from the Company’s proxy statement to be filed in connection with the 2006 Annual Meeting of Stockholders to be held May 9, 2006.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The disclosures required by this item are incorporated by reference from the Company’s proxy statement to be filed in connection with the 2006 Annual Meeting of Stockholders to be held May 9, 2006.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

The disclosures required herein are incorporated by reference from the Company’s proxy statement to be filed in connection with the 2006 Annual Meeting of Stockholders to be held May 9, 2006.

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PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) The following documents are filed as a part of this Annual Report for Transcend Services, Inc.:

1. Financial Statements

The Consolidated Financial Statements, the Notes to Consolidated Financial Statements and the Reports of Independent Public Accountants listed below are included in Item 8.

Report of Independent Public Accountants

Consolidated Balance Sheets as of December 31, 2005 and 2004

Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003

Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2005, 2004 and 2003

Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003

Notes to Consolidated Financial Statements

(b) Exhibits

The following exhibits are filed with or incorporated by reference into this report, as noted.

		Incorporation by Reference
Exhibit Number	Exhibit Description	Form	File No.	Exhibit	Filing Date
2.1	Asset Purchase Agreement dated October 13, 2000 with Provider HealthNet Services, Inc.	8-K	000-18217	2.7	October 30, 2000
2.2	Stock Purchase Agreement dated January 31, 2005 between Transcend Services, Inc. and Susan McGrogan, with respect to the purchase and sale of the capital stock of Medical Dictation, Inc.	10-K	000-18217	2.3	March 9, 2005
3.1	Certificate of Incorporation	S-3	333-106446	4.1	June 25, 2003
3.2	Restated Bylaws	10-K	000-18217	3 (a)	August 27, 1993
4.1	Stock Purchase Warrant granted to Premier Holding of Illinois dated October 27, 2004	10-K	000-18217	4.1	March 9, 2005
4.2	Promissory Note Payable dated January 31, 2005 for $3,500,000 in favor of Susan McGrogan	10-K	000-18217	4.3	March 9, 2005
4.3	Promissory Note dated as of March 1, 2005 between Transcend Services, Inc. and the Development Corporation of Abilene, Inc.	10-Q	000-18217	4.1	July 28, 2005
4.4	Loan and Security Agreement dated December 30, 2005 between Transcend Services, Inc. and HFG Healthco-4 LLC.	8-K/A	000-18217	4.1	January 12, 2006
4.5	Acquisition Promissory Note dated December 30, 2005 between Transcend Services, Inc. and HFG Healthco-4 LLC.	8-K/A	000-18217	4.2	January 12, 2006
4.6	Revolving Promissory Note dated December 30, 2005 between Transcend Services, Inc. and HFG Healthco-4 LLC.	8-K/A	000-18217	4.3	January 12, 2006
10.1	1992 Stock Option Plan, as Amended and Restated	S-8	333-16213	4.1	November 15, 1996
10.2	Form of Incentive Stock Option Agreement under 1992 Stock Option Plan, as Amended and Restated	S-8	333-16213	4.2	November 15, 1996
10.3	2001 Stock Option Plan	10-K	000-18217	4.1	March 6, 2002
10.4	2003 Stock Incentive Plan	10-Q	000-18217	4.3	July 29, 2004
10.5	2004 Employee Stock Purchase Plan	10-Q	000-18217	4.4	July 29, 2004

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		Incorporation by Reference
Exhibit Number	Exhibit Description	Form	File No.	Exhibit	Filing Date
10.6	Clinical Documentation Solution Agreement between Transcend Services, Inc. and MultiModal Technologies, Inc. effective September 28, 2004 (Confidential treatment has been requested for certain portions of this exhibit pursuant to Rule 24(b)(2) and accordingly, those portions have been omitted from this exhibit and filed separately with the Commission.)	10-K	000-18217	10.6	March 9, 2005
10.7	2005 Stock Incentive Plan	10-Q	000-18217	10.1	July 28, 2005
10.8	Agreement for Financial Assistance dated March 1, 2005 between the Development Corporation of Abilene, Inc. and Transcend Services, Inc,	10-Q	000-18217	10.1	April 28, 2005
10.9	Option Agreement to Purchase Stock dated August 15, 2005 between Susan McGrogan and Transcend Services, Inc.	10-Q	000-18217	10.2	October 26, 2005
10.10	Transcend Services, Inc. Stock Purchase Warrant to Purchase Shares of Common Stock, $.05 Par Value.	8-K/A	000-18217	10.1	February 27, 2006
10.11	Amendment to Option Agreement to Purchase Stock between Susan McGrogan and Transcend Services, Inc. dated December 21, 2005
10.12	2006 Executive Compensation Plan
10.13	Lease Agreement by and between Farnum Street Financial and Transcend Services, Inc. dated May 19, 2005.
10.14	Lease Schedule No. 001R to Lease Agreement by and between Farnum Street Financial and Transcend Services, Inc., dated December 20, 2005.
10.15	Lease Schedule No. 002R to Lease Agreement by and between Farnum Street Financial and Transcend Services, Inc., dated October 4, 2005.
10.16	Lease Schedule No. 003R to Lease Agreement by and between Farnum Street Financial and Transcend Services, Inc., dated December 21, 2005.
14.1	Transcend Services, Inc. Code of Business Conduct and Ethics Policy	10-K	000-18217	14.1	February 12, 2004
21.1	Subsidiaries of the Registrant
23.1	Consent of Miller Ray Houser & Stewart LLP
*31.1	Certification of Chief Executive Officer of the Registrant Pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
*31.2	Certification of Chief Financial Officer of the Registrant Pursuant to Rule 13a-14(a) and Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934, as amended
*32.1	Certification of Chief Executive Officer of the Registrant Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
*32.2	Certification of Chief Financial Officer of the Registrant Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

* This certification is furnished to, but not filed with, the Commission. This certification shall not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent that the Registrant specifically incorporates it by reference.

(c) No financial statement schedules are required to be filed with this annual report.

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SIGNATURES

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

Transcend Service, Inc.
By:	/s/ Larry G. Gerdes
	Larry G. Gerdes
	Chief Executive Officer and President
	(Principal Executive Officer)

Dated:  March 1, 2006

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

Signature	Title	Date
/s/ Larry G. Gerdes Larry G. Gerdes	Chairman of the Board and Chief Executive Officer (Principal Executive Officer)	March 1, 2006
/s/ Lance Cornell Lance Cornell	Chief Financial Officer (Principal Financial Officer)	March 1, 2006
/s/ Jeanne N. Bateman Jeanne N. Bateman	Controller and Chief Accounting Officer (Principal Accounting Officer)	March 2, 2006
/s/ Joseph P. Clayton Joseph P. Clayton	Director	March 1, 2006
/s/ James D. Edwards James D. Edwards	Director	March 1, 2006
/s/ Walter S. Huff Walter S. Huff, Jr.	Director	March 1, 2006
/s/ Charles E. Thoele Charles E. Thoele	Director	March 1, 2006

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EX-10.11

Exhibit 10.11

FIRST AMENDMENT TO OPTION AGREEMENT TO PURCHASE STOCK

THIS FIRST AMENDMENT TO OPTION AGREEMENT TO PURCHASE STOCK (this “Amendment”) is made and entered into as of December 21, 2005, by and between TRANSCEND SERVICES, INC., a Delaware corporation (the “Company”), and SUSAN McGROGAN, an individual resident of the State of Florida (“McGrogan”).

RECITALS:

WHEREAS, the Company and McGrogan have previously entered into that certain Option Agreement to Purchase Stock dated as of August 15, 2005 (the “Option Agreement”); and

WHEREAS, the parties hereto wish to amend the terms of the Option Agreement as more fully set forth below.

NOW, THEREFORE, for and in consideration of the premises and agreements contained herein, and other good and valuable consideration, the receipt, adequacy and sufficiency of which are hereby acknowledged, the parties hereto covenant and agree as follows:

1. Definitions. Capitalized terms used and not otherwise defined herein shall have the respective meanings ascribed to such terms in the Option Agreement.

2. Article I of the Option Agreement is hereby amended by deleting such article in its entirety and replacing such article with the following (it being acknowledged that Option #1 has already been exercised):

“The Company hereby irrevocably grants to McGrogan five (5) options (each an “Option” and collectively “Options”) to purchase shares of the Stock in accordance with the schedule set forth below and subject to the conditions set forth in this Agreement. The number of shares of Stock to be acquired upon the exercise of each Option is determined in Article V below.

