**Exhibit 99.3**

 

 

----

 

**Axcan Pharma Inc.**

 

**Consolidated Financial StatementsSeptember 30, 2007 and 2006**

 
| Management’s Report                                                                              | 2         |
|-------------------------------------------------------------------------------------------------------|-----------|
|                                                                                                  |      |
| Management’s Report on Internal Control over Financial Reporting                                 | 3         |
|                                                                                                  |      |
| Report of Independent Registered Public Accounting Firm                                               | 4         |
|                                                                                                  |      |
| Report of Independent Registered Public Accounting Firm on Internal  Control over Financial Reporting | 5         |
|                                                                                                  |      |
| Financial Statements                                                                                  |      |
|                                                                                                  |      |
| Consolidated Balance  Sheets                                                                          | 7         |
|                                                                                                  |      |
| Consolidated Operations                                                                               | 8         |
|                                                                                                  |      |
| Consolidated Shareholders’  Equity and Comprehensive Income                                      | 9         |
|                                                                                                  |      |
| Consolidated Cash Flows                                                                               | 10        |
|                                                                                                  |      |
| Notes to Consolidated  Financial Statements                                                           | 11  to 38 |

 

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**Management’sReport**

 

The consolidated financialstatements of Axcan Pharma Inc. and subsidiaries (collectively “the Company”)and the other financial information included in this annual report are theresponsibility of the Company’s management.

 

These consolidated financialstatements and the other financial information have been prepared by managementin accordance with accounting principles generally accepted in the UnitedStates of America. This responsibility includes the selection of appropriateaccounting principles and methods in the circumstances and the use of carefuljudgement in establishing reasonable accounting estimates.

 

Management maintains internalcontrol systems designed among other things, to provide reasonable assurancethat the Company’s assets are adequately safeguarded and that the accountingrecords are a reasonable basis to prepare relevant and reliable financialinformation.

 

The Audit Committee iscomposed solely of external directors. This Committee meets with the externalauditors and management to discuss matters relating to the audit, internalcontrol and financial information. The Committee also reviews the consolidatedquarterly and annual financial statements.

 

These consolidated financialstatements have been audited by Raymond Chabot Grant Thornton LLP, whose reportindicating the scope of their audits and their opinion on the consolidatedfinancial statements is presented hereafter.

 

The Board of Directors hasapproved the Company’s financial statements on the recommendation of the AuditCommittee.

 

 
| [s]Frank Verwiel, M.D.  |                  | [s]Steve Gannon |   |
|-------------------------|-----------------------|-----------------|--------|
| President and           | Senior Vice President |
| Chief Executive Officer | and Chief Financial   |
|                    | Officer               |

 

 

Mont-Saint-Hilaire, Quebec,CanadaNovember 29, 2007

 

2

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**Management’sReport on Inter Internal Control over Financial Reporting**

 

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting for the Company. Internal control over financial reporting is aprocess designed to provide reasonable assurance regarding the reliability ofour financial reporting and the preparation of financial statements for externalpurposes in accordance with accounting principles generally accepted in theUnited States of America. Internal control over financial reporting includesmaintaining records that, in reasonable detail, accurately and fairly reflectour transactions; providing reasonable assurance that transactions are recordedas necessary for the preparation of our financial statements; providingreasonable assurance that receipts and expenditures of the Company are madeunder the authorization of management and directors of the Company; andproviding reasonable assurance that unauthorized acquisition, use ordisposition of Company assets that could have a material effect on ourfinancial statements would be prevented or detected on a timely basis. Becauseof its inherent limitations, internal control over financial reporting is notintended to provide absolute assurance that a misstatement of our financialstatements would be prevented or detected.

 

Management conducted anevaluation of the effectiveness of the Company’s internal control overfinancial reporting based on the framework in *InternalControl – Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission. Based on this evaluation, managementconcluded that the Company’s internal control over financial reporting waseffective as of September 30, 2007.

 

Raymond Chabot GrantThornton LLP, our independent registered public accounting firm, has issued anattestation report on internal control over financial reporting for AxcanPharma Inc. as of September 30, 2007, which is included herein.

 

 
| [s]Frank Verwiel, M.D.  |                  | [s]Steve Gannon |   |
|-------------------------|-----------------------|-----------------|--------|
| President and           | Senior Vice President |
| Chief Executive Officer | and Chief Financial   |
|                    | Officer               |

 

 

Mont-Saint-Hilaire, Quebec,Canada

November 29, 2007

 

3

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**Report ofIndependent Registered Public Accounting Firm**

 

To the Board of Directorsand Shareholders ofAxcan Pharma Inc.

 

We have audited theconsolidated balance sheets of Axcan Pharma Inc. and subsidiaries as of September 30,2007 and 2006 and the consolidated statements of operations, shareholders’equity and comprehensive income and cash flows for each of the years in thethree-year period ended September 30, 2007. These financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform an audit toobtain reasonable assurance whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of Axcan Pharma Inc. and subsidiariesas of September 30, 2007 and 2006 and the results of their operations andtheir cash flows for each of the years in the three-year period ended September 30,2007 in conformity with accounting principles generally accepted in the UnitedStates of America.

 

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Axcan Pharma Inc. and subsidiaries’internal control over financial reporting as of September 30, 2007, basedon criteria established in Internal Control-Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), andour report dated November 29, 2007 expressed an unqualified opinion on theeffectiveness of the Company’s internal control over financial reporting.

 

 

/s/Raymond Chabot Grant Thornton LLP 

 

Raymond Chabot GrantThornton LLP 

Chartered Accountants

 

 

Montreal, Quebec,Canada  

November  29, 2007

 

4

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**Report ofIndependent Registered Public Accounting Firm on Internal Control overFinancial Reporting**

 

To the Board of Directorsand Shareholders ofAxcan Pharma Inc.

 

We have audited Axcan PharmaInc. and subsidiaries’ internal control over financial reporting as of September 30,2007, based on criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). Axcan Pharma Inc. and subsidiaries’ management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on the effectiveness of AxcanPharma Inc. and subsidiaries’ internal control over financial reporting basedon our audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control over financialreporting was maintained in all material respects. Our audit included obtainingan understanding of internal control over financial reporting, assessing therisk that a material weakness exists, testing and evaluating the design andoperating effectiveness of internal control based on assessed risk andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

 

A company’s internal controlover financial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation offinancial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the Company arebeing made only in accordance with authorizations of management and directorsof the Company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of theCompany’s assets that could have a material effect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

In our opinion, Axcan PharmaInc. and subsidiaries maintained, in all material respects, effective internalcontrol over financial reporting as of September 30, 2007, based oncriteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).

 

5

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We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Axcan Pharma Inc. andsubsidiaries as of September 30, 2007 and 2006 and the consolidatedstatements of operations, shareholders’ equity and comprehensive income andcash flows for each of the years in the three-year period ended September 30,2007 and our report dated November 29, 2007 expressed an unqualifiedopinion on those consolidated financial statements.

 

 

/s/Raymond Chabot Grant Thornton LLP 

 

Raymond Chabot GrantThornton LLP 

Chartered Accountants

 

 

Montreal, Quebec,Canada  

November  29, 2007

 

6

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**AxcanPharma Inc.**

**ConsolidatedBalance SheetsSeptember 30**

(in thousands of U.S.dollars, except share related data)

 
| ** **                                                                                                                                                                         | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                                                                                                         | ** ** | **$**    | ** ** | **$**    | ** ** |
| **ASSETS**                                                                                                                                                                         |       |     |       |     |       |
| Current assets                                                                                                                                                                     |       |     |       |     |       |
| Cash and cash equivalents                                                                                                                                                          |       | 179,672  |       | 55,830   |       |
| Short-term investments, available for sale (Note 4)                                                                                                                                |       | 129,958  |       | 117,151  |       |
| Accounts receivable, net (Note 5)                                                                                                                                                  |       | 36,674   |       | 30,939   |       |
| Income taxes receivable                                                                                                                                                            |       | 10,092   |       | 8,987    |       |
| Inventories (Note 6)                                                                                                                                                               |       | 26,706   |       | 37,349   |       |
| Prepaid expenses and deposits                                                                                                                                                      |       | 3,070    |       | 3,699    |       |
| Deferred income taxes (Note 7)                                                                                                                                                     |       | 15,955   |       | 8,423    |       |
| Total current assets                                                                                                                                                               |       | 402,127  |       | 262,378  |       |
| Property, plant and equipment, net (Note 8)                                                                                                                                        |       | 31,197   |       | 28,817   |       |
| Intangible assets, net (Note 9)                                                                                                                                                    |       | 367,217  |       | 375,680  |       |
| Goodwill, net                                                                                                                                                                      |       | 27,467   |       | 27,467   |       |
| Deferred debt issue expenses, net                                                                                                                                                  |       | —   |       | 1,475    |       |
| Deferred income taxes (Note 7)                                                                                                                                                     |       | 4,603    |       | —   |       |
| Total assets                                                                                                                                                                       |       | 832,611  |       | 695,817  |       |
| **LIABILITIES**                                                                                                                                                                    |       |     |       |     |       |
| Current liabilities                                                                                                                                                                |       |     |       |     |       |
| Accounts payable and accrued liabilities (Note 11)                                                                                                                                 |       | 83,196   |       | 60,733   |       |
| Income taxes payable                                                                                                                                                               |       | 18,938   |       | 2,099    |       |
| Instalments on long-term debt                                                                                                                                                      |       | 527      |       | 681      |       |
| Deferred income taxes (Note 7)                                                                                                                                                     |       | 2,076    |       | 1,104    |       |
| Total current liabilities                                                                                                                                                          |       | 104,737  |       | 64,617   |       |
| Long-term debt (Note 12)                                                                                                                                                           |       | 122      |       | 125,565  |       |
| Deferred income taxes (Note 7)                                                                                                                                                     |       | 37,555   |       | 38,211   |       |
| Total liabilities                                                                                                                                                                  |       | 142,414  |       | 228,393  |       |
| Commitments and contingencies (Note 18)                                                                                                                                            |       |     |       |     |       |
|                                                                                                                                                                               |       |     |       |     |       |
| **SHAREHOLDERS’ EQUITY**                                                                                                                                                      |       |     |       |     |       |
| Capital stock (Note 13)                                                                                                                                                            |       |     |       |     |       |
| Preferred shares, without par value;  unlimited shares authorized; no shares issued                                                                                                |       | —   |       | —   |       |
| Series A preferred shares, without par  value; shares authorized: 14,175,000; no shares issued                                                                                |       | —   |       | —   |       |
| Series B preferred shares, without par  value; shares authorized: 12,000,000; no shares issued                                                                                |       | —   |       | —   |       |
| Common shares, without par value; unlimited  shares authorized; 55,359,652 issued and outstanding as at  September 30, 2007 and 45,800,581 as at September 30, 2006 |       | 395,888  |       | 262,786  |       |
| Retained earnings                                                                                                                                                                  |       | 249,371  |       | 177,906  |       |
| Additional paid-in capital                                                                                                                                                         |       | 9,089    |       | 4,967    |       |
| Accumulated other comprehensive income                                                                                                                                             |       | 35,849   |       | 21,765   |       |
| Total shareholders’ equity                                                                                                                                                    |       | 690,197  |       | 467,424  |       |
| Total liabilities and shareholders’ equity                                                                                                                                    |       | 832,611  |       | 695,817  |       |

 

The accompanying notes are anintegral part of the consolidated financial statements.

 
| On behalf of the Board,   |       |
|---------------------------|------------|
|                      |       |
| [s] Léon F. Gosselin | , Director |
|                      |       |
| [s] Dr Claude Sauriol     | , Director |

