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 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 Services, Inc. ("Transcend") utilizes a combination of its proprietary internet-based voice and data distribution technology, customer-based technology and home-based medical language specialists to convert physicians' voice recordings into electronic documents.

On January 31, 2005, the Company purchased Medical Dictation, Inc. ("MDI") for $4.8 million. The purchase was financed with a $3.5 million promissory note, $1.0 million in cash and $300,000 of Transcend common stock. In 2006, the Company repaid $1.2 million of the promissory note with a combination of cash and Transcend common stock, leaving a remaining balance on the MDI promissory note of $1.2 million, which was outstanding at December 31, 2007. During first quarter of 2008, the Company repaid the remaining balance on the note.

On December 30, 2005, the Company entered into a four year, $5.6 million credit facility with Healthcare Finance Group (HFG). The facility includes a $3.6 million accounts receivable-based revolving promissory note and up to $2.0 million of term loans to fund acquisitions. At December 31, 2008, the balance on the facility was $4,000, which represents accrued interest expense.

Beginning January 1, 2006, the Company began including depreciation and amortization as a separate line item in operating expenses on the Consolidated Statement of Operations.

Transcend purchased certain assets of OTP Technologies, Inc. ("OTP"), a Chicago area medical transcription company, on January 16, 2007. Transcend paid $1,070,000, consisting of $520,000 in cash, a $330,000 promissory note and $220,000 (60,274 shares) of Transcend common stock. The Company, based on the final earn-out calculation stemming from 2007 revenue, paid $40,000 in additional consideration in January 2008.

The Company's income before income taxes has improved in 2006, 2007 and 2008 due in large part to improved customer retention combined with new sales, increased use of speech recognition technology and increased use of offshore transcription partners.

On January 1, 2009, the Company purchased certain assets of DeVenture Global Health Partners ("DeVenture"), a Canton, Ohio based medical transcription company, for a base purchase price of $4,250,000 plus potential consideration based on results for the first six months of 2009, and a final working capital adjustment.

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. The preparation of consolidated financial statements requires that management make estimates and assumptions based on knowledge of current events and actions; however, actual results may ultimately differ from estimates and assumptions. For a discussion of the Company's significant accounting policies, refer to Note 1 of Notes to Consolidated Financial Statements.

Goodwill and Intangible Assets. As of December 31, 2008, the Company reported goodwill and intangible assets at carrying amounts of $4.7 million and $0.3 million, respectively. The total of $5.0 million represents approximately 19% of total assets as of December 31, 2008. Intangible assets are amortized over their estimated useful lives. The goodwill and intangible assets are associated with two acquisitions during 2005 and one during 2007.

Management reviews 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, management calculates the fair value of the reporting units to which the goodwill and intangibles relate based on the present value of estimated future cash flows. As of December 31, 2008, the Company operates in one reporting unit - medical transcription services. The approach utilized is dependent on a number of factors including estimates of future revenues and costs, appropriate discount rates and other variables. Management bases estimates on assumptions that are believed to be reasonable, but which are unpredictable and inherently uncertain. Therefore, future impairments could result if actual results differ from those estimate.

Deferred Tax Asset - Net Operating Loss Carry Forwards. As of December 31, 2008, the Company has approximately $4.3 million of federal net operating loss carry forwards resulting in a combined federal and state deferred tax asset of $1.6 million. Deferred tax assets represent future tax benefits expected to be able to apply against future taxable income. The Company's ability to utilize deferred tax assets is dependent upon the Company's ability to generate future taxable income. SFAS 109, "Accounting for Income Taxes," requires the Company to record a valuation allowance against any deferred income tax benefits that management believes may expire before sufficient taxable income is generated to use them. The Company uses current estimates of future taxable income to determine whether a valuation allowance is needed. Projecting future taxable income requires the use of significant judgment regarding expected future revenues and expenses. In addition, the Company must assume that tax laws will not change sufficiently to materially impact the expected tax liability associated with expected taxable income. As of December 31, 2008, the Company determined that it was more likely than not that $26,000 of the deferred tax assets would not be realized prior to the expiration of state net operating loss carry forwards. Accordingly, a valuation allowance of $26,000 against these deferred tax assets has been established.