	Effective Date of Exercise	Notice Period Commencement Date	Total Exercise Price		Cash Consideration		Amount Applied in Reduction of Note Principal
Option #1	August 15, 2005	immediately	$	200,000	$	100,000	$	100,000
Option #2	December 26, 2005	December 15, 2005	$	300,000	$	0	$	300,000
Option #3	February 15, 2006	February 1, 2006	$	100,000	$	100,000	$	0
Option #4	August 15, 2006	August 1, 2006	$	100,000	$	100,000	$	0
Option #5	February 15, 2007	January 31, 2007	$	100,000	$	100,000	$	0	”

3. Article II of the Option Agreement is hereby amended by deleting such article in its entirety and replacing such article with the following:

“The total exercise price for all shares acquired for each Option (the “Exercise Price”) shall be as set forth in Article I above. The Exercise Price for each Option shall be comprised of the following: (i) cash in the amount, if any, set forth in Article I above as “Cash Consideration” with respect to the applicable Option (the “Cash Portion”) which Cash Portion, if applicable, shall be payable in immediately available funds on the Effective Date of Exercise and (ii) a reduction in the outstanding principal balance of the Note by the amount, if any, set forth in Article I above as “Amount Applied in Reduction of Note Principal” with respect to the applicable Option.”

4. Exercise of Option #2: By executing this Amendment, McGrogan hereby expresses her intent to exercise Option #2 set forth in Article I above in accordance with the terms and provisions of the Option Agreement and this Amendment. McGrogan hereby agrees that the outstanding principal balance of the Note shall be reduced by an amount equal to Three Hundred Thousand Dollars ($300,000) on the Effective Date of Exercise in payment for the exercise of this Option #2 and that for purposes of principal payments due under the terms of the Note, the aforesaid $300,000 shall be deducted from the principal amount which would otherwise be due on the Note on the next payment date under Section 1.2 of the Promissory Note.

5. Article IV of the Option Agreement is hereby amended by deleting the first sentence thereof and replacing such sentence with the following:

“The exercise of each Option shall be by written notice delivered to the Company in the form of Exhibit A attached hereto with respect to Option #1 set forth in Article I above and in the form of Exhibit B attached hereto with respect to each of Option #3, Option #4 and Option #5 set forth in Article I above (the “Written Notice”) together with the tender of the Cash Portion, if any, applicable to such Option.”

5. Article V of the Option Agreement is hereby amended by deleting the first paragraph of such article in its entirety and replacing such paragraph with the following:

“With regard to Options #1, #3, #4 and #5 set forth in Article I above, upon the timely exercise by McGrogan of any such Option in accordance with the terms and conditions set forth herein, including without limitation payment by McGrogan of the Cash Portion, if any, of the Exercise Price for such Option, the Company shall deliver to McGrogan within five (5) trading days after the Effective Date of Exercise for such Option a number of shares (the “Purchased Shares”) of the Stock determined by dividing the Total Exercise Price for such Option by one hundred and ten percent (110%) of the average closing price per share of the Stock on the National Association of Stock Dealers Automatic Quotation System (NASDAQ) for the ten (10) trading days immediately prior to the Effective Date of Exercise (the “Average Closing Price”). The Average Closing Price shall be determined by adding up the closing prices and dividing the sum total by ten (10). With regard to the timely exercise by McGrogan of Option #2 set forth in Article I above, the number of shares to be delivered by the Company to McGrogan with respect to Option #2 shall be determined by dividing the Total Exercise Price for such Option #2 by one hundred and five percent (105%) of the Average Closing Price.”

6. The Option Agreement is hereby amended by adding the following as Exhibit B to the Option Agreement:

“EXHIBIT B

FORM OF WRITTEN NOTICE

Effective Date of Exercise:                             

The undersigned, Susan McGrogan (“McGrogan”), hereby expresses McGrogan’s intent to exercise an option (the “Option”) to purchase shares of the Common Stock, par value $0.05 per share, of Transcend Services, Inc. (the “Company”) granted to McGrogan by the Company pursuant to that certain Option Agreement to Purchase Stock dated as of August 15, 2005 and amended pursuant to that certain First Amendment to Option Agreement to Purchase Stock dated as of December 15, 2005 by and between McGrogan and the Company (collectively, the “Option Agreement”), subject to the terms and conditions contained therein.

McGrogan hereby tenders to the Company the sum of One Hundred Thousand Dollars ($100,000) reduced for fractional shares in immediately available funds.

Capitalized terms used in this document not otherwise defined shall have the meaning ascribed to them in the Option Agreement.

Susan McGrogan
Date:	”

7. Remaining Terms Unaffected. Except for the amendments to the Option Agreement set forth herein, all other provisions of the Option Agreement shall remain in full force and effect and are incorporated herein as if fully set forth herein.

8. Governing Law. This Amendment shall be governed by, and construed and enforced in accordance with, the laws of the State of Georgia without giving effect to principles of conflicts of laws.

9. Counterparts. This Amendment may be executed in any number of counterparts, each of which shall be deemed an original and all of which together shall constitute one and the same instrument. This Amendment shall become binding when one or more counterparts hereof shall bear the signatures of all of the parties indicated as the signatories hereto.

[Signatures appear on the following page]

IN WITNESS WHEREOF, the parties have executed this Amendment as of the date first above written.

MCGROGAN:
/s/ Susan McGrogan
Susan McGrogan
COMPANY:
TRANSCEND SERVICES, INC.
By:	/s/ Larry Gerdes
Name:	Larry Gerdes
Title:	CEO

EX-10.12

Exhibit 10.12

TRANSCEND SERVICES, INC.

2006 EXECUTIVE COMPENSATION PLAN

On December 21, 2005, the Stock Option and Compensation Committee of the Board of Directors of Transcend Services, Inc. (the “Company”) approved a 2006 compensation plan for management, including the executive officers of the Company as follows:

Name	Title	Potential Annual Bonus as Percentage of Annual Salary *		Annual Salary (effective 1/1/2006)
Gerdes, Larry G.	Chief Executive Officer	50	%	$	235,000
Munoz, Juan Alejandro (“Alex”)	Executive Vice President - Operations	50	%**	$	200,000
Cornell, Lance	Chief Financial Officer, Treasurer and Secretary	50	%***	$	160,000
Bateman, Jeanne N.	Chief Accounting Officer, Controller and Assistant Secretary	25	%	$	80,000

* Based upon the Company exceeding the annual net income in the Company’s 2006 business plan approved by the Board of Directors on December 21, 2005.

** $50,000 of this bonus potential is guaranteed for Mr. Munoz.

*** In addition Mr. Cornell is eligible for a bonus of up to $10,000 based on the achievement of certain objectives during the first quarter of 2006.

EX-10.13

Exhibit 10.13

Lease Agreement Number TR051905

LEASE AGREEMENT

This Lease Agreement, dated May 19, 2005, by and between FARNAM STREET FINANCIAL, INC. (the “Lessor”) with an office located at 240 Pondview Plaza, 5850 Opus Parkway, Minnetonka, MN 55343 and TRANSCEND SERVICES, INC. (the “Lessee”) with an office located at 945 East Paces Ferry Road, Suite 1475, Atlanta, GA 30326.

Lessor hereby leases or grants to the Lessee the right to use and Lessee hereby rents and accepts the right to use the equipment listed by serial number and related services, and software and related services on the Lease Schedule(s) attached hereto or incorporated herein by reference from time to time (collectively, the equipment, software and services are the “Equipment”), subject to the terms and conditions hereof, as supplemented with respect to each item of Equipment by the terms and conditions set forth in the appropriate Lease Schedule. The term “Lease Agreement” shall include this Lease Agreement and the various Lease Schedule(s) identifying each item of Equipment or the appropriate Lease Schedule(s) identifying one or more particular items of Equipment.

1. TERM: This Lease Agreement is effective from the date it is executed by both parties. The term of this Lease Agreement, as to all Equipment designated on any particular Lease Schedule, shall commence on the Installation Date for all Equipment on such Lease Schedule and shall continue for an initial period ending that number of months from the Commencement Date as set forth in such Lease Schedule (the “Initial Term”) and shall continue from year to year thereafter until terminated. The term of this Lease Agreement as to all Equipment designated on any particular Lease Schedule may be terminated without cause at the end of the Initial Term or any year thereafter by either party mailing written notice of its termination to the other party not less than one-hundred twenty (120) days prior to such termination date.