 

7

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**AxcanPharma Inc.**

**ConsolidatedOperationsYears ended September 30**

(in thousands of U.S.dollars, except share related data)

 
| ** **                               | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                               | ** ** | **$**      | ** ** | **$**      | ** ** | **$**      | ** ** |
| Revenue                                  |       | 348,947    |       | 292,317    |       | 251,343    |       |
|                                     |       |       |       |       |       |       |       |
| Cost of goods sold (a)                   |       | 83,683     |       | 72,772     |       | 71,534     |       |
| Selling and administrative expenses (a)  |       | 101,273    |       | 93,338     |       | 85,997     |       |
| Research and development expenses (a)    |       | 28,655     |       | 39,789     |       | 31,855     |       |
| Depreciation and amortization            |       | 22,494     |       | 22,823     |       | 21,532     |       |
| Acquired in-process research (Note 3)    |       | 10,000     |       | —     |       | —     |       |
| Partial write-down of intangible assets  |       | —     |       | 5,800      |       | —     |       |
|                                     |       | 246,105    |       | 234,522    |       | 210,918    |       |
| Operating income                         |       | 102,842    |       | 57,795     |       | 40,425     |       |
|                                     |       |       |       |       |       |       |       |
| Financial expenses                       |       | 4,825      |       | 6,988      |       | 7,140      |       |
| Interest income                          |       | (11,367    | )          | (5,468     | )          | (1,340     | )          |
| Loss (gain) on foreign currency          |       | 2,352      |       | (1,110     | )          | (213       | )          |
|                                     |       | (4,190     | )          | 410        |       | 5,587      |       |
| Income before income taxes               |       | 107,032    |       | 57,385     |       | 34,838     |       |
| Income taxes (Note 7)                    |       | 35,567     |       | 18,266     |       | 8,413      |       |
| **Net income**                           |       | 71,465     |       | 39,119     |       | 26,425     |       |
|                                     |       |       |       |       |       |       |       |
| Income per common share                  |       |       |       |       |       |       |       |
| Basic                                    |       | 1.47       |       | 0.86       |       | 0.58       |       |
| Diluted                                  |       | 1.33       |       | 0.79       |       | 0.56       |       |
|                                     |       |       |       |       |       |       |       |
| Weighted average number of common shares |       |       |       |       |       |       |       |
| Basic                                    |       | 48,466,980 |       | 45,741,419 |       | 45,617,703 |       |
| Diluted                                  |       | 55,724,405 |       | 55,064,496 |       | 55,219,202 |       |

 

----

(a) Exclusive ofdepreciation and amortization

 

The accompanying notes are anintegral part of the consolidated financial statements. Note 14 presentsadditional information on consolidated operations.

 

8

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**AxcanPharma Inc.**

**ConsolidatedShareholders’ Equity and Comprehensive IncomeYears ended September 30**

(in thousands of U.S.dollars, except share related data)

 
| ** **                                                    | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| **Common shares (number)**                                    |       |       |       |       |       |       |       |
| Balance, beginning of year                                    |       | 45,800,581 |       | 45,682,175 |       | 45,562,336 |       |
| Shares issued on conversion of subordinated  notes            |       | 8,924,080  |       | —     |       | —     |       |
| Shares issued pursuant to the stock incentive  plans for cash |       | 634,991    |       | 118,406    |       | 119,839    |       |
| Balance, end of year                                          |       | 55,359,652 |       | 45,800,581 |       | 45,682,175 |       |

 
| ** **                                                    | ** ** | **$**   | ** ** | **$**   | ** ** | **$**   | ** ** |
|---------------------------------------------------------------|------------|---------|------------|---------|------------|---------|------------|
|                                                          |       |    |       |    |       |    |       |
| **Common shares**                                             |       |    |       |    |       |    |       |
| Balance, beginning of year                                    |       | 262,786 |       | 261,714 |       | 260,643 |       |
| Shares issued on conversion of subordinated  notes            |       | 125,000 |       | —  |       | —  |       |
| Stock-based compensation on exercised  options                |       | 845     |       | —  |       | —  |       |
| Shares issued pursuant to the stock incentive  plans for cash |       | 7,257   |       | 1,072   |       | 1,071   |       |
| Balance, end of year                                          |       | 395,888 |       | 262,786 |       | 261,714 |       |
| **Retained earnings**                                         |       |    |       |    |       |    |       |
| Balance, beginning of year                                    |       | 177,906 |       | 138,787 |       | 112,362 |       |
| Net income                                                    |       | 71,465  |       | 39,119  |       | 26,425  |       |
| Balance, end of year                                          |       | 249,371 |       | 177,906 |       | 138,787 |       |
| **Additional paid-in capital**                                |       |    |       |    |       |    |       |
| Balance, beginning of year                                    |       | 4,967   |       | 1,329   |       | —  |       |
| Stock-based compensation expense                              |       | 4,548   |       | 3,554   |       | —  |       |
| Stock-based compensation on exercised  options                |       | (845    | )          | —  |       | —  |       |
| Income tax deductions on stock options  exercise              |       | 419     |       | 84      |       | 1,329   |       |
| Balance, end of year                                          |       | 9,089   |       | 4,967   |       | 1,329   |       |
| **Accumulated other comprehensive income**                    |       |    |       |    |       |    |       |
| Balance, beginning of year                                    |       | 21,765  |       | 15,774  |       | 19,071  |       |
| Foreign currency translation adjustments                      |       | 14,084  |       | 5,991   |       | (3,297  | )          |
| Balance, end of year                                          |       | 35,849  |       | 21,765  |       | 15,774  |       |
| Total shareholders’ equity                               |       | 690,197 |       | 467,424 |       | 417,604 |       |
| **Comprehensive income**                                      |       |    |       |    |       |    |       |
| Foreign currency translation adjustments                      |       | 14,084  |       | 5,991   |       | (3,297  | )          |
| Net income                                                    |       | 71,465  |       | 39,119  |       | 26,425  |       |
| Total comprehensive income                                    |       | 85,549  |       | 45,110  |       | 23,128  |       |

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

9

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**AxcanPharma Inc.**

**ConsolidatedCash FlowsYears ended September 30**

(in thousands of U.S.dollars)

 
| ** **                                                       | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                                       | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| **OPERATING ACTIVITIES**                                         |       |     |       |     |       |     |       |
| Net income                                                       |       | 71,465   |       | 39,119   |       | 26,425   |       |
| Non-cash items                                                   |       |     |       |     |       |     |       |
| Non-cash financial expenses                                      |       | 1,475    |       | 1,117    |       | 1,100    |       |
| Other depreciation and amortization                              |       | 22,494   |       | 22,823   |       | 21,532   |       |
| Partial write-down of intangible assets                          |       | —   |       | 5,800    |       | —   |       |
| Loss on disposal and write-down of assets                        |       | 3,875    |       | 1,064    |       | —   |       |
| Stock-based compensation expense                                 |       | 4,548    |       | 3,554    |       | —   |       |
| Foreign currency fluctuations                                    |       | 1,763    |       | (739     | )          | (84      | )          |
| Deferred income taxes                                            |       | (11,696  | )          | 516      |       | (3,261   | )          |
| Changes in working capital items (Note 15)                       |       | 42,178   |       | 11,080   |       | 22,033   |       |
| Cash flows from operating activities                             |       | 136,102  |       | 84,334   |       | 67,745   |       |
| **INVESTING ACTIVITIES**                                         |       |     |       |     |       |     |       |
| Acquisition of short-term investments                            |       | (148,929 | )          | (117,151 | )          | (14,519  | )          |
| Disposal of short-term investments                               |       | 136,122  |       | 17,619   |       | 12,822   |       |
| Acquisition of property, plant and  equipment                    |       | (6,789   | )          | (4,038   | )          | (6,330   | )          |
| Disposal of property, plant and equipment                        |       | 219      |       | —   |       | —   |       |
| Acquisition of intangible assets                                 |       | (38      | )          | (4,569   | )          | (51      | )          |
| Cash flows from investing activities                             |       | (19,415  | )          | (108,139 | )          | (8,078   | )          |
| **FINANCING ACTIVITIES**                                         |       |     |       |     |       |     |       |
| Long-term debt                                                   |       | —   |       | 634      |       | —   |       |
| Repayment of long-term debt                                      |       | (704     | )          | (2,322   | )          | (1,857   | )          |
| Deferred debt issue expenses                                     |       | —   |       | —   |       | (589     | )          |
| Issue of shares                                                  |       | 7,257    |       | 1,072    |       | 1,071    |       |
| Cash flows from financing activities                             |       | 6,553    |       | (616     | )          | (1,375   | )          |
|                                                             |       |     |       |     |       |     |       |
| Foreign exchange gain (loss) on cash held  in foreign currencies |       | 602      |       | 282      |       | (302     | )          |
| **Net increase (decrease) in cash and cash****equivalents**      |       | 123,842  |       | (24,139  | )          | 57,990   |       |
| Cash and cash equivalents, beginning of  year                    |       | 55,830   |       | 79,969   |       | 21,979   |       |
| Cash and cash equivalents, end of year                           |       | 179,672  |       | 55,830   |       | 79,969   |       |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

10

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** **

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

** **

**1**      **–  GOVERNING STATUTES AND NATURE OF OPERATIONS**

 

Axcan Pharma Inc. isincorporated under the Canada Business Corporations Act. The Company isinvolved in the research, development, production and distribution ofpharmaceutical products, mainly in the field of gastroenterology.

** **

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

** **

**Basis ofpresentation**

 

These consolidated financialstatements have been prepared in U.S. dollars and in accordance with generallyaccepted accounting principles in the United States of America (“U.S. GAAP”).

** **

**Use ofestimates**

 

The preparation of financialstatements in accordance with generally accepted accounting principles requiresmanagement to make estimates and assumptions that affect the recorded amountsof assets and liabilities and the disclosure of contingent assets andliabilities as at the date of the financial statements and also affect therecognized amounts of revenues and expenses during the year. Significantestimates and assumptions made by management include allowances for accountsreceivable and inventories, reserves for product returns, rebates, chargebacksand distribution service agreement fees, the classification of intangibleassets between finite life and indefinite life, the useful lives of long-livedassets, the expected cash flows used in evaluating long-lived assets, goodwilland investments for impairment, stock-based compensation costs, pending legalsettlements, the establishment of provisions for income taxes including therealizability of deferred tax assets and the allocation of the purchase priceof acquired assets and businesses. The estimates are made using the historicalinformation and various other relevant factors available to management. TheCompany reviews all significant estimates affecting the financial statements ona recurring basis and records the effect of any adjustments when necessary.Actual results could differ from those estimates based upon future events,which could include, among other risks, changes in regulations governing themanner in which the Company sells its products, changes in the health careenvironment, foreign exchange and managed care consumptions patterns.

** **

**Principlesof consolidation**

 

These financial statementsinclude the accounts of Axcan Pharma Inc. and its subsidiaries, the mostsignificant being Axcan Scandipharm, Inc. (“Axcan Scandipharm”), AxcanPharma U.S. Inc. and Axcan Pharma S.A.. Significant intercompany balances andtransactions have been eliminated on consolidation.

 

11

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

** **

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

** **

**Revenuerecognition**

 

Revenue is recognized whenthe product is shipped to the Company’s customers, provided the Company has notretained any significant risks of ownership or future obligations with respectto the product shipped. Provisions for sales discounts and estimates for chargebacks,managed care and Medicaid rebates, products returns and distribution serviceagreement fees are established as a reduction of product sales revenues at thetime such revenues are recognized. These revenue reductions are established bythe Company at the time of sale, based on historical experience adjusted toreflect known changes in the factors that impact such reserves. In certaincircumstances, returns of products are allowed under the Company’s policy andprovisions are maintained accordingly. These revenue reductions are generallyreflected as an addition to accrued expenses. Amounts received from customersas prepayments for products to be shipped in the future are reported asdeferred revenue.