In 2007, it was determined that, except for certain deferred tax assets resulting from state net operating loss carry forwards, it will be more likely than not that the Company's deferred tax assets will be able to be utilized in the future and accordingly, the valuation allowance was reduced to zero related to those assets.

Legal Proceedings. From time to time, the Company is party to litigation. On January 16, 2008, the Company reached a mediated settlement with Our Lady of the Lakes Hospital, Inc. ("OLOL") which was finalized on February 21, 2008. Under the settlement, OLOL released all claims, in contract and in tort, which were asserted or could have been asserted in the litigation against Transcend. In return, the Company agreed to pay $130,000, which was accrued at December 31, 2007 and paid in the first quarter of 2008, to OLOL and released all claims under the Company's counterclaim against OLOL.

Stock-Based Compensation. The Company previously accounted for stock-based compensation using the intrinsic value method prescribed in APB No. 25. The Company grants stock options with exercise prices equal to the respective grant date's fair market value and, as such, recognized no compensation cost for such stock options under APB No. 25. Effective January 1, 2006, we adopted the provisions of SFAS No. 123R for our

stock-based awards. See Note 11 of the Financial Statements for further discussion of the impact on the Company's earnings. Under SFAS No. 123R, management makes assumptions regarding the Company's stock volatility and forfeiture rates required using the Black-Sholes-Merton option-pricing model used to calculate option compensation cost.

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007

Revenue increased $6.2 million, or 15%, to $48.7 million in 2008, compared to revenue of $42.5 million in 2007. The $6.2 million increase in revenue consisted of increased revenue from existing customers of $4.8 million, revenue from new customers of $3.0 million, partially offset by decreases in revenue of $1.6 million from customers who cancelled their contracts in 2008.

Direct costs increased $2.1 million, or 7%, to $30.9 million in 2008, compared to $28.8 million in 2007. Direct costs include costs attributable to compensation for transcriptionists, recruiting, management, customer service, technical support for operations, fees paid for speech recognition processing, telephone expenses and implementation of transcription services. 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. Speech recognition processing is a variable cost based on the minutes of dictation processed. All other direct costs referred to above are semi-variable production infrastructure costs that periodically change in anticipation of or in response to the overall level of production activity.

As a percentage of revenue, direct costs decreased to 63% in 2008 from 68% in 2007. The decrease in costs as a percentage of revenue is due primarily to cost savings that resulted from an increase in the use of the Company's speech recognition-enabled BeyondTXT platform, growth of semi-variable direct costs of operations at a slower rate than the rate of revenue growth and the use of increased offshore transcription resources. Approximately 19% of the Company's transcription work was performed offshore during 2008, compared to 14% during 2007. During 2008, approximately 30% of the Company's volume was edited using speech recognition technology on the BeyondTXT platform, compared to 24% during 2007. Gross profit increased $4.1 million, or 31%, to $17.8 million in 2008, compared to $13.7 million in 2007. Gross profit as a percentage of revenue increased to 37% in 2008 compared to 32% in 2007 (see direct costs discussion).

Sales and marketing expenses increased $681,000, or 152%, to $1,130,000 in 2008, compared to $449,000 in 2007. Sales and marketing expenses as a percentage of revenue were 2% and 1% in 2008 and 2007, respectively. The increase is due primarily to the addition of the Executive Vice President of Sales and Marketing and three Regional Sales Directors during 2008.

Research and development expenses increased $406,000, or 62%, to $1,065,000 in 2008, compared to $659,000 in 2007. Research and development expenses as a percentage of revenue in 2008 were 2% in 2008 and 2007. The increase is primarily due to increased data infrastructure expense and third-party software license expense.

General and administrative expenses increased $603,000, or 11%, to $5.9 million in 2008, compared to $5.3 million in 2007. General and administrative expenses as a percentage of revenue were 12% in 2008 and 2007. The increase was due primarily to an increase in healthcare insurance, compensation and audit costs.