2. COMMENCEMENT DATE: The Installation Date for each item of Equipment shall be the day said item of Equipment is installed at the Location of Installation, ready for use, and accepted in writing by the Lessee. The Commencement Date for any Lease Schedule is the first of the month following installation of all the Equipment on the Lease Schedule, unless the latest Installation Date for any Equipment on the Lease Schedule falls on the first day of the month, in which case that is the Commencement Date. The Lessee agrees to complete, execute and deliver a Certificate(s) of Acceptance to Lessor upon installation of the Equipment.

3. LEASE CHARGE: The lease charges for the Equipment leased pursuant to this Lease Agreement shall be the aggregate “Monthly Lease Charge(s)” as set forth on each and every Lease Schedule executed pursuant hereto (the aggregate “Monthly Lease Charge(s)” are the “Lease Charges”). Lessee agrees to pay to Lessor the Lease Charges in accordance with the Lease Schedule(s), and the payments shall be made at Lessor’s address indicated thereon. The Lease Charges shall be paid by Lessee monthly in advance with the first full month’s payment due on the Commencement Date. If the Installation Date does not fall on the first day of a month, the Lease Charge for the period from the Installation Date to the Commencement Date shall be an amount equal to the “Monthly Lease Charge” divided by thirty (30) and multiplied by the number of days from and including the Installation Date to the Commencement Date and such amount shall be due and payable upon receipt of an invoice from Lessor. Charges for taxes made in accordance with Section 4 and charges made under any other provision of this Lease Agreement and payable by Lessee shall be paid to Lessor at Lessor’s address specified on the Lease Schedule(s) on the date specified in invoices delivered to Lessee. If payment, as specified above, is not received by Lessor on the due date, Lessee agrees to and shall, to the extent permitted by law, pay on demand, as a late charge, an amount equal to one and one-half percent (1 ¹/2%), or the maximum percentage allowed by law if less, of the amount past due (“Late Charges”). Late Charges shall be charged and added to any past due amount on the date such payment is due and every thirty (30) days thereafter until all past due amounts are paid in full to Lessor.

4. TAXES: In addition to the Lease Charges set forth in Section 3, the Lessee shall reimburse Lessor for all license or registration fees, assessments, sales and use taxes, rental taxes, gross receipts taxes, personal property taxes and other taxes now or hereafter imposed by any government, agency, province or otherwise upon the Equipment, the Lease Charges or upon the ownership, leasing, renting, purchase, possession or use of the Equipment, whether the same be assessed to Lessor or Lessee (the “Taxes”). Lessor shall file all property tax returns and pay all Taxes when due. Lessee, upon notice to Lessor, may, in Lessee’s own name, contest or protest any Taxes, and Lessor shall honor any such notice except when in Lessor’s sole opinion such contest is futile or will cause a levy or lien to arise on the Equipment or cloud Lessor’s title thereto. Lessee shall, in addition, be responsible to Lessor for the payment and discharge of any penalties or interest as a result of Lessee’s actions or inactions. Nothing herein shall be construed to require Lessee to be responsible for any federal or state taxes or payments in lieu thereof, imposed upon or measured by the net income of Lessor, or state franchise taxes of Lessor, or except as provided hereinabove, any penalties or interest resulting from Lessor’s failure to timely remit such tax payments.

5. DELIVERY AND FREIGHT COSTS: Lessee shall accept delivery of the Equipment and allow the Equipment to be installed within seven (7) days after delivery.

All transportation charges upon the Equipment for delivery to Lessee’s designated Location of Installation are to be paid by Lessee. All rigging, drayage charges, structural alterations, rental of heavy equipment and/or other expense necessary to place the Equipment at the Location of Installation are to be promptly paid by Lessee.

6. INSTALLATION: Lessee agrees to pay for the actual installation of the Equipment at Lessee’s site. Lessee shall make available and agrees to pay for all costs associated with providing a suitable place of installation and necessary electrical power, outlets and air conditioning required for operating the Equipment as defined in the Equipment manufacturer’s installation manual or instructions. All supplies consumed or required by the Equipment shall be furnished and paid for by Lessee.

7. RETURN TO LESSOR: On the day following the last day of the lease term associated with a Lease Schedule (the “Return Date”), Lessee shall cause and pay for the Equipment on that Lease Schedule to be deinstalled, packed using the manufacturer’s standard packing materials and shipped to a location designated in writing by Lessor (the “Return Location”). If the Equipment on the applicable Lease Schedule is not at the Return Location within ten (10) days of the Return Date, or Lessee fails to deinstall and ship the Equipment on the Return Date, then any written notice of termination delivered by Lessee shall become void, and the Lease Schedule shall continue in accordance with this Lease Agreement. Irrespective of any other provision hereof, Lessee will bear the risk of damage from fire, the elements or otherwise until delivery of the Equipment to the Return Location. At such time as the Equipment is delivered to the Lessor at the Return Location, the Equipment will be at the risk of Lessor.

8. MAINTENANCE: Lessee, at its sole expense, shall maintain the Equipment in good working order and condition. Lessee shall enter into, pay for and maintain in force during the entire term of any Lease Schedule, a maintenance agreement with the original manufacturer of the Equipment providing for continuous uninterrupted maintenance of the Equipment (the “Maintenance Agreement”). Lessee will cause the manufacturer to keep the Equipment in good working order in accordance with the provisions of the Maintenance Agreement and make all necessary adjustments and repairs to the Equipment. The manufacturer is hereby authorized to accept the directions of Lessee with respect thereto. Lessee agrees to allow the manufacturer full and free access to the Equipment. All maintenance and service charges, whether under the Maintenance Agreement or otherwise, and all expenses, if any, of the manufacturer’s customer engineers incurred in connection with maintenance and repair services, shall be promptly paid by Lessee. Lessee warrants that all of the Equipment shall be in good working order operating according to manufacturer’s specification and eligible for the manufacturer’s standard maintenance agreement upon delivery to and inspection and testing by the Lessor. If the Equipment is not operating according to manufacturer’s specification, in good working order and/or eligible for the manufacturer’s standard maintenance agreement, Lessee agrees to reimburse Lessor for all costs, losses, expenses and fees associated with such equipment and the repair or replacement thereof.

9. LOCATION, OWNERSHIP AND USE: The Equipment shall, at all times, be the sole and exclusive property of Lessor. Lessee shall have no right or property interest therein, except for the right to use the Equipment in the normal operation of its business at the Location of Installation, or as otherwise provided herein. The Equipment is and shall remain personal property even if installed in or attached to real property. Lessor shall be permitted to display notice of its ownership on the Equipment by means of a suitable stencil, label or plaque affixed thereto.

Lessee shall keep the Equipment at all times free and clear from all claims, levies, encumbrances and process. Lessee shall give Lessor immediate notice of any such attachment or other judicial process affecting any of the Equipment. Without Lessor’s written permission, Lessee shall not attempt to or actually: (i) pledge, lend, create a security interest in, sublet, exchange, trade, assign, swap, use for an allowance or credit or otherwise; (ii) allow another to use; (iii) part with possession; (iv) dispose of; or (v) remove from the Location of Installation, any item of Equipment. If any item of Equipment is exchanged, assigned, traded, swapped, used for an allowance or credit or otherwise to acquire new or different equipment (the “New Equipment”) without Lessor’s prior written consent, then all of the New Equipment shall become Equipment owned by Lessor subject to this Lease Agreement and the applicable Lease Schedule.

Any feature(s) installed on the Equipment at the time of delivery that are not specified on the Lease Schedule(s) are and shall remain the sole property of the Lessor.

Lessee shall cause the Equipment to be operated in accordance with the applicable vendor’s or manufacturer’s manual of instructions by competent and qualified personnel.

10. FINANCING STATEMENT: Lessor is hereby authorized by Lessee to cause this Lease Agreement or other instruments, including Uniform Commercial Code Financing Statements, to be filed or recorded for the purposes of showing Lessor’s interest in the Equipment. Lessee agrees to execute any such instruments as Lessor may request from time to time.

11. ALTERATIONS AND ATTACHMENTS: Upon prior written notice to Lessor, Lessee may, at its own expense, make minor alterations in or add attachments to the Equipment, provided such alterations and attachments shall not interfere with the normal operation of the Equipment and do not otherwise involve the pledge, assignment, exchange, trade or substitution of the Equipment or any component or part thereof. All such alterations and attachments to the Equipment shall become part of the Equipment leased to Lessee and owned by Lessor. If, in Lessor’s sole determination, the alteration or attachment reduces the value of the Equipment or interferes with the normal and satisfactory operation or maintenance of any of the Equipment, or creates a safety hazard, Lessee shall, upon notice from Lessor to that effect, promptly remove the alteration or attachment at Lessee’s expense and restore the Equipment to the condition the Equipment was in just prior to the alteration or attachment.