** **

**Cash andcash equivalents**

 

The Company includes in cashand cash equivalents cash and all highly liquid short-term investments withinitial maturities of three months or less at the time of purchase. Cash equivalents are recorded at fair value.

** **

**Short-terminvestments**

 

The Company classifies itsshort-term investments as available-for-sale. These investments are recorded attheir fair value, and unrealized gains or losses, net of tax, are reported inAccumulated other  comprehensive incomein shareholders’ equity. As at September 30, 2007, 2006 and 2005 therewere no material unrealized gains or losses. The Company monitors its investments forother than temporary declines in fair value and charges impairment losses toincome when other than temporary decline in estimated value occurs.

** **

**Accountsreceivable**

 

The majority of theCompany’s accounts receivable are due from companies in the pharmaceuticalindustry. Credit is extended based on an evaluation of a customer’s financialcondition and, generally, collateral is not required. Accounts receivable are duewithin 30 to 60 days and are stated at amounts due from customers net of anallowance for doubtful accounts. Accounts outstanding longer than thecontractual payment terms are considered past due. The Company determines itsallowance by considering a number of factors, including the length of timetrade accounts receivable are past due, the Company’s previous loss history,the customer’s current ability to pay its obligation to the Company, and thecondition of the general economy and the industry as a whole. The Companywrites off accounts receivable when they become uncollectible, and paymentssubsequently received on such receivables are credited to bad debt expense.

 

12

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

** **

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

** **

**Inventoryvaluation**

 

Inventories of raw materialsand packaging material are valued at the lower of cost and replacement cost.Inventories of work in progress and finished goods are valued at the lower ofcost and net realizable value. Cost is determined by the first-in, first-outmethod. Cost for work in progress and finished goods includes raw materials,direct labour, subcontracts and an allocation for overhead. Allowances aremaintained for slow-moving inventories based on the remaining shelf life ofproducts and estimated time required to sell such inventories. Obsoleteinventory and rejected products are written off to cost of goods sold.

** **

**Researchand development**

 

Research and developmentexpenses are charged to operations in the year they are incurred. Acquiredin-process research and development having no alternative future use isexpensed at the time of acquisition. The cost of intangibles that are purchasedfrom others for a particular research and development project that have noalternative future use are expensed at the time of acquisition.

** **

**Depreciationand amortization**

 

Property, plant andequipment and intangible assets with a finite life are reported at cost, lessaccumulated depreciation and are depreciated or amortized over their estimateduseful lives according to the straight-line method over the following periods:

 
| Buildings                                                |   | 10 to 25 years |   |
|----------------------------------------------------------|--------|----------------|--------|
| Furniture and equipment                                  |   | 5 to 10 years  |   |
| Computer equipment                                       |   | 2 to 5 years   |   |
| Automotive equipment                                     |   | 4 to 5 years   |   |
| Leasehold and building improvements                      |   | 5 to 10 years  |   |
| Trademarks, trademark licenses and manufacturing  rights |   | 7 to 25 years  |   |

 

Depreciation or amortizationcommences when an asset is substantially completed and becomes available forproductive commercial use.

 

Goodwill and intangibleassets with an indefinite life have not been amortized since October 1,2001.

 

Deferred debt issue expenseswere amortized on a straight-line basis over the terms of the debts, until2008.

** **

**Impairmentof long lived-assets**

 

The value of goodwill andintangible assets with an indefinite life are subject to an annual impairmenttest and the intangible assets with a definite life and property, plant andequipment are subject to an impairment test whenever events or changes incircumstances indicate that the carrying amounts of these assets may not berecoverable. The Company compares the carrying value of the unamortized portionof property, plant and equipment and intangible assets with a definite life tothe future benefits of the Company’s activities or expected sales ofpharmaceutical products. For goodwill and intangible assets with an indefinitelife, the test is based on the comparison of the fair value of the asset withits carrying amount. Should there be a permanent impairment in value, awrite-down will be recognized for the current year to reflect the assets at fairvalue.

 

13

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

** **

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

** **

**Incometaxes**

 

Income taxes are calculatedusing the liability method. Under this method, deferred income tax assets andliabilities are recognized to account for the estimated taxes that will resultfrom the recovery or settlement of assets and liabilities recorded at theirfinancial statement carrying amounts. Deferred income tax assets andliabilities are measured based on enacted tax rates and laws at the date of thefinancial statements for the years in which the temporary differences areexpected to reverse. A valuation allowance is provided for the portion ofdeferred tax assets that is more likely than not to remain unrealized.Adjustments to the deferred income tax asset and liability balances arerecognized in net income as they occur.

 

The Company conductsbusiness in various countries throughout the world and is subject to tax innumerous jurisdictions. As a result of its business activities, the Companyfiles a significant number of tax returns that are subject to examination byvarious federal, state, and local tax authorities. Tax examinations are oftencomplex as tax authorities may disagree with the treatment of items reported bythe Company and this may require several years to resolve.

** **

**Stock-basedcompensation**

 

The Company maintainsstock-based compensation plans under which stock options, deferred share units(“DSUs”) and restricted share units (“RSUs”) may be granted to employees andnon-employee directors. Option awards made under the plans are granted at thestock market price on the last trading date prior to the date of grant and vestover periods ranging from 1 to 5 years.

 

Effective October 1,2005, the Company adopted Statement of Financial Accounting Standard (“SFAS”) No. 123(R),*“Share-Based Payment”.* SFAS No. 123(R) requiresall stock-based payments to employees to be expensed over the requisite serviceperiod based on the grant-date fair value of the awards and requires that theunvested portion of all outstanding awards upon adoption be recognized usingthe same fair value and attribution methodologies previously determined underSFAS No. 123, *“Accounting forStock-Based Compensation”*. The Company measures stock-basedcompensation cost at grant date, based on the estimated fair value of the award,and recognizes the cost as an expense on a straight-line basis (net ofestimated forfeitures) over the employee requisite service period. The Companycontinues to use the Black-Scholes valuation method and applied therequirements of SFAS 123(R) using the modified prospective transitionapproach. Prior to adoption of SFAS No. 123(R), the Company accounted forstock-based employee compensation including stock options, using the methodprescribed in Accounting Principles Board Opinion (“APB”) No. 25 “Accounting*for Stock Issued to Employees*” and SFAS No. 123“Accounting*for Stock-Based Compensation*”.Under the provision of APB No. 25 and SFAS No. 123 the compensationcost was recognized using the intrinsic value and pro-forma disclosure of netincome and income per share had to be presented in the financial statements asif the fair value method had been applied. The intrinsic value method measuresstock-based compensation expense as the amount at which the stock market priceat the date of grant exceeds the exercise price.

 

14

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

 

**Stock-basedcompensation (continued)**

 

If this change in accountingpolicy had been applied to the previous fiscal years, the Company’s net income,basic income per share and diluted income per share for the year ended September 30,2005 would have been reduced on a pro-forma basis as follows:

 
| ** **                                                                                                  | ** ** | **$**  | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------|------------|
| Net income as reported                                                                                      |       | 26,425 |       |
| Less: Total stock-based compensation  expense determined under fair value based method, net of income taxes |       | 4,274  |       |
| Pro-forma net income                                                                                        |       | 22,151 |       |
|                                                                                                        |       |   |       |
| Basic income per share                                                                                      |       |   |       |
| As reported                                                                                                 |       | 0.58   |       |
| Pro-forma                                                                                                   |       | 0.49   |       |
|                                                                                                        |       |   |       |
| Diluted income per share                                                                                    |       |   |       |
| As reported                                                                                                 |       | 0.56   |       |
| Pro-forma                                                                                                   |       | 0.48   |       |

 

**Selling andadministrative expenses**

 

Selling and administrativeexpenses include shipping and handling expenses, other than distributionservice agreement fees, and advertising expenses. Distribution serviceagreement fees are deducted from revenue. Advertising costs are expensed asincurred.

** **

**Foreigncurrency translation**

 

The current rate method oftranslation of foreign currencies is followed for subsidiaries consideredfinancially and operationally self-sustaining. Therefore, all gains and lossesarising from the translation of the financial statements of subsidiaries aredeferred in a cumulative foreign currency translation adjustments accountreported as a component of accumulated other comprehensive income inshareholders’ equity.

 

For the operations in Canadaand the United States of America, monetary assets and liabilities in currencyother than U.S. dollars are translated into U.S. dollars, the functional currencyof the Company, at the exchange rates in effect at the balance sheet datewhereas other assets and liabilities are translated at exchange rates in effectat transaction dates. Revenue and operating expenses in foreign currency aretranslated at the average rates in effect during the year, except fordepreciation and amortization, translated at historical rates. Gains and lossesare included in net income for the year.

 

15

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

** **

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

 

**Income pershare**

 

Basic income per share iscalculated using the weighted average number of common shares outstandingduring the year and relevant shares issuable under stock incentive plans. Thetreasury stock method is used for determining the dilution effect of options.Diluted income per share is calculated using the weighted average number ofshares outstanding during the year plus the incremental shares outstandingassuming the exercise of dilutive stock options, restricted stock and convertibleinstruments. The dilutive effect of convertible subordinated notes isdetermined using the “if-converted” method.

** **

**Recentlyissued accounting standards**

 

In June 2007, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 07-3, *“Accounting for Nonrefundable Advance Payments forGoods or Services Received for Use in Future Research and DevelopmentActivities.”*As a**resultof this consensus, non-refundable advance payments for goods or services thatwill be used or rendered for future research and development activities shouldbe deferred and capitalized. Such amounts should be recognized as an expense asthe related goods are delivered or the services are performed, or when thegoods or services are no longer expected to be provided. This Issue iseffective for financial statements issued for fiscal years beginning after December 15,2007, and earlier application is not permitted. This consensus is to be appliedprospectively for new contracts entered into on or after the effective date. TheCompany is currently evaluating the impact of adoption of this consensus on itsconsolidated financial statements.

 

In February 2007, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 159, *“The Fair Value Option for Financial Assets andFinancial Liabilities”*, which permits an entity to measure certainfinancial assets and financial liabilities at fair value. The objective of SFASNo. 159 is to improve financial reporting by allowing entities to mitigatevolatility in reported earnings caused by the measurement of related assets andliabilities using different attributes, without having to apply complex hedgeaccounting provisions. Under SFAS No. 159, entities that elect the fairvalue option (by instrument) will report unrealized gains and losses inearnings at each subsequent reporting date. The fair value option election isirrevocable, unless a new election date occurs. SFAS No. 159 establishespresentation and disclosure requirements to help financial statement usersunderstand the effect of the entity’s election on its earnings, but does noteliminate disclosure requirements of other accounting standards. Assets andliabilities that are measured at fair value must be displayed on the face ofthe balance sheet. This statement is effective for fiscal years beginning afterNovember 15, 2007. The Company is currently evaluating the impact of theadoption of the provisions of SFAS No. 159 on its consolidated financialstatements.