Depreciation and amortization expenses increased $29,000, or 4%, to $822,000 in 2008, compared to $793,000 in 2007. Depreciation and amortization expenses as a percentage of revenue in 2008 and 2007 were 2%. The increase is due to additional capital spending in 2008 and in late 2007.

Interest and other expense decreased $269,000, to $3,000 in 2008, compared to $272,000 in 2007. The decrease is due primarily to a reduction in the amount of debt outstanding during 2008 compared to 2007, along with increased cash which drove interest income higher.

The Company reported income tax expense of $3.2 million in 2008 compared to an income tax benefit of $3.4 million in 2007. During the fourth quarter of 2007, the Company performed a detailed review of its income tax position, specifically the valuation allowance that had been established against deferred tax assets. As a result of the review, management determined that it is more likely than not that the Company will be able to utilize all of its net operating loss carry forwards and that a valuation allowance was no longer necessary, except for a $219,000 valuation allowance as of December 31, 2007 against the deferred tax asset related to certain state net operating loss carry forwards which will more likely than not expire before being utilized. The reduction in the valuation allowance over the course of 2007 resulted in an income tax benefit of $6.5 million in 2007, offset by current and deferred tax expense of $3.1 million. During 2008, the Company recorded income tax expense at an effective rate of 36% based on a detailed review of the Company's tax provision and further reductions in the valuation allowance related to state net operating loss carry forwards.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006

Revenue increased $9.5 million, or 29%, to $42.4 million in 2007, compared to revenue of $32.9 million in 2006. The $9.5 million increase in revenue consisted of increased revenue from existing customers of $2.4 million, revenue from new customers of $6.9 million and revenue from the acquisition of OTP of $1.6 million, partially offset by decreases in revenue of $1.3 million from customers who cancelled their contracts in 2007 and a decrease of $102,000 in other revenue.

Direct costs increased $3.8 million, or 15%, to $28.8 million in 2007, compared to $25.0 million in 2006. Direct costs include costs attributable to compensation for transcriptionists, recruiting, management, customer service, technical support for operations, fees paid for speech recognition processing, telephone expenses and implementation of transcription services. 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. Speech recognition processing is a variable cost based on the minutes of dictation processed. All other direct costs referred to above are semi-variable production infrastructure costs that periodically change in anticipation of or in response to the overall level of production activity.

As a percentage of revenue, direct costs decreased to 68% in 2007 from 76% in 2006. The decrease in costs as a percentage of revenue is due primarily to cost savings that resulted from an increase in the use of the Company's speech recognition-enabled BeyondTXT platform, growth of semi-variable direct costs of operations at a slower rate than the rate of revenue growth and the use of increased offshore transcription resources.

Gross profit increased $5.7 million, or 72%, to $13.7 million in 2007, compared to $8.0 million in 2006. Gross profit as a percentage of revenue increased to 32% in 2007 compared to 24% in 2006 (see direct costs discussion).

Sales and marketing expenses increased $26,000, or 6%, to $449,000 in 2007, compared to $423,000 in 2006. Sales and marketing expenses as a percentage of revenue were 1% in both 2007 and 2006. The increase is due primarily to increased telemarketing expenses for the year.

Research and development expenses increased $268,000, or 69%, to $659,000 in 2007, compared to $391,000 in 2006. Research and development expenses as a percentage of revenue in 2007 were 2% compared to 1% in 2006. The increase is primarily due to an increase in compensation-related expenses.

General and administrative expenses increased $1.0 million, or 24%, to $5.3 million in 2007, compared to $4.3 million in 2006. General and administrative expenses as a percentage of revenue were 12% in 2007 compared to 13% in 2006. The increase was due primarily to an increase in healthcare insurance, contract services, 401(k) retirement plan contributions and Sarbanes-Oxley Act compliance costs.

Depreciation and amortization expenses decreased $37,000, or 4%, to $793,000 in 2007, compared to $830,000 in 2006. Depreciation and amortization expenses as a percentage of revenue in 2007 were 2% compared to 3% in 2006. The decrease is primarily due to a relatively slower rate of capital expenditures in recent years.