12. LOSS AND DAMAGE: Lessee shall assume and bear the risk of loss, theft and damage (including any governmental requisition, condemnation or confiscation) to the Equipment and all component parts thereof from any and every cause whatsoever, whether or not covered by insurance. No loss or damage to the Equipment or any component part thereof shall impair any obligation of Lessee under this Lease Agreement, which shall continue in full force and effect except as hereinafter expressly provided. Lessee shall repair or cause to be repaired all damage to the Equipment. In the event that all or part of the Equipment shall, as a result of any cause whatsoever, become lost, stolen, destroyed or otherwise rendered irreparably unusable or damaged (collectively, the “Loss”) then Lessee shall, within ten (10) days after the Loss, fully inform Lessor in writing of such a Loss and shall pay to Lessor the following amounts: (i) the Monthly Lease Charges (and other amounts) due and owing under this Lease Agreement, plus (ii) one-hundred (100%) percent of the original cost of the Equipment subject to the Loss if the loss occurs in the first nine months of the Initial Term, and, thereafter, the original cost of the Equipment amortized by the subsequent Monthly Lease Charges received by Lessor during the Initial Term using an amortization rate of eight hundred and ninety (890) basis points over the interest rate of the three (3) year United States Treasury Note as reported by the Federal Reserve on the Commencement Date (collectively, the sum of (i) plus (ii) shall be the “Casualty Loss Value”). Notwithstanding the proceeding, if Lessee has provided notice to terminate the applicable Lease Schedule prior to informing Lessor in writing of a Loss and such Loss is not covered by insurance proceeds pursuant to Section 13 hereof, then Lessee shall pay two (2) times the Casualty Loss Value on the Equipment subject to such Loss. Upon receipt by Lessor of the Casualty Loss Value: (i) the applicable Equipment shall be removed from the Lease Schedule; and (ii) Lessee’s obligation to pay Lease Charges associated with the applicable Equipment shall cease. Lessor may request, and Lessee shall complete, an affidavit(s) that swears out the facts supporting the Loss of any item of Equipment.

13. INSURANCE: Until the Equipment is returned to Lessor or as otherwise herein provided, whether or not this Lease Agreement has terminated as to the Equipment, Lessee, at its expense, shall maintain: (i) property and casualty insurance insuring the Equipment for its Casualty Loss Value naming Lessor or its assigns as sole loss payee; and (ii) comprehensive public liability and third-party property insurance naming Lessor and its assigns as additional

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loss payees. The insurance shall cover the interest of both the Lessor and Lessee in the Equipment, or as the case may be, shall protect both the Lessor and Lessee in respect to all risks arising out of the condition, delivery, installation, maintenance, use or operation of the Equipment. All such insurance shall provide for thirty (30) days prior written notice to Lessor of cancellation, restriction, or reduction of coverage. Lessee hereby irrevocably appoints Lessor as Lessee’s attorney-in-fact to make claim for, receive payment of and execute and endorse all documents, checks or drafts for loss or damage or return premium under any insurance policy issued on the Equipment. Prior to installation of the Equipment, all policies or certificates of insurance shall be delivered to Lessor by Lessee. Lessee agrees to keep the Equipment insured with an insurance company which is at least “A” rated by A.M. Best. The proceeds of any loss or damage insurance shall be payable to Lessor, but Lessor shall remit all such insurance proceeds to Lessee at such time as Lessee either (i) provides Lessor satisfactory proof that the damage has been repaired and the Equipment has been restored to good working order and condition or (ii) pays to Lessor the Casualty Loss Value. It is understood and agreed that any payments made by Lessee or its insurance carrier for loss or damage of any kind whatsoever to the Equipment are not made as accelerated rental payments or adjustments of rental, but are made solely as indemnity to Lessor for loss or damage of its Equipment.

14. ENFORCEMENT OF WARRANTIES: Upon receipt of a written request from Lessee, Lessor shall, so long as this Lease Agreement is in force, take all reasonable action requested by Lessee to enforce the Equipment manufacturer’s warranties, expressed or implied, issued on or applicable to the Equipment, which are enforceable by Lessor in its own name. Lessor shall obtain for Lessee all service furnished by manufacturer in connection therewith; provided, however, that Lessor shall not be required to commence any suit or action or resort to litigation to enforce any such warranty unless Lessee shall first pay to Lessor in advance all expenses in connection therewith, including attorney’s’ fees.

If any such warranty shall be enforceable by Lessee in its own name, Lessee shall, upon receipt of written request from Lessor, so long as this Lease Agreement is in force, take all reasonable action requested by Lessor to enforce any such warranty, which is enforceable by Lessee in its own name; provided, however, that Lessee shall not be obligated to commence any suit or action or resort to litigation to enforce any such warranty unless Lessor shall pay all expenses in connection therewith.

15. WARRANTIES, DISCLAIMERS AND INDEMNITY: THE LESSOR DOES NOT MAKE ANY WARRANTIES, EXPRESSED OR IMPLIED, INCLUDING THE WARRANTY OF MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE. LESSEE ACKNOWLEDGES THAT IT IS NOT RELYING ON LESSOR’S SKILL OR JUDGEMENT TO SELECT OR FURNISH GOODS SUITABLE FOR ANY PARTICULAR PURPOSE AND THAT THERE ARE NO WARRANTIES CONTAINED IN THIS LEASE AGREEMENT. LESSEE ACKNOWLEDGES AND AGREES THAT LESSOR HAS NOT MADE ANY STATEMENT, REPRESENTATION OR WARRANTY RELATIVE TO THE ACCOUNTING OR TAX ENTRIES, TREATMENT, BENEFIT, USE OR CLASSIFICATION OF THE LEASE AGREEMENT OR ASSOCIATED LEASE SCHEDULES. LESSEE ACKNOWLEDGES THAT IT AND/OR ITS INDEPENDENT ACCOUNTANTS ARE SOLELY RESPONSIBLE FOR (i) ANY AND ALL OF LESSEE’S ACCOUNTING AND TAX ENTRIES ASSOCIATED WITH THE LEASE AGREEMENT AND/OR THE LEASE SCHEDULES AND (ii) THE ACCOUNTING AND TAX TREATMENT, BENEFITS, USES AND CLASSIFICATION OF THE LEASE AGREEMENT OR ANY LEASE SCHEDULE. LESSOR SHALL NOT BE LIABLE FOR DAMAGES, INCLUDING SPECIAL, INCIDENTAL OR CONSEQUENTIAL DAMAGES ARISING OUT OF OR IN CONNECTION WITH THE PERFORMANCE OF THE EQUIPMENT OR ITS USE BY LESSEE, AND SHALL NOT BE LIABLE FOR ANY SPECIAL, INCIDENTAL OR CONSEQUENTIAL DAMAGES ARISING OUT OF OR IN CONNECTION WITH LESSOR’S FAILURE TO PERFORM ITS OBLIGATION HEREUNDER. THIS LEASE AGREEMENT IS A “FINANCE LEASE” AS THAT TERM IS DEFINED AND USED IN ARTICLE 2A OF THE UNIFORM COMMERCIAL CODE. NO RIGHTS OR REMEDIES REFERRED TO IN ARTICLE 2A OF THE UNIFORM COMMERCIAL CODE WILL BE CONFERRED ON LESSEE.

Lessee agrees that Lessor shall not be liable to Lessee for, and Lessee shall indemnify, defend and hold Lessor harmless with respect to, any claim from a third party for any liability, claim, loss, damage or expense of any kind or nature, whether based upon a theory of strict liability or otherwise, caused, directly or indirectly, by: (i) the inadequacy of any item of Equipment, including software, for any purpose; (ii) any deficiency or any latent or other defects in any Equipment, including software, whether or not detectable by Lessee; (iii) the selection, manufacture, rejection, ownership, lease, possession, maintenance, operation, use or performance of any item of Equipment, including software; (iv) any interruption or loss of service, use or performance of any item of Equipment, including software; (v) patent, trademark or copyright infringement; or (vi) any loss of business or other special, incidental or consequential damages whether or not resulting from any of the foregoing. Lessee’s duty to defend and indemnify Lessor shall survive the expiration, termination, cancellation or assignment of this Lease Agreement or a Lease Schedule and shall be binding upon Lessee’s successors and permitted assigns.