 

16

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

 

**Recentlyissued accounting standards (continued)**

 

In September 2006, theSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin(“SAB”) No. 108, *“Considering theEffects of Prior Year Misstatements when Quantifying the Misstatements inCurrent Year Financial Statements”* that expresses the Staff’s viewsregarding the process of quantifying financial statement misstatements. Thisbulletin is effective for any interim period of the first fiscal year endingafter November 15, 2006. SAB No. 108 requires that companies utilizea “dual approach” to assess the quantitative effects of financial statementmisstatements. The dual approach includes both an income statement focus andbalance sheet focus assessment. SAB No. 108 permits companies to recordthe cumulative effect of initially applying the dual approach in the first yearending after November 15, 2006 by recording any necessary correctingadjustments to the carrying values of assets and liabilities as of thebeginning of that year with the offsetting adjustment recorded to the openingbalance of retained earnings. The adoption of this bulletin did not have amaterial effect on the Company’s consolidated financial statements.

 

In September 2006, theFASB issued SFAS No. 157, *“Fair ValueMeasurements”*, which defines fair value, establishes a framework formeasuring fair value, and expands disclosures about fair value measurements.SFAS No. 157 replaces the different definitions of fair value in theaccounting literature with a single definition. It defines fair value as theprice that would be received to sell an asset or paid to transfer a liabilityin an orderly transaction between market participants at the measurement date.SFAS No. 157 is effective for fair-value measurements already required orpermitted by other standards for financial statements issued for fiscal yearsbeginning after November 15, 2008 and interim periods within those fiscalyears. The Company is currently evaluating the impact of the adoption of theprovisions of SFAS No. 157 on the consolidated financial statements.

 

In July 2006, the FASBissued FASB Interpretation (“FIN”) No. 48, “*Accounting for Uncertainty in Income Taxes, an Interpretation of FASBStatement No. 109*”. FIN No. 48 prescribes a recognitionthreshold and measurement attribute for the financial statements recognitionand measurement of a tax position taken or expected to be taken in a taxreturn. FIN No. 48 is effective for fiscal years beginning after December 15,2006 and is effective for the Company in the first quarter of the year beginningOctober 1, 2007. The Interpretation also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. Differences between taxpositions taken in a tax return and amounts recognized in the financialstatements are recorded as adjustments to income taxes payable or receivable,or adjustments to deferred taxes, or both. FIN No. 48 also requiresexpanded disclosure at the end of each annual reporting period including a tabularreconciliation of unrecognized tax benefits. In accordance with FIN No. 48,the Company will report the difference between the net amount of assets andliabilities recognized in the balance sheet prior to and after the applicationof FIN No. 48 as a cumulative effect adjustment to the opening balance ofretained earnings. The Company is currently evaluating the impact of theadoption of FIN No. 48 on the consolidated financial statements. In May 2007,the FASB issued FASB Staff Position (“FSP”) FIN 48-1, *“Definition of Settlement in FASB Interpretation No. 48”*,which is effective upon the initial adoption of FIN No. 48. FSP FIN 48-1provides guidance on how to determine whether a tax position is effectivelysettled for the purpose of recognizing previously unrecognized tax benefits.The Company will apply the principles set forth in this FSP upon its adoptionof FIN No. 48.

 

17

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

 

**Recentlyissued accounting standards (continued)**

 

During the June 2006meeting of the EITF, a consensus was reached on EITF Issue No. 06-3, *“How Taxes Collected from Customers and Remitted toGovernmental Authorities Should Be Presented in the Income Statement (That Is,Gross versus Net Presentation).”*The EITF reached a consensus thatthis Issue applies to any tax assessed by a governmental authority that is bothimposed on and concurrent with a specific revenue producing transaction between a seller and customer.Accordingly, taxes such as sales, use, value added, and some excise taxes maybe within the scope of this Issue. The EITF reached a consensus that the incomestatement presentation (gross or net) of such taxes is an accounting policydecision that should be disclosed. In addition, a company should disclose ininterim and annual financial statements the amount of such taxes reported on agross basis, if significant. This Issue became effective for interim and annualreporting periods beginning after December 15, 2006. The Company electedto present on a net basis taxes collected from customers and remitted togovernmental authorities; that is, they are excluded from revenues. Theadoption of this consensus did not have an effect on the Company’s consolidatedfinancial statements presentation.

 

During the June 2006meeting of the EITF, a consensus was reached on EITF Issue No. 05-1, “*Accounting for the Conversion of an Instrument thatBecame Convertible upon the Issuer’s Exercise of a Call option*”,that the issuance of equity securities to settle a debt instrument (pursuant tothe instrument’s original conversion terms) that became convertible upon theissuer’s exercise of a call option should be accounted for as a conversion ifthe debt instrument contained a substantive conversion feature as of itsissuance date. That is, no gain or loss should be recognized related to theequity securities issued to settle the instrument. The issuance of equitysecurities to settle a debt instrument that became convertible upon theissuer’s exercise of a call option should be accounted for as a debtextinguishment if the debt instrument did not contain a substantive conversionfeature as of its issuance date. That is, the fair value of the equitysecurities issued should be considered a component of the reacquisition priceof the debt. This Issue applies to all conversions within the scope of thisIssue that result from the exercise of call options and became effective forinterim or annual reporting periods beginning after June 28, 2006,irrespective of whether the instrument was entered into prior or subsequent toBoard ratification of this Issue. The adoption of this accounting pronouncementdid not have an impact on the Company’s consolidated financial statements.

 

18

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**2**      **–  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES(continued)**

 

**Recentlyissued accounting standards (continued)**

 

In November 2005, theFASB issued FSP No. 115-1 and No. 124-1, “*The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments*” (“FSP No. 115-1”), which provides guidanceon determining when investments in certain debt and equity securities areconsidered impaired, whether that impairment is other-than-temporary, and onmeasuring such impairment loss. FSP No. 115-1 also includes accountingconsiderations subsequent to the recognition of other-than-temporary impairmentand requires certain disclosures about unrealized losses that have not beenrecognized as other-than-temporary impairments.  FSP No. 115-1 is required to be applied to reporting periods beginning after December 15,2005 and was required to be adopted by the Company in the second quarter of2006. The Company adopted FSP No. 115-1 beginning on January 1, 2006,and the adoption of FSP No. 115-1 did not have a material impact on theCompany’s consolidated financial statements.

 

In May 2005, the FASB issuedSFAS No. 154, “*Accounting Changes andError Corrections*” which provides guidance on the accounting for andreporting of accounting changes and correction of errors. This statementchanges the requirements for the accounting for and reporting of a change inaccounting principle and applies to all voluntary changes in accountingprinciple. It also applies to changes required by an accounting pronouncementin the unusual instance that the pronouncement does not include specifictransition provisions. This statement is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. The adoption of this statement did not have an effect on the Company’sconsolidated financial statements.

 

In November 2004, theFASB issued SFAS No. 151, “*InventoryCosts, an Amendment of ARB No. 43, Chapter 4”.* SFAS No. 151 clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial and requires that such items be recognized as current-period chargesregardless of whether they meet the criterion of “so abnormal”. In addition,SFAS No. 151 requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the production facilities.SFAS No. 151 is effective for inventory costs incurred during fiscal yearsbeginning after June 15, 2005. The adoption of this statement did not havean effect on the Company’s consolidated financial statements.

 

During the September 2004meeting of the EITF, a consensus was reached on EITF Issue 04-8, *“The Effect of Contingently Convertible Instrumentson Diluted Earnings per Share”*. The EITF 04-8 requires companies toinclude certain convertible instruments, that were previously excluded, intotheir calculations of diluted earnings per share. The EITF concluded that Issue04-8 is effective for periods ending after December 15, 2004, and must beapplied by restating all periods during which time the applicable convertible instrumentswere outstanding. The common shares issuable under the 4.25% convertiblesubordinated notes issued in 2003, are therefore included in the Company’sdiluted income per share calculation.

 

19

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**Axcan Pharma Inc.**

**Notes to ConsolidatedFinancial Statements**

**September 30**

(Amounts in the tables are stated in thousands of U.S. dollars, exceptshare related data)

** **

**3****                ****–  ACQUISITIONS**

** **

**Product acquisitions**

 

During the fourth quarter offiscal 2007, the Company entered into an exclusive license and developmentagreement with Cellerix SL (“Cellerix”) of Spain, for the North American(United States, Canada and Mexico) rights to Cx401, a biological product indevelopment for the treatment of perianal fistulas. Cx401 uses non-embryonicstem-cells to treat perianal fistulas in Crohn’s and non-Crohn’s Diseasepatients. Under the terms of the agreement, as at September 30, 2007, theCompany recorded a $10,000,000 upfront payment payable to Cellerix, and willmake regulatory milestone payments that could total up to $30,000,000. As thisproduct had not reached technological feasibility, the upfront payment wasconsidered to be acquired in-process research and was expensed in the fourthquarter of the year ended September 30, 2007, the period of acquisition.

 

On December 3, 2002,the Company acquired the worldwide rights to the PANZYTRAT enzyme product linefrom Abbott for a cash purchase price of $45,000,000. During a transitionperiod ended during the year ended September 30, 2005, the seller acted asthe Company’s agent for the management of sales of this product. For the yearended September 30, 2005, a portion of the sales of this product was stillmanaged by the seller. The Company included in its revenue the net sales fromthe portion still managed by the seller less corresponding cost of goods soldand other seller-related expenses. Consequently, although net sales of suchproduct of the year ended September 30, 2005 were $2,431,789, the Companyonly included in its revenue an amount of $949,866 representing the net salesless cost of goods sold and other seller-related expenses.

** **

**4**                 **–  SHORT-TERMINVESTMENTS**

 

As at September 30,2007, short-term investments include short-term notes and municipal bonds(short-term notes only in 2006). Six short-term notes represent approximately87% (one short-term note for 11% in 2006) of the Company’s total short-terminvestments. Interest rates on short-term investments vary from 5.00% to 5.35%(2.02% to 5.25% in 2006).

** **

**5**                 **–  ACCOUNTSRECEIVABLE**

 
| ** **                                                                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                 | ** ** | **$**    | ** ** | **$**    | ** ** |
| Trade accounts, net of allowance for  doubtful accounts of  $222,457 ($143,501 in 2006)(a) |       | 34,486   |       | 30,650   |       |
| Taxes receivable                                                                           |       | 1,816    |       | 47       |       |
| Other                                                                                      |       | 372      |       | 242      |       |
|                                                                                       |       | 36,674   |       | 30,939   |       |

 

The Company believes thatthere is no unusual exposure associated with the collection of these accountsreceivable.

 

(a)               As at September 30, 2007, the accountsreceivable include amounts receivable from three major customers whichrepresent approximately 47% (44% in 2006) of the Company’s total accountsreceivable (see Note 16).