Interest and other expense decreased $287,000, or 51%, to $272,000 in 2007, compared to $559,000 in 2006. The decrease is due primarily to a reduction in the amount of debt outstanding during 2007 compared to 2006.

The Company reported an income tax benefit of $3.4 million in 2007 compared to an income tax provision of $31,000 in 2006. During the fourth quarter of 2007, the Company performed a detailed review of its income tax position, specifically the valuation allowance that had been established against deferred tax assets. As a result of the review, management determined that it is more likely than not that the Company will be able to utilize all of its net operating loss carry forwards and that a valuation allowance is no longer necessary, except for a $219,000 valuation allowance against the deferred tax asset related to certain state net operating loss carry forwards which will more likely than not expire before being utilized. The reduction in the valuation allowance over the course of 2007 resulted in an income tax benefit of $6.5 million in 2007, offset by current and deferred tax expense of $3.1 million. The income tax provision of $31,000 in 2006 was due to the expiration of certain state net operating loss carry forwards. The Company had federal pre-tax net operating loss carry forwards of approximately $15.7 million as of December 31, 2007.

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, 2008:



                                                        Payments due by period (000's)
                                                   Less than 1                                  More than
                                       Total           year         1-3 years     3-5 years      5 years
Long-term debt obligations (1)      $   723,000    $    485,000    $   238,000    $             $
Capital lease obligations           $              $               $              $             $
Operating lease obligations         $ 2,464,000    $    975,000    $   767,000    $  461,000    $  261,000
Purchase obligations                $              $               $              $             $
Other long term liabilities         $              $               $              $             $

Total                               $ 3,187,000    $  1,460,000    $ 1,005,000    $  461,000    $  261,000

(1) Includes projected interest payments.

LIQUIDITY AND CAPITAL RESOURCES

As of December 31, 2008, the Company had cash and cash equivalents of $12.3 million, working capital of $15.0 million, availability of approximately $3.6 million on its revolving promissory note based on eligible accounts receivable and $2.0 million on its acquisition term loan. The accounts receivable-based revolving promissory note and acquisition term loan both expire on December 31, 2009. The final installment of the MDI promissory note of $1.2 million was paid with available cash in the first quarter of 2008. See Note 4 of Notes to Consolidated Financial Statements.

Cash provided by operating activities for the years ended December 31, 2008, 2007 and 2006 was $9.5 million, $7.2 million, and $1.4 million, respectively. The fluctuations from year to year were primarily due to

changes in net income excluding the effects of changes in deferred income taxes in 2007 and 2008.

Net cash used in investing activities totaled $989,000 in 2008, $1.3 million in 2007, and $378,000 in 2006. The Company invested $949,000, $702,000, and $386,000 in property, equipment and software for the years ended December 31, 2008, 2007, and 2006, respectively. In January 2007, the Company purchased OTP for $1.1 million, of which $520,000 was paid in cash to the sellers plus $46,000 in acquisition-related costs.

Net cash (used in) financing activities totaled $(1.3) million, $(1.1) million, and $(1.5) million in 2008, 2007 and 2006, respectively. The $(1.3) million paid in 2008 was due primarily to the Company making the final installment of $1.2 million on the MDI promissory note.

The Company anticipates that cash on hand, together with cash flows from operations should be sufficient for the next twelve months to finance operations, make capital investments in the ordinary course of business, and pay indebtedness when due.

In light of the current state of the credit market, the Company must consider the impact of the potential inability of the Company to renew or replace its existing credit facility on acceptable terms and conditions with HFG or another financial institution upon expiration of the current credit facility on December 31, 2009. The Company does not anticipate the need to have or use any credit facility in the next twelve months to finance operations or make capital investments in the ordinary course of business.