16. EVENT OF DEFAULT: The occurrence of any of the following events shall constitute an Event of Default under this Lease Agreement and/or any Lease Schedule:

(1) the nonpayment by Lessee of any Lease Charges when due, or the nonpayment by Lessee of any other sum required hereunder to be paid by Lessee which non-payment continues for a period often (10) days from the date when due;

(2) the failure of Lessee to perform any other term, covenant or condition of this Lease Agreement, any Lease Schedule or any other document, agreement or instrument executed pursuant hereto or in connection herewith, which is not cured within ten (10) days after written notice thereof from Lessor;

(3) Lessee attempts to or does remove, transfer, sell, swap, assign, sublease, trade, exchange, encumber, receive an allowance or credit for, or part with possession of, any item of Equipment;

(4) Lessee or any guarantor of this Lease Agreement ceases doing business as a going concern, is insolvent, makes an assignment for the benefit of creditors, fails to pay its debts as they become due, offers a settlement to creditors or calls a meeting of creditors for any such purpose, files a voluntary petition in bankruptcy, is subject to an involuntary petition in bankruptcy, is adjudicated bankrupt or insolvent, files or has filed against it a petition seeking any reorganization, arrangement or composition, under any present or future statute, law or regulation;

(5) without Lessor’s consent, (i) Lessee or any guarantor of this Lease Agreement sells, conveys, leases, exchanges or transfers all or substantially all of its assets, (ii) Lessee or any guarantor of this Lease Agreement merges, consolidates, liquidates, dissolves or combines its assets with any other entity, or (iii) if Lessee or any guarantor of this Lease Agreement is a corporation, partnership, limited liability company or other entity, more than 35% of the outstanding equity interests of Lessee or such guarantor are owned directly or indirectly at any time during the Term of this Lease Agreement by a person or group of persons other than the person(s) who held all of the outstanding equity interests on the date of this Lease Agreement;

(6) any representations or warranties made at any time by Lessee or any guarantor in this Lease Agreement or in any agreement, statement, certificate, financial or credit

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information provided in connection herewith shall be false or misleading when made;

(7) Lessee or any guarantor of this Lease Agreement defaults under or otherwise has accelerated any material obligation, credit agreement, loan agreement, conditional sales contract, lease, indenture or debenture; or Lessee or any guarantor of this Lease Agreement defaults under any other agreement now existing or hereafter made with Lessor, including an Equipment Purchase Agreement; or

(8) the breach or repudiation by any party thereto of any guaranty, subordination agreement or other agreement running in favor of Lessor obtained in connection with this Lease Agreement.

17. REMEDIES: Should any Event of Default occur and be continuing, Lessor may, in order to protect its interests and reasonably expected profits, with or without notice or demand upon Lessee, pursue and enforce, alternatively, successively and/or concurrently, any one or more of the following remedies:

(1) recover from Lessee all accrued and unpaid Lease Charges and other amounts due and owing on the date of the default;

(2) recover from Lessee from time to time all Lease Charges and other amounts as and when becoming due hereunder;

(3) accelerate, cause to become immediately due and recover the present value of all Lease Charges and other amounts due and/or likely to become due hereunder from the date of the default to the end of the lease term using a discount rate of six (6%) percent;

(4) cause to become immediately due and payable and recover from Lessee the Casualty Loss Value of the Equipment;

(5) terminate any or all of the Lessee’s rights, but not its obligations, associated with the lease of Equipment under this Lease Agreement;

(6) retake (by Lessor, independent contractor, or by requiring Lessee to assemble and surrender the Equipment in accordance with the provisions of Section 7 hereinabove) possession of the Equipment without terminating the Lease Schedule or the Lease Agreement free from claims by Lessee which claims are hereby expressly waived by Lessee;

(7) require Lessee to deliver the Equipment to a location designated by Lessor;

(8) proceed by court action to enforce performance by Lessee of its obligations associated with any Lease Schedule and/or this Lease Agreement; and/or

(9) pursue any other remedy Lessor may otherwise have, at law, equity or under any statute, and recover damages and expenses (including attorneys’ fees) incurred by Lessor by reason of the Event of Default.

Upon repossession of the Equipment, Lessor shall have the right to lease, sell or otherwise dispose of such Equipment in a commercially reasonable manner, with or without notice, at a public or private sale. Lessor’s pursuit and enforcement of any one or more remedies shall not be deemed an election or waiver by Lessor of any other remedy. Lessor shall not be obligated to sell or re-lease the Equipment. Any sale or re-lease may be held at such place or places as are selected by Lessor, with or without having the Equipment present. Any such sale or re-lease, may be at wholesale or retail, in bulk or in parcels. Time and exactitude of each of the terms and conditions of this Lease Agreement are hereby declared to be of the essence. Lessor may accept past due payments in any amount without modifying the terms of this Lease Agreement and without waiving any rights of Lessor hereunder.

18. COSTS AND ATTORNEYS’ FEES: In the event of any default, claim, proceeding, including a bankruptcy proceeding, arbitration, mediation, counter-claim, action (whether legal or equitable), appeal or otherwise, whether initiated by Lessor or Lessee (or a debtor-in-possession or bankruptcy trustee), which arises out of, under, or is related in any way to this Lease Agreement, any Lease Schedule, or any other document, agreement or instrument executed pursuant hereto or in connection herewith, or any governmental examination or investigation of Lessee, which requires Lessor’s participation (individually and collectively, the “Claim”), Lessee, in addition to all other sums which Lessee may be called upon to pay under the provisions of this Lease Agreement, shall pay to Lessor, on demand, all costs, expenses and fees paid or payable in connection with the Claim, including, but not limited to, attorneys’ fees and out-of-pocket costs, including travel and related expenses incurred by Lessor or its attorneys.

19. LESSOR’S PERFORMANCE OPTION: Should Lessee fail to make any payment or to do any act as provided by this Lease Agreement, then Lessor shall have the right (but not the obligation), without notice to Lessee of its intention to do so and without releasing Lessee from any obligation hereunder to make or to do the same, to make advances to preserve the Equipment or Lessor’s title thereto, and to pay, purchase, contest or compromise any insurance premium, encumbrance, charge, tax, lien or other sum which in the judgment of Lessor appears to affect the Equipment, and in exercising any such rights, Lessor may incur any liability and expend whatever amounts in its absolute discretion it may deem necessary therefor. All sums so incurred or expended by Lessor shall be due and payable by Lessee within ten (10) days of notice thereof.

20. QUIET POSSESSION AND INSPECTION: Lessor hereby covenants with Lessee that Lessee shall quietly possess the Equipment subject to and in accordance with the provisions hereof so long as Lessee is not in default hereunder; provided, however, that Lessor or its designated agent may, at any and all reasonable times during business hours, enter Lessee’s premises for the purposes of inspecting the Equipment and the manner in which it is being used.

21. ASSIGNMENTS: This Lease Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns. Lessee, however, shall not assign this Lease Agreement or sublet any of the Equipment without first obtaining the prior written consent of Lessor and its assigns, if any. Lessee acknowledges that the terms and conditions of this Lease Agreement have been fixed in anticipation of the possible assignment of Lessor’s rights under this Lease Agreement and in and to the Equipment as collateral security to a third party (“Assignee” herein) which will rely upon and be entitled to the benefit of the provisions of this Lease Agreement. Lessee agrees to provide Lessor or its potential assigns with Lessee’s most recent audited and its most current financial statements. Lessee agrees with Lessor and such Assignee to recognize in writing any such assignment within fifteen (15) days after receipt of written notice thereof and to pay thereafter all sums due to Lessor hereunder directly to such Assignee if directed by Lessor, notwithstanding any defense, set-off or counterclaim whatsoever (whether arising from a breach of this Lease Agreement or not) that Lessee may from time to time have against Lessor. Upon such assignment, the Lessor shall remain obligated to perform any obligations it may have under this Lease Agreement and the Assignee shall (unless otherwise expressly agreed to in writing by the Assignee) have no obligation to perform such obligations. Any such assignment shall be subject to Lessee’s rights to use and possess the Equipment so long as Lessee is not in default hereunder.