 

20

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**6****                ****–  INVENTORIES**

 
| ** **                           | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------|------------|----------|------------|----------|------------|
| ** **                           | ** ** | **$**    | ** ** | **$**    | ** ** |
| Raw materials and packaging material |       | 9,451    |       | 15,979   |       |
| Work in progress                     |       | 1,998    |       | 1,413    |       |
| Finished goods                       |       | 15,257   |       | 19,957   |       |
|                                 |       | 26,706   |       | 37,349   |       |

 

**7****                ****–  INCOME TAXES**

 

The deferred income taxassets and liabilities result from differences between the tax value and book valueof the following items:

 
| ** **                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                 | ** ** | **$**    | ** ** | **$**    | ** ** |
| Short-term deferred income tax assets      |       |     |       |     |       |
| Inventories                                |       | 6,102    |       | 3,203    |       |
| Accounts receivable                        |       | 47       |       | —   |       |
| Accounts payable and accrued liabilities   |       | 7,995    |       | 5,220    |       |
| Unused capital losses                      |       | 1,811    |       | —   |       |
|                                       |       | 15,955   |       | 8,423    |       |
| Long-term deferred income tax assets       |       |     |       |     |       |
| Property, plant and equipment              |       | 962      |       | —   |       |
| Intangible assets                          |       | 3,354    |       | —   |       |
| Unused losses                              |       | 287      |       | —   |       |
|                                       |       | 4,603    |       | —   |       |
|                                       |       |     |       |     |       |
| Short-term deferred income tax liabilities |       |     |       |     |       |
| Accounts receivable                        |       | 651      |       | 410      |       |
| Prepaid expenses and deposits              |       | 465      |       | 694      |       |
| Research and development expenses          |       | 960      |       | —   |       |
|                                       |       | 2,076    |       | 1,104    |       |
| Long-term deferred income tax liabilities  |       |     |       |     |       |
| Property, plant and equipment              |       | 1,346    |       | 1,584    |       |
| Intangible assets                          |       | 29,931   |       | 34,072   |       |
| Goodwill                                   |       | 720      |       | 720      |       |
| Investments                                |       | 4,298    |       | —   |       |
| Other                                      |       | 1,260    |       | 1,835    |       |
|                                       |       | 37,555   |       | 38,211   |       |

 

21

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**7****                ****–  INCOME TAXES (continued)**

 

Income taxes included in thestatement of operations are as follows:

 
| ** **                                      | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                      | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| Current                                         |       | 47,263   |       | 17,750   |       | 11,674   |       |
| Deferred                                        |       |     |       |     |       |     |       |
| Creation and reversal of temporary  differences |       | (11,696  | )          | 580      |       | (3,054   | )          |
| Change in promulgated rates                     |       | —   |       | (64      | )          | (207     | )          |
|                                            |       | (11,696  | )          | 516      |       | (3,261   | )          |
|                                            |       | 35,567   |       | 18,266   |       | 8,413    |       |
| Domestic                                        |       |     |       |     |       |     |       |
| Current                                         |       | 16,073   |       | (68      | )          | (2,734   | )          |
| Deferred                                        |       | (8,394   | )          | 1,120    |       | (941     | )          |
|                                            |       | 7,679    |       | 1,052    |       | (3,675   | )          |
| Foreign                                         |       |     |       |     |       |     |       |
| Current                                         |       | 31,190   |       | 17,818   |       | 14,408   |       |
| Deferred                                        |       | (3,302   | )          | (604     | )          | (2,320   | )          |
|                                            |       | 27,888   |       | 17,214   |       | 12,088   |       |
|                                            |       | 35,567   |       | 18,266   |       | 8,413    |       |

 

The Company’s effectiveincome tax rate differs from the combined statutory federal and provincialincome tax rate in Canada (32.02% for 2007, 31.77% for 2006 and 31.02% for2005). This difference arises from the following:

 
| ** **                                     | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                     | ** ** | **%**    | ** ** | **$**    | ** ** | **%**    | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** |
| Combined basic rate applied to pre-tax  income |       | 32.02    |       | 34,272   |       | 31.77    |       | 18,231 |   | 31.02 |   | 10,807 |   |
| Increase (decrease) in taxes resulting  from:  |       |     |       |     |       |     |       |   |   |   |   |   |   |
| Large corporations tax                         |       | —   |       | —   |       | —   |       | — |   | 0.17 |   | 60 |   |
| Change in promulgated rates                    |       | —   |       | —   |       | (0.11    | )          | (64 | ) | (0.59 | ) | (207 | ) |
| Difference with foreign tax rates              |       | (2.38    | )          | (2,548   | )          | 1.46     |       | 837 |   | (0.73 | ) | (255 | ) |
| Non-deductible items                           |       | 4.79     |       | 5,131    |       | 5.11     |       | 2,935 |   | 4.51 |   | 1,570 |   |
| Non-taxable items                              |       | (0.14    | )          | (149     | )          | (2.78    | )          | (1,596 | ) | (2.16 | ) | (750 | ) |
| Investment tax credits                         |       | (2.01    | )          | (2,154   | )          | (4.44    | )          | (2,547 | ) | (7.52 | ) | (2,619 | ) |
| Other                                          |       | 0.95     |       | 1,015    |       | 0.82     |       | 470 |   | (0.55 | ) | (193 | ) |
|                                           |       | 33.23    |       | 35,567   |       | 31.83    |       | 18,266 |   | 24.15 |   | 8,413 |   |

 

As at September 30,2007, no provision has been made for income taxes on the undistributed earningsof the Company’s foreign subsidiaries that the Company intends to indefinitelyreinvest.

 

22

----

** **

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**8**                 **–  PROPERTY,PLANT AND EQUIPMENT**

 
| ** **                          | ** ** | **2007**   | ** ** |
|-------------------------------------|------------|------------|------------|
| ** **                          | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Cost**   | ** ** | **depreciation** | ** ** | **Net** | ** ** |
| ** **                          | ** ** | **$**      | ** ** | **$** | ** ** | **$** | ** ** |
| Land                                |       | 1,877      |       | — |   | 1,877 |   |
| Buildings                           |       | 23,796     |       | 6,267 |   | 17,529 |   |
| Furniture and equipment             |       | 14,331     |       | 10,983 |   | 3,348 |   |
| Automotive equipment                |       | 65         |       | 61 |   | 4 |   |
| Computer equipment                  |       | 19,277     |       | 10,848 |   | 8,429 |   |
| Leasehold and building improvements |       | 199        |       | 189 |   | 10 |   |
|                                |       | 59,545     |       | 28,348 |   | 31,197 |   |

 
| ** **                          | ** ** | **2006**   | ** ** |
|-------------------------------------|------------|------------|------------|
| ** **                          | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                          | ** ** | **Cost**   | ** ** | **depreciation** | ** ** | **Net** | ** ** |
| ** **                          | ** ** | **$**      | ** ** | **$** | ** ** | **$** | ** ** |
| Land                                |       | 1,823      |       | — |   | 1,823 |   |
| Buildings                           |       | 22,306     |       | 4,794 |   | 17,512 |   |
| Furniture and equipment             |       | 15,421     |       | 10,431 |   | 4,990 |   |
| Automotive equipment                |       | 65         |       | 48 |   | 17 |   |
| Computer equipment                  |       | 12,895     |       | 8,435 |   | 4,460 |   |
| Leasehold and building improvements |       | 103        |       | 88 |   | 15 |   |
|                                |       | 52,613     |       | 23,796 |   | 28,817 |   |

 

Acquisitions of property,plant and equipment amount to $7,855,240 ($3,476,308 in 2006 and $5,997,554 in2005).

 

The cost and accumulateddepreciation of equipment under capital leases amount to $6,751,459 and$4,588,246, respectively ($6,091,700 and $3,271,948, respectively in 2006).

 

23

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**9**                 **–  INTANGIBLEASSETS**

 
| ** **                                                        | ** ** | **2007**   | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|
| ** **                                                        | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **Cost**   | ** ** | **amortization** | ** ** | **Net** | ** ** |
| ** **                                                        | ** ** | **$**      | ** ** | **$** | ** ** | **$** | ** ** |
| Trademarks, trademark licenses and  manufacturing rights  with a: |       |       |       |   |   |   |   |
| Finite life                                                       |       | 353,619    |       | 77,923 |   | 275,696 |   |
| Indefinite life                                                   |       | 103,896    |       | 12,375 |   | 91,521 |   |
|                                                              |       | 457,515    |       | 90,298 |   | 367,217 |   |

 
| ** **                                                        | ** ** | **2006**   | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|
| ** **                                                        | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **Cost**   | ** ** | **amortization** | ** ** | **Net** | ** ** |
| ** **                                                        | ** ** | **$**      | ** ** | **$** | ** ** | **$** | ** ** |
| Trademarks, trademark licenses and  manufacturing rights  with a: |       |       |       |   |   |   |   |
| Finite life                                                       |       | 347,117    |       | 59,404 |   | 287,713 |   |
| Indefinite life                                                   |       | 100,342    |       | 12,375 |   | 87,967 |   |
|                                                              |       | 447,459    |       | 71,779 |   | 375,680 |   |

 

Further to budgetaryinitiatives implemented by the French government during the year ended September 30,2006, which resulted in the delisting of a number of pharmaceutical productsfrom government formularies and re-pricing of other pharmaceutical products,the Company reviewed the appropriate carrying value and useful life of itsFrench subsidiary’s intangible assets. The cost of the product LACTEOL wasconsequently transferred from intangible assets with an indefinite life to intangibleassets with a finite life. The net cost of LACTEOL as of October 1, 2005,which amounted to $11,347,600, is therefore amortized over a 15-year period.During the year ended September 30, 2006, a partial write-down of$5,800,000 was recognized on a French line of products including TAGAMET andTRANSULOSE, as the carrying value of the intangible assets associated withthese products exceeded their estimated fair value.

 

On October 1, 2005, thenet cost of ADEKs, amounting to $2,172,965, was also transferred fromintangible assets with an indefinite life to intangible assets with a finitelife following changes in market conditions and is amortized over a 15-yearperiod.

 

Acquisitions of intangibleassets amount to $37,736 ($4,569,407 in 2006 and $51,103 in 2005). The currentintangible assets with a finite life have a weighted-average remainingamortization period of approximately 17 years as at  September 30, 2006 and 2007.

 

24

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**9**                 **–  INTANGIBLEASSETS (continued)**

 

The annual amortizationexpenses without taking into account any future acquisitions expected for theyears 2008 through 2012 are as follows:

 
| ** ** | ** ** | **$**  | ** ** |
|------------|------------|--------|------------|
|       |       |   |       |
| 2008       |       | 17,430 |       |
| 2009       |       | 17,430 |       |
| 2010       |       | 17,430 |       |
| 2011       |       | 17,430 |       |
| 2012       |       | 17,430 |       |

 

**10**          **–  AUTHORIZED LINE OFCREDIT**

 

The Company has a creditfacility for an amount of up to $125,000,000. The amount of this facility maybe draw-down by the Company, subject to fulfilment of certain conditionsspecified in the credit agreement until April 30, 2012. Under certainconditions, the amount of the credit can be increased up to an additional $100,000,000and the maturity date extended.

 

The Company’s creditfacility is secured by a first priority security interest on all present andfuture acquired assets of the Company and its material subsidiaries, andprovides for the maintenance of certain financial ratios. Among therestrictions imposed by the credit facility is a covenant limiting cashdividends, share repurchases (other than redeemable shares issued in connectionwith a permitted acquisition) and similar distributions to shareholders to 50%(10% in 2006) of the Company’s net income for the preceding fiscal year.

 

The interest rate varies,depending on the Company’s leverage, between 5 and 75 (25 and 100 in 2006)basis points over the Canadian prime rate or U.S. base rate and between 90 and 175(125 and 200 in 2006) basis points over the LIBOR rate or bankers’ acceptances.The line of credit also provides for a stand-by fee of between 20 and 32.5 (25and 37.5 in 2006) basis points. The credit facility may be drawn in U.S.dollars, in Canadian dollars or in Euro equivalent. As at September 30,2007 and 2006 there was no amount outstanding under the line of credit.