Part of the growth strategy for Transcend is the completion of acquisitions. Management believes that available cash and the HFG credit facility (until expiration on December 31, 2009) together with other acquisition options, such as owner financing, are sufficient to complete small acquisitions, but insufficient for the full execution of the Company's acquisition strategy. Additional financing will be required for larger acquisitions. Transcend has not needed to access the credit markets for additional acquisition funding, and it is uncertain to what degree the Company can obtain acquisition financing should the need arise.

MANAGEMENT'S ASSESSMENT OF THE CURRENT ECONOMIC ENVIRONMENT

The U.S. economy has deteriorated significantly in recent months, stemming primarily from the disruptions in the global credit markets. If the economy were to further deteriorate, the Company could see deterioration in collection of its accounts receivable. In addition, the decrease in availability of consumer credit resulting from the financial crisis, as well as general unfavorable economic conditions, could also cause consumers to reduce their discretionary spending, including spending for medical care. It is also uncertain what effect the credit crisis may have on the security of the U.S. banking system, and specifically the bank where the Company's cash and cash equivalents are deposited. In addition, FDIC insurance does not adequately insure deposits, and it is estimated that $5.7 million of the Company's cash and cash equivalents were not insured at December 31, 2008

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In December 2007, the FASB issued SFAS No. 141(R), Business Combinations. This Statement retains the fundamental requirements in SFAS 141, Business Combinations. However, SFAS 141(R) requires that acquisition costs be recognized separately from the acquisition and also requires the recognition of assets and liabilities assumed arising from contractual contingencies as of the acquisition date. SFAS 141(R) is effective for the fiscal year beginning January 1, 2009. This Statement amends FASB Statement No. 109, Accounting for Income Taxes, to require the acquirer to recognize changes in the amount of its deferred tax benefits that are recognizable because of a business combination either in income from continuing operations in the period of the combination or directly in contributed capital, depending on the circumstances. The Statement also requires that a Company account for the potential tax effects of temporary differences, carry forwards, and any income tax uncertainties of the company acquired that exist at the acquisition date or that arise as a result of the acquisition in accordance with Statement 109, as amended, and related interpretative guidance, including FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. The adoption of SFAS 141(R) will likely have a significant impact on the accounting for any acquisitions completed after the effective date of the pronouncement.

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities-an Amendment of FASB Statement 133. SFAS 161 requires enhanced disclosures regarding how: (a) an entity uses derivative instruments; (b) derivative instruments and related hedged items are accounted for under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities; and (c) derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows. SFAS 161 is effective for fiscal years and interim periods beginning after November 15, 2008 with early application being encouraged. The Company does not have any derivative instruments nor is it currently involved in hedging activities and therefore adoption of SFAS 161 is not expected to have a material impact on the Company's consolidated financial statements.

In April 2008, the FASB issued FSP FAS No. 142-3, which amends the factors that must be considered in developing renewal or extension assumptions used to determine the useful life over which to amortize the cost of a recognized intangible asset under SFAS No. 142, "Goodwill and Other Intangible Assets." The FSP requires an entity that is estimating the useful life of a recognized intangible asset to consider its historical experience in renewing or extending similar arrangements or, in the absence of historical experience, must consider assumptions that market participants would use about renewal or extension that are both consistent with the asset's highest and best use and adjusted for entity-specific factors under SFAS No. 142. The FSP is effective for fiscal years beginning after December 15, 2008, and the guidance for determining the useful life of a recognized intangible asset must be applied prospectively to intangible assets acquired after the effective date. The Company does not expect the adoption of FSP FAS No. 142-3 to have a material effect on its consolidated financial statements.

In May 2008, the FASB issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles. SFAS 162 is intended to improve financial reporting by identifying a consistent framework, or hierarchy, for selecting accounting principles to be used in financial statements that are presented in conformity with U.S. generally accepted accounting principles for nongovernmental entities. SFAS 162 is effective 60 days following the SEC's approval of the Public Company Accounting Oversight Board amendments to AU Section 411, The Meaning of Present Fairly in Conformity With Generally Accepted Accounting Principles. The adoption of SFAS 162 is not expected to have a significant impact on the Company's consolidated financial statements.

IMPACT OF INFLATION

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