22. SURVIVAL OF OBLIGATIONS: All covenants, agreements, representations, and warranties contained in this Lease Agreement, any Lease Schedule, or in any document attached thereto, shall be for the benefit of Lessor and Lessee and their successors, any assignee or secured party. Further, all covenants, agreements, representations, and warranties contained in this Lease Agreement, any Lease Schedule, or in any document attached thereto, shall survive the execution and delivery of this Lease Agreement and the expiration or other termination of this Lease Agreement.

23. CORPORATE AUTHORITY: The parties hereto covenant and warrant that the persons executing this Lease Agreement and each Lease Schedule on their behalf have been duly authorized to do so, and this Lease Agreement and any Lease Schedule constitute

Page Number 4 of 5

a valid and binding obligation of the parties hereto. The Lessee will, if requested by Lessor, provide to Lessor, Certificates of Authority naming the officers of the Lessee who have the authority to execute this Lease Agreement and any Lease Schedules attached thereto.

24. LANDLORDS’ AND MORTGAGEES’ WAIVER: If requested, Lessee shall furnish waivers, in form and substance satisfactory to Lessor, from all landlords and mortgagees of any premises upon which any Equipment is located.

25. MISCELLANEOUS: This Lease Agreement, the Lease Schedule(s), attached riders and any documents or instruments issued or executed pursuant hereto will have been made, executed and delivered in, and shall be governed by the internal laws (as opposed to conflicts of law provisions) and decisions of, the State of Minnesota. Lessee and Lessor consent to jurisdiction of any local, state or federal court located within Minnesota. Venue shall be in Minnesota and Lessee hereby waives local venue and any objection relating to Minnesota being an improper venue to conduct any proceeding relating to this Lease Agreement. At Lessor’s sole election and determination, Lessor may select an alternative forum, including arbitration or mediation, to adjudicate any dispute arising out of this Lease Agreement.

This Lease Agreement was jointly drafted by the parties, and the parties hereby agree that neither should be favored in the construction, interpretation or application of any provision or any ambiguity. There are no unwritten or oral agreements between the parties. This Lease Agreement and associated Lease Schedule(s) constitute the entire understanding and agreement between Lessor and Lessee with respect to the lease of the Equipment superseding all prior agreements, understandings, negotiations, discussions, proposals, representations, promises, commitments and offers between the parties, whether oral or written. No provision of this Lease Agreement or any Lease Schedule shall be deemed waived, amended, discharged or modified orally or by custom, usage or course of conduct unless such waiver, amendment or modification is in writing and signed by an officer of each of the parties hereto. If any one or more of the provisions of this Lease Agreement or any Lease Schedule is for any reason held invalid, illegal or unenforceable, the remaining provisions of this Lease Agreement and any such Lease Schedule will be unimpaired, and the invalid, illegal or unenforceable provisions shall be replaced by a mutually acceptable valid, legal and enforceable provision that is closest to the original intention of the parties. Lessee agrees that neither the manufacturer, nor the supplier, nor any of their salespersons, employees or agents are agents of Lessor.

Any notice provided for herein shall be in writing and sent by certified or registered mail to the parties at the addresses stated on page 1 of this Lease Agreement.

This Lease Agreement shall not become effective until delivered to Lessor at its offices at Minnetonka, Minnesota and executed by Lessor. If this Lease Agreement shall be executed by Lessor prior to being executed by Lessee, it shall become void at Lessor’s option five (5) days after the date of Lessor’s execution hereof, unless Lessor shall have received by such date a copy hereof executed by a duly authorized representative of Lessee.

This Lease Agreement is made subject to the terms and conditions included herein and Lessee’s acceptance is effective only to the extent that such terms and conditions are consistent with the terms and conditions herein. Any acceptance which contains terms and conditions which are in addition to or inconsistent with the terms and conditions herein will be a counter-offer and will not be binding unless agreed to in writing by Lessor.

The terms used in this Lease Agreement, unless otherwise defined, shall have the meanings ascribed to them in the Lease Schedule(s).

26. REPOSSESSION: LESSEE ACKNOWLEDGES THAT, PURSUANT TO SECTION 17 HEREOF, LESSOR HAS BEEN GIVEN THE RIGHT TO REPOSSESS THE EQUIPMENT SHOULD LESSEE BECOME IN DEFAULT OF ITS OBLIGATIONS HEREUNDER. LESSEE HEREBY WAIVES THE RIGHT, IF ANY, TO REQUIRE LESSOR TO GIVE LESSEE NOTICE AND A JUDICIAL HEARING PRIOR TO EXERCISING SUCH RIGHT OF REPOSSESSION.

27. NET LEASE: This Lease Agreement is a net lease and Lessee’s obligations to pay all Lease Charges and other amounts payable hereunder shall be absolute and unconditional and, except as expressly provided herein, shall not be subject to any: (i) delay, abatement, reduction, defense, counterclaim, set-off, or recoupment; (ii) discontinuance or termination of any license; (iii) Equipment failure, defect or deficiency; (iv) damage to or destruction of the Equipment; or (v) dissatisfaction with the Equipment or otherwise, including any present or future claim against Lessor or the manufacturer, supplier, reseller or vendor of the Equipment. To the extent that the Equipment includes intangible (or intellectual) property, Lessee understands and agrees that: (i) Lessor is not a party to and does not have any responsibility under any software license and/or other agreement with respect to any software; and (ii) Lessee will be responsible to pay all of the Lease Charges and perform all its other obligations under this Lease Agreement despite any defect, deficiency, failure, termination, dissatisfaction, damage or destruction of any software or software license. Except as expressly provided herein, this Lease Agreement shall not terminate for any reason, including any defect in the Equipment or Lessor’s title thereto or any destruction or loss of use of any item of Equipment.

28. HEADINGS: Section headings herein are used for convenience only and shall not otherwise affect the provisions of this Lease Agreement.

IN WITNESS WHEREOF, the parties hereto have caused this Lease Agreement to be signed by their respective duly authorized representative.

Every Term is Agreed to and Accepted:		Every Term is Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC.		TRANSCEND SERVICES, INC.
By:	/s/ Steven C. Morgan	By:	/s/ Mark D. Meersman
Print Name:	Steven C. Morgan	Print Name:	Mark D. Meersman
Title:	President	Title:	CFO
Date:	June 15, 2005	Date:	6/10/05

Page Number 5 of 5

Rider Number:	001
Lease Agreement Number:	TR051905
Lease Schedule Number:	ALL
Lessee Name:	TRANSCEND SERVICES, INC.
Lease Dated:	MAY 19, 2005

INTEREST RATE FLUCTUATION

This Lease Schedule is intended to be a fixed rate lease during the installation period and from the Commencement Date to the end of the term. The three-year treasury rate is an integral part of the underlying rate of this lease. The Lessor and Lessee agree that the rate shall be fixed upon execution of this Lease and that should the three year treasury note increase between the execution of this Lease Schedule and the Commencement Date, the rate will be adjusted on the Commencement Date to reflect such increase and will then be fixed for the term of this Lease Schedule.

Every Term is Agreed to and Accepted:		Every Term is Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC.		TRANSCEND SERVICES, INC.
“LESSOR”		“LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Mark D. Meersman
Print Name:	Steven C. Morgan	Print Name:	Mark D. Meersman
Title:	President	Title:	CFO
Date:	June 15, 2005	Date:	6/10/05

Rider Number:	002
Lease Agreement Number:	TR051905
Lease Schedule Number:	001
Lessee Name:	TRANSCEND SERVICES, INC.
Lease Dated:	MAY 19, 2005

FAIR MARKET PURCHASE

Lessee shall have the option to purchase the Equipment in its physical possession and on this Lease Schedule at the end of the initial term, in whole and not in part, on an as-is, where-is basis, for the then determined mutually-agreed, in-place fair market value (plus applicable taxes) provided that (i) an Event of Default has not occurred, (ii) Lessor has received all of the Lease Charges due under the Lease Schedule prior to Lessee exercising this option to purchase, (iii) Lessor has received written notice of Lessee’s election to exercise said purchase option not less than one hundred twenty (120) days prior to the last date of the initial term of this Lease Schedule.