 

25

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**11**          **–  ACCOUNTS PAYABLE ANDACCRUED LIABILITIES**

 
| ** **                                                 | ** ** | **2007** | ** ** | **2006** | ** ** |
|------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                 | ** ** | **$**    | ** ** | **$**    | ** ** |
| Accounts payable                                           |       | 13,596   |       | 12,043   |       |
| Contract rebates, product returns and  accrued chargebacks |       | 29,986   |       | 20,726   |       |
| Accrued interest on subordinated notes                     |       | —   |       | 2,447    |       |
| Accrued royalty fees                                       |       | 4,284    |       | 5,508    |       |
| Accrued salaries                                           |       | 4,759    |       | 2,929    |       |
| Accrued bonuses                                            |       | 7,485    |       | 4,368    |       |
| Accrued research and development expenses                  |       | 15,785   |       | 6,588    |       |
| Other accrued liabilities                                  |       | 7,301    |       | 6,124    |       |
|                                                       |       | 83,196   |       | 60,733   |       |

 

**12****         ****– LONG-TERM DEBT**

 
| ** **                                                                                                                                                                          | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                                                                                                          | ** ** | **$**    | ** ** | **$**    | ** ** |
| Convertible subordinated notes, 4.25%,  interest payable semi-annually  starting October 15, 2003,  convertible into 8,924,113 common shares, maturing April 15, 2008.(a) |       | —   |       | 125,000  |       |
| Obligations under capital leases, interest  rates varying between 3.81%  and 6.2% payable in monthly  instalments, principal and interest, maturing on different dates until 2009.  |       | 649      |       | 1,246    |       |
|                                                                                                                                                                                |       | 649      |       | 126,246  |       |
| Instalments due within one year                                                                                                                                                     |       | 527      |       | 681      |       |
|                                                                                                                                                                                |       | 122      |       | 125,565  |       |

 

(a)               During the year ended September 30, 2007,the Company called for redemption all of its $125,000,000, 4.25% Convertiblesubordinated notes (“Notes”) and the holders of all of the Notes exercisedtheir right to convert their Notes, in lieu of redemption, by June 28,2007. The Company completed the conversion of the Notes by issuing an aggregateof 8,924,080 common shares and paying $613 in lieu of fractional shares.Long-term debt was consequently reduced by $125,000,000 and capital stockincreased by the same amount. As a result of the conversion, financial expensesfor the year were reduced by $2,525,158 in interest on long-term debt andincreased by $376,677 in amortization of deferred debt issue expenses comparedto fiscal 2006.

 

The Notes were convertibleinto 8,924,113 common shares. The holders could have converted their Notesduring any quarterly conversion period if the closing price per share for atthe least 20 consecutive trading days during the 30 consecutive trading-dayperiod ending on the first day of the conversion period exceeded 110% of theconversion price in effect on that thirtieth trading day. The holders couldalso have converted their Notes during the five business-day period followingany 10 consecutive trading-day period in which the daily average of the tradingprices for the Notes was less than 95% of the average conversion value for theNotes during that period. Finally, the holders could also have converted theirNotes upon the occurrence of specified corporate transactions, or if theCompany had called the Notes for redemption. From April 20, 2006, theCompany had the right, at its option, to redeem the Notes, in whole or in partat redemption prices varying from 101.70% to 100.85% of the principal amountplus any accrued and unpaid interest to the redemption date. The notes alsoincluded provisions for the redemption of all the notes for cash at the optionof the Company following some changes in tax treatment.

 

26

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**12****         ****– LONG-TERM DEBT (continued)**

 

As at September 30,2007, minimum instalments on long-term debt for the next two years are asfollows:

 
| ** **                                       | ** ** | **Obligations** | ** ** |
|--------------------------------------------------|------------|-----------------|------------|
| ** **                                       | ** ** | **under**       | ** ** |
| ** **                                       | ** ** | **capital**     | ** ** |
| ** **                                       | ** ** | **leases**      | ** ** |
| ** **                                       | ** ** | **$**           | ** ** |
| 2008                                             |       | 555             |       |
| 2009                                             |       | 143             |       |
|                                             |       | 698             |       |
| Interest included in the minimum lease  payments |       | 49              |       |
|                                             |       | 649             |       |

 

**13**          **–  CAPITAL STOCK**

** **

**Preferredshares**

 

The Company has an unlimitednumber of authorized preferred shares without par value, issuable in series,rights, privileges and restrictions determined at the creation date.

 

Two series of preferredshares have been created as follows:

 

Series A, sharesauthorized: 14,175,000 non-voting, annual preferential cumulative dividend of5%, redeemable on or prior to June 8, 2001 at CAN$1.00 per share payableat the option of the Company in cash or by the issuance of common shares or inany combination of cash and common shares.

 

Series B, sharesauthorized: 12,000,000 non-voting, redeemable on the fifth anniversary of theirissuance at CAN$1.00 per share payable in cash or by the issuance of commonshares at the option of the Company, convertible into common shares at theholder’s option on the basis of one common share for each 15 Series Bpreferred shares.

** **

**Stockincentive plans**

 

In 2006, the Company adopteda new stock incentive plan (the “2006 plan”) in replacement of its previousstock option plan and pursuant to which the Company may, among otherinstruments, grant options, RSUs and DSUs to eligible employees and directorsof the Company. The 2006 plan provides that a maximum of 2,300,000 commonshares are issuable pursuant to awards made under the 2006 plan, of which amaximum of 800,000 shares being available in the form of RSUs and DSUs. The pershare purchase price cannot be less than the market price of the common stockon the last trading day prior to the date of grant, and the options expire nolater than seven years from that date. Options may be exercised over a periodestablished at the date of grant except for the annual options granted tooutside directors which may be exercised one year after the date of grant. At September 30,2007, there were 544,850 outstanding options that may become exercisable underthe terms of the 2006 plan. These options may be exercised at a rate of 33% peryear.

 

27

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**13**          **–  CAPITAL STOCK(continued)**

** **

**Stockincentive plans (continued)**

 

Under the Company’s previousstock option plan established in 1995 (the “1995 plan”), a maximum of 4,500,000common shares were issuable pursuant to the exercise of options. Options weregranted at the market price of one common share on the last trading day priorto the granting date. Options granted under the 1995 plan may be exercised at arate of 20% per year and expire ten years after the granting date except forthe annual options granted to outside directors, which vested one year afterthe granting date. At September 30, 2007, there were 2,139,985 outstandingoptions that are or may become exercisable under the terms of the 1995 plan.

 

The changes to the number ofstock options outstanding are as follows:

 
| ** **                         | ** ** | **2007**           | ** ** | **2006**     | ** ** | **2005**           | ** ** |
|------------------------------------|------------|--------------------|------------|--------------|------------|--------------------|------------|
| ** **                         | ** ** | ** **         | ** ** | **Weighted** | ** ** | ** **         | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                         | ** ** | ** **         | ** ** | **average**  | ** ** | ** **         | ** ** | **average** | ** ** | ** ** | ** ** | **average** | ** ** |
| ** **                         | ** ** | **Number of** | ** ** | **exercise** | ** ** | **Number of** | ** ** | **exercise** | ** ** | **Number of** | ** ** | **exercise** | ** ** |
| ** **                         | ** ** | **options**        | ** ** | **price**    | ** ** | **options**        | ** ** | **price** | ** ** | **options** | ** ** | **price** | ** ** |
| ** **                         | ** ** | ** **         | ** ** | **$**        | ** ** | ** **         | ** ** | **$** | ** ** | ** ** | ** ** | **$** | ** ** |
| Balance, beginning of year         |       | 3,057,084          |       | 13.01        |       | 2,986,748          |       | 12.87 |   | 2,600,556 |   | 11.86 |   |
| Granted                            |       | 599,800            |       | 15.30        |       | 416,714            |       | 13.81 |   | 692,100 |   | 16.19 |   |
| Exercised                          |       | (634,991           | )          | 11.43        |       | (118,406           | )          | 9.07 |   | (119,839 | ) | 8.93 |   |
| Expired                            |       | (74,660            | )          | 17.06        |       | (35,650            | )          | 14.14 |   | (3,880 | ) | 13.88 |   |
| Forfeited                          |       | (262,398           | )          | 14.75        |       | (192,322           | )          | 14.89 |   | (182,189 | ) | 13.96 |   |
| Balance, end of year               |       | 2,684,835          |       | 13.61        |       | 3,057,084          |       | 13.01 |   | 2,986,748 |   | 12.87 |   |
| Options exercisable at end of year |       | 1,445,871          |       | 12.45        |       | 1,790,020          |       | 11.93 |   | 1,409,939 |   | 10.97 |   |

 

Stock options outstanding atSeptember 30, 2007 are as follows:

 
| ** **              | ** ** | **Options outstanding** | ** ** | **Options exercisable** | ** ** |
|-------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **              | ** ** | ** **                   | ** ** | **Weighted**                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **              | ** ** | ** **                   | ** ** | **average**                  | ** ** | **Weighted** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **                   | ** ** | **remaining**                | ** ** | **average** | ** ** | ** ** | ** ** | **average** | ** ** |
| ** **              | ** ** | ** **                   | ** ** | **contractual**              | ** ** | **exercise** | ** ** | ** ** | ** ** | **exercise** | ** ** |
| **Exercise price** | ** ** | **Number**                   | ** ** | **life**                     | ** ** | **price** | ** ** | **Number** | ** ** | **price** | ** ** |
| ** **              | ** ** | ** **                   | ** ** | ** **                   | ** ** | **$** | ** ** | ** ** | ** ** | **$** | ** ** |
| $4.06 – $5.00      |       | 10,000                       |       | 2.22                         |       | 4.06 |   | 10,000 |   | 4.06 |   |
| $5.01 – $7.00      |       | —                       |       | —                       |       | — |   | — |   | — |   |
| $7.01 – $10.00     |       | 483,097                      |       | 2.77                         |       | 8.57 |   | 483,097 |   | 8.57 |   |
| $10.01 – $13.00    |       | 287,570                      |       | 4.93                         |       | 11.53 |   | 238,210 |   | 11.60 |   |
| $13.01 – $16.00    |       | 1,330,048                    |       | 6.43                         |       | 14.28 |   | 445,534 |   | 14.03 |   |
| $16.01 – $19.00    |       | 416,620                      |       | 7.30                         |       | 16.68 |   | 189,530 |   | 16.93 |   |
| $19.01 – $19.99    |       | 157,500                      |       | 6.63                         |       | 19.95 |   | 79,500 |   | 19.99 |   |
|                    |       | 2,684,835                    |       | 5.74                         |       | 13.61 |   | 1,445,871 |   | 12.45 |   |

 

28

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**13**          **–  CAPITAL STOCK(continued)**

** **

**Stockincentive plans (continued)**

 

The changes to the number ofnon-vested stock options for the year ended September 30, 2007 are asfollows:

 
| ** **                 | ** ** | ** ** | ** ** | **Weighted**        | ** ** |
|----------------------------|------------|------------|------------|---------------------|------------|
| ** **                 | ** ** | ** ** | ** ** | **average**         | ** ** |
| ** **                 | ** ** | ** ** | ** ** | **grant date** | ** ** |
| ** **                 | ** ** | **Number** | ** ** | **fair value** | ** ** |
| ** **                 | ** ** | ** ** | ** ** | **$**               | ** ** |
| Balance, beginning of year |       | 1,267,064  |       | 6.57                |       |
| Granted                    |       | 599,800    |       | 5.89                |       |
| Vested                     |       | (365,502   | )          | 6.55                |       |
| Forfeited                  |       | (262,398   | )          | 6.28                |       |
|                       |       |       |       |                |       |
| Balance, end of year       |       | 1,238,964  |       | 6.26                |       |

 

The Company recorded$4,548,293 ($3,554,924 in 2006) of compensation expenses relative to stockoptions for the year ended September 30, 2007, in accordance with SFAS No. 123(R).The amount of expense has been reduced to take into account the estimatedforfeitures. As at September 30, 2007, there were $7,247,201 ($7,106,966in 2006) of total unrecognized compensation costs related to stock options.These costs are expected to be recognized over a weighted average period of 2.7(3.1 in 2006) years.

 

The weighted average fairvalue of granted stock options was $5.89, $6.41 and $7.01 for the years ended September 30,2007, 2006 and 2005.

 

The fair value of eachoption award is estimated on the date of grant using the Black-Scholesvaluation model and the assumptions noted in the following table. The expectedlife of options is based on observed historical exercise patterns. Groups ofemployees that have similar historical exercise patterns are consideredseparately for valuation purposes. The expected volatility is based solely onhistorical volatility. The risk free interest rate is based on the impliedyield on a U.S. or Canadian Treasury zero-coupon issue with a remaining termequal to the expected term of the option. The dividend yield reflects that theCompany has not paid any cash dividends since inception and does not intend topay any cash dividends in the foreseeable future.

 
| ** **                       | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                             |       |     |       |     |       |     |       |
| Expected term of options (years) |       | 4.5      |       | 5.8      |       | 6        |       |
| Expected stock price volatility  |       | 38       | %          | 42       | %          | 43       | %          |
| Risk-free interest rate          |       | 4.36     | %          | 4.28     | %          | 3.94     | %          |
| Expected dividend                |       | —   |       | —   |       | —   |       |

 

Under the 2006 plan, theCompany may also grant RSUs to directors and employees. The value of a RSU isalways equal to the market price of one common share of the Company. RSUsentitle the holder to receive common shares of the Company at the end of avesting period. The total number of RSUs granted in 2007 was 190,875 (40,950 in2006) with a fair value of $14.61 ($12.99 in 2006) each. As at September 30,2007, there were 201,025 (40,950 in 2006) outstanding RSUs. The RSUs granted in2006 and 2007 vest at the end of a three-year period.

 

29

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**13**          **–  CAPITAL STOCK(continued)**

** **

**Stockincentive plans (continued)**

 

The Company may also grantDSUs to directors or members of a select group of management. The value of a DSUis always equal to the market price of one common share of the Company. Since2006, directors receive an annual grant of DSUs having a value of $15,000 andeach of the eligible persons may elect to receive a portion of their annualcompensation in the form of DSUs. DSUs are credited with dividend equivalentswhen dividends are paid on the Company’s common shares. Directors may notreceive any distribution in respect of the DSUs until they withdraw from theBoard and members of management until cessation of employment. The amount ofcompensation deferred is converted into DSUs based on the market price of thecommon stock on the last trading day prior to the date of grant. As at September 30,2007, the Company’s directors held 9,961 (10,009 in 2006) DSUs.

** **

**14**          **–  FINANCIALINFORMATION INCLUDED IN THE CONSOLIDATED STATEMENT OF OPERATIONS**

 

**a)Financial expenses**

 
| ** **                                    | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                    | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| Interest on long-term debt                    |       | 2,870    |       | 5,416    |       | 5,542    |       |
| Bank charges                                  |       | 182      |       | 154      |       | 165      |       |
| Financing fees                                |       | 298      |       | 301      |       | 333      |       |
| Amortization of deferred debt issue  expenses |       | 1,475    |       | 1,117    |       | 1,100    |       |
|                                          |       | 4,825    |       | 6,988    |       | 7,140    |       |

 

**b) Otherinformation**

 
| ** **                                     | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                     | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| Rental expenses                                |       | 2,336    |       | 1,989    |       | 1,148    |       |
| Shipping and handling expenses                 |       | 5,911    |       | 5,097    |       | 4,901    |       |
| Advertising expenses                           |       | 13,557   |       | 11,488   |       | 16,592   |       |
| Depreciation of property, plant and  equipment |       | 5,356    |       | 5,901    |       | 5,339    |       |
| Amortization of intangible assets              |       | 17,138   |       | 16,922   |       | 16,193   |       |
| Stock-based compensation expense               |       | 4,548    |       | 3,554    |       | —   |       |

 

The Company incurredprofessional fees with entities, in which directors of the Company are partneror shareholder, totalling $294,280 for the year ended September 30, 2007($414,147 in 2006 and $400,396 in 2005). These transactions were concluded inthe normal course of operations, at the amount agreed to by the relatedparties.

 

In connection with areorganization of its international operations due to budgetary initiativesimplemented by the French government during the year ended September 30,2006, the Company undertook a reduction of its workforce in Europe. To thisend, in May 2006, the Company’s French subsidiary communicated areorganization plan to the employee representatives in France aimed at reducingits workforce. As this plan was implemented, the Company recorded a one-timerestructuring charge of $1,738,755 during the year ended September 30,2006. The restructuring charge included severance costs totalling $1,305,501and professional and legal fees for transition assistance totalling $433,254.As at September 30, 2006, $1,035,270 had been paid for severance costs and$390,764 for professional and legal fees. The balance payable of $312,721 hasbeen paid during the year ended September 30, 2007.

 

30

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**14**          **–  FINANCIALINFORMATION INCLUDED IN THE CONSOLIDATED STATEMENT OF OPERATIONS (continued)**

 

**c)  Income per common share**

 

The following tablesreconcile the numerators and denominators of the basic and diluted income pershare computations.

 
| ** **                                                                                                                      | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                                                                                                      | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| Net income available to common shareholders                                                                                     |       |     |       |     |       |     |       |
| Basic                                                                                                                           |       | 71,465   |       | 39,119   |       | 26,425   |       |
| Interest and amortization of deferred debt  issue expenses relating to the convertible subordinated notes, net of income  taxes |       | 2,793    |       | 4,328    |       | 4,257    |       |
| Net income available to common shareholders  on a diluted basis                                                                 |       | 74,258   |       | 43,447   |       | 30,682   |       |

 
| ** **                                                                                                     | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Weighted average number of common shares                                                                       |       |       |       |       |       |       |       |
| Weighted average number of common shares outstanding  and relevant shares issuable under stock incentive plans |       | 48,466,980 |       | 45,741,419 |       | 45,617,703 |       |
| Effect of dilutive stock options and  relevant shares issuable under stock incentive plans                     |       | 607,127    |       | 398,964    |       | 677,386    |       |
| Effect of dilutive convertible subordinated  notes                                                             |       | 6,650,298  |       | 8,924,113  |       | 8,924,113  |       |
| Adjusted weighted average number of common shares  outstanding                                                 |       | 55,724,405 |       | 55,064,496 |       | 55,219,202 |       |
| Number of common shares outstanding as at November 29,  2007                                              |       | 55,374,561 |       |       |       |       |       |

 

Options to purchase 481,475common shares (1,155,744 for 2006 and 706,950 for 2005) were outstanding butwere not included in the computation of diluted income per share as theexercise price of the options was greater than the average market price of thecommon shares.

** **

**15**          **–  FINANCIALINFORMATION INCLUDED IN THE CONSOLIDATED STATEMENT OF CASH FLOWS**

** **

**a) Changes in working capital items**

 
| ** **                               | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **                               | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| Accounts receivable                      |       | (4,047   | )          | 7,338    |       | 8,648    |       |
| Income taxes receivable                  |       | (492     | )          | (260     | )          | 1,610    |       |
| Inventories                              |       | 11,658   |       | (402     | )          | 1,490    |       |
| Prepaid expenses and deposits            |       | 770      |       | (1,812   | )          | 1,861    |       |
| Accounts payable and accrued liabilities |       | 17,712   |       | 7,263    |       | 4,429    |       |
| Income taxes payable                     |       | 16,577   |       | (1,047   | )          | 3,995    |       |
|                                     |       | 42,178   |       | 11,080   |       | 22,033   |       |

 

31

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**15**          **–  FINANCIALINFORMATION INCLUDED IN THE CONSOLIDATED STATEMENT OF CASH FLOWS (continued)**

** **

**b) Cashflows relating to interest and income taxes of operating activities**

 
| ** **        | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|-------------------|------------|----------|------------|----------|------------|----------|------------|
| ** **        | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| Interest received |       | 7,036    |       | 4,562    |       | 1,256    |       |
| Interest paid     |       | 5,627    |       | 5,416    |       | 5,626    |       |
| Income taxes paid |       | 29,404   |       | 19,568   |       | 6,984    |       |

 

**16**          **–  SEGMENTEDINFORMATION**

 

The Company operates in asingle field of activity, the pharmaceutical industry.

 

No customer represents morethan 10% of the Company’s revenue except for three major customers for whichthe sales represented77.3% of revenue for the year ended September 30,2007 (74.8% and 62.1% in 2006 and 2005) and are detailed as follows:

 
| ** ** | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| ** ** | ** ** | **%**    | ** ** | **%**    | ** ** | **%**    | ** ** |
| Customer A |       | 41.2     |       | 39.0     |       | 30.2     |       |
| Customer B |       | 25.0     |       | 24.4     |       | 20.9     |       |
| Customer C |       | 11.1     |       | 11.4     |       | 11.0     |       |
|       |       | 77.3     |       | 74.8     |       | 62.1     |       |

 

Purchases from one supplierrepresent approximately 19% of the cost of goods sold for the year ended September 30,2007 (two for 42% in 2006 and  one for15% in 2005).

 

The Company purchases itsinventory from third party manufacturers, many of whom are the sole source ofproducts for the Company. The failure of such manufacturers to provide anuninterrupted supply of products could adversely impact the Company’s abilityto sell such products.

 

32

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**16**          **–  SEGMENTEDINFORMATION (continued)**

 

The Company operates in thefollowing geographic areas:

 
| ** **     | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **$**    | ** ** | **$**    | ** ** | **$**    | ** ** |
| Revenue        |       |     |       |     |       |     |       |
| Canada         |       |     |       |     |       |     |       |
| Domestic sales |       | 37,950   |       | 37,956   |       | 34,412   |       |
| Foreign sales  |       | —   |       | —   |       | —   |       |
| United States  |       |     |       |     |       |     |       |
| Domestic sales |       | 250,774  |       | 195,954  |       | 155,261  |       |
| Foreign sales  |       | 3,958    |       | 5,801    |       | 4,394    |       |
| Europe         |       |     |       |     |       |     |       |
| Domestic sales |       | 45,859   |       | 43,374   |       | 46,225   |       |
| Foreign sales  |       | 10,011   |       | 8,702    |       | 10,857   |       |
| Other          |       | 395      |       | 530      |       | 194      |       |
|           |       | 348,947  |       | 292,317  |       | 251,343  |       |

 

Revenue is attributed togeographic areas based on the country of origin of the sales. 

 
| ** **                                                  | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                  | ** ** | **$**    | ** ** | **$**    | ** ** |
| Property, plant, equipment, intangible  assets and goodwill |       |     |       |     |       |
| Canada                                                      |       | 33,048   |       | 36,409   |       |
| United States                                               |       | 124,382  |       | 125,084  |       |
| Europe                                                      |       | 238,933  |       | 239,323  |       |
| Other                                                       |       | 29,518   |       | 31,148   |       |
|                                                        |       | 425,881  |       | 431,964  |       |

 

33

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**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**17**          **–  FINANCIALINSTRUMENTS**

** **

**Currencyrisk**

 

The Company is exposed tofinancial risk arising from fluctuations in foreign exchange rates and thedegree of volatility of those rates. The Company does not use derivativeinstruments to reduce its exposure to foreign currency risk. As at September 30,2007, the Company had financial assets totalling $344,489,729 ($203,872,919 in2006) including cash, cash equivalents and accounts receivable for CAN$983,118and 14,183,381 Euros respectively (CAN$3,814,612 and 11,097,255 Euros in 2006).The financial liabilities totalling $83,844,415 ($186,979,096 in 2006) includeaccounts payable and accrued liabilities and long-term debt for CAN$15,130,739and 9,978,971 Euros respectively (CAN$16,955,611, and 8,456,708 Euros in 2006).