Every Term is Agreed to and Accepted:		Every Term is Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC.		TRANSCEND SERVICES, INC.
“LESSOR”		“LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Mark D. Meersman
Print Name:	Steven C. Morgan	Print Name:	Mark D. Meersman
Title:	President	Title:	CFO
Date:	June 15, 2005	Date:	6/10/05

INCUMBENCY CERTIFICATE

I, Jeanne N. Bateman, Assistant Secretary of Transcend Services, Inc., a Delaware corporation (the “Company”) do hereby certify that:

1. The persons whose names, titles and signatures that appear below (“Authorized Person”) are duly elected or appointed, qualified and authorized, on behalf of the Company, to execute and deliver any lease agreement and related documents, including, but not limited to, lease schedules, documents, riders, certificates of acceptance by and between Farnam Street Financial, Inc. and the Company (collectively, the “Lease Documents”);

2. The Company shall be bound by any Lease Document that is executed and delivered by an Authorized Person;

3. The execution and delivery of any Lease Document is not prohibited by or in any manner restricted by the terms of the Company’s certificate of incorporation, its by-laws, or by any loan agreement, indenture or contract to which the Company is a party or under which it is bound; and

4. The signatures below are the true, correct and genuine signatures of the below-named persons:

Authorized Signature:	/s/ Mark D. Meersman	Authorized Signature:
Print Name:	Mark D. Meersman	Print Name:
Title:	CFO	Title:

Authorized Signature:	Authorized Signature:
Print Name:	Print Name:
Title:	Title:

IN WITNESS WHEREOF, the undersigned does hereby execute this Certificate this 19^th day of May, 2005.

/s/ Jeanne N. Bateman

Assistant Secretary

ADDENDUM NO. 1

This transaction is a true lease and is not intended by the parties as a secured transaction. Filing is only intended to make the true lease a matter of public record. Farnam Street Financial, Inc. is the owner of all the equipment contained on this filing and any and all other equipment now or hereafter the subject of any lease agreement or lease schedule by and between the parties and all accessories, attachments, additions, and any substitutions and/or replacement of the equipment contained on this filing or any lease agreement or lease schedule between the parties. The lessee has no rights, express or implied, to sell, exchange, encumber, or otherwise dispose of any equipment contained on this filing or any lease agreement or lease schedule by and between the parties. The parties agree that this financing statement covers any and all equipment now or hereafter the subject of any lease agreement or lease schedule by and between the parties, including, but not limited to, the following equipment contained on or subject to:

Lease Agreement Number	TR051905 or
Lease Schedule Number	001 or
Schedule A attached hereto

Together with all substitutions, replacements, accessions, process, rent, revenue, insurance, and proceeds related to the equipment contained on this filing or any lease agreement or lease schedule by and between the parties.

Every Term is Agreed to and Accepted:		Every Term is Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC.		TRANSCEND SERVICES, INC.
“LESSOR”		“LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Mark D. Meersman
Print Name:	Steven C. Morgan	Print Name:	Mark D. Meersman
Title:	President	Title:	CFO
Date:	June 15, 2005	Date:	6/10/05

EX-10.14

Exhibit 10.14

LEASE SCHEDULE NO. 001R

“This Lease Schedule No. 001R replaces Lease Schedule No. 001.”

This Lease Schedule is issued pursuant to the Lease Agreement Number TR051905 dated May 19, 2005. The terms of the Lease Agreement and serial numbers contained on Certificate of Acceptance Numbers TR051905-001-001 thru TR051905-001-003 are a part hereof and are incorporated by reference herein.

LESSOR	LESSEE
Farnam Street Financial, Inc.	Transcend Services, Inc.
240 Pondview Plaza	945 East Paces Ferry Road
5850 Opus Parkway	Suite 1475
Minnetonka, MN 55343	Atlanta, GA 30326
SUPPLIER OF EQUIPMENT	LOCATION OF EQUIPMENT
Various	Same as above

Term of Lease from Commencement Date: 60 Months

Monthly Lease Charge: $1,001.03

Delivery and Installation: August 2005 – November 2005

Commencement Date: December 1, 2005

Security Deposit: $1,001.03. At the end of the applicable lease term, provided that there is no event of default, this security deposit will be returned to Lessee.

EQUIPMENT

MANUFACTURER	QTY	MACHINE/MODEL	EQUIPMENT DESCRIPTION (including features)
			See Attachment A

The Monthly Lease Charge will be prorated and charged as interim rent between the date an item of equipment is accepted and the Commencement Date.

Every Term is Agreed to and Accepted:		Every Term is Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC. “LESSOR”		TRANSCEND SERVICES, INC. “LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Lance Cornell
Print Name:	Steven C. Morgan	Print Name:	Lance Cornell
Title:	President	Title:	C.F.O.
Date:	Dec. 20, 2005	Date:	12/19/05

Lease Agreement Number: TR051905

Lease Schedule Number: 001R

ATTACHMENT A

MANUFACTURER	QTY	MACHINE/MODEL	EQUIPMENT DESCRIPTION (incl. features)
GLS COMMUNICATIONS	2		50% Deposit
NORTEL	1	AASTRA	AASTRA CNX conference bridge with associated materials
NORTEL	51		T316E Phones, Black, 16 Button
NORTEL	1		T24 DSS 24 Button, Black, Console Attendant Phone
NORTEL	8		Nortel USB Headsets
NORTEL	1		BCM Voice over IP 8 seats
NORTEL	1		BCM Message Center with 68 Mailboxes
NORTEL	1		BCM Gold Bundle for 32 users - Call Center Professional (up to 20 agents) 32 seats unified messaging (Voicemail & fax) - Call Center Report
NORTEL	1		BCM Expansion unit with PS
NORTEL	2		BCM DTM - T1/PRI Card
NORTEL	2		BCM DSM 32+
NORTEL	4		BCM 8 Port analog media bay
NORTEL	1		BCM 400 Platform, Cabinet, Processor
NORTEL	1		BCM 200 Expansion Cabinet
NORTEL	1		64 additional mailboxes

Agreed to and Accepted:		Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC.		TRANSCEND SERVICES, INC.
“LESSOR”		“LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Lance Cornell
Print Name:	Steven C. Morgan	Print Name:	Lance Cornell
Title:	President	Title:	CFO
Date:	Dec. 20, 2005	Date:	12/19/05

Page 1 of 1

EX-10.15

Exhibit 10.15

LEASE SCHEDULE NO. 002R

“This Lease Schedule No. 002R replaces Lease Schedule No. 002.”

This Lease Schedule is issued pursuant to the Lease Agreement Number TR051905 dated May 19, 2005. The terms of the Lease Agreement and serial numbers contained on Certificates of Acceptance TR051905-002-001 thru TR051905-002-009 are a part hereof and are incorporated by reference herein.

LESSOR	LESSEE
Farnam Street Financial, Inc.	Transcend Services, Inc.
240 Pondview Plaza	945 East Paces Ferry Road
5850 Opus Parkway	Suite 1475
Minnetonka, MN 55343	Atlanta, GA 30326
SUPPLIER OF EQUIPMENT	LOCATION OF EQUIPMENT
eWorkz, Inc.	Various

Term of Lease from Commencement Date: 36 Months

Monthly Lease Charge: $15,627.23

Anticipated Delivery and Installation: July 2005 – September 2005

Security Deposit: $16,677.00. At the end of the applicable lease term, provided that there is no event of default, this security deposit will be returned to Lessee.

EQUIPMENT

MANUFACTURER	QTY	MACHINE/MODEL	EQUIPMENT DESCRIPTION (including features)
			See Attachment A

The Monthly Lease Charge will be prorated and charged as interim rent between the date an item of equipment is accepted and the Commencement Date.

Every Term is Agreed to and Accepted:		Every Term is Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC.		TRANSCEND SERVICES, INC.
“LESSOR”		“LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Mark D. Meersman
Print Name:	Steven C. Morgan	Print Name:	Mark D. Meersman
Title:	President	Title:	CFO
Date:	Oct. 4, 2005	Date:	9/30/05