** **

**Fair valueof the financial instruments on the balance sheet**

 

The estimated fair value ofthe financial instruments is as follows:

 
| ** **                               | ** ** | **2007**            | ** ** | **2006**     | ** ** |
|------------------------------------------|------------|---------------------|------------|--------------|------------|
| ** **                               | ** ** | ** **          | ** ** | **Carrying** | ** ** | ** ** | ** ** | **Carrying** | ** ** |
| ** **                               | ** ** | **Fair value** | ** ** | **amount**   | ** ** | **Fair value** | ** ** | **amount** | ** ** |
| ** **                               | ** ** | **$**               | ** ** | **$**        | ** ** | **$** | ** ** | **$** | ** ** |
| Assets                                   |       |                |       |         |       |   |   |   |   |
| Cash and cash equivalents                |       | 179,672             |       | 179,672      |       | 55,830 |   | 55,830 |   |
| Short-term investments                   |       | 129,958             |       | 129,958      |       | 117,151 |   | 117,151 |   |
| Accounts receivable, net                 |       | 34,859              |       | 34,859       |       | 30,892 |   | 30,892 |   |
| Liabilities                              |       |                |       |         |       |   |   |   |   |
| Accounts payable and accrued liabilities |       | 83,196              |       | 83,196       |       | 60,733 |   | 60,733 |   |
| Long-term debt                           |       | 649                 |       | 649          |       | 132,500 |   | 126,246 |   |

 

The following methods andassumptions were used to calculate the estimated fair value of the financialinstruments on the balance sheet.

** **

**a)****                         ****Financial instruments valuedat carrying amount**

 

The estimated fair value ofcertain financial instruments shown on the balance sheet is equivalent to theircarrying amount because they are realizable in the short-term. These financialinstruments include cash and cash equivalents, short-term investments, accountsreceivable and accounts payable and accrued liabilities.

** **

**b)****                         ****Long-term debt**

 

The fair value of long-termdebt is established by discounting the future cash flows at interest ratescorresponding to those the Company would have obtained at year end date forloans with similar maturity dates and terms. In 2006, the fair value of theconvertible subordinated notes is based on the trading price at the end of theyear.

 

34

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**18****         ****–  COMMITMENTS AND CONTINGENCIES**

** **

**a)****                         ****Commitments**

 

The Company has entered intonon-cancellable operating leases and service agreements with fixed minimumpayment obligations expiring on different dates until December 2013 forthe rental of office space, automotive equipment and other equipment and foradministrative, research and development and other services.

 

Minimum future paymentsunder these commitments for the next years are as follows:

 
| ** **          | ** ** | **$**  | ** ** |
|---------------------|------------|--------|------------|
|                |       |   |       |
| 2008                |       | 4,015  |       |
| 2009                |       | 1,969  |       |
| 2010                |       | 834    |       |
| 2011                |       | 381    |       |
| 2012 and thereafter |       | 121    |       |
|                |       | 7,320  |       |

 

**b)****                         ****Licensing agreements**

 

In May 2000, theCompany entered into agreements with QLT PhotoTherapeutics Inc. (“QLT”)relating to the purchase of PHOTOFRIN, which provided for milestone payments tobe made by the Company to QLT that could reach a maximum of CAN$20,000,000 uponreceipt of certain regulatory approvals for specific or additional indicationsfor PHOTOFRIN or other conditions. Each milestone payment had to be made at theoption of the Company either in cash or in Series B preferred shares or ina combination of cash and preferred shares provided that at least one-half ofthe milestone payable had to be paid in cash. In 2006, the final milestonepayment of CAN$5,000,000 ($4,495,999) was paid by the Company. To date, themaximum of CAN$20,000,000 ($15,440,767) has been paid in cash and recorded inintangible assets with a finite life.

 

In October 2000, theCompany entered into a licensing agreement with the Children’s HospitalResearch Foundation for a series of sulfated derivatives of ursodeoxycholigicacid compounds (“SUDCA”). The Company has, as at September 30, 2007, paid$839,562 in cash. The Company also agreed to pay milestones for a maximumamount of $200,000 when a SUDCA product receives regulatory approval and abonus when certain conditions are met; finally, the Company agreed to payroyalties based on net sales.

 

35

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**18****         ****–  COMMITMENTS AND CONTINGENCIES (continued)**

** **

**b)****                         ****Licensing agreements(continued)**

 

In May 2002, theCompany signed a co-development and licensing agreement with NicOx S.A. (“NicOx”)for NCX-1000 a nitric oxide-donating ursodiol derivative for the treatment ofchronic liver diseases including portal hypertension and Hepatitis “C”,pursuant to which, the Company obtained from NicOx an exclusive license tocommercialize NCX-1000 in Canada and Poland as well as an option to acquire thesame exclusive rights for the United States market. Under the terms of theagreement, the Company agreed to pay NicOx options or milestone paymentstotalling up to $17,000,000 at various stages of development. An upfront amountof $2,000,000 was paid in 2003. Following review of initial clinical results,the Company decided to cease development of this compound in fiscal 2007.

 

In October 2002, theCompany acquired from Gentium S.p.A., an Italian company, exclusive rights todevelop and market in North America, a patented 4 gram rectal gel formulationof mesalamine (5-ASA) for the treatment of active distal ulcerative colitis. Inreturn the Company agreed to make milestone payments totalling approximately$1,500,000, the majority of which payable upon approval in the United States.An amount of approximately $200,000 was paid in 2003. The Company also agreedto pay a royalty of 4% on net sales for a ten-year period from product’slaunch. In fiscal 2007, the Company decided to cease the development of thisproduct.

 

In July 2003, theCompany acquired from Merz Pharmaceutical GmbH (“Merz”) an exclusive licence touse, develop and submit for approval of certain injectable and oral granuleformulations containing L-ornithine and L-aspartate. In consideration of therights and licenses granted by Merz under this agreement, the Company agreed topay a royalty of 6% of net sales or 4% of net sales if the Company develops anypatentable invention or improvement and Merz incorporates such invention or improvementinto its products. In fiscal 2007, the Company decided to cease the developmentof this product.

 

In August 2003, theCompany signed an agreement to acquire the exclusive license for North America,the European Union and Latin America to develop, manufacture and market ITAXwhich provides for milestone payments for an amount of $20,000,000 uponregulatory submission and an amount of $45,000,000 upon regulatory approval.The Company also agreed to pay royalties of 9% of net sales from the date of firstcommercial sale until the expiration of the patent and 6% for ten years thenafter. As previously announced, the Company decided to cease the development ofITAX for the treatment of Functional Dyspepsia during the year ended September 30,2006.

 

In February 2005, theCompany signed a license agreement with Lisapharma S.p.A., an Italian company,to submit for approval and commercialize, in North America, products in gelsachet and tablet dosage forms that contain sucralfate as the main activeingredient. Under the agreement, the Company agreed to pay license fees of upto $2,000,000 over a maximum period of four years (as at September 30,2006 an amount of $1,000,000 had been recorded as expense) and make milestonepayments totalling up to $3,000,000 upon regulatory approvals. The Company alsoagreed to pay royalties of 6% of net sales of products enjoying patentprotection and 3% of net sales of products not enjoying patent protection forup to five years from a first commercial sale. During fiscal 2007, the Companydecided to cease the development of this product and terminated its agreementwith Lisapharma S.p.A.

 

36

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**18****         ****–  COMMITMENTS AND CONTINGENCIES (continued)**

** **

**b)****                         ****Licensing agreements(continued)**

 

In May 2005, theCompany signed a license and technology agreement with Howard J. Smith &Associates PTY LTD (“HSA”), an Australian company, to develop and marketproducts for the treatment of viral hepatitis. The Company agreed to makemilestone payments totalling up to $17,000,000 at various stages of developmentor commercialization. The Company also agreed to pay royalties of 4.5% of netsales in countries where an HSA patent is in force and 2.25% of net sales incountries where no HSA patent is in force, for a maximum of ten years after thefirst commercial sale of a product in the relevant country. During fiscal 2007,the Company decided to cease the development of this product.

 

In September 2006, theCompany entered into a license and co-development agreement with AGITherapeutics Research Ltd (“AGI”). Pursuant to this agreement, AGI and theCompany will co-develop a controlled release omeprazole product, AGI-010, forthe treatment of gastro-oesophageal reflux disease. Under the agreement, theCompany and AGI have agreed to share certain development expenses and theCompany paid a $1,500,000 upfront fee, accounted for as a research anddevelopment expense. The Company may also be required to make specifiedmilestone payments that could total up to $17,500,000 at various stages ofdevelopment up to and including regulatory approvals. Finally, the Companyagreed to pay royalties varying between 4% and 7.5% of net sales.

 

In September 2007, theCompany entered into an exclusive license and development agreement withCellerix SL (“Cellerix”) of Spain, for the North American (United States,Canada and Mexico) rights to Cx401, a biological product in development for thetreatment of perianal fistulas. Cx401 uses non-embryonic stem-cells to treatperianal fistulas in Crohn’s and non-Crohn’s Disease patients. Under the termsof the agreement, as at September 30, 2007, the Company recorded a$10,000,000 upfront payment payable to Cellerix, plus regulatory milestonepayments that could total up to $30,000,000. The Company has also agreed tomake an equity investment of up to $5,000,000 in Cellerix, should Cellerixcomplete its initial public offering by September 30, 2010. Finally, theCompany agreed to pay royalties varying between 12% and 18% of net sales.

** **

**c)****                         ****Royalties**

 

The Company pays royaltieson the sales of certain of its products to unrelated third parties underlicense and similar agreements, at rates ranging between 1% and 6%.

 

During the year ended September 30,2007, the Company charged to cost of goods sold a total of $4,107,635($3,768,515 in 2006 and $3,695,087 in 2005) in royalties in connection with thesales of its URSO, ULTRASE, PHOTOFRIN, ADEKs and PYLERA products.

 

37

----

 

**Axcan Pharma Inc.**

**Notes toConsolidated Financial Statements**

**September 30**

(Amounts in the tables arestated in thousands of U.S. dollars, except share related data)

 

**18****         ****–  COMMITMENTS AND CONTINGENCIES (continued)**

** **

**d)****                         ****Contingencies**

 

As at September 30,2005, the Company had accrued $2,900,000 to cover any future settlements inconnection with an indemnification claim and product liability lawsuitsinitiated against its subsidiary, Axcan Scandipharm, relating to the productline it markets under the name ULTRASE. During the year ended September 30,2006, following a series of favourable decisions in the indemnification claim, theCompany revaluated its exposure and this accrual was reversed, thus reducingthe selling and administrative expenses by the same amount.

** **

**e)****                         ****Employee benefit plan**

 

A subsidiary of the Companyhas a defined contribution plan (the “Plan”) for its U.S. employees.Participation is available to substantially all U.S. employees. Employees maycontribute up to 15% of their gross pay or up to limits set by the U.S.Internal Revenue Service. The Company may make matching contributions of adiscretionary percentage. During the year ended September 30, 2007, theBoard of Directors approved, and the Company charged to operations,contributions to the Plan totalling $454,015 ($385,018 in 2006 and $495,195 in2005).

** **

**f)****                           ****Other**

 

The Company has been auditedby Canada Revenue Agency, mainly on transfer pricing issues, for fiscal years2002 to 2004. As a result of this audit, which was completed in the secondquarter of fiscal 2007, the Company received new assessments from CanadaRevenue Agency, which allowed management to confirm that the current estimateof the tax provision is reasonable.

 

38

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