Lease Agreement Number: TR051905

Lease Schedule Number: 002R

ATTACHMENT A

MANUFACTURER	QTY	MACHINE/MODEL	EQUIPMENT DESCRIPTION (incl. features)
DEPARTMENT OF REVENU	21		Sales Tax
DEPARTMENT OF REVENU	1		IL Sales Tax
DEPARTMENT OF REVENU	1		Sales Tax
DEPARTMENT OF REVENU	3		Sales Tax
EWORKZ, INC.	4		Freight
EWORKZ, INC.	4	TECH HRLY	Load Ghost Image
EWORKZ, INC.	110	IN-155	IN-155 Foot Pedal
EWORKZ, INC.	140	10363129	SAV Corp ED10
EWORKZ, INC.	2		Sales Tax
EWORKZ, INC.	280		Sales Tax
EWORKZ, INC.	426		Load Ghost Image
EWORKZ, INC.	395		Freight
EWORKZ, INC.	58	10363128	SAV Corp ED10 SVR LIC
HEWLETT PACKARD	4	DW984A#ABA	Hewlett Packard Pentium 4 2.8GHz 256MB/40GB HDD/CD/LAN/WINXP Pro
HEWLETT PACKARD	430	781761581	STED Plus Stan 2005 SU
HEWLETT PACKARD	24	970082-0403	Labtec Spin 75 2PC SPKR System Blk
HEWLETT PACKARD	345	CN5614RV	56K V.92 Internal Modem
HEWLETT PACKARD	8	STC-D320/512	HP Pavilion 512MB PC2700 DDR Memory
HEWLETT PACKARD	430	DS710B	1.44MB Internal Floppy Drive
HEWLETT PACKARD	552	STH-D530/256	Hewlett Packard EVO D530 256MB PC3200 DDR Mem Mod
HEWLETT PACKARD	112	DW984A#ABA	Hewlett Packard P4 2.8GHz 256MB/40GB HDD/CD/LAN/WINXP PRO
HEWLETT PACKARD	104	STC-D320/512	HP Pavilion 512MB PC2700 DDR Memory
HEWLETT PACKARD	4	STC-D320/512	Hewlett Packard Pavilion 512MB PC2700 DDR Memory
HEWLETT PACKARD	314	PX836AA#ABA	Hewlett Packard DX 2000 MT Pentium 4 2.8 A
HEWLETT PACKARD	418	IC-510012	SIIG Sound Wave Pro PCI
HEWLETT PACKARD	8	IC-137012	SIIG Sound Wave 3D Pro PCI
HEWLETT PACKARD	4	IC-1370I2	SIGG Soundwave 3D Pro PCI
IL TAX	1		IL Sales Tax
LABTEC	380	970082-0403	Labtec Spin 75 2PC SPKR System Blk
LABTEC	9	970087-0403	Labtec Spin 75 PC MultiMedia Speakers
MICROSOFT	430	070-02632	Microsoft Works 8.0 Win32 English OLP NL
OLYMPUS	428	146023	Olympus E99 Headset Digital Voice Recorder
SIMPLE TECH	76	SVM-DDR3200/256	Simple Tech 256MB Module
SYMANTEC	232	10233978	Norton Virus LIC
VIEWSONIC	346	Q71B-9	Viewsonic 17” Black CRT Monitor

Page 1 of 2

Lease Agreement Number: TR051905

Lease Schedule Number: 002R

ATTACHMENT A

MANUFACTURER QTY MACHINE/MODEL EQUIPMENT DESCRIPTION (incl. features)

Agreed to and Accepted:		Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC.		TRANSCEND SERVICES, INC.
“LESSOR”		“LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Mark D. Meersman
Print Name:	Steven C. Morgan	Print Name:	Mark Meersman
Title:	President	Title:	CFO
Date:	Oct. 4, 2005	Date:	9/30/05

Page 2 of 2

EX-10.16

Exhibit 10.16

LEASE SCHEDULE NO. 003R

“This Lease Schedule No. 003R replaces Lease Schedule No. 003.”

This Lease Schedule is issued pursuant to the Lease Agreement Number TR051905 dated May 19, 2005. The terms of the Lease Agreement and serial numbers contained on Certificates of Acceptance are a part hereof and are incorporated by reference herein.

LESSOR	LESSEE
Farnam Street Financial, Inc.	Transcend Services, Inc.
240 Pondview Plaza	945 East Paces Ferry Road
5850 Opus Parkway	Suite 1475
Minnetonka, MN 55343	Atlanta, GA 30326
SUPPLIER OF EQUIPMENT	LOCATION OF EQUIPMENT
eWorkz, Digital Voice Systems,	Same as above
Tridia, Various

Term of Lease from Commencement Date: 24 Months

Monthly Lease Charge: $26,258.00

Anticipated Delivery and Installation: October 2005 – February 2006

Projected Commencement Date: March 1, 2006

Security Deposit: Upon Lessee’s execution of this Lease Schedule, Lessee shall deliver a security deposit in the amount of $26,258.00. At the end of the applicable lease term, provided that there is no event of default, this security deposit will be returned to Lessee.

EQUIPMENT

MANUFACTURER	QTY	MACHINE/MODEL	EQUIPMENT DESCRIPTION (including features)
Dictaphone			Transcription hardware and software
Milner Voice & Data			Voice Fusion Software
eWorkz			Servers
Digital Voice Systems			PCs
Tridia			DVI Expansion, software
Various			Various hardware and software for Data Center

All of the Equipment on this Lease Schedule shall be defined as a total of $616,000.00. The Monthly Lease Charge listed above is calculated based on the agreement that this cost will be comprised of $362,000.00 of hardware at a lease rate of 0.041240 per $1.00 and $254,000.00 of soft costs (software, installation, service, maintenance, deposits, etc.) at a lease rate factor of 0.044604 per $1.00. This Lease Schedule shall Commence in accordance with the Lease Agreement when all of the Equipment cost described above is installed and accepted under Certificates of Acceptance issued pursuant to this Lease Schedule. The Monthly Lease Charge will be prorated and charged as interim rent between the date an item of equipment is accepted and the Commencement Date. If the exact description of the Equipment changes from what is listed above or on the Attachment A or should Lessee and Lessor agree to revise the total cost or the proportion of hardware to soft costs, a revised Lease Schedule shall be executed by both parties to reflect these changes.

Every Term is Agreed to and Accepted:		Every Term is Agreed to and Accepted:
FARNAM STREET FINANCIAL, INC. “LESSOR”		TRANSCEND SERVICES, INC. “LESSEE”
By:	/s/ Steven C. Morgan	By:	/s/ Lance B. Cornell
Print Name:	Steven C. Morgan	Print Name:	Lance B. Cornell
Title:	President	Title:	C.F.O.
Date:	Dec. 21, 2005	Date:	12/20/05

EX-21.1

Exhibit 21.1

SUBSIDIARIES OF THE REGISTRANT

Medical Dictation, Inc.

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS

As independent public accountants, we hereby consent to the inclusion of our report dated February 1, 2006 included in Transcend Services, Inc.’s Annual Report on Form 10-K for the year ended December 31, 2005 as well as the incorporation by reference of such report into the Company’s previously filed Registration Statements File Nos. 333-106454, 333-106446, 33-83344, 033-41361, 333-04777, 033-59115, 333-19177, 333-16213, 333-116911, 333-116910, 333-78777 and 333-131059.

/s/ Miller Ray Houser & Stewart LLP

Atlanta, Georgia

March 3, 2006

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Larry G. Gerdes, certify that:

1. I have reviewed this Annual Report on Form 10-K of Transcend Services, Inc. for the year ended December 31, 2005;

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

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

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) [Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986];

c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

d) disclosed in this report any change in the registrant’s internal controls over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 1, 2006

/s/ Larry G. Gerdes

Larry G. Gerdes

Chief Executive Officer

(Principal Executive Officer)

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Lance Cornell, certify that:

1. I have reviewed this Annual Report on Form 10-K of Transcend Services, Inc. for the year ended December 31, 2005;

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

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

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and we have:

a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) [Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986];

c) evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

d) disclosed in this report any change in the registrant’s internal controls over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 1, 2006

/s/ Lance Cornell

Lance Cornell

Chief Financial Officer

(Principal Financial Officer)

EX-32.1

Exhibit 32.1

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

The undersigned, as Chief Executive Officer of Transcend Services, Inc., certifies that to the undersigned’s knowledge, the Form 10-K for the year ended December 31, 2005, which accompanies this certification fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the annual report fairly presents, in all material respects, the financial condition and results of operations of Transcend Services, Inc. at the dates and for the periods indicated. The foregoing certification is made solely for purposes of Title 18, Chapter 63, Section 1350 of the United States Code.

/s/ Larry G. Gerdes

Larry G. Gerdes

Chief Executive Officer

Date: March 1, 2006

EX-32.2

Exhibit 32.2

Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

The undersigned, as Chief Financial Officer of Transcend Services, Inc., certifies that to the undersigned’s knowledge, the Form 10-K for the year ended December 31, 2005, which accompanies this certification fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the annual report fairly presents, in all material respects, the financial condition and results of operations of Transcend Services, Inc. at the dates and for the periods indicated. The foregoing certification is made solely for purposes of Title 18, Chapter 63, Section 1350 of the United States Code.

/s/ Lance Cornell

Lance Cornell

Chief Financial Officer

Date: March 1, 2006